diff --git a/raw/filings/0000350868/2002/0001047469-03-022912/filing.txt b/raw/filings/0000350868/2002/0001047469-03-022912/filing.txt new file mode 100644 index 0000000000000000000000000000000000000000..f1a1ada4c93bc3872769e1cfba46c87fb23c36ad --- /dev/null +++ b/raw/filings/0000350868/2002/0001047469-03-022912/filing.txt @@ -0,0 +1,4351 @@ +10-K +1 +a2113700z10-k.htm +10-K +QuickLinks +-- Click here to rapidly navigate through this document +SECURITIES AND EXCHANGE COMMISSION +Washington, D.C. 20549 +FORM 10-K +FOR ANNUAL AND TRANSITION REPORTS PURSUANT TO SECTIONS 13 OR 15(d) +OF THE SECURITIES EXCHANGE ACT OF 1934 +(Mark One) +ý +ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 +For the fiscal year ended March 31, 2003 +OR +o +TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 +For the transition period +from to +Commission file number 001-08762 +ODETICS, INC. +(Exact Name of Registrant as Specified in Its Charter) +Delaware +(State or Other Jurisdiction +of Incorporation or Organization) +95-2588496 +(I.R.S. Employer +Identification No.) +1515 South Manchester Avenue, Anaheim, California 92802 +(Address of Principal Executive Offices) (Zip Code) +Registrant's +Telephone Number, Including Area Code: (714) 774-5000 +Securities +registered pursuant to Section 12(b) of the Act: None +Securities +registered pursuant to Section 12(g) of the Act: +Class A common stock, $.10 par value +Class B common stock, $.10 par value +(Title of Class) +Indicate +by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the +preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past +90 days. Yes ý No o +Indicate +by a check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of +registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this +Form 10-K ý +Indicate +by a check mark whether the registrant is an accelerated filer (as defined in Exchange Act +Rule 12b-2). Yes o No ý +Based +on the closing sale price on Nasdaq SmallCap Market on September 30, 2002, the last business day of the registrant's most recently completed second fiscal quarter, the +aggregate market value of the voting stock held by nonaffiliates of the registrant was $10,081,109. For the purposes of this calculation, shares owned by officers, directors and 10% stockholders known +to the registrant have been deemed to be owned by affiliates. This determination of affiliate status is not necessarily a conclusive determination for other purposes. +Odetics +has two classes of common stock outstanding, the Class A common stock and the Class B common stock. The rights, preferences and privileges of each class of common +stock are identical in all respects, except for voting rights. Each share of Class A common stock entitles its holder to one-tenth of one vote per share and each share of +Class B common stock entitles its holder to one vote per share. As of June 27, 2003, there were 14,112,823 shares of Class A common stock and 1,003,932 shares of Class B +common stock outstanding. Unless otherwise indicated, all references to common stock collectively refer to the Class A common stock and the Class B common stock. +DOCUMENTS INCORPORATED BY REFERENCE +Part III incorporates by reference certain information from the registrant's definitive proxy statement for its Annual Meeting of Stockholders, which is +expected to be held on August 28, 2003. Except with respect to the information specifically incorporated by reference in this report, the proxy statement is not deemed to be filed as a part of this +report. +ODETICS, INC. +FORM 10-K ANNUAL REPORT +TABLE OF CONTENTS +Page +PART I +ITEM 1. +BUSINESS +1 +ITEM 2. +PROPERTIES +6 +ITEM 3. +LEGAL PROCEEDINGS +7 +ITEM 4. +SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS +7 +PART II +ITEM 5. +MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS +8 +ITEM 6. +SELECTED CONSOLIDATED FINANCIAL DATA +9 +ITEM 7. +MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS +11 +RISK FACTORS +21 +ITEM 7A. +QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK +30 +ITEM 8. +FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA +30 +ITEM 9. +CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE +30 +PART III +ITEM 10. +DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT +31 +ITEM 11. +EXECUTIVE COMPENSATION +31 +ITEM 12. +SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT +31 +ITEM 13. +CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS +31 +ITEM 14. +CONTROLS AND PROCEDURES +32 +PART IV +ITEM 15. +EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K +33 +In +this report, "Odetics," the "Company," the "Registrant," "we," "us" and "our" collectively refers to Odetics, Inc. and its subsidiaries. +PART I +ITEM 1. BUSINESS. +Overview +Odetics, Inc. provides products, systems and services that control and manage the use of public roadways and secure access and safety of public and private +facilities. Our company was founded in 1969 to supply digital recorders for use in the United States space program. We broadened our information automation product line to include +time-lapse videocassette recorders for commercial security and surveillance applications through our Gyyr division, which was subsequently incorporated to form our Gyyr Incorporated +subsidiary. We formed our Zyfer, Inc. subsidiary to develop and manufacture timing and synchronization products for telecommunication networks. Timing and synchronization products are devices +that contain both hardware and software to synchronize the data streams in telecommunications networks and are used to increase the reliability and operability of such networks. +In +the early 1980s, we established our Odetics Broadcast division, which we later incorporated as Broadcast, Inc. Broadcast developed and supplied software-based systems that +integrated, controlled and automated the management of multiple classes of equipment used in the operation of a broadcast studio and satellite uplink facility in the television, cable and satellite +industries. +Leveraging +our expertise in video image processing, we entered into the intelligent transportation systems ("ITS") business with the introduction of a video-based vehicle detection +system in 1993. In June 1997, we acquired certain assets comprising the Transportation Systems business from Rockwell International, creating our ITS division, which expanded our offerings to +include advanced traffic management systems and advanced traveler information systems. We incorporated our ITS division as Odetics ITS, Inc. and broadened our systems offerings by acquiring +Meyer, Mohaddes Associates, Inc. in +1998. In January 2000, we reincorporated Odetics ITS in Delaware and changed its name to Iteris, Inc. As of June 30, 2003, Odetics owned 74.5% of the outstanding common stock of +Iteris and 59.1% of the common stock assuming full conversion of the outstanding Series A preferred stock of Iteris. We currently operate Meyer, Mohaddes Associates, Inc. as a +wholly-owned subsidiary of Iteris. +Beginning +in late 2001, we began divesting certain of our business units in order to reduce our operating expenses and to focus on what we believe to be our core businesses, +Iteris, Inc. and MAXxess Systems, Inc. In September 2001, we sold the assets of our Gyyr Closed Circuit Television ("CCTV") Products line, which included video recorders and +equipment that facilitated video switching and multiplexing. Upon completion of this sale, we changed the name of our Gyyr subsidiary to MAXxess Systems, Inc., which currently designs and +manufactures security management systems that feature a broad array of detection, monitoring and management capabilities for both governmental and commercial customers. +In +March 2003, we decided to cease the development and sale of any new Broadcast products and to sell Zyfer. As a result, we reduced our Broadcast organization to only support +existing customer contracts for service and support through their expiration dates. In May 2003, we sold substantially all of the assets of Zyfer. +After +giving effect to our divestitures and narrowed focus mentioned above, we currently operate in only two business segments: ITS and Security Products. Our ITS segment consists of +Iteris, our 59.11% owned subsidiary, and our Security Products segment consists of MAXxess, Inc., our wholly-owned subsidiary. +1 +Iteris, Inc. +Iteris, Inc. designs, develops, markets and implements sensors and systems for surface transportation. Using its proprietary software and ITS industry +expertise, Iteris provides video sensor systems and transportation management and traveler information systems for the ITS industry. The ITS industry is comprised of companies applying a variety of +technologies to enable the safe and efficient movement of people and goods. Iteris uses its outdoor image recognition software expertise to develop proprietary algorithms for video sensor systems that +improve vehicle safety and the flow of traffic. Using its knowledge of the ITS industry, Iteris designs and implements transportation management systems that help public agencies reduce traffic +congestion and provide greater access to traveler information. +Iteris' +proprietary image recognition systems include AutoVue™ and Vantage™. AutoVue is a small windshield mounted sensor that uses proprietary software +to detect and warn drivers of unintended lane departures. Iteris has approximately 3,000 production AutoVue units that are in use on truck platforms in the European market and are offered as an option +on certain Actros trucks, which are part of the Daimler group. Iteris believes that AutoVue is a broad sensor platform that, through additional software development, may be expanded to incorporate +additional safety and convenience features. Vantage is a video vehicle sensing system that detects the presence of vehicles at signalized intersections enabling a more efficient allocation of green +signal time. +Iteris' +transportation management systems includes the design, development and implementation of its software-based systems that integrate sensors, video surveillance, computers and +advanced communications equipment to enable public agencies to monitor, control and direct traffic flow, assist in the quick dispatch of emergency crews and distribute real-time +information about traffic conditions. Our services include planning and other engineering for the implementation of transportation related communications systems, analysis and study related to goods +movement and commercial vehicle operations, and parking systems designs. +Sales, Marketing and Principal Customers. Iteris markets and sells its transportation management systems and services +directly to government agencies pursuant to negotiated contracts that involve competitive bidding and specific qualification requirements. Most of our contracts with federal, state, and municipal +customers provide for cancellation or renegotiation at the option of the customer upon reasonable notice and fees paid for modification. We use selected members of our engineering team divided on a +regional basis to serve in sales and business development functions. We do not engage in international ITS sales. Sales of Iteris' systems contracts generally involve long lead times and require +extensive specification development, evaluation and price negotiations. No single customer of Iteris accounted for more than 10% of our total net sales and contract revenues. +Iteris +sells its Vantage vehicle detection systems primarily through indirect sales channels comprised of independent dealers in the United States and Canada who sell integrated systems +and related products to the traffic intersection market. The independent dealers for Iteris are primarily responsible for sales, installation and support of Vantage systems. These dealers maintain an +inventory of demonstration traffic products including the Vantage vehicle detection systems and sell directly to government agencies and installation contractors. These dealers often have +long-term arrangements with the government agencies in their territory for the supply of various products for the construction and renovation of traffic intersections. Iteris holds +technical training classes for its dealers and maintains a full-time staff of customer support technicians to provide technical assistance when needed. +The +marketing strategy for AutoVue is to establish it as the leading platform for in vehicle video sensing for trucks and passenger cars. AutoVue is sold directly by Iteris to vehicle +manufacturers and major automotive suppliers. Iteris also markets to the manufacturers of automobiles through a strategic relationship with Valeo. +2 +Manufacturing and Materials. Iteris uses local manufacturers based near our Anaheim facility to build subassemblies that are +used in its Vantage products. These subassemblies are delivered to our Anaheim facility where they go through a final assembly and test prior to the shipment to our customers. Iteris' manufacturing +activities are conducted in approximately 6,000 square feet of space at our Anaheim facility. Most subassemblies used in our products are manufactured by subcontractors who are local to our Anaheim, +California facilities. Certain of our cameras used in our products have historically been provided by a Japanese supplier who is sole sourced; however, we are currently qualifying other sources of +supply. Production volume is based upon quarterly forecasts that Iteris readjusts on a monthly basis to control inventory. Iteris subcontracts the manufacture of its AutoVue systems to one +manufacturer, and our internal processes are limited primarily to testing and final verification. Iteris currently does not manufacture any of the hardware used in the transportation management and +traveler information systems that it designs and implements. The production facility for Iteris is currently ISO 9001 certified. +Customer Support and Services. We provide warranty service for each of our products, as well as follow-up service +and support, for which we typically charge separately. We view customer support services as a critical competitive factor as well as a revenue source. +MAXxess Systems, Inc. +MAXxess Systems, Inc. designs, develops and manufactures security management systems that include detection, monitoring and management capabilities for +both governmental and commercial customers. MAXxess offers software, hardware and other technologies for creating and using electronic access control products such as identification and access badges +that are based on smart cards and other electronic devices. These products are principally used to control and manage physical access to facilities. We also provide software-based systems and hardware +used for detection and response of management to dangerous chemicals and gases in and around facilities. +During +fiscal 2003, we introduced our Environmental Security Systems, which integrate our legacy AXxess 202 product family with new detection technologies for toxic chemicals and gases. +During fiscal 2003, MAXxess further extended its Environmental Security Systems offering by introducing its Safe Cities™ System, which is a software-based management system for use by +municipal customers that integrates disparate information and detection infrastructure within a city in order to provide rapid response for emergency management against threats of terrorism and +weapons of mass destruction. MAXxess believes that its Environmental Security Systems provide enhanced levels of monitoring, control and detection that will be required across a broad cross section of +municipal infrastructure and in various public facilities including buildings, airports, ports and other potential targets of terrorism. +Sales, Marketing and Principal Customers. MAXxess generally markets and sells its products globally through a network of +system integrators, in addition to selling direct to municipal customers. In the United States, MAXxess has three regional sales managers who oversee three geographical regions and manage the systems +integrators. MAXxess operates a full service branch office in Bracknell Berkshire U.K., which serves the sales needs of the European, Middle East and Asian regions. The Bracknell +office also provides local product availability and technical support for the region. MAXxess has also partnered with Draeger Safety of Lubeck, Germany, to market its chemical detectors principally to +governmental customers. These chemical detectors are primarily focused on the Immune Building Program, which is sponsored by Defense Advanced Research Projects Agency ("DARPA"). No single customer of +MAXxess represented more than 10% of our total net sales and contract revenues for fiscal 2003. +Manufacturing and Materials. Similar to Iteris, MAXxess uses local manufacturers based near our Anaheim manufacturing +facility to build subassemblies that are used in our final products. These subassemblies and other components are delivered to our Anaheim manufacturing facility where they +3 +go +through a final assembly and test prior to shipment to its customers. MAXxess builds inventory according to our sales forecasts. MAXxess maintains a dedicated manufacturing area of approximately +2,500 square feet located within our Anaheim facilities. MAXxess maintains infrastructure to support production and inventory control, purchasing, quality assurance and manufacturing engineering. +Although we consolidate our materials sourcing and subcontract manufacturing to minimize production costs. We believe that each of our sources are capable of being substituted for minimal cost and +production delay. There are currently no sole sourced raw materials used in our products. +Customer Support and Services. We provide warranty service and support for each of our products and follow-up +service and support, for which we charge separately. Service revenue accounts for less than 5% of total net sales and contract revenues. Customer support is a critical competitive factor. We provide +warranty and customer service internationally from our Bracknell Berkshire offices. +Backlog +Our backlog of unfulfilled firm orders was approximately $24.0 million as of March 31, 2003 and was approximately $42.7 million as of +March 31, 2002. Approximately 67% of our backlog at March 31, 2002 was recognized as revenues in the fiscal year ended March 31, 2003, and approximately 87% of our backlog at +March 31, 2003 is expected to be recognized as revenues in the fiscal year ended March 31, 2004. Pursuant to the customary terms of our agreements with government contractors and other +customers, customers can generally cancel or reschedule orders with little or no penalties. Lead times for the release of purchase orders depend upon the scheduling and forecasting practices of our +individual customers, which also can affect the timing of the conversion of our backlog into revenues. For these reasons, among others, our backlog at a particular date may not be indicative of our +future revenues. +Product Development +MAXxess and Iteris each direct and staff its own product development activities. Most of our development activities are conducted at our principal facilities in +Anaheim, California. Our company-sponsored research and development costs and expenses were approximately $7.5 million in fiscal 2001, $4.4 million in fiscal 2002 and $4.2 million +in fiscal 2003. Although spending for product development declined sharply in fiscal 2002 compared to fiscal 2001, principally due to the discontinuation of development activities related to +personalized traveler information products in Iteris and the sale of Gyyr's CCTV Products line, we expect to continue to pursue significant product development programs and incur significant research +and development expenditures in each of our business units. +Competition +Our business units generally face significant competition in each of their respective markets. Increased competition may result in price reductions, reduced gross +margins and loss of market share, any of which could have a material adverse effect on our business, financial condition and results of operations. +MAXxess +principally competes with Casi-Rusco, Cardkey, Lenel and Northern Computers in the sale of access control systems. The market for electronic access control products +is highly fragmented, We estimate that there are approximately 100 competitors comprising approximately $800 million in annual sales. MAXxess is substantially smaller in terms of annual revenue +than its leading competitors. In the area of chemical and gas detection, MAXxess primarily competes with Smiths Detection. MAXxess is a smaller company in terms of annual revenue than Smiths +Detection, but MAXxess does not believe there is any direct competitor for its Safe Cities system. MAXxess generally competes on the basis of its distributed processing system architecture, which is +an open system that readily integrates other security subsystems and new detection capabilities, and a superior operator interface. +4 +We +believe that AutoVue is the only commercially-available lane departure warning system used in the U.S. and in Europe, potential competitors of AutoVue include Delphi Automotive +Systems Corporation domestically, NEC Corporation and Hitachi Ltd. in Japan and Robert Bosch Gmbh in Europe, which we suspect are currently developing video sensor technologies for the vehicle +industry that could be used for lane departure warning systems. In the market for our Vantage vehicle detection systems, Iteris competes with manufacturers of other "above ground" video camera +detection systems such as Econolite Control Products, Inc., Trafficon, N.V. Peek Traffic Systems, and other non-intrusive detection devices including microwave, infrared, ultrasonic +and magnetic detectors, as well as manufacturers and installers of in-pavement inductive loop products. Our competitors for Vantage products do not disclose specific sales numbers, either +because +they are private companies or because they are part of larger companies. Based on our interface with them in the market, we believe that we are leading our competitors in annual sales volume for video +detection products. +The +transportation management and traveler information systems market is highly fragmented and is subject to evolving national and regional quality and safety standards. Iteris' +competitors vary in number, scope and breadth of the products and services they offer. Iteris' competitors in advanced transportation management and traveler information systems include large +multi-national corporations such as Transcore, Lockheed Martin Corporation, PB Farradyne Inc., Kimley-Horn and Associates, Inc. and National Engineering +Technology, Inc. Iteris' competitors in transportation engineering, planning and design include major firms such as Parsons Brinkerhoff, Inc. and Parsons Transportation +Group Inc., as well as many smaller regional engineering firms. We believe that the transportation management and traveler information systems business of Iteris is one of the leading +competitors in the ITS market. +In +general, the markets for the products and services offered by our businesses are highly competitive and are characterized by rapidly changing technology and evolving standards. Many +of our current and prospective competitors have longer operating histories, greater name recognition, access to larger customer bases and significantly greater financial, technical, manufacturing, +distribution and marketing resources than us. As a result, they may be able to adapt more quickly to new or emerging standards or technologies or to devote greater resources to the promotion and sale +of their products. It is also possible that new competitors or alliances among competitors could emerge and rapidly acquire significant market share. We believe that our ability to compete effectively +in our target markets will depend on a number of factors, including the success and timing of our new product development, the compatibility of our products with a broad range of computing systems, +product quality and performance, reliability, functionality, price, and service and technical support. Our failure to provide services and develop and market products that compete successfully with +those of other suppliers and consultants in our target markets would have a material adverse effect on our business, financial condition and results of operations. +Intellectual Property and Proprietary Rights +Our ability to compete effectively depends in part on our ability to develop and maintain the proprietary aspects of our technology. Our policy is to obtain +appropriate proprietary rights protection for any potentially significant new technology acquired or developed each of our business units. Iteris currently holds six U.S. patents, which expire +commencing in 2012, and has eighteen U.S. patent applications pending, mostly relating to our outdoor image processing techniques used in our AutoVue and Vantage systems. Two of our patents relate +specifically to our AutoVue technology and provide a basis for enhanced functionality for rain sensing and improved performance. We believe that our other patents, while important for our technology +platform, are less critical to near term product strategy. We cannot assure you that any new patents will be granted pursuant to any outstanding or subsequent applications. +5 +We +own a patent and have three patents pending for StealthKey technology, which technology is not currently part of our product family. Our intention is to pursue product development for +a high-speed security processor designed around the StealthKey patent. +In +addition to patent laws, we rely on copyright and trade secret laws to protect our proprietary rights. We attempt to protect our trade secrets and other proprietary information +through agreements with customers and suppliers, proprietary information agreements with our employees and consultants, and other similar measures. Iteris does not have any material licenses or +trademarks other than those relating to product names. We cannot be certain that we will be successful in protecting our proprietary rights. While we believe our patents, patent applications, software +and other proprietary know-how have value, changing technology makes our future success dependent principally upon our employees' technical competence and creative skills for continuing +innovation. +Litigation +has been necessary in the past and may be necessary in the future to enforce our proprietary rights, to determine the validity and scope of the proprietary rights of others, +or to defend us against claims of infringement or invalidity by others. An adverse outcome in such litigation or similar proceedings could subject us to significant liabilities to third parties, +require disputed rights to be licensed from others or require us to cease marketing or using certain products, any of which could have a material adverse effect on our business, financial condition +and results of operations. In addition, the cost of addressing any intellectual property litigation claim, both in legal fees and expenses, as well as from the diversion of management's resources, +regardless of whether the claim is valid, could be significant and could have a material adverse effect on our business, financial condition and results of operations. +Employees +We refer to our employees as associates. As of June 12, 2003, Odetics and its subsidiaries employed an aggregate of 253 associates, including 70 associates +in general management, administration and finance; 17 associates in sales and marketing; 119 associates in product development; 35 associates in operations, manufacturing and quality; and 12 +associates in customer service. None of our associates are represented by a labor union, and we have never experienced a work stoppage. +Government Regulation +Our manufacturing operations are subject to various federal, state and local laws and regulations, including those restricting the discharge of materials into the +environment. We are not involved in any pending or, to our knowledge, threatened governmental proceedings, which would require curtailment of our operations because of such laws and regulations. We +continue to expend funds in connection with our compliance with applicable environmental regulations. These expenditures have not, however, been significant in the past, and we do not expect any +significant expenditure in the near future. Currently, compliance with foreign laws has not had a material impact on our business and is not expected to have a material impact in the near future. +Subsequent to the downsizing and reorganization of our foreign operations, our only international operations are for MAXxess Ltd, a U.K., based subsidiary of our MAXxess Inc. subsidiary +in the United States. +ITEM 2. PROPERTIES. +Our headquarters and principal operations consist of leased facilities located in Southern California and consist of a two building complex containing +approximately 257,900 square feet situated on approximately 14 acres located at 1515 and 1585 South Manchester Boulevard in Anaheim, California. These facilities house our administrative offices +(approximately 20,000 dedicated square feet), as well as the operations of MAXxess, (approximately 10,000 dedicated square feet), and Iteris (approximately 55,000 dedicated square feet). In addition, +FEI-Zyfer, the acquirer of substantially all of +6 +the +assets of our subsidiary Zyfer, Inc., subleases 20,000 dedicated square feet in our 1585 South Manchester facility under a two year sublease. As of March 31, 2003, as a result of +substantial downsizing and divestitures or shutdowns of our Broadcast, Gyyr, and Mariner Networks subsidiaries over the prior two fiscal years, we have approximately 140,000 square feet of idle +capacity. +In +May 2002, we completed the sale and leaseback of our Anaheim facilities for an aggregate sales price of $22.6 million. We entered into a 30-month lease for +1585 South Manchester for a monthly rental payments of $57,553, and a ten-year lease for 1515 South Manchester for a monthly rental payment of $152,150. Iteris is a sublessee to Odetics +for 55,000 square feet under similar terms to the master lease between Odetics and the master lessor. We are currently in negotiations with the landlord for our Anaheim facilities to reduce our +overall operating expenses to a level commensurate with our existing operations. We cannot assure you that we will be able to complete these negotiations successfully. +We +also lease approximately 7,400 square feet in Austin, Texas. Subsequent to the discontinuance of Broadcast, we operate a service organization in support of Broadcast customers in this +facility. Iteris leases twelve office suites representing an aggregate of approximately 20,000 square feet within the United States for its support staff and development teams. +We +currently operate a single shift in each of our manufacturing and assembly facilities, and we believe that our facilities are adequate for our needs for at least the next twelve +months. +ITEM 3. LEGAL PROCEEDINGS. +We are not currently a party to any material legal proceedings. +ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. +No matters were submitted to a vote of our security holders during the three months ended March 31, 2003. +7 +PART II +ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS. +Since April 22, 2002, our Class A common stock and Class B common stock has been listed on the Nasdaq SmallCap Market under the symbols +"ODETA" and "ODETB," respectively. Our Class B common stock was delisted from the Nasdaq SmallCap Market in April 2003 and is currently quoted on the OTC Bulletin Board. Prior to +April 22, 2002, our Class A common stock and Class B common stock were listed on the Nasdaq National Market. The following table sets forth for the fiscal periods indicated the +high and low sales prices for the Class A common stock and Class B common stock as reported by the Nasdaq SmallCap Market. +Class A Common Stock +Class B Common Stock +High +Low +High +Low +Fiscal 2002 +Quarter Ended June 30, 2001 +$ +4.60 +$ +1.88 +$ +4.64 +$ +2.95 +Quarter Ended September 30, 2001 +2.49 +1.24 +3.80 +1.37 +Quarter Ended December 31, 2001 +2.10 +1.05 +2.58 +1.35 +Quarter Ended March 31, 2002 +1.95 +1.34 +3.75 +1.82 +Fiscal 2003 +Quarter Ended June 30, 2002 +1.70 +1.27 +2.57 +1.85 +Quarter Ended September 30, 2002 +1.52 +.85 +2.00 +1.00 +Quarter Ended December 31, 2002 +1.03 +.45 +1.00 +.42 +Quarter Ended March 31, 2003 +.74 +.51 +.75 +.52 +Fiscal 2004 +Quarter Ending June 30, 2003 (through June 27, 2003) +.89 +.45 +.53 +.20 +As +of June 27, 2003, we had 509 holders of record of Class A common stock and 105 holders of record of Class B common stock according to information furnished by our +transfer agent. +Dividend Policy +We have never paid or declared cash dividends on either class of our common stock, and have no current plans to pay such dividends in the foreseeable future. We +currently intend to retain any earnings for working capital and general corporate purposes. The payment of any future dividends will be at the discretion of our Board of Directors, and will depend +upon a number of factors, including, but not limited to, future earnings, the success of our business, activities, our capital requirements, our general financial condition and future prospects, +general business conditions, the consent of our lender and such other factors as the Board may deem relevant. +Recent Sales of Unregistered Securities +During the quarter ended March 31, 2003, we did not sell or issue any unregistered securities. +8 +ITEM 6. SELECTED CONSOLIDATED FINANCIAL DATA. +The following selected consolidated financial data with respect to our consolidated statement of operations for each of the five fiscal years in the period ended +March 31, 2003 and the consolidated balance sheet data at March 31, 1999, 2000, 2001, 2002 and 2003 are derived from our audited consolidated financial statements. The consolidated +statements of operation data for the fiscal years ended March 31, 1999 and 2000 and the consolidated balance sheet data at March 31, 1999, 2000 and 2001 are not included in the +consolidated financial statements included elsewhere in this report. The following information should be read in conjunction with "Management's Discussion and Analysis of Financial Condition and +Results of Operations" and with our consolidated financial statements and the related notes thereto included elsewhere in this report. +Fiscal Year Ended March 31, +1999 +2000 +2001 +2002 +2003 +(in thousands, except per share data) +Consolidated Statement of Operations Data: +Net sales +$ +45,291 +$ +44,467 +$ +42,363 +$ +29,343 +$ +22,541 +Contract revenues +13,331 +18,666 +20,039 +22,846 +25,086 +Total net sales and contract revenues +58,622 +63,133 +62,402 +52,189 +47,627 +Costs and expenses: +Cost of net sales +32,245 +33,455 +31,028 +16,769 +11,424 +Cost of contract revenues +9,007 +13,431 +13,781 +13,132 +16,034 +Selling, general and administrative expenses +20,119 +25,177 +25,219 +18,491 +16,157 +Research and development expenses +6,566 +6,558 +7,549 +4,385 +4,215 +Restructuring charges +— +— +757 +2,189 +— +Total costs and expenses +67,927 +78,621 +78,334 +54,966 +47,830 +Loss from operations +(9,315 +) +(15,488 +) +(15,932 +) +(2,777 +) +(203 +) +Non-operating income (expense): +Royalty income +— +38,437 +17,825 +— +— +Other income, net +228 +— +1,340 +2,919 +388 +Interest expense, net +(1,807 +) +(2,048 +) +(1,762 +) +(4,190 +) +(761 +) +Income (loss) before income tax +(10,894 +) +21,007 +1,471 +(4,048 +) +(576 +) +Income tax benefit +— +— +— +785 +— +Income (loss) from continuing operations before minority interest +(10,894 +) +21,007 +1,471 +(3,263 +) +(576 +) +Minority interest in earnings of subsidiary +— +— +— +(1,910 +) +(3,818 +) +Income (loss) from continuing operations +(10,894 +) +21,007 +1,471 +(5,173 +) +(4,394 +) +Loss from discontinued operations, net of income tax +(9,224 +) +(23,286 +) +(34,011 +) +(20,965 +) +(8,754 +) +Extraordinary loss from early extinguishment debt, net of tax of $0 +— +— +— +(450 +) +— +Net loss +$ +(20,118 +) +$ +(2,279 +) +$ +(32,540 +) +$ +(26,588 +) +$ +(13,148 +) +Basic earnings (loss) per share: +Continuing operations +$ +(1.39 +) +$ +2.31 +$ +0.15 +$ +(0.46 +) +$ +(0.31 +) +Discontinued operations +(1.18 +) +(2.56 +) +(3.41 +) +(1.86 +) +(0.61 +) +Extraordinary loss +— +— +— +(0.04 +) +— +Basic net loss per share +$ +(2.57 +) +$ +(0.25 +) +$ +(3.26 +) +$ +(2.36 +) +$ +(0.92 +) +Diluted earnings (loss) per share: +Continuing operations +$ +(1.39 +) +$ +2.22 +$ +0.14 +$ +(0.46 +) +$ +(0.31 +) +Discontinued operations +$ +(1.18 +) +(2.47 +) +(3.33 +) +(1.86 +) +(0.61 +) +Extraordinary loss +— +— +— +(0.04 +) +— +Diluted net loss per share +$ +(2.57 +) +$ +(0.24 +) +$ +(3.19 +) +$ +(2.36 +) +$ +(0.92 +) +Shares used in calculating basic earnings (loss) per share +7,820 +9,089 +9,977 +11,267 +14,276 +Shares used in calculating diluted earnings (loss) per share +7,820 +9,444 +10,209 +11,267 +14,276 +9 +At March 31, +1999 +2000 +2001 +2002 +2003 +(in thousands) +Consolidated Balance Sheet Data: +Working capital (deficit) +$ +26,066 +$ +22,283 +$ +(3,704 +) +$ +(7,604 +) +$ +3,345 +Total assets +81,355 +81,850 +68,061 +52,238 +34,842 +Long-term debt (less current portion) +19,962 +11,666 +4,800 +2,042 +1,265 +Accumulated deficit +(23,913 +) +(26,192 +) +(58,732 +) +(85,320 +) +(98,468 +) +Total stockholders' equity (deficit) +36,323 +36,110 +20,378 +5,255 +(4,288 +) +10 +ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. +Cautionary Statement +This report including the following discussion and analysis contains forward-looking statements that are based on our current +expectations, estimates and projections about our business and our industry, and reflect management's beliefs and certain assumptions made by us based upon information available to us as of the date +of this report. When used in this report and the information incorporated herein by reference, the words "expect(s)," "feel(s)," "believe(s)," "should," "will," "may," "anticipate(s)," "estimates" and +similar expressions or variations of these words are intended to identify forward-looking statements. These forward-looking statements include but are not limited to statements regarding our +anticipated revenue, expenses, capital needs, competition, backlog and manufacturing capabilities and the status of our facilities and product development. These statements are not guarantees of +future performance and are subject to certain risks and uncertainties which could cause actual results to differ materially from those projected. You should not place undue reliance on these +forward-looking statements that speak only as of the date hereof. We undertake no obligation to republish revised forward-looking statements to reflect events or circumstances after the date hereof or +to reflect the occurrence of unanticipated events. We encourage you to carefully review and consider the various disclosures made by us which describe certain factors which could affect our business, +including in "Risk Factors" set forth at the end of Part II, Item 7 of this report and in "Management's Discussion and Analysis of Financial Condition and Results of Operations" below +before deciding to invest in our company or to maintain or increase your investment. We undertake no obligation to revise or update publicly any forward-looking statement for any +reason. +General +During the fiscal year ended March 31, 2003 ("fiscal 2003"), we operated in three business segments consisting of ITS, video products and telecom products. +The ITS segment consisted of our majority-owned subsidiary, Iteris, Inc., which designs, develops, markets and implements video sensor systems and transportation management and traveler +information systems for the ITS industry. The video products segment consisted of our wholly-owned subsidiaries, MAXxess Systems, Inc. (previously known as Gyyr Incorporated) and +Broadcast, Inc. Our telecom segment consisted of our wholly-owned subsidiary, Zyfer, Inc., which prior to its incorporation was operated as our Communications division. All +references to our subsidiaries in this report include the prior business and results of operations of such subsidiaries as our business units prior to their incorporation. +In +April 2001, we bifurcated Gyyr's operations into the Gyyr CCTV Products line, which manufactured analog and digital storage systems, and the Gyyr Electronic Access Control +division, which develops and manufactures enterprise security management systems for facility security and trace detection of dangerous chemicals. In September 2001, we sold substantially all +of the assets and certain liabilities of the Gyyr CCTV Products line for $8.8 million. In connection with this sale, we changed the name of Gyyr to MAXxess Systems, Inc. to reflect the +focus of this business on electronic access control systems. +Broadcast +provided software-based systems that integrate, control and automate the management of multiple classes of equipment used in the operation of a broadcast studio and satellite +uplink facility. In March 2003, we decided to discontinue the operations of Broadcast. +Zyfer +provided GPS-aided precision timing and synchronization products, including its CommSynch II product family and its digital timing subsystems for the cellular +telephone industry. In May 2003, we sold substantially all of the assets of our Zyfer subsidiary for a purchase price of $2.3 million in cash plus future incentive payments of up to +$1 million in each of the years ended April 30, 2004 and 2005. The amount of these future incentive payments will be based on the revenues generated by the sale of Zyfer's products or +the license of its technologies. +11 +During +the quarter ended December 31, 2000, we began a restructuring to reduce our overall expenses and to focus our business on those areas that we believe would provide the +highest return for our stockholders. This restructuring resulted in a 25% reduction in our workforce in the fiscal year ended March 31, 2001 ("fiscal 2001") as compared to the prior year and +the discontinuation of certain product lines. In September 2001, in connection with continued cost control efforts and the slowdown in the telecommunications industry, our Board of Directors +approved the immediate discontinuation of Mariner Networks, Inc., our wholly-owned subsidiary, which was historically part of our telecom segment. Mariner had previously been a manufacturer of +telecommunications equipment. +As +a result of the sale of the Gyyr CCTV Products line and the discontinuation of Mariner Networks, we reorganized our European operations and reduced our overall staffing levels. The +reorganization of the European operations included the discontinuation of our Odetics Europe Ltd., Gyyr Europe Ltd., Mariner France and Mariner Europe Ltd. operations, and the +transition of our Broadcast and MAXxess international operations to branch office operations with the intent of lowering our international costs. In connection with this restructuring, 34 employees +were terminated in the quarter ended December 31, 2001 and 78 employees were terminated in the quarter ended March 31, 2002. +In +fiscal 2003, in order to further align our operations with our objectives of pursuing business opportunities focused in the ITS and security markets, we began the process of selling +the assets of Zyfer and discontinuing the manufacturing operations of Broadcast referenced above. In the fourth quarter of fiscal 2003, we incurred a loss from discontinued operations of +$6.3 million related to the wind-down of Broadcast. The operations of Broadcast currently consist of seven people at March 31, 2003, all of whom are focused solely on +servicing existing customer commitments and contracts for product and system service through their expiration dates. +In +the fiscal year ending March 31, 2004, we anticipate that we will only be operating in two business segments. ITS and Security Products, consisting of Iteris, Inc. and +MAXxess Systems, Inc. respectively. +Our +financial statements contained in this report have been restated for all periods reported to reflect the discontinuation of the operations of Broadcast, Mariner Networks and Zyfer +and, accordingly, only reflect the operations of Iteris and MAXxess. +We +have generated net losses from operations of $203,000 in fiscal 2003, $2.8 million in fiscal 2002 and $15.9 million in fiscal 2001. While we have substantially reduced +our operating losses in recent periods, we have experienced negative cash flows from operations in the amount of $4.8 million in fiscal 2003, $18.2 million in fiscal 2002 and +$20.1 million in fiscal 2001, and had a stockholders' deficit of $4.3 million at March 31, 2003. We expect that our operations will continue to use net cash at least through the +end of calendar 2003. We also expect to have an ongoing need to raise cash by securing additional debt or equity financing, or by divesting certain assets to fund our operations until we return to +profitability and positive operating cash flows. We cannot assure you that any additional funding will be available on a timely basis, on acceptable terms, or at all. These conditions, together with +our recurring losses, cash requirements and stockholders' deficiency, raise substantial doubt about our ability to continue as a going concern. +Critical Accounting Policies And Estimates +Management's Discussion and Analysis of Financial Condition and Results of Operations is based on our consolidated financial statements included herein, which +have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires management to make estimates and assumptions +that affect the reported amounts of assets and liabilities and related disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and +expenses during the reporting period. +12 +On +an ongoing basis, we evaluate these estimates and assumptions, including those related to the collectibility of accounts receivables, the valuation of inventories, the recoverability of +long-lived assets, including goodwill, and reserves for restructuring and related activities. We base these estimates on historical experience and on various other factors that we believe +to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. +These estimates and assumptions by their nature involve risks and uncertainties, and may prove to be inaccurate. In the event that any of our estimates or assumptions are inaccurate in any material +respect, it could have a material adverse effect on our reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the +reporting period. +The +following critical accounting policies affect our more significant judgments and estimates used in the preparation of our consolidated financial statements. +Revenue Recognition. We record product revenues and related cost of sales upon transfer of title, which is generally upon +shipment or, if required, upon acceptance by the customer, provided that we believe collectibility of the net sales amount is probable. Accordingly, at the date revenue is recognized, the significant +uncertainties concerning the sale have been resolved. Unless otherwise stated in our product literature, we provide a one to two year warranty on all product material and workmanship, and establish +reserves for potential warranty returns as products are shipped. Defective products are either repaired or replaced, at our option, upon meeting certain criteria. +Contract +revenue is derived primarily from long-term contracts with governmental agencies. Contract revenue includes costs incurred plus a portion of estimated fees or +profits determined on the percentage of completion method of accounting based on the relationship of costs incurred to total estimated costs. We record a charge to earnings for any anticipated losses +on contracts in the period in which such losses are identified. Changes in job performance and estimated profitability, including those arising from contract penalty provisions and final contract +settlements, may result in revisions to cost and revenue and are recognized in the period in which the revisions are determined. We include profit incentives in revenue in the period in which their +realization is reasonably assured. +We +record revenues from follow-on service and support, for which we charge separately, in the period in which such services are performed. +Accounts Receivable. We estimate the collectibility of customer receivables on an ongoing basis by periodically reviewing +invoices outstanding over a certain period of time. We have recorded reserves for receivables deemed to be at risk for collection as well as a general reserve based on our historical collections +experience. A considerable amount of judgment is required in assessing the ultimate realization of these receivables, including the current credit-worthiness of each customer. If the financial +condition of our customers deteriorates, resulting in an impairment of their ability to make required payments, additional allowances may be required which could adversely affect our operating +results. +Inventory. We state our inventories at the lower of cost or market and provide reserves for potentially excess and obsolete +inventory. In assessing the ultimate realization of inventories, we make judgments as to future demand requirements and compare that with the current or committed inventory levels. Reserves are +established for inventory levels that exceed future demand. It is possible that reserves over and above those already established may be required in the future if market conditions for our products +should deteriorate. +Impairment of Assets and Restructuring. During fiscal 2003, we recorded reserves and asset write-downs in connection with the +sale of substantially all of the assets of Zyfer and the discontinuation of Broadcast. These include estimates pertaining to the fair value of assets and facility closure costs. +13 +Although +we do not anticipate significant changes, the actual assets values and closure costs may differ from the amounts estimated. +Results of Operations +The following table sets forth certain income statement data as a percentage of total net sales and contract revenues for the periods indicated and should be read +in conjunction with Management's Discussion and Analysis of Financial Condition and Results of Operations. +Fiscal Year Ended March 31, +2001 +2002 +2003 +Net sales and contract revenues: +Net sales +67.9 +% +56.2 +% +47.3 +% +Contract revenues +32.1 +43.8 +52.7 +Total net sales and contract revenues +100.0 +% +100.0 +% +100.0 +% +Costs and expenses: +Cost of net sales +49.7 +32.1 +24.0 +Cost of contract revenues +22.1 +25.2 +33.7 +Selling, general and administrative expense +40.4 +35.4 +33.8 +Research and development expense +12.1 +8.4 +8.9 +Restructuring charges +1.2 +4.2 +— +Total costs and expenses +(125.5 +) +(105.3 +) +(100.4 +) +Loss from operations +(25.5 +) +(5.3 +) +(0.4 +) +Non-operating income (expense): +Royalty income +28.6 +— +— +Other income +2.1 +5.5 +.8 +Interest expense, net +(2.8 +) +(8.0 +) +(1.6 +) +Income (loss) before tax +2.4 +(7.8 +) +(1.2 +) +Income tax benefit +— +1.5 +— +Income (loss) from continuing operations before minority interest +2.4 +(6.3 +) +(1.2 +) +Minority interest in earnings of subsidiary +— +(3.7 +) +(8.0 +) +Income (loss) from continued operations +2.4 +(9.9 +) +(9.2 +) +Income (loss) from discontinued operations, net of income tax +(54.5 +) +(40.3 +) +(18.4 +) +Extraordinary loss from early extinguishment of debt +— +(0.8 +) +— +Net loss +(52.1 +)% +(51.0 +)% +(27.6 +)% +Net Sales and Contract Revenues. Net sales and contract revenues consist of (i) sales of products and services to +commercial and municipal agencies ("net sales") and (ii) revenues derived from contracts with state, county and municipal agencies for ITS projects ("contract revenues"). We currently have a +diverse customer base and no customer constituted over 10% of our total net sales and contract revenues for fiscal year ended March 31, 2003 ("fiscal 2003"). Total net sales and contract +revenues decreased 8.7% to $47.6 million for fiscal 2003 compared to $52.2 million for the fiscal year ended March 31, 2002 ("fiscal 2002"), and decreased 16.4% for the fiscal +year ended March 31, 2002 compared to $62.4 million for the fiscal year ended March 31, 2001 ("fiscal 2001"). Sales of Iteris' transportation management systems and video sensor +systems represented 86.9% of our total net sales +14 +and +contract revenues for fiscal 2003, 71.5% in fiscal 2002 and 40.4% in fiscal 2001. We anticipate that Iteris will continue to represent a majority of our total net sales and contract revenues for +the fiscal year ending March 31, 2004. Sales of Iteris' Vantage vehicle detection systems represented 37.0% of our consolidated net sales and contract revenues in fiscal 2003, 29.4% in fiscal +2002, and 16.0% in fiscal 2001. Contract revenues in Iteris systems represented 46.8% of consolidated net sales and contract revenues in fiscal 2003, 38.7% in fiscal 2002 and 27.9% in fiscal 2001. +Net +sales decreased 23.2% to $22.5 million in fiscal 2003 compared to $29.3 million in fiscal 2002. The decrease in net sales in fiscal 2003 compared to fiscal 2002 was +primarily attributable to our sale of the Gyyr CCTV Products line late in the second quarter of fiscal 2002. Sales from Gyyr's CCTV Products line contributed $8.3 million in fiscal 2002 and $0 +in fiscal 2003. After excluding the revenue from Gyyr's CCTV Products line in fiscal 2002, net sales in fiscal 2003 increased approximately 8.5% over net sales in fiscal 2002, which primarily reflects +an increase in the unit sales of Iteris' Vantage vehicle detection systems, and to a lesser extent increased sales of our Iteris' AutoVue lane departure warning systems. +Net +sales decreased 30.7% to $29.3 million in fiscal 2002 compared to $42.4 million in fiscal 2001 principally as a result of the sale of our Gyyr CCTV Products line, and a +decrease in MAXxess unit net sales. Gyyr CCTV Products sales comprised $26.4 million and $8.3 million of net sales in fiscal 2001 and fiscal 2002, respectively. Gyyr CCTV Products sales +in fiscal 2002 include sales only through the date of the divestiture. The $18.1 million decline in sales of Gyyr CCTV Products was partially offset by increased unit sales of Vantage vehicle +detection systems and AutoVue lane departure warning systems sold. The decrease in MAXxess net sales primarily reflects the decrease in sales to a major telecommunications customer in fiscal 2002 +compared to fiscal 2001. +Contract +revenues increased 9.8% to $25.1 million in fiscal 2003 compared to $22.8 million in fiscal 2002, and increased 14.0% compared to $20.0 million in fiscal +2000. The increase in contract revenues in both fiscal 2003 and fiscal 2002 primarily reflects an increase in Iteris' contract revenues for ITS projects. +Contract +revenues derived from Iteris represented 88.8% of total contract revenues in fiscal 2003 compared to 88.4% of total contract revenues in fiscal 2002, and 87.0% of total contract +revenues in fiscal 2001. The balance of the contract revenues were derived from the sale of space-borne recorders +and related service and equipment to agencies of the United States Government. In March 2003, we were notified that our contract to provide continued maintenance for space-borne recorders for +the United States Government would not be renewed and we do not anticipate any future revenue from this activity. +Gross Profit. Total gross profit decreased 9.5% to $20.2 million in fiscal 2003 compared to $22.3 million in +fiscal 2002, and increased 26.8% in fiscal 2002 compared to $17.6 million in fiscal 2001. Total gross profit as a percent of net sales and contract revenues decreased to 42.3% in fiscal 2003 +compared to 42.7% in fiscal 2002 and 28.2% in fiscal 2001. Gross profit as a percentage of net sales increased to 49.3% in fiscal 2003 compared to 42.9% in fiscal 2002 and 26.8% in fiscal 2001. +The +increase in gross profit as a percent of net sales in fiscal 2003 compared to 2002 reflects a 350 basis point increase in gross profit on sales of Iteris' Vantage video detection +systems, in conjunction with a 14.8% increase in sales of these products in fiscal 2003 compared to 2002. Gross profit on MAXxess sales, as a percent of net sales, was relatively unchanged in fiscal +2003 compared to fiscal 2002. Fiscal 2002 revenues and gross profits included revenue contribution from the Gyyr CCTV Products line, at lower gross profits relative to net sales. The divestiture of +this product line in September 2001 had the effect of increasing our consolidated gross profit performance beginning in the third quarter of fiscal 2002, which contributed to an overall +increase in gross profit in fiscal 2003 compared to fiscal 2002. +15 +Gross +profit in fiscal 2001 was net of charges of $3.1 million for the write-off of inventories associated with discontinued product lines. Before the effect of these +write-offs, gross profit as percent of net sales in fiscal 2001 was 33.2%. The increase in gross profit as a percent of net sales in fiscal 2002 compared to fiscal 2001 primarily reflects +increased gross profit on Iteris' net sales. Iteris' gross profit improved in fiscal 2002 primarily as a result of a 53.5% increase in Vantage sales and related improved manufacturing efficiencies. +The increase in gross profit in fiscal 2002 also reflects the benefit of the divestiture of the Gyyr CCTV Products line, which had historically low gross margins relative to net sales in fiscal 2001. +Gross +profit as a percent of contract revenues decreased to 36.1% in fiscal 2003 compared to 42.5% in fiscal 2002, and compared to 31.2% in fiscal 2001. This decrease in fiscal 2003 +reflects a mix of lower margin contracts in fiscal 2003 as compared to fiscal 2002. Furthermore, gross profit on contract revenues in fiscal 2002 benefited approximately 610 basis points from a +$1.4 million reduction in loss reserves on certain Iteris long-term contracts resulting from changes in the scope of work defined by a major customer, most of which were +nonrecurring in fiscal 2003. Net of such adjustments and profit realizations, we anticipate that gross profits as a percent of contract revenues are typically realized in a range of 31.0% to 35.0%, +depending upon the mix and scope of work undertaken during any given reporting period. We recognize contract revenues and related gross profit using percentage of completion contract accounting, and +the underlying mix of contract activity primarily affects the related gross profit recognized in any given year. As noted above, in March 2003, +we were notified that our contract to provide continued maintenance for space-borne recorders for the United States Government would not be renewed and we do not anticipate any future revenue from +this activity. +Selling, General and Administrative Expenses. Selling, general and administrative expenses decreased 12.6% to +$16.2 million (or 33.8% of total net sales and contract revenues) in fiscal 2003 compared to $18.5 million (or 35.4% of total net sales and contract revenues) in fiscal 2002, and +decreased 23.8% in fiscal 2002 compared to $25.2 million (or 40.4% of total net sales and contract revenues) in fiscal 2001. Approximately $1.6 million of the decrease in selling, +general and administrative expenses in fiscal 2003 compared to 2002 represents the cost reductions associated with the divestiture of the Gyyr CCTV Products line in the second quarter of fiscal 2002. +The decrease in selling, general and administrative expenses in fiscal 2003 also reflects general cost reductions related to staffing and outside services for legal and accounting expenses, which was +partially offset by increased sales and marketing costs in Iteris. The restructuring activities, which commenced during the third quarter of fiscal 2001, resulted in substantial decreases in selling, +general and administrative expenses in MAXxess and Iteris in fiscal 2002, which were augmented by further cost reductions associated with the divestiture of the Gyyr CCTV Products line in +September 2001. +Research and Development Expenses. Research and development expenses decreased 3.9% to $4.2 million (or 8.9% of total +net sales and contract revenues) in fiscal 2003 compared to $4.4 million (or 8.4% of total net sales and contract revenues) in fiscal 2002, and decreased 41.9% in fiscal 2002 compared to +$7.6 million (or 12.1% of total net sales and contract revenues) in fiscal 2001. For competitive reasons, we closely guard the confidentiality of specific development projects. +The +decrease in research and development expenses in fiscal 2003 compared to 2002 reflects the net of increased spending in Iteris and MAXxess, partially offset by cost savings +associated with the divestiture of the Gyyr CCTV Products line at the end of the second quarter of fiscal 2002. The increases in Iteris relate principally to software algorithm development and new +hardware designs for enhancements to its existing product family of Video Detection systems, in addition to development of video detection products that are expected to be announced in fiscal 2004. +Increases in research and development expense at MAXxess primarily relate to the software development of new performance feature for its AXxess 202/NS line of electronic access control systems. The +features introduced in fiscal 2003 to the AXxess 202/NS product line include a universal gateway for integrating other manufacturers systems and improved data encryption capabilities. +16 +The +decrease in research and development expenses in fiscal 2002 was associated with the divestiture of the Gyyr CCTV Products line at the end of the second quarter of fiscal 2002, and +with a substantial cost reduction in Iteris related to its development of technology to support personalized traveler information systems. The decrease in research and development expense in fiscal +2002 also reflects the full fiscal year cost benefit of the restructuring, which was begun in the fourth quarter of fiscal 2001. +The restructuring resulted in substantial decreases in research and development expenditures, primarily in the areas of payroll and related benefits, prototype material costs and consulting fees. +Restructuring Charges. We commenced the restructuring of our business to reduce our overall expenses and to focus our +business on those areas that we believe would provide the highest return for our stockholders. The restructuring included a reorganization of our European operations to lower our international costs. +The restructuring charge of $2.2 million in fiscal 2002 reflects charges of approximately $1.5 million related to the reorganization of our European operations and $700,000 in severance +charges incurred upon the retirement of the former Chief Executive Officer of Odetics. +In +fiscal 2001, we incurred restructuring charges of $0.8 million related to severance payments for staffing reductions across all of our business units. +Royalty Income. During fiscal 2001, in connection with the settlement of patent litigation that Odetics filed against +StorageTek, we received proceeds, net of expenses and fees, of approximately $17.8 million in full settlement of the amounts due to us. +Other Income. Other income, net reflects the following: +Year Ended March 31, +2001 +2002 +2003 +(in thousands) +Gain on sale of real estate +$ +— +$ +— +$ +640 +Loss on sale of Iteris common stock +— +(1,596 +) +(310 +) +Gain on sale of Gyyr assets +— +4,391 +— +Gain on sale of solid state recorder assets +1,231 +— +— +Other +109 +124 +58 +Other income, net +$ +1,340 +$ +2,919 +$ +388 +Other +income, net in fiscal 2003 includes a gain of $640,000 recognized on the sale and leaseback of our Anaheim, California facility, which was consummated in May 2002. We sold +shares of our Iteris common stock that yielded gross proceeds of $3.8 million and $900,000 in fiscal 2002 and 2003, respectively. During fiscal 2002, we sold substantially all of the assets of +Gyyr's CCTV Products line and Gyyr's Dome Products line. We realized an aggregate net gain of $4.4 million on these sales. During fiscal 2001, we sold the assets of our solid state recorder +business, which yielded gross proceeds of $1.9 million and a net gain of $1.2 million. +Interest Expense, Net. Interest expense, net reflects the net of interest expense and interest income as follows: +Year Ended March 31, +2001 +2002 +2003 +(in thousands) +Interest expense +$ +2,012 +$ +4,190 +$ +761 +Interest income +250 +— +— +Interest expense, net +$ +1,762 +$ +4,190 +$ +761 +17 +Interest +expense decreased 87.7% in fiscal 2003 compared to fiscal 2002 and increased 108.3% in fiscal 2002 compared to fiscal 2001. As a result of the sale and leaseback of our Anaheim, +California facilities, we repaid a $16.4 million outstanding indebtedness under a promissory note in May 2002. The increase in interest expense in fiscal 2002 reflects an increase in our +average outstanding borrowings, an increase in our cost of borrowing and $1.2 million of amortization of debt discount associated with a warrant issued in connection with certain of our +financing transactions. +Extraordinary Item. The extraordinary loss incurred in fiscal 2002 relates to a prepayment penalty we incurred in fiscal 2002 +in connection with the retirement of our mortgage note payable resulting from the refinancing of our Anaheim real property. +Income Taxes. During fiscal 2002, we recognized an income tax benefit of $785,000 for the recovery of net operating loss +carry backs made available under the Job Creation and Workers Association Act of 2002. We have not provided income tax benefit for the losses incurred in fiscal 2003 due to the uncertainty as to the +ultimate realization of the related benefit. +Minority Interest in Subsidiary. The minority interest represents the minority stockholders' share of Iteris' net income or +loss and the accretion of the redemption preference of Iteris's Series A preferred stock. +Liquidity and Capital Resources +During fiscal 2003, we used $4.8 million of cash to fund our operations. Operating cash flow reflects our net loss of $13.1 million in fiscal 2003 +increased for non-cash gains of $1.7 million related to the sale of our real estate assets, and decreased by $4.9 million in non-cash reserves for asset +impairments related to the write-down of the assets of the discontinued operations of Broadcast and Zyfer, by non-cash charges of $3.8 million related to the minority +interest in our Iteris subsidiary and $1.1 million for depreciation and amortization. As of March 31, 2003, we had cash of $437,000. +In +May 2002, we completed the sale and leaseback of our Anaheim, California facilities for an aggregate sale price of $22.6 million. Approximately $16.4 million of +the proceeds from this sale were used to repay +the outstanding indebtedness under a promissory note, which was secured by a first deed of trust on our Anaheim facilities. In connection with the sale and leaseback, we pledged cash of +$2.5 million to secure our obligations under the lease. The pledged amounts will be released to us based upon our continued compliance with financial covenants and performance under the lease. +The balance of the proceeds from this sale was used for general working capital purposes. We committed to lease one of the two buildings on this property for a period of ten years, and to lease the +other building for a period of 30 months. +On +August 16, 2002, we completed a private placement of 2,500,000 of our Class A common stock to an institutional investor for $3.0 million in cash. The transaction, +net of expenses, raised net proceeds of approximately $2.7 million. In connection with this offering, we also issued warrants to the investor to purchase up to another 1,250,000 shares at an +exercise price of $1.50 per share, and up to 1,250,000 shares at an exercise price of $1.80 per share. The warrants are exercisable at any time by the investor, and are callable by us if +the market price of our Class A common stock trades for 20 consecutive days at a price equal or greater than two times the exercise price of the warrants. If all of the warrants are exercised, +the total gross proceeds from this transaction are expected to be $7.2 million. The proceeds from the transaction were used to fund general working capital requirements. +In +May 2003, we completed the sale of substantially all the assets of our wholly-owned subsidiary, Zyfer, Inc., for $2.3 million in cash plus the assumption of liabilities. +The cash proceeds were used to fund working capital requirements and pay short-term liabilities. The asset purchase agreement provides for future incentive payments to us of up to +$1.0 million in each of the twelve months ended +18 +April 30, +2004 and 2005 based upon the achievement of certain revenues goals related to the sale of Zyfer products or the licensing of its technologies. +Our +contractual obligations are as follows at March 31, 2003: +Payments Due by Period +Total +One Year +or Less +Two to Three +Years +Four to Five +Years +After +Five Years +(in thousands) +Lines of credit +1,485 +235 +1,250 +— +— +Operating leases +17,417 +2,171 +3,975 +3,663 +7,608 +Total +18,902 +2,406 +5,225 +3,663 +7,608 +We +expect that our operations will continue to use net cash at least through the end of calendar 2003. We also expect to have an ongoing need to raise cash by securing additional debt or +equity financing, or by divesting certain assets to fund our operations until we return to profitability and positive operating cash flows. We believe that our future ability to obtain additional +funding will be dependent upon our ability to narrow our operating losses and provide a favorable expectation of future operating profitability. We believe our ability to raise additional capital may +also be adversely affected if Nasdaq determines to delist our Class A common stock from the Nasdaq SmallCap Market. The steps undertaken in fiscal 2002 and fiscal 2003 were intended to lower +our operating costs, widen our gross profits, and generally provide more opportunity to return to profitability. Furthermore, we believe that a focused business model provides a more compelling +opportunity for appreciation in stockholder value. Notwithstanding the recent refinements to our business model and our more defined focus, we cannot be certain that we will be able to secure +additional debt or equity financing on terms acceptable to us, on a timely basis, or at all. +Our +future cash requirements will be highly dependent upon our ability to control expenses, as well as the successful execution of the revenue plans by both Iteris and MAXxess. A +critical element of controlling expenses relates to the restructuring of our facilities lease arrangements. We are currently in negotiations with our landlords to restructure our leases for our +principal facilities in order to reduce our overall operating expenses to a level commensurate with our existing operations. We cannot be assured of the outcome of these negotiations and, as a result, +any projections of future cash requirements and cash flows are subject to substantial uncertainty. +These +conditions, together with our recurring losses, raise substantial doubt about our ability to continue as a going concern. Our consolidated financial statements do not include any +adjustments to reflect the possible future effects on the recoverability and classification of assets or liabilities that may result from the outcome of this uncertainty. +Recent Accounting Pronouncements +In 2003, we adopted Statement of Financial Accounting Standards No. 141, Business Combinations +("SFAS 141"). SFAS 141 requires that the purchase method of accounting be used for all business combinations initiated after June 30, 2001. SFAS 141 also includes guidance +on the initial recognition and measurement of goodwill and other intangible assets arising from business combinations completed after June 30, 2001. Application of this statement did not have a +significant effect on our consolidated results of operations or financial position. +In +July 2002, the FASB issued Statement No. 146, Accounting for Costs Associated with Exit or Disposal Activities +("Statement 146"). Statement 146 addresses financial accounting and reporting for costs associated with exit or disposal activities and nullifies EITF Issue No. 94-3, Liability Recognition for Certain Employee +Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a +Restructuring) ("EITF 94-3"). Statement 146 requires that a liability for a cost associated +19 +with +an exit or disposal activity be recognized when the liability is incurred. We adopted the provisions of Statement 146 on January 1, 2003. +In +November 2002, the FASB issued Interpretation No. 45, Guarantor's Accounting and Disclosure Requirements for Guarantees, Including Indirect +Guarantees of Indebtedness of Others ("FIN 45"), effective prospectively for guarantees issued or modified after December 31, 2002. The disclosure requirements of +FIN 45 are effective for periods ending after December 15, 2002. Under FIN 45, a guarantor is required to recognize, at the inception of certain guarantees, a fair value liability +for the obligations it has undertaken in issuing the guarantee, including its ongoing obligation to stand ready to perform over the term of the guarantee in the event that the specified triggering +events or conditions occur. All guarantees subject to the disclosure provisions of FIN 45, such as product warranties, have been +disclosed in the accompanying notes to the consolidated financial statements. We do not have any other outstanding guarantees at March 31, 2003 required to be disclosed or recorded as +obligations upon adoption of FIN 45. +In +January 2003, the FASB issued Interpretation No. 46, Consolidation of Variable Interest Entities ("FIN 46"). This +Interpretation changes the method of determining whether certain entities should be included in our consolidated financial statements. An entity is subject to FIN 46 and is called a variable +interest entity ("VIE") if it has (1) equity that is insufficient to permit the entity to finance its activities without additional subordinated financial support from other parties, or +(2) equity investors that cannot make significant decisions about the entity's operations, or that do not absorb the expected losses or receive the expected returns of the entity. All other +entities are evaluated for consolidation under SFAS No. 94, Consolidation of All Majority-Owned Subsidiaries . The provisions of FIN 46 are +to be applied immediately to VIEs created after January 31, 2003, and to VIEs in which an enterprise obtains an interest after that date. For VIEs in which an enterprise holds a variable +interest that it acquired before February 1, 2003, FIN 46 applies in the first fiscal period beginning after June 15, 2003. We have not yet determined the impact, if any, that the +adoption of FIN 46 will have on our financial position, results of operations or cash flows. +20 +RISK FACTORS +Our business is subject to a number of risks, some of which are discussed below. Other risks are presented elsewhere in this report and in +the information incorporated by reference into this report. You should consider the following risks carefully in addition to the together information contained in this report and our other filings +with the SEC, including our subsequent reports on Forms 10-Q and 8-K before deciding to buy, sell or hold our common stock. The risks and uncertainties described below are not +the only ones facing our company. Additional risks and uncertainties not presently known to us or that we currently deem immaterial may also affect our business operations. If any of these risks +actually occurs, our business, financial condition or results of operations could be seriously harmed. In that event, the market price for our common stock could decline and you may lose all or part +of your investment. +We Have Experienced Substantial Losses and May Continue to Experiencing Losses for the Foreseeable Future. We experienced +losses from continuing operations of $4.4 million in the year ended March 31, 2003 and $5.2 million in the year ended March 31, 2002. In the three months ended +September 30, 2001, we downsized our business in connection with our sale of the Gyyr CCTV Products line, the discontinuation of the business of our Mariner Networks subsidiary and the +reorganization of our European operations to reduce our operating expenses. In addition, in May 2003, we sold our Zyfer business and we are continuing to explore the divestiture of the assets +related to our Broadcast business. We cannot assure you that our efforts to downsize our operations or reduce our operating expenses or sell portions of our business will improve our financial +performance, or that we will be able to achieve profitability on a quarterly or annual basis in the future. Most of our expenses are fixed in advance, and we generally are unable to reduce our +expenses significantly in the short-term to compensate for any unexpected delay or decrease in anticipated revenues. As a result, we may continue to experience losses, which would make it +difficult to fund our operations and achieve our business plan, and could cause the market price of our common stock to decline. +We Will Need to Raise Additional Capital in the Future, But We May Not Be Able to Secure Adequate Funds on Terms Acceptable to Us, or at +All. We have generated significant net losses in recent periods, and have experienced negative cash flows from operations of $4.8 million in the year ended +March 31, 2003, $18.2 million in the year ended March 31, 2002 and $20.1 million in the year ended March 31, 2001. Although we completed the sale of our Anaheim, +California property in May 2002 and the sale of our Zyfer subsidiary in May 2003, the majority of the proceeds from such sales were used to pay outstanding debts and accounts payables. +In addition, $3.0 million of the proceeds from the sale of the Anaheim property have been pledged to secure our performance under the leases for our Anaheim facility and we have yet to monetize +the assets of our Broadcast subsidiary. As of March 31, 2003, our cash balance was approximately $0.4 million and we anticipate that we will need to raise additional capital in the +future. Our Iteris subsidiary currently maintains a line of credit with a maximum availability of +$5.0 million, which expires in August 2004. Substantially all of the assets of Iteris have been pledged to the lender to secure the outstanding indebtedness under this facility (although +there were no amounts outstanding under the line of credit at March 31, 2003). +We +plan to raise additional capital in the near future, either through bank borrowings, other debt or equity financings, or the divestiture of additional business units or select assets. +We cannot assure you that any additional capital will be available on a timely basis, on acceptable terms, or at all. These conditions, together with our recurring losses and cash requirements, raise +substantial doubt about our ability to continue as a going concern. +Our +capital requirements will depend on many factors, including: +• our +ability to control costs; +• market +acceptance of our products and the overall level of sales of our products; +• our +ability to generate operating income; +21 +• our +ability to renegotiate our real property leases; +• increased +research and development funding, and required investments in our business units; +• increased +sales and marketing expenses; +• technological +advancements and our competitors' response to our products; +• capital +improvements to new and existing facilities; +• potential +acquisitions of businesses and product lines; +• our +relationships with customers and suppliers; and +• general +economic conditions, including the effects of the current economic slowdown and international conflicts. +If +our capital requirements are materially different from those currently planned, we may need additional capital sooner than anticipated. If additional funds are raised through the +issuance of equity or convertible debt securities, the percentage ownership of our stockholders will be reduced and such securities may have rights, preferences and privileges senior to our common +stock. Additional financing may not be available on favorable terms or at all. If adequate funds are not available or are not available on acceptable terms, we may be unable to continue our operations +as planned, develop or enhance our products, expand our sales and marketing programs, take advantage of future opportunities or respond to competitive pressures. +The Trading Price of Our Common Stock Is Highly Volatile and Our Shares Could be Delisted from the Nasdaq Small Cap Market and You May Not Be Able to Resell Your +Shares of Stock at or Above the Price You Paid for Them. The trading price of our common stock has been subject to wide fluctuations in the past. Since +January 2000, our Class A common stock has traded at prices as low as $0.45 per share and as high as $29.44 per share and our Class B common stock has traded at prices as low as +$0.20 per share and as high as $29.62 per share. In April 2002, because we failed to meet the minimum stockholder's equity requirement for continued listing on the Nasdaq National Market, both +our Class A common stock and Class B common stock were delisted from the Nasdaq National Market and subsequently approved for listing on the Nasdaq SmallCap Market. In +November 2002, we received a Nasdaq Staff Determination that we had not maintained compliance with the continued listing criteria and that our common stock was subject to delisting from the +Nasdaq SmallCap Market. Our Class B common stock was delisted from the Nasdaq SmallCap Market in April 2003. We requested and received an extension of such delisting proceedings but +subsequently received, in May 2003, a second Nasdaq Staff Determination stating that we were not in compliance with the continued listing criteria, and that our Class A common stock was +also subject to delisting from the Nasdaq SmallCap Market. We participated in a hearing before a Nasdaq Listing Qualifications Panel in June 2003 to appeal the +Staff Determination but a final determination by the panel has not yet been issued. Odetics' listing status will not change until such final determination has been issued by the panel. However, there +can be no assurance that the panel will grant our request for continued listing on the Nasdaq SmallCap Market, and if we are unsuccessful in our appeal and are delisted from the Nasdaq SmllCap Market, +there may not be an active trading market for our stock. As such, you may not be able to resell your shares of common stock at or above the price you paid for them. +In +the event our Class A common stock is delisted, trading, if any, in our Class A common stock thereafter may be conducted in the over-the-counter +market in the so-called "pink sheets" or the OTC Bulletin Board. In addition, our securities could become subject to "penny stock" restrictions, including Rule 15g-9 +under the Exchange Act, which imposes additional sales practice requirements on broker-dealers, such as requirements pertaining to the suitability of the investment for the purchaser and the delivery +of specific disclosure materials and monthly statements. Consequently, the liquidity of our securities could be impaired, not only in the number of securities which could be bought and sold, but +22 +also +through delays in the timing of the transactions, reduction in security analysts' and the news media's coverage of us, adverse effects on the ability of broker-dealers to sell our securities, and +lower prices for our securities than might otherwise be attained. +The +market price of our common stock could continue to fluctuate in the future in response to various factors, including, but not limited to: +• quarterly +variations in operating results; +• our +ability to control costs and improve cash flow; +• shortages +announced by suppliers; +• announcements +of technological innovations or new products by our competitors, customers or us; +• acquisitions +or businesses, products or technologies; +• changes +in pending litigation or new litigation; +• changes +in investor perceptions; +• our +ability to spin-off any business unit; +• applications +or product enhancements by us or by our competitors; +• changes +in earnings estimates or investment recommendations by securities analysts; and +• international +conflicts and political unrest. +The +stock market in general has recently experienced volatility, which has particularly affected the market prices of equity securities of many high technology companies. This volatility +has often been unrelated to the operating performance of these companies. These broad market fluctuations may adversely affect the market price of our common stock. In the past, companies that have +experienced volatility in the market price of their securities have been the subject of securities class action litigation. If we were to become the subject of a class action lawsuit, it could result +in substantial losses and divert management's attention and resources from other matters. +We Depend on Government Contracts and Subcontracts, and Because Many of our Government Contracts are Fixed Price Contracts, Higher Than Anticipated Costs Will +Reduce Our Profit and Could Adversely Impact our Operating Results. A significant portion of the sales by Iteris were derived from contracts with governmental +agencies, either as a general contractor, subcontractor or supplier. Government contracts represented approximately 26%, 38% and 47% of our total net sales and contract revenues for the years ended +March 31, 2001, 2002 and 2003, respectively. We anticipate that +revenue from government contracts will continue to increase in the near future. Government business is, in general, subject to special risks and challenges, including: +• long +purchase cycles or approval processes; +• competitive +bidding and qualification requirements; +• performance +bond requirements; +• changes +in government policies and political agendas; +• delays +in funding, budgetary constraints and cut-backs; and +• milestone +requirements and liquidated damage provisions for failure to meet contract milestones. +23 +In +addition, a large number of our government contracts are fixed price contracts. As a result, we may not be able to recover for any cost overruns. These fixed price contracts require +us to estimate the total project cost based on preliminary projections of the project's requirements. The financial viability of any given project depends in large part on our ability to estimate +these costs accurately and complete the project on a timely basis. In the event our costs on these projects exceed the fixed contractual amount, we will be required to bear the excess costs. These +additional costs adversely affect our financial condition and results of operations. Moreover, certain of our government contracts are subject to termination or renegotiation at the convenience of the +government, which could result in a large decline in our net sales in any given quarter. Our inability to address any of the foregoing concerns or the loss or renegotiation of any material government +contract could seriously harm our business, financial condition and results of operations. +Economic Slowdown and Related Uncertainties Could Adversely Impact the Demand for Our Products. Concerns about inflation, +decreased consumer confidence, reduced corporate profits and capital spending, and recent international conflicts and terrorist and military actions have resulted in a downturn in worldwide economic +conditions, particularly in the United States. As a result of these unfavorable economic conditions, we have experienced a slowdown in customer orders, cancellations and rescheduling of backlog and +higher overhead costs. In addition, recent political and social turmoil related to international conflicts and terrorist acts can be expected to put further pressure on economic conditions in the U.S. +and worldwide. These political, social and economic conditions make it extremely difficult for our customers, our suppliers and us to accurately forecast and plan future business activities. If such +conditions continue or worsen, our business, financial condition and results of operations will likely be materially and adversely affected. +Our Quarterly Operating Results Fluctuate as a Result of Many Factors. Therefore, We May Fail to Meet or Exceed the Expectations of Securities Analysts and +Investors, Which Could Cause Our Stock Price to Decline. Our quarterly revenues and operating results have fluctuated and are likely to continue to vary from +quarter to quarter due to a number of factors, many of which are not within our control. Factors that could affect our revenues include, among others, the following: +• our +ability to raise additional capital; +• our +significant investment in research and development for our subsidiaries and business units; +• our +ability to control costs; +• international +conflicts and acts of terrorism; +• our +ability to develop, introduce, market and gain market acceptance of new products applications and product enhancements in a timely manner; +• the +size, timing, rescheduling or cancellation of significant customer orders; +• the +introduction of new products by competitors; +• the +availability of components used in the manufacture of our products; +• changes +in our pricing policies and the pricing policies by our suppliers and competitors, pricing concessions on volume sales, as well as increased price competition in +general; +• the +long lead times associated with government contracts or required by vehicle manufacturers; +• our +success in expanding and implementing our sales and marketing programs; +• the +effects of technological changes in our target markets; +• our +relatively small level of backlog at any given time; +• the +mix of sales among our business units; +24 +• deferrals +of customer orders in anticipation of new products, applications or product enhancements; +• risks +and uncertainties associated with our international business; +• currency +fluctuations and our ability to get currency out of certain foreign countries; and +• general +economic and political conditions. +In +addition, our sales in any quarter may consist of a relatively small number of large customer orders. As a result, the timing of a small number of orders may impact our +quarter-to-quarter results. The loss of or a substantial reduction in orders from any significant customer could seriously harm our business, financial condition and results of +operations. +Due +to all of the factors listed above and, our future operating results could be below the expectations of securities analysts or investors. If that happens, the trading price of our +common stock could decline. As a result of these quarterly variations, you should not rely on quarter-to-quarter comparisons of our operating results as an indication of our +future performance. +We Have Adopted a New Operating Strategy, Which Is Untried and Exposes Us to New Risks. Recently, we divested ourselves of +many of our business units and have begun to focus our business on the emerging homeland security opportunities and the business of our Iteris subsidiary. We continue to explore options for the sale +of our other business units and continue to change our incubator strategy, which required us to make significant investments in our business units with the goal of achieving profitability in each of +our business units, and to a lesser extent, to monetize those business units for the benefit of our stockholders through an initial public offering or sale to a strategic buyer. The new focus of our +business may not be profitable and the current climate of international conflicts and political unrest may not translate to a profitable market for our products. Our current business strategy is +untried there is no assurance that the new business plan or the continued execution of the Iteris business will be successful. +If We Do Not Keep Pace with Rapid Technological Changes and Evolving Industry Standards, We Will Not be Able to Remain Competitive and There Will Be No Demand for +Our Products. Our target markets are in general characterized by the following factors: +• rapid +technological advances; +• downward +price pressure in the marketplace as technologies mature; +• changes +in customer requirements; +• frequent +new product introductions and enhancements; and +• evolving +industry standards and changes in the regulatory environment. +Our +future success will depend upon our ability to anticipate and adapt to changes in technology and industry standards, and to effectively develop, introduce, market and gain broad +acceptance of new products and product enhancements incorporating the latest technological advancements. +We +believe that we must continue to make substantial investments to support ongoing research and development in order to remain competitive. We need to continue to develop and introduce +new products that incorporate the latest technological advancements in hardware, storage media, operating system software and applications software in response to evolving customer requirements. Our +business and results of operations could be adversely affected if we do not anticipate or respond adequately to technological developments or changing customer requirements. We cannot assure you that +any such investments in research and development will lead to any corresponding increase in revenue. +25 +If We Are Unable to Develop and Introduce New Products and Product Enhancements Successfully and in a Cost-Effective and Timely Manner, or to Achieve +Market Acceptance of Our New Products, Our Operating Results Would be Adversely Affected. We believe our revenue growth and future operating results will depend on +our ability to complete development of new products and enhancements, introduce these products in a timely, cost-effective manner, achieve broad market acceptance of these products and +enhancements, and reduce our product costs. We may not be able to introduce any new products or any enhancements to our existing products on a timely basis, or at all. In addition, the introduction of +any new products could adversely affect the sales of certain of our existing products. +Our +future success will also depend in part on the success of several products including AutoVue, our lane departure warning system. Iteris currently outsources the manufacture of its +AutoVue product line to a single manufacturer. This manufacturer may not be able to produce sufficient quantities of this product in a timely manner or at a reasonable cost, which could materially and +adversely affect our ability to launch or gain market acceptance of AutoVue. +MAXxess +is expecting its product offering to include chemical detection systems and a security solution for municipalities called Safe Cities. Our ability to be successful in this +endeavor is dependent upon the completion of software development tasks and the continued cooperation of Draeger Safety, Inc. +Market +acceptance of our new products depends upon many factors, including our ability to accurately predict market requirements and evolving industry standards, our ability to resolve +technical challenges in a timely and cost-effective manner and achieve manufacturing efficiencies, the perceived advantages of our new products over traditional products and the marketing +capabilities of our independent distributors and strategic partners. Our business and results of operations could be seriously harmed by any significant delays in our new product development. Certain +of our new products could contain undetected design faults and software errors or "bugs" when first released by us, despite our testing. We may not discover these faults or errors until after a +product has been installed and used by our customers. Any faults or errors in our existing products or in any new products may cause delays in product introduction and shipments, require design +modifications or harm customer relationships, any of which could adversely affect our business and competitive position. +We Have Significant International Sales and Our International Business Operations May be Threatened by Many Factors That are Outside of Our +Control. Despite the reorganization of our European operations and the resulting reduction in international sales, such sales continue to be significant to our +business, particularly for our AutoVue and Vantage product lines. International sales represented 1.9% of our net sales and contract revenues for the fiscal year ended March 31, 2003, 3.5% of +our net sales and contract revenues for the fiscal year ended March 31, 2002 and 10.3% for the fiscal year ended March 31, 2001. The recent terrorist attacks in the United States and +abroad and heightened security may adversely impact our international sales and could make our international operations more expensive. +International +business operations are also subject to other inherent risks, including, among others: +• unexpected +changes in regulatory requirements, tariffs and other trade barriers or restrictions; +• longer +accounts receivable payment cycles; +• difficulties +in managing and staffing international operations; +• potentially +adverse tax consequences; +• the +burdens of compliance with a wide variety of foreign laws; +26 +• import +and export license requirements and restrictions of the United States and each other country in which we operate; +• exposure +to different legal standards and reduced protection for intellectual property rights in some countries; +• currency +fluctuations and restrictions; and +• political, +social and economic instability. +We +believe that international sales will continue to represent a significant portion of our revenues, and that continued growth and profitability could require expansion of our +international operations. Nearly all of our international sales from this point on are denominated in U.S. dollars. As a result, an increase in the relative value of the dollar could make our products +more expensive and potentially less price competitive in international markets. We do not engage in any transactions as a hedge against risks of loss due to foreign currency fluctuations. +Any +of the factors mentioned above may adversely affect our future international sales and, consequently, affect our business, financial condition and operating results. Furthermore, as +we increase our international sales, our total revenues may also be affected to a greater extent by seasonal fluctuations resulting from lower sales that typically occur during the summer months in +Europe and other parts of the world. +Acquisitions of Companies or Technologies May Require Us to Undertake Significant Capital Infusions and Result in Disruptions of Our Business and Diversion of +Resources and Management Attention. Over the past few years, we have expanded our operations and made several substantial acquisitions of diverse businesses, +including Meyer Mohaddes Associates, Inc., Viggen Corporation, and certain assets of the Transportation Systems business of Rockwell International. We may continue to engage in acquisitions of +complementary businesses, products and technologies. Acquisitions may require significant capital infusions and, in general, acquisitions also involve a number of special risks, including: +• potential +disruption of our ongoing business and the diversion of our resources and management's attention; +• the +failure to retain or integrate key acquired personnel; +• the +challenge of assimilating diverse business cultures, and the difficulties in integrating the operations, technologies and information system of the acquired companies; +• increased +costs to improve managerial, operational, financial and administrative systems and to eliminate duplicative services; +• the +incurrence of unforeseen obligations or liabilities; +• potential +impairment of relationships with employees or customers as a result of changes in management; and +• increased +interest expense and amortization of acquired intangible assets. +Acquisitions +may also materially and adversely affect our operating results due to large write-offs, contingent liabilities, substantial depreciation, deferred compensation +charges or goodwill amortization, or other adverse tax or audit consequences. Our failure to manage growth and integrate our acquisitions successfully could adversely affect our business, financial +condition and results of operations. +Our +competitors are also soliciting potential acquisition candidates, which could both increase the price of any acquisition targets and decrease the number of attractive companies +available for +27 +acquisition. +We cannot assure you that we will be able to consummate any additional acquisitions, successfully integrate any acquisitions or realize the benefits anticipated from any acquisition. +The Markets in Which We Operate Are Highly Competitive and Have Many More Established Competitors, Which Could Adversely Affect Our Sales or the Market Acceptance +of Our Products. We compete with numerous other companies in our target markets and we expect such competition to increase due to technological advancements, +industry consolidations and reduced barriers to entry. Increased competition is likely to result in price reductions, reduced gross margins and loss of market share, any of which could seriously harm +our business, financial condition and results of operations. Many of our competitors have far greater name recognition and greater financial, technological, marketing and customer service resources +than we do. This may allow them to respond more quickly to new or emerging technologies and changes in customer requirements. It may also allow them to devote greater resources to the development, +promotion, sale and support of their products than we can. Recent consolidations of end users, distributors and manufacturers in our target markets have exacerbated this problem. As a result of the +foregoing factors, we may not be able to compete effectively in our target markets and competitive pressures could adversely affect our business, financial condition and results of operations. +We Do Not Have Employment Agreements with Any Key Personnel and We May be Unable to Attract and Retain Key Personnel, Which Could Seriously Harm Our +Business. Due to the specialized nature of our business, we are highly dependent on the continued service of our executive officers and other key management, +engineering and technical personnel, particularly Joel Slutzky, our Chairman of the Board, who recently retired as our Chief Executive Officer, and Gregory A. Miner, our Chief Executive Officer and +Chief Financial Officer. We do not have any employment contracts with any of our officers or key employees. The loss of any of these individuals could adversely affect our business, financial +condition or results of operations. +Our +success will also depend in large part upon our ability to continue to attract, retain and motivate qualified engineering and other highly skilled technical personnel. Competition +for employees, particularly development engineers, is intense. We may not be able to continue to attract and retain sufficient numbers of such highly skilled employees. Our inability to attract and +retain additional key employees or the loss of one or more of our current key employees could adversely affect our business, financial condition and results of operations. +We May Not be Able to Adequately Protect or Enforce Our Intellectual Property Rights, Which Could Harm Our Competitive +Position. If we are not able to adequately protect or enforce the proprietary aspects of our technology, competitors could be able to access our proprietary +technology and our business, financial condition and results of operations will likely be seriously harmed. We currently attempt to protect our technology through a combination of patent, copyright, +trademark and trade secret laws, employee and third party nondisclosure agreements and similar means. Despite our efforts, other parties may attempt to disclose, obtain or use our technologies or +systems. Our competitors may also be able to independently develop products that are substantially equivalent or superior to our products or design around our patents. In addition, the laws of some +foreign countries do not protect our proprietary rights as fully as do the laws of the United States. As a result, we may not be able to protect our proprietary rights adequately in the United States +or abroad. +From +time to time, we have received notices that claim we have infringed upon the intellectual property of others. Even if these claims are not valid, they could subject us to +significant costs. We have engaged in litigation in the past, and litigation may be necessary in the future to enforce our intellectual property rights or to determine the validity and scope of the +proprietary rights of others. Litigation may also be necessary to defend against claims of infringement or invalidity by others. An adverse outcome in litigation or any similar proceedings could +subject us to significant liabilities to third parties, require us to license disputed rights from others or require us to cease marketing or using +28 +certain +products or technologies. We may not be able to obtain any licenses on terms acceptable to us, or at all. We also may have to indemnify certain customers or strategic partners if it is +determined that we have infringed upon or misappropriated another party's intellectual property. Any of these results could adversely affect our business, financial condition and results of +operations. In addition, the cost of addressing any intellectual property litigation claim, both in legal fees and expenses, and the diversion of management resources, regardless of whether the claim +is valid, could be significant and could seriously harm our business, financial condition and results of operations. +Some of Our Directors, Officers and Their Affiliates Can Control the Outcome of Matters that Require the Approval of Our Stockholders, and Accordingly We Will Not +be Able to Engage in Certain Transactions Without Their Approval. As of June 18, 2003, our officers and directors beneficially owned approximately 21% of +the total combined voting power of the outstanding shares of our Class A common stock and Class B common stock. As a result of their stock ownership, our management will be able to +significantly influence the election of our directors and the outcome of corporate actions requiring stockholder approval, such as mergers and acquisitions, regardless of how our other stockholders +may vote. This concentration of voting control may have a significant effect in delaying, +deferring or preventing a change in our management or change in control and may adversely affect the voting or other rights of other holders of common stock. +Our Stock Structure and Certain Anti-Takeover Provisions May Affect the Price of Our Common Stock and Discourage a Third Party from Acquiring +Us. Certain provisions of our certificate of incorporation and our stockholder rights plan could make it difficult for a third party to acquire us, even though an +acquisition might be beneficial to our stockholders. These provisions could limit the price that investors might be willing to pay in the future for shares of our common stock. Our Class A +common stock entitles the holder to one-tenth of one vote per share and our Class B common stock entitles the holder to one vote per share. The disparity in the voting rights +between our common stock, as well as our insiders' significant ownership of the Class B common stock, could discourage a proxy contest or make it more difficult for a third party to effect a +change in our management and control. In addition, our Board of Directors is authorized to issue, without stockholder approval, up to 2,000,000 shares of preferred stock with voting, conversion and +other rights and preferences superior to those of our common stock, as well as additional shares of Class B common stock. Our future issuance of preferred stock or Class B common stock +could be used to discourage an unsolicited acquisition proposal. +In +March 1998, we adopted a stockholder rights plan and declared a dividend of preferred stock purchase rights to our stockholders. In the event a third party acquires more than +15% of the outstanding voting control of our company or 15% of our outstanding common stock, the holders of these rights will be able to purchase the junior participating preferred stock at a +substantial discount off of the then current market price. The exercise of these rights and purchase of a significant amount of stock at below market prices could cause substantial dilution to a +particular acquiror and discourage the acquiror from pursuing our company. The mere existence of a stockholder rights plan often delays or makes a merger, tender offer or proxy contest more difficult. +We Do Not Pay Cash Dividends. We have never paid cash dividends on our common stock and do not anticipate paying any cash +dividends on either class of our common stock in the foreseeable future. +We May Be Subject to Additional Risks. The risks and uncertainties described above are not the only ones facing our company. +Additional risks and uncertainties not presently known to us or that we currently deem immaterial may also adversely affect our business operations. +29 +ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK. +Our exposure to interest rate risk is limited to our lines of credit. Iteris' and Odetics' lines of credit bear interest at the prevailing prime rate, plus 2% and +4%, respectively. Our $16.0 million note payable, prior to its repayment in May 2002, carried a fixed rate of interest. We estimate that, based on amounts outstanding at March 31, +2003, a 10% increase in the prime rate would result in an increase in interest expense, on an annualized basis, of less than $0.1 million. +ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. +The financial statements and supplementary data required by Regulation S-X are included in this Form 10-K commencing on page +F-1. +ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE. +Not applicable. +30 +PART III +ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT. +Directors and Executive Officers +(a) Identification of Directors. The information under the caption "Election of Directors," appearing in our +proxy statement, is incorporated herein by reference. +(b) Identification of Executive Officers. The information under the caption "Executive Compensation and Other +Information," appearing in our proxy statement, is incorporated herein by reference. +(c) Compliance with Section 16(a) of the Exchange Act. The information under the caption "Executive +Compensation and Other Information," appearing in our proxy statement, is incorporated herein by reference. +ITEM 11. EXECUTIVE COMPENSATION. +The information under the caption "Executive Compensation and Other Information," appearing in our proxy statement, is incorporated herein by reference. +ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS. +As of March 31, 2003, Odetics had only one plan, the 1997 Stock Incentive Plan, pursuant to which equity securities of Odetics are authorized for issuance. +The following table sets forth certain information regarding this plan: +(a) +(b) +(c) +Number of +Securities +to be Issued +Upon Exercise of +Outstanding +Options, +Warrants and +Rights +Weighted Average +Exercise Price of +Outstanding +Options, +Warrants and +Rights +Number of Securities +Remaining Available +under Equity +Compensation +Plans (excluding some +securities reflected +in column (a)) +Equity Compensation Plans Approved by Security Holders +1997 Stock Incentive Plan +961,920 +$3.73 +689,000 +Equity Compensation Plans Not Approved by Security Holders +None +Total +961,920 +689,000 +The +information under the caption "Principal Stockholders and Common Stock Ownership of Certain Beneficial Owners and Management," appearing in our proxy statement, is incorporated +herein by reference. +ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS. +The information under the caption "Certain Transactions," appearing in our proxy statement, is incorporated herein by reference. +31 +ITEM 14. CONTROLS AND PROCEDURES. +We maintain disclosure controls and procedures that are designed to ensure that information required to be disclosed in the our Exchange Act reports is recorded, +processed, summarized and reported within the time periods specified in the SEC's rules and forms, and that such information is accumulated and communicated to our management, including our Chief +Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure. In designing and evaluating the disclosure controls and procedures, management +recognized that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives, and management necessarily was +required to apply its judgment in evaluating the cost-benefit relationship of possible controls and procedures. +Within +90 days prior to the date of this Report, the Company carried out an evaluation, under the supervision and with the participation of management, including our Chief +Executive Officer and our Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures. Based on the foregoing, our Chief Executive Officer and +Chief Financial Officer concluded that our disclosure controls and procedures were effective. +There +have been no significant changes in our internal controls or in other factors that could significantly affect the internal controls subsequent to the date we completed our +evaluation. +32 +PART IV +ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K. +(a) Documents +filed as part of this report: +1. Financial Statements. The following financial statements of Odetics are included in a separate section of +this Annual Report on Form 10-K commencing on the pages referenced below: +Page +Report of Independent Auditors +F-2 +Consolidated Balance Sheets as of March 31, 2002 and 2003 +F-3 +Consolidated Statements of Operations for the years ended March 31, 2001, 2002 and 2003 +F-4 +Consolidated Statements of Stockholders' Equity for the years ended March 31, 2001, 2002 and 2003 +F-5 +Consolidated Statements of Cash Flows for the years ended March 31, 2001, 2002 and 2003 +F-6 +Notes to Consolidated Financial Statements +F-7 +2. Financial +Statement Schedules. +Schedule II—Valuation and Qualifying Accounts +S-1 +All +other schedules have been omitted because they are not required or the required information is included in our consolidated financial statements and notes thereto. +33 +3. (a) +Exhibits. +3.1 +Certificate of Incorporation of Odetics, as amended (incorporated by reference to Exhibit 19.2 to Odetics' Quarterly Report on Form 10-Q for the quarter ended September 30, 1987). +3.2 +Bylaws of Odetics, as amended (incorporated by reference to Exhibit 4.2 to Odetics' Registration Statement on Form S-1 (Reg. No. 033-67932) as filed with the SEC on July 6, 1993). +4.1 +Specimen of Class A common stock and Class B common stock certificates (incorporated by reference to Exhibit 4.3 to Amendment No. 1 to Odetics' Registration Statement on Form S-1 (Reg. No. 033-67932) as filed with the SEC on September 30, +1993). +4.2 +Form of rights certificate for Odetics' preferred stock purchase rights (incorporated by reference to Exhibit A of Exhibit 4 to Odetics' Current Report on Form 8-K as filed with the SEC on May 1, 1998). +10.1 +Profit Sharing Plan and Trust (incorporated by reference to Exhibit 10.3 to Odetics' Amendment No. 2 to the Registration Statement on Form S-8 (Reg. No. 002-98656) as filed with the SEC on May 5, 1988). +10.2 +Form of Executive Deferral Plan between Odetics and certain employees of Odetics (incorporated by reference to Exhibit 10.4 to Odetics' Annual Report on Form 10-K for the year ended March 31, 1988). +10.3 +Form of Indemnity Agreement entered into by Odetics and certain of its officers and directors (incorporated by reference to Exhibit 19.4 to Odetics' Quarterly Report on Form 10-Q for the quarter ended September 30, 1988). +10.4 +Amendment Nos. 3 and 4 to the Profit Sharing Plan and Trust (incorporated by reference to Exhibits 4.3.1 and 4.3.2, respectively, to Amendment No. 3 to Odetics' Registration Statement on Form S-3 (Reg. No. 002-86220) as filed with the SEC on June 13, +1990) +10.5 +1997 Stock Incentive Plan of Odetics (as amended on May 3, 2002). +10.6 +Form of Notice of Grant of Stock Option (incorporated by reference to Exhibit 99.2 to Odetics' Registration Statement on Form S-8 (File No. 333-30396) as filed with the SEC on February 14, 2000) +10.7 +Form of Stock Option Agreement (incorporated by reference to Exhibit 99.3 to Odetics' Registration Statement on Form S-8 (File No. 333-30396) as filed with the SEC on February 14, 2000). +10.8 +Form of Addendum to Stock Option Agreement—Involuntary Termination Following Corporate Transaction or Change in Control (incorporated by reference to Exhibit 99.4 to Odetics' Registration Statement on Form S-8 (File No. 333-30396) as filed with +the SEC on February 14, 2000). +10.9 +Form of Addendum to Stock Option Agreement—Limited Stock Appreciation Rights (incorporated by reference to Exhibit 99.5 to Odetics' Registration Statement on Form S-8 (File No. 333-30396) as filed with the SEC on February 14, 2000). +10.10 +Form of Stock Issuance Agreement (incorporated by reference to Exhibit 99.6 to Odetics' Registration Statement on Form S-8 (File No. 333-30396) as filed with the SEC on February 14, 2000) +34 +10.11 +Form of Addendum to Stock Issuance Agreement—Involuntary Termination Following Corporate Transaction/Change in Control (incorporated by reference to Exhibit 99.7 to Odetics' Registration Statement on Form S-8 (File No. 333-30396) as filed with +the SEC on February 14, 2000). +10.12 +Form of Notice of Grant of Automatic Stock Option—Initial Grant filed as Exhibit 99.8 filed as Exhibit (incorporated by reference to Exhibit 99.8 to Odetics' Registration Statement on Form S-8 (File No. 333-30396) as filed with the SEC on +February 14, 2000). +10.13 +Form of Notice of Grant of Automatic Stock Option—Annual Grant (incorporated by reference to Exhibit 99.9 to Odetics' Registration Statement on Form S-8 (File No. 333-30396) as filed with the SEC on February 14, 2000). +10.14 +Form of Automatic Stock Option Agreement filed as Exhibit 99.10 to the (incorporated by reference to Exhibit 99.10 to Odetics' Registration Statement on Form S-8 (File No. 333-30396) as filed with the SEC on February 19, 2000). +10.15 +Rights Agreement dated April 24, 1998 between Odetics and BankBoston, N.A., which includes the form of Certificate of Designation for the junior participating preferred stock as Exhibit A, the form of rights certificate as Exhibit B and the summary +of rights to purchase Series A preferred shares as Exhibit C (incorporated by reference to Exhibit 4 to Odetics' Current Report on Form 8-K as filed with the SEC on May 1, 1998). +10.16 +1994 Long-Term Equity Plan of Odetics (incorporated by reference to Exhibit 4.3 to Odetics' Registration Statement on Form S-8 (File No. 333-05735) as filed with the SEC on June 11, 1996). +10.17 +Amendment to Rights Agreement, dated May 21, 2001, by and between Odetics and Fleet National Bank (a.k.a. Bank Boston, N.A.) (incorporated by reference to Exhibit 99.4 to Odetics' Current Report on Form 8-K as filed with the SEC on June 1, +2001). +10.18 +Amended and Restated Agreement of Purchase and Sale and Escrow Instructions, dated February 19, 2002, by and between Odetics, Inc. and 1515 South Manchester, LLC (incorporated by reference to Exhibit 2.1 to Odetics' Current Report on Form 8-K as +filed with the SEC on June 12, 2002). +10.19 +Sublease Agreement dated May 7, 2003 by and between Odetics, Inc. and FEI-Zyfer, Inc. +21 +Subsidiaries of Odetics. +23.1 +Consent of Independent Auditors. +99.1 +Section 906 Certification, as furnished by the Chief Executive Officer and Chief Financial Officer pursuant to SEC Release No. 33-8212, 34-47551. +(b) Reports +on Form 8-K +No +reports on Form 8-K were filed during the quarter ended March 31, 2003. +35 +SIGNATURES +Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this Report to be signed on its +behalf by the undersigned, thereunto duly authorized, in the City of Anaheim, State of California, on June 27, 2003. +ODETICS, INC. +By: +/s/ GREGORY A. MINER Gregory A. Miner, +Chief Executive Officer +and Chief Financial Officer +POWER OF ATTORNEY +We, the undersigned officers and directors of Odetics, Inc., do hereby constitute and appoint Gary Smith and Gregory A. Miner, and each of them, our true +and lawful attorneys-in-fact and agents, each with full power of substitution and resubstitution, for him and in his name, place and stead, in any and all capacities, to sign +any and all amendments to this report, and to file the same, with exhibits thereto, and other documents in connection therewith, with the Securities and Exchange Commission, granting unto said +attorneys-in-fact and agents, and each of them, full power and authority to do and perform each and every act and thing requisite or necessary to be done in and about the +premises, as fully to all intents and purposes as he might or could do in person, hereby, ratifying and confirming all that each of said attorneys-in-fact and agents, or his +substitute or substitutes, may lawfully do or cause to be done by virtue hereof. +Pursuant +to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons in the capacities and on the dates indicated: +Signature +Title +Date +/s/ GREGORY A. MINER Gregory A. Miner +(principal executive officer and +principal financial officer) +Director, Chief Executive Officer and Chief Financial Officer +June 27, 2003 +/s/ JOEL SLUTZKY Joel Slutzky +Chairman of the Board +June 27, 2003 +/s/ KEVIN C. DALY Kevin C. Daly, Ph.D +Director +June 27, 2003 +/s/ CRANDALL GUDMUNDSON Crandall Gudmundson +Director +June 27, 2003 +36 +/s/ JERRY MUENCH Jerry Muench +Director +June 27, 2003 +/s/ JOHN SEAZHOLTZ John Seazholtz +Director +June 27, 2003 +/s/ GARY SMITH Gary Smith +Vice President and Controller (principal accounting officer) +June 27, 2003 +/s/ THOMAS L. THOMAS Thomas L. Thomas +Director +June 27, 2003 +/s/ PAUL E. WRIGHT Paul E. Wright +Director +June 27, 2003 +37 +CERTIFICATION +I, +Gregory A. Miner, certify that: +1. I +have reviewed this annual report on Form 10-K of Odetics, Inc. +2. Based +on my knowledge, this annual report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, +in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this annual report; +3. Based +on my knowledge, the financial statements, and other financial information included in this annual report, fairly present in all material respects the financial +condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this annual report; +4. I +am responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) +for the registrant and have: +a. designed +such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to +us by others within those entities, particularly during the period in which this annual report is being prepared; +b. evaluated +the effectiveness of the registrant's disclosure controls and procedures as of a date within 90 days prior to the filing date of this annual report (the +"Evaluation Date"); and +c. presented +in this annual report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date; +5. I +have disclosed, based on our most recent evaluation, to the registrant's auditors and the audit committee of registrant's board of directors (or persons performing the +equivalent functions): +a. all +significant deficiencies in the design or operation of internal controls which could adversely affect the registrant's ability to record, process, summarize and +report financial data and have identified for the registrant's auditors any material weaknesses in internal controls; and +b. any +fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal controls; and +6. I +have indicated in this annual report whether there were significant changes in internal controls or in other factors that could significantly affect internal controls +subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses. +Date: June 27, 2003 +/s/ GREGORY A. MINER Gregory A. Miner, +Chief Executive Officer and Chief Financial Officer +(Principal Executive Officer and Principal Financial Officer) +38 +Odetics, Inc. +Index to Consolidated Financial Statements +Page +Report of Independent Auditors +F-2 +Consolidated Balance Sheets as of March 31, 2002 and 2003 +F-3 +Consolidated Statements of Operations for the years ended March 31, 2001, 2002 and 2003 +F-4 +Consolidated Statements of Stockholders' Equity for the years ended March 31, 2001, 2002 and 2003 +F-5 +Consolidated Statements of Cash Flows for the years ended March 31, 2001, 2002 and 2003 +F-6 +Notes to Consolidated Financial Statements +F-7 +F-1 +Report of Independent Auditors +Stockholders +and Board of Directors +Odetics, Inc. +We +have audited the accompanying consolidated balance sheets of Odetics, Inc. as of March 31, 2002 and 2003, and the related consolidated statements of operations, +stockholders' equity, and cash flows for each of the three years in the period ended March 31, 2003. Our audits also included the financial statement schedule listed in Item 15(a). These +financial statements and schedule are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. +We +conducted our audits in accordance with auditing standards generally accepted in the United States. Those standards require that we plan and perform the audit to obtain reasonable +assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial +statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe +that our audits provide a reasonable basis for our opinion. +In +our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of Odetics, Inc. at +March 31, 2002 and 2003, and the consolidated results of its operations and its cash flows for each of the three years in the period ended March 31, 2003, in conformity with accounting +principles generally accepted in the United States. Also, in our opinion, the related financial statement schedule, when considered in relation to the basic financial statements taken as a whole, +presents fairly in all material respects the information set forth therein. +The +accompanying consolidated financial statements have been prepared assuming the Company will continue as a going concern. As discussed in Note 1 to the consolidated financial +statements, the Company's recurring losses from operations raise substantial doubt about its ability to continue as a +going concern. Management's plans as to these matters are also described in Note 1. The consolidated financial statements do not include any adjustments that might result from the outcome of +this uncertainty. +/s/Ernst & +Young LLP +Orange +County, California +June 3, 2003 +F-2 +Odetics, Inc. +Consolidated Balance Sheets +(In thousands, except share and per share amounts) +March 31, +2002 +2003 +Assets +Current assets: +Cash and cash equivalents +$ +408 +$ +437 +Trade accounts receivable, net of allowance for doubtful accounts of $115 in 2002 and $156 in 2003 +8,617 +8,549 +Costs and estimated earnings in excess of billings on uncompleted contracts +3,565 +2,398 +Inventories: +Finished goods +155 +211 +Work in process +25 +419 +Materials and supplies +3,528 +3,634 +Prepaid expenses and other +1,621 +435 +Assets of discontinued operations +8,525 +4,392 +Total current assets +26,444 +20,475 +Restricted cash +— +2,516 +Property, plant and equipment: +Land +2,060 +— +Buildings and improvements +19,005 +43 +Equipment +7,322 +7,256 +Allowances for depreciation +(12,390 +) +(5,336 +) +15,997 +1,963 +Goodwill +9,769 +9,807 +Other assets +28 +81 +Total assets +$ +52,238 +$ +34,842 +Liabilities and stockholders' equity (deficit) +Current liabilities: +Trade accounts payable +$ +4,646 +$ +5,862 +Accrued payroll and related +4,696 +5,731 +Accrued expenses +1,761 +858 +Billings in excess of costs and estimated earnings on uncompleted contracts +2,236 +304 +Advances under receivables purchase agreement with related party +— +235 +Liabilities of discontinued operations +4,585 +4,139 +Current portion of long-term debt +16,124 +— +Total current liabilities +34,048 +17,129 +Revolving line of credit +767 +— +Revolving line of credit with related party +1,250 +1,250 +Deferred gain on sale of building +— +6,025 +Other liabilities +25 +15 +Minority interest +10,893 +14,711 +Commitments and contingencies +Stockholders' equity (deficit): +Preferred stock: +Authorized shares—2,000,000 +Issued and outstanding—none +— +— +Common stock, $.10 par value: +Authorized shares—50,000,000 of Class A and 2,600,000 of Class B +Issued and outstanding shares—11,490,530 of Class A and 1,035,841 of Class B at March 31, 2002; 14,080,914 of Class A and 1,035,841 of Class B at March 31, 2003 +1,252 +1,512 +Paid-in capital +89,134 +92,819 +Treasury stock, 93 and 93 shares in 2002 and 2003, respectively +(1 +) +(1 +) +Notes receivable from employees +(51 +) +(51 +) +Accumulated other comprehensive income +241 +(99 +) +Accumulated deficit +(85,320 +) +(98,468 +) +Total stockholders' equity (deficit) +5,255 +(4,288 +) +Total liabilities and stockholders' equity (deficit) +$ +52,238 +$ +34,842 +See +accompanying notes. +F-3 +Odetics, Inc. +Consolidated Statements of Operations +(In thousands, except per share information) +Year ended March 31, +2001 +2002 +2003 +Net sales and contract revenues: +Net sales +$ +42,363 +$ +29,343 +$ +22,541 +Contract revenues +20,039 +22,846 +25,086 +62,402 +52,189 +47,627 +Costs and expenses: +Cost of sales +31,028 +16,769 +11,424 +Cost of contract revenues +13,781 +13,132 +16,034 +Selling, general and administrative expenses +25,219 +18,491 +16,157 +Research and development expenses +7,549 +4,385 +4,215 +Restructuring charges +757 +2,189 +— +78,334 +54,966 +47,830 +Loss from operations +(15,932 +) +(2,777 +) +(203 +) +Non-operating income (expense) +Royalty income +17,825 +— +— +Other income, net +1,340 +2,919 +388 +Interest expense, net +(1,762 +) +(4,190 +) +(761 +) +Income (loss) before income tax +1,471 +(4,048 +) +(576 +) +Income tax benefit +— +785 +— +Income (loss) from continuing operations before minority interest +1,471 +(3,263 +) +(576 +) +Minority interest in earnings of subsidiary +— +(1,910 +) +(3,818 +) +Income (loss) from continuing operations +1,471 +(5,173 +) +(4,394 +) +Loss from discontinued operations, net of taxes of $0 +(34,011 +) +(20,965 +) +(8,754 +) +Extraordinary loss from early extinguishment of debt, net of tax of $0 +— +(450 +) +— +Net loss +$ +(32,540 +) +$ +(26,588 +) +$ +(13,148 +) +Basic earnings (loss) per share: +Continuing operations +$ +0.15 +$ +(0.46 +) +$ +(0.31 +) +Discontinued operations +(3.41 +) +(1.86 +) +(0.61 +) +Extraordinary loss +— +(0.04 +) +— +Basic loss per share +$ +(3.26 +) +$ +(2.36 +) +$ +(0.92 +) +Diluted earnings (loss) per share: +Continuing operations +$ +0.14 +$ +(0.46 +) +$ +(0.31 +) +Discontinued operations +(3.33 +) +(1.86 +) +(0.61 +) +Extraordinary loss +— +(0.04 +) +— +Diluted loss per share +$ +(3.19 +) +$ +(2.36 +) +$ +(0.92 +) +Shares used in computing basic earnings (loss) per share +9,977 +11,267 +14,276 +Shares used in computing diluted earnings (loss) per share +10,209 +11,267 +14,276 +See +accompanying notes. +F-4 +Odetics, Inc. +Consolidated Statements of Stockholders' Equity +(In thousands) +Common stock +Shares outstanding +Notes +receivable +from +employees +Accumulative +other +comprehensive +income +Class A +common +stock +Class B +common +stock +Amount +Paid-in +capital +Treasury +stock +Accumulated +deficit +Total +Comprehensive +income +Balance at March 31, 2000 +8,183 +1,052 +$ +923 +$ +61,200 +$ +(22 +) +$ +(61 +) +$ +262 +$ +(26,192 +) +$ +36,110 +$ +— +Issuances of Odetics common stock +1,270 +— +127 +17,348 +21 +— +— +— +17,496 +— +Conversion of Class B common stock +16 +(16 +) +— +— +— +— +— +— +— +— +Payments on notes receivable +— +— +— +— +— +10 +— +— +10 +— +Foreign currency translation adjustments +— +— +— +— +— +— +(698 +) +— +(698 +) +(698 +) +Net loss +— +— +— +— +— +— +— +(32,540 +) +(32,540 +) +(32,540 +) +Balance at March 31, 2001 +9,469 +1,036 +1,050 +78,548 +(1 +) +(51 +) +(436 +) +(58,732 +) +20,378 +(33,238 +) +Issuances of Odetics common stock +2,022 +— +202 +3,716 +— +— +3,918 +— +Issuance of Iteris common stock +— +— +— +5,513 +— +— +— +— +5,513 +Issuance of warrants +— +— +— +1,357 +— +— +1,357 +— +Foreign currency translation adjustments +— +— +— +— +— +— +677 +— +677 +677 +Net loss +— +— +— +— +— +— +— +(26,588 +) +(26,588 +) +(26,588 +) +Balance at March 31, 2002 +11,491 +1,036 +1,252 +89,134 +(1 +) +(51 +) +241 +(85,320 +) +5,255 +(25,911 +) +Issuances of Odetics common stock +2,590 +— +260 +2,814 +— +— +— +— +3,074 +— +Issuance of Iteris common stock +— +— +— +871 +— +— +— +— +871 +Foreign currency translation adjustments +— +— +— +— +— +— +(340 +) +— +(340 +) +(340 +) +Net loss +— +— +— +— +— +— +— +(13,148 +) +(13,148 +) +(13,148 +) +Balance at March 31, 2003 +14,081 +1,036 +$ +1,512 +$ +92,819 +$ +(1 +) +$ +(51 +) +$ +(99 +) +$ +(98,468 +) +$ +(4,288 +) +$ +(13,488 +) +See +accompanying notes. +F-5 +Odetics, Inc. +Consolidated Statements of Cash Flows +(In thousands) +Year ended March 31, +2001 +2002 +2003 +Operating activities +Net loss +$ +(32,540 +) +$ +(26,588 +) +$ +(13,148 +) +Adjustments to reconcile net loss to net cash used in operating activities: +Depreciation and amortization +4,967 +3,776 +816 +Amortization of warrants +— +1,230 +246 +Amortization of deferred gain on sale-leaseback +— +— +(1,665 +) +Write-off of discontinued subsidiaries +— +8,361 +4,909 +Minority interest in earnings of subsidiary +— +1,910 +3,818 +Loss on sale of Iteris common stock +— +1,597 +310 +Loss on disposal of assets +— +48 +2 +Write-off of capitalized software +4,014 +— +— +Gain on sale of product lines +(1,230 +) +(3,385 +) +— +Provision for losses on accounts receivable +78 +102 +— +Changes in operating assets and liabilities (Note 15) +4,621 +(5,284 +) +(77 +) +Net cash provided by (used in) operating activities +(20,090 +) +(18,233 +) +(4,789 +) +Investing activities +Purchases of property, plant and equipment, net +(2,502 +) +(426 +) +(518 +) +Repurchase of real estate option +(5,000 +) +— +— +Proceeds from sale of product lines +1,877 +9,884 +— +Proceeds from sale of building +— +— +18,951 +Purchase of net assets of acquired business +(42 +) +(200 +) +— +Other +(688 +) +677 +(340 +) +Net cash provided by (used in) investing activities +(6,355 +) +9,935 +18,093 +Financing activities +Proceeds from line of credit and long-term borrowings +26,644 +28,720 +— +Principal payments on line of credit and long-term debt +(19,857 +) +(30,929 +) +(16,912 +) +Proceeds from sale of Iteris common and preferred stock +— +8,697 +871 +Proceeds from issuance of common stock +16,996 +— +2,766 +Net cash provided by (used in) financing activities +23,783 +6,488 +(13,275 +) +Increase (decrease) in cash +(2,662 +) +(1,810 +) +29 +Cash and cash equivalents at beginning of year +4,880 +2,218 +408 +Cash and cash equivalents at end of year +$ +2,218 +$ +408 +$ +437 +See +accompanying notes. +F-6 +Odetics, Inc. and Subsidiary +Notes to Consolidated Financial Statements +March 31, 2003 +1. Formation and Operations +Odetics, Inc. (the Company) provides products, systems and services that control and manage the use of public roadways and services access and safety of +public and private facilities. Odetics currently operates through its wholly-owned subsidiaries, MAXxess Systems, Inc., formally known as Gyyr Incorporated (MAXxess), and its majority-owned +subsidiary, Iteris, Inc. (Iteris). +During +fiscal 2002 and fiscal 2003, the Company incurred net losses of $26.6 million and $13.1 million, respectively. The Company financed its operations in fiscal 2002 and +fiscal 2003 largely through cash received from debt and equity financings, the sale of assets and the divestiture of certain of its subsidiaries. +On +May 28, 2002, the Company completed the sale and leaseback of its Anaheim, California facility for an aggregate sale price of $22.6 million. Under the terms of the sale +and leaseback agreement, the Company will continue to lease one of the two buildings located on the property for an initial ten-year period at a rate of $152,150 per month and the other +building for a period of 30 months at a rate of approximately $57,553 per month. Approximately $16.4 million of the proceeds from the sale was used to repay the outstanding indebtedness +and accrued interest under a promissory note that was secured by a first deed of trust on the Anaheim facility (Note 6), and $2.5 million is being held in escrow as a security deposit on +future lease payments. The balance of the proceeds was available for general working capital purposes. The gain on the sale of the facility was approximately $8.2 million, of which $640,000 was +recognized immediately, and the remainder was deferred and is being amortized against rent expenses over the term of the leases. +On +August 16, 2002, the Company completed a private placement of 2,500,000 of our Class A common stock to an institutional investor for $3.0 million in cash. The +transaction, net of expenses, raised net proceeds of approximately $2.7 million. In connection with this offering, the Company also issued warrants to the investor to purchase up to another +1,250,000 shares at an exercise price of $1.50 per share, and up to 1,250,000 shares at an exercise price of $1.80 per share. The warrants are exercisable at any time by the investor, and are callable +by us if the market price of the Company's Class A common stock trades for 20 consecutive days at a price equal or greater than two times the exercise price of the warrants. If all of the +warrants are exercised, the total gross proceeds from this transaction are expected to be $7.2 million. The proceeds from the transaction were used to fund general working capital requirements. +On +May 9, 2003, the Company completed the sale of substantially all of the assets of its Zyfer subsidiary for $2.3 million in cash plus the assumption of certain +liabilities. The asset purchase agreement provides for future incentive payments of up to $1 million in each of the twelve month periods ended April 30, 2004 and 2005, based on the +achievement of certain revenue goals related to the sale of Zyfer products or the licensing of its technologies. +The +Company expects that its operations will continue to use net cash at least through the end of calendar 2003. The Company also expects to have an ongoing need to raise cash by +securing additional debt or equity financing, or by divesting certain assets to fund its operations until the Company returns to profitability and positive operating cash flows. The Company believes +that its future ability to obtain additional funding will be dependent upon its ability to narrow our operating losses and provide a favorable expectation of future operating profitability. The +Company believes its ability to raise additional capital may also be adversely affected if Nasdaq determines to delist the Company's Class A common stock from the Nasdaq SmallCap Market. The +steps undertaken in fiscal 2002 and fiscal 2003 +F-7 +were +intended to lower its operating costs, widen its gross profits, and generally provide more opportunity to return to profitability. Furthermore, the Company believes that a focused business model +provides a more compelling opportunity for appreciation in stockholder value. Notwithstanding the recent refinements to our business model and its more defined focus, the Company cannot be certain +that it will be able to secure additional debt or equity financing on acceptable terms, on a timely basis, or at all. +The +Company's future cash requirements will be highly dependent upon its ability to control expenses, as well as the successful execution of the revenue plans by both Iteris and MAXxess. +A critical element of controlling expenses relates to the restructuring of the Company's facilities lease arrangements. Management is currently in negotiations with the Company's landlords to +restructure its leases for its principal facilities in order to reduce the Company's overall operating expenses to a level commensurate with its existing operations. The outcome of these negotiations +cannot be assured and, as a result, any projections of future cash requirements and cash flows are subject to substantial uncertainty. +These +conditions, together with the Company's recurring losses, raise substantial doubt about its ability to continue as a going concern. The accompanying consolidated financial +statements do not include any adjustments to reflect the possible future effects on the recoverability and classification of assets or liabilities that may result from the outcome of this uncertainty. +Principles of Consolidation +The accompanying consolidated financial statements include the accounts of the Company and its subsidiaries. All significant intercompany accounts and +transactions have been eliminated in consolidation. +Use of Estimates +The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that +affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from those estimates. Significant estimates made in preparing the consolidated financial +statements include the allowances for doubtful accounts deferred tax assets, inventory reserves, certain accrued liabilities, costs to complete long-term contracts and estimates of future +cash flows used to determine the recoverability of long lived assets. +Revenue Recognition +Product revenues and related cost of sales are recognized upon the transfer of title, which generally occurs upon shipment or, if required, upon acceptance by the +customer, provided that the Company believes collectibility of the net sales amount is probable. Accordingly, at the date revenue is recognized, the significant uncertainties concerning the sale have +been resolved. +Contract +revenues are derived primarily from long-term contracts with governmental agencies. Contract revenue includes costs incurred plus a portion of estimated fees or +profits determined on the percentage of completion method of accounting based on the relationship of costs incurred to total estimated costs. Any anticipated losses on contracts are charged to +earnings when identified. Changes in job performance and estimated profitability, including those arising from contract penalty provisions +F-8 +and +final contract settlements may result in revisions to cost and revenue and are recognized in the period in which the revisions are determined. Profit incentives are included in revenue when their +realization is reasonably assured. +Revenues +from follow-on service and support, for which the Company charges separately, is recorded in the period in which the services are performed. +Cash and Cash Equivalents +Cash and cash equivalents consist of cash and short-term investments with initial maturities of less than ninety days. +Concentration of Credit Risk +The Company maintains reserves for potential credit losses, estimating the collectibility of customer receivables on an ongoing basis by periodically reviewing +invoices outstanding over a certain period of time. The Company has recorded reserves for receivables deemed to be at risk for collection, as well as a general reserve based on historical collections +experience. A considerable amount of judgment is required in assessing the ultimate realization of these receivables, including the current credit-worthiness of each customer. Such losses have been +minimal and within management's estimates. Receivables from customers are generally unsecured. At March 31, 2002 and 2003, accounts receivable from governmental agencies and prime government +contractors were approximately $3,575,000 and $3,362,000, respectively. +Fair Values of Financial Instruments +Fair values of cash and cash equivalents approximate the carrying value because of the short period of time to maturity. The fair value of line of credit +agreements approximate carrying value because the related rates of interest approximate current market rates. +Inventories +Inventories are stated at the lower of cost or market. Cost is determined on the first-in, first-out method. +Property, Plant and Equipment +Property, plant and equipment are recorded at cost. Equipment is depreciated principally by the declining balance method over their estimated useful lives ranging +from four to eight years. Depreciation expense from continuing operations for the years ended March 31, 2001, 2002 and 2003 was $1.1 million, $1.1 million and $0.8 million, +respectively. +Long-Lived Assets +Long-lived assets held and used by the Company are reviewed for impairment whenever events or changes in circumstances indicate that the carrying +amount of an asset may not be recoverable. The Company believes no impairment of the carrying value of its long-lived assets existed at March 31, 2003. The Company's analysis was +based on an estimate of future undiscounted cash flows using forecasts contained in the Company strategic plan. It is at least reasonably possible that the Company's estimate of future undiscounted +cash flows may change during fiscal 2004. If the Company's estimate of +F-9 +future +undiscounted cash flow should change or if the strategic plan is not achieved, future analyses may indicate insufficient future undiscounted cash flows to recover the carrying value of the +Company's long-lived assets, in which case such assets would be written down to estimated fair value. +Goodwill +Goodwill, representing the excess of the purchase price over the fair value of the net assets of acquired entities. At March 31, 2003, all goodwill is +attributable to the Company's Intelligent Transportation segment. +On +April 1, 2002, the Company adopted Financial Accounting Standards Board (FASB) Statement No. 142, Goodwill and Other Intangible +Assets (Statement 142). Under Statement 142, goodwill is no longer amortized but is subject to impairment tests based upon a comparison of the fair value of each of the +Company's reporting units, as defined, and the carrying value of the reporting units' net assets, including goodwill. Pursuant to Statement 142, upon adoption the Company tested its goodwill for +impairment and, based upon recent sales of equity securities, determined that no impairment existed. Statement 142 requires a review for impairment at least annually or when circumstances exist that +would indicate an impairment of such goodwill. The Company performs the annual impairment review as of January 1 of each year. The 2003 annual review resulted in no impairment of the carrying +value of goodwill. Adjusted net income and the related earnings per share impact of the adoption of Statement 142 is as follows: +Year ended March 31, +2001 +2002 +2003 +Reported income (loss) from continuing operations +$ +1,471 +$ +(5,173 +) +$ +(4,394 +) +Add back goodwill amortization +1,924 +1,516 +— +Adjusted net income (loss) from continuing operations +3,395 +(3,657 +) +(4,394 +) +Loss from discontinued operations, net of income taxes +(34,011 +) +(20,965 +) +(8,754 +) +Extraordinary loss on early extinguishment of debt +— +(450 +) +— +Adjusted net income (loss) +$ +(30,616 +) +$ +(25,072 +) +$ +(13,148 +) +Basic earnings (loss) per share: +Reported income (loss) from continuing operations +$ +0.15 +$ +(0.46 +) +$ +(0.31 +) +Add back goodwill amortization +0.19 +0.13 +— +Adjusted net income (loss) from continuing operations +0.34 +(0.33 +) +(0.31 +) +Loss from discontinued operations, net of income taxes +(3.41 +) +(1.86 +) +(0.61 +) +Extraordinary loss on early extinguishment of debt +— +(0.04 +) +— +Adjusted net income (loss) +$ +(3.07 +) +$ +(2.23 +) +$ +(0.92 +) +Diluted earnings (loss) per share: +Reported income (loss) from continuing operations +$ +0.14 +$ +(0.46 +) +$ +(0.31 +) +Add back goodwill amortization +0.19 +0.13 +— +Adjusted net income (loss) from continuing operations +0.33 +(0.33 +) +(0.31 +) +Loss from discontinued operations, net of income taxes +(3.33 +) +(1.86 +) +(0.61 +) +Extraordinary loss on early extinguishment of debt +— +(0.04 +) +— +Adjusted net income (loss) +$ +(3.00 +) +$ +(2.23 +) +$ +(0.92 +) +F-10 +Research and Development Expenditures +Research and development expenditures are charged to expense in the period incurred. +Warranty +Unless otherwise stated, the Company provides a one-year warranty from the original invoice date on all product material and workmanship. Products +sold to certain original equipment manufacturer customers sometimes carry longer warranties. Defective products will be either repaired or replaced, generally at the Company's option, upon meeting +certain criteria. The Company accrues a provision for the estimated costs that may be incurred for product warranties relating to a product as a component of cost of sales at the time revenue for that +product is recognized. +The +activity in accrued warranty obligations is as follows: +March 31, +2001 +2002 +2003 +(in thousands) +Balance at beginning of year +$ +321 +$ +209 +$ +274 +Additions charged to cost of sales +95 +153 +323 +Warranty claims +(207 +) +(88 +) +(316 +) +Balance at end of year +$ +209 +$ +274 +$ +281 +Foreign Currency Translation +The balance sheet accounts of the Company's foreign based subsidiaries are translated at the current year-end exchange rate and income statement items +are translated at the average exchange rate for the year. Resulting translation adjustments are made directly to a separate component of stockholders' equity. Gains and losses resulting from +transactions of the Company and its subsidiaries which are made in currencies different from their own are immaterial and are included in income as they occur. +Comprehensive Income +The only component of accumulated other comprehensive income is the cumulative foreign currency translation adjustment recorded in stockholders' equity. +Income Taxes +Deferred income tax assets and liabilities are computed for differences between financial statement and tax basis of assets and liabilities based on enacted tax +laws and rates applicable to the period in which differences are expected to affect taxable income. Valuation allowances are established when necessary to reduce deferred tax assets to amounts which +are more likely than not to be realized. The provision for income taxes is the taxes payable or refundable for the period plus or minus the change during the period in deferred income tax assets and +liabilities. +F-11 +Earnings (Loss) Per Share +The following table sets forth the computation of basic and diluted loss per share: +Year ended March 31, +2001 +2002 +2003 +Numerator: +Net loss +$ +(32,540 +) +$ +(26,588 +) +$ +(13,148 +) +Denominator: +Denominator for basic loss per share—weighted-average shares +9,977 +11,267 +14,276 +Effect of dilutive securities: +Employee stock options +232 +— +— +Denominator for diluted loss per share +10,209 +11,267 +14,276 +Basic loss per share +$ +(3.26 +) +$ +(2.36 +) +$ +(0.92 +) +Diluted loss per share +$ +(3.19 +) +$ +(2.36 +) +$ +(0.92 +) +Stock-Based Compensation +The Company accounts for stock-based employee compensation arrangements in accordance with Accounting Principles Board Opinion No. 25, Accounting for +Stock-Issued to Employees (APB No. 25) and related interpretations, and complies with the disclosure provisions of FASB Statement +No. 123, Accounting for Stock-Based Compensation (Statement 123). Under APB No. 25, compensation cost is recognized based on the +difference, if any, on the date of the grant between the fair value of the Company's stock and the amount the employee must pay to acquire the stock. +In +December 2002, the FASB issued Statement No. 148, Accounting for Stock-Based Compensation—Transition and +Disclosure , (Statement 148) providing alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee +compensation. In addition, Statement 148 amends the disclosure requirements to require prominent disclosures in both annual and interim financial statements about the method of accounting for +stock-based employee compensation and the effect of the method used on reported results. The Company does not currently plan to change its stock-based employee compensation accounting to the fair +value method. The accompanying financial statements reflect all of the disclosures required by Statement 148. +In +calculating pro forma information regarding net income and earning per share, as required by Statement No. 123, the fair value was estimated at the date of grant using a +Black-Scholes option pricing model with the following assumption: +Years ended March 31, +2001 +2002 +2003 +Dividend rate +0.0 +0.0 +0.0 +Expected life—years +7.0 +7.0 +7.0 +Risk-free interest rate +6.0 +4.5 +2.0 +Volatility of common stock +0.4 +0.4 +0.4 +F-12 +For +purposes of pro forma disclosures, the estimated fair value of the options is amortized to expense over the options' vesting period. The Company's pro forma information for the year +ended March 31, 2001, 2002 and 2003 follows (in thousands, except per share data): +Year ended March 31, +2001 +2002 +2003 +(In thousands except per share amounts) +Net loss—reported +$ +(32,540 +) +$ +(26,588 +) +$ +(13,148 +) +Employee compensation expense under fair value method +(972 +) +(201 +) +(637 +) +Net loss—pro forma +$ +(33,512 +) +$ +(26,789 +) +$ +(13,785 +) +Basic loss per share—reported +$ +(3.26 +) +$ +(2.36 +) +$ +(0.92 +) +Basic loss per share—pro forma +$ +(3.36 +) +$ +(2.38 +) +$ +(0.97 +) +Diluted loss per share—reported +$ +(3.19 +) +$ +(2.36 +) +$ +(0.92 +) +Diluted loss per share—pro forma +$ +(3.28 +) +$ +(2.38 +) +$ +(0.97 +) +Advertising Expenses +The Company expenses advertising costs as incurred. Advertising expense totaled $1,211,000, $420,000 and $544,000 in the years ended March 31, 2001, 2002 +and 2003, respectively. +Discontinued Operations +In August 2001, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards No. 144, Accounting for the Impairment or +Disposal of Long-Lived Assets (SFAS 144). The Statement supersedes FASB Statement No. 121, Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed +Of , however, it retains the +fundamental provisions of that statement related to the recognition and measurement of the impairment of long-lived assets to be "held and used." SFAS 144 also supersedes the +accounting and reporting provisions of Accounting Principles Board Opinion No. 30, Reporting the Results of Operation's—Reporting the Effects of Disposal of +a Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring Events and Transactions (APB 30), for the disposal of a segment of a business. Under +SFAS 144, a component of a business that is held for sale is reported in discontinued operations if (i) the operations and cash flows will be, or have been, eliminated from the ongoing +operations of the company and, (ii) the company will not have any significant continuing involvement in such operations. In the quarter ended September 30, 2001, the Company adopted the +provisions of SFAS 144 effective April 1, 2001. +In +September 2001, the Company's Board of Directors approved a plan to discontinue the operations of Mariner which was part of the Company's telecom products segment. The +aggregate losses recognized to write down the assets of Mariner to their fair value less cost to sell were approximately $6.7 million. In addition, the Company accrued $1.7 million for +severance and other direct costs to exit the operation. +In +March 2003, the Company decided to divest of its Zyfer, Inc. subsidiary (Zyfer). On May 9, 2003, the Company completed the sale of substantially all of the net +assets of Zyfer, with a net book +F-13 +value +of approximately $2.3 million, for $2.3 million. The Company may also receive incentive payments of up to $2 million should Zyfer meet certain revenue targets in the twelve +month periods ended April 30, 2004 and 2005. The initial purchase price is subject to adjustment within 45 days of the closing in the event that the assets purchased less the liabilities +assumed by the buyer is less than $2.2 million. In connection with the Zyfer sale, the Company accrued $1.1 million for certain future lease obligations of Zyfer that were not +transferred to the buyer. +In +March 2003, the Company ceased the development and sale of products in its Broadcast, Inc. subsidiary (Broadcast) and reduced the headcount in Broadcast to only support +the existing customer contracts for service and support through their expiration dates. The aggregate losses recognized to write down the assets of Broadcast to their fair value less cost to sell were +approximately $3.4 million. In addition, the Company accrued $0.4 million for employees severed in March 2003 and other direct costs to wind down the operation. +The +asset write-downs and accrued costs are included in the loss from discontinued operations in the year ending March 31, 2003. The results of operations of Mariner, Zyfer and +Broadcast for all periods presented have been reclassified and presented as discontinued operations in the accompanying consolidated statement of operations. Interest expense was not reclassified to +discontinued operations because the discontinuances did not eliminate any of the Company's debt. +The +net sales and loss from discontinued operations are as follows: +Year ended March 31, +2001 +2002 +2003 +Net sales: +Zyfer +$ +4,464 +$ +4,475 +$ +6,487 +Broadcast +9,292 +2,824 +3,599 +Mariner +910 +533 +— +Total net sales +$ +14,666 +$ +7,832 +$ +10,086 +Loss from discontinued operations: +Zyfer +$ +(5,284 +) +$ +(5,100 +) +$ +(1,718 +) +Broadcast +(16,822 +) +(2,941 +) +(2,468 +) +Mariner +(11,905 +) +(4,563 +) +— +Total loss from discontinued operations +(34,011 +) +(12,604 +) +(4,186 +) +Loss recognized upon discontinuance of operations +— +(8,361 +) +(4,909 +) +Gain on sale of assets of discontinued operations +— +— +341 +$ +(34,011 +) +$ +(20,965 +) +$ +(8,754 +) +F-14 +The +assets and liabilities of the discontinued operations consisted of the following: +March 31, +2002 +2003 +Accounts receivable +$ +1,684 +$ +1,632 +Inventories +4,704 +1,892 +Prepaid expenses & other assets +211 +125 +Property, plant and equipment, net +1,926 +743 +Total assets of discontinued operations +$ +8,525 +$ +4,392 +Accounts payable +$ +3,223 +$ +2,250 +Accrued expenses +1,362 +1,889 +Total liabilities of discontinued operations +$ +4,585 +$ +4,139 +Recent Accounting Pronouncements +In 2003, the Company adopted Statement of Financial Accounting Standards No. 141, Business Combinations +(SFAS 141). SFAS 141 requires that the purchase method of accounting be used for all business combinations initiated after June 30, 2001. SFAS 141 also includes guidance on +the initial recognition and measurement of goodwill and other intangible assets arising from business combinations completed after June 30, 2001. Application of this statement did not have a +significant effect on the Company's consolidated results of operations or financial position. +In +July 2002, the FASB issued Statement No. 146, Accounting for Costs Associated with Exit or Disposal Activities (Statement +146). Statement 146 addresses financial accounting and reporting for costs associated with exit or disposal activities and nullifies EITF Issue No. 94-3, Liability +Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring) (EITF 94-3). +Statement 146 requires that a liability for a cost associated with an exit or disposal activity be recognized when the liability is incurred. The Company adopted Statement 146 on January 1, +2003. +In +November 2002, the FASB issued Interpretation No. 45, Guarantor's Accounting and Disclosure Requirements for Guarantees, Including Indirect +Guarantees of Indebtedness of Others (FIN 45), effective prospectively for guarantees issued or modified after December 31, 2002. The disclosure requirements of FIN 45 +are effective for periods ending after December 15, 2002. Under FIN 45, a guarantor is required to recognize, at the inception of certain guarantees, a fair value liability for the obligations +it has undertaken in issuing the guarantee, including its ongoing obligation to stand ready to perform over the term of the guarantee in the event that the specified triggering events or conditions +occur. All guarantees subject to the disclosure provisions of FIN 45, such as product warranties, have been disclosed in the accompanying notes to the consolidated financial statements. The Company +does not have any other outstanding guarantees at March 31, 2003 required to be disclosed or recorded as obligations upon adoption of FIN 45. +In +January 2003, the FASB issued Interpretation No. 46, Consolidation of Variable Interest Entities (FIN 46). This +Interpretation changes the method of determining whether certain entities should be included in the Company's Consolidated Financial Statements. An entity is subject to FIN 46 and is called a variable +interest entity (VIE) if it has (1) equity that is insufficient to permit the entity to +F-15 +finance +its activities without additional subordinated financial support from other parties, or (2) equity investors that cannot make significant decisions about the entity's operations, or +that do not absorb the expected losses or receive the expected returns of the entity. All other entities are evaluated for consolidation under SFAS No. 94, Consolidation +of All Majority-Owned Subsidiaries . The provisions of FIN 46 are to be applied immediately to VIEs created after January 31, 2003, and to VIEs in which an enterprise +obtains an interest after that date. For VIEs in which an enterprise holds a variable interest that it acquired before February 1, 2003, FIN 46 applies in the first fiscal period beginning +after June 15, 2003. The Company has not yet determined the impact, if any, that the adoption of FIN 46 will have on the Company's financial position, results of operations or cash flows. +Reclassifications +Certain amounts in the fiscal 2001 and fiscal 2002 consolidated financial statements have been reclassified to conform with the 2003 presentation. +3. Acquisitions and Dispositions +In October 1998, the Company, through Iteris, acquired Meyer, Mohaddes Associates, Inc., a provider of transportation, engineering and planning +services (MMA). Pursuant to the terms of the merger agreement, the Company purchased all of the issued and outstanding shares of stock of MMA for $4.3 million, by issuing 55,245 shares of the +Company's Class A common stock valued at $250,000 and 810,153 shares of Iteris, Inc.'s common stock. +The +merger agreement provided for MMA shareholders to receive additional shares of the Company's Class A common stock with a then market value of $250,000 at each of +April 16, 1999, October 16, 1999, April 16, 2000, October 16, 2000 and April 16, 2001 in the event the Company did not consummate an initial public offering of the +common stock of Iteris, Inc. by each and any of those dates. Pursuant to this provision, Odetics issued an additional 219,706 shares of its Class A common stock to the MMA shareholders, +which was recorded by the Company as additional goodwill. In addition, as a result of Iteris' failure to complete an initial public offering by October 2001, the MMA shareholder exercised their +rights under the agreement and required Odetics to exchange 1,107,301 shares of Odetics' Class A common stock for 155,149 shares of Iteris common stock. This transaction resulted in additional +goodwill of $2.5 million. +During +fiscal 2001, the Company sold certain assets of its sold state recording product line of its Zyfer subsidiary for cash proceeds of $1.9 million. In connection with these +sales the Company recorded gains aggregating $1.2 million. +In +April 2001, the Company sold its Vortex Dome and Quarterback Controller product lines for approximately $1.1 million in net cash proceeds. In connection with this +transaction, the Company realized a gain of $0.1 million. +In +September 2001, the Company sold substantially all of the assets of its Gyyr CCTV Products line for $8.8 million in cash, plus the assumption of $1.0 million in +debt. In connection with this transaction, the Company wrote-off goodwill with a net book value of $2.3 million and, net of this write-off, realized a gain of +$4.3 million. +F-16 +4. Restructuring Charges +During fiscal 2001 and 2002, the Company approved a number of actions to reduce operating expenses and improve profitability and cash flows. These actions +included a reduction in workforce of 222 and +130 employees in 2001 and 2002 respectively. As a result of these actions, the Company recorded the following as restructuring charges (in thousands): +Severance and related +costs +2001 restructuring charge +$ +757 +Cash expenditures +(757 +) +Balance at March 31, 2001 +— +2002 restructuring charge +2,189 +Cash expenditures +(858 +) +Balance at March 31, 2002 +1,331 +Cash expenditures +(911 +) +Balance at March 31, 2003 +$ +420 +F-17 +5. Costs and Estimated Earnings on Uncompleted Contracts +Costs incurred, estimated earnings and billings on uncompleted long-term contracts are as follows: +March 31, +2002 +2003 +(In thousands) +Costs incurred on uncompleted contracts +$ +17,998 +$ +15,645 +Estimated earnings +1,355 +1,173 +19,353 +16,818 +Less billings to date +18,024 +14,724 +$ +1,329 +$ +2,094 +Included in accompanying balance sheets: +Costs and estimated earnings in excess of billings on uncompleted contracts +$ +3,565 +$ +2,398 +Billings in excess of costs and estimated earnings on uncompleted contracts +2,236 +(304 +) +$ +1,329 +$ +2,094 +Costs +and estimated earnings in excess of billings at March 31, 2002 and 2003 include $136,114 and $244,172 respectively, that were not billable as certain milestone objectives +specified in the contracts had not been attained. Substantially all costs and estimated earnings in excess of billings at March 31, 2002 are expected to be billed and collected during the year +ending March 31, 2003. +6. Revolving Lines of Credit and Long-Term Debt +In February 2002, the Company entered into a $1.25 million line of credit with a partnership controlled by the Company's Chairman of the Board. The +line of credit is collateralized by substantially all of the Company's assets other than real property. Borrowings on the line of credit bear interest at the prime rate plus 4% (8.25% at +March 31, 2003) and matures in April 2004. +Borrowings +on the line of credit totaled $1.25 million at March 31, 2002 and 2003. Interest expense under the line of credit totaled $8,000 and $110,000 in the years ended +March 31, 2002 and 2003. +In +October 2002, the Company entered into a receivables purchase agreement with a partnership controlled by the Company's Chairman of the Board to sell certain receivables. Under +certain conditions of the agreement the Company may be required to buy back any uncollected receivables. The total amount transferred under the agreement was $1.2 million with +$0.4 million uncollected as of March 31, 2003. The total fees and interest expense under the agreement was $0.1 million during the year ended March 31, 2003. +In +August 2001, the Company through Iteris, entered into a loan and security agreement with a maximum available credit line of $5.0 million. At March 31, 2002, there +were no outstanding borrowings under this line of credit and amounts available for future borrowing totalled $4.1 million. Under the terms of the agreement, the Company may borrow against its +eligible accounts receivable and the value of its eligible inventory, as defined. Interest on borrowed amounts is payable monthly at the prime rate plus 2% (6.25% at March 31, 2003). +Additionally, Iteris is obligated to pay an unused line fee of 0.5% per annum applied to the amount by which the maximum credit amount exceeds the average daily principal balance during the preceding +month, and a monthly collateral management fee of $2,000. The agreement is secured by substantially all of Iteris' assets and expires in August 2004. Either party can terminate the agreement +with thirty days written notice. Should Iteris elect to +F-18 +terminate +the agreement, a one-time termination fee of 3%, 2% and 1% of the maximum credit limit would apply in years 1 through 3, respectively. +In +January 2000, the Company through Iteris, entered into a joint venture agreement, pursuant to which Iteris obtained a Subordinated Convertible Promissory Note in the amount of +$3.75 million. In July 2001, the note holder converted the note and related accrued interest into common and preferred stock of Iteris (Note 11). +In +May 2001, the Company entered into a $16 million promissory note secured by a first trust deed on its principal facilities in Anaheim, California, which bore interest at +10% per annum. The promissory note was paid in full at its scheduled maturity date in May 2002 (Note 1). In connection with the note the Company issued warrants to the lender to purchase +426,667 shares of Class A common stock at an exercise price of $4.00 per share. The Company repriced the warrants to $3.00 per share, in connection with a forbearance agreement negotiated in +November 2001. The issuance of the warrant represented a discount on the note totaling $1,357,000, which was amortized over the life of the note. +Approximately +$6.0 million of the proceeds of the promissory note was used to retire the pre-existing note payable on the Anaheim facility, which included a prepayment +penalty of $450,000. This prepayment penalty is reflected as an extraordinary item in the accompanying consolidated statement of operations. +Long-term +debt consisted of the following: +March 31, +2002 +2003 +(In thousands) +Note payable, net of discount of $244,000 at March 31, 2002, paid in May 2002 +$ +15,756 +$ +— +Notes payable, accruing interest at 7.55% to 17.08%, collateralized by equipment, payable in monthly installments through fiscal 2003 +402 +— +16,158 +— +Less current portion +16,133 +— +$ +25 +$ +— +7. Income Taxes +The reconciliation of the income tax benefit from continuing operations to taxes computed at U.S. federal statutory rates is as follows: +Year ended March 31, +2001 +2002 +2003 +(In thousands) +Income tax benefit at statutory rates +$ +500 +$ +(1,376 +) +$ +(196 +) +State income taxes net of federal benefit +— +— +4 +Increase in valuation allowance associated with federal deferred tax assets +(2,138 +) +(208 +) +(273 +) +Foreign losses recorded without benefit +1,185 +347 +310 +Nondeductible goodwill amortization +153 +176 +— +Other +303 +276 +155 +$ +— +$ +(785 +) +$ +— +F-19 +United +States and foreign income (loss) from continuing operations before income taxes are as follows: +Year ended March 31, +2001 +2002 +2003 +(In thousands) +Pretax income (loss): +Domestic +$ +4,960 +$ +(3,603 +) +$ +(182 +) +Foreign +(3,489 +) +(1,021 +) +(394 +) +$ +1,471 +$ +(4,048 +) +$ +(576 +) +The +components of deferred tax assets and liabilities are as follows: +March 31, +2002 +2003 +(In thousands) +Deferred tax assets: +Net operating losses +$ +21,267 +$ +19,289 +Book over tax depreciation +— +6,025 +Credit carryforwards +1,503 +1,999 +Deferred compensation and payroll +1,192 +1,231 +Bad debt allowances and other reserves +357 +265 +Other, net +1,121 +406 +Total deferred tax assets +25,440 +29,215 +Valuation allowance +(23,557 +) +(28,748 +) +Net deferred tax assets +1,883 +467 +Deferred tax liabilities: +Tax over book depreciation +(1,416 +) +— +Capitalized interest and taxes +(421 +) +(421 +) +Other, net +(46 +) +(46 +) +Total deferred tax liabilities +(1,883 +) +(467 +) +Net deferred taxes +$ +— +$ +— +At +March 31, 2003, the Company had approximately $1,299,000 in federal general business credit carryforwards that begin to expire in 2006 and $700,000 in state general business +credit carryforwards that can be carried forward indefinitely. The Company had $48,231,000 of federal net operating loss carryforwards that begin to expire in 2019 and $31,000,000 of state net +operating loss carryforwards that begin to expire in 2003. For financial reporting purposes, a valuation allowance has been recorded to offset the deferred tax asset related to these credits and net +operating losses. Any future benefits recognized from the reduction of the valuation allowance related to these carryforwards will result in a reduction of income tax expense. +In +December 2001, the Company's ownership interest in Iteris fell below the threshold required for the Company to file a consolidated tax return. As a result, Iteris will +no longer be included in the Odetics consolidated group for income tax purposes, and instead will be required to file a separate tax return. At March 31, 2003, for federal income tax +purposes, Iteris had approximately $583,000 of the net operating loss carryforwards described above. Iteris's portion of the net operating losses begins to expire in 2021. +F-20 +On +September 11, 2003, the Governor of California signed into law new tax legislation that suspends the use of net operating loss carryforward into tax years beginning on or after +January 1, 2002 and 2003. Should the Company have taxable income for the year ending March 31, 2003 and 2004, it may not look to California net operating losses generated in prior years +to offset taxable income. This suspension will not apply to tax years beginning in 2004 and beyond. +Because +of the "change of ownership" provision of the Tax Reform Act of 1986, utilization of the Company's net operating loss carryforwards may be subject to an annual limitation against +taxable income in future periods. As a result of the annual limitation, a portion of these carryforwards may expire before ultimately becoming available to reduce future income tax liabilities. +8. Associate Incentive Programs +Under the terms of a Profit Sharing Plan, the Company contributes to a trust fund such amounts as are determined annually by the Board of Directors. No +contributions were made in 2001, 2002 or 2003. +In +May 1990, the Company adopted a 401(k) Plan as an amendment and replacement of the former Associate Stock Purchase Plan that was an additional feature of the Profit Sharing +Plan. Under the 401(k) Plan, eligible associates voluntarily contribute to the plan up to 15% of their salary through payroll deductions. The Company matches 50% of contributions up to a stated limit. +Under the provisions of the 401(k) Plan, associates have four investment choices, one of which is the purchase of Odetics, Class A common stock at market price. Company matching contributions +were approximately $812,000, $722,000 and $544,000 in 2001, 2002 and 2003, respectively. +9. Deferred Compensation Plans +During 1986, the Company adopted an Executive Deferral Plan under which certain executives may defer a portion of their annual compensation. All deferred amounts +earn interest, generally with no guaranteed rate of return. Compensation charged to operations and deferred under the plan totaled $128,000, $66,000, and $43,000 for 2001, 2002 and 2003, respectively. +10. Iteris Preferred and Common Stock +In July 2001, Iteris issued 1,781,268 shares of its Series A preferred stock (Iteris preferred stock) to an institutional investor in exchange for +$5.0 million in cash. In addition, Iteris issued 1,343,645 shares of its Iteris preferred stock and 547,893 shares of its common stock in exchange for $500,000 in cash and the retirement of its +$3.75 million Subordinated Convertible Promissory Note plus related accrued interest of $0.4 million. +Shares +of Iteris preferred stock are convertible into shares of Iteris common stock at the conversion rate in effect at the time, as defined. Each share of Iteris preferred stock will +automatically convert into shares of Iteris common stock immediately upon the closing of a firmly underwritten public offering pursuant to an effective registration statement under the Securities Act +of 1933 with aggregate gross proceeds to the Company of not less than $30 million and price per share of not less than two times the original Iteris preferred stock issue price of $2.80 per +share. +In +the event that the Company fails to consummate an initial public offering of Iteris common stock or complete a sale of Iteris to a third party with aggregate proceeds of +$25 million by January 1, 2004 and/or the holders of Iteris preferred stock elect not to exercise their rights to convert into common stock, the Company will be obligated to redeem the +Iteris preferred stock at a sum equal to two times the original Iteris preferred stock issue price. +At +March 31, 2002, the liquidation preference on Iteris preferred stock totals $17.5 million. The difference between the initial issue price, net of related issuance costs, +and the liquidation preference is +F-21 +being +amortized over the redemption period and is reflected in minority interest in earnings of subsidiary in the accompanying consolidated statement of operations. +In +August and December 2001, Odetics sold 1,539,241 shares of Iteris common stock that it held at an aggregate purchase price of $3.8 million to a group of investors, which +included certain members of management of Odetics and Iteris. In connection with this transaction, Odetics realized a loss of $1.6 million which is reflected in other income (net) in the +accompanying consolidated statement of operations. +In +April 2002 and February 2003, the Company sold 322,581 shares of Iteris common stock that it held at an aggregate purchase price of $0.9 million to a group of +investors, which included certain members of management of Odetics and Iteris. In connection with this transaction, the Company realized a loss of $0.3 million that is reflected in other income +(net) in the accompanying consolidated statement of operations. In February 2003 Iteris purchased back from the Company 288,500 shares of Iteris common stock that the Company held. Odetics +realized a loss of $310,000 on this transaction, which is reflected in other income, net in the accompanying consolidated statement of operations. At March 31, 2003, the Company held 75.1% of +the outstanding common stock of Iteris. +11. Stock Option Plans +The Company has adopted an Associate Stock Option Plan which provides that options for shares of the Company's unissued Class A common stock may be granted +to directors and associates of the Company. Options granted enable the option holder to purchase one share of Class A common stock at prices which are equal to or greater than the fair market +value of the shares at the date of grant. Options expire ten years after date of grant or 90 days after termination of employment and vest ratably at 33% on each of the first three +anniversaries of the grant date. +A +summary of all Company stock option activity is as follows: +Year ended March 31, +2001 +2002 +2003 +Options +Weighted +Average +Exercise +Price +Options +Weighted +Average +Exercise +Price +Options +Weighted +Average +Exercise +Price +(In thousands, except per share data) +Options outstanding at beginning of year +801 +$ +7.68 +804 +$ +8.44 +329 +$ +8.37 +Granted +120 +13.47 +30 +2.28 +659 +1.38 +Exercised +(24 +) +7.95 +— +— +— +— +Cancelled +(93 +) +8.21 +(505 +) +8.06 +(26 +) +4.29 +Options outstanding at end of year +804 +$ +8.44 +329 +$ +8.37 +962 +$ +3.73 +Exercisable at end of year +531 +237 +879 +Available for grant at end of year +487 +1,322 +689 +Weighted average fair value of options granted +$ +7.03 +$ +1.20 +$ +0.68 +The +exercise price for options outstanding as of March 31, 2003, ranged from $1.02 to $15.625. The weighted-average remaining contractual life of those options is +8.8 years. +Iteris, Inc.'s Stock Options +In September 1997, Iteris granted options to purchase up to 899,960 shares of its common stock to certain members of its senior management at an exercise +price of $1.07 per share. As of March 31, 2002, options to purchase 759,345 shares of common stock were outstanding. +F-22 +Subsequently, +Iteris' Board of Directors adopted and approved the 1998 Stock Incentive Plan (the Plan), as amended in February 2000, authorized 3,000,000 shares of Iteris' common +stock for issuance under the Plan. Options to purchase 2,228,492 shares of common stock, at exercise prices ranging from $1.60 to $9.07 per share, were outstanding at March 31, 2002. Under the +Plan, options expire ten years after date of grant or 90 days after termination of employment. The options granted vested ratably at 25% on each of the first four anniversaries of the grant +date. +12. Commitments +The Company has lease commitments for facilities in various locations throughout the United States. The annual commitment under these noncancelable operating +leases at March 31, 2003 is as follows: +Fiscal Year +(in thousands) +2004 +$ +2,171 +2005 +2,047 +2006 +1,928 +2007 +1,837 +2008 +1,826 +Thereafter +7,608 +Rent +expense under operating leases totaled $1,040,000, $1,139,000 and $2,597,000, respectively for the years ended March 31, 2001, 2002 and 2003. +Common +stock reserved for future issuance at March 31, 2003: +Issuable under stock options plans +1,651,000 +Issuable upon the exercise of warrants +2,926,667 +13. Business Segment and Geographic Information +The Company operates in three reportable segments: intelligent transportation systems, video products, which includes products for the television broadcast and +video security markets, and telecom products. The accounting policies of the reportable segments are the same as those described in the summary of significant accounting policies except that certain +expenses, such as interest, amortization of certain intangibles and certain corporate expenses are not allocated to the segments. In addition, certain assets including cash and cash equivalents, +deferred taxes and certain long-lived and intangible assets are not allocated to the segments. Intersegment sales are recorded at the selling segment's cost plus profit. +The +reportable segments are each managed separately because they manufacture and distribute distinct products or provide services with different processes. +F-23 +Selected +financial information for the Company's reportable segments as of and for the years ended March 31, 2001, 2002 and 2003 follows: +Intelligence +Transportation +Video +Products +Telecom +Products +Total +(In thousands) +Year ended March 31, 2001 +Revenue from external customers +$ +28,057 +$ +31,736 +$ +2,609 +$ +62,402 +Depreciation and amortization +1,502 +922 +125 +2,549 +Segment income (loss) +(3,942 +) +(4,526 +) +1,120 +(7,348 +) +Segment assets +18,709 +15,438 +375 +34,522 +Expenditure for long-lived assets +1,392 +253 +50 +1,695 +Year ended March 31, 2002 +Revenue from external customers +$ +37,308 +$ +12,240 +$ +2,641 +$ +52,189 +Depreciation and amortization +1,759 +83 +75 +1,917 +Segment income (loss) +2,979 +(420 +) +1,316 +3,875 +Segment assets +25,736 +1,519 +250 +27,505 +Expenditure for long-lived assets, net +272 +17 +25 +314 +Year ended March 31, 2003 +Revenue from external customers +$ +41,395 +$ +3,231 +$ +3,001 +$ +47,627 +Depreciation and amortization +705 +14 +60 +779 +Segment income (loss) +2,459 +(872 +) +1,706 +3,293 +Segment assets +26,005 +806 +— +26,811 +Expenditure for long-lived assets, net +309 +— +— +309 +F-24 +The +following reconciles segment income to consolidated income before income taxes and segment assets and deprecation and amortization to consolidated assets and consolidated +depreciation and amortization: +March 31, +2001 +2002 +2003 +(In thousands) +Segment Income (loss) +Total income (loss) for reportable segments +$ +(7,348 +) +$ +3,875 +$ +3,293 +Other income +1,340 +2,919 +388 +Unallocated amounts: +Corporate and other expenses +(7,827 +) +(4,463 +) +(3,496 +) +Royalty income +17,825 +— +— +Restructuring charges +(757 +) +(2,189 +) +— +Interest expense +(1,762 +) +(4,190 +) +(761 +) +Income (loss) from continuing operations before income taxes +$ +1,471 +$ +(4,048 +) +$ +(576 +) +Assets +Total assets for reportable segments +$ +34,522 +$ +27,505 +$ +26,811 +Assets held at Corporate +33,539 +24,733 +8,031 +Total assets +$ +68,061 +$ +52,238 +$ +34,842 +Depreciation and Amortization +Depreciation and amortization for reportable segments +$ +2,549 +$ +1,917 +$ +779 +Other +2,418 +1,859 +37 +Total depreciation and amortization +$ +4,967 +$ +3,776 +$ +816 +Selected +financial information for the Company's continuing operations by geographic segment is as follows: +March 31, +2001 +2002 +2003 +(In thousands) +Geographic Area Revenue +United States +$ +55,968 +$ +50,376 +$ +46,716 +Europe +6,434 +1,813 +911 +Total net revenue +$ +62,402 +$ +52,189 +$ +47,627 +Geographic Area Long-Lived Assets +United States +$ +28,275 +$ +25,773 +$ +11,830 +Europe +23 +21 +21 +Total long-lived assets +$ +28,298 +$ +25,794 +$ +11,851 +F-25 +14. Supplemental Cash Flow Information +Year ended March 31, +2001 +2002 +2003 +(In thousands) +Net cash used in changes in operating assets and liabilities, net of acquisitions: +(Increase) decrease in accounts receivable +$ +(882 +) +$ +3,897 +$ +68 +(Increase) decrease in net costs and estimated earnings in excess of billings +1,259 +(608 +) +(704 +) +(Increase) decrease in inventories +4,499 +(1,542 +) +(556 +) +Increase in prepaids and other assets +861 +(735 +) +1,051 +Increase (decrease) in accounts payable and accrued expenses +(1,116 +) +(3,170 +) +1,348 +Change in net operating assets of discontinued operations +— +(3,126 +) +(1,284 +) +Net cash used in changes in operating assets and liabilities +$ +4,621 +$ +(5,284 +) +$ +(77 +) +Cash paid (received) during the year: +Interest +$ +1,768 +$ +2,514 +$ +507 +Income taxes paid (refunded) +86 +— +— +Noncash transactions during the year: +Proceeds from sale leaseback held in escrow +$ +$ +$ +2,516 +Contribution of common stock to 401(k) Plan +— +791 +141 +Exchange of note payable and accrued interest for Iteris stock +— +4,203 +— +Stock issuance to former MMA shareholders +500 +2,737 +— +Issuance of common stock in settlement of accounts payable +— +390 +— +15. Legal Proceedings +On October 11, 1999, the Company settled a patent infringement case it had brought against Storage Technology Corporation (StorageTek). Through an +agreement, StorageTek agreed to pay the Company a license fee totaling $100.0 million for use of the Company's United States Patent No. 4,779,151. Under the agreement, the license fee +was payable in three installments: $80.0 million upon signing of the agreement, and two annual installments of $10.0 million payable in each of October 2000 and 2001. On +June 12, 2000, the Company and StorageTek amended the agreement, whereby StorageTek agreed to pay a final discounted payment of $17.8 million immediately in full settlement of the +$20.0 million +otherwise due to complete the settlement, which is reflected in the accompanying consolidated financial statements as royalty income. +From +time to time, the Company may be involved in litigation relating to claims arising out of its operations in the normal course of business. The Company currently is not a party to +any legal proceedings, the adverse outcome of which, in management's opinion, individually or in the aggregate, would have a material adverse effect on its consolidated results of operations, +financial position or cash flows. +F-26 +16. Supplementary Quarterly Consolidated Financial Data (Unaudited) +All quarters presented in the following schedule have been restated for the discontinuance of Mariner, Zyfer and Broadcast. +Net +Sales +Gross +Profit +Loss from +Continuing +Operations +Net +Loss +Loss per +Share from +Continuing +Operations +June 30, 2001 +$ +14,268 +4,819 +(2,168 +) +(7,775 +) +$ +(0.21 +) +September 30, 2001(1) +14,609 +5,900 +(2,077 +) +(15,164 +) +(0.20 +) +December 31, 2001 +11,435 +4,893 +(964 +) +(2,331 +) +(0.08 +) +March 31, 2002 +11,877 +6,676 +36 +(1,318 +) +(0.00 +) +June 30, 2002 +11,945 +5,124 +(485 +) +(1,300 +) +(0.04 +) +September 30, 2002 +11,168 +4,575 +(1,306 +) +(2,617 +) +(0.09 +) +December 31, 2002 +12,452 +5,496 +(384 +) +(905 +) +(0.03 +) +March 31, 2003(2) +12,062 +4,974 +(2,219 +) +(8,326 +) +(0.16 +) +(1) During +the quarter ended September 30, 2001, the Company discontinued the operations of its Mariner subsidiary and restructured its European operations. In connection with +these actions, the Company recorded severance and other charges and wrote down assets totaling $9.9 million. +(2) During +the quarter ended March 31, 2003, the Company discontinued the operations of its Zyfer and Broadcast subsidiaries. In connection with those actions, the Company recorded +severance payments and other charges and wrote down assets totaling $4.9 million. +F-27 +Schedule II +Valuation and Qualifying Accounts +Description +Balance at +Beginning of +Period +Charged to +Costs and +Expenses +Charged to +Accounts +Deductions +Describe +Balance at +End of Period +Year ended March 31, 2001 +Deducted from asset accounts: +Allowance for doubtful accounts +$ +990,000 +$ +78,000 +$ +(502,000 +) +$ +— +$ +1,644,000 +Reserve for inventory obsolescence +1,184,000 +4,925,000 +(4,443,000 +) +— +3,968,000 +Year ended March 31, 2002 +Deducted from asset accounts: +Allowance for doubtful accounts +$ +600,000 +$ +— +$ +(485,000 +) +$ +— +$ +115,000 +Reserve for inventory obsolescence +2,048,000 +65,000 +(1,735,000 +) +— +378,000 +Year ended March 31, 2003 +Deducted from asset accounts: +Allowance for doubtful accounts +$ +115,000 +$ +78,000 +$ +(37,000 +) +$ +— +$ +156,000 +Reserve for inventory obsolescence +378,000 +— +(130,000 +) +— +248,000 +S-1 +QuickLinks +ODETICS, INC. FORM 10-K ANNUAL REPORT TABLE OF CONTENTS +PART I +ITEM 1. BUSINESS. +ITEM 2. PROPERTIES. +ITEM 3. LEGAL PROCEEDINGS. +ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. +PART II +ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS. +ITEM 6. SELECTED CONSOLIDATED FINANCIAL DATA. +ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. +RISK FACTORS +ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK. +ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. +ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE. +PART III +ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT. +ITEM 11. EXECUTIVE COMPENSATION. +ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS. +ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS. +ITEM 14. CONTROLS AND PROCEDURES. +PART IV +ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K. +SIGNATURES +POWER OF ATTORNEY +CERTIFICATION +Odetics, Inc. Index to Consolidated Financial Statements +Report of Independent Auditors +Odetics, Inc. Consolidated Balance Sheets (In thousands, except share and per share amounts) +Odetics, Inc. Consolidated Statements of Operations (In thousands, except per share information) +Odetics, Inc. Consolidated Statements of Stockholders' Equity (In thousands) +Odetics, Inc. Consolidated Statements of Cash Flows (In thousands) +Odetics, Inc. and Subsidiary Notes to Consolidated Financial Statements March 31, 2003 +Schedule II Valuation and Qualifying Accounts \ No newline at end of file diff --git a/raw/filings/0000350868/2002/0001047469-03-022912/filing_metadata.csv b/raw/filings/0000350868/2002/0001047469-03-022912/filing_metadata.csv new file mode 100644 index 0000000000000000000000000000000000000000..41a827089d6e097dba025b4a1a52b22339d50816 --- /dev/null +++ b/raw/filings/0000350868/2002/0001047469-03-022912/filing_metadata.csv @@ -0,0 +1,2 @@ +cik,ticker,company_name,form,filing_date,report_date,acceptance_datetime,accession_number,primary_document,primary_doc_description,size,is_xbrl,is_inline_xbrl,document_url,filing_index_url,year,fiscal_year,is_primary_filing +0000350868,ITI,"ITERIS, INC.",10-K,2003-06-30,2003-03-31,2003-06-30T21:17:29.000Z,0001047469-03-022912,a2113700z10-k.htm,10-K,829644,0,0,https://www.sec.gov/Archives/edgar/data/350868/000104746903022912/a2113700z10-k.htm,https://www.sec.gov/Archives/edgar/data/350868/000104746903022912/,2002,2002,1 diff --git a/raw/filings/0000350868/2002/0001047469-03-022912/item1.txt b/raw/filings/0000350868/2002/0001047469-03-022912/item1.txt new file mode 100644 index 0000000000000000000000000000000000000000..5049cb5303ac89553a3b14be8e11c22d377b3bd9 --- /dev/null +++ b/raw/filings/0000350868/2002/0001047469-03-022912/item1.txt @@ -0,0 +1,180 @@ +ITEM 1. BUSINESS. +Overview +Odetics, Inc. provides products, systems and services that control and manage the use of public roadways and secure access and safety of public and private +facilities. Our company was founded in 1969 to supply digital recorders for use in the United States space program. We broadened our information automation product line to include +time-lapse videocassette recorders for commercial security and surveillance applications through our Gyyr division, which was subsequently incorporated to form our Gyyr Incorporated +subsidiary. We formed our Zyfer, Inc. subsidiary to develop and manufacture timing and synchronization products for telecommunication networks. Timing and synchronization products are devices +that contain both hardware and software to synchronize the data streams in telecommunications networks and are used to increase the reliability and operability of such networks. +In +the early 1980s, we established our Odetics Broadcast division, which we later incorporated as Broadcast, Inc. Broadcast developed and supplied software-based systems that +integrated, controlled and automated the management of multiple classes of equipment used in the operation of a broadcast studio and satellite uplink facility in the television, cable and satellite +industries. +Leveraging +our expertise in video image processing, we entered into the intelligent transportation systems ("ITS") business with the introduction of a video-based vehicle detection +system in 1993. In June 1997, we acquired certain assets comprising the Transportation Systems business from Rockwell International, creating our ITS division, which expanded our offerings to +include advanced traffic management systems and advanced traveler information systems. We incorporated our ITS division as Odetics ITS, Inc. and broadened our systems offerings by acquiring +Meyer, Mohaddes Associates, Inc. in +1998. In January 2000, we reincorporated Odetics ITS in Delaware and changed its name to Iteris, Inc. As of June 30, 2003, Odetics owned 74.5% of the outstanding common stock of +Iteris and 59.1% of the common stock assuming full conversion of the outstanding Series A preferred stock of Iteris. We currently operate Meyer, Mohaddes Associates, Inc. as a +wholly-owned subsidiary of Iteris. +Beginning +in late 2001, we began divesting certain of our business units in order to reduce our operating expenses and to focus on what we believe to be our core businesses, +Iteris, Inc. and MAXxess Systems, Inc. In September 2001, we sold the assets of our Gyyr Closed Circuit Television ("CCTV") Products line, which included video recorders and +equipment that facilitated video switching and multiplexing. Upon completion of this sale, we changed the name of our Gyyr subsidiary to MAXxess Systems, Inc., which currently designs and +manufactures security management systems that feature a broad array of detection, monitoring and management capabilities for both governmental and commercial customers. +In +March 2003, we decided to cease the development and sale of any new Broadcast products and to sell Zyfer. As a result, we reduced our Broadcast organization to only support +existing customer contracts for service and support through their expiration dates. In May 2003, we sold substantially all of the assets of Zyfer. +After +giving effect to our divestitures and narrowed focus mentioned above, we currently operate in only two business segments: ITS and Security Products. Our ITS segment consists of +Iteris, our 59.11% owned subsidiary, and our Security Products segment consists of MAXxess, Inc., our wholly-owned subsidiary. +1 +Iteris, Inc. +Iteris, Inc. designs, develops, markets and implements sensors and systems for surface transportation. Using its proprietary software and ITS industry +expertise, Iteris provides video sensor systems and transportation management and traveler information systems for the ITS industry. The ITS industry is comprised of companies applying a variety of +technologies to enable the safe and efficient movement of people and goods. Iteris uses its outdoor image recognition software expertise to develop proprietary algorithms for video sensor systems that +improve vehicle safety and the flow of traffic. Using its knowledge of the ITS industry, Iteris designs and implements transportation management systems that help public agencies reduce traffic +congestion and provide greater access to traveler information. +Iteris' +proprietary image recognition systems include AutoVue™ and Vantage™. AutoVue is a small windshield mounted sensor that uses proprietary software +to detect and warn drivers of unintended lane departures. Iteris has approximately 3,000 production AutoVue units that are in use on truck platforms in the European market and are offered as an option +on certain Actros trucks, which are part of the Daimler group. Iteris believes that AutoVue is a broad sensor platform that, through additional software development, may be expanded to incorporate +additional safety and convenience features. Vantage is a video vehicle sensing system that detects the presence of vehicles at signalized intersections enabling a more efficient allocation of green +signal time. +Iteris' +transportation management systems includes the design, development and implementation of its software-based systems that integrate sensors, video surveillance, computers and +advanced communications equipment to enable public agencies to monitor, control and direct traffic flow, assist in the quick dispatch of emergency crews and distribute real-time +information about traffic conditions. Our services include planning and other engineering for the implementation of transportation related communications systems, analysis and study related to goods +movement and commercial vehicle operations, and parking systems designs. +Sales, Marketing and Principal Customers. Iteris markets and sells its transportation management systems and services +directly to government agencies pursuant to negotiated contracts that involve competitive bidding and specific qualification requirements. Most of our contracts with federal, state, and municipal +customers provide for cancellation or renegotiation at the option of the customer upon reasonable notice and fees paid for modification. We use selected members of our engineering team divided on a +regional basis to serve in sales and business development functions. We do not engage in international ITS sales. Sales of Iteris' systems contracts generally involve long lead times and require +extensive specification development, evaluation and price negotiations. No single customer of Iteris accounted for more than 10% of our total net sales and contract revenues. +Iteris +sells its Vantage vehicle detection systems primarily through indirect sales channels comprised of independent dealers in the United States and Canada who sell integrated systems +and related products to the traffic intersection market. The independent dealers for Iteris are primarily responsible for sales, installation and support of Vantage systems. These dealers maintain an +inventory of demonstration traffic products including the Vantage vehicle detection systems and sell directly to government agencies and installation contractors. These dealers often have +long-term arrangements with the government agencies in their territory for the supply of various products for the construction and renovation of traffic intersections. Iteris holds +technical training classes for its dealers and maintains a full-time staff of customer support technicians to provide technical assistance when needed. +The +marketing strategy for AutoVue is to establish it as the leading platform for in vehicle video sensing for trucks and passenger cars. AutoVue is sold directly by Iteris to vehicle +manufacturers and major automotive suppliers. Iteris also markets to the manufacturers of automobiles through a strategic relationship with Valeo. +2 +Manufacturing and Materials. Iteris uses local manufacturers based near our Anaheim facility to build subassemblies that are +used in its Vantage products. These subassemblies are delivered to our Anaheim facility where they go through a final assembly and test prior to the shipment to our customers. Iteris' manufacturing +activities are conducted in approximately 6,000 square feet of space at our Anaheim facility. Most subassemblies used in our products are manufactured by subcontractors who are local to our Anaheim, +California facilities. Certain of our cameras used in our products have historically been provided by a Japanese supplier who is sole sourced; however, we are currently qualifying other sources of +supply. Production volume is based upon quarterly forecasts that Iteris readjusts on a monthly basis to control inventory. Iteris subcontracts the manufacture of its AutoVue systems to one +manufacturer, and our internal processes are limited primarily to testing and final verification. Iteris currently does not manufacture any of the hardware used in the transportation management and +traveler information systems that it designs and implements. The production facility for Iteris is currently ISO 9001 certified. +Customer Support and Services. We provide warranty service for each of our products, as well as follow-up service +and support, for which we typically charge separately. We view customer support services as a critical competitive factor as well as a revenue source. +MAXxess Systems, Inc. +MAXxess Systems, Inc. designs, develops and manufactures security management systems that include detection, monitoring and management capabilities for +both governmental and commercial customers. MAXxess offers software, hardware and other technologies for creating and using electronic access control products such as identification and access badges +that are based on smart cards and other electronic devices. These products are principally used to control and manage physical access to facilities. We also provide software-based systems and hardware +used for detection and response of management to dangerous chemicals and gases in and around facilities. +During +fiscal 2003, we introduced our Environmental Security Systems, which integrate our legacy AXxess 202 product family with new detection technologies for toxic chemicals and gases. +During fiscal 2003, MAXxess further extended its Environmental Security Systems offering by introducing its Safe Cities™ System, which is a software-based management system for use by +municipal customers that integrates disparate information and detection infrastructure within a city in order to provide rapid response for emergency management against threats of terrorism and +weapons of mass destruction. MAXxess believes that its Environmental Security Systems provide enhanced levels of monitoring, control and detection that will be required across a broad cross section of +municipal infrastructure and in various public facilities including buildings, airports, ports and other potential targets of terrorism. +Sales, Marketing and Principal Customers. MAXxess generally markets and sells its products globally through a network of +system integrators, in addition to selling direct to municipal customers. In the United States, MAXxess has three regional sales managers who oversee three geographical regions and manage the systems +integrators. MAXxess operates a full service branch office in Bracknell Berkshire U.K., which serves the sales needs of the European, Middle East and Asian regions. The Bracknell +office also provides local product availability and technical support for the region. MAXxess has also partnered with Draeger Safety of Lubeck, Germany, to market its chemical detectors principally to +governmental customers. These chemical detectors are primarily focused on the Immune Building Program, which is sponsored by Defense Advanced Research Projects Agency ("DARPA"). No single customer of +MAXxess represented more than 10% of our total net sales and contract revenues for fiscal 2003. +Manufacturing and Materials. Similar to Iteris, MAXxess uses local manufacturers based near our Anaheim manufacturing +facility to build subassemblies that are used in our final products. These subassemblies and other components are delivered to our Anaheim manufacturing facility where they +3 +go +through a final assembly and test prior to shipment to its customers. MAXxess builds inventory according to our sales forecasts. MAXxess maintains a dedicated manufacturing area of approximately +2,500 square feet located within our Anaheim facilities. MAXxess maintains infrastructure to support production and inventory control, purchasing, quality assurance and manufacturing engineering. +Although we consolidate our materials sourcing and subcontract manufacturing to minimize production costs. We believe that each of our sources are capable of being substituted for minimal cost and +production delay. There are currently no sole sourced raw materials used in our products. +Customer Support and Services. We provide warranty service and support for each of our products and follow-up +service and support, for which we charge separately. Service revenue accounts for less than 5% of total net sales and contract revenues. Customer support is a critical competitive factor. We provide +warranty and customer service internationally from our Bracknell Berkshire offices. +Backlog +Our backlog of unfulfilled firm orders was approximately $24.0 million as of March 31, 2003 and was approximately $42.7 million as of +March 31, 2002. Approximately 67% of our backlog at March 31, 2002 was recognized as revenues in the fiscal year ended March 31, 2003, and approximately 87% of our backlog at +March 31, 2003 is expected to be recognized as revenues in the fiscal year ended March 31, 2004. Pursuant to the customary terms of our agreements with government contractors and other +customers, customers can generally cancel or reschedule orders with little or no penalties. Lead times for the release of purchase orders depend upon the scheduling and forecasting practices of our +individual customers, which also can affect the timing of the conversion of our backlog into revenues. For these reasons, among others, our backlog at a particular date may not be indicative of our +future revenues. +Product Development +MAXxess and Iteris each direct and staff its own product development activities. Most of our development activities are conducted at our principal facilities in +Anaheim, California. Our company-sponsored research and development costs and expenses were approximately $7.5 million in fiscal 2001, $4.4 million in fiscal 2002 and $4.2 million +in fiscal 2003. Although spending for product development declined sharply in fiscal 2002 compared to fiscal 2001, principally due to the discontinuation of development activities related to +personalized traveler information products in Iteris and the sale of Gyyr's CCTV Products line, we expect to continue to pursue significant product development programs and incur significant research +and development expenditures in each of our business units. +Competition +Our business units generally face significant competition in each of their respective markets. Increased competition may result in price reductions, reduced gross +margins and loss of market share, any of which could have a material adverse effect on our business, financial condition and results of operations. +MAXxess +principally competes with Casi-Rusco, Cardkey, Lenel and Northern Computers in the sale of access control systems. The market for electronic access control products +is highly fragmented, We estimate that there are approximately 100 competitors comprising approximately $800 million in annual sales. MAXxess is substantially smaller in terms of annual revenue +than its leading competitors. In the area of chemical and gas detection, MAXxess primarily competes with Smiths Detection. MAXxess is a smaller company in terms of annual revenue than Smiths +Detection, but MAXxess does not believe there is any direct competitor for its Safe Cities system. MAXxess generally competes on the basis of its distributed processing system architecture, which is +an open system that readily integrates other security subsystems and new detection capabilities, and a superior operator interface. +4 +We +believe that AutoVue is the only commercially-available lane departure warning system used in the U.S. and in Europe, potential competitors of AutoVue include Delphi Automotive +Systems Corporation domestically, NEC Corporation and Hitachi Ltd. in Japan and Robert Bosch Gmbh in Europe, which we suspect are currently developing video sensor technologies for the vehicle +industry that could be used for lane departure warning systems. In the market for our Vantage vehicle detection systems, Iteris competes with manufacturers of other "above ground" video camera +detection systems such as Econolite Control Products, Inc., Trafficon, N.V. Peek Traffic Systems, and other non-intrusive detection devices including microwave, infrared, ultrasonic +and magnetic detectors, as well as manufacturers and installers of in-pavement inductive loop products. Our competitors for Vantage products do not disclose specific sales numbers, either +because +they are private companies or because they are part of larger companies. Based on our interface with them in the market, we believe that we are leading our competitors in annual sales volume for video +detection products. +The +transportation management and traveler information systems market is highly fragmented and is subject to evolving national and regional quality and safety standards. Iteris' +competitors vary in number, scope and breadth of the products and services they offer. Iteris' competitors in advanced transportation management and traveler information systems include large +multi-national corporations such as Transcore, Lockheed Martin Corporation, PB Farradyne Inc., Kimley-Horn and Associates, Inc. and National Engineering +Technology, Inc. Iteris' competitors in transportation engineering, planning and design include major firms such as Parsons Brinkerhoff, Inc. and Parsons Transportation +Group Inc., as well as many smaller regional engineering firms. We believe that the transportation management and traveler information systems business of Iteris is one of the leading +competitors in the ITS market. +In +general, the markets for the products and services offered by our businesses are highly competitive and are characterized by rapidly changing technology and evolving standards. Many +of our current and prospective competitors have longer operating histories, greater name recognition, access to larger customer bases and significantly greater financial, technical, manufacturing, +distribution and marketing resources than us. As a result, they may be able to adapt more quickly to new or emerging standards or technologies or to devote greater resources to the promotion and sale +of their products. It is also possible that new competitors or alliances among competitors could emerge and rapidly acquire significant market share. We believe that our ability to compete effectively +in our target markets will depend on a number of factors, including the success and timing of our new product development, the compatibility of our products with a broad range of computing systems, +product quality and performance, reliability, functionality, price, and service and technical support. Our failure to provide services and develop and market products that compete successfully with +those of other suppliers and consultants in our target markets would have a material adverse effect on our business, financial condition and results of operations. +Intellectual Property and Proprietary Rights +Our ability to compete effectively depends in part on our ability to develop and maintain the proprietary aspects of our technology. Our policy is to obtain +appropriate proprietary rights protection for any potentially significant new technology acquired or developed each of our business units. Iteris currently holds six U.S. patents, which expire +commencing in 2012, and has eighteen U.S. patent applications pending, mostly relating to our outdoor image processing techniques used in our AutoVue and Vantage systems. Two of our patents relate +specifically to our AutoVue technology and provide a basis for enhanced functionality for rain sensing and improved performance. We believe that our other patents, while important for our technology +platform, are less critical to near term product strategy. We cannot assure you that any new patents will be granted pursuant to any outstanding or subsequent applications. +5 +We +own a patent and have three patents pending for StealthKey technology, which technology is not currently part of our product family. Our intention is to pursue product development for +a high-speed security processor designed around the StealthKey patent. +In +addition to patent laws, we rely on copyright and trade secret laws to protect our proprietary rights. We attempt to protect our trade secrets and other proprietary information +through agreements with customers and suppliers, proprietary information agreements with our employees and consultants, and other similar measures. Iteris does not have any material licenses or +trademarks other than those relating to product names. We cannot be certain that we will be successful in protecting our proprietary rights. While we believe our patents, patent applications, software +and other proprietary know-how have value, changing technology makes our future success dependent principally upon our employees' technical competence and creative skills for continuing +innovation. +Litigation +has been necessary in the past and may be necessary in the future to enforce our proprietary rights, to determine the validity and scope of the proprietary rights of others, +or to defend us against claims of infringement or invalidity by others. An adverse outcome in such litigation or similar proceedings could subject us to significant liabilities to third parties, +require disputed rights to be licensed from others or require us to cease marketing or using certain products, any of which could have a material adverse effect on our business, financial condition +and results of operations. In addition, the cost of addressing any intellectual property litigation claim, both in legal fees and expenses, as well as from the diversion of management's resources, +regardless of whether the claim is valid, could be significant and could have a material adverse effect on our business, financial condition and results of operations. +Employees +We refer to our employees as associates. As of June 12, 2003, Odetics and its subsidiaries employed an aggregate of 253 associates, including 70 associates +in general management, administration and finance; 17 associates in sales and marketing; 119 associates in product development; 35 associates in operations, manufacturing and quality; and 12 +associates in customer service. None of our associates are represented by a labor union, and we have never experienced a work stoppage. +Government Regulation +Our manufacturing operations are subject to various federal, state and local laws and regulations, including those restricting the discharge of materials into the +environment. We are not involved in any pending or, to our knowledge, threatened governmental proceedings, which would require curtailment of our operations because of such laws and regulations. We +continue to expend funds in connection with our compliance with applicable environmental regulations. These expenditures have not, however, been significant in the past, and we do not expect any +significant expenditure in the near future. Currently, compliance with foreign laws has not had a material impact on our business and is not expected to have a material impact in the near future. +Subsequent to the downsizing and reorganization of our foreign operations, our only international operations are for MAXxess Ltd, a U.K., based subsidiary of our MAXxess Inc. subsidiary +in the United States. \ No newline at end of file diff --git a/raw/filings/0000350868/2002/0001047469-03-022912/item13.txt b/raw/filings/0000350868/2002/0001047469-03-022912/item13.txt new file mode 100644 index 0000000000000000000000000000000000000000..3ad781d10df7d7dc9429351f8331e6e07fbee441 --- /dev/null +++ b/raw/filings/0000350868/2002/0001047469-03-022912/item13.txt @@ -0,0 +1,3 @@ +ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS. +The information under the caption "Certain Transactions," appearing in our proxy statement, is incorporated herein by reference. +31 \ No newline at end of file diff --git a/raw/filings/0000350868/2002/0001047469-03-022912/item9a.txt b/raw/filings/0000350868/2002/0001047469-03-022912/item9a.txt new file mode 100644 index 0000000000000000000000000000000000000000..e69de29bb2d1d6434b8b29ae775ad8c2e48c5391 diff --git a/raw/filings/0000350868/2002/0001047469-03-022912/rp_note.txt b/raw/filings/0000350868/2002/0001047469-03-022912/rp_note.txt new file mode 100644 index 0000000000000000000000000000000000000000..e69de29bb2d1d6434b8b29ae775ad8c2e48c5391 diff --git a/raw/filings/0000350868/2002/0001047469-03-022912/rpt_disclosure.txt b/raw/filings/0000350868/2002/0001047469-03-022912/rpt_disclosure.txt new file mode 100644 index 0000000000000000000000000000000000000000..e69de29bb2d1d6434b8b29ae775ad8c2e48c5391 diff --git a/raw/filings/0000350868/2003/0001104659-04-018476/filing.txt b/raw/filings/0000350868/2003/0001104659-04-018476/filing.txt new file mode 100644 index 0000000000000000000000000000000000000000..3ffb89b754b23e3d3987f3600c3821b868a413b5 --- /dev/null +++ b/raw/filings/0000350868/2003/0001104659-04-018476/filing.txt @@ -0,0 +1,5871 @@ +10-K +1 +a04-7432_110k.htm +10-K +SECURITIES AND EXCHANGE COMMISSION +Washington, D.C. 20549 +FORM 10-K +FOR +ANNUAL AND TRANSITION REPORTS PURSUANT TO SECTIONS 13 OR 15(d) +OF THE SECURITIES EXCHANGE ACT OF 1934 +(Mark +One) +ý +ANNUAL REPORT PURSUANT TO +SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 +For +the fiscal year ended March 31, 2004 +OR +o +TRANSITION REPORT PURSUANT +TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 +For the transition +period from +to +Commission file number 001-08762 +ITERIS HOLDINGS, INC. +(Exact Name of Registrant as Specified in Its +Charter) +Delaware +95-2588496 +(State or Other Jurisdiction +of Incorporation or Organization) +(I.R.S. Employer +Identification No.) +1515 South Manchester Avenue, Anaheim, +California 92802 +(Address of Principal Executive Offices) (Zip Code) +Registrant’s Telephone Number, Including Area Code: (714) 774-5000 +Securities registered pursuant to Section 12(b) of the Act: None +Securities registered pursuant to Section 12(g) of the Act: +Class A common stock, $.10 par value +Class B common +stock, $.10 par value +(Title of Class) +Indicate by check +mark whether the registrant: (1) has filed all reports required to be filed by +Section 13 or 15(d) of the Securities Exchange Act of 1934 during the +preceding 12 months (or for such shorter period that the registrant was +required to file such reports), and (2) has been subject to such filing +requirements for the past 90 days. Yes ý +No o +Indicate by a +check mark if disclosure of delinquent filers pursuant to Item 405 of +Regulation S-K is not contained herein, and will not be contained, to the best +of registrant’s knowledge, in definitive proxy or information statements +incorporated by reference in Part III of this Form 10-K or any amendment to +this Form 10-K ý +Indicate by a +check mark whether the registrant is an accelerated filer (as defined in +Exchange Act Rule 12(b-2). Yes o +No ý +Based on the +closing sale price on the OTC Bulletin Board on September 30, 2003, the +last business day of the registrant’s most recently completed second fiscal +quarter, the aggregate market value of the voting common stock held by +nonaffiliates of the registrant was $14,668,955. For the purposes of this +calculation, shares owned by officers, directors and 10% stockholders known to +the registrant have been deemed to be owned by affiliates. This determination +of affiliate status is not necessarily a conclusive determination for other +purposes. +Iteris Holdings, +Inc. has two classes of common stock outstanding, the Class A common stock and +the Class B common stock. The rights, preferences and privileges of each class +of common stock are identical in all respects, except for voting rights. Each +share of Class A common stock entitles its holder to one-tenth of one vote per +share and each share of Class B common stock entitles its holder to one vote +per share. As of June 21, 2004, there were 22,117,930 shares of Class A +common stock and 922,067 shares of Class B common stock outstanding. Unless otherwise +indicated, all references to common stock collectively refer to the Class A +common stock and the Class B common stock. +DOCUMENTS INCORPORATED BY REFERENCE +Information +required by Items 10 through 14 of Part III of this report is incorporated +herein by reference to portions of the registrant’s definitive proxy statement +for its 2004 Annual Meeting of Stockholders, which will be filed with the +Securities and Exchange Commission not later than 120 days after the end of the +fiscal year ended March 31, 2004. +ITERIS HOLDINGS, INC. +FORM 10-K ANNUAL REPORT +TABLE OF CONTENTS +PART +I +ITEM +1. +BUSINESS +ITEM 2. +PROPERTIES +ITEM 3. +LEGAL PROCEEDINGS +ITEM 4. +SUBMISSION OF MATTERS TO A VOTE OF SECURITY +HOLDERS +PART II +ITEM 5. +MARKET FOR REGISTRANT’S COMMON EQUITY, +RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASERS OF EQUITY SECURITIES +ITEM 6. +SELECTED CONSOLIDATED FINANCIAL DATA +ITEM 7. +MANAGEMENT’S DISCUSSION AND ANALYSIS OF +FINANCIAL CONDITION AND RESULTS OF OPERATIONS +RISK +FACTORS +ITEM 7A. +QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT +MARKET RISK +ITEM 8. +FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA +ITEM 9. +CHANGES IN AND DISAGREEMENTS WITH +ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE +ITEM 9A. +CONTROLS AND PROCEDURES +PART III +ITEM 10. +DIRECTORS AND EXECUTIVE OFFICERS OF THE +REGISTRANT +ITEM 11. +EXECUTIVE COMPENSATION +ITEM 12. +SECURITY OWNERSHIP OF CERTAIN BENEFICIAL +OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS +ITEM 13. +CERTAIN RELATIONSHIPS AND RELATED +TRANSACTIONS +ITEM 14. +PRINCIPAL ACCOUNTANT FEES AND SERVICES +PART IV +ITEM 15. +EXHIBITS, FINANCIAL STATEMENT SCHEDULES, +AND REPORTS ON FORM 8-K +In this report, the “Company,” the “Registrant,” “we,” “us” and “our” +collectively refers to Iteris Holdings, Inc. and its subsidiaries. +Cautionary Statement +This +report contains forward-looking statements, which include but are not limited +to, statements concerning projected revenue, expenses and gross profit; our +accounting estimates, assumptions and judgments; the market acceptance and +performance of our products; manufacturing capacity; the competitive nature of +and anticipated growth in our markets; our ability to acquire the remaining +minority interest and to complete the merger of Iteris, Inc. into Iteris +Holdings, Inc.; the status of evolving technologies and their growth potential; +the timing of new product introductions; the adoption of future industry standards +and the need for additional capital. +These forward-looking statements are based on our current expectations, +estimates and projections about our industry, management’s beliefs, and certain +assumptions made by us, all of which are subject to change. Forward-looking +statements can often be identified by words such as “anticipates,” “expects,” +“intends,” “plans,” “predicts,” “believes,” “seeks,” “estimates,” “may,” +“will,” “should,” “would,” “could,” “potential,” “continue,” similar +expressions, and variations or negatives of these words. These statements are +not guarantees of future performance and are subject to risks, uncertainties +and assumptions that are difficult to predict. Therefore, our actual results +could differ materially and adversely from those expressed in any +forward-looking statements as a result of various factors, some of which are +listed under the section “Risk Factors” at the end of Item 7 of this +Report. These forward-looking statements speak only as of the date of this +Report. We undertake no obligation to revise or update publicly any +forward-looking statement for any reason. +PART I +ITEM 1. BUSINESS +Overview +Iteris Holdings, Inc. is +the majority stockholder of Iteris, Inc., a leading provider of outdoor machine +vision systems and sensors that optimize the flow of traffic and enhance driver +safety. Using our proprietary software and Intelligent Transportation Systems +(“ITS”) industry expertise, we provide video sensor systems and transportation +management and traveler information systems for the ITS industry. The ITS +industry is comprised of companies applying a variety of technologies to enable +the safe and efficient movement of people and goods. We use our outdoor image +recognition software expertise to develop proprietary algorithms for video +sensor systems that improve vehicle safety and the flow of traffic. Using our +knowledge of the ITS industry, we design and implement transportation +management systems that help public agencies reduce traffic congestion and +provide greater access to traveler information. +Our proprietary image +recognition systems include AutoVue TM and Vantage TM . AutoVue is a small windshield mounted sensor +that uses proprietary software to detect and warn drivers of unintended lane +departures. Iteris has approximately 6,000 production AutoVue units that are in +use on truck platforms in the European market and are offered as an option on +certain Actros trucks, which are part of the Daimler group. We believe that +AutoVue is a broad sensor platform that, through additional software +development, may be expanded to incorporate additional safety and convenience +features. Vantage is a video vehicle sensing system that detects the presence +of vehicles at signalized intersections enabling a more efficient allocation of +green signal time. +Our transportation +management systems include the design, development and implementation of our +software-based systems that integrate sensors, video surveillance, computers +and advanced communications equipment to enable public agencies to monitor, +control and direct traffic flow, assist in the quick dispatch of emergency +crews and distribute real-time information about traffic conditions. Our +services include planning and other engineering for the implementation of +transportation related communications systems, analysis and study related to +goods movement and commercial vehicle operations, and parking systems designs. +Sales, Marketing and Principal Customers +We sell our Vantage +vehicle detection systems primarily through indirect sales channels comprised +of independent dealers in the United States and Canada who sell integrated +systems and related products to the traffic intersection market. Our +independent dealers are primarily responsible for sales, installation and +support of Vantage systems. These dealers maintain an inventory of +demonstration traffic products including the Vantage vehicle detection systems +and sell directly to government agencies and installation contractors. These +dealers often have +1 +long-term +arrangements with the government agencies in their territory for the supply of +various products for the construction and renovation of traffic intersections. +We hold technical training classes for dealers and maintain a full-time staff +of customer support technicians to provide technical assistance when needed. +Our marketing strategy +for AutoVue is to establish it as the leading platform for in vehicle video +sensing for trucks and passenger cars. We sell AutoVue directly to vehicle +manufacturers and major automotive suppliers. We also market to the +manufacturers of automobiles through a strategic relationship with Valeo Group, +an independent automotive supplier. +We market and sell our +transportation management systems and services directly to government agencies +pursuant to negotiated contracts that involve competitive bidding and specific +qualification requirements. Most of our contracts with federal, state and +municipal customers provide for cancellation or renegotiation at the option of +the customer upon reasonable notice and fees paid for modification. We use +selected members of our engineering team divided on a regional basis to serve +in sales and business development functions. We do not engage in international +ITS sales. Sales of our systems contracts generally involve long lead times and +require extensive specification development, evaluation and price negotiations. +No single customer of Iteris, Inc. accounted for more than 10% of our total net +sales and contract revenues. +Manufacturing and Materials +We use local +manufacturers based near our Anaheim, California facility to build +subassemblies that are used in our Vantage products. These subassemblies are +delivered to our Anaheim facility where they go through final assembly and +testing prior to shipment to our customers. Our manufacturing activities are +conducted in approximately 6,000 square feet of space at our Anaheim +facility. Certain of our cameras used +in our products have historically been provided by a Japanese supplier who is +sole sourced; however, we are currently qualifying other sources of supply. +Production volume at our subcontractors is based upon quarterly forecasts that +we adjust on a monthly basis to control inventory. For sales to the truck +market, we subcontract the manufacture of our AutoVue systems to one +manufacturer, and our internal processes are limited primarily to testing and +final verification. For sales to the +passenger car market, we anticipate that all manufacturing will be done by the +Valeo Group. We currently do not +manufacture any of the hardware used in the transportation management and +traveler information systems that we design and implement. Our production +facility is currently ISO 9001 certified. +Customer +Support and Services +We provide warranty +service and support for each of our products and follow-up service and support, +for which we charge separately. Service revenue accounted for less than 1.0% of +total net sales and contract revenues for the year ended March 31, 2004 +(“fiscal 2004”). We believe customer +support is a key competitive factor. +Backlog +Our backlog of +unfulfilled firm orders was approximately $21.6 million as of March 31, +2004 and was approximately $24.8 million as of March 31, 2003. +Approximately 63.0% of our backlog at March 31, 2003 was recognized as +revenues in the fiscal year ended March 31, 2004, and approximately 60.0% +of our backlog at March 31, 2004 is expected to be recognized as revenues +in the fiscal year ended March 31, 2005. +Pursuant to the customary terms of our agreements with government +contractors and other customers, customers can generally cancel or +reschedule orders with little or no penalties. Lead times for the release +of purchase orders depend upon the scheduling and forecasting practices of our +individual customers, which also can affect the timing of the conversion of our +backlog into revenues. For these reasons, among others, our backlog at a +particular date may not be indicative of our future revenues. +Product +Development +Most of our development +activities are conducted at our principal facilities in Anaheim, California. +Our company-sponsored research and development costs and expenses were +approximately $3.4 million for the year ended March 31, 2002 ("Fiscal +2002"), $3.9 million in for the year ended March 31, 2003 ("Fiscal +2003") and $3.9 million in fiscal 2004. +We expect to continue to pursue significant product development programs +and incur significant research and development expenditures. +2 +Competition +We generally face +significant competition in each of our target markets. Increased competition +may result in price reductions, reduced gross margins and loss of market share, +any of which could have a material adverse effect on our business, financial +condition and results of operations. We believe that AutoVue is the only +commercially-available lane departure warning system used in the U.S. and in +Europe. Potential competitors of +AutoVue include Delphi Automotive Systems Corporation domestically, NEC +Corporation and Hitachi Ltd. in Japan and Robert Bosch Gmbh in Europe, which +could be currently developing video sensor technologies for the vehicle +industry that could be used for lane departure warning systems. In the market +for our Vantage vehicle detection systems, we compete with manufacturers of +other “above ground” video camera detection systems such as Econolite Control +Products, Inc., Trafficon, N.V., Peek Traffic Systems, and other non-intrusive +detection devices including microwave, infrared, ultrasonic and magnetic +detectors, as well as manufacturers and installers of in-pavement inductive +loop products. Our competitors for Vantage products do not disclose specific +sales numbers, either because they are private companies or because they are +part of larger companies. Based on our interface with them in the market, we +believe that we are leading our competitors in annual sales volume for video +detection products. +The transportation +management and traveler information systems market is highly fragmented and is +subject to evolving national and regional quality and safety standards. Our +competitors vary in number, scope and breadth of the products and services they +offer. Our competitors in advanced transportation management and traveler +information systems include large multi-national corporations such as +Transcore, Lockheed Martin Corporation, PB Farradyne Inc., Kimley-Horn and +Associates, Inc. and National Engineering Technology, Inc. Iteris, Inc.’s +competitors in transportation engineering, planning and design include major +firms such as Parsons Brinkerhoff, Inc. and Parsons Transportation Group Inc., +as well as many smaller regional engineering firms. +In general, the markets +for the products and services offered by our businesses are highly competitive +and are characterized by rapidly changing technology and evolving standards. +Many of our current and prospective competitors have longer operating +histories, greater name recognition, access to larger customer bases and significantly +greater financial, technical, manufacturing, distribution and marketing +resources than us. As a result, they may be able to adapt more quickly to new +or emerging standards or technologies or to devote greater resources to the +promotion and sale of their products. It is also possible that new competitors +or alliances among competitors could emerge and rapidly acquire significant +market share. We believe that our ability to compete effectively in our target +markets will depend on a number of factors, including the success and timing of +our new product development, the compatibility of our products with a broad +range of computing systems, product quality and performance, reliability, +functionality, price, and service and technical support. Our failure to provide +services and develop and market products that compete successfully with those +of other suppliers and consultants in our target markets would have a material +adverse effect on our business, financial condition and results of operations. +Intellectual +Property and Proprietary Rights +Our ability to compete +effectively depends in part on our ability to develop and maintain the +proprietary aspects of our technology. Our policy is to obtain appropriate +proprietary rights protection for any potentially significant new technology +acquired or developed by us. We +currently hold six U.S. patents, which expire commencing in 2012, and have +eighteen U.S. patent applications pending, mostly relating to our outdoor image +processing techniques used in our AutoVue and Vantage systems. Two of our +patents relate specifically to our AutoVue technology and provide a basis for +enhanced functionality for rain sensing and improved performance. We believe +that our other patents, while important for our technology platforms are less +critical to near term product strategy. We cannot assure you that any new +patents will be granted pursuant to any outstanding or subsequent applications. +In addition to patent +laws, we rely on copyright and trade secret laws to protect our proprietary +rights. We attempt to protect our trade secrets and other proprietary +information through agreements with customers and suppliers, proprietary +information agreements with our employees and consultants, and other similar +measures. We do not have any material licenses or trademarks other than those +relating to product names. We cannot be certain that we will be successful in +protecting our proprietary rights. While we believe our patents, patent +applications, software and other proprietary know-how have value, changing +technology makes our future success dependent principally upon our employees’ +technical competence and creative skills for continuing innovation. +Litigation has been +necessary in the past and may be necessary in the future to enforce our proprietary +rights, to determine the validity and scope of the proprietary rights of +others, or to defend us against claims of infringement or invalidity by others. +An adverse outcome in such litigation or similar proceedings could subject us +to significant liabilities to third parties, require disputed rights to be +licensed from others or require us to cease marketing or using certain +products, any of which could have a material adverse effect on our business, +financial condition and results of operations. In addition, the cost of +addressing any intellectual property litigation claim, both in legal fees and +expenses, as well as from the diversion of management’s resources, regardless +of whether the claim is valid, could be significant and could have a material +adverse effect on our business, financial condition and results of operations. +3 +Employees +We refer to our employees +as associates. As of June 3, 2004, we employed an aggregate of 204 +associates, including 50 associates in general management, administration and +finance; 20 associates in sales and marketing; 104 associates in product +development; 21 associates in operations, manufacturing and quality; and nine +associates in customer service. None of our associates are represented by a +labor union, and we have never experienced a work stoppage. +Government +Regulation +Our manufacturing +operations are subject to various federal, state and local laws and +regulations, including those restricting the discharge of materials into the +environment. We are not involved in any pending or, to our knowledge, +threatened governmental proceedings, which would require curtailment of our +operations because of such laws and regulations. We continue to expend funds in +connection with our compliance with applicable environmental regulations. These +expenditures have not, however, been significant in the past, and we do not +expect any significant expenditure in the near future. Currently, compliance +with foreign laws has not had a material impact on our business and is not +expected to have a material impact in the near future. +Legal +Proceedings +We are not currently a +party to any material legal proceedings. +ITEM 2. PROPERTIES +Our headquarters and +principal operations consist of 86,000 +square feet of space located at 1515 South Manchester Boulevard in Anaheim, +California. The Anaheim facility is +leased by us under three separate agreements and houses our administrative +offices (approximately 15,000 dedicated square feet), the operations of our +former subsidiary, MAXxess Systems, Inc. (approximately 10,000 dedicated square +feet), as well as the operations of Iteris, Inc. (approximately 58,000 +dedicated square feet). Two of the +three Anaheim leases representing 80,000 of the 86,000 square feet commenced on +July 1, 2003 and have four year terms at a monthly lease rate of $56,908 +for 65,000 square feet and $13,133 per month for 15,000 square feet. Approximately 10,000 square feet is sub-leased +to MAXxess at a rate of $10,000 per month. +On March 1, 2004, Iteris, Inc. entered into a third lease in +Anaheim for 6,000 additional square feet at a rate of $3,300 per month. All three Anaheim leases expire on +October 31, 2007. +ITEM 3. LEGAL PROCEEDINGS +From time to time, we +have been involved in litigation relating to claims arising out of our +operations in the normal course of business. +We are not currently a party to any material legal proceedings. +ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY +HOLDERS. +No matters were submitted +to a vote of our security holders during the three months ended March 31, +2004. +4 +PART II +ITEM 5 . MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED +STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES +Our Class A common stock +and Class B common stock are quoted on the OTC Bulletin Board under the symbols +“ITRSA.OB” and “ITRSB.OB,” respectively. Our Class A common stock and our Class +B common stock were delisted from the Nasdaq SmallCap Market in August 2003, +and April 2003, respectively, and is currently quoted on the OTC Bulletin +Board. Prior to that, our Class A +common stock and Class B common stock were listed on the Nasdaq National +Market. The following table sets forth +for the fiscal periods indicated the high and low sales prices for the Class A +common stock and Class B common stock as reported by the Nasdaq SmallCap Market +or the OTC Bulletin Board for applicable periods. +Class A Common Stock +Class B Common Stock +High +Low +High +Low +Fiscal +2003 +Quarter Ended +June 30, 2002 +$ +1.70 +$ +1.27 +$ +2.57 +$ +1.85 +Quarter Ended +September 30, 2002 +1.52 +.85 +2.00 +1.00 +Quarter Ended +December 31, 2002 +1.03 +.45 +1.00 +.42 +Quarter Ended +March 31, 2003 +.74 +.51 +.75 +.52 +Fiscal +2004 +Quarter Ended +June 30, 2003 +$ +.89 +$ +.45 +$ +.53 +$ +.20 +Quarter Ended +September 30, 2003 +1.75 +.51 +.20 +.20 +Quarter Ended +December 31, 2003 +2.60 +1.36 +.40 +.20 +Quarter Ended +March 31, 2004 +4.15 +1.91 +3.00 +.40 +Fiscal +2005 +Quarter Ending +June 30, 2004 (through +June 29, 2004) +$ +4.10 +$ +2.60 +$ +3.00 +$ +3.00 +As of June 21, 2004, +we had 508 holders of record of Class A common stock and 96 holders of record +of Class B common stock according to information furnished by our transfer +agent. +Dividend Policy +We have never paid or +declared cash dividends on either class of our common stock, and have no +current plans to pay such dividends in the foreseeable future. We currently +intend to retain any earnings for working capital and general corporate +purposes. The payment of any future dividends will be at the discretion of our +Board of Directors, and will depend upon a number of factors, including, but +not limited to, future earnings, the success of our business, activities, our +capital requirements, our general financial condition and future prospects, +general business conditions, the consent of our lender and such other factors +as the Board may deem relevant. +Recent Sales of +Unregistered Securities +During the quarter ended +March 31, 2004, we issued 89,332 unregistered shares of our Class A common +stock valued at $151,000 to an accredited investor to settle a trade payable +incurred during our fiscal year ended March 31, 2002. The offer and sale of the securities +described above were effected without registration in reliance on the exemption +afforded by Regulation D promulgated under the Securities Act of 1933, as +amended. +5 +ITEM 6. SELECTED CONSOLIDATED FINANCIAL DATA +The following table sets +forth our selected consolidated financial data for each of the five fiscal +years ended March 31, 2004. The +statement of operations and balance sheet data for the years ended and as of +March 31, 2000, 2001, 2002, 2003 and 2004 are derived from our audited +consolidated financial statements. The +accompanying consolidated financial statements have been restated to reflect +the classification and presentation of Broadcast, Inc., Zyfer Inc., Mariner +Networks, Inc., Gyyr, Inc. and MAXxess Systems, Inc. as discontinued operations +for all periods presented. See Note 1 +to the accompanying consolidated financial statements. The following information should be read in +conjunction with “Management’s Discussion and Analysis of Financial Condition +and Results of Operations” and with our consolidated financial statements and +the related notes thereto included elsewhere in this report. +Fiscal Year Ended +March 31, +2000 +2001 +2002 +2003 +2004 +(in thousands, except per +share data) +Consolidated +Statement of Operations Data: +Net sales and +contract revenues: +Net sales +$ +7,740 +$ +10,626 +$ +17,104 +$ +19,112 +$ +23,470 +Contract revenues +15,671 +17,430 +20,205 +22,283 +21,813 +Total net +sales and contract revenues +23,411 +28,056 +37,309 +41,395 +45,283 +Costs and +expenses: +Cost of net +sales +4,308 +5,558 +8,401 +9,366 +12,758 +Cost of +contract revenues +11,310 +11,463 +12,043 +15,110 +14,712 +Selling, +general and administrative expenses +15,201 +15,882 +14,627 +14,105 +12,844 +Research and +development expenses +3,698 +5,526 +3,434 +3,908 +3,923 +Restructuring +charges +— +367 +1,142 +— +— +Total costs +and expenses +34,517 +38,796 +39,647 +42,489 +44,237 +Income (loss) +from operations +(11,106 +) +(10,740 +) +(2,338 +) +(1,094 +) +1,046 +Non-operating +income (expense): +Royalty income +38,437 +17,825 +— +— +— +Other income +(expense), net +— +188 +(1,365 +) +417 +1,003 +Interest +expense, net +(1,919 +) +(1,762 +) +(4,190 +) +(761 +) +(123 +) +Income (loss) +before income tax +25,412 +5,511 +(7,893 +) +(1,438 +) +1,926 +Income tax +benefit (provision) +— +— +785 +— +(100 +) +Income (loss) +from continuing operations before minority interest +25,412 +5,511 +(7,108 +) +(1,438 +) +1,826 +Minority +interest in earnings of subsidiary +— +— +(1,910 +) +(3,818 +) +(3,034 +) +Income (loss) +from continuing operations +25,412 +5,511 +(9,018 +) +(5,256 +) +(1,208 +) +Income (loss) +from discontinued operations, net of +taxes of $0 +(27,691 +) +(38,051 +) +(17,120 +) +(7,892 +) +1,215 +Extraordinary +loss from early extinguishment debt, net of taxes of $0 +— +— +(450 +) +— +— +Net income (loss) +$ +(2,279 +) +$ +(32,540 +) +$ +(26,588 +) +$ +(13,148 +) +$ +7 +Basic earnings +(loss) per share: +Continuing +operations +$ +2.80 +$ +0.55 +$ +(0.80 +) +$ +(0.37 +) +$ +(0.06 +) +Discontinued +operations +(3.05 +) +(3.81 +) +(1.52 +) +(0.55 +) +0.06 +Extraordinary +loss +— +— +(0.04 +) +— +— +Basic earnings +(loss) per share +$ +(0.25 +) +$ +(3.26 +) +$ +(2.36 +) +$ +(0.92 +) +$ +0.00 +Diluted +earnings (loss) per share: +Continuing +operations +$ +2.69 +$ +0.54 +$ +(0.80 +) +$ +(0.37 +) +$ +(0.06 +) +Discontinued +operations +(2.93 +) +(3.73 +) +(1.52 +) +(0.55 +) +0.06 +Extraordinary +loss +— +— +(0.04 +) +— +— +Diluted +earnings (loss) per share +$ +(0.24 +) +$ +(3.19 +) +$ +(2.36 +) +$ +(0.92 +) +$ +0.00 +Shares used in +calculating basic earnings (loss) per share +9,089 +9,977 +11,267 +14,276 +19,454 +Shares used in +calculating diluted earnings (loss) per share +9,444 +10,209 +11,267 +14,276 +19,680 +6 +At March 31, +2000 +2001 +2002 +2003 +2004 +(in thousands) +Consolidated +Balance Sheet Data : +Working +capital (deficit) +$ +26,830 +$ +2,114 +$ +(7,349 +) +$ +3,368 +$ +9,369 +Total assets +81,850 +68,061 +52,238 +34,842 +30,051 +Long-term debt +(less current portion) +10,649 +4,791 +2,042 +1,265 +849 +Accumulated +deficit +(26,192 +) +(58,732 +) +(85,320 +) +(98,468 +) +(98,461 +) +Total +stockholders’ equity (deficit) +36,110 +20,378 +5,255 +(4,288 +) +623 +ITEM +7. MANAGEMENT’S +DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS +You should read the following discussion and +analysis in conjunction with our Consolidated Financial Statements and related +Notes thereto included in Part IV, Item 15 of this report and the “Risk +Factors” section at the end of this Item 7, as well as other cautionary +statements and risks described elsewhere in this report, before deciding to +purchase, hold or sell our common stock. +Overview +We have historically +operated multiple business units. During the fiscal year ended March 31, +2003 (“fiscal 2003”), we operated in three business segments consisting of ITS, +video products and telecom products. The ITS segment consisted of our +majority-owned subsidiary, Iteris, Inc., which designs, develops, markets and +implements video sensor systems and transportation management and traveler +information systems for the ITS industry. The video products segment consisted +of our former wholly-owned subsidiaries, MAXxess Systems, Inc. (previously +known as Gyyr Incorporated), which designed and manufactured security +management systems, and Broadcast, Inc., which developed and supplied software +based systems to automate and control the multiple classes of equipment used in +broadcast studios and satellite uplink facilities. Our telecom segment +consisted of our wholly-owned subsidiary, Zyfer, Inc., which developed and +manufactured timing and synchronization products and which, prior to its +incorporation, was operated as our Communications division. +Beginning in the fiscal +year ended March 31, 2001 (“fiscal 2001”), we began divesting certain of +our business units in order to reduce our operating expenses and to focus on +what we believe is our core business, Iteris, Inc. These divestitures and related restructuring included the following +transactions: +• In September 2001, we sold +substantially all of the assets and certain liabilities of the Gyyr CCTV +Products line for $8.8 million and changed the name of Gyyr to MAXxess Systems, +Inc. +• In September 2001, we +discontinued the operations of Mariner Networks, Inc., our former wholly-owned +subsidiary that was historically part of our telecom segment. +• As a result of the sale of the Gyyr +CCTV Products line and the discontinuation of Mariner Networks, we reorganized +our European operations and further reduced our overall staffing levels. The +reorganization of the European operations included the discontinuation of our +Odetics Europe Ltd., Gyyr Europe Ltd., Mariner France and Mariner Europe Ltd. +operations, and the transition of our Broadcast and MAXxess international +operations to branch office operations with the intent of lowering our +international costs. In connection with this restructuring, 34 employees were +terminated in the quarter ended December 31, 2001 and 78 employees were +terminated in the quarter ended March 31, 2002. +7 +• In March 2003, we ceased the +development and sale of any new Broadcast products and in September 2003, +we sold the balance of our Broadcast business. +• In May 2003, we sold the assets of +Zyfer for a purchase price of $2.3 million in cash and the assumption of +liabilities, plus future incentive payments of up to $1.0 million in each of +the twelve months ended April 30, 2004 and 2005. The amount of these future +incentive payments will be based on the revenues generated by the sale of +Zyfer’s products or the license of its technologies. +• In September 2003, we sold +substantially all of the assets of MAXxess to an investor group that included +certain members of the MAXxess management group. The consideration for the sale +consisted of the assumption of $2.7 million of liabilities, resulting in a net +gain of $2.3 million on this sale. +Our financial statements +for all periods presented in this report have been restated to reflect the +discontinuation of the operations of Gyyr, Broadcast, Zyfer, Mariner Networks +and MAXxess and, accordingly, only reflect the operations of Iteris, Inc. +In May 2004, we completed +the private placement of $10.1 million in subordinated convertible debentures +and a $5.0 million senior term credit facility and purchased all of the +outstanding preferred stock of our Iteris, Inc. subsidiary for $17.5 million in +cash, which shares were held by DaimlerChrysler Ventures (“DCV”) and +Hockensheim Investment Pte. Ltd. (“Hockenheim”). DCV exchanged its common stock in Iteris, Inc. for shares of +Class A common stock of Iteris Holdings as a part of this transaction. +We intend to enter into +an exchange agreement with certain of the holders of the common stock of +Iteris, Inc., pursuant to which these holders agreed to exchange an aggregate +of 1,319,541 shares of Iteris, Inc. common stock for an aggregate of 2,639,082 +shares of Iteris Holdings Class A common stock. We anticipate that this exchange will be completed in +June 2004. Upon completion of this +exchange, we plan to merge Iteris, Inc. into Iteris Holdings and all of the +outstanding shares of common stock of Iteris, Inc. will convert into shares of +Class A common stock of Iteris Holdings. +The final step in this roll-up transaction is anticipated to be +completed within the next six months and is subject to the approval of the +stockholders of Iteris, Inc. and the California Department of +Corporations. The foregoing +transactions are part of our plan of reorganization to consolidate Iteris, Inc. +into and with Iteris Holdings. +Iteris Holdings currently +operates in two reportable segments: Sensors and Systems. The Sensors segment +includes Vantage vehicle detection systems for traffic +intersection control and AutoVue sensors for in vehicle safety. The Systems segment includes transportation +engineering and consulting activities. +Critical +Accounting Policies And Estimates +Management’s Discussion +and Analysis of Financial Condition and Results of Operations is based on our +consolidated financial statements included herein, which have been prepared in +accordance with accounting principles generally accepted in the United States. +The preparation of these financial statements requires management to make +estimates and assumptions that affect the reported amounts of assets and +liabilities and related disclosure of contingent assets and liabilities at the +date of the financial statements and the reported amounts of revenues and +expenses during the reporting period. On an ongoing basis, we evaluate these +estimates and assumptions, including those related to the collectibility of +accounts receivables, the valuation of inventories, the recoverability of +long-lived assets, including goodwill, and reserves for restructuring and +related activities. We base these estimates on historical experience and on +various other factors that we believe to be reasonable under the circumstances, +the results of which form the basis for making judgments about the carrying +values of assets and liabilities that are not readily apparent from other +sources. These estimates and assumptions by their nature involve risks and +uncertainties, and may prove to be inaccurate. In the event that any of our +estimates or +8 +assumptions are +inaccurate in any material respect, it could have a material adverse effect on +our reported amounts of assets and liabilities at the date of the financial +statements and the reported amounts of revenues and expenses during the +reporting period. +The following critical +accounting policies affect our more significant judgments and estimates used in +the preparation of our consolidated financial statements. +Revenue +Recognition . We +record product revenues and related cost of sales upon transfer of title, which +is generally upon shipment or, if required, upon acceptance by the customer, +provided that we believe collectibility of the net sales amount is probable. +Accordingly, at the date revenue is recognized, the significant uncertainties +concerning the sale have been resolved. Unless otherwise stated, we provide a +one to two year warranty from the original invoice date on all product material +and workmanship. Defective products are +either repaired or replaced, at our option, upon meeting certain criteria. We accrue a provision for the estimated +costs that may be incurred for product warranties relating to a product as a +component of cost of sales at the time revenue for that product is recognized. Should actual experience of warranty returns +be higher than anticipated, additional warranty reserves may be required, and +may adversely affect our operating results. +Contract revenue is +derived primarily from long-term contracts with governmental agencies. Contract +revenue includes costs incurred plus a portion of estimated fees or profits +determined on the percentage of completion method of accounting based on the +relationship of costs incurred to total estimated costs. Any anticipated losses on contracts are +charged to earnings when identified. +Changes in job performance and estimated profitability, including those +arising from contract penalty provisions and final contract settlements, may +result in revisions to cost and revenue and are recognized in the period in +which the revisions are determined. +Profit incentives are included in revenue when their realization is +reasonably assured. +In addition to product +and contract revenue, we derive revenue from technology access fees and the +provision of specific non-recurring contract engineering services. Technology +access fees are amortized to revenue over the life of the related agreement and +are based on contractual values. Contract engineering revenues are recognized +in the period in which services are performed based on contractual billing +terms. Technology access fee revenues and contract engineering revenues are +included in net sales on the accompanying statements of operations. +Revenues from follow-on +service and support, for which we charge separately, is recorded in the period +in which the services are performed. +Accounts +Receivable . We +estimate the collectibility of customer receivables on an ongoing basis by +periodically reviewing invoices outstanding greater than a certain period of +time. We have recorded reserves for receivables deemed to be at risk for +collection as well as a general reserve based on our historical collections +experience. A considerable amount of judgment is required in assessing the +ultimate realization of these receivables, including the current credit-worthiness +of each customer. If the financial condition of our customers deteriorates, +resulting in an impairment of their ability to make required payments, +additional allowances may be required which could adversely affect our +operating results. +Inventory . We state our inventories at the lower of +cost or market and provide reserves for potentially excess and obsolete +inventory. In assessing the ultimate realization of inventories, we make +judgments as to future demand requirements and compare that with the current or +committed inventory levels. Reserves are established for inventory levels that +exceed future demand. It is possible that reserves over and above those already +established may be required in the future if market conditions for our products +deteriorate. +Goodwill +and Purchased Intangible Assets . The purchase method of accounting for acquisitions requires +extensive use of accounting estimates and judgments to allocate the purchase +price to the fair value of the net tangible and intangible assets acquired. +Goodwill and intangible assets deemed to have +9 +indefinite lives +are no longer amortized but are subject to annual impairment tests. The amounts +and useful lives assigned to other intangible assets impact future +amortization. If the assumptions and estimates used to allocate the purchase +price are not correct or if business conditions change, purchase price +adjustments or future asset impairment charges could be required. +Impairment +of Assets and Restructuring . +During fiscal 2003, we recorded reserves and asset write-downs in +connection with the sale of substantially all of the assets of Zyfer and the +discontinuation of Broadcast. These include estimates pertaining to the fair +value of assets and facility closure costs. Although we do not anticipate +significant changes, the actual assets values and closure costs may differ from +the amounts estimated. +Results of Operations +The following table sets +forth certain statement of operations data as a percentage of total net sales +and contract revenues for the periods indicated. The following table should be +read in conjunction with Management’s Discussion and Analysis of Financial +Condition and Results of Operations. +Fiscal Year Ended March 31, +2002 +2003 +2004 +Net sales and contract revenues: +Net sales +45.8 +% +46.2 +% +51.8 +% +Contract +revenues +54.2 +53.8 +48.2 +Total net +sales and contract revenues +100.0 +% +100.0 +% +100.0 +% +Costs and +expenses: +Cost of net +sales +22.5 +22.6 +28.2 +Cost of +contract revenues +32.3 +36.5 +32.5 +Selling, +general and administrative expenses +39.2 +34.1 +28.4 +Research and +development expenses +9.2 +9.4 +8.7 +Restructuring +charges +3.1 +— +— +Total costs +and expenses +106.3 +102.6 +97.8 +Income (loss) +from operations +(6.3 +) +(2.6 +) +2.2 +Non-operating +income (expense): +Other income +(expense), net +(3.7 +) +1.0 +2.2 +Interest +expense, net +(11.2 +) +(1.8 +) +(0.2 +) +Income (loss) +before tax +(21.2 +) +(3.4 +) +4.2 +Income tax +benefit (provision) +2.1 +— +(0.2 +) +Income (loss) +from continuing operations before minority interest +(19.1 +) +(3.4 +) +4.0 +Minority +interest in earnings of subsidiary +(5.1 +) +(9.2 +) +(6.7 +) +Loss from continued +operations +(24.2 +) +(12.6 +) +(2.7 +) +Income (loss) +from discontinued operations, net of income taxes of $0 +(45.9 +) +(19.1 +) +2.7 +Extraordinary +loss from early extinguishment of debt, net of income taxes of $0 +(1.2 +) +— +— +Net income +(loss) +(71.3 +)% +(31.7 +)% +0.0 +% +Years +Ended March 31, 2004, 2003 and 2002 +Net +Sales and Contract Revenues . +Net sales and contract revenues consist principally of (i) sales of +products and services to commercial customers and municipal agencies (“net +sales”) and primarily consists of sales of our Vantage video detection systems +and AutoVue lane departure warning +10 +systems, as well +as technology access fees and contract engineering revenues; and (ii) revenues +derived from systems integration and ITS consulting services with state, county +and municipal agencies (“contract revenues”). We currently have a diverse +customer base and no customer constituted over 10% of our total net sales and +contract revenues in fiscal 2004. Total net sales and contract revenues +increased 9.4% to $45.3 million for the fiscal year ended March 31, 2004 +(“fiscal 2004”) compared to $41.4 million in fiscal 2003, and increased 11.0% +for the fiscal year ended March 31, 2003 (“fiscal 2003”) compared to $37.3 +million for the fiscal year ended March 31, 2002 (“fiscal 2002”). +Net sales increased 22.8% +to $23.5 million in fiscal 2004 compared to $19.1 million in fiscal 2003, and +increased 11.7% in fiscal 2003 compared to $17.1 million in fiscal 2002. The +increase in net sales in each of the periods primarily reflected an increase in +the unit sales of our Vantage vehicle detection systems and increased sales of +our AutoVue lane departure warning systems. +Net sales from AutoVue products increased 173.1% in fiscal 2004 compared +to fiscal 2003, and represented 17.9% of total net sales in fiscal 2004 and +8.0% of total net sales in fiscal 2003. +The increase in sales of AutoVue products principally reflected license +fee revenue and fees for non-recurring engineering costs derived from Valeo, +our strategic partner for the passenger car OEM customer base, and increased +unit sales of lane departure warning systems in the European commercial truck +market. Vantage sales comprised 89.6%, 92.0%, and 82.1% of net sales in each of +the three fiscal years ended 2002, 2003, and 2004, respectively. All of the +Vantage revenues were derived from sales within North America. The sales growth +was primarily due to increased market adoption of video based detection +technologies for traffic intersection management. +Contract revenues +decreased 2.1% to $21.8 million in fiscal 2004 compared to $22.3 million in +fiscal 2003, and increased 10.3% compared to $20.2 million in fiscal 2002. Contract revenues reflect a broad range of +fixed price and cost plus fixed fee contracts for engineering study and design, +systems integration and system implementation. +Contract revenues are dependent upon the continued availability of +funding on both the State and Federal levels from the various departments of +transportation. The decrease in fiscal +2004 compared to 2003 principally reflects budget constraints in both the +Federal and California markets, where a significant portion of our contract revenues +have been derived during the last several fiscal years, The increase in contract revenues in fiscal +2003 compared to fiscal 2002 primarily reflects an increase in volume of ITS +projects. The growth in contract revenues in fiscal 2003 reflected a general +expansion of our systems consulting and integration business. This expansion +was characterized by the addition of new offices into additional geographic +regions including Georgia, Colorado and Idaho. All of our contract revenue is +currently derived from North America. +Gross +Profit . Total gross +profit increased 5.3% to $17.8 million in fiscal 2004 compared to $16.9 million +in fiscal 2003, and was unchanged at $16.9 million in fiscal 2003 compared to +fiscal 2002. Total gross profit as a percent of net sales and contract revenues +decreased to 39.3% in fiscal 2004 compared to 40.8% in fiscal 2003 and 45.2% in +fiscal 2002. +Gross profit as a +percentage of net sales decreased to 45.6% in fiscal 2004 compared to 51.0% in +fiscal 2003 and 50.9% in fiscal 2002. The decrease in gross profit in fiscal +2004 compared to 2003 reflects lower unit pricing on large, high volume, state +contracts for Vantage products, in addition to lower gross profits on AutoVue +products as a result of increased unit sales of product to the commercial truck +market. The increase in gross profit as +a percent of net sales in fiscal 2003 compared to 2002 reflects the net effect +of increased gross profit on Vantage product sales, which was partially offset +by decreased margins on AutoVue product sales. We achieved a 200 basis point +increase in gross profit on sales of Iteris’ Vantage video detection systems in +fiscal 2003, in conjunction with a 14.7% increase in sales of these products in +fiscal 2003 compared to 2002. In fiscal 2003, however, AutoVue product sales +began transitioning from low volume, high margin sample sales to early +production volume of units for the truck market. +Gross profit as a percent +of contract revenues increased to 32.6% in fiscal 2004 compared to 32.2% in +fiscal 2003 and 40.4% in fiscal 2002. +We recognize contract revenues and related gross profit using percentage +of completion contract accounting, and the underlying mix of contract +activity affects the related gross +profit recognized in any given year. +The decrease in fiscal 2003 reflects a mix of lower +11 +margin contracts +in fiscal 2003 as compared to fiscal 2002. Furthermore, gross profit on +contract revenues in fiscal 2002 benefited approximately 610 basis points from +a $1.4 million reduction in loss reserves on certain long-term contracts +resulting from changes in the scope of work defined by a major customer, most +of which were nonrecurring in fiscal 2003. +Selling, +General and Administrative Expense . Selling, general and administrative expense decreased 8.9% to +$12.8 million (or 28.4% of total net sales and contract revenues) in fiscal +2004 compared to $14.1 million (or 34.1% of total net sales and contract +revenues) in fiscal 2003, and decreased 3.6% in fiscal 2003 compared to $14.6 +million (or 39.2% of total net sales and contract revenues) in fiscal +2002. The decrease in fiscal 2004 +compared to fiscal 2003 reflects principally increased costs to support +expanded sales and marketing efforts in Vantage and AutoVue products in fiscal +2004, offset by decreased facilities lease expense related to the restructuring +of lease commitments for our Anaheim facilities in June 2003, and reduced +salaries expenses for corporate support personnel related to the divestiture of +our Broadcast, Zyfer and MAXxess Systems businesses in fiscal 2004. The decrease in selling, general and +administrative expense in fiscal 2003 compared to fiscal 2002 reflects general +cost reductions related to staffing and outside services for legal and +accounting expenses, which was partially offset by increased sales and +marketing costs to support Vantage and AutoVue products. +Research +and Development Expense . +Research and development expense increased 0.4% to $3.9 million (or 8.7% of total net sales and +contract revenues) in fiscal 2004 compared to $3.9 million (or 9.4% of total +net sales and contract revenues) in fiscal 2003, and increased 13.8% in fiscal +2003 compared to $3.4 million (or 9.2% of total net sales and contract +revenues) in fiscal 2002. The increase in research and development expense in +fiscal 2004 compared to 2003 reflects increased spending to support the +development of Vantage products which was partially offset by decreased +spending to support the development of AutoVue products. Vantage product development primarily +reflects activities for product line extensions to support new communications +platforms and to accommodate new camera designs. The increases were primarily in the areas of personnel costs and +related benefits and overhead, prototype material costs, and consulting fees. +The increase in research +and development expense in fiscal 2003 compared to 2002 primarily reflects +software algorithm development and new hardware designs for enhancements to our +existing product family of Vantage video detection systems. +For competitive reasons, +we closely guard the confidentiality of specific development projects. +Restructuring +Charges . The +restructuring charge of $1.1 million in fiscal 2002 reflects costs related to +the reorganization of our European operations and costs for severance for labor +reductions domestically and abroad totaling approximately $400,000 in addition +to $700,000 related to severance charges incurred upon the retirement of the +former Chief Executive Officer of Iteris Holdings. +Other +Income (Expense), Net . +Other income (expense), net reflects the following (in thousands): +Year Ended March 31, +2002 +2003 +2004 +Gain on sale of real estate +$ +— +$ +640 +$ +970 +Loss on sale of Iteris common stock +(1,596 +) +(310 +) +— +Other +231 +87 +33 +Other income (expense), net +$ +(1,365 +) +$ +417 +$ +1,003 +Other income (expense), +net in fiscal 2003 and 2004 included a gain of $640,000 and $970,000, +respectively, recognized on the sale and leaseback of our Anaheim, California +facility, which was consummated in May 2002. We sold shares of our Iteris +subsidiary common stock that yielded gross proceeds of $3.8 million and +$900,000 in fiscal 2002 and 2003, respectively. +12 +Interest +Expense, Net . +Interest expense, net reflects the net of interest expense and interest +income as follows (in thousands): +Year Ended March 31, +2002 +2003 +2004 +Interest expense +$ +4,190 +$ +761 +$ +125 +Interest income +— +— +(2 +) +Interest +expense, net +$ +4,190 +$ +761 +$ +123 +Interest expense +decreased 83.8% in fiscal 2004 compared to fiscal 2003 and decreased 81.8% in +fiscal 2003 compared to fiscal 2002. The decrease in fiscal 2004 reflected +lower average outstanding borrowings during fiscal 2004. The decrease in fiscal 2003 reflected the +sale and leaseback of our Anaheim, California facilities, and our subsequent +repayment in May 2002 of a $16.4 million promissory note. +Extraordinary +Item . The +extraordinary loss incurred in fiscal 2002 relates to a prepayment penalty we +incurred in fiscal 2002 in connection with the retirement of our mortgage note +payable upon the refinancing of our Anaheim real property. +Income +Taxes . During fiscal +2004, we recognized income tax expense of $100,000 and a related deferred tax +asset of $821,000 directly related to the profitable operations of our +subsidiary Iteris, Inc. The ability to +record the deferred tax asset was based on the more likely than not criteria of +FAS 109 since Iteris, Inc. has historically been profitable and it has utilized +all its federal net operating loss carryovers and thus, can carryback and +realize the reversal of future tax deductions. +No income tax benefit for losses incurred in fiscal 2003 was recorded +due to uncertainty as to the ultimate realization of the related benefit. A $785,000 tax benefit was recognized in +fiscal 2002 for the recovery of net operating loss carrybacks made available +under the Job Creation Workers Associate Act of 2002. +Minority +Interest in Subsidiary . +The minority interest represents the minority stockholders’ share of +Iteris, Inc.’s net income or loss and the accretion of the redemption +preference of Iteris’s Series A preferred stock. Upon our acquisition of the remaining minority interest in +Iteris, Inc. and the related roll-up merger, we will no longer report a +minority interest. +Liquidity +and Capital Resources +During fiscal 2004, we +used $718,000 of cash to fund our operations. +Net cash used in operating activities principally reflected our net +income of $7,000, increased for non-cash charges of $857,000 for depreciation +and amortization, and $3.0 million in non-cash charges related to the minority +interest in our Iteris subsidiary, and decreased $855,000 for non-cash gains +related to amortization of deferred gain on real-estate sales and the usage of +$4.0 million in cash to fund changes in operating assets and liabilities. Most of the cash requirements for operating +assets and liabilities during fiscal 2004 related to $2.4 million in cash used +to reduce trade accounts payable, accrued payroll, accrued expenses and income +tax payable, associated with the downsizing and reorganization of our business +model. +In May 2002, we completed +the sale and leaseback of our Anaheim, California facility for an aggregate +sale price of $22.6 million. Approximately $16.4 million of the proceeds from +this sale were used to repay the outstanding indebtedness under a promissory +note, which was secured by a first deed of trust on our Anaheim facility. In connection +with the sale and leaseback, we pledged cash of $2.5 million to secure our +obligations under the lease. The pledged amounts were to be released to us +based upon our continued compliance with financial covenants and performance +under the lease. The balance of the proceeds from this sale was used for +general working capital purposes. We committed to lease one of the two +buildings on this property for a period of ten years, and to lease the other +building for a period of 30 months. +In May 2003, we completed +the sale of substantially all the assets of our wholly-owned subsidiary, Zyfer, +Inc., for $2.3 million in cash plus the assumption of certain liabilities. The +cash +13 +proceeds were used +to fund working capital requirements and pay short-term liabilities. The asset +purchase agreement provides for future incentive payments to us of up to $1.0 +million in each of the twelve months ended April 30, 2004 and 2005. The amount of these future incentive payments +will be based on the revenues generated by the sale of Zyfer’s products or the +license of its technologies. Based on +the terms of the sale agreement, Zyfer, Inc. has 60 days to provide us with +support for the incentive payments. We +expect to receive information for fiscal 2004 by the end of June 2004. +In July 2003, we +concluded a restructuring of our facility lease obligations for our principal +operating facility located in Anaheim, California. Under the revised terms, +Iteris Holdings and its Iteris, Inc. subsidiary entered into two separate +leases for space totaling 80,000 square feet located at our current Anaheim +location. We have been relieved of a continuing lease obligation on +approximately 257,000 square feet. In consideration for the restructured +agreement, we paid approximately $2.5 million in cash that had been previously +pledged as collateral on the lease, in addition to issuing to the lessor +425,000 shares of Iteris Holdings Class A common stock valued at $255,000 and a +note payable for $811,000. +Also, in July 2003, +we completed a private placement of 3,666,666 of our Class A common stock to +seven accredited investors for net proceeds of $1.9 million in cash. In +connection with this offering, we also issued warrants to the investors to purchase +up to another 366,666 shares at an exercise price of $1.50 per share. The fair +value of these warrants was $55,000 calculated using the Black Scholes +Model. The warrants are considered a +cost of raising capital and were recorded in equity as an offset to additional +paid-in capital. The warrants expire in +July 2006 and became exercisable in January 2003. The proceeds from +the transaction were used to fund our general working capital requirements. +In September 2003, +we completed the sale of the assets of our MAXxess subsidiary to an investor +group that included certain members of the MAXxess management group. The +consideration for the sale consisted of the assumption by the buyer of $2.7 +million of liabilities, resulting in a net gain to Iteris Holdings of +approximately $2.3 million. We did not receive any cash in this transaction. +On May 28, 2004, we completed the purchase of all of the outstanding +shares of the Series A preferred stock of Iteris, Inc., which shares were held +by DaimlerChrysler Ventures GmbH ("DCV") and Hockenheim Investment +Pte. Ltd. (“Hockenheim”), in exchange for a payment of approximately $17.5 +million in cash. In addition, we +acquired all of the shares of the common stock of Iteris, Inc. held by DCV in +exchange for the issuance of 1,219,445 shares of our Class A common stock. The purchase and exchange of the shares were +made pursuant to a Stock Purchase and Exchange Agreement, dated March 31, +2004, by and among Iteris Holdings, Iteris, Inc., DCV and Hockenheim (the +“Purchase and Exchange Agreement”). +Pursuant to the Purchase and Exchange Agreement, we purchased 3,124,913 +shares of Series A Preferred Stock of Iteris from DCV and Hockeneheim for a +purchase price of $5.61 per share. The +purchase price represented the stated redemption value of the preferred +stock. The purchase of the shares was +financed principally with a $10.1 million convertible debenture financing +completed in May 2004 with a group of institutional investors, in addition to a +$5.0 million senior credit facility arranged through a bank. +In accordance with the Purchase and Exchange Agreement, we issued +1,219,445 shares of our Class A common stock (the “Exchange Shares”) to DCV in +exchange for 547,893 shares of the common stock of Iteris, Inc. held by +DCV. Subject to certain exceptions, DCV +has agreed not to sell or otherwise transfer the Exchange Shares during the +year following the Closing Date. +However, beginning on November 28, 2005, DCV may require us to +repurchase up to 50% of the Exchange Shares at a purchase price of $1.438 per +share; and beginning on May 28, 2007, DCV may require us to repurchase up to +100% of the Exchange Shares at a purchase price of $1.438 per share. All such rights to require the repurchase of +the Exchange Shares expire on September 28, 2007. +Beginning on May 28, 2005, DCV will have the right to request +registration of all of the shares of the Class A common stock of Iteris +Holdings held by it. In the event we +decide not to file a registration statement for all such shares, DCV may require +repurchase of any or all of its shares of our +14 +common stock at a purchase price of $1.438 per share. +In order to finance the purchase of the shares of Iteris, Inc. +preferred stock, we entered into a Debenture and Warrant Purchase Agreement +dated May 19, 2004 (the “Debenture Purchase Agreement”) with a group of +institutional investors, which included certain of our officers, pursuant to +which it sold and issued subordinated convertible debentures in the aggregate +principal amount of $10.1 million and issued warrants to purchase an aggregate +of 639,847 shares of our Class A common stock. +The debentures are due in five years, provide for 6.0% annual interest, +payable quarterly, and are convertible into our Class A common stock at an +initial conversion price of $3.61 per share, subject to certain adjustments, +including adjustments for dilutive issuances. +From May 19, 2007 until May 18, 2008, the debentures may be redeemed by +us, at our option, at 120% of the principal amount being redeemed; and from May +19, 2008 until the maturity date of May 18, 2009, the debentures may be +redeemed at 110% of the principal amount being redeemed. +Pursuant to the Debenture Purchase Agreement, each investor also +received two warrants to purchase shares of the Class A common stock. For every dollar of debenture purchased, +each investor received one warrant to purchase approximately 0.03235 shares of +our Class A common stock at an exercise price of $3.83 per share and a second +warrant to purchase approximately 0.03100 shares of our Class A common stock at +an exercise price of $4.03 per share. +The exercise prices are subject to certain adjustments, including +adjustments for dilutive issuances. The +warrants expire on May 18, 2009. +In conjunction with the Debenture and Warrant Purchase Agreement we +issued 34,036 warrants to purchase shares of our Class A Common Stock at $3.61 +per share as commissions related to the transaction. The warrants expire on May 18, 2009. +We have agreed to register for resale the shares underlying the +debentures and the warrants. Under the +terms of the Debenture Purchase Agreement, we may be required to make certain +payments to the investors if we do not file a registration statement with the +Securities and Exchange Commission on or prior to July 14, 2004 or if we +do not respond to comments to such registration statement, if any, from the SEC +within certain time limits. In +addition, we have granted to each investor a right of first offer with respect +to new issuances of its securities, subject to certain exceptions. +Concurrent with the issuance of the debentures, we, through our +subsidiary Iteris, Inc., entered into a $5.0 term note payable with a bank. +Proceeds form the note payable were used to purchase Iteris, Inc. preferred +stock as described above. The note is due in four years, on May 27, 2008, and +provides for monthly payments of principal and interest of approximately +$104,000. Interest accrues at the current stated prime rate plus 0.5% through +June 30, 2004 and then at the current stated prime rate plus 0.25% +thereafter. +As part of the Purchase and Exchange Agreement of the Series A +preferred stock, we also exchanged an aggregate of 547,893 shares of Iteris, +Inc. common stock held by DCV for an aggregate of 1,219,445 shares of Iteris +Holdings Class A common stock. +Also on May 28, 2004, Iteris, Inc. renegotiated its existing line of +credit agreement and entered into a new line of credit agreement with the same +bank. The new agreement has a one year term that expires on August 1, 2005 +and a maximum available credit line of $5.0 million. Under the terms of the new +agreement, Iteris, Inc. may borrow against its eligible accounts receivable and +the value of its eligible inventory, as defined. Interest on borrowed amounts +is payable monthly at the prime rate. +Additionally, Iteris, Inc. is obligated to pay an unused line fee of +0.25% per annum applied to the amount by which the maximum credit amount exceeds +the average daily principal balance during the preceding month. There is no +monthly collateral management fee associated with the new line of credit and no +pre-payment or early termination fees. The 1.0% cancellation fee to terminate +the prior line was waived by the bank. +Both the term note payable +and the line of credit are secured by substantially all of the assets of +Iteris, Inc. +15 +Our contractual +obligations are as follows at March 31, 2004 (in thousands): +Payments Due by Period +Total +2005 +2006 +2007 +After +2007 +Line of credit +$ +100 +$ +100 +$ +— +$ +— +$ +— +Capital lease obligations +12 +4 +4 +4 +— +Notes payable +921 +38 +50 +630 +203 +Operating leases +3,599 +1,205 +984 +897 +513 +Total +$ +4,632 +$ +1,347 +$ +1,038 +$ +1,531 +$ +716 +Subsequent to the +repurchase of the preferred stock and the exchange of the common stock held by +DCV, the minority interest in Iteris, Inc. has been reduced to approximately +16.6%. Our intention is to exchange the +residual outstanding 16.6% common stockholding minority interest in Iteris Inc. +for Class A common stock of Iteris Holdings and merge the two entities. +Although we have achieved +operating income and earnings before interest, taxes, depreciation and +amortization during the fiscal year ended March 31, 2004, our operations +may continue to use net cash. At March 31, 2004, our Iteris subsidiary had +a revolving line of credit with its principal bank, which expired +August 2004, and which provided for available borrowings up to $5.0 +million subject to a borrowing formula based upon qualified accounts receivable +as defined in the agreement. Borrowings on the line of credit bear interest at +prime plus 2.0% (6.0% at March 31, 2004). There were no borrowings on the +line at March 31, 2004, and $4.5 million was available for borrowing +subject to the borrowing base in the credit agreement. In May 2004, we entered +into a new $5.0 million line of credit with our principal bank to replace the +former revolving line, subject to similar borrowing formulas. Borrowings under the new line of credit bear +interest at the bank’s prime rate (4.0% at May 31, 2004). We believe that the combination of +available borrowings on our line of credit and our internally generated cash +flows will be sufficient to enable us to execute our operating plans and meet +our obligations on a timely basis. +Recent Accounting Pronouncements +In November 2002, the Emerging Issues Task Force (“EITF”) issued +EITF No. 00-21, “ Revenue Arrangements with +Multiple Deliverables ,” which provides guidance on the timing and +method of revenue recognition for sales arrangements that include the delivery +of more than one product or service. EITF No. 00-21 is effective prospectively +for arrangements entered into in fiscal periods beginning after June 15, +2003. The adoption of EITF No. 00-21 did not have a material effect on our +financial position, results of operations or cash flows. +In December 2002, the Financial Accounting Standards Board +(“FASB”) issued Statement of Financial Accounting Standards No. 148, “ Accounting for Stock-Based Compensation-Transition +and Disclosure ” (“SFAS No. 148”) which is effective for fiscal years +ending after December 15, 2002. SFAS No. 148 amends Statement of Financial +Accounting Standards No. 123, “ Accounting +for Stock-Based Compensation ” (“SFAS No. 123”) to provide +alternative methods of transition to SFAS No. 123’s fair value method of +accounting for stock-based employee compensation if a company elects to account +for its equity awards under this method. SFAS No. 148 also amends the +disclosure provisions of SFAS No. 123 and Accounting Principles Board Opinion +No. 28, “ Interim Financial Reporting ” +(“APB 25”) to require disclosure effects of an entity’s accounting policy with +respect to stock-based employee compensation on reported net income (loss) and +net income (loss) per share in both annual and interim financial statements. We +follow the disclosure-only provisions of SFAS No. 123, as amended by SFAS No. +148, and, accordingly, account for our stock-based compensation plans using the +intrinsic value method under Accounting Principles Board Opinion No. 25, “ Accounting for Stock Issued to Employees ” +and related interpretations. +16 +In January 2003, the FASB issued Interpretation No. 46, Consolidation of Variable Interest Entities (“FIN +46”). This Interpretation changes the method of determining whether certain +entities should be included in our Consolidated Financial Statements. An entity +is subject to FIN 46 and is called a variable interest entity (“VIE”) if it has +(1) equity that is insufficient to permit the entity to finance its activities +without additional subordinated financial support from other parties, or (2) +equity investors that cannot make significant decisions about the entity’s +operations, or that do not absorb the expected losses or receive the expected +returns of the entity. All other entities are evaluated for consolidation under +SFAS No. 94, Consolidation of All Majority-Owned Subsidiaries. The provisions +of FIN 46 are to be applied immediately to VIEs created after January 31, +2003, and to VIEs in which an enterprise obtains an interest after that date. +For VIEs in which an enterprise holds a variable interest that it acquired +before February 1, 2003, FIN 46 applies in the first fiscal period +beginning after June 15, 2003. +Adoption of FIN 46 did not have a material impact on our financial +position, results of operations or cash flows. +In May 2003, the FASB +issued SFAS 150, “ Accounting For Certain +Financial Instruments with Characteristics of Both Liabilities and Equity ” +(“SFAS No. 150”) which establishes standards for how an issuer of financial +instruments classifies and measures certain financial instruments with characteristics +of both liabilities and equity. It requires that an issuer classify a financial +instrument that is within its scope as a liability (or an asset in some +circumstances) if, at inception, the monetary value of the obligation is based +solely or predominantly on a fixed monetary amount known at inception, +variations in something other than the fair value of the issuer’s equity shares +or variations inversely related to changes in the fair value of the issuer’s +equity shares. SFAS No. 150 is effective for financial instruments entered into +or modified after May 31, 2003, and otherwise is effective at the beginning of +the first interim period beginning after June 15, 2003. The adoption of +SFAS 150 did not have a material impact on our financial position, results of +operations or cash flows. +17 +RISK +FACTORS +Our business is subject to a number +of risks, some of which are discussed below. +Other risks are presented elsewhere in this report and in the information +incorporated by reference into this report. +You should consider the following risks carefully in addition to the +together information contained in this report and our other filings with the +SEC, including our subsequent reports on Forms 10-Q and 8-K before deciding to +buy, sell or hold our common stock. The risks and uncertainties described below +are not the only ones facing our company. +Additional risks and uncertainties not presently known to us or that we +currently deem immaterial may also affect our business operations. If any of these risks actually occurs, our +business, financial condition or results of operations could be seriously +harmed. In that event, the market price +for our common stock could decline and you may lose all or part of your +investment. +We Have Experienced Substantial +Losses And May Continue To Experiencing Losses For The Foreseeable Future . We experienced net income of $7,000 in the +year ended March 31, 2004 and a net loss of $13.1 million in the year ended +March 31, 2003. While we have divested +all of our business units other than our Iteris, Inc. subsidiary, we cannot +assure you that our efforts to downsize our operations or reduce our operating +expenses will improve our financial performance, or that we will be able to +achieve profitability on a quarterly or annual basis in the future. Most of our +expenses are fixed in advance. As such, we generally are unable to reduce our +expenses significantly in the short-term to compensate for any unexpected delay +or decrease in anticipated revenues. As a result, we may continue to experience +operating losses and net losses, which would make it difficult to fund our +operations and achieve our business plan, and could cause the market price of +our common stock to decline. +We May Need To Raise Additional +Capital In The Future, But We May Not Be Able To Secure Adequate Funds On Terms +Acceptable To Us, Or At All . +We have generated significant net losses and operating losses in recent +periods, and have experienced negative cash flows from operations of $718,000 +in the year ended March 31, 2004, $4.8 million in the year ended March 31, 2003 +and $18.2 million in the year ended March 31, 2002. Although in May 2004, we +completed a $10.1 million convertible debenture financing and closed a $5.0 +million term loan, the majority of the proceeds from such financings were used +to purchase the preferred stock of Iteris, Inc. held by outside investors. We may need to raise additional capital in +the future to fund our operations or to purchase the minority interests in +Iteris, Inc. Our Iteris, Inc. subsidiary currently maintains a line of credit +with a maximum availability of $5.0 million, which expires in August 2005. +Substantially all of the assets of Iteris, Inc. have been pledged to the lender +to secure the outstanding indebtedness under this facility ($0 was outstanding +under the line of credit at March 31, 2004). +We may raise additional capital in the near future, +either through bank borrowings, or other debt or equity financings. We cannot +assure you that any additional capital will be available on a timely basis, on +acceptable terms, or at all. +Our capital requirements will depend on many factors, +including, but not limited to: +• our +ability to control costs; +• market +acceptance of our products and the overall level of sales of our products; +• our +ability to generate operating income; +• increased +research and development funding, and required investments in our Iteris, Inc. +subsidiary; +• increased +sales and marketing expenses; +• technological +advancements and our competitors’ response to our products; +• capital +improvements to new and existing facilities; +18 +• potential +acquisitions of businesses and product lines; +• our +relationships with customers and suppliers; and +• general +economic conditions, including the effects of the current economic slowdown and +international conflicts. +If our capital requirements are materially different +from those currently planned, we may need additional capital sooner than +anticipated. If additional funds are raised through the issuance of equity or +convertible debt securities, the percentage ownership of our stockholders will +be reduced and such securities may have rights, preferences and privileges senior +to our common stock. Additional financing may not be available on favorable +terms or at all. If adequate funds are not available or are not available on +acceptable terms, we may be unable to continue our operations as planned, +develop or enhance our products, expand our sales and marketing programs, take +advantage of future opportunities or respond to competitive pressures, +We Have Adopted A New Operating +Strategy, Which Is Untried And Exposes Us To New Risks . We recently divested ourselves of many of our +business units and significantly scaled back our operations in order to focus +on the business of our Iteris, Inc. subsidiary. We have abandoned our strategy +of incubating emerging companies, which historically required us to make +significant investments in new business units. Our current business strategy is +narrow and untried, and there is no assurance that our new business strategy or +the continued execution of the Iteris, Inc. business will be successful. +The Trading Price Of Our Common Stock +Is Highly Volatile And Our Shares Are Listed On The OTC Bulletin Board. As Such, It May Be Difficult To Resell Your +Shares Of Stock At Or Above The Price You Paid For Them Or At All . The trading price of our common stock has +been subject to wide fluctuations in the past. Since January 2000, our Class A +common stock has traded at prices as low as $0.45 per share and as high as +$29.44 per share and our Class B common stock has traded at prices as low as +$0.20 per share and as high as $29.62 per share. In 2003, because we failed to +meet the minimum stockholder’s equity and minimum share price requirements for +continued listing on the Nasdaq SmallCap Market, both our Class A common stock +and Class B common stock were delisted from the Nasdaq SmallCap Market and currently +trade on the OTC Bulletin Board. As such, the average daily trading volume of +common stock has decreased, and it may be more difficult for you to sell your +shares in the future at or above the price you paid for them, or at all. This +delisting may also make it more difficult for us to raise additional funds in +the future. In addition, our securities are subject to “penny stock” +restrictions, including Rule 15g-9 under the Securities Exchange Act of 1934, +as amended, which imposes additional sales practice requirements on +broker-dealers, such as requirements pertaining to the suitability of the +investment for the purchaser and the delivery of specific disclosure materials +and monthly statements. Consequently, the liquidity of our securities could be +impaired, not only in the number of securities that can be bought and sold, but +also through delays in the timing of the transactions, reduction in security +analysts’ and the news media’s coverage of us, adverse effects on the ability +of broker-dealers to sell our securities, and lower prices for our securities +than might otherwise be obtained. +The market price of our common stock could continue to +fluctuate in the future in response to various factors, including, but not +limited to: +• quarterly +variations in operating results; +• our +ability to control costs and improve cash flow; +• our +ability to raise additional capital or repurchase the minority interest in +Iteris, Inc.; +• shortages +announced by suppliers; +• announcements +of technological innovations or new products or applications by our +competitors, customers or us; +19 +• acquisitions +or businesses, products or technologies; +• the +impact of any litigation; +• changes +in investor perceptions; +• changes +in earnings estimates or investment recommendations by securities analysts; and +• international +conflicts, political unrest and acts of terrorism. +The stock market in general has recently experienced +volatility, which has particularly affected the market prices of equity +securities of many technology companies. This volatility has often been +unrelated to the operating performance of these companies. These broad market +fluctuations may adversely affect the market price of our common stock. In the +past, companies that have experienced volatility in the market price of their +securities have been the subject of securities class action litigation. If we +were to become the subject of a class action lawsuit, it could result in +substantial losses and divert management’s attention and resources from other +matters. +We Depend On Government Contracts And +Subcontracts, And Because Many Of Our Government Contracts Are Fixed Price +Contracts, Higher Than Anticipated Costs Will Reduce Our Profit And Could +Adversely Impact Our Operating Results. +A significant +portion of the sales by Iteris, Inc. were derived from contracts with +governmental agencies, either as a general contractor, subcontractor or +supplier. Government contracts represented approximately 54.0%, 54.0% and 48.0% +of our total net sales and contract revenues for the years ended March 31, +2002, 2003 and 2004, respectively. We anticipate that revenue from government +contracts will continue to increase in the near future. Government business is, +in general, subject to special risks and challenges, including: +• long +purchase cycles or approval processes; +• competitive +bidding and qualification requirements; +• the +impact of international conflicts; +• performance +bond requirements; +• changes +in government policies and political agendas; +• delays +in funding, budgetary constraints and cut-backs; and +• milestone +requirements and liquidated damage provisions for failure to meet contract +milestones +In addition, a large number of our government +contracts are fixed price contracts. As a result, we may not be able to recover +any cost overruns we may incur. These +fixed price contracts require us to estimate the total project cost based on +preliminary projections of the project’s requirements. The financial viability +of any given project depends in large part on our ability to estimate these +costs accurately and complete the project on a timely basis. In the event our +costs on these projects exceed the fixed contractual amount, we will be +required to bear the excess costs. These additional costs adversely affect our +financial condition and results of operations. Moreover, certain of our +government contracts are subject to termination or renegotiation at the +convenience of the government, which could result in a large decline in our net +sales in any given quarter. Our inability to address any of the foregoing +concerns or the loss or renegotiation of any material government contract could +seriously harm our business, financial condition and results of operations. +Economic Slowdown And Related +Uncertainties Could Adversely Impact The Demand For Our Products . Concerns about inflation, decreased consumer +confidence, reduced corporate profits and capital spending, and recent +international conflicts and terrorist and military actions have resulted in a +downturn in worldwide economic conditions, particularly in the United States. +These unfavorable economic conditions may have a negative impact on customer +orders, cancellations and rescheduling of backlog. In addition, recent political and social turmoil related to +international conflicts and terrorist acts +20 +can be expected to put further +pressure on economic conditions in the U.S. and worldwide. These political, +social and economic conditions make it extremely difficult for our customers, +our suppliers and us to accurately forecast and plan future business +activities. If such conditions continue or worsen, our business, financial +condition and results of operations will likely be materially and adversely +affected. +Our Quarterly Operating Results +Fluctuate As A Result Of Many Factors. Therefore, We May Fail To Meet Or Exceed +The Expectations Of Securities Analysts And Investors, Which Could Cause Our +Stock Price To Decline . +Our quarterly revenues and operating results have fluctuated and are +likely to continue to vary from quarter to quarter due to a number of factors, +many of which are not within our control. Factors that could affect our +revenues include, among others, the following: +• our +ability to raise additional capital and repurchase the minority interest in +Iteris, Inc.; +• our +ability to control costs; +• international +conflicts and acts of terrorism; +• our +ability to develop, introduce, market and gain market acceptance of new +products, applications and product enhancements in a timely manner, or at all; +• the +size, timing, rescheduling or cancellation of significant customer orders; +• the +introduction of new products by competitors; +• the +availability of components used in the manufacture of our products; +• changes +in our pricing policies and the pricing policies by our suppliers and +competitors, pricing concessions on volume sales, as well as increased price +competition in general; +• the +long lead times associated with government contracts or required by vehicle +manufacturers; +• our +success in expanding and implementing our sales and marketing programs; the +effects of technological changes in our target markets; +• our +relatively small level of backlog at any given time; +• the +mix of our sales; +• deferrals +of customer orders in anticipation of new products, applications or product +enhancements; +• risks +and uncertainties associated with our international business; +• currency +fluctuations and our ability to get currency out of certain foreign countries; +and +• general +economic and political conditions. +Due to all of the factors listed above and, our future +operating results could be below the expectations of securities analysts or +investors. If that happens, the trading price of our common stock could +decline. As a result of these quarterly variations, you should not rely on +quarter-to-quarter comparisons of our operating results as an indication of our +future performance. +21 +If We Do Not Keep Pace With Rapid +Technological Changes And Evolving Industry Standards, We Will Not Be Able To +Remain Competitive And There Will Be No Demand For Our Products. Our markets are in general characterized +by the following factors: +• rapid +technological advances; +• downward +price pressure in the marketplace as technologies mature; +• changes +in customer requirements; +• frequent +new product introductions and enhancements; and +• evolving +industry standards and changes in the regulatory environment. +Our future success will depend upon our ability to +anticipate and adapt to changes in technology and industry standards, and to +effectively develop, introduce, market and gain broad acceptance of new +products and product enhancements incorporating the latest technological +advancements. +We believe that we must continue to make substantial +investments to support ongoing research and development in order to remain +competitive. We need to continue to develop and introduce new products that +incorporate the latest technological advancements in outdoor image processing +hardware, software and camera technologies in response to evolving customer +requirements. Our business and results of operations could be adversely +affected if we do not anticipate or respond adequately to technological +developments or changing customer requirements. We cannot assure you that any +such investments in research and development will lead to any corresponding +increase in revenue. +If We Are Unable To Develop And Introduce +New Products And Product Enhancements Successfully And In A Cost-Effective And +Timely Manner, Or To Achieve Market Acceptance Of Our New Products, Our +Operating Results Would Be Adversely Affected . We believe our revenue growth and future +operating results will depend on our ability to complete development of new +products and enhancements, introduce these products in a timely, cost-effective +manner, achieve broad market acceptance of these products and enhancements, and +reduce our product costs. We may not be able to introduce any new products or +any enhancements to our existing products on a timely basis, or at all. In +addition, the introduction of any new products could adversely affect the sales +of certain of our existing products. Our future success will also depend in +part on the success of several products including AutoVue TM , our +lane departure warning system. We currently outsource the manufacture of our +AutoVue product line to a single manufacturer. This manufacturer may not be +able to produce sufficient quantities of this product in a timely manner or at +a reasonable cost, which could materially and adversely affect our ability to +launch or gain market acceptance of AutoVue. +Market acceptance of our new products depends upon +many factors, including our ability to accurately predict market requirements +and evolving industry standards, our ability to resolve technical challenges in +a timely and cost-effective manner and achieve manufacturing efficiencies, the +perceived advantages of our new products over traditional products and the +marketing capabilities of our independent distributors and strategic partners. +Our business and results of operations could be seriously harmed by any +significant delays in our new product development. Certain of our new products +could contain undetected design faults and software errors or “bugs” when first +released by us, despite our testing. We may not discover these faults or errors +until after a product has been installed and used by our customers. Any faults or +errors in our existing products or in any new products may cause delays in +product introduction and shipments, require design modifications or harm +customer relationships, any of which could adversely affect our business and +competitive position. +The Markets In Which We Operate Are +Highly Competitive And Have Many More Established Competitors, Which Could +Adversely Affect Our Sales Or The Market Acceptance Of Our Products . We compete with numerous other companies in +our target markets including, but not +22 +limited to, large, +multinational corporations and many smaller regional engineering firms. We +expect such competition to increase due to technological advancements, industry +consolidations and reduced barriers to entry. Increased competition is likely +to result in price reductions, reduced gross margins and loss of market share, +any of which could seriously harm our business, financial condition and results +of operations. Many of our competitors have far greater name recognition and +greater financial, technological, marketing and customer service resources than +we do. This may allow them to respond more quickly to new or emerging +technologies and changes in customer requirements. It may also allow them to +devote greater resources to the development, promotion, sale and support of +their products than we can. Recent consolidations of end users, distributors +and manufacturers in our target markets have exacerbated this problem. As a +result of the foregoing factors, we may not be able to compete effectively in +our target markets and competitive pressures could adversely affect our +business, financial condition and results of operations. +We May Be Unable To Attract And +Retain Key Personnel, Which Could Seriously Harm Our Business . Due to the specialized nature of our +business, we are highly dependent on the continued service of our executive +officers and other key management, engineering and technical personnel, +particularly Gregory A. Miner, our current Chief Executive Officer and Chief +Financial Officer, and Jack Johnson, the Chief Executive Officer of Iteris, +Inc. In connection with the roll-up +merger of Iteris, Inc. into Iteris Holdings, we announced that Mr. Johnson will +be appointed to serve as the Chief Executive Officer of Iteris Holdings, and +Mr. Miner will assume the role as Chairman of the Board of Iteris +Holdings. The loss of any of these +individuals or the transition of Mr. Miner to his new role could adversely +affect our business, financial condition or results of operations. Our success will also depend in large part +upon our ability to continue to attract, retain and motivate qualified +engineering and other highly skilled technical personnel. Competition for +employees, particularly development engineers, is intense. We may not be able +to continue to attract and retain sufficient numbers of such highly skilled +employees. Our inability to attract and retain additional key employees or the +loss of one or more of our current key employees could adversely affect our +business, financial condition and results of operations. +We May Not be Able To Adequately +Protect Or Enforce Our Intellectual Property Rights, Which Could Harm Our +Competitive Position . +If we are not able to adequately protect or enforce the proprietary +aspects of our technology, competitors could be able to access our proprietary +technology and our business, financial condition and results of operations will +likely be seriously harmed. We currently attempt to protect our technology through +a combination of patent, copyright, trademark and trade secret laws, employee +and third party nondisclosure agreements and similar means. Despite our +efforts, other parties may attempt to disclose, obtain or use our technologies +or systems. Our competitors may also be able to independently develop products +that are substantially equivalent or superior to our products or design around +our patents. In addition, the laws of some foreign countries do not protect our +proprietary rights as fully as do the laws of the United States. As a result, +we may not be able to protect our proprietary rights adequately in the United +States or abroad. +From time to time, we have received notices that claim +we have infringed upon the intellectual property of others. Even if these +claims are not valid, they could subject us to significant costs. We have +engaged in litigation in the past, and litigation may be necessary in the +future to enforce our intellectual property rights or to determine the validity +and scope of the proprietary rights of others. Litigation may also be necessary +to defend against claims of infringement or invalidity by others. An adverse +outcome in litigation or any similar proceedings could subject us to +significant liabilities to third parties, require us to license disputed rights +from others or require us to cease marketing or using certain products or +technologies. We may not be able to obtain any licenses on terms acceptable to +us, or at all. We also may have to indemnify certain customers or strategic +partners if it is determined that we have infringed upon or misappropriated +another party’s intellectual property. Any of these results could adversely +affect our business, financial condition and results of operations. In +addition, the cost of addressing any intellectual property litigation claim, +both in legal fees and expenses, and the diversion of management’s resources, +regardless of whether the claim is valid, could be significant and could +seriously harm our business, financial condition and results of operations. +23 +We +May Engage In Acquisitions Of Companies Or Technologies That May Require Us To +Undertake Significant Capital Infusions And Could Result In Disruptions Of Our +Business And Diversion Of Resources And Management Attention. We have historically, and may in the future, +acquire complementary businesses, products and technologies. Acquisitions may +require significant capital infusions and, in general, acquisitions also +involve a number of special risks, including: +• potential +disruption of our ongoing business and the diversion of our resources and +management’s attention; +• the +failure to retain or integrate key acquired personnel; +• the +challenge of assimilating diverse business cultures, and the difficulties in +integrating the operations, technologies and information system of the acquired +companies; +• increased +costs to improve managerial, operational, financial and +• administrative +systems and to eliminate duplicative services; +• the +incurrence of unforeseen obligations or liabilities; +• potential +impairment of relationships with employees or customers as a result of changes +in management; and +• increased +interest expense and amortization of acquired intangible assets. +Our competitors are also soliciting potential +acquisition candidates, which could both increase the price of any acquisition +targets and decrease the number of attractive companies available for +acquisition. Acquisitions may also materially and adversely affect our operating +results due to large write-offs, contingent liabilities, substantial +depreciation, deferred compensation charges or intangible asset amortization, +or other adverse tax or audit consequences. We cannot assure you that we will +be able to identify or consummate any additional acquisitions, successfully +integrate any acquisitions or realize the benefits anticipated from any +acquisition. +Some Of Our Directors, Officers And +Their Affiliates Can Control The Outcome Of Matters That Require The Approval Of +Our Stockholders, And Accordingly We Will Not be Able To Engage In Certain +Transactions Without Their Approval . As of March 31, 2004, our officers and +directors beneficially owned approximately 11.4% of the total combined voting +power of the outstanding shares of our Class A common stock and Class B common +stock. As a result of their stock ownership, our management will be able to +significantly influence the election of our directors and the outcome of +corporate actions requiring stockholder approval, such as mergers and +acquisitions, regardless of how our other stockholders may vote. This +concentration of voting control may have a significant effect in delaying, +deferring or preventing a change in our management or change in control and may +adversely affect the voting or other rights of other holders of common stock. +Our Stock Structure And Certain +Anti-Takeover Provisions May Affect The Price Of Our Common Stock And +Discourage A Third Party From Acquiring Us . Certain provisions of our certificate of incorporation +and our stockholder rights plan could make it difficult for a third party to +acquire us, even though an acquisition might be beneficial to our stockholders. +These provisions could limit the price that investors might be willing to pay +in the future for shares of our common stock. Our Class A common stock entitles +the holder to one-tenth of one vote per share and our Class B common stock +entitles the holder to one vote per share. The disparity in the voting rights +between our common stock, as well as our insiders’ significant ownership of the +Class B common stock, could discourage a proxy contest or make it more +difficult for a third party to effect a change in our management and control. +In addition, our Board of Directors is authorized to issue, without stockholder +approval, up to 2,000,000 shares of preferred stock with voting, conversion and +other rights and preferences superior to those of our common stock, as well as +additional shares of Class B common stock. Our future issuance of preferred +stock or Class B common stock could be used to discourage an unsolicited +acquisition proposal. +In March 1998, we adopted a stockholder rights plan +and declared a dividend of preferred stock purchase rights to our stockholders. +In the event a third party acquires more than 15% of the outstanding voting +control of our company or 15% of our outstanding common stock, the holders of +these rights will be able to purchase the junior participating preferred stock +at a substantial discount off of the then current market price. The exercise of +these rights and purchase of a significant amount of stock at below market +prices could cause substantial dilution to a particular acquirer and discourage +the acquirer from pursuing our company. The mere existence of a stockholder +rights plan often delays or makes a merger, tender offer or proxy contest more +difficult. +24 +ITEM +7A. QUANTITATIVE AND QUALITATIVE DISCLOSURE +ABOUT MARKET RISK +Our exposure to interest rate risk is limited to our +lines of credit. Iteris Inc.’s and Iteris Holdings’ lines of credit bear +interest at the prevailing prime rate, plus 2.0% and 4.0% (6.0% and 10.0% as of +March 31, 2003), respectively. We +estimate that, based on amounts outstanding at March 31, 2004, a 10.0% increase +in the prime rate would result in an increase in interest expense, on an +annualized basis, of less than $100,000. +ITEM +8. FINANCIAL STATEMENTS AND SUPPLEMENTARY +DATA +The financial statements and supplementary data +required by Regulation S-X are included in this Form 10-K commencing on page +F-1. +ITEM +9. CHANGES IN AND +DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE +Not applicable. +ITEM +9A . CONTROLS AND +PROCEDURES +Evaluation +of Disclosure Controls and Procedures +Our management, +with the participation of our Chief Executive Officer and Chief Financial +Officer, has evaluated the effectiveness of our disclosure controls and +procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities +Exchange Act of 1934) as of the end of the period covered by this report. Based +upon that evaluation, our Chief Executive Officer and Chief Financial Officer +concluded that, as of the end of the period covered by this report, our +disclosure controls and procedures were effective in timely alerting them to +the material information relating to us (or our consolidated subsidiaries) +required to be included in the reports we file or submit under the Securities +Exchange Act of 1934. +Changes +in Internal Controls +During the most recent completed fiscal quarter +covered by this report, there has been no change in our internal controls over +financial reporting (as defined in Rules 13a-15(f) and 15d-15(f) under the +Securities Exchange Act of 1934) that has materially affected, or is reasonably +likely to materially affect, our internal controls over financial reporting. +PART III +ITEM +10. DIRECTORS +AND EXECUTIVE OFFICERS OF THE REGISTRANT +(a) Identification of Directors. The +information under the caption “Election of Directors,” appearing in our proxy +statement for the 2004 Annual Meeting of Stockholders, is incorporated herein +by reference. +(b) Identification of Executive Officers. The +information under the caption “Executive Compensation and Other Information,” +appearing in our proxy statement for the 2004 Annual Meeting of Stockholders, +is incorporated herein by reference. +(c) Compliance with Section 16(a) of the Exchange Act. The +information under the caption “Executive Compensation and Other Information,” +appearing in our proxy statement for the 2004 Annual Meeting of Stockholders, +is incorporated herein by reference. +25 +(d) Code of +Ethics . The information +under the caption “Corporate Governance and Board Composition,” appearing in +our proxy statement for the 2004 Annual Meeting of Stockholders, is +incorporated herein by reference. +ITEM +11 . EXECUTIVE +COMPENSATION +The information under the caption “Executive +Compensation and Other Information,” appearing in our proxy statement for the +2004 Annual Meeting of Stockholders, is incorporated herein by reference. +ITEM 12. SECURITY +OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER +MATTERS +As of March 31, 2004, Iteris Holdings had only one +plan, the 1997 Stock Incentive Plan, pursuant to which equity securities of +Iteris Holdings are authorized for issuance. The following table sets forth +certain information regarding this plan: +(a) +Number of +Securities +to be Issued +Upon Exercise of +Outstanding +Options, +Warrants and +Rights +(b) +Weighted Average +Exercise Price of +Outstanding +Options, +Warrants and +Rights +(c) +Number of Securities +Remaining Available +under Equity +Compensation +Plans (excluding some +securities reflected +in column (a)) +Equity Compensation Plans +Approved by Security Holders +1997 Stock Incentive Plan +$ +1,132,101 +$ +2.98 +518,499 +Equity Compensation Plans Not Approved by +Security Holders +None +— +— +— +Total +$ +1,132,101 +$ +2.98 +518,499 +The information under the caption “Principal +Stockholders and Common Stock Ownership of Certain Beneficial Owners and +Management,” appearing in our proxy statement for the 2004 Annual Meeting of +Stockholders, is incorporated herein by reference. +ITEM +13. CERTAIN +RELATIONSHIPS AND RELATED TRANSACTIONS +The information under the caption “Certain +Transactions,” appearing in our proxy statement for the 2004 Annual Meeting of +Stockholders, is incorporated herein by reference. +ITEM +14. PRINCIPAL ACCOUNTANT +FEES AND SERVICES +The information under the caption “Principal +Accountant Fees and Services,” appearing in our proxy statement for the 2004 +Annual Meeting of Stockholders, is incorporated herein by reference. +26 +PART IV +ITEM +15. EXHIBITS, +FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K. +(a) Documents filed as part of this report: +1. Financial +Statements. The following financial statements of Iteris Holdings, +Inc. are included in a separate section of this Annual Report on Form 10-K +commencing on the pages referenced below: +Report +of Independent Registered Public Accounting Firm +Consolidated Balance Sheets +as of March 31, 2003 and 2004 +Consolidated +Statements of Operations for the years ended March 31, 2002, 2003 and 2004 +Consolidated +Statements of Stockholders’ Equity (Deficit) for the years ended March 31, 2002, 2003 and 2004 +Consolidated +Statements of Cash Flows for the years ended March 31, 2002, 2003 and 2004 +Notes to +Consolidated Financial Statements +2. Financial +Statement Schedules. +Schedule +II— Valuation and Qualifying Accounts +All other +schedules have been omitted because they are not required or the required +information is included in our consolidated financial statements and notes +thereto. +(a) Exhibits . +The following +exhibits are filed herewith or incorporated by reference to the location +indicated below: +Exhibit +Number +Description +Where Located +3.1 +Certificate of Incorporation of Iteris +Holdings, as amended +Exhibit 19.2 to the registrant’s Quarterly +Report on Form 10-Q for the quarter ended September 30, 1987 +3.2 +Certificates of Amendment to the +Certificate of Incorporation of Iteris Holdings, as filed with the Delaware +Secretary of State on September 28, 1988 and November 7, 2001; Certificate of +Designation as filed on April 29, 1998 +Exhibit 3.2 to the registrant’s Annual +Report on Form 10-K/A for the year ended March 31, 2003 as filed with the SEC +on July 29, 2003. +3.3 +Certificate of Amendment to the Certificate +of Incorporation of Iteris Holdings, as filed with the Delaware Secretary of +State on September 15, 2003. +Exhibit 3.3 to Amendment No. 1 to the +registrant’s Registration Statement on Form S-1 as filed with the SEC on February +17, 2004. +3.4 +Bylaws of Iteris Holdings, as amended +Exhibit 4.2 to the registrant’s +Registration Statement on Form S-1 (Reg. No. 033-67932) as filed with the SEC +on July 6, 1993. +3.5 +Certificates of Amendment to Bylaws of +Iteris Holdings dated April 24, 1998 and August 10, 2001 +Exhibit 3.4 to the registrant’s Annual +Report on Form 10-K/A for the year ended March 31, 2003 as filed with the SEC +on July 29, 2003 +27 +Exhibit +Number +Description +Where Located +4.1 +Specimen of Class A common stock and Class +B common stock certificates. +Exhibit 4.3 to registrant’s Amendment No. 1 +to the Registration Statement on Form S-1 (Reg. No. 033-67932) as filed with +the SEC on September 30, 1993. +4.2 +Form of rights certificate for preferred +stock purchase rights +Exhibit A of Exhibit 4 to the registrant’s +Current Report on Form 8-K as filed with the SEC on May 1, 1998 +10.1 +Profit Sharing Plan and Trust +Exhibit 10.3 to the registrant’s Amendment +No. 2 to the Registration Statement on Form S-8 (Reg. No. 002-98656) as filed +with the SEC on May 5, 1988 +10.2 +Amendment Nos. 3 and 4 to the Profit +Sharing Plan and Trust +Exhibits 4.3.1 and 4.3.2, respectively, to +Amendment No. 3 to Iteris Holdings’ Registration Statement on Form S-3 (Reg. +No. 002-86220) as filed with the SEC on June 13, 1990 +10.3 +Form of Executive Deferral Plan between the +registrant and certain employees of the registrant). +Exhibit 10.4 to the registrant’s Annual +Report on Form 10-K for the year ended March 31, 1988 +10.4 +Form of Indemnity Agreement entered into by +the registrant and certain of its officers and directors +Exhibit 19.4 to the registrant’s Quarterly +Report on Form 10-Q for the quarter ended September 30, 1988 +10.5 +Form of Indemnification Agreement entered +into by the registrant and certain of its officers and directors +Filed Herewith. +10.6 +1997 Stock Incentive Plan of Iteris +Holdings (as amended on May 3, 2002) +Exhibit 10.5 to the registrant’s Annual +Report on Form 10-K for the year ended March 31, 2003 as filed with the SEC +on June 30, 2003 +107 +Form of Notice of Grant of Stock Option +Exhibit 99.2 to the registrant’s +Registration Statement on Form S-8 (File No. 333-30396) as filed with the SEC +on February 14, 2000 +10.8 +Form of Stock Option Agreement +Exhibit 99.3 to the registrant’s +Registration Statement on Form S-8 (File No. 333-30396) as filed with the SEC +on February 14, 2000 +10.9 +Form of Addendum to Stock Option +Agreement—Involuntary Termination Following Corporate Transaction or Change +in Control +Exhibit 99.4 to the registrant’s +Registration Statement on Form S-8 (File No. 333-30396) as filed with the SEC +on February 14, 2000 +10.10 +Form of Addendum to Stock Option +Agreement—Limited Stock Appreciation Rights +Exhibit 99.5 to the registrant’s +Registration Statement on Form S-8 (File No. 333-30396) as filed with the SEC +on February 14, 2000 +10.11 +Form of Stock Issuance Agreement +Exhibit 99.6 to the registrant’s +Registration Statement on Form S-8 (File No. 333-30396) as filed with the SEC +on February 14, 2000 +28 +Exhibit +Number +Description +Where Located +10.12 +Form of Addendum to Stock Issuance +Agreement—Involuntary Termination Following Corporate Transaction/Change in +Control +Exhibit 99.7 to the registrant’s +Registration Statement on Form S-8 (File No. 333-30396) as filed with the SEC +on February 14, 2000 +10.13 +Form of Notice of Grant of Automatic Stock +Option—Initial Grant) +Exhibit 99.8 to Exhibit 99.8 to +registrant’s Registration Statement on Form S-8 (File No. 333-30396) as filed +with the SEC on February 14, 2000 +10.14 +Form of Notice of Grant of Automatic Stock +Option—Annual Grant +Exhibit 99.9 to the registrant’s +Registration Statement on Form S-8 (File No. 333-30396) as filed with the SEC +on February 14, 2000 +10.15 +Form of Automatic Stock Option Agreement. +Exhibit 99.10 to the registrant’s +Registration Statement on Form S-8 (File No. 333-30396) as filed with the SEC +on February 19, 2000 +10.16 +Amended and Restated Rights Agreement, +dated as of May 10, 2004, by and between the registrant and U.S. Stock +Transfer Corporation, including the exhibits thereto. +Exhibit 99.1 to the registrant’s +Registration Statement on Form 8-A/A +as filed with the SEC on June 18, 2004. +10.17 +1994 Long-Term Equity Plan Exhibit 4.3 to +the registrant’s Registration Statement on Form S-8 (File No. 333-05735) as +filed with the SEC on June 11, 1996). +Exhibit 4.3 to the registrant’s +Registration Statement on Form S-8 (File No. 333-05735) as filed with the SEC +on June 11, 1996 +10.18 +Amended and Restated Agreement of Purchase +and Sale and Escrow Instructions, dated February 19, 2002, by and between +Iteris, Inc. and 1515 South Manchester, LLC +Exhibit 2.1 to the registrant’s Current +Report on Form 8-K as filed with the SEC on June 12, 2002 +10.19 +Sublease Agreement dated May 7, 2003 by and +between Iteris, Inc. and FEI-Zyfer, Inc. +Exhibit 10.19 to registrant’s Annual Report +on Form 10-K for the year ended March 31, 2003 as filed with the SEC on June +30, 2003 +10.20 +Loan and Security Agreement dated February +22, 2002 by and between the registrant and Technology Lending Partners, +L.L.C. +Exhibit 10.20 to the registrant’s Annual +Report on Form 10-K/A for the year ended March 31, 2003 as filed with the SEC +on July 29, 2003 +10.21 +Receivables Purchase Agreement dated +October 18, 2002 by and between the registrant and Technology Lending +Partners, L.L.C., as amended by Amendment Number One dated November 27, 2002 +and Amendment Number Two dated January 7, 2003 +Exhibit 10.21 to the registrant’s Annual +Report on Form 10-K/A for the year ended March 31, 2003 as filed with the SEC +on July 29, 2003 +10.22 +Change in Control Agreement dated May 8, +2003 by and between the registrant and Gregory A. Miner +Exhibit 10.1 to the registrant’s Annual +Report on Form 10-Q for the quarter ended June 30, 2003 as filed with the SEC +on August 14, 2003 +10.23 +Change in Control Agreement dated May 20, +2003 by and between the registrant +Exhibit 10.23 to Amendment No. 1 to the +registrant’s Registration Statement on Form S-1 +29 +Exhibit +Number +Description +Where Located +and Jack E. Johnson +as filed with the SEC on February 17, 2004. +21 +Subsidiaries of the registrant +Filed Herewith +23.1 +Consent of Independent Registered Public Accounting +Firm +Filed Herewith +31 +Certification of the Chief Executive +Officer and Chief Financial Officer Pursuant to Section 302 of the +Sarbanes-Oxley Act of 2002 +Filed Herewith +32 +Certification of the Chief Executive +Officer and Chief Financial Officer Pursuant to 18 U.S.C. Section 1350, as +Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 +Filed Herewith +(b) Reports on Form 8-K +1. Form 8-K filed on January 30, 2004 to +furnish disclosure under Item 12 of the Report regarding financial results for +the quarter ended December 31, 2003. +30 +SIGNATURES +Pursuant to the requirements of Section 13 or 15(d) of +the Securities Exchange Act of 1934, the Registrant has duly caused this Report +to be signed on its behalf by the undersigned, thereunto duly authorized, in +the City of Anaheim, State of California, on June 29, 2004. +ITERIS HOLDINGS, INC. +By: +/s/ GREGORY A. MINER +Gregory A. Miner, +Chief Executive Officer +and Chief Financial Officer +POWER OF ATTORNEY +We, the undersigned officers and directors of Iteris +Holdings, Inc., do hereby constitute and appoint James S. Miele and Gregory A. +Miner, and each of them, our true and lawful attorneys-in-fact and agents, each +with full power of substitution and resubstitution, for him and in his name, +place and stead, in any and all capacities, to sign any and all amendments to +this report, and to file the same, with exhibits thereto, and other documents +in connection therewith, with the Securities and Exchange Commission, granting +unto said attorneys-in-fact and agents, and each of them, full power and +authority to do and perform each and every act and thing requisite or necessary +to be done in and about the premises, as fully to all intents and purposes as +he might or could do in person, hereby, ratifying and confirming all that each +of said attorneys-in-fact and agents, or his substitute or substitutes, may +lawfully do or cause to be done by virtue hereof. +Pursuant to the requirements of the Securities +Exchange Act of 1934, this report has been signed below by the following +persons in the capacities and on the dates indicated: +Signature +Title +Date +/s/ GREGORY A. MINER +Director, Chief Executive Officer +June 29, 2004 +Gregory A. Miner +and Chief Financial Officer +(principal executive +officer and +principal financial officer) +/s/ JOEL SLUTZKY +Chairman of the Board +June 29, 2004 +Joel Slutzky +/s/ KEVIN C. DALY +Director +June 29, 2004 +Kevin C. Daly, Ph.D +/s/ CRANDALL GUDMUNDSON +Director +June 29, 2004 +Crandall Gudmundson +31 +/s/ JERRY MUENCH +Director +June 29, 2004 +Jerry Muench +/s/ JOHN +SEAZHOLTZ +Director +June 29, 2004 +John +Seazholtz +/s/ JAMES S. +MIELE +Controller and Secretary +June 29, 2004 +James S. Miele +/s/ THOMAS +L. THOMAS +Director +June 29, 2004 +Thomas L. +Thomas +/s/ PAUL E. +WRIGHT +Director +June 29, 2004 +Paul E. +Wright +32 +Iteris +Holdings, Inc. +Index to +Consolidated Financial Statements +Report of Independent Registered Public +Accounting Firm +Consolidated Balance Sheets as of March 31, 2003 and 2004 +Consolidated Statements of Operations for +the years ended +March 31, 2002, 2003 and 2004 +Consolidated Statements of Stockholders’ +Equity (Deficit) for the years ended +March 31, 2002, 2003 and 2004 +Consolidated Statements of Cash Flows for +the years ended +March 31, 2002, 2003 and 2004 +Notes to Consolidated Financial Statements +F-1 +Report of Independent Registered +Public Accounting Firm +Stockholders and Board of Directors +Iteris Holdings, Inc. +We have audited the accompanying consolidated balance sheets of Iteris +Holdings, Inc. as of March 31, 2003 and 2004, and the related consolidated +statements of operations, stockholders’ equity (deficit), and cash flows for +each of the three years in the period ended March 31, 2004. Our audits also included the financial +statement schedule listed in the index at Item 15(a). These financial statements and schedule are +the responsibility of the Company’s management. Our responsibility is to +express an opinion on these financial statements and schedule based on our +audits. +We conducted our audits in accordance with the standards of the Public +Company Accounting Oversight Board (United States). Those standards require +that we plan and perform the audit to obtain reasonable assurance about whether +the financial statements are free of material misstatement. An audit includes examining, +on a test basis, evidence supporting the amounts and disclosures in the +financial statements. An audit also includes assessing the accounting +principles used and significant estimates made by management, as well as +evaluating the overall financial statement presentation. We believe that our +audits provide a reasonable basis for our opinion. +In our opinion, the consolidated financial statements referred to above +present fairly, in all material respects, the consolidated financial position +of Iteris Holdings, Inc. at March 31, 2003 and 2004, and the consolidated +results of its operations and its cash flows for each of the three years in the +period ended March 31, 2004, in conformity with U.S. generally accepted +accounting principles. Also, in our opinion, the related financial statement +schedule, when considered in relation to the basic financial statements taken +as a whole, present fairly in all material respects the information set forth +therein. +/S/ ERNST & YOUNG LLP +Orange County, California +June 8, 2004 +F-2 +Iteris +Holdings, Inc. +Consolidated Balance Sheets +(In thousands) +March 31, +2003 +2004 +Assets +Current assets: +Cash and cash equivalents +$ +437 +$ +2,612 +Trade accounts receivable, net of allowance +for doubtful accounts of $156 in 2003 and $204 in 2004. +8,167 +8,255 +Costs and estimated earnings in excess of +billings on uncompleted contracts +2,398 +2,653 +Notes receivable +— +125 +Deferred tax assets +— +821 +Inventories: +Finished goods +211 +542 +Work in process +393 +294 +Materials and supplies +3,299 +2,762 +Prepaid expenses and other +355 +323 +Assets of discontinued operations +5,237 +— +Total current assets +20,497 +18,387 +Restricted +cash +2,516 +— +Property, plant and equipment: +Leasehold improvements +— +97 +Equipment +7,263 +7,724 +Allowances for depreciation +(5,322 +) +(6,179 +) +1,941 +1,642 +Goodwill +9,807 +9,807 +Other assets +81 +215 +Total +assets +$ +34,842 +$ +30,051 +See accompanying notes. +F-3 +Iteris Holdings, Inc. +Consolidated Balance Sheets +(In thousands, except share and per share +amounts) +March 31, +2003 +2004 +Liabilities +and stockholders’ equity (deficit) +Current liabilities: +Trade accounts payable +$ +5,187 +$ +3,560 +Accrued payroll and related expenses +5,622 +3,218 +Accrued expenses +785 +838 +Income taxes payable +— +485 +Deferred revenue +— +226 +Billings in excess of costs and estimated +earnings on uncompleted contracts +304 +549 +Advances under receivables purchase +agreement with related party +235 +— +Revolving line of credit with related party +— +100 +Liabilities of discontinued operations +4,996 +— +Current portion of long-term debt +— +42 +Total current liabilities +17,129 +9,018 +Revolving line of credit with related party +1,250 +— +Deferred gain on sale of building +6,025 +1,774 +Long-term debt +15 +891 +Minority interest +14,711 +17,745 +Commitments and contingencies +Stockholders’ equity (deficit): +Preferred stock: +Authorized shares – 2,000,000 +Issued and outstanding – none +— +— +Common stock, $.10 par value: +Authorized shares – 50,000,000 of Class A +and 2,600,000 of Class B +Issued and outstanding shares – 14,080,914 +of Class A and 1,035,841 of Class B at March 31, 2003; 20,476,568 of +Class A and 928,317 of Class B at March 31, 2004. +1,512 +2,141 +Additional paid-in capital +92,819 +96,989 +Treasury stock – 93 shares in 2003 and 2004 +(1 +) +(1 +) +Notes receivable from employees +(51 +) +(45 +) +Accumulated other comprehensive income +(99 +) +— +Accumulated deficit +(98,468 +) +(98,461 +) +Total stockholders’ equity (deficit) +(4,288 +) +623 +Total liabilities and stockholders’ equity +(deficit) +$ +34,842 +$ +30,051 +See accompanying notes. +F-4 +Iteris +Holdings, Inc. +Consolidated Statements of Operations +(In +thousands, except per share information) +Year Ended +March 31, +2002 +2003 +2004 +Net sales and contract revenues: +Net sales +$ +17,104 +$ +19,112 +$ +23,470 +Contract revenues +20,205 +22,283 +21,813 +Total net sales and contract revenues +37,309 +41,395 +45,283 +Costs and expenses: +Cost of net sales +8,401 +9,366 +12,758 +Cost of contract revenues +12,043 +15,110 +14,712 +Selling, general and administrative +expenses +14,627 +14,105 +12,844 +Research and development expenses +3,434 +3,908 +3,923 +Restructuring charges +1,142 +— +— +Total costs and expenses +39,647 +42,489 +44,237 +Income (loss) from operations +(2,338 +) +(1,094 +) +1,046 +Non-operating income (expense) +Other income (expense), net +(1,365 +) +417 +1,003 +Interest expense, net +(4,190 +) +(761 +) +(123 +) +Income (loss) before income tax +(7,893 +) +(1,438 +) +1,926 +Income tax benefit (provision) +785 +— +(100 +) +Income (loss) from continuing operations +before minority interest +(7,108 +) +(1,438 +) +1,826 +Minority interest in earnings of subsidiary +(1,910 +) +(3,818 +) +(3,034 +) +Loss from continuing operations +(9,018 +) +(5,256 +) +(1,208 +) +Income (loss) from discontinued operations, +net of taxes of $0 +(17,120 +) +(7,892 +) +1,215 +Extraordinary loss from early +extinguishment of debt, net of taxes of $0 +(450 +) +— +— +Net income (loss) +$ +(26,588 +) +$ +(13,148 +) +$ +7 +Basic earnings (loss) per share: +Continuing operations +$ +(0.80 +) +$ +(0.37 +) +$ +(0.06 +) +Discontinued operations +(1.52 +) +(0.55 +) +0.06 +Extraordinary loss +(0.04 +) +— +— +Basic earnings (loss) per share +$ +(2.36 +) +$ +(0.92 +) +$ +0.00 +Diluted earnings (loss) per share: +Continuing operations +$ +(0.80 +) +$ +(0.37 +) +$ +(0.06 +) +Discontinued operations +(1.52 +) +(0.55 +) +0.06 +Extraordinary loss +(0.04 +) +— +— +Diluted earnings (loss) per share +$ +(2.36 +) +$ +(0.92 +) +$ +0.00 +Shares used in computing basic earnings +(loss) per share +11,267 +14,276 +19,454 +Shares used in computing diluted earnings +(loss) per share +11,267 +14,276 +19,680 +See accompanying notes . +F-5 +Iteris +Holdings, Inc. +Consolidated Statements of +Stockholders’ Equity (Deficit) +(In thousands) +Common +stock +Shares +outstanding +Amount +Additional +paid-in +capital +Treasury +stock +Notes +receivable +from +employees +Accumulative +other compre- +hensive +income +Accumulated +deficit +Total +Stockholders' +equity +(deficit) +Compre- +hensive +income +(loss) +Class A +common +stock +Class B +common +stock +Balance at March 31, 2001 +9,469 +1,036 +$ +1,050 +$ +78,548 +$ +(1 +) +$ +(51 +) +$ +(436 +) +$ +(58,732 +) +$ +20,378 +$ +(33,238 +) +Issuances of Iteris Holdings, Inc. Class A common +stock +2,022 +— +202 +9,229 +— +— +— +— +9,431 +— +Issuance of warrants +— +— +— +1,357 +— +— +— +— +1,357 +— +Foreign currency translation adjustments +— +— +— +— +— +— +677 +— +677 +677 +Net loss +— +— +— +— +— +— +— +(26,588 +) +(26,588 +) +(26,588 +) +Balance at March 31, 2002 +11,491 +1,036 +1,252 +89,134 +(1 +) +(51 +) +241 +(85,320 +) +5,255 +$ +(25,911 +) +Issuances of Iteris Holdings, Inc. Class A common +stock +2,590 +— +260 +3,685 +— +— +— +— +3,945 +— +Foreign currency translation adjustments +— +— +— +— +— +— +(340 +) +— +(340 +) +(340 +) +Net loss +— +— +— +— +— +— +— +(13,148 +) +(13,148 +) +(13,148 +) +Balance at March 31, 2003 +14,081 +1,036 +1,512 +92,819 +(1 +) +(51 +) +(99 +) +(98,468 +) +(4,288 +) +$ +(13,488 +) +Issuances of Iteris Holdings, Inc. Class A common +stock and warrants +6,288 +— +629 +4,170 +— +— +— +— +4,799 +— +Conversion of Class B common stock +108 +(108 +) +— +— +— +— +— +— +— +— +Payments on notes receivable +— +— +— +— +— +6 +— +— +6 +— +Foreign currency +translation adjustments +— +— +— +— +— +— +99 +— +99 +99 +Net income +— +— +— +— +— +— +— +7 +7 +7 +Balance at March 31, 2004 +20,477 +928 +$ +2,141 +$ +96,989 +$ +(1 +) +$ +(45 +) +$ +— +$ +(98,461 +) +$ +623 +$ +106 +See accompanying notes. +F-6 +Iteris +Holdings, Inc. +Consolidated Statements of Cash Flows +(In thousands) +Year Ended +March 31, +2002 +2003 +2004 +Operating +activities +Net loss from continuing operations +$ +(9,018 +) +$ +(5,256 +) +$ +(1,208 +) +Net income (loss) from discontinued +operations +(17,120 +) +(7,892 +) +1,215 +Extraordinary loss +(450 +) +— +— +Adjustments to reconcile net income (loss) +to net cash used in operating activities: +Depreciation and amortization +2,816 +816 +857 +Amortization of warrants +1,230 +246 +— +Amortization of deferred gain on +sale-leaseback +— +(1,665 +) +(855 +) +Minority interest in earnings of subsidiary +1,910 +3,818 +3,034 +Loss on sale of Iteris, Inc. common stock +1,596 +310 +— +Loss on disposal of assets +49 +2 +— +Gain on sale of product lines +(3,385 +) +— +— +Provision for losses on accounts receivable +102 +— +— +Net assets (liabilities) of discontinued +operations +17,735 +(4,188 +) +241 +Changes in operating assets and liabilities +(Note 12) +(13,698 +) +9,020 +(4,002 +) +Net cash used in operating activities +(18,233 +) +(4,789 +) +(718 +) +Investing +activities +Purchases of property, plant and equipment, +net +(426 +) +(518 +) +(558 +) +Proceeds from sale of product lines +9,884 +— +— +Proceeds from sale of building +— +18,951 +— +Purchase of net assets of acquired business +(200 +) +— +— +Other +677 +(340 +) +99 +Net cash provided by (used in) investing +activities +9,935 +18,093 +(459 +) +Financing +activities +Proceeds (repayments) from line of credit +and long-term borrowings, net +28,720 +— +(467 +) +Principal payments on line of credit and +long-term debt +(30,929 +) +(16,912 +) +— +Proceeds from sale of subsidiary common and +preferred stock +8,697 +871 +— +Proceeds from issuance of common stock and +related warrants +— +2,766 +3,813 +Payments on notes receivable from employees +— +— +6 +Net cash provided by (used in) financing +activities +6,488 +(13,275 +) +3,352 +Increase (decrease) in cash +(1,810 +) +29 +2,175 +Cash and cash equivalents at beginning of +year +2,218 +408 +437 +Cash and cash equivalents at end of year +$ +408 +$ +437 +$ +2,612 +See accompanying notes. +F-7 +Iteris +Holdings, Inc. +Notes to Consolidated Financial +Statements +March 31, 2004 +1. Formation +and Operations +Iteris Holdings, Inc. (the “Company” or “Iteris Holdings”), formerly +known as Odetics, Inc., designs, develops, markets and implements software +based solutions that improve the safety and efficiency of vehicle +transportation. The Company +incorporates its software into sensor systems (“Sensors”) that it sells to +vehicle manufacturers in North America and Europe and to governmental agencies, +principally in the United States. It +also develops transportation management information systems (“Systems”) for the +intelligent transportation systems, or ITS, industry. These systems are sold to local, state and national +transportation agencies in the United States. +Iteris Holdings currently operates through its majority-owned +subsidiary, Iteris, Inc. Iteris +Holdings was incorporated in Delaware in October 1987 as Odetics, Inc. and +changed its name to Iteris Holdings, Inc. in September 2003. +The Company has incurred losses from operations during the fiscal years +ended March 31, 2002 and 2003 of $2.4 million and $1.1 million, +respectively, while reporting income from operations of $1.0 million for the +fiscal year ended March 31, 2004. +However, the Company has reported negative operating cash flows for each +of the years presented. As of +March 31, 2004, the Company had an accumulated deficit of $98.5 million +and cash and cash equivalents on hand of $2.6 million. The Company believes that its existing cash +on hand and any cash generated from operations will be sufficient to fund its +working capital requirements, capital expenditures, debt and other obligations +through the next 12 months. The Company +may face significant risks associated with the successful execution of its +business strategy and may need to raise additional capital in order to fund +more rapid expansion, to expand its marketing activities, to develop new or +enhance existing services or products, and to respond to competitive pressures +or to acquire complementary services, businesses, or technologies. If the Company is not successful in +generating sufficient cash flow from operations, it may need to raise +additional capital through public or private financing, strategic +relationships, or other arrangements. +Principles +of Consolidation +The accompanying consolidated financial statements include the accounts +of the Company and its subsidiaries. All significant intercompany accounts and +transactions have been eliminated in consolidation. +Use +of Estimates +The preparation of consolidated financial statements in conformity with +U.S., generally accepted accounting principles requires management to make +certain estimates and assumptions that affect the reported amounts of assets +and liabilities and disclosures of contingent assets and liabilities at the +date of the financial statements, and reported amounts of revenues and expenses +during the reporting period. Actual +results could differ from those estimates. +Significant estimates made in the preparation of the consolidated +financial statements include the allowance for doubtful accounts, deferred tax +assets, inventory and warranty reserves, costs to complete long-term contracts, +contract reserves and estimates of future cash flows used to assess the +recoverability of long-lived assets and goodwill. +Revenue Recognition +Product revenues and related cost of sales are recognized upon the +transfer of title, which generally occurs upon shipment or, if required, upon +acceptance by the customer, provided that the Company believes collectibility +of the net sales amount is probable. +Accordingly, at the date revenue is recognized, the significant +uncertainties concerning the sale have been resolved. +Contract revenues are derived primarily from long-term contracts with +governmental agencies. Contract +revenues include costs incurred plus a portion of estimated fees or profits +determined on the percentage of completion method of accounting based on the +relationship of costs incurred to total +F-8 +estimated costs. Any +anticipated losses on contracts are charged to earnings when identified. Changes in job performance and estimated +profitability, including those arising from contract penalty provisions and +final contract settlements may result in revisions to cost and revenue and are +recognized in the period in which the revisions are determined. Profit incentives are included in revenue +when their realization is reasonably assured. +In addition to product and contract revenue, the Company derives +revenue from technology access fees and the provision of specific non-recurring +contract engineering services. Technology access fees are amortized to revenue +over the life the related agreement and are based on contractual values. Contract +engineering revenues are recognized in the period in which services are +performed based on contractual billing terms. Technology access fee revenues +and contract engineering revenues are included in net sales on the accompanying +statement of operations. +Revenues from follow-on service and support, for which the Company +charges separately, is recorded in the period in which the services are +performed. +Cash and Cash +Equivalents +Cash and cash equivalents consist of cash and short-term investments +with initial maturities of ninety days or less. +Concentration +of Credit Risk +The Company maintains reserves for potential credit losses, estimating +the collectibility of customer receivables on an ongoing basis by periodically +reviewing invoices outstanding greater than a certain period of time. The +Company has recorded reserves for receivables deemed to be at risk for +collection, as well as a general reserve based on historical collections +experience. A considerable amount of judgment is required in assessing the +ultimate realization of these receivables deemed to be at risk for collection +including the current credit-worthiness of each customer. Such losses have +historically been minimal and within management’s estimates. Receivables from +customers are generally unsecured. At March 31, 2003 and 2004, accounts +receivable from governmental agencies and prime government contractors were +approximately $3.4 million and $3.5 million, respectively. No customer or government agency had a +receivable balance greater than 10% of net sales or contract revenues at +March 31, 2003 and 2004. +Fair Values of +Financial Instruments +Fair values of cash and cash equivalents, receivables, inventories, +accounts payables and accrued expenses, approximates fair value because of the short +period of time to maturity. The fair value of line of credit agreements +approximate carrying value because the related rates of interest approximate +current market rates. +Inventories +Inventories are stated at the lower of cost or market. Cost is determined +on the first-in, first-out method. +Property, Plant and Equipment +Property, plant and equipment are recorded at cost. Equipment is +depreciated principally by the declining balance method over its estimated +useful life ranging from four to eight years. +F-9 +Long-Lived Assets +Long-lived assets held and used by the Company are reviewed for +impairment whenever events or changes in circumstances indicate that the +carrying amount of an asset may not be recoverable. The Company believes no +impairment of the carrying value of its long-lived assets existed at +March 31, 2004. The Company’s analysis was based on an estimate of future +undiscounted cash flows using forecasts contained in the Company’s strategic +plan. It is at least reasonably +possible that the Company’s estimate of future undiscounted cash flows may +change during fiscal 2005. If the Company’s estimate of future undiscounted +cash flows should change or if the strategic plan is not achieved, future +analyses may indicate insufficient future undiscounted cash flows to recover +the carrying value of the Company’s long-lived assets, in which case such +assets would be written down to estimated fair value. +Goodwill +Goodwill represents the excess of the purchase price over the fair +value of the net assets of acquired entities. +On April 1, 2002, the Company adopted Financial Accounting +Standards Board (“FASB”) Statement No. 142, Goodwill +and Other Intangible Assets (“Statement 142”). Under Statement 142, +goodwill is no longer amortized but is subject to impairment tests based upon a +comparison of the fair value of each of the Company’s reporting units, as +defined, and the carrying value of the reporting units’ net assets, including +goodwill. Pursuant to Statement 142, upon adoption the Company tested its +goodwill for impairment and, based upon recent sales of equity securities, +determined that no impairment existed. Statement 142 requires a review for +impairment at least annually or when circumstances exist that would indicate an +impairment of such goodwill. The Company performs the annual impairment review +as of January 1 of each year. The 2004 annual review resulted in no +impairment of the carrying value of goodwill. Adjusted net income (loss) and +the related earnings (loss) per share impact of the adoption of Statement 142 +is as follows (in thousands, except per share amounts): +Year Ended +March 31, +2002 +2003 +2004 +Reported loss from continuing operations +$ +(9,018 +) +$ +(5,256 +) +$ +(1,208 +) +Add back goodwill amortization +1,208 +— +— +Adjusted net loss from continuing +operations +(7,810 +) +(5,256 +) +(1,208 +) +Income (loss) from discontinued operations, +net of income taxes +(17,120 +) +(7,892 +) +1,215 +Extraordinary loss on early extinguishment +of debt +(450 +) +— +— +Adjusted net income (loss) +$ +(25,380 +) +$ +(13,148 +) +$ +7 +Basic earnings (loss) per share: +Reported loss from continuing operations +$ +(0.80 +) +$ +(0.37 +) +$ +(0.06 +) +Add back goodwill amortization +0.11 +— +— +Adjusted net loss from continuing +operations per share +(0.69 +) +(0.37 +) +(0.06 +) +Income (loss) from discontinued operations, +net of income taxes +(1.52 +) +(0.55 +) +0.06 +Extraordinary loss on early extinguishment +of debt +(0.04 +) +— +— +Adjusted net income (loss) per share +$ +(2.25 +) +$ +(0.92 +) +$ +0.00 +Diluted earnings (loss) per share: +Reported loss from continuing operations +$ +(0.80 +) +$ +(0.37 +) +$ +(0.06 +) +Add back goodwill amortization +0.11 +— +— +Adjusted net loss from continuing +operations +(0.69 +) +(0.37 +) +(0.06 +) +Income (loss) from discontinued operations, +net of income taxes +(1.52 +) +(0.55 +) +0.06 +Extraordinary loss on early extinguishment +of debt +(0.04 +) +— +— +Adjusted +net income (loss) +$ +(2.25 +) +$ +(0.92 +) +$ +0.00 +F-10 +Research and +Development Expenditures +Research and development +expenditures are charged to expense in the period incurred. +Warranty +Unless otherwise stated, the Company +provides a one to two year warranty from the original invoice date on all +product material and workmanship. Products sold to certain original equipment +manufacturer customers sometimes carry longer warranties. Defective products +will be either repaired or replaced, generally at the Company’s option, upon +meeting certain criteria. The Company accrues a provision for the estimated +costs that may be incurred for product warranties relating to a product as a +component of cost of sales at the time revenue for that product is recognized. The accrued warranty provision is included +within accrued expenses on the balance sheets. +The activity in accrued warranty +obligations is as follows (in thousands): +March 31, +2002 +2003 +2004 +Balance at beginning of year +$ +95 +$ +249 +$ +256 +Additions charged to cost of sales +325 +323 +161 +Warranty claims +(171 +) +(316 +) +(225 +) +Balance at end of year +$ +249 +$ +256 +$ +192 +Comprehensive Income +The only component of accumulated other comprehensive income is the +cumulative foreign currency translation adjustment recorded in stockholders’ +equity (deficit). +Income Taxes +Deferred income tax assets and liabilities are computed for differences +between financial statement and tax basis of assets and liabilities based on +enacted tax laws and rates applicable to the period in which differences are +expected to affect taxable income. Valuation allowances are established when +necessary to reduce deferred tax assets to amounts which are more likely than +not to be realized. The provision for income taxes is the taxes payable or +refundable for the period plus or minus the change during the period in +deferred income tax assets and liabilities. +F-11 +Earnings (Loss) Per Share +The following table sets forth the computation of basic and diluted +income (loss) per share (in thousands, except per share amounts): +Year Ended +March 31, +2002 +2003 +2004 +Numerator: +Net income (loss) +$ +(26,588 +) +$ +(13,148 +) +$ +7 +Denominator: +Denominator for basic loss per share - +weighted-average shares +11,267 +14,276 +19,454 +Effect of dilutive securities: +Employee stock options and warrants +— +— +226 +Denominator for diluted loss per share +11,267 +14,276 +19,680 +Basic earnings (loss) per share +$ +(2.36 +) +$ +(0.92 +) +$ +0.00 +Diluted earnings (loss) per share +$ +(2.36 +) +$ +(0.92 +) +$ +0.00 +Stock-Based +Compensation +The Company accounts for stock-based employee compensation arrangements +in accordance with Accounting Principles Board Opinion No. 25, Accounting for Stock-Issued to Employees (“APB +No. 25”) and related interpretations, and complies with the disclosure +provisions of Financial Accounting Standards Board (“FASB”) Statement No. 123, Accounting for Stock-Based Compensation (“SFAS +123”). Under APB No. 25, compensation cost is recognized based on the +difference, if any, on the date of the grant between the fair value of the +Company’s stock and the amount the employee must pay to acquire the stock. +In December 2002, the FASB issued Statement of Financial +Accounting Standards No. 148, Accounting for +Stock-Based Compensation—Transition and Disclosure , (“SFAS 148”) +providing alternative methods of transition for a voluntary change to the fair +value based method of accounting for stock-based employee compensation. In +addition, SFAS 148 amends the disclosure requirements to require prominent +disclosures in both annual and interim financial statements about the method of +accounting for stock-based employee compensation and the effect of the method +used on reported results. The Company does not currently plan to change its +stock-based employee compensation accounting to the fair value method. The +accompanying financial statements reflect all of the disclosures required by +SFAS 148. +In calculating pro forma information regarding net income (loss) and +earnings (loss) per share, as required by SFAS 123, the fair value was +estimated at the date of grant using a Black-Scholes option pricing model with +the following assumption: +Years +Ended March 31, +2002 +2003 +2004 +Dividend rate +0.0 +0.0 +0.0 +Expected life – years +7.0 +7.0 +7.0 +Risk-free interest rate +4.5 +2.0 +2.0 +Volatility of common stock +0.4 +0.4 +0.4 +F-12 +For purposes of pro forma disclosures, the estimated fair value of the +options is amortized to expense over the options’ vesting period. The Company’s +pro forma information follows (in thousands, except per share amounts): +Year Ended +March 31, +2002 +2003 +2004 +Net income (loss) — reported +$ +(26,588 +) +$ +(13,148 +) +$ +7 +Employee compensation expense under fair value +method +(201 +) +(637 +) +(385 +) +Net loss — pro forma +$ +(26,789 +) +$ +(13,785 +) +$ +(378 +) +Basic and diluted earnings (loss) per share — +reported +$ +(2.36 +) +$ +(0.92 +) +$ +0.00 +Basic and diluted loss per share — pro forma +$ +(2.38 +) +$ +(0.97 +) +$ +(0.02 +) +Shipping +and Handling Costs +Shipping and handling costs are included as cost of sales in the period +during which the products ship. +Repair +and Maintenance Costs +The Company incurs repair and maintenance costs in the normal course of +business. Should the activity result in a permanent improvement to one of the +Company’s leased facilities, the cost is capitalized as a leasehold improvement +and amortized over its useful life or the remainder of the lease period, +whichever is shorter. Non- permanent +repair and maintenance costs are charged to expense as incurred. +Advertising +Expenses +The Company expenses advertising costs as incurred. Advertising expense +totaled $71,000, $77,000 and $127,000 in the years ended March 31, 2002, +2003 and 2004, respectively. +Discontinued Operations +In August 2001, the FASB issued Statement of Financial Accounting +Standards No. 144, Accounting for the +Impairment or Disposal of Long-Lived Assets (“SFAS 144”). The +Statement supersedes FASB Statement No. 121, Accounting +for the Impairment of Long-Lived Assets and for Long-Lived Assets to be +Disposed Of , however, it retains the fundamental provisions of that +statement related to the recognition and measurement of the impairment of +long-lived assets to be “held and used.” SFAS 144 also supersedes the +accounting and reporting provisions of Accounting Principles Board Opinion No. +30, Reporting the Results of +Operation’s—Reporting the Effects of Disposal of a Segment of a Business, and +Extraordinary, Unusual and Infrequently Occurring Events and Transactions (“APB +30”), for the disposal of a segment of a business. Under SFAS 144, a component +of a business that is held for sale is reported in discontinued operations if +(i) the operations and cash flows will be, or have been, eliminated from the +ongoing operations of the company and, (ii) the company will not have any significant +continuing involvement in such operations. In the quarter ended +September 30, 2001, the Company adopted the provisions of SFAS 144 +effective April 1, 2001. +F-13 +In April 2001, the Company bifurcated its Gyyr subsidiary into the +Gyyr Closed Circuit Television Products Line, which manufactured analog and +digital storage systems, and the Gyyr Electronic Access Control division. In +September 2001, the Company sold substantially all of the assets and certain +liabilities of the Gyyr Closed Circuit Television Products line for $8.8 +million. In connection with this sale, the Company changed the name of its Gyyr +subsidiary to MAXxess Systems, Inc. (“MAXxess”). +In September 2001, the Company approved a plan to discontinue the +operations of Mariner Networks, Inc. (“Mariner”) which was part of the +Company’s telecom products segment. The aggregate losses recognized to write +down the assets of Mariner to their fair value less cost to sell were +approximately $6.7 million. In addition, the Company accrued $1.7 million for +severance and other direct costs to exit the operation. As of March 2004, the Company was in +the process of settling certain employee obligations related to the +discontinuance of Mariner operations in France. The Company's estimated ultimate liability of $100,000 is +included in accrued expenses on the March 31, 2004 balance sheet. +In March 2003, the Company ceased the development and sale of +products in its Broadcast, Inc. subsidiary (“Broadcast”) and reduced the +headcount in Broadcast to only support the existing customer contracts for +service and support through their expiration dates. The aggregate losses +recognized to write down the assets of Broadcast to their fair value less cost +to sell were approximately $3.4 million. In addition, the Company accrued +$400,000 for employees severed in March 2003 and other direct costs to +wind down the operation. +On May 9, 2003, the Company completed the sale of substantially all of +the assets of its Zyfer, Inc. (“Zyfer”) subsidiary for $2.3 million in cash +plus the assumption of certain liabilities. The asset purchase agreement +provides for future incentive payments of up to $1.0 million in each of the +twelve month periods ended April 30, 2004 and 2005, based on the +achievement of certain revenue goals related to the sale of Zyfer products or +the licensing of its technologies. +Based on the terms of the sale agreement, Zyfer has 60 days to provide +the Company with support for the incentive payments. The Company is expecting to receive this information for fiscal +2004 by the end of June 2004. +In September 2003, the Company sold substantially all of the +assets of MAXxess to an investor group that included certain members of the +MAXxess management group. The consideration for the assets consisted of the +assumption of $2.7 million of liabilities, resulting in a net gain of $2.4 +million from the sale. +Asset write-downs and accrued costs are included in the income (loss) +from discontinued operations in the years ending March 31, 2002, 2003 and +2004. The results of operations of +Broadcast, Mariner, Zyfer and MAXxess (including Gyyr) for all periods +presented have been reclassified and presented as discontinued operations in +the accompanying consolidated statements of operations. Interest expense was +not reclassified to discontinued operations because the discontinuances did not +eliminate any of the Company’s debt. +F-14 +The net sales and income (loss) from discontinued operations are as +follows (in thousands): +Year Ended +March 31, +2002 +2003 +2004 +Net sales and contract revenues: +MAXxess +$ +14,880 +$ +6,232 +$ +1,747 +Zyfer +4,475 +6,487 +— +Broadcast +2,824 +3,599 +385 +Mariner +533 +— +— +Total net sales and contract revenues +$ +22,712 +$ +16,318 +$ +2,132 +Net income (loss) from discontinued +operations: +MAXxess +$ +3,845 +$ +862 +$ +199 +Zyfer +(5,100 +) +(1,718 +) +— +Broadcast +(2,941 +) +(2,468 +) +(122 +) +Mariner +(4,563 +) +— +— +(8,759 +) +(3,324 +) +77 +Loss recognized upon discontinuance of +operations +(8,361 +) +(4,909 +) +(1,226 +) +Gain on sale of assets of discontinued +operations +— +341 +2,364 +Income (loss) from discontinued operations +$ +(17,120 +) +$ +(7,892 +) +$ +1,215 +F-15 +The assets and liabilities of the discontinued operations consisted of +the following (in thousands): +March 31, +2003 +2004 +Accounts receivable +$ +2,013 +$ +— +Inventories +2,253 +— +Prepaid expenses and other assets +207 +— +Property, plant and equipment, net +764 +— +Total assets of discontinued operations +$ +5,237 +$ +— +Accounts payable +$ +2,925 +— +Accrued expenses +2,071 +— +Total liabilities of discontinued +operations +$ +4,996 +$ +— +Recent Accounting Pronouncements +In November 2002, the Emerging Issues Task Force (“EITF”) issued +EITF No. 00-21, “ Revenue Arrangements with +Multiple Deliverables ,” which provides guidance on the timing and +method of revenue recognition for sales arrangements that include the delivery +of more than one product or service. EITF No. 00-21 is effective prospectively +for arrangements entered into in fiscal periods beginning after June 15, +2003. The adoption of EITF No. 00-21 did not have a material effect on the +Company’s financial position, results of operations or cash flows. +In December 2002, the FASB issued Statement of Financial +Accounting Standards No. 148, “ Accounting +for Stock-Based Compensation-Transition and Disclosure ” (“SFAS No. +148”) which is effective for fiscal years ending after December 15, 2002. +SFAS No. 148 amends Statement of Financial Accounting Standards No. 123, “ Accounting for Stock-Based Compensation ” +(“SFAS No. 123”) to provide alternative methods of transition to SFAS No. 123’s +fair value method of accounting for stock-based employee compensation if a +company elects to account for its equity awards under this method. SFAS No. 148 +also amends the disclosure provisions of SFAS No. 123 and Accounting Principles +Board Opinion No. 28, “ Interim Financial +Reporting ” (“APB 25”) to require disclosure effects of an entity’s +accounting policy with respect to stock-based employee compensation on reported +net income (loss) and net income (loss) per share in both annual and interim +financial statements. The Company follows the disclosure-only provisions of +SFAS No. 123, as amended by SFAS No. 148, and, accordingly, accounts for its +stock-based compensation plans using the intrinsic value method under Accounting +Principles Board Opinion No. 25, “ Accounting +for Stock Issued to Employees ” and related interpretations. +In January 2003, the FASB issued Interpretation No. 46, Consolidation of Variable Interest Entities (“FIN +46”). This Interpretation changes the method of determining whether certain +entities should be included in the Company’s Consolidated Financial Statements. +An entity is subject to FIN 46 and is called a variable interest entity (“VIE”) +if it has (1) equity that is insufficient to permit the entity to finance its +activities without additional subordinated financial support from other +parties, or (2) equity investors that cannot make significant decisions about +the entity’s operations, or that do not absorb the expected losses or receive +the expected returns of the entity. All other entities are evaluated for +consolidation under SFAS No. 94, Consolidation of All Majority-Owned +Subsidiaries. The provisions of FIN 46 are to be applied immediately to VIEs +created after January 31, 2003, and to VIEs in which an enterprise obtains +an interest after that date. For VIEs in which an enterprise holds a variable +interest that it acquired before February 1, 2003, FIN 46 applies in the +first fiscal period beginning after June 15, 2003. Adoption of FIN 46 did not have a material +impact on the Company’s financial position, results of operations or cash +flows. +In May 2003, the FASB issued SFAS 150, “ Accounting For Certain Financial Instruments with Characteristics of +Both Liabilities and Equity ” (“SFAS No. 150”) which establishes +standards for how an issuer of financial instruments classifies and measures +certain financial instruments with characteristics of +F-16 +both liabilities and equity. It requires that an issuer +classify a financial instrument that is within its scope as a liability (or an +asset in some circumstances) if, at inception, the monetary value of the +obligation is based solely or predominantly on a fixed monetary amount known at +inception, variations in something other than the fair value of the issuer’s +equity shares or variations inversely related to changes in the fair value of +the issuer’s equity shares. SFAS No. 150 is effective for financial instruments +entered into or modified after May 31, 2003, and otherwise is effective at the +beginning of the first interim period beginning after June 15, 2003. The +adoption of SFAS 150 did not have a material impact on the Company’s financial +position, results of operations or cash flows. +Reclassifications +Certain amounts in the fiscal 2002 and fiscal 2003 consolidated +financial statements have been reclassified to conform with the fiscal 2004 +presentation. +2. Restructuring +Charges +During fiscal 2001 and 2002, the Company approved a number of actions to +reduce operating expenses and improve profitability and cash flows. These +actions included a reduction in workforce of 222 and 130 employees in 2001 and +2002 respectively. As a result of these actions, the Company recorded the +following as restructuring charges (in thousands): +Severance +and +Related Costs +2001 restructuring charge +$ +367 +Cash expenditures +(367 +) +Balance at March 31, 2001 +— +2002 restructuring charge +1,142 +Cash expenditures +(858 +) +Balance at March 31, 2002 +284 +Cash expenditures +(284 +) +Balance at March 31, 2003 +$ +— +3. Costs +and Estimated Earnings on Uncompleted Contracts +Costs incurred, estimated earnings and billings on uncompleted +long-term contracts are as follows (in thousands): +March 31, +2003 +2004 +Costs incurred on uncompleted contracts +$ +15,645 +$ +20,840 +Estimated earnings +1,173 +2,084 +16,818 +22,924 +Less billings to date +(14,724 +) +(20,820 +) +$ +2,094 +$ +2,104 +Included in accompanying balance sheets: +Costs and estimated earnings in excess of +billings on uncompleted contracts +$ +2,398 +$ +2,653 +Billings in excess of costs and estimated +earnings on uncompleted contracts +(304 +) +(549 +) +$ +2,094 +$ +2,104 +F-17 +Costs and estimated earnings in excess of billings at March 31, +2003 and 2004 include $244,000 and $534,000 respectively, that were not +billable as certain milestone objectives specified in the contracts had not +been attained. Substantially all costs and estimated earnings in excess of +billings at March 31, 2004 are expected to be billed and collected during +the year ending March 31, 2005. +4. Revolving +Lines of Credit and Long-Term Debt +In May 2001, the Company entered into a $16.0 million promissory note +secured by a first trust deed on its principal facility in Anaheim, California, +which bore interest at 10% per annum. The promissory note was paid in full at +its scheduled maturity date in May 2002. In connection with the note the +Company issued warrants to the lender to purchase 426,667 shares of Class A +common stock at an exercise price of $4.00 per share and a warrant to purchase +an additional 426,667 shares of Class A common stock at an exercise price of +$1.28 per share. The Company repriced +the $4.00 per share warrants to $3.00 per share, in connection with a +forbearance agreement negotiated in November 2001. The issuance of the +warrants represented a discount on the note totaling $1.4 million, which was +amortized over the life of the note. +Approximately $6.0 million of the proceeds of the promissory note were +used to retire the pre-existing note payable on the Anaheim facility, which +included a prepayment penalty of $450,000. This prepayment penalty is reflected +as an extraordinary item in the accompanying consolidated statements of +operations. +In August 2001, the Company through Iteris, Inc. entered into a +loan and security agreement with a maximum available credit line of $5.0 +million. At March 31, 2004, there were no outstanding borrowings under +this line of credit and amounts available for future borrowing totaled $4.5 +million. +Under the terms of the agreement, Iteris, Inc. may borrow against its +eligible accounts receivable and the value of its eligible inventory, as +defined. Interest on borrowed amounts is payable monthly at the prime rate plus +2.0% (6.0% at March 31, 2004). +Additionally, Iteris, Inc. is obligated to pay an unused line fee of +0.5% per annum applied to the amount by which the maximum credit amount exceeds +the average daily principal balance during the preceding month, and a monthly +collateral management fee of $2,000. The agreement is secured by substantially +all of Iteris Inc.’s assets and expires in August 2004. Either party can +terminate the agreement with thirty days written notice. Should Iteris, Inc. +elect to terminate the agreement, a one-time termination fee of 3.0%, 2.0% and +1.0% of the maximum credit limit would apply in years 1 through 3, +respectively. +In February 2002, the Company entered into a $1.25 million line of +credit with a partnership controlled by the Company’s Chairman of the Board. +The line of credit is collateralized by substantially all of the Company’s +assets other than real property. Borrowings on the line of credit bear interest +at the prime rate plus 4.0% (8.0% at March 31, 2004) and matures in +April 2004. +Borrowings on the line of credit totaled $1.25 million at +March 31, 2003 and $100,000 at March 31, 2004. Interest expense under the line of credit +totaled $8,000, $110,000 and $6,000 in the years ended March 31, 2002, +2003 and 2004, respectively. +In October 2002, the Company entered into a receivables purchase +agreement with a partnership controlled by the Company’s Chairman of the Board +to sell certain receivables. Under certain conditions of the agreement the +Company may be required to buy back any uncollected receivables. The total +amount transferred under the agreement was $1.2 million with $400,000 +uncollected as of March 31, 2003 and no accounts were uncollected as of March +31, 2004. The total fees and interest expense under the agreement was $100,000 +during the year ended March 31, 2003. +On July 1, 2003, the Company entered into a $811,347 promissory +note with its landlord as a concession for relief on the ten year lease term of +the Anaheim facility. The note accrues interest at a rate of prime plus 2.0% +(6.0% at March 31, 2004). Under the terms of the agreement accrued +interest for the +F-18 +period from July 1, 2003 through June 20, +3004 will be added to the principal balance. Beginning on October 1, 2006, +the Company will make four equal quarterly payments of principal and accrued +interest and on July 2, 2007 all outstanding accrued interest and +principal shall be payable in full. +On October 9, 2003, the Company entered into a $126,473 note +payable agreement to settle trade payables. The note is secured by the +equipment related to the payable. The note bears interest at 4.0% and is +payable in monthly installments of $3,850 for 36 months and is payable in full +on October 20, 2006. +Long-term debt consisted of the following (in thousands): +March 31, +2003 +2004 +Note payable, accruing interest at 4.0%, +payable in monthly installments of $3,850 until October 2006 +$ +— +$ +109 +Notes payable, accruing interest at prime +plus 2.0% (6.0%) at March 31, 2004, quarterly payments of principal and +interest to begin on October 1, 2006 until July 1, 2007 +— +811 +Note payable in connection with capital +lease +15 +13 +15 +933 +Less current portion +— +(42 +) +$ +15 +$ +891 +5. Income +Taxes +The reconciliation of the income tax benefit from continuing operations +to taxes computed at U.S. federal statutory rates is as follows (in thousands): +Year Ended +March 31, +2002 +2003 +2004 +Income tax (benefit) provision at statutory +rates +$ +(2,683 +) +$ +(489 +) +$ +655 +State income taxes net of federal benefit +— +4 +20 +Change in valuation allowance associated +with federal deferred tax assets +1,446 +330 +(611 +) +Nondeductible goodwill amortization +176 +— +— +Other permanent differences +276 +155 +36 +$ +(785 +) +$ +— +$ +100 +F-19 +The components of deferred tax assets and liabilities are as follows +(in thousands): +March 31, +2003 +2004 +Deferred tax assets: +Net operating losses +$ +19,289 +$ +20,244 +Book over tax depreciation +6,025 +5,323 +Credit carry forwards +1,999 +2,420 +Deferred compensation and payroll +1,231 +977 +Bad debt allowances and other reserves +265 +209 +Other, net +406 +202 +Total deferred tax assets +29,215 +29,375 +Valuation allowance +(28,748 +) +(28,119 +) +Net deferred tax assets +467 +1,256 +Deferred tax liabilities: +Capitalized interest and taxes +(421 +) +(404 +) +Other, net +(46 +) +(31 +) +Total deferred tax liabilities +(467 +) +(435 +) +Net deferred taxes +$ +— +$ +821 +The components of current and deferred federal and state income tax +benefits and provisions are as follows (in thousands): +Year Ended +March 31, +2002 +2003 +2004 +Current income tax (benefit) provision +Federal +$ +(785 +) +$ +35 +$ +891 +State +— +— +30 +Deferred income tax (benefit) provision +Federal +— +(35 +) +(821 +) +State +— +— +— +Net income tax (benefit) provision +$ +(785 +) +$ +0 +$ +100 +At March 31, 2004, the Company had approximately $1.7 million in +federal general business credit carryforwards that begin to expire in 2006 and +$707,000 in state general business credit carryforwards that can be carried +forward indefinitely. The Company had $51.1 million of federal net operating +loss carryforwards at March 31, 2004 that begin to expire in 2019 and +$31.0 million of state net operating loss carryforwards that begin to expire in +2005. For financial reporting purposes, a valuation allowance has been recorded +to offset the deferred tax asset related to these credits and net operating +losses. Any future benefits recognized from the reduction of the valuation allowance +related to these carryforwards will result in a reduction of income tax +expense. +The Company’s ownership interest in Iteris, Inc. is below the threshold +required for the Company to file a consolidated tax return. As a result, +Iteris, Inc. is not included in the Company’s consolidated group for federal +income tax purposes, and instead is required to file a separate income tax +return. +At March 31, 2004, the Company recorded a valuation allowance +against its net deferred tax assets of approximately $28.0 million. FASB +Statement 109 “ Accounting for Income Taxes ” +("SFAS 109"). SFAS 109 requires that a valuation allowance must be +established when it +F-20 +is more likely than not that all or a portion of deferred +tax assets will not be realized. In making such determination, a review of all +available positive and negative evidence must be considered, including +scheduled reversal of deferred tax liabilities potential carryback, projected +future taxable income, tax planning strategies, and recent financial +performance. In accordance with SFAS 109 at March 31, 2004, the Company has +established a partial valuation allowance against its existing net deferred tax +assets, and recorded a net deffered tax asset of $821,000 related to Iteris, +Inc. +Because of the “change of ownership” provision of the Tax Reform Act of +1986, utilization of the Company’s net operating loss carryforwards may be +subject to an annual limitation against taxable income in future periods. As a +result of the annual limitation, a portion of these carryforwards may expire +before ultimately becoming available to reduce future income tax liabilities. +6 . Associate +Incentive Programs +Under the terms of a Profit Sharing Plan, the Company contributes to a +trust fund such amounts as are determined annually by the Board of Directors. +No contributions were made in 2002, 2003 or 2004. +In May 1990, the Company adopted a 401(k) Plan as an amendment and +replacement of the former Associate Stock Purchase Plan that was an additional +feature of the Profit Sharing Plan. Under the 401(k) Plan, eligible associates +voluntarily contribute to the plan up to 15% of their salary through payroll +deductions. The Company matches 50% of contributions up to a stated limit. +Under the provisions of the 401(k) Plan, associates have thirteen investment +choices, one of which is the purchase of Iteris Holdings’ Class A common stock +at market price. Company matching contributions were approximately $722,000, +$544,000 and $403,000 in 2002, 2003 and 2004, respectively. +7. Deferred Compensation Plans +During 1986, the Company adopted an Executive Deferral Plan under which +certain executives may defer a portion of their annual compensation. All +deferred amounts earn interest, generally with no guaranteed rate of return. +Compensation charged to operations and deferred under the plan totaled $66,000, +$43,000 and $0 for 2002, 2003 and 2004, respectively. +8. Equity +The Company has two classes of common stock outstanding — the Class A +common stock and the Class B common stock. The rights, preferences and +privileges of each class of common stock are identical in all respects except +for voting and conversion rights. The +holders of the Class A common stock are entitled to elect 25% of the Board of +Directors rounded up to the nearest whole number, or two directors, and the +holders of the Class A common stock and the Class B common stock, voting +together as a single class, are entitled to elect the balance of the Board, or +six directors. On all other matters to be addressed by a stockholder vote, the +holders of Class A common stock have one-tenth of one vote per share held and +the holders of Class B common stock have one vote per share held. In addition, +each share of Class B common stock is convertible into one share of Class A +common stock at the option of the holder of such Class B common stock. +Subject to the rights specifically granted to holders of any then +outstanding shares of the Company’s preferred stock, the Company’s common +stockholders are entitled to any dividends that may be declared by the board of +directors. Upon dissolution, +liquidation or winding up, holders of common stock are entitled to share +ratably in net assets after payment or provision for all liabilities and any +preferential liquidation rights of preferred stock then outstanding. Common stockholders do not have preemptive +or redemption rights. The rights, +preferences and privileges of holders of common stock will be subject to those +of the holders of any shares of common stock and preferred stock the Company +may issue in the future. +F-21 +The Company’s certificate of incorporation provides for the issuance of +up to 2,000,000 shares of preferred stock. +As of March 31, 2003 and 2004, there are no outstanding shares of +preferred stock, and the Company does not have any plans to issue any shares of +preferred stock. The Company’s board of +directors is authorized to issue from time to time such authorized but unissued +shares of preferred stock in one or more series and to fix or alter the +designations, preferences, rights and any qualifications, limitations or +restrictions of the shares of each such series, including the dividend, +conversion, voting, redemption and liquidation rights. +In July 2001 the company’s subsidiary, Iteris, Inc. issued +1,781,268 shares of its Series A preferred stock (Iteris, Inc. preferred stock) +to an institutional investor in exchange for $5.0 million in cash. In addition, +Iteris, Inc. issued 1,343,645 shares of its Iteris, Inc. preferred stock and +547,893 shares of its common stock in exchange for $500,000 in cash and the +retirement of its $3.75 million Subordinated Convertible Promissory Note plus +related accrued interest of $375,000. +Shares of Iteris, Inc. preferred stock are convertible into shares of +Iteris, Inc. common stock at the conversion rate in effect at the time, as +defined. Each share of Iteris, Inc. +preferred stock will automatically convert into shares of Iteris, Inc. common +stock immediately upon the closing of a firmly underwritten public offering +pursuant to an effective registration statement under the Securities Act of +1933 with aggregate gross proceeds to the Company of not less than $30.0 +million and price per share of not less than two times the original Iteris, +Inc. preferred stock issue price of $2.80 per share. +In the event that the Company failed to consummate an initial public +offering of Iteris, Inc. common stock or complete a sale of Iteris, Inc. to a +third party with aggregate proceeds of $25.0 million by January 1, 2004 +and/or the holders of Iteris, Inc. preferred stock elect not to exercise their +rights to convert into common stock, the Company was obligated to redeem the +Iteris, Inc. preferred stock at a sum equal to two times the original Iteris, +Inc. preferred stock issue price. +At March 31, 2004, the liquidation preference on Iteris, Inc. +preferred stock totaled $17.5 million. The difference between the initial issue +price, net of related issuance costs, and the liquidation preference is being +amortized over the redemption period and is reflected in minority interest in +earnings of subsidiary in the accompanying consolidated statement of +operations. +Prior to January 1, 2004, holders of the Iteris, Inc. Series A +Preferred Stock granted the Company an extension of the redemption date until +May 31, 2004. On May 28, 2004, the Company completed the purchase of all the +outstanding shares of the preferred stock of Iteris, Inc. (Note 14). +In August and December 2001, the Company sold 1,539,241 +shares of Iteris, Inc. common stock that it held at an aggregate purchase price +of $3.8 million to a group of investors, which included certain members of +management of the Company and Iteris, Inc.. In connection with this transaction, +the Company realized a loss of $1.6 million which is reflected in other income +(net) in the accompanying consolidated statements of operations. +In April 2002 and February 2003, the Company sold 322,581 +shares of Iteris, Inc. common stock that it held at an aggregate purchase price +of $900,000 to a group of investors, which included certain members of +management of the Company and Iteris, Inc.. In connection with this +transaction, the Company realized a loss of $300,000 that is reflected in other +income (expense), net in the accompanying consolidated statements of +operations. In February 2003, +Iteris, Inc. purchased back from the Company 288,500 shares of Iteris, Inc. +common stock that the Company held. The +Company realized a loss of $310,000 on this transaction, which is reflected in +other income, net in the accompanying consolidated statements of +operations. At March 31, 2004, the +Company held 75.1% of the outstanding common stock of Iteris, Inc. +F-22 +On August 16, 2002, the Company completed a private placement of +2,500,000 of its Class A common stock to an institutional investor for $3.0 +million in cash. The transaction, net of expenses, raised net proceeds of +approximately $2.7 million. In connection with this offering, the Company also +issued warrants to the investor to purchase up to another 1,250,000 shares at +an exercise price of $1.50 per share, and up to 1,250,000 shares at an exercise +price of $1.80 per share. The warrants are exercisable at any time by the +investor, and are callable by the Company if the market price of the Company’s +Class A common stock trades for 20 consecutive days at a price equal or greater +than two times the exercise price of the warrants and expire in August 2007. +The fair value of these warrants was $712,500 calculated using the Black +Scholes Model. The warrants are considered a cost of raising capital and were +recorded in equity as an offset to additional paid-in capital. The proceeds +from the August 2002 transaction were used to fund general working capital +requirements. In March 2004, 1,250,000 warrants at $1.50 per share become +callable and were exercised by the holder. +In July 2003, the Company completed a private placement of +3,666,666 of its Class A common stock to seven accredited investors for net +proceeds of $1.9 million in cash. In connection with this offering, The Company also issued warrants to purchase +an additional 366,666 shares of class A common stock at an exercise price of +$1.50 per share. The fair value of +these warrants was $55,000 calculated using the Black Scholes Model. The warrants are considered a cost of +raising capital and were recorded in equity as an offset to additional paid-in +capital. The warrants expire in +July 2006 and became exercisable in January 2003. +In September 2003, the Company issued 425,000 shares of its Class +A common stock valued at $255,000 and 75,000 warrants at an exercise price of +$5.00 per share, to settle liabilities related to the sale lease-back of the +Anaheim facility and the renegotiation of the related lease. The warrants are immediately exercisable and +expire in July 2010. The fair value of these warrants was $5,250 calculated +using the Black Scholes Model. The +value of the warrants was recorded as a reduction of the deferred gain on the +sale of the building. +During fiscal year 2004, the Company issued 657,132 shares of its Class +A common stock valued at $578,000 and 89,332 shares of its Class A common stock +valued at $151,000 to settle 401(k) match liabilities and prior trade +liabilities in Company stock, respectively. +In November 2001, the Company issued 426,667 warrants to purchase +shares of the Company’s class A common stock at an exercise price of $3.00 per +share and 426,667 warrants to purchase shares of the Company’s class A common +stock at an exercise price of $1.28 per share (Note 4). The $1.4 million value of these warrants +represented a discount in connection with the promissory note on the Company’s +Anaheim, California facility and was being amortized to interest expense over +the life of the note. The warrants are immediately exercisable and expire in +May 2006. On May 28, 2002 the note was repaid in full from proceeds from the +sale of the Anaheim facilities (Note 10) and the remaining unamortized discount +was recorded as a reduction of the gain on the sale. In March 2004, 200,000 +warrants at $1.28 per share were exercised by the holder. +In September 2002, the Company issued 75,000, 50,000 and 62,500 +warrants at exercise prices of $1.44, $1.68 and $1.95, respectively, in +connection with prior year fund raising activities. The warrants are +immediately exercisable and expire in August 2007. The fair value of these +warrants was $130,000 calculated using the Black Scholes Model. The warrants are considered a cost of +raising capital and were recorded in equity as an offset to additional pain-in +capital. +As of March 31, 2004, the Company had outstanding warrants to +purchase 2,532,500 shares of its common stock at a weighted average exercise +price of $2.00 per share. Exercise +prices range from $1.28 to $5.00 per share. +All of the warrants are presently exercisable. +9. Stock +Option Plans +The Company has adopted the Iteris Holdings 1997 Stock Incentive Plan, +which provides that options for shares of the Company’s unissued Class A common +stock may be granted to directors, associates and consultants to the Company. +Options granted enable the option holder to purchase one share +F-23 +of Class A common stock at prices which are equal to +or greater than the fair market value of the shares at the date of grant. +Options expire ten years after the date of grant or 90 days after termination +of employment and vest ratably at 33% on each of the first three anniversaries +of the grant date. +A summary of all Company stock option activity is as follows (in +thousands, except per share amounts): +Year Ended +March 31, +2002 +2003 +2004 +Options +Weighted +Average +Exercise +Price +Options +Weighted +Average +Exercise +Price +Options +Weighted +Average +Exercise +Price +Options outstanding at beginning of year +804 +$ +8.44 +329 +$ +8.37 +962 +$ +3.73 +Granted +30 +2.28 +659 +1.38 +230 +0.78 +Exercised +— +— +— +— +— +— +Cancelled +(505 +) +8.06 +(26 +) +4.29 +(60 +) +6.76 +Options outstanding at end of year +329 +$ +8.37 +962 +$ +3.73 +1,132 +$ +2.98 +Exercisable at end of year +237 +879 +778 +Available for grant at end of year +1,322 +689 +519 +Weighted average fair value of options +granted +$ +1.20 +$ +0.68 +$ +0.55 +The exercise price for options outstanding as of March 31, 2004, +ranged from $0.65 to $15.625. +The weighted-average remaining contractual life of those options is 6.9 +years. +F-24 +Iteris, Inc.’s +Stock Options +The following table summarizes information regarding the Company’s +stock options at March 31, 2004: +Exercise +Price +Number of +shares +outstanding +Number of +shares +Exercisable +Weighted +Average +Remaining +Contractual Life +(in Years) +$ +0.65 +200,000 +29,167 +9.4 +$ +0.78 +30,000 +— +9.4 +$ +1.02 +30,000 +10,000 +8.4 +$ +1.40 +607,000 +483,666 +5.5 +$ +2.28 +30,000 +20,000 +7.4 +$ +4.63 +66,601 +66,601 +3.8 +$ +5.69 +21,000 +21,000 +4.4 +$ +8.00 +5,000 +5,000 +5.1 +$ +10.31 +67,500 +67,500 +5.5 +$ +14.13 +45,000 +45,000 +6.3 +$ +15.63 +30,000 +30,000 +6.4 +1,132,101 +777,934 +6.9 +In September 1997, the Company’s subsidiary Iteris, Inc. granted +options to purchase up to 899,960 shares of Iteris, Inc.’s common stock to +certain members of its senior management at an exercise price of $1.07 per +share. As of March 31, 2004, options to purchase 759,345 shares of common +stock were outstanding. +In addition to the 1997 Plan, the Company’s Board of Directors adopted +and approved the 1998 Stock Incentive Plan (the “Plan”), as amended in +February 2000, authorizing 3,000,000 shares of Iteris Inc.’s common stock +for issuance under the Plan. Options to purchase 3,280,964 shares of Iteris, +Inc.’s common stock, at exercise prices ranging from $1.60 to $9.07 per share, +were outstanding at March 31, 2004. Under the Plan, options expire ten +years after date of grant or 90 days after termination of employment. The +options granted vested ratably at 25% on each of the first four anniversaries +of the grant date. +10. Commitments +On May 28, 2002, the Company completed the sale and leaseback of its +Anaheim, California facility for an aggregate sale price of $22.6 million. +Under the terms of the sale and leaseback agreement, the Company will continue +to lease one of the two buildings located on the property for an initial +ten-year period at a rate of $152,150 per month and the other building for a +period of 30 months at a rate of approximately $57,553 per month. Approximately +$16.4 million of the proceeds from the sale was used to repay the outstanding +indebtedness and accrued interest under a promissory note that was secured by a +first deed of trust on the Anaheim facility (Note 4), at March 31, 2003, $2.5 million was being held in escrow as +a security deposit on future lease payments and is included in restricted cash +on the accompanying consolidated balance sheets at March 31, 2003. The balance of the proceeds was available +for general working capital purposes. The gain on the sale of the facility was +approximately $8.2 million, of which $640,000 was recognized immediately and +the remainder was deferred and is being amortized against rent expenses over +the term of the leases. +On July 1, 2003, the Company renegotiated the terms of its +existing lease for its Anaheim facilities whereby the initial lease term of ten +years was reduced to four years and the Company +F-25 +was relieved of its obligation to lease both +buildings. Under the terms of the new +lease, the Company is only responsible for 86,000 square feet at a rate of +$73,340 per month. In addition, the Company +has a sub-lease for 10,000 of the 86,000 square feet at its Anaheim, California +facility for a period of four years at a monthly rate of $10,000. The aggregate future minimum rentals of the +sublease are $120,000 for the year ending March 31, 2005 and 2006, +respectively, and $70,000 for the year ending March 31, 2007. Also, as a result of the new lease, $2.5 +million of restricted cash was released to the Company and the deferred gain on +the sale of the building was adjusted to reflect the changes in the lease +term. The remaining deferred gain was +$1.8 million at March 31, 2004. +The Company has gross lease commitments for facilities in various +locations throughout the United States. The annual commitment under these +noncancelable operating leases at March 31, 2004 is as follows (in +thousands): +Fiscal Year +2005 +$ +1,205 +2006 +984 +2007 +897 +2008 +513 +Rent expense under operating leases totaled $1,139,000, $2,597,000 and +$2,241,000, respectively, for the years ended March 31, 2002, 2003 and +2004. +Common stock reserved for future issuance at March 31, 2004: +Issuable under stock options plans +1,651,000 +Issuable upon the exercise of warrants +2,532,500 +4,183,500 +11. Business +Segment and Geographic Information +The Company currently operates in two reportable segments: Sensors and +Systems. The accounting policies of the reportable segments are the same as +those described in the summary of significant accounting policies except that +certain expenses, such as interest, amortization of certain intangibles and +certain corporate expenses are not allocated to the segments. In addition, +certain assets including cash and cash equivalents, deferred taxes and certain +long-lived and intangible assets are not allocated to the segments. +The reportable segments are each managed separately because they +manufacture and distribute distinct products or provide services with different +processes. Transactions between +segments are reported at the fair value of the revenue earned or services +provided in the appropriate segments financial records. +F-26 +All segment revenues are derived from external +customers. +Selected financial information for the Company’s reportable segments as +of and for the years ended March 31, 2001, 2002 and 2003 follows (in +thousands): +Sensors +Systems +Total +Year Ended +March 31, 2002 +Revenue from external customers +$ +17,104 +$ +20,205 +$ +37,309 +Depreciation and amortization +339 +1,444 +1,783 +Allocated goodwill +200 +9,567 +9,767 +Segment income +522 +3,370 +3,922 +Year Ended +March 31, 2003 +Revenue from external customers +$ +19,112 +$ +22,283 +$ +41,395 +Depreciation and amortization +253 +452 +705 +Allocated goodwill +200 +9,607 +9,807 +Segment income (loss) +(190 +) +2,302 +2,112 +Year Ended +March 31, 2004 +Revenue from external customers +$ +22,470 +$ +21,813 +$ +45,283 +Depreciation and amortization +233 +440 +673 +Allocated goodwill +200 +9,607 +9,807 +Segment income +286 +2,207 +2,493 +The Sensor segment had three customers with revenues greater than 10.0% +of total segment revenues which accounted for approximately 42.1% of the $22.5 +million. The Systems segment had one +customer with revenues greater than 10.0 % of total segment revenues which +accounted for approximately 20.0% of the $21.8 million. +The following reconciles segment income loss to consolidated income +(loss) from continuing operations before minority interest and income taxes and +segment assets to consolidated assets (in thousands): +March 31, +2002 +2003 +2004 +Segment +income +Total income for reportable segments +$ +3,922 +$ +2,112 +$ +2,493 +Unallocated amounts: +Corporate and other expenses +(6,483 +) +(2,789 +) +(444 +) +Restructuring charges +(1,142 +) +— +— +Interest expense, net +(4,190 +) +(761 +) +(123 +) +Income (loss) from continuing operations +before income taxes +$ +(7,893 +) +$ +(1,438 +) +$ +1,926 +Assets +Total assets for reportable segments +$ +25,309 +$ +26,005 +$ +28,856 +Assets held at Corporate +26,929 +8,837 +1,195 +Total assets +$ +52,238 +$ +34,842 +$ +30,051 +The Company’s revenues from +continuing operations are generated and the Company’s assets are held +substantially in the United States. +F-27 +12. Supplemental +Cash Flow Information (in thousands) +Year Ended +March 31, +2002 +2003 +2004 +Net cash provided by (used in) operating +assets and liabilities +Accounts Receivable +$ +(2,912 +) +$ +(518 +) +$ +(88 +) +Net costs and estimated earnings in excess +of billings +(138 +) +187 +(10 +) +Inventories +(6,203 +) +(741 +) +305 +Prepaids and other assets +(969 +) +(1,388 +) +1,186 +Deferred gain on sale of building +— +7,690 +(3,396 +) +Accounts payable and accrued expenses +(3,476 +) +3,790 +(2,057 +) +Deferred revenues +— +— +226 +Net cash provided by (used in) operating +assets and liabilities +$ +(13,698 +) +$ +9,020 +$ +(4,002 +) +Cash paid (received) during the year: +Interest +$ +2,514 +$ +507 +$ +123 +Income taxes paid (refunded) +— +— +320 +Noncash transactions during the year: +Proceeds from sale leaseback held in escrow +$ +— +$ +2,516 +$ +— +Contribution of common stock to 401(k) Plan +791 +141 +578 +Issuance of common stock to settle +liabilities +390 +— +416 +Exchange of note payable and accrued +interest for Iteris, Inc.’s common stock +4,203 +— +— +Stock issuance in connection with +acquistion +2,737 +— +— +13. Legal +Proceedings +From time to time, the Company has been involved in litigation relating +to claims arising out of its operations in the normal course of business. The +Company currently is not a party to any legal proceedings, the adverse outcome +of which, in management’s opinion, individually or in the aggregate, would have +a material adverse effect on its consolidated results of operations, financial +position or cash flows. +F-28 +14. Subsequent Events +On May 28, 2004, (the “Closing Date”), the Company completed the +purchase of all of the outstanding shares of the Series A preferred stock of +Iteris, Inc. ("the Series A Preferred Stock"), which shares were held +by DaimlerChrysler Ventures GmbH (“DCV”) and Hockenheim Investment Pte. Ltd. +(“Hockenheim”), in exchange for a payment of approximately $17.5 million in +cash. In addition, the Company acquired +all of the shares of the common stock of Iteris, Inc. held by DCV in exchange +for the issuance of 1,219,445 shares of the Class A common stock. The purchase and exchange of the shares were +made pursuant to a Stock Purchase and Exchange Agreement, dated March 31, +2004, by and among the Company, Iteris, Inc., DCV and Hockenheim (the “Purchase +and Exchange Agreement”). +Pursuant to the Purchase and Exchange Agreement, the Company purchased +3,124,913 shares of the Series A Preferred Stock of Iteris from DCV and +Hockeneheim for a purchase price of $5.61 per share. The purchase price represented the stated redemption value of the +preferred stock. The purchase of the +shares was financed principally with a $10.1 million convertible debenture +financing completed in May 2004, with a group of institutional investors, in +addition to a $5.0 million senior credit facility arranged through a bank. +In accordance with the Purchase and Exchange Agreement, the Company +issued 1,219,445 shares of its Class A common stock (the “Exchange Shares”) to +DCV in exchange for 547,893 shares of the common stock of Iteris, Inc. held by +DCV. Subject to certain exceptions, DCV +has agreed not to sell or otherwise transfer the Exchange Shares during the +year following the Closing Date. +However, beginning on November 28, 2005, DCV may require the +Company to repurchase up to 50% of the Exchange Shares at a purchase price of +$1.438 per share; and beginning on May 28, 2007, DCV may require Iteris +Holdings to repurchase up to 100% of the Exchange Shares at a purchase price of +$1.438 per share. All such rights to +require the repurchase of the Exchange Shares expire on September 28, +2007. +Beginning on May 28, 2005, DCV will have the right to request +registration of all of the shares of the Class A common stock of the Company +held by it. In the event the Company +decides not to file a registration statement for all such shares, DCV may +require repurchase of any or all of its shares of the Company’s common stock at +a purchase price of $1.438 per share. +In order to finance the purchase of the shares of the Series A +Preferred Stock, the Company entered into a Debenture and Warrant Purchase +Agreement dated May 19, 2004 (the “Debenture and Warrant Purchase Agreement”) +with a group of institutional investors, which included certain officers of the +Company, pursuant to which it sold and issued subordinated convertible +debentures in the aggregate principal amount of $10.1 million and issued +warrants to purchase an aggregate of 639,847 shares of its Class A common +stock. +The debentures are due in five years, provide for 6.00% annual +interest, payable quarterly, and are convertible into the Company's Class A +common stock at an initial conversion price of $3.61 per share, subject to +certain adjustments, including adjustments for dilutive issuances. From May 19, 2007 until May 18, 2008, the +debentures may be redeemed by the Company, at its option, at 120% of the +principal amount being redeemed; and from May 19, 2008 until the maturity date +of May 18, 2009, the debentures may be redeemed at 110% of the principal amount +being redeemed. +Pursuant to the Debenture Purchase Agreement, each investor also +received two warrants to purchase shares of the Company's Class A common +stock. For every dollar of debenture +purchased, each investor received one warrant to purchase approximately 0.03235 +shares of the Company's Class A common stock at an exercise price of $3.83 per +share and a second warrant to purchase approximately 0.03100 shares of the +Company's Class A common stock at an exercise price of $4.03 per share. The exercise prices are subject to certain +adjustments, including adjustments for dilutive issuances. The warrants expire on May 18, 2009. +In conjunction with the Debenture and Warrant Purchase Agreement the +Company issued 34,036 warrants to purchase shares of its Class A common stock +at $3.61 per share as commissions related to the transaction. The warrants +expire on May 18, 2009. +F-29 +The Company has agreed to register for resale the shares underlying the +debentures and the warrants. Under the +terms of the Debenture and Warrant Purchase Agreement, the Company may be required +to make certain payments to the investors if it does not file a registration +statement with the Securities and Exchange Commission (“SEC”) on or prior to +July 14, 2004 or if it does not respond to comments to such registration +statement, if any, from the SEC within certain time limits. In addition, the Company has granted to each +investor a right of first offer with respect to new issuances of its +securities, subject to certain exceptions. +Concurrent with the issuance of the debentures, Iteris, Inc., entered +into a $5.0 million term note payable with a bank. Proceeds from the note +payable were used to purchase Iteris, Inc. preferred stock as described above. +The note is due in four years, on May 27, 2008, and provides for monthly +payments of principal and interest of approximately $104,000. Interest accrues +at the current stated prime rate plus 0.5% through June 30, 2004 and then +at the current stated prime rate plus 0.25% thereafter. +Also on May 28, 2004, Iteris, Inc. renegotiated its existing line of +credit agreement and entered into a new line of credit agreement with the same +bank. The new agreement has a one year term and expires on August 1, 2005 +and a maximum available credit line of $5.0 million. Under the terms of the new +agreement, Iteris, Inc. may borrow against its eligible accounts receivable and +the value of its eligible inventory, as defined. Interest on borrowed amounts +is payable monthly at the current stated prime rate. Additionally, Iteris, Inc. is obligated to pay an unused line fee +of 0.25% per annum applied to the amount by which the maximum credit amount +exceeds the average daily principal balance during the preceding month. There +is no monthly collateral management fee associated with the new line of credit +and no pre-payment or early termination fees. The 1.0% cancellation fee to +terminate the prior line was waived by the bank. +Both the term note payable and the line of credit are secured by +substantially all of the Iteris, Inc.’s assets. +F-30 +15. Supplementary Quarterly Consolidated +Financial Data (Unaudited) +All quarters presented in the following schedule have been +restated for the discontinuance of Broadcast, Zyfer, Mariner, Gyyr and MAXxess +(in thousands, except per share amounts): +Net +Sales +Gross +Profit +Income +(loss) +from +Continuing +Operations +Net Income +(loss) +Income +(loss) +per Share +from +Continuing +Operations +June 30, 2001 +$ +7,711 +$ +2,756 +$ +(2,116 +) +$ +(7,775 +) +$ +(0.20 +) +September 30, 2001 (1) +9,637 +4,222 +(3,164 +) +(15,164 +) +(0.30 +) +December 31, 2001 +9,799 +4,203 +(3,370 +) +(2,331 +) +(0.29 +) +March 31, 2002 +10,162 +5,684 +(368 +) +(1,318 +) +(0.03 +) +$ +37,309 +$ +16,865 +$ +(9,018 +) +$ +(26,588 +) +$ +(0.80 +)* +June 30, 2002 +$ +10,258 +$ +4,236 +$ +(782 +) +$ +(1,300 +) +$ +(0.06 +) +September 30, 2002 +9,685 +3,987 +(1,308 +) +(2,617 +) +(0.09 +) +December 31, 2002 +10,565 +4,268 +(1,056 +) +(905 +) +(0.07 +) +March 31, 2003 (2) +10,887 +4,428 +(2,110 +) +(8,326 +) +(0.15 +) +$ +41,395 +$ +16,919 +$ +(5,256 +) +$ +(13,148 +) +$ +(0.37 +)* +June 30, 2003 +$ +11,530 +$ +4,547 +$ +(1,259 +) +$ +(1,954 +) +$ +(0.08 +) +September 30, 2003 (3) +11,250 +4,441 +207 +2,584 +0.01 +December 31, 2003 +11,128 +4,402 +(740 +) +(740 +) +(0.04 +) +March 31, 2004 (4) +11,375 +4,423 +584 +117 +0.03 +$ +45,283 +$ +17,813 +$ +(1,208 +) +$ +7 +$ +(0.06 +)* +* +Annual per share amounts may not agree to the sum of the quarterly +per share amounts due to differences between average shares outstanding +during the periods. +(1) +During the quarter ended September 30, 2001, the Company +discontinued the operations of its Mariner subsidiary and restructured its +European operations. In connection with these actions, the Company recorded +severance and other charges and wrote down assets totaling $9.9 million. +(2) +During the quarter ended March 31, 2003, the Company +discontinued the operations of its Zyfer and Broadcast subsidiaries. In +connection with those actions, the Company recorded severance payments and +other charges and wrote down assets totaling $4.9 million. +(3) +In September 2003, the Company sold substantially all of the +assets of MAXxess to an investor group that included certain members of the +MAXxess management group. The consideration for the assets consisted of the +assumption of $2.7 million of liabilities, resulting in a net gain of $2.3 +million from the sale. +(4) +The fourth quarter ended March 31, 2004 included a reduction of +$644,000 of income tax provisions due to the release of valuation allowances +related to Iteris, Inc. deferred tax assets. It was determined in the 4th +quarter that the Company would have sufficient taxable income on a carryback +basis to quantify the deferred tax asset. +F-31 +Schedule II +Valuation +and Qualifying Accounts +Description +Balance at +Beginning of +Period +Charged to +Costs and +Expenses +Charged to +Accounts +Deductions +Describe +Balance at +End +of Period +Year Ended March 31, 2002 +Deducted from asset accounts: +Allowance for doubtful accounts +$ +600,000 +$ +— +$ +(485,000 +) +$ +115,000 +Reserve for inventory obsolescence +2,048,000 +65,000 +(1,735,000 +) +— +378,000 +Year Ended March 31, 2003 +Deducted from asset accounts: +Allowance for doubtful accounts +$ +115,000 +$ +78,000 +$ +(37,000 +) +— +$ +156,000 +Reserve for inventory obsolescence +378,000 +— +(130,000 +) +— +248,000 +Year Ended March 31, 2004 +Deducted from asset accounts: +Allowance for doubtful accounts +$ +156,000 +$ +87,000 +(39,000 +) +— +$ +204,000 +Reserve for inventory obsolescence +248,000 +251,000 +(100,000 +) +— +399,000 +S-1 \ No newline at end of file diff --git a/raw/filings/0000350868/2003/0001104659-04-018476/filing_metadata.csv b/raw/filings/0000350868/2003/0001104659-04-018476/filing_metadata.csv new file mode 100644 index 0000000000000000000000000000000000000000..725f84b66a3ea6f11edb910f19602e5906725dda --- /dev/null +++ b/raw/filings/0000350868/2003/0001104659-04-018476/filing_metadata.csv @@ -0,0 +1,2 @@ +cik,ticker,company_name,form,filing_date,report_date,acceptance_datetime,accession_number,primary_document,primary_doc_description,size,is_xbrl,is_inline_xbrl,document_url,filing_index_url,year,fiscal_year,is_primary_filing +0000350868,ITI,"ITERIS, INC.",10-K,2004-06-29,2004-03-31,2004-06-29T21:30:06.000Z,0001104659-04-018476,a04-7432_110k.htm,10-K,1901144,0,0,https://www.sec.gov/Archives/edgar/data/350868/000110465904018476/a04-7432_110k.htm,https://www.sec.gov/Archives/edgar/data/350868/000110465904018476/,2003,2003,1 diff --git a/raw/filings/0000350868/2003/0001104659-04-018476/item1.txt b/raw/filings/0000350868/2003/0001104659-04-018476/item1.txt new file mode 100644 index 0000000000000000000000000000000000000000..031b74f70d9b381035fe2d379243371918dbd5bb --- /dev/null +++ b/raw/filings/0000350868/2003/0001104659-04-018476/item1.txt @@ -0,0 +1,239 @@ +ITEM 1. BUSINESS +Overview +Iteris Holdings, Inc. is +the majority stockholder of Iteris, Inc., a leading provider of outdoor machine +vision systems and sensors that optimize the flow of traffic and enhance driver +safety. Using our proprietary software and Intelligent Transportation Systems +(“ITS”) industry expertise, we provide video sensor systems and transportation +management and traveler information systems for the ITS industry. The ITS +industry is comprised of companies applying a variety of technologies to enable +the safe and efficient movement of people and goods. We use our outdoor image +recognition software expertise to develop proprietary algorithms for video +sensor systems that improve vehicle safety and the flow of traffic. Using our +knowledge of the ITS industry, we design and implement transportation +management systems that help public agencies reduce traffic congestion and +provide greater access to traveler information. +Our proprietary image +recognition systems include AutoVue TM and Vantage TM . AutoVue is a small windshield mounted sensor +that uses proprietary software to detect and warn drivers of unintended lane +departures. Iteris has approximately 6,000 production AutoVue units that are in +use on truck platforms in the European market and are offered as an option on +certain Actros trucks, which are part of the Daimler group. We believe that +AutoVue is a broad sensor platform that, through additional software +development, may be expanded to incorporate additional safety and convenience +features. Vantage is a video vehicle sensing system that detects the presence +of vehicles at signalized intersections enabling a more efficient allocation of +green signal time. +Our transportation +management systems include the design, development and implementation of our +software-based systems that integrate sensors, video surveillance, computers +and advanced communications equipment to enable public agencies to monitor, +control and direct traffic flow, assist in the quick dispatch of emergency +crews and distribute real-time information about traffic conditions. Our +services include planning and other engineering for the implementation of +transportation related communications systems, analysis and study related to +goods movement and commercial vehicle operations, and parking systems designs. +Sales, Marketing and Principal Customers +We sell our Vantage +vehicle detection systems primarily through indirect sales channels comprised +of independent dealers in the United States and Canada who sell integrated +systems and related products to the traffic intersection market. Our +independent dealers are primarily responsible for sales, installation and +support of Vantage systems. These dealers maintain an inventory of +demonstration traffic products including the Vantage vehicle detection systems +and sell directly to government agencies and installation contractors. These +dealers often have +1 +long-term +arrangements with the government agencies in their territory for the supply of +various products for the construction and renovation of traffic intersections. +We hold technical training classes for dealers and maintain a full-time staff +of customer support technicians to provide technical assistance when needed. +Our marketing strategy +for AutoVue is to establish it as the leading platform for in vehicle video +sensing for trucks and passenger cars. We sell AutoVue directly to vehicle +manufacturers and major automotive suppliers. We also market to the +manufacturers of automobiles through a strategic relationship with Valeo Group, +an independent automotive supplier. +We market and sell our +transportation management systems and services directly to government agencies +pursuant to negotiated contracts that involve competitive bidding and specific +qualification requirements. Most of our contracts with federal, state and +municipal customers provide for cancellation or renegotiation at the option of +the customer upon reasonable notice and fees paid for modification. We use +selected members of our engineering team divided on a regional basis to serve +in sales and business development functions. We do not engage in international +ITS sales. Sales of our systems contracts generally involve long lead times and +require extensive specification development, evaluation and price negotiations. +No single customer of Iteris, Inc. accounted for more than 10% of our total net +sales and contract revenues. +Manufacturing and Materials +We use local +manufacturers based near our Anaheim, California facility to build +subassemblies that are used in our Vantage products. These subassemblies are +delivered to our Anaheim facility where they go through final assembly and +testing prior to shipment to our customers. Our manufacturing activities are +conducted in approximately 6,000 square feet of space at our Anaheim +facility. Certain of our cameras used +in our products have historically been provided by a Japanese supplier who is +sole sourced; however, we are currently qualifying other sources of supply. +Production volume at our subcontractors is based upon quarterly forecasts that +we adjust on a monthly basis to control inventory. For sales to the truck +market, we subcontract the manufacture of our AutoVue systems to one +manufacturer, and our internal processes are limited primarily to testing and +final verification. For sales to the +passenger car market, we anticipate that all manufacturing will be done by the +Valeo Group. We currently do not +manufacture any of the hardware used in the transportation management and +traveler information systems that we design and implement. Our production +facility is currently ISO 9001 certified. +Customer +Support and Services +We provide warranty +service and support for each of our products and follow-up service and support, +for which we charge separately. Service revenue accounted for less than 1.0% of +total net sales and contract revenues for the year ended March 31, 2004 +(“fiscal 2004”). We believe customer +support is a key competitive factor. +Backlog +Our backlog of +unfulfilled firm orders was approximately $21.6 million as of March 31, +2004 and was approximately $24.8 million as of March 31, 2003. +Approximately 63.0% of our backlog at March 31, 2003 was recognized as +revenues in the fiscal year ended March 31, 2004, and approximately 60.0% +of our backlog at March 31, 2004 is expected to be recognized as revenues +in the fiscal year ended March 31, 2005. +Pursuant to the customary terms of our agreements with government +contractors and other customers, customers can generally cancel or +reschedule orders with little or no penalties. Lead times for the release +of purchase orders depend upon the scheduling and forecasting practices of our +individual customers, which also can affect the timing of the conversion of our +backlog into revenues. For these reasons, among others, our backlog at a +particular date may not be indicative of our future revenues. +Product +Development +Most of our development +activities are conducted at our principal facilities in Anaheim, California. +Our company-sponsored research and development costs and expenses were +approximately $3.4 million for the year ended March 31, 2002 ("Fiscal +2002"), $3.9 million in for the year ended March 31, 2003 ("Fiscal +2003") and $3.9 million in fiscal 2004. +We expect to continue to pursue significant product development programs +and incur significant research and development expenditures. +2 +Competition +We generally face +significant competition in each of our target markets. Increased competition +may result in price reductions, reduced gross margins and loss of market share, +any of which could have a material adverse effect on our business, financial +condition and results of operations. We believe that AutoVue is the only +commercially-available lane departure warning system used in the U.S. and in +Europe. Potential competitors of +AutoVue include Delphi Automotive Systems Corporation domestically, NEC +Corporation and Hitachi Ltd. in Japan and Robert Bosch Gmbh in Europe, which +could be currently developing video sensor technologies for the vehicle +industry that could be used for lane departure warning systems. In the market +for our Vantage vehicle detection systems, we compete with manufacturers of +other “above ground” video camera detection systems such as Econolite Control +Products, Inc., Trafficon, N.V., Peek Traffic Systems, and other non-intrusive +detection devices including microwave, infrared, ultrasonic and magnetic +detectors, as well as manufacturers and installers of in-pavement inductive +loop products. Our competitors for Vantage products do not disclose specific +sales numbers, either because they are private companies or because they are +part of larger companies. Based on our interface with them in the market, we +believe that we are leading our competitors in annual sales volume for video +detection products. +The transportation +management and traveler information systems market is highly fragmented and is +subject to evolving national and regional quality and safety standards. Our +competitors vary in number, scope and breadth of the products and services they +offer. Our competitors in advanced transportation management and traveler +information systems include large multi-national corporations such as +Transcore, Lockheed Martin Corporation, PB Farradyne Inc., Kimley-Horn and +Associates, Inc. and National Engineering Technology, Inc. Iteris, Inc.’s +competitors in transportation engineering, planning and design include major +firms such as Parsons Brinkerhoff, Inc. and Parsons Transportation Group Inc., +as well as many smaller regional engineering firms. +In general, the markets +for the products and services offered by our businesses are highly competitive +and are characterized by rapidly changing technology and evolving standards. +Many of our current and prospective competitors have longer operating +histories, greater name recognition, access to larger customer bases and significantly +greater financial, technical, manufacturing, distribution and marketing +resources than us. As a result, they may be able to adapt more quickly to new +or emerging standards or technologies or to devote greater resources to the +promotion and sale of their products. It is also possible that new competitors +or alliances among competitors could emerge and rapidly acquire significant +market share. We believe that our ability to compete effectively in our target +markets will depend on a number of factors, including the success and timing of +our new product development, the compatibility of our products with a broad +range of computing systems, product quality and performance, reliability, +functionality, price, and service and technical support. Our failure to provide +services and develop and market products that compete successfully with those +of other suppliers and consultants in our target markets would have a material +adverse effect on our business, financial condition and results of operations. +Intellectual +Property and Proprietary Rights +Our ability to compete +effectively depends in part on our ability to develop and maintain the +proprietary aspects of our technology. Our policy is to obtain appropriate +proprietary rights protection for any potentially significant new technology +acquired or developed by us. We +currently hold six U.S. patents, which expire commencing in 2012, and have +eighteen U.S. patent applications pending, mostly relating to our outdoor image +processing techniques used in our AutoVue and Vantage systems. Two of our +patents relate specifically to our AutoVue technology and provide a basis for +enhanced functionality for rain sensing and improved performance. We believe +that our other patents, while important for our technology platforms are less +critical to near term product strategy. We cannot assure you that any new +patents will be granted pursuant to any outstanding or subsequent applications. +In addition to patent +laws, we rely on copyright and trade secret laws to protect our proprietary +rights. We attempt to protect our trade secrets and other proprietary +information through agreements with customers and suppliers, proprietary +information agreements with our employees and consultants, and other similar +measures. We do not have any material licenses or trademarks other than those +relating to product names. We cannot be certain that we will be successful in +protecting our proprietary rights. While we believe our patents, patent +applications, software and other proprietary know-how have value, changing +technology makes our future success dependent principally upon our employees’ +technical competence and creative skills for continuing innovation. +Litigation has been +necessary in the past and may be necessary in the future to enforce our proprietary +rights, to determine the validity and scope of the proprietary rights of +others, or to defend us against claims of infringement or invalidity by others. +An adverse outcome in such litigation or similar proceedings could subject us +to significant liabilities to third parties, require disputed rights to be +licensed from others or require us to cease marketing or using certain +products, any of which could have a material adverse effect on our business, +financial condition and results of operations. In addition, the cost of +addressing any intellectual property litigation claim, both in legal fees and +expenses, as well as from the diversion of management’s resources, regardless +of whether the claim is valid, could be significant and could have a material +adverse effect on our business, financial condition and results of operations. +3 +Employees +We refer to our employees +as associates. As of June 3, 2004, we employed an aggregate of 204 +associates, including 50 associates in general management, administration and +finance; 20 associates in sales and marketing; 104 associates in product +development; 21 associates in operations, manufacturing and quality; and nine +associates in customer service. None of our associates are represented by a +labor union, and we have never experienced a work stoppage. +Government +Regulation +Our manufacturing +operations are subject to various federal, state and local laws and +regulations, including those restricting the discharge of materials into the +environment. We are not involved in any pending or, to our knowledge, +threatened governmental proceedings, which would require curtailment of our +operations because of such laws and regulations. We continue to expend funds in +connection with our compliance with applicable environmental regulations. These +expenditures have not, however, been significant in the past, and we do not +expect any significant expenditure in the near future. Currently, compliance +with foreign laws has not had a material impact on our business and is not +expected to have a material impact in the near future. +Legal +Proceedings +We are not currently a +party to any material legal proceedings. \ No newline at end of file diff --git a/raw/filings/0000350868/2003/0001104659-04-018476/item13.txt b/raw/filings/0000350868/2003/0001104659-04-018476/item13.txt new file mode 100644 index 0000000000000000000000000000000000000000..e240902523e39751b38471b69334d2f85fb73503 --- /dev/null +++ b/raw/filings/0000350868/2003/0001104659-04-018476/item13.txt @@ -0,0 +1,3 @@ +ITEM 13. +CERTAIN RELATIONSHIPS AND RELATED +TRANSACTIONS \ No newline at end of file diff --git a/raw/filings/0000350868/2003/0001104659-04-018476/item9a.txt b/raw/filings/0000350868/2003/0001104659-04-018476/item9a.txt new file mode 100644 index 0000000000000000000000000000000000000000..4c2d7f51229455c726eba811d0188a2216dc99fe --- /dev/null +++ b/raw/filings/0000350868/2003/0001104659-04-018476/item9a.txt @@ -0,0 +1,3 @@ +ITEM 9A. +CONTROLS AND PROCEDURES +PART III \ No newline at end of file diff --git a/raw/filings/0000350868/2003/0001104659-04-018476/rp_note.txt b/raw/filings/0000350868/2003/0001104659-04-018476/rp_note.txt new file mode 100644 index 0000000000000000000000000000000000000000..e69de29bb2d1d6434b8b29ae775ad8c2e48c5391 diff --git a/raw/filings/0000350868/2003/0001104659-04-018476/rpt_disclosure.txt b/raw/filings/0000350868/2003/0001104659-04-018476/rpt_disclosure.txt new file mode 100644 index 0000000000000000000000000000000000000000..e69de29bb2d1d6434b8b29ae775ad8c2e48c5391 diff --git a/raw/filings/0000350868/2004/0001104659-05-032468/filing.txt b/raw/filings/0000350868/2004/0001104659-05-032468/filing.txt new file mode 100644 index 0000000000000000000000000000000000000000..df5c4623caec66585923924c257b3ab1f31614e8 --- /dev/null +++ b/raw/filings/0000350868/2004/0001104659-05-032468/filing.txt @@ -0,0 +1,6431 @@ +10-K +1 +a05-11244_110k.htm +10-K +UNITED STATES +SECURITIES AND EXCHANGE COMMISSION +Washington, D.C. 20549 +FORM 10-K +(Mark +One) +ý +ANNUAL REPORT PURSUANT TO +SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 +For +the fiscal year ended March 31, 2005 +OR +o +TRANSITION REPORT PURSUANT +TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 +For the transition +period from +to +Commission file number 001-08762 +ITERIS, INC. +(Exact Name of Registrant as Specified in Its +Charter) +Delaware +95-2588496 +(State or Other Jurisdiction +of Incorporation or Organization) +(I.R.S. Employer +Identification No.) +1515 South Manchester Avenue, Anaheim, +California 92802 +(Address of Principal Executive Offices) (Zip Code) +Registrant’s Telephone Number, Including Area Code: (714) 774-5000 +Securities registered pursuant to Section 12(b) of the Act: +Title of each class +Name of each exchange on which registered +Common +Stock, $0.10 par value +American +Stock Exchange +Securities registered pursuant to Section 12(g) of the Act: None +Indicate by check +mark whether the registrant (1) has filed all reports required to be filed by +Section 13 or 15(d) of the Securities Exchange Act of 1934 during the +preceding 12 months (or for such shorter period that the registrant was +required to file such reports), and (2) has been subject to such filing +requirements for the past 90 days. Yes ý No o +Indicate by a +check mark if disclosure of delinquent filers pursuant to Item 405 of +Regulation S-K is not contained herein, and will not be contained, to the best +of registrant’s knowledge, in definitive proxy or information statements +incorporated by reference in Part III of this Form 10-K or any amendment to +this Form 10-K ý +Indicate by a +check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 +of the Act). Yes o No ý +Based on the +closing sale price on the OTC Bulletin Board on September 30, 2004, the +last business day of the registrant’s most recently completed second fiscal quarter, +the aggregate market value of the voting common stock held by nonaffiliates of +the registrant was $44,496,650. For the +purposes of this calculation, shares owned by officers, directors and 10% +stockholders known to the registrant have been deemed to be owned by +affiliates. This determination of affiliate status is not necessarily a +conclusive determination for other purposes. +As of June 22, +2005, there were 28,409,905 shares of common stock outstanding. +DOCUMENTS INCORPORATED BY REFERENCE +Information +required by Items 10 through 14 of Part III of this report is incorporated +herein by reference to portions of the registrant’s definitive proxy statement +for its 2005 Annual Meeting of Stockholders, which will be filed with the +Securities and Exchange Commission not later than 120 days after the end of the +fiscal year ended March 31, 2005. Except with respect to +information specifically incorporated by reference in this report, the +registrant’s proxy statement is not deemed to be filed as part hereof. +ITERIS, INC. +FORM 10-K ANNUAL REPORT +TABLE OF CONTENTS +PART I +ITEM +1. +BUSINESS +ITEM 2. +PROPERTIES +ITEM 3. +LEGAL PROCEEDINGS +ITEM 4. +SUBMISSION +OF MATTERS TO A VOTE OF SECURITY HOLDERS +PART II +ITEM 5. +MARKET FOR REGISTRANT’S COMMON EQUITY, +RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES +ITEM 6. +SELECTED CONSOLIDATED FINANCIAL DATA +ITEM 7. +MANAGEMENT’S DISCUSSION AND ANALYSIS OF +FINANCIAL CONDITION AND RESULTS OF OPERATIONS +RISK +FACTORS +ITEM +7A. +QUANTITATIVE +AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK +ITEM 8. +FINANCIAL +STATEMENTS AND SUPPLEMENTARY DATA +ITEM 9. +CHANGES +IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE +ITEM +9A. +CONTROLS +AND PROCEDURES +ITEM +9B. +OTHER +INFORMATION +PART III +ITEM +10. +DIRECTORS +AND EXECUTIVE OFFICERS OF THE REGISTRANT +ITEM +11. +EXECUTIVE +COMPENSATION +ITEM +12. +SECURITY +OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER +MATTERS +ITEM +13. +CERTAIN +RELATIONSHIPS AND RELATED TRANSACTIONS +ITEM +14. +PRINCIPAL +ACCOUNTING FEES AND SERVICES +PART IV +ITEM +15. +EXHIBITS +AND FINANCIAL STATEMENT SCHEDULES +Unless otherwise indicated in this report, the “registrant,” “we,” “us” +and “our” collectively refers to Iteris, Inc. (formerly known as Iteris +Holdings, Inc. and Odetics, Inc.) and its subsidiary, Meyer, Mohaddes +Associates, Inc. +Autovue TM , Iteris TM and Vantage TM are +among the trademarks of Iteris, Inc. Any +other trademarks or trade names mentioned herein are the property of their +respective owners. +2 +Cautionary Statement +This +report, including the following discussion and analysis, contains +forward-looking statements (within the meaning of the Private Securities +Litigation Reform Act of 1995) that are based on our current expectations, +estimates and projections about our business and our industry, and reflect +management’s beliefs and certain assumptions made by us based upon information +available to us as of the date of this report. When used in this report and the +information incorporated herein by reference, the words “expect(s),” “feel(s),” +“believe(s),” “should,” “will,” “may,” “anticipate(s),” “estimate(s)” and +similar expressions or variations of these words are intended to identify +forward-looking statements. These forward-looking statements include but are +not limited to statements regarding our anticipated sales, revenue, expenses, +profits, capital needs, competition, backlog and manufacturing capabilities, +the practical market applications, future applications and acceptance of our +products and services, and the status of our facilities, product development +and renegotiations with our lender. These statements are not guarantees of +future performance and are subject to certain risks and uncertainties which +could cause actual results to differ materially from those projected. You +should not place undue reliance on these forward-looking statements that speak +only as of the date hereof. We undertake no obligation to republish revised +forward-looking statements to reflect events or circumstances after the date +hereof or to reflect the occurrence of unanticipated events. We encourage you +to carefully review and consider the various disclosures made by us which +describe certain factors which could affect our business, including those “ Risk Factors” at the end +of Item 7 of this report, before deciding to invest in our company or to +maintain or increase your investment. We undertake no obligation to revise or +update publicly any forward-looking statement for any reason. +PART I +ITEM 1. BUSINESS +Overview +Iteris, Inc., +formerly known as Iteris Holdings, Inc., is a leading provider of outdoor +machine vision systems and sensors that optimize the flow of traffic and +enhance driver safety. Using proprietary software and Intelligent +Transportation Systems (“ITS”) industry expertise, we provide video sensor +systems, transportation management and traveler information systems and other +engineering consulting services to the ITS industry. The ITS industry is +comprised of companies applying a variety of technologies to enable the safe +and efficient movement of people and goods. We use our outdoor image +recognition software expertise to develop proprietary algorithms for video +sensor systems that improve vehicle safety and the flow of traffic. Using our +knowledge of the ITS industry, we design and implement transportation +management systems that help public agencies reduce traffic congestion and +provide greater access to traveler information. +On October 22, 2004, we completed a merger with our majority-owned +subsidiary, Iteris, Inc. (the “Iteris Subsidiary”), and officially changed our +corporate name from Iteris Holdings, Inc. to Iteris, Inc. We were originally +incorporated in Delaware in 1987 as Odetics, Inc. and in September 2003 changed +our name to Iteris Holdings, Inc. to reflect our focus on the ITS industry and our +capital structure at that time. +Our proprietary image +recognition systems include AutoVue and Vantage. AutoVue is a small windshield mounted sensor +that uses proprietary software to detect and warn drivers of unintended lane +departures. We have sold approximately 13,000 production AutoVue Lane Departure +Warning (“LDW”) systems for use on truck platforms in the European and North +American markets, and our AutoVue LDW system is currently offered as an option +on certain Mercedes, MAN, Freightliner and International trucks. We believe +that our AutoVue LDW technology is a broad sensor platform that, through +additional software development, may be expanded to incorporate additional +safety and convenience features. Vantage is a video-based vehicle sensing +system that detects vehicles on roadways, enabling more efficient traffic +management. Applications include traffic +signal operations, incident detection and data collection. +Our transportation +management systems include the design, development and implementation of our +software-based systems that integrate sensors, video surveillance, computers +and advanced communications equipment to enable public agencies to monitor, +control and direct traffic flow, assist in the quick dispatch of emergency +crews and distribute real-time information about traffic conditions. We also +offer related services that include planning and other engineering for the +implementation of transportation related communications systems, analysis and +studies related to goods movement and commercial vehicle operations, and +parking systems designs. +We currently operate in three +reportable segments: Roadway Sensors, Automotive Sensors and Systems. The Roadway +Sensors segment includes our Vantage vehicle detection systems. The Automotive Sensors segment includes our AutoVue +LDW systems for vehicle safety. The Systems segment includes transportation +engineering and consulting services, and the development of transportation +management and traveler information systems for the ITS industry. +3 +Sales, Marketing and Principal Customers +We sell our Vantage vehicle detection systems +primarily through indirect sales channels comprised of independent dealers in +the United States and Canada who sell integrated systems and related products +to the traffic management market. Our independent dealers are primarily +responsible for sales, installation and support of Vantage systems. These +dealers maintain an inventory of demonstration traffic products from various +manufacturers including our Vantage vehicle detection systems and sell directly +to government agencies and installation contractors. These dealers often have +long-term arrangements with the government agencies in their territory for the +supply of various products for the construction and renovation of traffic +intersections. We hold technical training classes for dealers and end users and +maintain a full-time staff of customer support technicians to provide technical +assistance when needed. +Our marketing strategy +for AutoVue is to establish it as the leading platform for in-vehicle video +sensing for heavy trucks and passenger cars. We sell AutoVue directly to heavy +truck manufacturers and to U.S. truck fleets. We also market to the +manufacturers of passenger automobiles through a strategic relationship with +Valeo Schalter and Sensuren GmbH (“Valeo”), an independent automotive supplier. +We market and sell our +transportation management systems and traveler information services directly to +government agencies pursuant to negotiated contracts that involve competitive +bidding and specific qualification requirements. Most of our contracts with +federal, state and municipal customers provide for cancellation or +renegotiation at the option of the customer upon reasonable notice and fees +paid for modification. We use selected members of our engineering team divided +on a regional basis to serve in sales and business development functions. We do +not engage in sales of transportation management systems and traveler +information services outside of the U.S. Sales of our transportation management +systems contracts generally involve long lead times and require extensive +specification development, evaluation and price negotiations. +Our largest customer +accounted for 12.8% of total net sales and contract revenues in the fiscal year +ended March 31, 2005 (“Fiscal 2005”). +Manufacturing and Materials +We use contract +manufacturers to build subassemblies that are used in our Vantage products. Additionally, +we procure certain components from qualified suppliers, both globally and +locally, and use multi-sourcing strategies when technically and economically +feasible to mitigate supply risk. These +subassemblies and components are delivered to our Anaheim facility where they +go through final assembly and testing prior to shipment to our customers. Our +manufacturing activities are conducted in approximately 8,000 square feet of +space at our Anaheim facility. +Production volume at our subcontractors is based upon quarterly +forecasts that we adjust on a monthly basis to control inventory. For sales of +Autovue LDW systems to the truck market, we subcontract the manufacture of our +AutoVue LDW systems to one manufacturer, and our internal processes are limited +primarily to testing and final verification. +We are currently in the process of qualifying an additional +subcontractor for the manufacture of LDW systems to mitigate production risk +and handle increased demand. For Autovue +LDW sales to the passenger car market, we anticipate that all manufacturing +will be done by Valeo; however, we plan to continue to provide engineering +support to Valeo. We currently do not +manufacture any of the hardware used in the transportation management and +traveler information systems that we design and implement. Our production +facility is currently ISO 9001 certified. +Customer +Support and Services +We provide warranty +service and support for our Vantage and AutoVue products as well as follow-up +service and support for which we charge separately. Service revenue accounted +for less than 1.0% of total net sales and contract revenues for Fiscal 2005. We believe customer support is a key +competitive factor. +Backlog +Our backlog of +unfulfilled firm orders was approximately $18.9 million as of March 31, +2005, which was comprised of $1.7 million related to Roadway Sensors, $3.4 +million related to Automotive Sensors and $13.8 million related to Systems. All backlog for Roadway Sensors and +Automotive Sensors is expected to be recognized as revenue in the fiscal year +ending March 31, 2006 (“Fiscal 2006”) while approximately 60.0% of Systems +backlog is expected to be recognized as revenue in Fiscal 2006. At March 31, 2004, we had backlog of approximately +$21.6 million, which was comprised of $4.7 million related to Roadway Sensors, +$3.9 million related to Automotive Sensors and $13.0 million related to +Systems. At March 31, +4 +2004, backlog for +Roadway Sensors and Automotive Sensors was recognized as revenue in Fiscal 2005 +while 63.8% of Systems March 31, 2004, backlog was recognized as revenue in +Fiscal 2005. Pursuant to the customary +terms of our agreements with government contractors and other customers, +customers can generally cancel or reschedule orders with little or no +penalties. Lead times for the release of purchase orders often depend upon the +scheduling and forecasting practices of our individual customers, which also +can affect the timing of the conversion of our backlog into revenues. For these +reasons, among others, our backlog at a particular date may not be indicative +of our future revenues. +Product +Development +Most of our development +activities are conducted at our principal facilities in Anaheim, California. +Our company-sponsored research and development costs and expenses were +approximately $4.2 million for Fiscal 2005, $3.9 million for the fiscal year +ended March 31, 2004 (“Fiscal 2004”), and $3.9 million for the fiscal year +ended March 31, 2003 (“Fiscal 2003”). We +expect to continue to pursue significant product development programs and incur +significant research and development expenditures. +Competition +We generally face +significant competition in each of our target markets. Increased competition +may result in price reductions, reduced gross margins and loss of market share, +any of which could have a material adverse effect on our business, financial +condition and results of operations. We believe that AutoVue is the only +commercially-available lane departure warning system used in the U.S. and in +Europe in the heavy truck market. Potential +competitors of AutoVue include Delphi Automotive Systems Corporation +domestically, NEC Corporation and Hitachi Ltd. in Japan and Robert Bosch GmbH +in Europe, as well as Siemens, Continental Tavis and Visteon, which could be +currently developing video sensor technologies for the vehicle industry that +could be used for lane departure warning systems. In the market for our Vantage +vehicle detection systems, we compete with manufacturers of other “above ground” +video camera detection systems such as Econolite Control Products, Inc., +Traficon, N.V., Quixote, and other non-intrusive detection devices including +microwave, infrared, ultrasonic and magnetic detectors, as well as +manufacturers and installers of in-pavement inductive loop products. +The transportation +management and traveler information systems market is highly fragmented and is +subject to evolving national and regional quality and safety standards. Our +competitors vary in number, scope and breadth of the products and services they +offer. Our competitors in advanced transportation management and traveler +information systems include large multi-national corporations such as +Transcore, Lockheed Martin Corporation, PB Farradyne, Inc., Kimley-Horn and +Associates, Inc. and National Engineering Technology, Inc. Our competitors in +transportation engineering, planning and design include major firms such as +Parsons Brinkerhoff, Inc. and Parsons Transportation Group, Inc., as well as +many smaller regional engineering firms. +In general, the markets +for the products and services offered by our businesses are highly competitive +and are characterized by rapidly changing technology and evolving standards. +Many of our current and prospective competitors have longer operating +histories, greater name recognition, access to larger customer bases and +significantly greater financial, technical, manufacturing, distribution and +marketing resources than us. As a result, they may be able to adapt more +quickly to new or emerging standards or technologies or to devote greater +resources to the promotion and sale of their products. It is also possible that +new competitors or alliances among competitors could emerge and rapidly acquire +significant market share. We believe that our ability to compete effectively in +our target markets will depend on a number of factors, including the success +and timing of our new product development, the compatibility of our products +with a broad range of computing systems, product quality and performance, +reliability, functionality, price, and service and technical support. Our +failure to provide services and develop and market products that compete +successfully with those of other suppliers and consultants in our target +markets would have a material adverse effect on our business, financial condition +and results of operations. +Intellectual +Property and Proprietary Rights +Our ability to compete +effectively depends in part on our ability to develop and maintain the +proprietary aspects of our technology. Our policy is to obtain appropriate +proprietary rights protection for any potentially significant new technology +acquired or developed by us. We +currently hold ten U.S. patents, which expire commencing in 2012, and have three U.S. patent applications pending, mostly relating to our +outdoor image processing techniques used in our AutoVue systems. Two of our +patents relate specifically to our AutoVue technology and provide a basis for +enhanced functionality for rain sensing and improved performance. We believe +that our other patents, while important for our technology platforms, are less +critical to our near term product strategy. We cannot assure you that any new +patents will be granted pursuant to any outstanding or subsequent applications. +In addition to patent +laws, we rely on copyright and trade secret laws to protect our proprietary +rights. We attempt to protect our trade secrets and other proprietary +information through agreements with customers and suppliers, proprietary +5 +information +agreements with our employees and consultants, and other similar measures. We +do not have any material licenses or trademarks other than those relating to +product names. We cannot be certain that we will be successful in protecting +our proprietary rights. While we believe our patents, patent applications, +software and other proprietary know-how have value, changing technology makes +our future success dependent principally upon our employees’ technical +competence and creative skills for continuing innovation. +Litigation has been +necessary in the past and may be necessary in the future to enforce our +proprietary rights, to determine the validity and scope of the proprietary +rights of others, or to defend us against claims of infringement or invalidity +by others. An adverse outcome in such litigation or similar proceedings could +subject us to significant liabilities to third parties, require disputed rights +to be licensed from others or require us to cease marketing or using certain +products, any of which could have a material adverse effect on our business, +financial condition and results of operations. In addition, the cost of +addressing any intellectual property litigation claim, both in legal fees and +expenses, as well as from the diversion of management’s resources, regardless +of whether the claim is valid, could be significant and could have a material +adverse effect on our business, financial condition and results of operations. +Employees +We refer to our employees +as associates. As of June 8, 2005, we employed an aggregate of 215 +associates, including 48 associates in general management, administration and +finance; 20 associates in sales and marketing; 113 associates in engineering +and product development; 26 associates in operations, manufacturing and +quality; and 8 associates in customer service. None of our associates are +represented by a labor union, and we have never experienced a work stoppage. +Government +Regulation +Our manufacturing +operations are subject to various federal, state and local laws and regulations, +including those restricting the discharge of materials into the environment. We +are not involved in any pending or, to our knowledge, threatened governmental +proceedings, which would require curtailment of our operations because of such +laws and regulations. We continue to expend funds in connection with our +compliance with applicable environmental regulations. These expenditures have +not, however, been significant in the past, and we do not expect any +significant expenditure in the near future. Currently, compliance with foreign +laws has not had a material impact on our business and is not expected to have +a material impact in the near future. +ITEM 2. PROPERTIES +Our headquarters and +principal operations consist of 88,000 square feet of space located at 1515 +South Manchester Boulevard in Anaheim, California. The Anaheim facility is leased by us under +three separate agreements and houses our operations and administrative offices +(approximately 78,000 dedicated square feet) and the operations of our former +subsidiary, MAXxess Systems, Inc. (approximately 10,000 dedicated square +feet). Two of the three Anaheim leases +representing 82,000 of the 88,000 square feet commenced on July 1, 2003 +and have four year terms at a monthly lease rate of $60,000 for 65,000 square +feet and $14,000 per month for 17,000 square feet. Approximately 10,000 square feet is subleased +to MAXxess at a rate of $10,000 per month. +On March 1, 2004, we entered into a third lease in Anaheim for +6,000 additional square feet at a rate of $3,000 per month. All three Anaheim leases expire on +October 31, 2007. +ITEM 3 . LEGAL PROCEEDINGS +The information set forth +under Note 7 of Notes to Consolidated Financial Statements, included in Part +IV, Item 15 of this report, is incorporated herein by reference. +ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS +No matters were submitted +to a vote of our security holders during the three months ended March 31, +2005. +6 +PART +II +ITEM 5 . +MARKET FOR +REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES +OF EQUITY SECURITIES +In October 2004, we amended +our certificate of incorporation to (a) change the voting rights of our Class A +common stock from one-tenth to one vote per share, (b) remove the ability to +issue any further shares of Class B common stock, and (c) rename our Class A +common stock as common stock. As a result, we currently have only one class of +common stock outstanding, the common stock. Our Class A common stock and Class +B common stock were delisted from the Nasdaq SmallCap Market in August 2003 and +April 2003, respectively, and were quoted on the OTC Bulletin Board thereafter +until December 9, 2004, when our common +stock began trading on the American Stock Exchange (“AMEX”) under the symbol “ITI.” +Class A Common Stock +Class B Common Stock +High +Low +High +Low +Fiscal 2004 +Quarter Ended June 30, +2003 +$ +.89 +$ +.45 +$ +.53 +$ +.20 +Quarter Ended +September 30, 2003 +1.75 +.51 +.20 +.20 +Quarter Ended December 31, +2003 +2.60 +1.36 +.40 +.20 +Quarter Ended March 31, +2004 +4.15 +1.91 +3.00 +.40 +Fiscal 2005 +Quarter Ended June 30, +2004 +$ +4.10 +$ +2.60 +$ +3.00 +$ +3.00 +Quarter Ended September 30, +2004 +3.60 +2.85 +3.00 +3.00 +Quarter Ended December 31, +2004 +3.87 +2.90 +3.00 +3.00 +Quarter Ended March 31, +2005 +3.43 +2.30 +N/A +N/A +On July 13, 2005, the +last reported sale price of our common stock on the AMEX was $2.78. As of July 13, 2005, we had 599 holders of +record of our common stock according to information furnished by our transfer +agent. +Dividend Policy +We have never paid or +declared cash dividends on our common stock, and have no current plans to pay +such dividends in the foreseeable future. We currently intend to retain any +earnings for working capital and general corporate purposes. The payment of any +future dividends will be at the discretion of our Board of Directors and will +depend upon a number of factors, including, but not limited to, future earnings, +the success of our business, our capital requirements, our general financial +condition and future prospects, general business conditions, the consent of our +lender and such other factors as the Board of Directors may deem relevant. +7 +ITEM 6 . SELECTED CONSOLIDATED FINANCIAL DATA +The following table sets +forth selected consolidated financial data for each of the five fiscal years +ended March 31, 2005. The statement +of operations and balance sheet data for the years ended and as of +March 31, 2005, 2004, 2003, 2002 and 2001 are derived from our audited +consolidated financial statements. The +accompanying consolidated financial statements have been restated to reflect +the classification and presentation of our former subsidiaries, Broadcast, +Inc., Zyfer Inc., Mariner Networks, Inc., Gyyr, Inc. and MAXxess Systems, Inc., +as discontinued operations for all periods presented. See Note 1 to the accompanying consolidated financial +statements. The following information +should be read in conjunction with “Management’s Discussion and Analysis of +Financial Condition and Results of Operations” and with our consolidated +financial statements and the related notes thereto included elsewhere in this +report. +The +financial information for the year ended March 31, 2004 has been restated for +the impact of adjustments discussed in Note 1 to the consolidated financial +statements. +Fiscal Year Ended +March 31, +2005 +2004 +2003 +2002 +2001 +(in thousands, except per share +data) +(Restated) +Consolidated Statement of +Operations Data: +Net sales and contract +revenues: +Net sales +$ +29,062 +$ +23,470 +$ +19,112 +$ +17,104 +$ +10,626 +Contract revenues +17,335 +21,813 +22,283 +20,205 +17,430 +Total net sales and contract +revenues +46,397 +45,283 +41,395 +37,309 +28,056 +Costs and expenses: +Cost of net sales +15,645 +12,758 +9,366 +8,401 +5,558 +Cost of contract revenues +11,398 +14,712 +15,110 +12,043 +11,463 +Selling, general and +administrative expenses +13,964 +12,844 +14,105 +14,627 +15,882 +Research and development +expenses +4,193 +3,923 +3,908 +3,434 +5,526 +Stock-based compensation +11,777 +— +— +— +— +Deferred compensation expense +(benefit) +(484 +) +868 +— +— +— +Disposal of fixed assets +422 +— +— +— +— +Acquired in-process research +and development +140 +— +— +— +— +Amortization of intangible +assets +114 +— +— +— +— +Restructuring charges +— +— +— +1,142 +367 +Total costs and expenses +57,169 +45,105 +42,489 +39,647 +38,796 +Income (loss) from operations +(10,772 +) +178 +(1,094 +) +(2,338 +) +(10,740 +) +Non-operating income (expense): +Royalty income +— +— +— +— +17,825 +Other income (expense), net +1,054 +1,003 +417 +(1,365 +) +188 +Interest expense, net +(1,178 +) +(123 +) +(761 +) +(4,190 +) +(1,762 +) +Income (loss) from continuing +operations before income taxes and minority interest +(10,896 +) +1,058 +(1,438 +) +(7,893 +) +5,511 +Income tax benefit (provision) +94 +(100 +) +— +785 +— +Minority interest in earnings +of subsidiary +(526 +) +(2,813 +) +(3,818 +) +(1,910 +) +— +Income (loss) from continuing +operations +(11,328 +) +(1,855 +) +(5,256 +) +(9,018 +) +5,511 +Income (loss) from discontinued +operations, net of taxes +— +1,215 +(7,892 +) +(17,120 +) +(38,051 +) +Extraordinary loss from early +extinguishment of debt, net of taxes +— +— +— +(450 +) +— +Net loss +$ +(11,328 +) +$ +(640 +) +$ +(13,148 +) +$ +(26,588 +) +$ +(32,540 +) +Basic earnings (loss) per +share: +Continuing operations +$ +(0.45 +) +$ +(0.09 +) +$ +(0.37 +) +$ +(0.80 +) +$ +0.55 +Discontinued operations +— +0.06 +(0.55 +) +(1.52 +) +(3.81 +) +Extraordinary loss +— +— +— +(0.04 +) +— +Basic loss per share +$ +(0.45 +) +$ +(0.03 +) +$ +(0.92 +) +$ +(2.36 +) +$ +(3.26 +) +Diluted earnings (loss) per +share: +Continuing operations +$ +(0.45 +) +$ +(0.09 +) +$ +(0.37 +) +$ +(0.80 +) +$ +0.54 +Discontinued operations +— +0.06 +(0.55 +) +(1.52 +) +(3.73 +) +Extraordinary loss +— +— +— +(0.04 +) +— +Diluted loss per share +$ +(0.45 +) +$ +(0.03 +) +$ +(0.92 +) +$ +(2.36 +) +$ +(3.19 +) +Shares used in calculating +basic earnings (loss) per share +25,284 +19,454 +14,276 +11,267 +9,977 +Shares used in calculating +diluted earnings (loss) per share +25,284 +19,454 +14,276 +11,267 +10,209 +8 +At March 31, +2005 +2004 +2003 +2002 +2001 +(in thousands) +(Restated) +Consolidated Balance Sheet +Data: +Working capital (deficit) +$ +2,197 +$ +9,369 +$ +3,368 +$ +(7,349 +) +$ +2,114 +Total assets +46,656 +30,065 +34,842 +52,238 +68,061 +Long-term debt (less current +portion) +10,315 +891 +1,265 +2,042 +4,791 +Accumulated deficit +(110,436 +) +(99,108 +) +(98,468 +) +(85,320 +) +(58,732 +) +Total stockholders’ equity +(deficit) +17,462 +(1,076 +) +(5,340 +) +4,203 +20,378 +9 +ITEM 7 . +MANAGEMENT’S DISCUSSION AND ANALYSIS OF +FINANCIAL CONDITION AND RESULTS OF OPERATIONS +You should read the following discussion and +analysis in conjunction with our Consolidated Financial Statements and related +Notes thereto included in Part IV, Item 15 of this report and the “Risk Factors” +section at the end of this Item 7, as well as other cautionary statements +and risks described elsewhere in this report, before deciding to purchase, hold +or sell our common stock. +Overview +We are a leading provider +of outdoor machine vision systems and sensors that optimize the flow of traffic +and enhance driver safety. Using our proprietary software and ITS industry +expertise, we provide video sensor systems and transportation management systems +and traveler information and other engineering services to the ITS industry. We +use our outdoor image recognition software expertise to develop proprietary +algorithms for video sensor systems that improve vehicle safety and the flow of +traffic. Using our knowledge of the ITS industry, we design and implement +transportation management systems that help public agencies reduce traffic +congestion and provide greater access to traveler information. +Our Vantage product is a +video vehicle sensing system that detects the presence of vehicles at +signalized intersections enabling a more efficient allocation of green signal +time and has certain incident detection and highway traffic data collection +applications. We sell and distribute our Vantage products primarily to +commercial customers and municipal agencies. +Our AutoVue LDW systems +consist of a small windshield mounted sensor that uses proprietary software to +detect and warn drivers of unintended lane departures. Approximately 13,000 +production AutoVue units have been sold for truck platforms in the North American +and European markets. Our AutoVue LDW +systems are currently offered as an option on certain Mercedes, MAN, +Freightliner and International trucks. In +September 2003, we entered into an agreement with Valeo, which granted Valeo +the exclusive right to sell and manufacture our AutoVue LDW systems to the +worldwide passenger car market in exchange for royalty payments for each +AutoVue unit sold. We provided specific +contract engineering services, technical marketing and sales support to Valeo +to enable the launch of our LDW technology on the Infiniti FX45 platform in +October 2004. Additionally, our LDW system is offered on the 2006 Infiniti M35 +and M45 luxury sedans as part of Infiniti’s Technology Package. Valeo is currently in negotiations to provide +our LDW system to other passenger car original equipment manufacturers (“OEMs”); +however, we cannot assure you that such negotiations will be successful. We plan to provide technical marketing and +sales support to Valeo in our efforts to win new OEM customers for the +passenger car market as well as contract engineering services related to the +possible launch of new Infiniti platforms that include our LDW system. We believe that AutoVue is a broad sensor +platform that, through additional software development, may be expanded to +incorporate additional safety and convenience features. +Our transportation +management systems business includes transposition engineering and consulting +services focused on the design, development, and implementation of software-based +systems that integrate sensors, video surveillance, computers and advanced +communications equipment to enable public agencies to monitor, control, and +direct traffic flow, assist in the quick dispatch of emergency crews and +distribute real-time information about traffic conditions. Our services include planning and other +engineering for the implementation of transportation related communications +systems, analysis and study related to goods movement and commercial vehicle +operations, and parking systems designs. These services and systems are sold to local, +state, and national transportation agencies in the United States. Our transportation management systems +business is largely dependent upon governmental funding and budgetary issues. +The adoption of the Federal Highway Bill has been delayed, which adversely +impacted our transportation management systems business in Fiscal 2005. Further delays in this bill or other +governmental funding could materially and adversely affect our business in +Fiscal 2006 as well. +We have historically +operated multiple business units. During +Fiscal 2003, we operated in three business segments consisting of ITS, video +products, and telecom products. The ITS +segment consisted of our current operations, the ITS business, which was +previously conducted by the Iteris Subsidiary. +The video products segment consisted of our former wholly-owned +subsidiaries, MAXxess Systems, Inc. (“MAXxess,” previously known as Gyyr +Incorporated), which designed and manufactured security management systems, and +Broadcast, Inc. (“Broadcast”), which developed and supplied software based +systems to automate and control the multiple classes of equipment used in +broadcast studios and satellite uplink facilities. Our telecom segment +consisted of our wholly-owned subsidiary, Zyfer, Inc. (“Zyfer”), which +developed and manufactured timing and synchronization products and which, prior +to its incorporation, was operated as our Communications division. +10 +Beginning in Fiscal 2003, +we began divesting certain of our business units in order to reduce our +operating expenses and to focus on the operations of our Iteris +Subsidiary. These divestitures and +related restructuring activities included the following transactions: +• In March 2003, we ceased the development and sale of +any new Broadcast products and in September 2003, we sold the balance of our +Broadcast business. +• In May 2003, we sold the assets of Zyfer for a purchase +price of $2.3 million in cash and the assumption of liabilities, plus future +incentive payments of up to $1.0 million in each of the twelve months ended +April 30, 2004 and 2005. The amount of these future incentive payments was to be +based on the revenues generated by the sale of Zyfer’s products or the license +of its technologies. In October 2004, we received an incentive payment of +$135,000 related to the twelve month period ended April 30, 2004. We expect to receive information related to +the incentive payment for the twelve month period ended April 30, 2005, by the +end of July 2005. +• In September 2003, we sold substantially all of the +assets of MAXxess to an investor group that included certain members of the +MAXxess management group. The consideration for the sale consisted of the assumption +of $2.7 million of liabilities, resulting in a net gain of $2.3 million on this +sale. +• In May 2004, we repurchased all of the outstanding +shares of Series A preferred stock of the Iteris Subsidiary for an aggregate +purchase price of approximately $17.5 million in cash and we purchased 547,893 +shares of the Iteris Subsidiary common stock from DaimlerChrysler Ventures GmbH +(“DCV”) in consideration for the issuance of 1,219,445 shares of our common +stock. We financed the purchase price +for the Iteris Subsidiary Series A preferred stock through the issuance of +convertible debentures in the original principal amount of $10.1 million, a +$5.0 million term note payable to our bank and $2.4 million in cash. +• In June 2004, we issued 2,639,082 shares of our common +stock valued at $8.6 million at the date of issuance in exchange for an +aggregate of 1,319,541 shares of common stock of the Iteris Subsidiary, which +had the effect of reducing the residual minority interest in our Iteris +Subsidiary to 8.1%. +• In October 2004, we merged the Iteris Subsidiary into +us and the remaining minority interest in the Iteris Subsidiary (consisting of +1,228,981 shares of common stock of the Iteris Subsidiary) was converted to +2,457,962 shares of our common stock valued at $7.6 million at the merger date. +Immediately following the merger, we +converted all of our outstanding Class B common stock (921,917 shares) into +1,014,108 shares of our common stock (formerly designated as Class A common +stock). In connection with this merger, +we also assumed all of the outstanding options and warrants to purchase common +stock of the Iteris Subsidiary, which now represent options and warrants to +purchase an aggregate of 6,039,556 and 654,718 shares, respectively, of our +common stock. +• In October 2004, we amended our certificate of +incorporation to (a) change the voting rights of our Class A common stock from +one-tenth to one vote per share, (b) remove the ability to issue any further +shares of Class B common stock, and (c) rename our Class A common stock to +common stock. As a result, we currently have only one class of common stock +outstanding, the common stock. +Our financial statements +for all periods presented in this report have been restated to reflect the +discontinuation of the operations of Broadcast, Zyfer and MAXxess and the +financial information for the year ended March 31, 2004 has also been restated +for the impact of adjustments discussed in Note 1 of the consolidated financial +statements. +We currently operate in three +reportable segments: Roadway Sensors, Automotive Sensors and Systems. The Roadway +Sensors segment includes our Vantage vehicle detection systems for traffic +intersection control, incident detection and certain highway traffic data +collection applications. The Automotive +Sensors segment includes our AutoVue LDW systems for vehicle safety. The +Systems segment includes transportation engineering and consulting services and +the development of transportation management and traveler information systems +for the ITS industry. +Critical +Accounting Policies and Estimates +Management’s Discussion and +Analysis of Financial Condition and Results of Operations is based on our +consolidated financial statements included herein, which have been prepared in +accordance with generally accepted accounting principles in the United States (“GAAP”). +The preparation of these financial +statements requires management to make estimates and assumptions that affect +the reported amounts of assets and liabilities and related disclosures of +contingent assets and liabilities at the date of the financial statements and +the reported amounts of revenues and expenses during the reporting period. On an ongoing basis, we evaluate these +estimates and assumptions, including those related to the collectibility of +11 +accounts receivable, the valuation of +inventories, the recoverability of long-lived assets and goodwill and warranty +reserves. We base these estimates on +historical experience and on various other factors that we believe to be +reasonable under the circumstances, the results of which form the basis for +making judgments about the carrying values of assets and liabilities that are +not readily apparent from other sources. These estimates and assumptions by their +nature involve risks and uncertainties, and may prove to be inaccurate. In the +event that any of our estimates or assumptions are inaccurate in any material +respect, it could have a material adverse effect on our reported amounts of +assets and liabilities at the date of the financial statements and the reported +amounts of revenues and expenses during the reporting period. +The following critical +accounting policies affect our more significant judgments and estimates used in +the preparation of our consolidated financial statements. +Revenue Recognition . We record product revenues and related costs +of sales upon transfer of title, which is generally upon shipment or, if +required, upon acceptance by the customer, provided that we believe collectibility +of the net sales amount is reasonably assured. Accordingly, at the date revenue is +recognized, the significant uncertainties concerning the sale have been +resolved. +Contract revenue is +derived primarily from long-term contracts with governmental agencies. Contract revenues include costs incurred plus +a portion of estimated fees or profits determined using the percentage of +completion method of accounting based on the relationship of costs incurred to +total estimated costs. Any anticipated +losses on contracts are charged to earnings when identified. Changes in job performance and estimated +profitability, including those arising from contract penalty provisions and +final contract settlements, may result in revisions to recognized costs and +revenues and are recognized in the period in which the revisions are +determined. Profit incentives are +included in revenue when their realization is reasonably assured. +In addition to product and +contract revenue, we derive revenue from technology access fees, the provision +of specific non-recurring contract engineering services related to our AutoVue LDW +system, and royalties related to unit sales of our AutoVue LDW systems by our +strategic partner Valeo to the passenger car market. Combined technology access +fees and contract engineering revenues are recognized on the percentage of +completion method of accounting based on the relationship of hours incurred to +total estimated hours. Royalty revenue is +recorded based on unit sales of our products by Valeo and is recognized in the +period in which such sales occur. +Technology access fee revenues, contract engineering revenues and +royalty revenues are included in net sales in the accompanying consolidated +statements of operations. +Revenues from follow-on +service and support, for which we charge separately, are recorded in the period +in which the services are performed. +Accounts Receivable . We estimate the collectibility of customer +receivables on an ongoing basis by periodically reviewing invoices outstanding +greater than a certain period of time. We +have recorded reserves for receivables deemed to be at risk for collection as +well as a general reserve based on our historical collections experience. A considerable amount of judgment is required +in assessing the ultimate realization of trade receivables, including the +current credit-worthiness of each customer. If the financial condition of our customers +deteriorates, resulting in an impairment of their ability to make required +payments, additional allowances may be required that could adversely affect our +operating results. +Inventory . +Inventories consist of finished goods, work-in-process and raw materials and +are stated at the lower of cost or market. We provide reserves for potentially excess and +obsolete inventory. In assessing the ultimate realization of inventories, we +make judgments as to future demand requirements and compare that with the +current or committed inventory levels. Reserves are established for inventory levels +that exceed future demand. It is possible +that reserves over and above those already established may be required in the +future if market conditions for our products deteriorate. +Goodwill . Goodwill +is tested for impairment annually in the fourth fiscal quarter at the reporting +unit level unless a change in circumstances indicates that more frequent +impairment analysis is required. +Impairment, if any, is measured based on the estimated fair value of the +reporting units with the recorded goodwill. Fair value is determined by using the income +approach methodology of valuation which utilizes discounted cash flows. Significant management judgment is required +in the forecasts of future operating results that are used in the discounted +cash flow method of valuation. In +estimating future cash flows, we generally use the financial assumptions in our +current budget and our current strategic plan, subject to modification as +considered necessary, including sales and expense growth rates and the discount +rates we estimate to represent our cost of funds. It is possible, however, that the plans and +estimates used may be incorrect. If our +actual results, or the plans and estimates used in future impairment analyses, +are lower than the original estimates used to assess the recoverability of +goodwill, we could incur impairment charges. +Warranty. Unless otherwise stated, we provide a one to +three year warranty from the original invoice date on all products, materials +and workmanship. Defective products are +either repaired or replaced, at our option, upon meeting certain criteria. We accrue a provision for the estimated costs +that may be incurred for product warranties relating to a product as a +component of cost of sales at the time revenue for that product is recognized. The accrued warranty provision is included +within accrued expenses on the accompanying consolidated balance sheets. Should our actual experience of warranty +returns be higher than anticipated, additional warranty reserves may be +required, which may adversely affect our operating results. +12 +Taxes. We recorded a valuation allowance to +reduce our deferred tax assets to amounts that we believe are more likely than +not to be realized. Realization of deferred tax assets (such as net operating +loss carryforwards) is dependent on future taxable earnings and is therefore +uncertain. On a quarterly basis, we assess the likelihood that our deferred tax +asset balance will be recovered from future taxable income. To the extent we +believe that recovery is not likely, we establish a valuation allowance against +our deferred tax asset, increasing our income tax expense in the period such +determination is made. +On an interim +basis, we estimate what our anticipated annual effective tax rate will be and +record a quarterly income tax provision in accordance with this anticipated +rate. As the fiscal year progresses, we refine our estimates based upon actual +events and earnings during the year. This estimation process can result in +significant changes to our expected effective tax rate. When this occurs, we +adjust the income tax provision during the quarter in which the change in +estimate occurs so that the year-to-date provision reflects the expected annual +rate. The changes described in the preceding sentence and the recording of +valuation allowances may create fluctuations in our overall effective tax rate +from quarter to quarter. +Results of Operations +The following table sets +forth certain statement of operations data as a percentage of total net sales +and contract revenues for the periods indicated. The following table should be +read in conjunction with Management’s Discussion and Analysis of Financial +Condition and Results of Operations. +Fiscal Year Ended March 31, +2005 +2004 +2003 +(Restated) +Net sales and contract revenues: +Net sales +62.6 +% +51.8 +% +46.2 +% +Contract revenues +37.4 +48.2 +53.8 +Total net sales and contract +revenues +100.0 +% +100.0 +% +100.0 +% +Costs and expenses: +Cost of net sales +33.7 +28.2 +22.6 +Cost of contract revenues +24.6 +32.5 +36.5 +Selling, general and +administrative expenses +30.1 +28.4 +34.1 +Research and development +expenses +9.0 +8.6 +9.4 +Stock-based compensation +expense (benefit) +25.4 +— +— +Deferred compensation +(1.0 +) +1.9 +— +Disposal of fixed assets +0.9 +— +— +Acquired in-process research +and development +0.3 +— +— +Amortization of intangible +assets +0.2 +— +— +Total costs and expenses +123.2 +99.6 +102.6 +Income (loss) from operations +(23.2 +) +0.4 +(2.6 +) +Non-operating income (expense): +Other income net +2.2 +2.2 +1.0 +Interest expense, net +(2.5 +) +(0.3 +) +(1.8 +) +Income (loss) from continuing +operations before income taxes and minority interest +(23.5 +) +2.3 +(3.4 +) +Income tax benefit (provision) +0.2 +(0.2 +) +— +Minority interest in earnings +of subsidiary +(1.1 +) +(6.2 +) +(9.2 +) +Loss from continuing operations +(24.4 +) +(4.1 +) +(12.6 +) +Income (loss) from discontinued +operations, net of income taxes +0.0 +2.7 +(19.1 +) +Net loss +(24.4 +)% +(1.4 +)% +(31.7 +)% +Years +Ended March 31, 2005, 2004, and 2003 +Net +Sales and Contract Revenues . +Net sales consist principally of sales of our Vantage video detection +systems and AutoVue LDW systems, as well as technology access fees, contract +engineering revenue and royalty revenue generated from AutoVue related +activities. Contract revenue consists +principally of revenue derived from systems integration and ITS consulting +services with state, county and municipal agencies. We currently have a diverse +customer base with our largest customer constituting 12.8% of total net sales +and contract revenues in Fiscal 2005. Total net sales and contract revenues +increased 2.5% to $46.4 million in Fiscal 2005 compared to $45.3 million in Fiscal +2004, and increased 9.4% in Fiscal 2004 compared to $41.4 million in Fiscal 2003. The increases were a result of increased net +sales offset by decreased contract revenues, as discussed below. +13 +Net sales +increased 23.8% to $29.1 million in Fiscal 2005 compared to $23.5 million in Fiscal +2004, and increased 22.8% in Fiscal 2004 compared to $19.1 million in Fiscal 2003. +The increase in net sales in each of the +periods primarily reflected an increase in the unit sales of our Vantage +vehicle detection systems and increased unit sales of our AutoVue LDW systems. Net sales from AutoVue products increased +70.2% in Fiscal 2005 compared to Fiscal 2004, and represented 24.6% of our +total net sales in Fiscal 2005 versus 17.9% of total our net sales in Fiscal 2004. The increase in sales of AutoVue products was +principally related to increased unit sales of LDW systems in the European and +North American commercial heavy truck markets, and to a lesser extent, +increased license fee revenue and fees for non-recurring engineering services +derived from Valeo, our strategic partner for the passenger car OEM customer +base. AutoVue sales in Fiscal 2006 may be adversely impacted due to potential +supply issues as a new production unit for the heavy truck market is being +redesigned and qualified. Vantage sales comprised 75.4%, 82.1% and 92.0% of net +sales in Fiscal 2005, Fiscal 2004 and Fiscal 2003, respectively. The majority of Vantage revenues were derived +from sales within North America. The Vantage +sales growth was primarily due to increased market adoption of video-based +detection technologies for traffic intersection management and our ability +to obtain additional contracts with state departments of transportation. +Contract revenues +decreased 20.5% to $17.3 million in Fiscal 2005 compared to $21.8 million in Fiscal +2004, and decreased 2.1% in Fiscal 2004 compared to $22.3 million in Fiscal 2003. Contract revenues reflect a broad range of +fixed price and cost plus fixed fee contracts for engineering study and design, +systems integration and system implementation. +Contract revenues are dependent upon the continued availability of +funding on both the state and federal levels from the various departments of +transportation. We believe the decrease +in Fiscal 2005 revenues compared to Fiscal 2004 and Fiscal 2003 principally +reflects budget constraints in both the federal and California markets, where a +significant portion of our contract revenues have been derived during the last +several years, which constraints have been exacerbated by the continued delay +in the adoption of the Federal Highway Bill. +All of our contract revenue is currently derived from work performed in +North America. +Gross +Profit . Total gross profit +increased 8.7% to $19.4 million in Fiscal 2005 compared to $17.8 million in Fiscal +2004, and increased 5.3% from $16.9 million in Fiscal 2003 compared to Fiscal 2004. +Total gross profit as a percent of net sales and contract revenues increased to +41.7% in Fiscal 2005 compared to 39.3% in Fiscal 2004 and 40.9% in Fiscal 2003. +Gross profit as a +percentage of net sales was 46.2% in Fiscal 2005 compared to 45.6% in Fiscal 2004 +and 51.0% in Fiscal 2003. The 0.6% +increase in gross profit in Fiscal 2005 compared to Fiscal 2004 was primarily a +result of increased margins on AutoVue activities due to better overhead +absorption on higher unit sales of LDW systems to the heavy truck market as +well as the recognition of technology access fee revenue and royalty revenue from +Valeo, both of which provide a 100% gross margin, which was somewhat offset by +declining margins related to the sales of Vantage products due to lower unit +pricing on large, high volume state contracts and increased price pressure in +the industry. +The decrease in +gross profit as a percent of net sales in Fiscal 2004 compared to 2003 primarily +reflected lower unit pricing on large, high volume state contracts for Vantage +products, in addition to lower gross profits realized on AutoVue products and +services principally related to fewer sales of sample LDW systems which +generated higher gross profits in Fiscal 2004 compared to Fiscal 2003. We +expect that price pressure will continue into the foreseeable future for both +our Vantage and AutoVue product lines and we are constantly analyzing various +strategies to reduce the impact of further price pressure on gross profits. +Gross profit as a +percent of contract revenues increased to 34.2% in Fiscal 2005 compared to 32.6% +in Fiscal 2004 and 32.2% in Fiscal 2003. +We recognize contract revenues and related gross profit using percentage +of completion contract accounting and the underlying mix of contract activity +affects the related gross profit recognized in any given year. The increase in Fiscal 2005 reflects a mix of +higher margin contracts in Fiscal 2005 as compared to Fiscal 2004 and Fiscal 2003. +Selling, +General and Administrative Expense . Selling, general and administrative expense +increased 8.7% to $14.0 million (or 30.1% of total net sales and contract +revenues) in Fiscal 2005 compared to $12.8 million (or 28.4% of total net sales +and contract revenues) in Fiscal 2004, and decreased 8.9% in Fiscal 2004 +compared to $14.1 million (or 34.1% of total net sales and contract revenues) +in Fiscal 2003. The increase in Fiscal 2005 +compared to Fiscal 2004 was principally related to $807,000 of severance charges +recorded in connection with the merger and acquisition of the Iteris Subsidiary +in October 2004, as well as increased costs to support expanded sales and +marketing efforts for our Vantage and AutoVue products in Fiscal 2005. The +decrease in Fiscal 2004 compared to Fiscal 2003 principally reflected decreased +facilities lease expense related to the restructuring of lease commitments for +our Anaheim facilities in June 2003, reduced further by salary expense for +corporate support personnel related to the divestiture of our Broadcast, Zyfer +and MAXxess Systems businesses in Fiscal 2004. +14 +Research +and Development Expense . +Research and development expense increased 6.9% to $4.2 million (or 9.0% +of total net sales and contract revenues) in Fiscal 2005 compared to $3.9 +million (or 8.6% of total net sales and contract revenues) in Fiscal 2004, and +increased 0.4% in Fiscal 2004 compared to $3.9 million (or 9.4% of total net +sales and contract revenues) in Fiscal 2003. The increase in research and +development expense in Fiscal 2005 compared to Fiscal 2004 reflects increased +spending to support the development of AutoVue products, which was partially +offset by decreased spending to support the development of Vantage +products. AutoVue product development +primarily related to the development of the next generation LDW unit for the +heavy truck market, particularly for the re-engineering and qualification for a +new imager. The increases were primarily in the areas of personnel costs and +related benefits and overhead, prototype material costs, and consulting fees. +Vantage product development primarily reflects activities for product line +extensions to support new communications platforms and to accommodate new +camera designs. The modest increase in +research and development expense in Fiscal 2004 compared to Fiscal 2003 +primarily reflects software algorithm development and new hardware designs for +enhancements to our existing product family of Vantage video detection systems. +For competitive +reasons, we closely guard the confidentiality of specific development projects. +Stock-Based +Compensation. On October 22, 2004, we recorded an $11.3 +million charge for stock-based compensation in connection with the assumption +and exchange of vested Iteris Subsidiary stock options for stock options +immediately exercisable into our common stock. This charge was based on the differences +between the fair market value of our common stock on the merger date and the +exercise prices of the modified stock options. Additionally, we recorded approximately +$1.4 million in deferred compensation expense related to the unvested Iteris +Subsidiary stock options also assumed as part of the merger, which will be +amortized to stock-based compensation expense as the options vest. We amortized +$508,000 of the $1.4 million of deferred compensation to stock-based +compensation expense in Fiscal 2005. +Deferred +Compensation Expense (Benefit): The $868,000 non-cash charge +for the change in value of common stock held in trust by our deferred +compensation savings plan in Fiscal 2004 related to the estimated appreciation +in value of the Iteris Subsidiary common stock held in the plan for the period +ending March 31, 2004. In Fiscal 2005, the Iteris Subsidiary was merged into +the Company and shares of Iteris Subsidiary common stock held in the plan were +exchanged for shares of common stock of the Company. The $484,000 non-cash benefit for deferred +compensation plan expenses related to the decline in value of the Company’s +common stock during Fiscal 2005. Non-cash charges or benefits for deferred +compensation plan expenses will be recorded in future periods based on increases +or decreases in the fair value of the Company’s common stock at the end of each +reporting period. “We intend to amend this plan in the near future to prohibit +diversification of any shares of our common stock held in the plan, which we +believe will prevent any future deferred compensation charges or other impact +on the Company’s financial statements as a result of changes in the value of +our common stock held in this plan.” +Disposal +of Fixed Assets. After the October 22, 2004, merger of the Iteris +Subsidiary into us, we conducted a review of our property and equipment and +determined that certain corporate property and equipment would not provide +value to our on-going operations. These +assets primarily consisted of furniture and fixtures and computer equipment. +Accordingly, we recorded a $422,000 loss on disposal of fixed assets in Fiscal 2005. +Other +Income, Net . Other +income, net reflects the following: +Year Ended March 31, +2005 +2004 +2003 +(In thousands) +Gain on sale of real estate +$ +— +$ +970 +$ +640 +Loss on sale of Iteris common stock +— +— +(310 +) +Gain on settlement of lawsuit +949 +— +— +Other +105 +33 +87 +Other income, net +$ +1,054 +$ +1,003 +$ +417 +Other +income, net in Fiscal 2005 primarily reflects a $949,000 gain recognized on the +settlement of litigation. We were a +beneficiary of, but not a party to, litigation between Rockwell International +and the Michigan Department of Transportation. Other income, net in Fiscal 2004 +and 2003 includes a gain of $970,000 and $640,000, respectively, recognized on +the sale and leaseback of our Anaheim, California facility, which was +consummated in May 2002. +Interest +Expense, Net . Interest +expense, net reflects the net of interest expense and interest income as +follows: +Year Ended March 31, +2005 +2004 +2003 +(In thousands) +Interest expense +$ +1,180 +$ +125 +$ +761 +Interest income +(2 +) +(2 +) +— +Interest expense, net +$ +1,178 +$ +123 +$ +761 +Interest +expense increased 844.0% in Fiscal 2005 compared to Fiscal 2004 and decreased +83.8% in Fiscal 2004 compared to Fiscal 2003. The increase in Fiscal 2005 is +due to additional interest expense incurred related to the $5.0 million term +debt entered into by the Iteris Subsidiary on May 28, 2004 (which was assumed by +us in October 2004), interest expense related to the $10.1 million convertible +debentures issued by us on May 19, 2004, the amortization of debt discounts +15 +associated +with the issuance of the convertible debentures and related warrants, and increased +borrowings on our line of credit. The decrease in Fiscal 2004 compared to Fiscal +2003 reflected the sale and leaseback of our Anaheim, California facilities, +and our subsequent repayment in May 2002 of a $16.4 million promissory note. +Income +Taxes . During Fiscal 2005, +we recognized an income tax benefit of $94,000, and at March 31, 2005, we +recorded a net deferred tax asset of $660,000. +The ability to record the deferred tax asset was based on the more likely +than not criteria of Statement of Financial Accounting Standards (“SFAS”) No. +109, Accounting for Income Taxes , since the +Iteris Subsidiary had historically been profitable and had utilized all its +federal net operating loss carryovers and could thus carryback and realize the +reversal of future tax deductions. +During Fiscal 2004, we recognized an income tax expense of $100,000 and at +March 31, 2004, we recorded a net deferred tax asset of $821,000 directly +related to the profitable operations of the Iteris Subsidiary. No income tax +benefit for losses incurred in Fiscal 2003 was recorded due to uncertainty as +to the ultimate realization of the related benefit. +At March 31, 2005, +we had $50.5 million of federal net operating loss carryforwards and $33.0 +million of state net operating loss carryforwards that begin to expire in 2019 +and 2005, respectively. As a result of +these net operating loss carryforwards and the valuation allowance, we have +recorded against the related net deferred tax assets in our consolidated +balance sheet, we believe that future income tax payments and income tax +expense will be substantially lower than the income tax liability and income +tax expense calculated using statutory tax rates. +Minority +Interest in Earnings of Subsidiary . Minority interest in earnings of subsidiary +represents the minority stockholders’ share of the Iteris Subsidiary’s net +income or loss combined with the accretion of the redemption preference of the +Iteris Subsidiary’s Series A preferred stock. +The decrease in minority interest from $2.8 million in Fiscal 2004 to $526,000 +in Fiscal 2005 was the result of the merger and acquisition of the Iteris Subsidiary +by us. On October 22, 2004, we fully completed the merger and acquisition of +the Iteris Subsidiary, and as a result, we do not anticipate incurring any +further charges for minority interest. +Income (Loss) from Discontinued Operations, +net of income taxes . +As discussed in the Overview to Management’s Discussion and Analysis of +Financial Condition and Results of Operations, the results of operations +related to certain businesses discontinued by us in Fiscal 2004 and Fiscal 2003 +are reflected as discontinued operations in our consolidated financial +statements. As of the end of Fiscal 2004, +we had completed all such restructuring activities so that we could focus our +efforts in the ITS marketplace. +Restatement of Consolidated Financial +Statements for the year ended March 31, 2004 +As further +discussed in Note 1 to the consolidated financial statements, we have restated +our consolidated financial statements for the year ended March 31, 2004. This restatement was necessary in order to +reflect the consolidation of our deferred compensation savings plan, the +principal effects of which were to increase operating expenses by a non-cash +charge of $868,000 for the year ended March 31, 2004, and decrease minority +interest in the earnings of the Iteris Subsidiary by $221,000 for the year +ended March 31, 2004. This restatement +had no impact on our consolidated cash flows. +Liquidity +and Capital Resources +During Fiscal 2005, +we generated $858,000 in cash from operating activities and used this cash to partially +fund our investing and financing activities. +Net cash provided by operating activities principally reflected our net +loss of $11.3 million increased for non-cash charges of $11.8 million related +to stock-based compensation, $1.2 million for depreciation and amortization, $296,000 +in charges related to the minority interest in the Iteris Subsidiary and +$422,000 related to the disposal of fixed assets, offset by a decrease of $609,000 +for non-cash gains related to amortization of the deferred gain on real-estate +sales and $914,000 related to the usage of cash to fund changes in operating +assets and liabilities. Most of the cash +requirements for operating assets and liabilities during Fiscal 2005 related to +$746,000 in cash used to purchase inventory and $485,000 used to pay income +taxes. +In May 2002, we completed the sale and leaseback of our +Anaheim, California facility for an aggregate sale price of $22.6 million. Under the terms of the sale and leaseback +agreement, we agreed to lease one of the two buildings located on the property +for an initial ten-year period at a rate of $152,150 per month and the other building +for a period of 30 months at a rate of approximately $57,553 per month. +Approximately $16.4 million of the proceeds from the sale was used to repay the +outstanding indebtedness and accrued interest under a promissory note that was +secured by a first deed of trust on the Anaheim facility. The balance of the proceeds was available for +general working capital purposes. The +gain on the sale of the facility was approximately $8.2 million, of which +$640,000 was recognized immediately and the remainder was deferred and is being +amortized against rent expenses over the term of the leases. +In May 2003, we +completed the sale of substantially all the assets of our wholly-owned +subsidiary, Zyfer, for $2.3 million in cash plus the assumption of certain +liabilities. The cash proceeds were used to fund working capital requirements +and pay short-term liabilities. The asset purchase agreement provides for +incentive payments to us of up to $1.0 million in each of the twelve months +ended April 30, 2004 and 2005. The +amount of these incentive payments are based on the revenues generated by the +sale of Zyfer’s products or the license of its technologies. Based on the terms of the sale agreement, +Zyfer has 60 days to provide us with support for the incentive payments. In +October 2004, we received a payment of approximately $135,000 related to the +twelve month period ended April 30, 2004. We expect to receive information for the +twelve month period ended April 30, 2005 by the end of July 2005. +16 +In July 2003, +we renegotiated the terms of our existing lease for our Anaheim facilities +whereby the initial lease term of ten years was reduced to four years and we were +relieved of our obligation to lease both buildings. In consideration for the restructured +agreement, we paid approximately $2.5 million in cash that had been previously +pledged as collateral on the lease, in addition to issuing to the lessor +425,000 shares of our common stock valued at $255,000 and a note payable for +$811,000. Under the terms of the new +lease, we are only responsible for 88,000 square feet at a rate of $77,000 per +month. In addition, are subleasing +10,000 of the 88,000 square feet at our Anaheim facility for a period of four +years at a rate of $10,000 per month. +The aggregate future rental payments under this sublease are $120,000 +for the year ending March 31, 2006 and $70,000 for the year ending +March 31, 2007. Also, as a result +of the new lease, the deferred gain on the sale of the building was adjusted to +reflect the changes in the lease term. +The remaining deferred gain was $733,000 at March 31, 2005. +Also, in +July 2003, we completed a private placement of 3,666,666 of our common +stock to seven accredited investors for net proceeds of $1.9 million in cash. +In connection with this offering, we also issued warrants to the investors to +purchase up to another 366,666 shares in the aggregate at an exercise price of +$1.50 per share. The fair value of these +warrants was $55,000 calculated using the Black Scholes Model. The warrants are considered a cost of raising +capital and were recorded in equity as an offset to additional paid-in +capital. The warrants expire in July 2006 +and became exercisable in January 2003. The proceeds from this transaction were used +to fund our general working capital requirements. +In +September 2003, we completed the sale of the assets of our MAXxess +subsidiary to an investor group that included certain members of the MAXxess +management group. The consideration for the sale consisted of the assumption by +the buyer of $2.7 million of liabilities, resulting in a net gain to the +Company of approximately $2.3 million. We did not receive any cash in this +transaction. +In +May 2004, we issued convertible debentures in the original principal amount of +$10.1 million and entered into a $5.0 million term note with our bank. We purchased the outstanding Series A +preferred stock of the Iteris Subsidiary from DCV and Hockenheim Investment +Pte. Ltd. for $17.5 million, which was comprised of $2.4 million of available +cash and the proceeds from the debenture financing and the bank term note. DCV also exchanged its outstanding Iteris +Subsidiary common stock for 1,219,445 shares of our common stock (the “Exchange +Shares”). Beginning on May 28, 2005 , +DCV has the right to request registration of all 1,219,445 shares of our common +stock held as part of this exchange. In +the event we decide not to file a registration statement to register all such +shares, DCV may require us to repurchase any or all of DCV’s shares of our +common stock at a purchase price of $1.438 per share. On February 1, 2005, DCV announced that it +was sold to European-based Cipio Partners for an undisclosed sum. All repurchase and registration rights +associated with the DCV shares have inured to the benefit of Cipio Partners. +The +debentures are due in full in May 2009, provide for 6.0% annual interest, +payable quarterly, and are convertible into our common stock at an initial +conversion price of $3.61 per share, subject to certain adjustments, including +adjustments for dilutive issuances. From +May 19, 2007 until May 18, 2008, the debentures may be redeemed by us, at our +option, at 120% of the principal amount being redeemed; and from May 19, 2008, +until the maturity date, the debentures may be redeemed at 110% of the +principal amount being redeemed. +Each +individual investor in the debenture financing also received two warrants to +purchase shares of our common stock. For +every dollar of debenture purchased, each investor received one warrant to +purchase approximately 0.03235 shares of common stock at an exercise price of +$3.86 per share and a second warrant to purchase approximately 0.03100 shares +of common stock at an exercise price of $4.03 per share. The exercise prices are subject to certain +adjustments, including adjustments for dilutive issuances. The warrants to purchase 639,347 shares of +common stock issued to these investors expire on May 18, 2009, and none of the warrants had been exercised +at March 31, 2005. +In conjunction +with the debenture financing, we also issued warrants to purchase 34,036 shares +of our common stock at an exercise price of $3.61 per share as commissions +related to the transaction. These +warrants also expire on May 18, 2009. +Concurrent with +the issuance of the debentures, our Iteris Subsidiary entered into a $5.0 +million term note payable with a bank. Proceeds from the debentures and note +payable were used to purchase the Series A preferred stock of our Iteris +Subsidiary as described above. The four year bank note is due and payable on +May 27, 2008, and provides for monthly principal payments of $104,167. Interest +accrues at the current stated prime rate plus 0.25%. +Also in May 2004, our +Iteris Subsidiary renegotiated its existing line of credit agreement and +entered into a new line +17 +of credit agreement with +the same bank. The new agreement has a +one year term that expires on August 1, 2005 and a maximum available +credit line of $5.0 million. We assumed +this line of credit and the $5.0 million term note described above in +October 2004 in connection with our merger with the Iteris Subsidiary. Under the terms of this agreement, we may +borrow against our eligible accounts receivable and the value of our eligible +inventory, as defined in such agreement. Interest on borrowed amounts is +payable monthly at the prime rate (5.50% at March 31, 2005). Additionally, we are obligated to pay an +unused line fee of 0.25% per annum applied to the amount by which the maximum +credit amount exceeds the average daily principal balance during the preceding +month. There are no monthly collateral management fees associated with our line +of credit and no pre-payment or early termination fees. Both the term note payable and the line of +credit are secured by substantially all of our assets. +In +November 2004, we amended our existing lease for our Anaheim facility and +increased the $860,000 note payable to the landlord by $432,000 resulting in a +total payable of $1.3 million. This increase was recorded as a decrease to the +deferred gain on the sale of the building. +The increase was negotiated as a settlement to release us from +obligations under the existing lease related to the separation of buildings +located at 1515 and 1585 S. Manchester Avenue in Anaheim, California, and other +facility improvements to be made at the Anaheim location. This note is payable in quarterly +installments of principal and interest beginning on October 1, 2006 and +accrues interest at the current stated prime rate plus 2.0%. +We had a cash +balance of $46,000 as of March 31, 2005, and generally do not have a +substantial amount of cash on hand at any given time. In order to minimize interest expense on our +line of credit, available funds are swept from our cash accounts to pay down +the line of credit if a balance due exists. +Our contractual +obligations are as follows at March 31, 2005: +Payments Due by Period +2006 +2007 +2008 +2009 +2010 +Thereafter +Total +(In thousands) +Lines of credit +$ +945 +$ +— +$ +— +$ +— +$ +— +$ +— +$ +945 +Notes payable and capital leases +4,008 +670 +649 +— +— +— +5,327 +Convertible debentures +— +— +— +— +9,850 +— +9,850 +Operating leases +1,116 +1,005 +601 +3 +— +— +2,725 +Total +$ +6,069 +$ +1,675 +$ +1,250 +$ +3 +$ +9,850 +$ +— +$ +18,847 +At March 31, 2005, +we had firm commitments to purchase inventory in the amount of $271,000 during +the first quarter of Fiscal 2006. +Although we +incurred a net loss of $11.3 million in Fiscal 2005, our operations generated +positive cash of $858,000 for such fiscal year. However, we used $625,000 of cash in investing +activities and $2.8 million of available cash in financing activities and ended +the year with a cash balance of $46,000. At March 31, 2005, we had a +revolving line of credit with our principal bank, which expires in +August 2005 and provides for available borrowings up to $5.0 million +subject to a borrowing formula based upon qualified accounts receivable and +inventories as defined in the credit agreement. At March 31, 2005, $4.4 million +was available for borrowing subject to the borrowing base in the credit +agreement, of which $3.4 million was unused. +Due to covenant violations as of March 31, 2005, we are re-negotiating +the line of credit facility as well as the term loan with the bank. We believe +these negotiations will be successful and that the combination of available +borrowings on our line of credit and our internally generated cash flows will +be sufficient to enable us to execute our operating plans and meet our +obligations on a timely basis. As +discussed in Note 5 to the consolidated financial statements, the entire +balance of the bank term loan is presented as a current liability in our March +31, 2005, consolidated balance sheet. +Recent Accounting Pronouncements +In November 2004, the FASB issued SFAS No. 151, Inventory +Costs , which clarifies the accounting for abnormal amounts of idle +facility expense, freight, handling costs, and wasted material. SFAS No. 151 will be effective for inventory +costs incurred during fiscal years beginning after June 15, 2005. We do not believe the adoption of SFAS No. +151 will have a material impact on our financial statements. +On December 16, 2004, the FASB issued SFAS No. 123 (revised 2004), Share-Based Payment (“SFAS 123R”), which replaced SFAS No. +123, Accounting for Stock-Based Compensation , +supersedes Accounting Principles Board Opinion No. 25, Accounting +for Stock Issued to Employees , and amends SFAS No. 95, Statement of Cash Flows . +Generally, the +18 +approach in SFAS 123R is similar to the approach described in SFAS +123. However, SFAS 123R requires all +share-based payments to employees, including grants of employee stock options, to +be recognized in the financial statements based on their fair values (i.e., pro +forma disclosure is no longer an alternative to financial statement +recognition). In accordance with SEC +Release No. 33-8568, SFAS 123R will become effective for us beginning April 1, +2006. We are currently assessing the +impact of SFAS 123R. As of the date of +this filing, no decisions have been made as to whether we will apply the +modified prospective or retrospective transition method of application. +19 +RISK FACTORS +Our business is subject to a number +of risks, some of which are discussed below. +Other risks are presented elsewhere in this report and in the +information incorporated by reference into this report. You should consider the following risks +carefully in addition to the other information contained in this report and our +other filings with the SEC, including our subsequent reports on Forms 10-Q and +8-K, before deciding to buy, sell or hold our common stock. The risks and +uncertainties described below are not the only ones facing our company. Additional risks and uncertainties not +presently known to us or that we currently deem immaterial may also affect our +business operations. If any of these +risks actually occurs, our business, financial condition or results of +operations could be seriously harmed. In +that event, the market price for our common stock could decline and you may +lose all or part of your investment. +We Have +Experienced Substantial Losses And May Continue To Experience Losses For The +Foreseeable Future. We experienced net losses from continuing +operations of $11.3 million, $1.9 million and $5.3 million in the years ended +March 31, 2005, 2004, and 2003, respectively. While we have divested all of our other business +units and merged with our Iteris Subsidiary, we cannot assure you that our +efforts to downsize our operations or reduce our operating expenses will +improve our financial performance, or that we will be able to achieve +profitability on a quarterly or annual basis in the future. Most of our +expenses are fixed in advance. As such, we generally are unable to reduce our +expenses significantly in the short-term to compensate for any unexpected delay +or decrease in anticipated revenues. As a result, we may continue to experience +operating losses and net losses, which would make it difficult to fund our +operations and achieve our business plan, and could cause the market price of +our common stock to decline. +We May Need To Raise Additional Capital In The Future, But We May Not +Be Able To Secure Adequate Funds On Terms Acceptable To Us, Or At All. We +have generated significant net losses and operating losses in recent periods, +and have experienced volatility in our cash flows from operations ranging from positive +cash flows from operations of $858,000 in the year ended March 31, 2005, to +negative cash flows from operations of $718,000 and $4.8 million in the years +ended March 31, 2004, and 2003, respectively. While we completed a $10.1 million convertible +debenture financing and our Iteris Subsidiary closed a $5.0 million term +loan in May 2004, the majority of the proceeds from such financings were used +to purchase the Series A preferred stock of our Iteris Subsidiary held by +outside investors. +As +further described in Note 5 to the consolidated financial statements, we failed +to meet some of our debt covenants under our current credit agreement with our +bank. At March 31, 2005, we had $4.0 +million in term debt and $945,000 in revolving credit outstanding in connection +with this credit agreement. Although we +are currently in negotiations to restructure this credit facility, we cannot assure +you that we will be able to complete this restructuring under acceptable terms, +or at all. +We +may raise additional capital in the near future to fund our operations or to +repay indebtedness. Such additional +capital may be raised through bank borrowings, or other debt or equity +financings. We cannot assure you that +any additional capital will be available on a timely basis, on acceptable +terms, or at all. +Our +capital requirements will depend on many factors, including, but not limited +to: +• our ability to successfully renegotiate a new +credit arrangement with our bank; +• our ability to control costs; +• market acceptance of our products and the +overall level of sales of our products; +• our ability to generate operating income; +• increased research and development funding; +• increased sales and marketing expenses; +• technological advancements and our competitors’ +response to our products; +• capital improvements to new and existing +facilities; +20 +• potential acquisitions of businesses and product lines; +• our relationships with customers and suppliers; and +• general economic conditions, including the effects of the current +economic slowdown and international conflicts. +If our capital requirements +are materially different from those currently planned, we may need additional +capital sooner than anticipated. If additional funds are raised through the +issuance of equity or convertible debt securities, the percentage ownership of +our stockholders will be reduced and such securities may have rights, +preferences and privileges senior to our common stock. Additional financing may +not be available on favorable terms or at all. If adequate funds are not +available or are not available on acceptable terms, we may be unable to +continue our operations as planned, develop or enhance our products, expand our +sales and marketing programs, take advantage of future opportunities or respond +to competitive pressures. +If Our Internal Controls Over Financial Reporting Do Not Comply With +The Requirements Of The Sarbanes-Oxley Act, Our Business And Stock Price Could +Be Adversely Affected. We and our independent +registered public accounting firm are evaluating the effectiveness of our +internal controls over financial reporting to comply with Section 404 of +the Sarbanes-Oxley Act of 2002. Section 404 +requires us to evaluate the effectiveness of our internal controls over +financial reporting as the end of each fiscal year beginning in Fiscal 2006, +and to include a management report assessing the effectiveness of our internal +controls over financial reporting in all annual reports beginning with our +Annual Report on Form 10-K for the fiscal year ending March 31, +2006. Section 404 also requires our +independent accountant to attest to, and report on, management’s assessment of +our internal controls over financial reporting. +Our management, including +our CEO and CFO, does not expect that our internal controls over financial +reporting will prevent all error and all fraud. +A control system, no matter how well designed and operated, can provide +only reasonable, not absolute, assurance that the control system’s objectives +will be met. Further, the design of a +control system must reflect the fact that there are resource constraints, and +the benefits of controls must be considered relative to their costs. Because of the inherent limitations in all +control systems, no evaluation of controls can provide absolute assurance that +all control issues and instances of fraud, if any, within the company have +been, or will be detected. These +inherent limitations include the realities that judgments in decision-making +can be faulty and that breakdowns can occur because of simple error or mistake. Controls can also be circumvented by the +individual acts of some persons, by collusion of two or more people, or by +management override of the controls. The +design of any system of controls is based in part on certain assumptions about +the likelihood of future events, and we cannot assure you that any design will +succeed in achieving its stated goals under all potential future +conditions. Over time, controls may +become inadequate because of changes in conditions or deterioration in the +degree of compliance with policies or procedures. Because of the inherent limitations in a +cost-effective control system, misstatements due to error or fraud may occur +and not be detected. +As of March +31, 2005 we became aware of a material weakness in our internal controls +related to the accounting for the consolidation of our deferred compensation +savings plan. We cannot assure you that +we or our independent registered public accounting firm will not identify another +material weakness in our internal controls. +A material weakness is a control deficiency, or combination of control +deficiencies, that results in more than a remote likelihood that a material +misstatement of the annual or interim financial statements will not be +prevented or detected. Based on our evaluation under the framework in Internal Control—Integrated Framework , our +management has concluded that, as of March 31, 2004, our internal control +over financial reporting was not effective due to the existence of one material +weakness. If our internal controls over financial reporting are not +considered adequate, we may experience a loss of public confidence, which could +have an adverse effect on our business and our stock price. +We Rely +On A Single Manufacturer For Our AutoVue LDW Systems And May Experience Supply +Issues For This Product Which Could Materially And Adversely Impact Our Sales And +Ultimate Market Acceptance Of AutoVue. We outsource the manufacture of our AutoVue +product line to a single manufacturer. We are currently negotiating with a +second supplier for the AutoVue product line. This manufacturer may not be able +to produce sufficient quantities of this product in a timely manner or at a +reasonable cost, which could materially and adversely affect our ability to +launch or gain market acceptance of AutoVue. We are currently experiencing +shortages on certain components used in the manufacture of AutoVue LDW units +sold to the heavy truck market and must design and qualify a next generation +system before our existing supplies are exhausted. AutoVue production +availability may also be impacted by long lead times on replacement components +or an inability to design these new components into production units. Based on +current sales and unit forecasts, we believe we currently have a four month +supply of these components on hand. We are searching world-wide supply sources +to acquire additional components, but we cannot assure you that we will be able +to obtain sufficient quantities of these components or that such components +will be available on a timely basis. +Should we not be able to procure these components before our current +inventory is depleted or we engineer and qualify a next generation system, we +could experience a shortfall in revenues for a brief period of time until such +components can be located or the qualification of a new component is complete. +21 +We +Depend On Government Contracts And Subcontracts, And Because Many Of Our +Government Contracts Are Fixed Price Contracts, Higher Than Anticipated Costs +Will Reduce Our Profit And Could Adversely Impact Our Operating Results. A +significant portion of our sales were derived from contracts with governmental +agencies, either as a general contractor, subcontractor or supplier. Government +contracts represented approximately 37.4%, 48.2% and 53.8% of our total net +sales and contract revenues for the years ended March 31, 2005, 2004 and +2003, respectively. We anticipate that revenue from government contracts will +continue to increase in the near future. Government business is, in general, +subject to special risks and challenges, including: +• long purchase cycles or approval processes; +• competitive bidding and qualification requirements; +• the impact of international conflicts; +• performance bond requirements; +• changes in government policies and political agendas; +• delays in funding, budgetary constraints and cut-backs; and +• milestone requirements and liquidated damage provisions for failure to +meet contract milestones +In addition, a large number +of our government contracts are fixed price contracts. As a result, we may not +be able to recover any cost overruns we may incur. These fixed price contracts require us to +estimate the total project cost based on preliminary projections of the project’s +requirements. The financial viability of +any given project depends in large part on our ability to estimate these costs +accurately and complete the project on a timely basis. In the event our costs on these projects +exceed the fixed contractual amount, we will be required to bear the excess +costs. Such additional costs would adversely +affect our financial condition and results of operations. Moreover, certain of our government contracts +are subject to termination or renegotiation at the convenience of the +government, which could result in a large decline in our net sales in any given +quarter. Our inability to address any of +the foregoing concerns or the loss or renegotiation of any material government +contract could seriously harm our business, financial condition and results of +operations. +If We +Are Unable To Develop And Introduce New Products And Product Enhancements +Successfully And In A Cost-Effective And Timely Manner, Or Are Unable To +Achieve Market Acceptance Of Our New Products, Our Operating Results Would Be +Adversely Affected. We believe our revenue growth and future +operating results will depend on our ability to complete development of new +products and enhancements, introduce these products in a timely, cost-effective +manner, achieve broad market acceptance of these products and enhancements, and +reduce our product costs. We may not be able to introduce any new products or +any enhancements to our existing products on a timely basis, or at all. In +addition, the introduction of any new products could adversely affect the sales +of certain of our existing products. Our future success will also depend in +part on the success of several products including our AutoVue LDW system. +We believe that we must +continue to make substantial investments to support ongoing research and +development in order to remain competitive. We need to continue to develop and +introduce new products that incorporate the latest technological advancements +in outdoor image processing hardware, software and camera technologies in +response to evolving customer requirements. Our business and results of +operations could be adversely affected if we do not anticipate or respond +adequately to technological developments or changing customer requirements. We +cannot assure you that any such investments in research and development will lead +to any corresponding increase in revenue. +Market acceptance of our new products depends +upon many factors, including our ability to accurately predict market +requirements and evolving industry standards, our ability to resolve technical +challenges in a timely and cost-effective manner and achieve manufacturing +efficiencies, the perceived advantages of our new products over traditional +products and the marketing capabilities of our independent distributors and +strategic partners. In particular, we +have granted Valeo the exclusive right to sell and manufacture our AutoVue lane +departure warning system to the worldwide passenger market in exchange for +royalty payments for each AutoVue unit sold. +As such, the future success and broad market acceptance of our AutoVue +technologies will depend upon Valeo’s ability to manufacture, market and sell +our technologies, and to convince more OEM passenger car manufacturers to adopt +our technologies. The success of our +AutoVue system will also depend in part on the success of the automotive +vehicles that incorporate our technology, as well as the success of optional +equipment that OEMs bundle with our technologies. +22 +Our +business and results of operations could also be seriously harmed by any +significant delays in our new product development. Certain of our new products +could contain undetected design faults and software errors or “bugs” when first +released by us, despite our testing. We may not discover these faults or errors +until after a product has been installed and used by our customers. Any faults +or errors in our existing products or in any new products may cause delays in +product introduction and shipments, require design modifications or harm +customer relationships, any of which could adversely affect our business and +competitive position. +An Economic +Slowdown And Related Uncertainties Could Adversely Impact The Demand For Our +Products. Concerns about inflation, decreased consumer +confidence, reduced corporate profits and capital spending, and recent +international conflicts and terrorist and military actions have resulted in a +downturn in worldwide economic conditions, particularly in the United States. These unfavorable economic conditions may have +a negative impact on customer orders, cancellations and rescheduling of +backlog. In addition, recent political and social turmoil related to +international conflicts and terrorist acts can be expected to put further +pressure on economic conditions in the U.S. and worldwide. These political, social and economic +conditions make it extremely difficult for our customers, our suppliers and us +to accurately forecast and plan future business activities. If such conditions continue or worsen, our +business, financial condition and results of operations will likely be +materially and adversely affected. +Our Quarterly Operating Results Fluctuate As A Result Of Many +Factors. Therefore, We May Fail To Meet Or Exceed The Expectations Of +Securities Analysts And Investors, Which Could Cause Our Stock Price To +Decline. Our quarterly revenues and operating results +have fluctuated and are likely to continue to vary from quarter to quarter due +to a number of factors, many of which are not within our control. Factors that +could affect our revenues include, among others, the following: +• our ability to raise additional capital; +• our ability to control costs; +• international conflicts and acts of terrorism; +• our ability to develop, introduce, patent, market and gain market +acceptance of new products, applications and product enhancements in a timely +manner, or at all; +• the size, timing, rescheduling or cancellation of significant customer +orders; +• the introduction of new products by competitors; +• the availability of components used in the manufacture of our products; +• changes in our pricing policies and the pricing policies of our +suppliers and competitors, pricing concessions on volume sales, as well as +increased price competition in general; +• the long lead times associated with government contracts or required by +vehicle manufacturers; +• continued delays in the passage of the six year transportation bill by +the U.S. government; +• our success in expanding and implementing our sales and marketing +programs; +• the effects of technological changes in our target markets; +• our relatively small level of backlog at any given time; +• seasonality due to winter weather conditions; +• the mix of our sales; +• deferrals of customer orders in anticipation of new products, +applications or product enhancements; +23 +• risks and uncertainties associated with our international business; +• currency fluctuations and our ability to get currency out of certain +foreign countries; and +• general economic and political conditions. +Due to all of the factors +listed above as well as other unforeseen factors, our future operating results +could be below the expectations of securities analysts or investors. If that happens, the trading price of our +common stock could decline. As a result of these quarterly variations, you +should not rely on quarter-to-quarter comparisons of our operating results as +an indication of our future performance. +If We +Do Not Keep Pace With Rapid Technological Changes And Evolving Industry +Standards, We Will Not Be Able To Remain Competitive And There Will Be No +Demand For Our Products. Our markets are in general characterized by +the following factors: +• rapid technological advances; +• downward price pressure in the marketplace as technologies mature; +• changes in customer requirements; +• frequent new product introductions and enhancements; and +• evolving industry standards and changes in the regulatory environment. +Our future success will +depend upon our ability to anticipate and adapt to changes in technology and +industry standards, and to effectively develop, introduce, market and gain +broad acceptance of new products and product enhancements incorporating the +latest technological advancements. +We Have +Adopted A New Operating Strategy, Which Is Untried And Exposes Us To New Risks. We +recently divested ourselves of all of our other business units and merged with +our Iteris Subsidiary and significantly scaled back our operations in order to +focus on the ITS business. We have +abandoned our strategy of incubating emerging companies, which historically +required us to make significant investments in new business units. Our current business strategy is narrow and +untried, and we cannot assure you that our new business strategy or the +continued execution of this business will be successful. +The +Markets In Which We Operate Are Highly Competitive And Have Many More +Established Competitors, Which Could Adversely Affect Our Sales Or The Market +Acceptance Of Our Products. We compete with numerous other +companies in our target markets including, but not limited to, large, +multinational corporations and many smaller regional engineering firms. We +expect such competition to increase due to technological advancements, industry +consolidations and reduced barriers to entry. Increased competition is likely +to result in price reductions, reduced gross margins and loss of market share, +any of which could seriously harm our business, financial condition and results +of operations. Many of our competitors have far greater name recognition and +greater financial, technological, marketing and customer service resources than +we do. This may allow them to respond more quickly to new or emerging +technologies and changes in customer requirements. It may also allow them to +devote greater resources to the development, promotion, sale and support of +their products than we can. Recent consolidations of end users, distributors +and manufacturers in our target markets have exacerbated this problem. As a +result of the foregoing factors, we may not be able to compete effectively in +our target markets and competitive pressures could adversely affect our +business, financial condition and results of operations. +We May Be +Unable To Attract And Retain Key Personnel, Which Could Seriously Harm Our +Business. Due to the specialized nature of our +business, we are highly dependent on the continued service of our executive +officers and other key management, engineering and technical personnel, +particularly Jack Johnson. In connection +with the roll-up merger of the Iteris Subsidiary, Mr. Johnson became our +Chief Executive Officer and Mr. James Miele, the former Controller of our +Iteris Subsidiary, was promoted to serve as our Chief Financial Officer. The +loss of either of these individuals or of any of our executive officers or key +members of management could adversely affect our business, financial condition +or results of operations. Our success +will also depend in large part upon our ability to continue to attract, retain and +motivate qualified engineering and other highly skilled technical personnel. +Competition for employees, particularly development engineers, is intense. We may not be able to continue to attract and +retain sufficient numbers of such highly skilled employees. Our inability to attract and retain additional +key employees or the loss of one or more of our current key employees could +adversely affect our business, financial condition and results of operations. +24 +We May Not +Be Able To Adequately Protect Or Enforce Our Intellectual Property Rights, +Which Could Harm Our Competitive Position. If we +are not able to adequately protect or enforce the proprietary aspects of our +technology, competitors could be able to access our proprietary technology and +our business, financial condition and results of operations will likely be +seriously harmed. We currently attempt to protect our technology through a +combination of patent, copyright, trademark and trade secret laws, employee and +third party nondisclosure agreements and similar means. Despite our efforts, +other parties may attempt to disclose, obtain or use our technologies or +systems. Our competitors may also be able to independently develop products +that are substantially equivalent or superior to our products or design around +our patents. In addition, the laws of some foreign countries do not protect our +proprietary rights as fully as do the laws of the United States. As a result, +we may not be able to protect our proprietary rights adequately in the United +States or abroad. +From time to time, we have +received notices that claim we have infringed upon the intellectual property of +others. Even if these claims are not valid, they could subject us to +significant costs. We have engaged in litigation in the past, and litigation +may be necessary in the future to enforce our intellectual property rights or +to determine the validity and scope of the proprietary rights of others. +Litigation may also be necessary to defend against claims of infringement or +invalidity by others. An adverse outcome in litigation or any similar +proceedings could subject us to significant liabilities to third parties, +require us to license disputed rights from others or require us to cease marketing +or using certain products or technologies. We may not be able to obtain any +licenses on terms acceptable to us, or at all. We also may have to indemnify +certain customers or strategic partners if it is determined that we have +infringed upon or misappropriated another party’s intellectual property. Any of +these results could adversely affect our business, financial condition and +results of operations. In addition, the cost of addressing any intellectual +property litigation claim, both in legal fees and expenses, and the diversion +of management’s attention and resources, regardless of whether the claim is +valid, could be significant and could seriously harm our business, financial +condition and results of operations. +The +Trading Price Of Our Common Stock Is Highly Volatile. The +trading price of our common stock has been subject to wide fluctuations in the +past. Since January 2000, our Class A common stock (now known as our +common stock) has traded at prices as low as $0.45 per share and as high as +$29.44 per share. The market price of our common stock could continue to +fluctuate in the future in response to various factors, including, but not +limited to: +• quarterly variations in operating results; +• our ability to control costs and improve cash flow; +• our ability to raise additional capital; +• shortages announced by suppliers; +• announcements of technological innovations or new products or +applications by our competitors, customers or us; +• acquisitions of businesses, products or technologies; +• the impact of any litigation; +• changes in investor perceptions; +• changes in earnings estimates or investment recommendations by +securities analysts; and +• international conflicts, political unrest and acts of terrorism. +The stock market in general +has recently experienced volatility, which has particularly affected the market +prices of equity securities of many technology companies. This volatility has +often been unrelated to the operating performance of these companies. These +broad market fluctuations may adversely affect the market price of our common +stock. In the past, companies that have experienced volatility in the market +price of their securities have been the subject of securities class action +litigation. If we were to become the subject of a class action lawsuit, it +could result in substantial losses and divert management’s attention and +resources from other matters. +We May Engage +In Acquisitions Of Companies or Technologies That May Require Us To +Undertake Significant Capital Infusions And Could Result In Disruptions Of Our +Business And Diversion Of Resources And Management Attention. We +have historically, and may in the future, acquire complementary businesses, +products and technologies. Acquisitions may require significant capital +infusions and, in general, acquisitions also involve a number of special risks, +including: +• potential disruption of our ongoing business and the diversion of our +resources and management’s attention; +• the failure to retain or integrate key acquired personnel; +• the challenge of assimilating diverse business cultures, and the +difficulties in integrating the operations, technologies and information system +of the acquired companies; +25 +• increased costs to improve managerial, operational, financial and +administrative systems and to eliminate duplicative services; +• the incurrence of unforeseen obligations or liabilities; +• potential impairment of relationships with employees or customers as a +result of changes in management; and +• increased interest expense and amortization of acquired intangible +assets. +Our competitors are also +soliciting potential acquisition candidates, which could both increase the +price of any acquisition targets and decrease the number of attractive +companies available for acquisition. Acquisitions may also materially and +adversely affect our operating results due to large write-offs, contingent +liabilities, substantial depreciation, deferred compensation charges or +intangible asset amortization, or other adverse tax or accounting consequences. +We cannot assure you that we will be able to identify or consummate any +additional acquisitions, successfully integrate any acquisitions or realize the +benefits anticipated from any acquisition. +Our International +Business Operations May Be Threatened By Many Factors That Are Outside Of +Our Control. We currently market our AutoVue and Vantage +products internationally and we anticipate that our international operations +will expand in the near future. International business operations are subject +to various inherent risks including, among others: +• currency fluctuations and restrictions; +• political, social and economic instability; +• reduced protection for intellectual property rights in some countries; +• unexpected changes in regulatory requirements, tariffs and other trade +barriers or restrictions; +• the burdens of compliance with a wide variety of foreign laws and more +restrictive labor laws and obligations; +• longer accounts receivable payment cycles; +• difficulties in managing and staffing international operations; +• potentially adverse tax consequences; and +• import and export license requirements and restrictions of the United +States and each other country in which we operate. +All of our international +sales from this point on are denominated in U.S. dollars. As a result, an +increase in the relative value of the dollar could make our products more +expensive and potentially less price competitive in international markets. We +do not engage in any transactions as a hedge against risks of loss due to +foreign currency fluctuations. +Any of the factors mentioned +above may adversely affect our future international sales and, consequently, +affect our business, financial condition and operating results. Furthermore, as +we increase our international sales, our total revenues may also be affected to +a greater extent by seasonal fluctuations resulting from lower sales that +typically occur during the summer months in Europe and other parts of the +world. +Some Of +Our Directors, Officers And Their Affiliates Can Control The Outcome Of Matters +That Require The Approval Of Our Stockholders, And Accordingly We Will Not Be +Able To Engage In Certain Transactions Without Their Approval. As of +March 31, 2005, our officers and directors owned approximately 16% of the +outstanding shares of our common stock (and approximately 25% of our common +stock when including options, warrants and other convertible securities held by +them which are currently exercisable or convertible or will become exercisable +or convertible within 60 days after March 31, 2005). As a result of +their stock ownership, our management will be able to significantly influence +the election of our directors and the outcome of corporate actions requiring stockholder +approval, such as mergers and acquisitions, regardless of how our other +stockholders may vote. This concentration of voting control may have a +significant effect in delaying, deferring or preventing a change in our +management or change in control and may adversely affect the voting or other +rights of other holders of common stock. +26 +Certain +Anti-Takeover Provisions May Affect The Price Of Our Common Stock And +Discourage A Third Party From Acquiring Us. +Certain provisions of our certificate of incorporation and our +stockholder rights plan could make it difficult for a third party to acquire +us, even though an acquisition might be beneficial to our stockholders. Such +provisions could limit the price that investors might be willing to pay in the +future for shares of our common stock. Under the terms of our certificate of +incorporation, our Board of Directors is authorized to issue, without +stockholder approval, up to 2,000,000 shares of preferred stock with voting, +conversion and other rights and preferences superior to those of our common +stock. Our future issuance of preferred stock could be used to discourage an +unsolicited acquisition proposal. In addition, in March 1998, we adopted a +stockholder rights plan and declared a dividend of preferred stock purchase +rights to our stockholders. We amended this plan in May 2004. In the event +a third party acquires more than 15% of the outstanding voting control of our +company or 15% of our outstanding common stock, the holders of these rights +will be able to purchase the junior participating preferred stock at a +substantial discount off of the then current market price. The exercise of +these rights and purchase of a significant amount of stock at below market +prices could cause substantial dilution to a particular acquirer and discourage +the acquirer from pursuing our company. The mere existence of a stockholder +rights plan often delays or makes a merger, tender offer or proxy contest more +difficult. +27 +ITEM +7A . QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT +MARKET RISK +Our exposure to interest +rate risk is limited to our lines of credit. Our lines of credit bear interest +based on the prevailing prime rate (5.50% at March 31, 2005). A 10% +increase in the interest rate on our line of credit (from 5.50% to 6.05%) would +not have a material impact on our financial position, operating results, or +cash flows. In addition, we believe that the carrying value of our outstanding +debt approximates fair value. +ITEM +8 . FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA +The financial statements and supplementary data +required by Regulation S-X are included in Part IV, Item 15 of this report. +ITEM +9 . CHANGES IN AND DISAGREEMENTS WITH +ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE +On a Form 8-K filed with the Securities and +Exchange Commission on October 12, 2004, as amended on November 12, +2004, we previously reported our decision to dismiss our former independent registered +public accounting firm, Ernst & Young LLP, effective October 5, +2004 and appoint McGladrey & Pullen, LLP as its new independent +registered public accounting firm, to perform auditing services beginning with +the second fiscal quarter ended September 30, 2004. +ITEM +9A . CONTROLS AND PROCEDURES +Evaluation +of Disclosure Controls and Procedures +Our management is +responsible for establishing and maintaining adequate internal control over +financial reporting, as such term is defined in Exchange Act Rule 13a-15(f). +Under the supervision and with the participation of our management, including +our principal executive officer and principal financial officer, we conducted +an evaluation of the effectiveness of our internal control over financial +reporting and concluded that our disclosure controls and procedures were ineffective +in timely alerting them to the material information involving transactions +occurring in the normal course of business relating to us required to be +included in the reports we file or submit under the Securities Exchange Act of +1934. The Company concluded that it has +a material weakness related to the administration and proper accounting for +certain types of its contracts and agreements. +A material +weakness is a control deficiency, or combination of control deficiencies, that +results in more than a remote likelihood that a material misstatement of the +annual or interim financial statements will not be prevented or detected. The material weakness described above +resulted in improper accounting treatment for the Iteris Subsidiary’s Deferred +Compensation Savings Plan. The material weakness resulted in restatement to our +2004 financial statements with respect to deferred compensation expense and +compensation saving plan liabilities. +Management’s +Response and Plan for Improvement +Management has responded to the +identification of the material weakness related to the consolidation and proper +accounting for the Plan in the 2004 financial statements by performing +additional accounting, financial analysis and managerial review of procedures +in order to ensure that the financial information contained in our Annual +Report on Form 10-K is reliable. +Additionally, we intend to amend the Plan to clarify its original intent +and prohibit diversification of any shares of Company common stock held in the +plan, which we believe will prevent any compensation charges or other impact on +our financial statements as a result of changes in the value of the Company’s +common stock held in the Plan. +Changes +in Internal Controls +Except as set forth above, during the most recent +completed fiscal quarter covered by this report, there has been no change in +our internal controls over financial reporting (as defined in Rules 13a-15(f) and +15d-15(f) under the Securities Exchange Act of 1934) that has materially +affected, or is reasonably likely to materially affect, our internal controls +over financial reporting. +ITEM 9B . OTHER INFORMATION +None. +28 +PART III +ITEM +10 . DIRECTORS AND EXECUTIVE OFFICERS OF THE +REGISTRANT +(a) Identification +of Directors. The information under the caption “Election of +Directors,” appearing in our proxy statement for the 2005 Annual Meeting of +Stockholders, is incorporated herein by reference. +(b) Identification +of Executive Officers. The information under the caption “Executive Officers,” +appearing in our proxy statement for the 2005 Annual Meeting of Stockholders, +is incorporated herein by reference. +(c) Compliance +with Section 16(a) of the Exchange Act. The information +under the caption Section 16(a) Beneficial Ownership Reporting +Compliance appearing in our proxy statement for the 2005 Annual Meeting of Stockholders +is incorporated herein by reference. +(d) Code of Ethics . The information under the caption “Corporate Governance,” +appearing in our proxy statement for the 2005 Annual Meeting of Stockholders, +is incorporated herein by reference. +ITEM +11 . EXECUTIVE COMPENSATION +The information under the caption “Executive +Compensation and Other Information,” appearing in our proxy statement for the +2005 Annual Meeting of Stockholders, is incorporated herein by reference. +ITEM +12 . SECURITY +OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER +MATTERS +The information under the captions “Equity +Compensation Plans” and “Principal Stockholders and Common Stock Ownership of +Certain Beneficial Owners and Management,” appearing in our proxy statement for +the 2005 Annual Meeting of Stockholders, is incorporated herein by reference. +ITEM +13 . CERTAIN RELATIONSHIPS AND +RELATED TRANSACTIONS +The information under the caption “Certain +Transactions,” appearing in our proxy statement for the 2005 Annual Meeting of +Stockholders, is incorporated herein by reference. +ITEM +14 . PRINCIPAL ACCOUNTING FEES +AND SERVICES +The information under the caption “Fees Paid to +Independent Auditors,” appearing in our proxy statement for the 2005 Annual +Meeting of Stockholders, is incorporated herein by reference. +PART IV +ITEM +15 . EXHIBITS AND FINANCIAL +STATEMENT SCHEDULES +(a) Documents +filed as part of this report: +1. Financial Statements. The following +financial statements of Iteris, Inc. are included in a separate section of +this Annual Report on Form 10-K commencing on the pages referenced +below: +Report of Independent Registered Public +Accounting Firm, McGladrey & Pullen, LLP +F-2 +Report of Independent Registered Public +Accounting Firm, Ernst & Young LLP +F-3 +Consolidated Balance Sheets as of March 31, +2005 and 2004 (Restated) +F-4 +Consolidated Statements of Operations for +the years ended March 31, 2005, 2004 (Restated) and 2003 +F-6 +Consolidated Statements of Stockholders’ +Equity (Deficit) for the years ended March 31, 2005, 2004 (Restated) and 2003 +F-7 +Consolidated Statements of Cash Flows for +the years ended March 31, 2005, 2004 (Restated) and 2003 +F-8 +Notes to Consolidated Financial Statements +F-10 +29 +2. Financial Statement Schedules . +Schedule II— Valuation and Qualifying +Accounts +All other +schedules have been omitted because they are not required or the required +information is included in our consolidated financial statements and notes +thereto. +3. Exhibits . +The following +exhibits are filed herewith or incorporated by reference to the location +indicated below: +Exhibit +Number +Description +Where Located +3.1 +Amended and Restated Certificate of +Incorporation of the registrant +Exhibit 3.1 to the registrant’s current +Report on Form 8-K as filed with the SEC on October 28, 2004 +3.2 +Bylaws of the registrant, as amended +Exhibit 4.2 to the registrant’s +Registration Statement on Form S-1 (Reg. No. 033-67932) as filed +with the SEC on July 6, 1993 +3.3 +Certificates of Amendment to Bylaws of the +registrant dated April 24, 1998 and August 10, 2001 +Exhibit 3.4 to the registrant’s Annual +Report on Form 10-K/A for the year ended March 31, 2003 as filed +with the SEC on July 29, 2003 +30 +Exhibit +Number +Description +Where Located +4.1 +Specimen of common stock certificate +Exhibit 4.1 to registrant’s Amendment No. 1 +to the Registration Statement on Form 8-A as filed with the SEC on December 8, +2004 +4.2 +Form of rights certificate for +preferred stock purchase rights +Exhibit A of Exhibit 4 to the +registrant’s Current Report on Form 8-K as filed with the SEC on May 1, +1998 +10.1* +Profit Sharing Plan and Trust +Exhibit 10.3 to the registrant’s +Amendment No. 2 to the Registration Statement on Form S-8 (Reg. No. 002-98656) +as filed with the SEC on May 5, 1988 +10.2* +Amendment Nos. 3 and 4 to the Profit +Sharing Plan and Trust +Exhibits 4.3.1 and 4.3.2, respectively, to +Amendment No. 3 to Iteris Holdings’ Registration Statement on Form S-3 +(Reg. No. 002-86220) as filed with the SEC on June 13, 1990 +10.3 * +Form of Executive Deferral Plan +between the registrant and certain employees of the registrant). +Exhibit 10.4 to the registrant’s +Annual Report on Form 10-K for the year ended March 31, 1988 +10.4 +Form of Indemnity Agreement entered +into by the registrant and certain of its officers and directors +Exhibit 19.4 to the registrant’s +Quarterly Report on Form 10-Q for the quarter ended September 30, +1988 +10.5 +Form of Indemnification Agreement +entered into by the registrant and certain of its officers and directors +Exhibit 10.5 to the registrant’s +Annual Report on Form 10-K for the year ended March 31, 2004 as +filed with the SEC on June 29, 2004 +10.6 * +1997 Stock Incentive Plan (as amended on May 3, +2002) +Exhibit 10.5 to the registrant’s +Annual Report on Form 10-K for the year ended March 31, 2003 as +filed with the SEC on June 30, 2003 +107 * +Form of Notice of Grant of Stock +Option +Exhibit 99.2 to the registrant’s +Registration Statement on Form S-8 (File No. 333-30396) as filed +with the SEC on February 14, 2000 +10.8 * +Form of Stock Option Agreement +Exhibit 99.3 to the registrant’s +Registration Statement on Form S-8 (File No. 333-30396) as filed +with the SEC on February 14, 2000 +10.9 * +Form of Addendum to Stock Option +Agreement—Involuntary Termination Following Corporate Transaction or Change +in Control +Exhibit 99.4 to the registrant’s +Registration Statement on Form S-8 (File No. 333-30396) as filed +with the SEC on February 14, 2000 +10.10 * +Form of Addendum to Stock Option +Agreement—Limited Stock Appreciation Rights +Exhibit 99.5 to the registrant’s +Registration Statement on Form S-8 (File No. 333-30396) as filed +with the SEC on February 14, 2000 +10.11 * +Form of Stock Issuance Agreement +Exhibit 99.6 to the registrant’s +Registration Statement on Form S-8 (File No. 333-30396) as filed +with the SEC on February 14, 2000 +31 +Exhibit +Number +Description +Where Located +10.12 * +Form of Addendum to Stock Issuance +Agreement—Involuntary Termination Following Corporate Transaction/Change in +Control +Exhibit 99.7 to the registrant’s +Registration Statement on Form S-8 (File No. 333-30396) as filed +with the SEC on February 14, 2000 +10.13 * +Form of Notice of Grant of Automatic +Stock Option—Initial Grant +Exhibit 99.8 to Exhibit 99.8 to +registrant’s Registration Statement on Form S-8 (File No. 333-30396) +as filed with the SEC on February 14, 2000 +10.14 * +Form of Notice of Grant of Automatic +Stock Option—Annual Grant +Exhibit 99.9 to the registrant’s +Registration Statement on Form S-8 (File No. 333-30396) as filed +with the SEC on February 14, 2000 +10.15 * +Form of Automatic Stock Option Agreement. +Exhibit 99.10 to the registrant’s +Registration Statement on Form S-8 (File No. 333-30396) as filed +with the SEC on February 19, 2000 +10.16 +Amended and Restated Rights Agreement, +dated as of May 10, 2004, by and between the registrant and U.S. Stock +Transfer Corporation, including the exhibits thereto. +Exhibit 99.1 to the registrant’s +Registration Statement on Form 8-A/A as filed with the SEC on June 18, +2004. +10.17 * +1994 Long-Term Equity Plan Exhibit 4.3 +to the registrant’s Registration Statement on Form S-8 (File No. 333-05735) +as filed with the SEC on June 11, 1996). +Exhibit 4.3 to the registrant’s +Registration Statement on Form S-8 (File No. 333-05735) as filed +with the SEC on June 11, 1996 +10.18 +Amended and Restated Agreement of Purchase +and Sale and Escrow Instructions, dated February 19, 2002, by and +between Iteris, Inc. and 1515 South Manchester, LLC +Exhibit 2.1 to the registrant’s +Current Report on Form 8-K as filed with the SEC on June 12, 2002 +10.19 +Sublease Agreement dated May 7, 2003 +by and between Iteris, Inc. and FEI-Zyfer, Inc. +Exhibit 10.19 to registrant’s Annual +Report on Form 10-K for the year ended March 31, 2003 as filed with +the SEC on June 30, 2003 +10.20 +Loan and Security Agreement dated February 22, +2002 by and between the registrant and Technology Lending Partners, L.L.C. +Exhibit 10.20 to the registrant’s +Annual Report on Form 10-K/A for the year ended March 31, 2003 as +filed with the SEC on July 29, 2003 +10.21 +Receivables Purchase Agreement dated October 18, +2002 by and between the registrant and Technology Lending Partners, L.L.C., +as amended by Amendment Number One dated November 27, 2002 and Amendment +Number Two dated January 7, 2003 +Exhibit 10.21 to the registrant’s Annual +Report on Form 10-K/A for the year ended March 31, 2003 as filed +with the SEC on July 29, 2003 +10.22 * +Change in Control Agreement dated May 8, +2003 by and between the registrant and Gregory A. Miner +Exhibit 10.1 to the registrant’s +Annual Report on Form 10-Q for the quarter ended June 30, 2003 as +filed with the SEC on August 14, 2003 +10.23 * +Change in Control Agreement dated May 20, +2003 by and between the registrant and Jack E. Johnson +Exhibit 10.23 to Amendment No. 1 +to the registrant’s Registration Statement on Form S-1 as filed with the +SEC on February 17, 2004 +32 +Exhibit +Number +Description +Where Located +10.24 * +1998 Stock Incentive Plan (as amended on February 7, +2000) +Filed Herewith +10.25 +Wells Fargo Bank Credit Agreement dated May 27, +2004 +Filed Herewith +10.26 +Wells Fargo Bank Assumption and Amendment Agreement +dated October 20, 2004 +Filed Herewith +10.27 +Wells Fargo Bank Revolving Line of Credit Note +dated May 27, 2004 +Filed Herewith +10.28 +Wells Fargo Bank Term Note dated May 27, +2004 +Filed Herewith +10.29 +Wells Fargo Bank Continuing Security Agreement +Rights to Payment and Inventory dated May 27, 2004 +Filed Herewith +10.30 +Wells Fargo Bank Security Agreement Equipment +dated May 27, 2004 +Filed Herewith +10.31* +Iteris, Inc. Deferred Compensation Savings +Plan and Grantor Trust +Filed Herewith +10.32* +1997 Stock Incentive Plan (as amended on +May 3, 2003, as further amended on December 15, 2004) +Filed Herewith +21 +Subsidiaries of the registrant +Filed Herewith +23.1 +Consent of Independent Registered Public +Accounting Firm, McGladrey & Pullen, LLP +Filed Herewith +23.2 +Consent of Independent Registered Public +Accounting Firm, Ernst & Young, LLP +Filed Herewith +31.1 +Certification of the Chief Executive +Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 +Filed Herewith +31.2 +Certification of the Chief Financial +Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 +Filed Herewith +32.1 +Certification of the Chief Executive +Officer Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 +of the Sarbanes-Oxley Act of 2002 +Filed Herewith +32.2 +Certification of the Chief Financial +Officer Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 +of the Sarbanes-Oxley Act of 2002 +Filed Herewith +* Indicates a management contract or +compensatory plan or arrangement +33 +SIGNATURES +Pursuant to the requirements of Section 13 or 15(d) of +the Securities Exchange Act of 1934, the registrant has duly caused this Report +to be signed on its behalf by the undersigned, thereunto duly authorized. +ITERIS, +INC. +(Registrant) +By +/s/ JACK +JOHNSON +Jack Johnson +President and Chief +Executive Officer +POWER OF ATTORNEY +We, the undersigned officers and directors of Iteris, Inc., +do hereby constitute and appoint James S. Miele and Jack Johnson, and each of +them, our true and lawful attorneys-in-fact and agents, each with full power of +substitution and resubstitution, for him and in his name, place and stead, in +any and all capacities, to sign any and all amendments to this report, and to +file the same, with exhibits thereto, and other documents in connection +therewith, with the Securities and Exchange Commission, granting unto said +attorneys-in-fact and agents, and each of them, full power and authority to do +and perform each and every act and thing requisite or necessary to be done in +and about the premises, as fully to all intents and purposes as he might or +could do in person, hereby, ratifying and confirming all that each of said +attorneys-in-fact and agents, or his substitute or substitutes, may lawfully do +or cause to be done by virtue hereof. +Pursuant to the requirements of the Securities +Exchange Act of 1934, this report has been signed below by the following +persons on behalf of the registrant in the capacities and on the dates +indicated: +Signature +Title +Date +/s/ JACK JOHNSON +Director, President and Chief Executive Officer +July 12, 2005 +Jack Johnson +(principal executive officer) +/s/ JAMES S. MIELE +Chief Financial Officer +July 12, 2005 +James S. Miele +(principal financial and accounting officer) +/s/ GREGORY A. MINER +Chairman of the Board +July 12, 2005 +Gregory A. Miner +/s/ KEVIN C. DALY +Director +July 12, 2005 +Kevin C. Daly, Ph.D. +34 +/s/ GARY HERNANDEZ +Director +July 12, 2005 +Gary Hernandez +/s/ HARTMUT MARWITZ +Director +July 12, 2005 +Hartmut Marwitz, Ph.D. +/s/ JOHN +SEAZHOLTZ +Director +July 12, 2005 +John +Seazholtz +/s/ JOEL SLUTZKY +Director +July 12, 2005 +Joel Slutzky +/s/ THOMAS +L. THOMAS +Director +July 12, 2005 +Thomas L. +Thomas +/s/ PAUL E. +WRIGHT +Director +July 12, 2005 +Paul E. +Wright +35 +Iteris, Inc. +Index to Consolidated Financial Statements +Report of Independent Registered Public Accounting Firm, McGladrey & +Pullen, LLP +F-2 +Report of Independent Registered Public Accounting Firm, Ernst & +Young LLP +F-3 +Consolidated Balance Sheets as of March 31, 2005 and 2004 (Restated) +F-4 +Consolidated Statements of Operations for the years ended +March 31, 2005, 2004 (Restated) and 2003 +F-6 +Consolidated Statements of Stockholders’ +Equity (Deficit) for the years ended +March 31, 2005, 2004 (Restated) and 2003 +F-7 +Consolidated Statements of Cash Flows for +the years ended +March 31, 2005, 2004 (Restated) and 2003 +F-8 +Notes to Consolidated Financial Statements +F-10 +F-1 +Report +of Independent Registered Public Accounting Firm +To the Board of Directors +Iteris, Inc. +Anaheim, California +We have audited the consolidated balance sheet of Iteris, Inc. as +of March 31, 2005, and the related consolidated statements of operations, +stockholders’ equity and cash flows for the year then ended. Our audit also included the 2005 financial +statement schedule listed at Item 15. These financial statements and the schedule are +the responsibility of the Company’s management. +Our responsibility is to express an opinion on these financial +statements and schedule based on our audit. +We conducted our audit in accordance with the standards of the Public +Company Accounting Oversight Board (United States). Those standards require that we plan and +perform the audit to obtain reasonable assurance about whether the financial +statements are free of material misstatement. +An audit includes examining, on a test basis, evidence supporting the +amounts and disclosures in the financial statements. An audit also includes assessing the +accounting principles used and significant estimates made by management, as +well as evaluating the overall financial statement presentation. We believe that our audit provided a +reasonable basis for our opinion. +In our opinion, the consolidated financial statements referred to above +present fairly, in all material respects, the financial position of Iteris, Inc. +as of March 31, 2005, and the results of its operations and its cash flows +for the year then ended, in conformity with U.S. generally accepted accounting +principles. Also, in our opinion, such +financial statement schedule, when considered in relation to the basic +consolidated financial statements taken as a whole, presents fairly in all +material respects the information set forth therein. +/s/ McGladrey & Pullen, LLP +Irvine, California +June 1, 2005, except for the four paragraphs under the caption +“Deferred Compensation Plan” in Note 7 as to which the date is July 12, 2005 +F-2 +Report +of Independent Registered Public Accounting Firm +Stockholders and Board of Directors +Iteris, Inc. +We have audited the accompanying consolidated +balance sheet of Iteris, Inc. as of March 31, 2004, and the related +consolidated statements of operations, stockholders’ equity (deficit), and cash +flows for each of the two years in the period ended March 31, 2004. Our +audits also included the financial statement schedule listed in the index +at Item 15(a). These financial +statements and schedule are the responsibility of the Company’s +management. Our responsibility is to express +an opinion on these financial statements and schedule based on our audits. +We conducted our audits in accordance with +the standards of the Public Company Accounting Oversight Board (United States). +Those standards require that we plan and perform the audit to obtain reasonable +assurance about whether the financial statements are free of material +misstatement. We were not engaged to perform an audit of the Company’s internal +control over financial reporting. Our audits included consideration of internal +control over financial reporting as a basis for designing audit procedures that +are appropriate in the circumstances, but not for the purpose of expressing an +opinion on the effectiveness of the Company’s internal control over financial +reporting. Accordingly, we express no such opinion. An audit also includes +examining, on a test basis, evidence supporting the amounts and disclosures in +the financial statements, assessing the accounting principles used and +significant estimates made by management, and evaluating the overall financial +statement presentation. We believe that +our audits provide a reasonable basis for our opinion. +As discussed in Note 1, the accompanying +financial statements as of and for the year ended March 31, 2004 have been +restated to reflect the consolidation of the Company’s Subsidiary’s deferred +compensation plan. +In our opinion, the financial statements +referred to above present fairly, in all material respects, the consolidated +financial position of Iteris, Inc. at March 31, 2004, and the +consolidated results of its operations and its cash flows for each of the two +years in the period ended March 31, 2004, in conformity with accounting +principles generally accepted in the United States. Also, in our opinion, the related financial +statement schedule, when considered in relation to the basic financial +statements taken as a whole, presents fairly in all material respects the +information set-forth therein. +/s/ Ernst & Young LLP +Orange County, California +June 8, 2004, +except for Note 1 - Restatement of Consolidated Financial Statements for the Year +Ended March 31, 2004, and Note 7 - Deferred Compensation Plan, as to which +the date is July 13, 2005. +F-3 +Iteris, Inc. +Consolidated Balance +Sheets +(In thousands) +March 31, +2005 +2004 +(Restated) +Assets +Current assets: +Cash and cash equivalents +$ +46 +$ +2,612 +Trade accounts receivable, net of allowance +for doubtful accounts of $239 and $204 at March 31, 2005, and 2004, +respectively. +8,866 +8,255 +Costs and estimated earnings in excess of +billings on uncompleted contracts +2,086 +2,653 +Notes receivable +— +125 +Deferred income taxes +101 +821 +Inventories, net of reserve for inventory +obsolescence of $514 and $399 at March 31, 2005, and 2004 respectively +4,344 +3,598 +Prepaid expenses and other current assets +384 +323 +Total current assets +15,827 +18,387 +Property and equipment: +Leasehold improvements +105 +97 +Equipment +5,281 +7,724 +Accumulated depreciation +(4,283 +) +(6,179 +) +1,103 +1,642 +Deferred income taxes +559 +— +Intangible assets, net of accumulated +amortization of $114 at March 31, 2005 +698 +— +Goodwill +27,774 +9,807 +Other assets +695 +229 +Total assets +$ +46,656 +$ +30,065 +See accompanying notes. +F-4 +Iteris, Inc. +Consolidated Balance Sheets +(In thousands, except share and per share +amounts) +March 31, +2005 +2004 +(Restated) +Liabilities and stockholders’ equity +(deficit) +Current liabilities: +Trade accounts payable +$ +3,936 +$ +3,560 +Accrued payroll and related expenses +3,007 +3,218 +Accrued liabilities +790 +1,064 +Revolving line of credit +945 +— +Billings in excess of costs and estimated +earnings on uncompleted contracts +944 +549 +Income taxes payable +— +485 +Revolving line of credit with related party +— +100 +Current portion of long-term debt +4,008 +42 +Total current liabilities +13,630 +9,018 +Non-current payroll related liability +330 +— +Deferred compensation plan liability +772 +1,256 +Deferred gain on sale of building +733 +1,774 +Long-term debt and capital lease obligation +1,319 +891 +Convertible debentures, net +8,996 +— +Minority interest +— +18,202 +Commitments and contingencies +Redeemable common stock +Issued and outstanding shares – 1,219,445 +and none at March 31, 2005, and 2004, respectively +3,414 +— +Stockholders’ equity (deficit): +Preferred stock: +Authorized shares – 2,000,000 +Issued and outstanding – none +— +— +Common stock, $.10 par value: +Authorized shares – 50,000,000 at +March 31, 2005, and 50,000,000 of Class A and 2,600,000 of +Class B at March 31, 2004 +Issued and outstanding shares – 27,089,661 +at March 31, 2005; 20,476,568 of Class A and 928,317 of +Class B at March 31, 2004 +2,709 +2,141 +Additional paid-in capital +126,534 +95,937 +Deferred stock-based compensation +(925 +) +— +Common stock held in trust – 310,510 shares +at March 31, 2005 and none at March 31, 2004 +(374 +) +— +Treasury stock – 93 shares at +March 31, 2005, and 2004 +(1 +) +(1 +) +Notes receivable from employees +(45 +) +(45 +) +Accumulated deficit +(110,436 +) +(99,108 +) +Total stockholders’ equity (deficit) +17,462 +(1,076 +) +Total liabilities and stockholders’ equity +(deficit) +$ +46,656 +$ +30,065 +See accompanying notes. +F-5 +Iteris, Inc. +Consolidated Statements of Operations +(In thousands, except per share amounts) +Year Ended March 31, +2005 +2004 +2003 +(Restated) +Net sales and contract revenues: +Net sales +$ +29,062 +$ +23,470 +$ +19,112 +Contract revenues +17,335 +21,813 +22,283 +Total net sales and contract revenues +46,397 +45,283 +41,395 +Costs and expenses: +Cost of net sales +15,645 +12,758 +9,366 +Cost of contract revenues +11,398 +14,712 +15,110 +Selling, general and administrative +expenses +13,964 +12,844 +14,105 +Research and development expenses +4,193 +3,923 +3,908 +Stock-based compensation +11,777 +— +— +Deferred compensation expense (benefit) +(484 +) +868 +— +Disposal of fixed assets +422 +— +— +Acquired in-process research and +development +140 +— +— +Amortization of intangible assets +114 +— +— +Total costs and expenses +57,169 +45,105 +42,489 +Income (loss) from operations +(10,772 +) +178 +(1,094 +) +Non-operating income (expense): +Other income, net +1,054 +1,003 +417 +Interest expense, net +(1,178 +) +(123 +) +(761 +) +Income (loss) from continuing operations +before income taxes and minority interest +(10,896 +) +1,058 +(1,438 +) +Income tax benefit (provision) +94 +(100 +) +— +Minority interest in earnings of subsidiary +(526 +) +(2,813 +) +(3,818 +) +Loss from continuing operations +(11,328 +) +(1,855 +) +(5,256 +) +Income (loss) from discontinued operations, +net of taxes of $0 +— +1,215 +(7,892 +) +Net loss +$ +(11,328 +) +$ +(640 +) +$ +(13,148 +) +Basic and diluted earnings (loss) per +share: +Continuing operations +$ +(0.45 +) +$ +(0.09 +) +$ +(0.37 +) +Discontinued operations +— +0.06 +(0.55 +) +Basic earnings (loss) per share +$ +(0.45 +) +$ +(0.03 +) +$ +(0.92 +) +Shares used in computing basic earnings +(loss) per share +25,284 +19,454 +14,276 +Shares used in computing diluted earnings +(loss) per share +25,284 +19,454 +14,276 +See accompanying notes . +F-6 +Iteris, Inc. +Consolidated Statements of and Stockholders’ Equity (Deficit) +(In thousands) +Common +Stock +Shares outstanding +Notes +Accumulated +Class A +common +stock +Class B +common +stock +Amount +Additional +paid-in capital +Treasury +stock +receivable +from +employees +other +comprehensive +income +Deferred +stock-based +compensation +Common +Stock +held in trust +Accumulated +deficit +Total +Stockholder’s +equity (deficit) +Comprehensive +income (loss) +Balance at +March 31, 2002 +11,491 +1,036 +$ +1,252 +$ +88,082 +$ +(1 +) +$ +(51 +) +$ +241 +$ +— +$ +— +$ +(85,320 +) +$ +4,203 +Issuances of +Class A common stock +2,590 +— +260 +3,685 +— +— +— +— +— +— +3,945 +— +Foreign currency +translation adjustments +— +— +— +— +— +— +(340 +) +— +— +— +(340 +) +$ +(340 +) +Net loss +— +— +— +— +— +— +— +— +— +(13,148 +) +(13,148 +) +(13,148 +) +Balance at +March 31, 2003 +14,081 +1,036 +1,512 +91,767 +(1 +) +(51 +) +(99 +) +— +— +(98,468 +) +(5,340 +) +$ +(13,488 +) +Issuance of Class A +common stock and warrants +6,288 +— +629 +4,170 +— +— +— +— +— +— +4,799 +— +Conversion of +Class B common stock +108 +(108 +) +— +— +— +— +— +— +— +— +— +— +Payments on notes +receivable +— +— +— +— +— +6 +— +— +— +— +6 +— +Foreign currency +translation adjustments +— +— +— +— +— +— +99 +— +— +— +99 +$ +99 +Net loss (Restated) +— +— +— +— +— +— +— +— +— +(640 +) +(640 +) +(640 +) +Balance at +March 31, 2004 (Restated) +20,477 +928 +2,141 +95,937 +(1 +) +(45 +) +— +— +— +(99,108 +) +(1,076 +) +$ +(541 +) +Warrant exercises +402 +— +40 +344 +— +— +— +— +— +— +384 +— +Stock option exercises +25 +— +2 +49 +— +— +— +— +— +— +51 +— +Issuance of warrants in +connection with convertible debentures +— +— +— +1,101 +— +— +— +— +— +— +1,101 +— +Conversion of +Class B common stock +1,020 +(928 +) +9 +(9 +) +— +— +— +— +— +— +— +— +Convertible debenture +conversion to common stock +69 +— +7 +205 +— +— +— +— +— +— +212 +— +Issuance of common stock +in connection with merger of Iteris Subsidiary +4,787 +— +479 +14,722 +— +— +— +— +— +— +15,201 +— +Issuance of warrants +— +— +— +26 +— +— +— +— +— +— +26 +— +Assumption of Iteris +subsidiary stock options and warrants +— +— +— +13,816 +— +— +— +(1,433 +) +— +— +12,383 +— +Common stock held in +trust +310 +— +31 +343 +— +— +— +— +(374 +) +— +— +— +Amortization of deferred +stock-based compensation +— +— +— +— +— +— +508 +— +— +508 +— +Net loss +— +— +— +— +— +— +— +— +— +(11,328 +) +(11,328 +) +$ +(11,328 +) +Balance at +March 31, 2005 +27,090 +— +$ +2,709 +$ +126,534 +$ +(1 +) +$ +(45 +) +$ +— +$ +(925 +) +$ +(374 +) +$ +(110,436 +) +$ +17,462 +$ +(11,328 +) +See +accompanying notes. +F-7 +Iteris, Inc. +Consolidated Statements of Cash Flows +(In thousands) +Year Ended March 31, +2005 +2004 +2003 +(Restated) +Operating activities +Net loss from continuing operations +$ +(11,328 +) +$ +(1,855 +) +$ +(5,256 +) +Net income (loss) from discontinued +operations +— +1,215 +(7,892 +) +Adjustments to reconcile net income (loss) +to net cash provided by (used in) operating activities: +Depreciation and amortization +787 +857 +816 +Write-off of acquired in-process research +and development +140 +— +— +Minority interest in earnings of subsidiary +526 +2,813 +3,818 +Amortization of warrants +— +— +246 +Amortization of deferred gain on +sale-leaseback +(609 +) +(855 +) +(1,665 +) +Amortization of intangible assets +114 +— +— +Amortization of debt discounts +184 +— +— +Amortization of deferred financing costs +121 +— +— +Fair value of warrants issued for services +26 +— +— +Stock-based compensation +11,777 +— +— +Loss on sale of Iteris subsidiary common +stock +— +— +310 +Loss on disposal of assets +422 +— +2 +Change in deferred tax assets +(200 +) +— +— +Changes in operating assets and +liabilities: +Accounts receivable +(611 +) +(88 +) +(518 +) +Net costs and estimated earnings in excess +of billings +961 +(10 +) +187 +Inventories +(746 +) +305 +(741 +) +Prepaid expenses and other assets +41 +1,454 +(1,388 +) +Deferred gain on sale of building +— +(3,396 +) +7,690 +Accounts payable and accrued expenses +(521 +) +(1,625 +) +3,790 +Deferred revenue +(226 +) +226 +— +Net assets (liabilities) of discontinued +operations +— +241 +(4,188 +) +Net cash provided by (used in) operating +activities +858 +(718 +) +(4,789 +) +Investing activities +Purchases of property and equipment net +(670 +) +(558 +) +(518 +) +Proceeds from sale of building +— +— +18,951 +Notes receivable +125 +— +— +Acquistion costs +(80 +) +— +— +Other +— +99 +(340 +) +Net cash provided by (used in) investing +activities +(625 +) +(459 +) +18,093 +Financing activities +Proceeds (payments) from borrowings on +lines of credit, net +845 +(1,385 +) +(767 +) +Proceeds from long-term debt +5,000 +918 +— +Payments on long-term debt and capital +lease obligations +(1,038 +) +— +(16,145 +) +Proceeds from issuance of common stock and +related warrants +— +3,813 +2,766 +Proceeds from issuance of convertible +debentures +9,436 +— +— +Purchase of Iteris subsidiary Series A +preferred stock +(17,543 +) +— +— +Proceeds from stock option and warrant +exercises +501 +— +— +Proceeds from sale of common and preferred +stock +— +— +871 +Payments on notes receivable from employees +— +6 +— +Net cash provided by (used in) financing +activities +(2,799 +) +3,352 +(13,275 +) +Increase (decrease) in cash +(2,566 +) +2,175 +29 +Cash and cash equivalents at beginning of +year +2,612 +437 +408 +Cash and cash equivalents at end of year +$ +46 +$ +2,612 +$ +437 +F-8 +Supplemental cash flow information: +Cash paid during the period: +Interest +$ +747 +$ +123 +$ +507 +Income taxes +624 +320 +— +Supplemental schedule of non-cash +investing and financing activities: +Proceeds from sale-leaseback held in escrow +$ +— +$ +— +$ +2,516 +Issuance of Common Stock to settle +liabilities +— +416 +— +Increase in promissory note to landlord to +settle lease obligation +432 +— +— +Acquistion of minority interest of the +Iteris subsidiary +Intangible assets +812 +— +— +Deferred tax liabilities +360 +— +— +Goodwill +17,887 +— +— +Reduction of minority interest +1,253 +— +— +Issuance of warrants in connection with +Debenture and Warrant Purchase Agreement +1,101 +— +— +Conversion of convertible debt to equity +250 +— +— +Contribution of common stock to 401(k) plan +to settle employer match +— +578 +141 +See +accompanying notes. +F-9 +Iteris, Inc. +Notes to Consolidated +Financial Statements +March 31, 2005 +1. Description of Business and +Summary of Significant Accounting Policies +Description of Business +Iteris, Inc., +formerly known as Iteris Holdings, Inc. (the “Company”), is a leading +provider of outdoor machine vision systems and sensors that optimize the flow +of traffic and enhance driver safety. Using proprietary software and +Intelligent Transportation Systems (“ITS”) industry expertise, the Company +provides video sensor systems and transportation management and traveler information +systems to the ITS industry. The ITS industry is comprised of companies +applying a variety of technologies to enable the safe and efficient movement of +people and goods. The Company uses its outdoor image recognition software +expertise to develop proprietary algorithms for video sensor systems that +improve vehicle safety and the flow of traffic. Using its knowledge of the ITS +industry, the Company designs and implements transportation management systems +that help public agencies reduce traffic congestion and provide greater access +to traveler information. On October 22, 2004, the Company completed the +merger with its majority-owned subsidiary, Iteris, Inc. (the “Iteris +Subsidiary”), and officially changed the Company’s corporate name from Iteris Holdings, Inc. +to Iteris, Inc. (Note 3). The +Company was originally incorporated in Delaware in 1987 as Odetics, Inc. +and in September 2003 changed its name to Iteris Holdings, Inc. to +reflect its focus on the ITS industry and its capital structure at that time. +The Company has incurred losses from continuing operations of $11.3 +million, $1.9 million and $5.3 million during the fiscal years ended March 31, +2005, 2004 and 2003, respectively. +Operating activities generated cash of $858,000 in the fiscal year ended +March 31, 2005; and utilized cash of $718,000 and $4.8 million in the +fiscal years ended March 31, 2004, and 2003, respectively. As of March 31, 2005, the Company had an +accumulated deficit of $110.4 million, cash and cash equivalents on hand of $46,000, +and borrowings of $945,000 against its $5.0 million line of credit. As discussed further in Note 5, at March 31, +2005, the Company was in violation of certain covenants associated with its +line of credit and term debt facility and is currently in the process of +restructuring this facility. The Company +believes that cash generated from operations and the restructuring of its +credit facility will provide sufficient funding to meet working capital +requirements, capital expenditures, debt and other obligations through the next +12 months. The Company may face +significant risks associated with the successful execution of its business +strategy and may need to raise additional capital in order to fund more rapid +expansion, to expand its marketing activities, to develop new or enhance +existing services or products, and to respond to competitive pressures or to +acquire complementary services, businesses, or technologies. If the Company is not successful in +generating sufficient cash flow from operations or is unable to restructure its +credit facility, it may need to raise additional capital through public or +private financing, strategic relationships or other arrangements. However, +there are no assurances that any additional capital will be available at a cost +or in an amount sufficient to execute the Company’s business strategy. +Restatement of +Consolidated Financial Statements for the Year Ended March 31, 2004 +The Company has restated its consolidated financial statements for the +year ended March 31, 2004 as previously reported on Form 10-K. The restatement +was necessary in order to reflect the consolidation of the Iteris Deferred +Compensation Savings Plan (the “Deferred Compensation Plan” – Note 7), the +principal effects of which were to increase operating expenses by a non-cash +charge of $868,000 for the year ended March 31, 2004 and decrease minority +interest in the earnings of the Iteris Subsidiary by $221,000 for the year +ended March 31, 2004. This +restatement had no impact on the Company’s consolidated cash flows. +The effect of the restatement had the following impact on the Company’s +net income (loss) and net income (loss) per share for the year ended March 31, +2004 (in thousands, except share data): +As previously +reported +Restatement +As restated +Loss from continuing operations +$ +(1,208 +) +$ +(647 +) +$ +(1,855 +) +Loss from discontinued operations +1,215 +— +1,215 +Net income (loss) +$ +7 +$ +(647 +) +$ +(640 +) +Basic and diluted loss per share: +Loss from continuing operations +(0.06 +) +(0.03 +) +(0.09 +) +Loss from discontinued operations +0.06 +— +0.06 +Net income (loss) +$ +0.00 +$ +(0.03 +) +$ +(0.03 +) +Basis of Presentation +The accompanying consolidated financial statements include the accounts +of the Company and its subsidiaries. All significant intercompany accounts and +transactions have been eliminated in consolidation. The consolidated financial +statements have been restated to reflect the discontinuation of all operations +except those of the Company and its remaining subsidiary, Meyer Mohaddes +Associates, Inc.. The Company also +consolidated the Deferred Compensation Plan (Note 7). +As discussed further in Note 11, the Company previously discontinued +the operations of its Broadcast, Inc. subsidiary (“Broadcast”), its Zyfer, Inc. +subsidiary (“Zyfer”), and its MAXxess Systems, Inc. subsidiary (“MAXxess”), +so that the Company could focus on its ITS business. The results of operations for these +businesses are presented as discontinued operations in the accompanying consolidated +financial statements. +Use of Estimates +The +preparation of consolidated financial statements in conformity with accounting +principles generally accepted in the U.S. requires management to make certain +estimates and assumptions that affect the reported amounts of assets and +liabilities and disclosures of contingent assets and liabilities at the date of +the financial statements, and reported amounts of revenues and expenses during +the reporting period. Actual results +could differ from those estimates. +Significant estimates made in the preparation of the consolidated +financial statements include the allowance for doubtful accounts, deferred tax +assets, inventory and warranty reserves, costs to complete long-term contracts, +overhead rates used in cost-plus contracts, contract reserves and estimates of +future cash flows used to assess the recoverability of long-lived assets, the +valuation of equity instruments and the realization of goodwill. +F-10 +Reclassifications +Certain +reclassifications have been made to the prior years financial statements to +conform with the current year presentation. +Revenue Recognition +Product revenues and related costs of sales are recognized upon the +transfer of title, which generally occurs upon shipment or, if required, upon +acceptance by the customer, provided that the Company believes collectibility +of the net sales amount is probable. +Accordingly, at the date revenue is recognized, the significant +uncertainties concerning the sale have been resolved. +Contract revenues are derived primarily from long-term contracts with +governmental agencies. Contract revenues +include costs incurred plus a portion of estimated fees or profits determined +on the percentage of completion method of accounting based on the relationship +of costs incurred to total estimated costs. +Any anticipated losses on contracts are charged to earnings when +identified. Changes in job performance +and estimated profitability, including those arising from contract penalty +provisions and final contract settlements, may result in revisions to costs and +revenues and are recognized in the period in which the revisions are +determined. Profit incentives are +included in revenue when their realization is reasonably assured. +In addition to product and contract revenue, the Company derives +revenue from technology access fees, the provision of specific non-recurring +contract engineering services and royalties. +Technology access fees and contract engineering revenues are recognized +on the percentage of completion method of accounting based on the relationship +of hours incurred to total estimated hours. +Royalty revenue is recorded in the period in which the royalty is earned, +based on unit sales of the Company’s products. +Technology access fee revenues, contract engineering revenues and +royalty revenues are included in net sales in the accompanying consolidated +statements of operations. +Revenues from follow-on service and support, for which the Company +charges separately, are recorded in the period in which the services are +performed. +Concentration of Credit Risk +Accounts receivable are derived from revenues earned from customers +located throughout North America and Europe. +The Company generally does not require collateral or other security from +customers. Collectibility of receivable balances is estimated through review of +invoices outstanding greater than a certain period of time and ongoing credit +evaluations of customers’ financial condition. +Reserves are maintained for potential credit losses, and such losses +have historically been within management’s expectations. +At March 31, 2005, and 2004, accounts receivable from governmental +agencies and prime government contractors were approximately $3.5 million. No customer or government agency had a +receivable balance greater than 10% of our total net sales or contract revenues +at March 31, 2005 and 2004. +Fair Values of Financial Instruments +The fair values of cash and cash equivalents, +receivables, inventories, accounts payable and accrued expenses approximate +carrying value because of the short period of time to maturity. The fair values +of line of credit agreements and long-term debt approximate carrying value +because the related rates of interest approximate current market rates. The fair value of convertible debentures +approximates carrying value because the effective interest rate, taking into +account recorded debt discounts, approximates current market rates. The fair value of redeemable common stock approximates +carrying value since these shares are not tradable in any public equity +markets. If the redeemable shares become +registered, the fair value of such shares may differ from the carrying value +based on the value of the shares as determined in the public equity +markets. +Cash and Cash Equivalents +Cash and cash equivalents consist of cash and short-term investments +with initial maturities of ninety days or less. +Inventories +Inventories are stated at the lower of cost +or market. Cost is determined using the first-in, first-out method. +F-11 +Property and Equipment +Property and equipment are recorded at cost +and are depreciated principally by the double declining balance method over the +estimated useful life ranging from three to eight years. Leasehold improvements are depreciated over +the term of the related lease. +Goodwill and Long-Lived Assets +In accordance with Statement of Financial +Accounting Standards (“SFAS”) No. 142, Goodwill and Intangible +Assets (“SFAS 142”), goodwill is tested for impairment at the +reporting unit level (operating segment or one level below an operating +segment) on an annual basis in the Company’s fourth fiscal quarter or more +frequently if indicators of impairment exist. The performance of the test +involves a two-step process. The first step of the impairment test involves +comparing the fair value of the Company’s reporting units with the reporting +unit’s carrying amount, including goodwill. +The fair value of reporting units is generally determined using the +income approach. If the carrying amount +of a reporting unit exceeds the reporting unit’s fair value, the second step of +the goodwill impairment test is performed to determine the amount of any +impairment loss. The second step of the goodwill impairment test involves +comparing the implied fair value of the reporting unit’s goodwill with the +carrying amount of that goodwill. +The Company evaluates long-lived assets for +impairment in accordance with SFAS No. 144, “Accounting +for the Impairment or Disposal of Long-Lived Assets,” which requires +impairment evaluation on long-lived assets used in operations when indicators +of impairment are present. Reviews are performed to determine whether the +carrying value of assets is impaired, based on comparison to undiscounted +expected future cash flows. If this comparison indicates that there is +impairment, the impaired asset is written down to fair value, which is +typically calculated using discounted expected future cash flows using a +discount rate based upon the Company’s weighted average cost of capital +adjusted for risks associated with the related operations. Impairment is based +on the excess of the carrying amount over the fair value of those assets. +Income Taxes +The Company utilizes the liability method of accounting for income +taxes as set forth in SFAS No. 109, Accounting for Income +Taxes (“SFAS 109”). Under the liability method, deferred taxes are +determined based on the temporary differences between the financial statement +and tax bases of assets and liabilities using enacted tax rates. A valuation +allowance is recorded when it is more likely than not that some of the deferred +tax assets will not be realized. See Note 6. +Stock-Based Compensation +The Company accounts for stock-based employee compensation arrangements +in accordance with Accounting Principles Board Opinion No. 25, Accounting for Stock-Issued to Employees (“APB +25”) and related interpretations, and complies with the disclosure-only +provisions of SFAS No. 123, Accounting +for Stock-Based Compensation (“SFAS 123”) and SFAS 148, Accounting for Stock-Based Compensation – Transition and Disclosure +(“SFAS 148”). Under APB 25, compensation +cost is recognized based on the difference, if any, on the date of the grant +between the fair value of the Company’s stock and the amount the employee must +pay to acquire the stock. +In accordance with the requirements of the disclosure-only alternative +of SFAS 123 and SFAS 148, set forth below are the assumptions used and the pro +forma statement of operations data of the Company giving effect to valuing +stock-based awards to employees using the Black-Scholes option pricing model +instead of the guidelines provided by APB 25. +Among other factors, the Black-Scholes model considers the expected life +of the option and the expected volatility of the Company’s stock price in +arriving at an option valuation. +The per share fair value of stock options granted in connection with +stock option plans has been estimated with the following weighted average +assumptions: +Years Ended March 31, +2005 +2004 +2003 +Dividend rate +0.0 +0.0 +0.0 +Expected life – years +7.0 +7.0 +7.0 +Risk-free interest rate +4.5 +2.0 +2.0 +Volatility of common stock +0.5 +0.4 +0.4 +F-12 +For purposes of pro forma disclosures, the estimated fair value of the +options is amortized to expense over the options’ vesting period. The Company’s +pro forma information follows: +Year Ended March 31, +2005 +2004 +2003 +(In thousands, except per share amounts) +(Restated) +Net loss — as reported +$ +(11,328 +) +$ +(640 +) +$ +(13,148 +) +Add: +Stock-based compensation expense included in net loss – as reported +11,777 +— +— +Deduct: +Stock-based compensation expense determined under fair value method +(12,806 +) +(385 +) +(637 +) +Net loss — pro forma +$ +(12,357 +) +$ +(1,025 +) +$ +(13,785 +) +Basic and diluted loss per share — as +reported +$ +(0.45 +) +$ +(0.03 +) +$ +(0.92 +) +Basic and diluted loss per share — pro +forma +$ +(0.49 +) +$ +(0.05 +) +$ +(0.97 +) +Research and Development Expenditures +Research and +development expenditures are charged to expense in the period incurred. +Shipping and Handling Costs +Shipping and handling costs are included as cost of sales in the period +during which the products ship. +Advertising Expenses +Advertising costs are expensed in the period incurred and totaled +$112,000, $127,000 and $77,000 in the years ended March 31, 2005, 2004 and +2003, respectively. +Warranty +Unless otherwise stated, +the Company provides a one to three year warranty from the original invoice +date on all products, materials, and workmanship. Products sold to certain +original equipment manufacturer (“OEM”) customers sometimes carry longer +warranties. Defective products will be either repaired or replaced, generally +at the Company’s option, upon meeting certain criteria. The Company accrues a +provision for the estimated costs that may be incurred for product warranties +relating to a product as a component of cost of sales at the time revenue for +that product is recognized. The accrued +warranty provision is included within accrued expenses on the accompanying +condensed consolidated balance sheets. +Repair and Maintenance Costs +The Company incurs repair and maintenance costs in the normal course of +business. Should the activity result in a permanent improvement to one of the +Company’s leased facilities, the cost is capitalized as a leasehold improvement +and amortized over its useful life or the remainder of the lease period, +whichever is shorter. Non-permanent +repair and maintenance costs are charged to expense as incurred. +Comprehensive Income +The only component of accumulated other +comprehensive income is the cumulative foreign currency translation adjustment +recorded in stockholders’ equity (deficit), which was eliminated through +transactions that occurred during the year ended March 31, 2004. +Recent +Accounting Pronouncements +In November 2004, the FASB issued SFAS No. 151, +Inventory Costs (“SFAS 151”), which +clarifies the accounting for abnormal amounts of idle facility expense, +freight, handling costs, and wasted material. +SFAS 151 will be effective for inventory costs incurred during fiscal +years beginning after June 15, 2005. +Management does not believe the adoption of SFAS 151 will have a +material impact on the Company’s consolidated financial statements. +F-13 +On December 16, 2004, the FASB issued +SFAS No. 123 (revised 2004), Share-Based Payment +(“SFAS 123R”) which replaces SFAS 123, supersedes APB 25 and amends SFAS No. 95, +Statement of Cash Flows . Generally, the approach in SFAS 123R is +similar to the approach described in SFAS 123. +However, SFAS 123R requires all share-based payments to employees, including +grants of employee stock options, to be recognized in the financial statements +based on their fair values (i.e., pro forma disclosure is no longer an +alternative to financial statement recognition). In accordance with SEC Release No. 33-8568, +SFAS 123R will be effective for the Company beginning April 1, 2006. The Company is currently assessing the impact +of SFAS 123R. As of the date of this +filing, no decisions have been made as to whether the Company will apply the +modified prospective or retrospective transition method of application. +Reclassifications +Certain prior year amounts have been reclassified to conform to the +current year presentation. +2. Supplementary +Financial Information +Inventories +The following table presents details of the Company’s inventories: +March 31, +2005 +2004 +(In thousands) +Materials and supplies +$ +3,204 +$ +2,762 +Work in process +558 +294 +Finished goods +582 +542 +$ +4,344 +$ +3,598 +Goodwill and Identifiable Intangible Assets +March 31, 2005 +March 31, 2004 +Gross +Carrying +Amount +Accumulated +Amortization +Gross +Carrying +Amount +Accumulated +Amortization +(In thousands) +Intangible assets subject to amortization: +Developed Technology +$ +495 +$ +(78 +) +$ +— +$ +— +Patents +317 +(36 +) +— +— +Total +$ +812 +$ +(114 +) +$ +— +$ +— +Amortization +expense for intangible assets subject to amortization was $114,000 for the year +ended March 31, 2005. Future estimated amortization expense for the next +five years and thereafter is as follows (in thousands): +Year ending March 31: +(In thousands) +2006 +$ +147 +2007 +147 +2008 +147 +2009 +147 +2010 +58 +Thereafter +52 +$ +698 +At March 31, +2005, goodwill was comprised of $18.0 million associated with the October 2004 +merger of the Iteris Subsidiary (Note 3); $9.6 million associated with the +acquisitions of the Rockwell International Transportation Systems Group, Meyer +Mohaddes Associates and the Viggen Systems Consulting Group; and $200,000 +associated with the purchase of the assets of Mil-Lektron, a complimentary +product to the Company’s Vantage video detection business. +F-14 +Warranty Reserve Activity +The following table +presents activity in accrued warranty obligations: +March 31, +2005 +2004 +2003 +(In thousands) +Balance at beginning of year +$ +192 +$ +256 +$ +249 +Additions charged to cost of sales +614 +161 +323 +Warranty claims +(480 +) +(225 +) +(316 +) +Balance at end of year +$ +326 +$ +192 +$ +256 +Earnings (Loss) Per Share +The following table sets forth the computation of basic and diluted +income (loss) per share: +Year Ended March 31, +2005 +2004 +2003 +(Restated) +(In thousands, except per share amounts) +Numerator: +Loss from continuing operations +$ +(11,328 +) +$ +(1,855 +) +$ +(5,256 +) +Income (loss) from discontinued operations +— +1,215 +(7,892 +) +Net loss +$ +(11,328 +) +$ +(640 +) +$ +(13,148 +) +Denominator: +Denominator for basic and diluted loss per +share +25,284 +19,454 +14,276 +Basic and diluted earnings (loss) per +share: +Loss from continuing operations +$ +(0.45 +) +$ +(0.09 +) +$ +(0.37 +) +Income (loss) from discontinued operations +— +0.06 +(0.55 +) +Net loss +$ +(0.45 +) +$ +(0.03 +) +$ +(0.92 +) +The following shares were excluded from the computation of diluted +earnings (loss) per share as their effect would have been anti-dilutive: +Year Ended March 31, +2005 +2004 +2003 +(In thousands) +Stock options +4,560 +162 +61 +Warrants +1,095 +64 +— +3. Merger +of the Company and the Iteris Subsidiary +On +May 28, 2004 (the “Closing Date”), in order to simplify the Company’s +capital structure and facilitate the merger of the Iteris Subsidiary into the +Company, the Company completed the purchase of all of the outstanding shares of +the Series A preferred stock of the Iteris Subsidiary (the “Series A +preferred stock”), which were held by DaimlerChrysler Ventures GmbH (“DCV”) and +Hockenheim Investment Pte. Ltd. (“Hockenheim”), in exchange for approximately +$17.5 million in cash. In addition, the +Company acquired all of the 547,893 shares of common stock of the Iteris +Subsidiary held by DCV in exchange for the issuance of 1,219,445 shares (the “Exchange +Shares”) of the Company’s Class A common stock (now known as the Company’s +common stock) which was valued at $3.4 million at the date of issuance. The +fair value of the Company’s common stock issued in the transaction was based on +the quoted market price of the Company’s stock on the OTC Bulletin Board +averaged over a five-day period. The purchase and exchange of the shares were +made pursuant to a Stock Purchase and Exchange Agreement dated March 31, +2004, by and among the Company, the Iteris Subsidiary, DCV and Hockenheim (the “Purchase +and Exchange Agreement”). +Pursuant +to the Purchase and Exchange Agreement, the Company purchased 3,124,913 shares +of the Series A preferred stock of the Iteris Subsidiary from DCV and +Hockenheim for a purchase price of $5.61 per share. The purchase price represented the stated +redemption value of the Series A preferred stock. The purchase of the shares was financed +primarily with a $10.1 million convertible debenture financing completed in May 2004 +with a group of accredited investors, in addition to a $5.0 million senior +credit facility arranged through a bank and $2.4 million in cash (Note 5). +F-15 +On +June 30, 2004, the Company and certain minority stockholders of the Iteris +Subsidiary (including certain officers and directors) entered into an exchange +agreement whereby an aggregate of 1,319,541 shares of common stock of the +Iteris Subsidiary were exchanged for 2,639,082 shares of the Company’s newly +issued common stock valued at $8.6 million at the date of issuance. The fair +value of the Company’s stock issued in the transaction was based on the quoted +market price of the Company’s common stock on the OTC Bulletin Board averaged +over a five-day period. The effect of this exchange was to reduce the residual +minority interest in the Iteris Subsidiary to 8.1%. +On October 22, 2004, the Iteris Subsidiary was merged into the +Company. The remaining 8.1% minority interest in the Iteris Subsidiary +(consisting of 1,228,981 shares of common stock of the Iteris Subsidiary) was +converted to 2,457,962 shares of the Company’s common stock valued at $7.6 +million at the merger date. Immediately following the merger, the Company +converted all of its outstanding Class B common stock (921,917 shares) +into 1,014,108 shares of its common stock (formerly designated as Class A +common stock). The exchange ratio used in conversion was determined by the +Company’s Board of Directors. The fair +value of the Company’s common stock issued in the transaction was based on the +quoted market price of the Company’s common stock on the OTC Bulletin Board +averaged over a five-day period. In October 2004, the Company also amended +its certificate of incorporation to (a) change the voting rights of its +common stock from one-tenth to one vote per share, (b) remove the ability +to issue any further shares of Class B common stock, and (c) rename +its Class A common stock to common stock. As a result, the Company +currently has only one class of common stock outstanding, the common stock. +In connection with the merger, the Company assumed all outstanding +options and warrants to purchase shares of common stock of the Iteris +Subsidiary that were outstanding immediately prior to the merger, whether +vested or unvested, together with the Iteris Subsidiary’s 1998 Stock Incentive +Plan (the “Option Plan”). Each such option and warrant assumed by the Company +shall continue to have, and be subject to, the same terms and conditions as +were applicable immediately prior to the merger, provided that (A) such +option or warrant shall be exercisable for that number of whole shares of the +Company’s common stock equal to the product of the number of shares of the +Company’s common stock that were issuable upon exercise of such assumed option or +warrant immediately prior to the merger multiplied by two (2) (the “Exchange +Ratio”) rounded down to the nearest whole number of shares and (B) the per +share exercise price for the shares of the Company’s common stock issuable upon +exercise of such assumed option or warrant is equal to the quotient determined +by dividing the exercise price per share at which such option or warrant was +exercisable immediately prior to the merger by the Exchange Ratio (rounded up +to the nearest whole cent). As a result, +options and warrants to purchase approximately 3.1 million shares and +327,000 shares, respectively, of common stock of the Iteris Subsidiary assumed +in the merger became options and warrants to purchase approximately 6.1 million +and 654,000 shares of common stock of the Company, respectively. The +weighted-average exercise prices of the assumed options and warrants were $1.09 +and $2.32, respectively. Stock-based +compensation expense of $11.3 million was recorded in connection with the +assumption and exchange of vested Iteris Subsidiary stock options for stock +options immediately exercisable into the Company’s common stock based on the +difference between the fair market value of the Company’s common stock on the October 22, +2004, merger date and the exercise price of the modified stock option. +Additionally, the Company recorded approximately $1.4 million in deferred +compensation related to the assumption of unvested stock options to purchase +common stock of the Iteris Subsidiary. Deferred compensation is being amortized +to stock-based compensation expense as the options vest. The Company also recorded $1.1 million of +goodwill and additional paid-in-capital in connection with the 654,000 vested +warrants assumed in the merger and acquisition of the Iteris Subsidiary. The $1.1 million value was based on the +difference between the fair market value of the Company’s common stock on the October 22, +2004, merger date and modified exercise price of the assumed warrant awards. +The +excess of the purchase price over the proportionate amount of minority interest +acquired was allocated to acquired intangible assets based on the estimated +fair values with the residual allocated to goodwill. Accordingly, the Company +recorded goodwill of $18.0 million, which represents the excess of the purchase +price over the fair value of the proportionate identifiable net assets +acquired. The estimated fair value of the intangible assets was determined +using the income method and discounting future expected returns. The estimated +useful life for each of the acquired intangible assets is provided below: +Patents +7 +years +Developed +technology +5 +years +F-16 +The following +table summarizes fair values of the assets acquired and liabilities assumed and +the allocation of the purchase price at the date of acquisition (in thousands): +Acquisition costs: +Issuance of common stock +$ +18,617 +Assumption of Iteris Subsidiary warrants +1,114 +Purchase of Iteris Subsidiary Series A +preferred stock +17,543 +Acquisition costs +80 +Total acquisition costs +$ +37,354 +Purchase price allocation: +Fair value of 41% of Iteris Subsidiary +Patents +$ +318 +Developed technology +495 +Acquired in-process research and +development +140 +Deferred tax liabilities +(360 +) +Reduction of minority interest +18,794 +Goodwill (not deductable for tax purposes) +17,967 +Total purchase price allocation +$ +37,354 +On +October 22, 2004, in connection with the Company’s merger with the Iteris +Subsidiary, the Chief Executive Officer of the Iteris Subsidiary, Mr. Jack +Johnson, was promoted to President and Chief Executive Officer of the Company, +replacing Mr. Gregory Miner. This merger triggered certain obligations +under the Company’s change-in-control agreement with Mr. Miner. +Accordingly, the Company recorded approximately $807,000 in severance expense, +which included $57,000 for related payroll taxes, as a charge to operations for +the year ended March 31, 2005. The +severance amount will be paid to Mr. Miner in bi-weekly installments over +the next 30 months. Mr. Miner is not required to render any services to +the Company in connection with this agreement. +4. Costs +and Estimated Earnings on Uncompleted Contracts +Costs incurred, estimated earnings and billings on uncompleted +long-term contracts are as follows: +March 31, +2005 +2004 +(In thousands) +Total estimated contract value +$ +71,835 +$ +64,434 +Costs incurred on uncompleted contracts +$ +16,553 +$ +20,840 +Estimated earnings +1,655 +2,084 +18,208 +22,924 +Less billings to date +(17,066 +) +(20,820 +) +$ +1,142 +$ +2,104 +Included in accompanying consolidated +balance sheets: +Costs and estimated earnings in excess of +billings on uncompleted contracts +$ +2,086 +$ +2,653 +Billings in excess of costs and estimated +earnings on uncompleted contracts +(944 +) +(549 +) +$ +1,142 +$ +2,104 +Costs and estimated earnings in excess of billings at March 31, +2005, and 2004 include $481,000 and $534,000, respectively, that were not +billable as certain milestone objectives specified in the contracts had not +been attained. Substantially all costs and estimated earnings in excess of +billings at March 31, 2005, are expected to be billed and collected during +the year ending March 31, 2006. +5. Revolving +Lines of Credit and Long-Term Debt +Revolving Lines of Credit +On May 28, 2004, Iteris Subsidiary entered into a line of credit +agreement with a bank, which expires on August 1, 2005, and provides for a +maximum available credit line of $5.0 million. +This line of credit was assumed by the Company in October 2004. +Under the terms of this agreement, the Company may borrow against its eligible +accounts receivable and the value of its eligible inventory, as defined in the +credit agreement. Interest on borrowed amounts is payable monthly at the +current stated prime rate. Additionally, +the Company is obligated to pay an unused line fee of 0.25% per annum applied +to the amount by which the maximum credit amount exceeds the average daily principal +balance during the preceding month. +F-17 +There are no monthly collateral management fees and no +pre-payment or early termination fees. On March 31, 2005, the available +credit under this line of credit agreement was $4.4 million, of which $3.4 +million was unused. +At March 31, 2004, the Company had $100,000 outstanding under a +$1.25 million line of credit with a partnership controlled by the Company’s +then Chairman of the Board. This line of +credit agreement was cancelled during the year ended March 31, 2005, and +all amounts were repaid. +Long-Term Debt +Long-term debt consists of the following: +March 31, +2005 +2004 +(In thousands) +Convertible debentures, net +$ +8,996 +$ +— +Bank term note +3,958 +— +Promissory note to landlord +1,292 +811 +4% note payable +67 +109 +Capital lease obligation +$ +10 +$ +13 +14,323 +933 +Less current portion +(4,008 +) +(42 +) +$ +10,315 +$ +891 +Convertible Debentures, Net. In order to finance the purchase of the +Iteris Subsidiary Series A preferred stock (Note 3), the Company entered +into a Debenture and Warrant Purchase Agreement dated May 19, 2004 (the “Debenture +and Warrant Purchase Agreement”), with a group of accredited investors, which +included certain officers of the Company, pursuant to which the Company sold +and issued subordinated convertible debentures in the aggregate original +principal amount of $10.1 million. In +connection with the issuance of the convertible debentures, the Company issued +detachable warrants to purchase an aggregate of 639,847 shares of its common +stock (Note 9), the value of which was recorded as a debt discount against the +face amount of the debentures on the date of issuance and is being amortized to +interest expense over the term of the convertible debentures. +The debentures are due in full on May 19, 2009, provide for 6.0% +annual interest, payable quarterly, and are convertible into the Company’s +common stock at an initial conversion price of $3.61 per share, subject to +certain adjustments, including adjustments for dilutive issuances. From May 19, 2007, until May 18, +2008, the debentures may be redeemed by the Company, at its option, at 120% of +the principal amount being redeemed; and from May 19, 2008, until the +maturity date, the debentures may be redeemed at 110% of the principal amount +being redeemed. As of March 31, +2005, $250,000 of convertible debentures had been converted into 69,252 shares +of common stock leaving $9.9 million of the originally issued convertible +debentures outstanding at March 31, 2005. +Bank Term Note. Concurrent with the issuance of the +convertible debentures, Iteris Subsidiary entered into a $5.0 million term note +payable with a bank. This note was assumed by the Company in October 2004.The +proceeds from the note were used to purchase the Series A preferred stock +of the Iteris Subsidiary (Note 3). The note is due on May 27, 2008, and +provides for monthly principal payments of approximately $104,000. Interest accrues at the current stated prime +rate plus 0.25% (5.75% at March 31, 2005). +Both the term note payable and the line of credit are held by one bank +under the same credit agreement and are secured by substantially all of the +assets of the Company. At March 31, +2005, the Company failed to meet certain financial covenants under the credit +agreement. On May 12, 2005, the +bank waived its right of default regarding the covenant violations for the +quarter ended March 31, 2005, only. +The Company is currently renegotiating the entire credit facility to +modify the covenant requirements to allow the Company to meet its future +covenants and also provide sufficient financing to fund future working capital +requirements. Because the bank has not +waived its default rights for a period of at least twelve months and because +the Company has not entered into a definitive agreement for a modified credit +agreement, the entire balance of the bank term note is presented as a current +liability in the accompanying March 31, 2005, consolidated balance +sheet. +Promissory Note to Landlord. As discussed further in Note 7, on July 1, +2003, the Company amended the terms of its lease for its headquarters and +entered into a $811,000 unsecured promissory note payable to its landlord. On November 1, 2004, $432,000 was added +to the principal balance of this note to settle prior lease obligations, +bringing the total principal +F-18 +balance to $1.3 million. Under the terms of the note agreement, interest +is payable quarterly and accrues at a rate of prime plus 2.0% (7.5% at March 31, +2005). Beginning on October 1, +2006, the Company is required to make four equal quarterly payments of +principal and accrued interest. All +outstanding accrued interest and principal shall be payable in full on July 2, +2007. +4% Note Payable. On October 9, 2003, the Company entered +into a $126,000 unsecured note payable agreement to settle trade payables. The +note is secured by the equipment related to the payable. The note bears +interest at 4.0%, is payable in monthly installments of $4,000 for 36 months +and is payable in full on October 20, 2006. +Scheduled aggregate maturities of long-term debt principal as of March 31, +2005, were as follows: +Year ending March 31, +(In thousands) +2006 +$ +4,008 +2007 +670 +2008 +649 +2009 +— +2010 +9,850 +$ +15,177 +6. Income +Taxes +The reconciliation of the income tax provision (benefit) from +continuing operations to taxes computed at U.S. federal statutory rates is as +follows: +Year Ended March 31, +2005 +2004 +2003 +(In thousands) +(Restated) +Income tax (benefit) provision at statutory +rates +$ +(3,705 +) +$ +360 +$ +(489 +) +State income taxes net of federal benefit +(72 +) +20 +4 +Change in valuation allowance associated +with federal deferred tax assets +(755 +) +(316 +) +330 +Compensation charges +3,692 +— +— +Adjustment to prior year deferred taxes +229 +— +— +Expiration of unused credits +266 +— +— +Other permanent differences +251 +36 +155 +$ +(94 +) +$ +100 +$ +— +The components of deferred tax assets and liabilities are as follows: +March 31, +2005 +2004 +(In thousands) +Deferred tax assets: +Net operating losses +$ +19,880 +$ +20,244 +Property and equipment +1,695 +5,323 +Credit carry forwards +1,914 +2,420 +Deferred compensation and payroll +1,626 +977 +Bad debt allowances and other reserves +422 +209 +Other, net +204 +202 +Total deferred tax assets +25,741 +29,375 +Valuation allowance +(24,417 +) +(28,119 +) +Net deferred tax assets +1,324 +1,256 +Deferred tax liabilities: +Capitalized interest and taxes +(369 +) +(404 +) +Acquired intangibles +(295 +) +— +Other, net +— +(31 +) +Total deferred tax liabilities +(664 +) +(435 +) +Net deferred tax assets +$ +660 +821 +Current portion of net deferred taxes +101 +821 +Long-term portion of net deferred taxes +559 +— +Net deferred tax assets +$ +660 +$ +821 +F-19 +The components of current and deferred federal and state income tax +benefits and provisions are as follows: +Year Ended March 31, +2005 +2004 +2003 +(In thousands) +Current income tax (benefit) provision +Federal +$ +91 +$ +891 +$ +35 +State +14 +30 +— +Deferred income tax (benefit) provision +Federal +(75 +) +(821 +) +(35 +) +State +(124 +) +— +— +Net income tax (benefit) provision +$ +(94 +) +$ +100 +$ +— +At March 31, 2005, the Company had approximately $1.4 million in +federal general business credit carryforwards that begin to expire in 2006 and +$700,000 in state general business credit carryforwards that can be carried +forward indefinitely. The Company had $54.5 million of federal net operating +loss carryforwards at March 31, 2005, that begin to expire in 2019 and $35.0 +million of state net operating loss carryforwards that begin to expire in 2005. +For financial reporting purposes, a valuation allowance has been recorded to +offset the deferred tax asset related to these credits and net operating losses. +Any future benefits recognized from the reduction of the valuation allowance +related to these carryforwards will result in a reduction of income tax +expense. +Prior to May 28, 2004, the Iteris Subsidiary was required to file +a separate federal income tax return. On +May 28, 2004, the Company acquired a greater than 80% ownership interest +in the Iteris Subsidiary. From that date +forward, income taxes are provided on a consolidated basis for federal income +tax purposes. Due to changes in stock +ownership, the prior year $49.8 million federal net operating loss +carryforwards and other federal tax attributes of the Company are subject to a Section 382 +limitation estimated at approximately $2.9 million annually which can be +utilized to offset federal consolidated taxable income. To the extent such limitation is not exceeded +in a particular year, the excess limitation accumulates and adds to subsequent +years’ limitations. As a result of the +annual limitation, a portion of the Company’s carryforwards will expire before +ultimately becoming available to reduce future income tax liabilities. +At March 31, 2005, the Company recorded a valuation allowance +against its net deferred tax assets of approximately $24.0 million for that +portion of deferred tax assets that it is more likely than not will not be +realized. In making such determination, a review of all available positive and +negative evidence was considered, including scheduled reversal of deferred tax +liabilities potential carryback, projected future taxable income, tax planning +strategies, and recent financial performance. At March 31, 2005, the +Company has established a partial valuation allowance against its existing net +deferred tax assets, and recorded a net deferred tax asset of $660,000 related +to the consolidated group. +7. Commitments +and Contingencies +Litigation +On June 29, 2004, a supplier to Mariner Networks, Inc., the +Company’s former subsidiary, filed a complaint in Orange County Superior Court +against the Company alleging various breaches of written contract claims +arising out of alleged purchase orders. +The plaintiff in this lawsuit seeks monetary damages aggregating +approximately $850,000 plus attorney fees and related costs. Discovery has commenced with respect to this +matter, and no trial date has been set. +Settlement discussions are currently pending at this time, but there can +be no assurance that this lawsuit will be settled in a timely manner or for a +reasonable amount. +The Company believes that the ultimate resolution of this claim will not have a +material impact on the Company’s financial position, results of operations or +cash flows, and, accordingly, has not recorded any amounts in the accompanying +consolidated financial statements in connection with this matter. +In June 2004, the Company received $949,000 as part of a +settlement between Rockwell International and the Michigan Department of +Transportation, pursuant to which the Company was a third party +beneficiary. This amount was recorded in +other income in the consolidated statement of operations for the year ended March 31, +2005. +F-20 +From time to time, the Company has been involved in litigation relating +to claims arising out of its operations in the normal course of business. The +Company currently is not a party to any legal proceedings except as described +above, the adverse outcome of which, in management’s opinion, individually or +in the aggregate, would have a material adverse effect on its consolidated +results of operations, financial position or cash flows. +Operating Leases +In May 2002, the Company completed the sale and leaseback of its +headquarters in Anaheim, California whereby the Company entered into a lease +with an initial term of ten years. In +connection with the sale leaseback transaction, the Company originally recorded +a deferred gain of approximately $7.6 million that was being amortized against +operating expenses over the term of the initial lease. On July 1, 2003, the Company +renegotiated the terms of this lease whereby the square footage under lease was +reduced and the initial lease term of ten years was reduced to four years. As a result of the new lease agreement, $2.5 +million of restricted cash was released to the Company and paid to the +landlord, the Company entered into a promissory note agreement with the +landlord for $811,000 (Note 5), and the deferred gain on the sale of the +building was adjusted. On November 1, +2004, the Company again amended this lease and increased the note payable to +the landlord by $432,000 as a settlement to release the Company from its +obligations under the existing lease related to the separation of buildings +located at the Anaheim facility and other facility improvements to be made at +the location. The $432,000 was recorded +as a reduction of the deferred gain on the sale of the building. The remaining deferred gain was $733,000 at March 31, +2005 which will be amortized through October 2007. +The Company has lease commitments for facilities in various locations +throughout the United States. Future minimum rental payments under +noncancelable operating leases are as follows at March 31, 2005: +Year ending March 31, +(In thousands) +2006 +$ +1,116 +2007 +1,005 +2008 +601 +2009 +3 +$ +2,725 +Rent expense under operating leases totaled $1,722,000, $2,241,000 and +$2,597,000, respectively, for the years ending March 31, 2005, 2004 and +2003. +The Company subleases 10,000 of the 88,000 square feet that it leases +in Anaheim, California at a monthly rate of $10,000. Aggregate future minimum rental income from +this sublease agreement is $120,000 and $70,000 for the years ending March 31, +2006, and 2007, respectively. +Inventory Purchase Commitments +At March 31, 2005, the Company had firm commitments to purchase inventory +in the amount of $271,000 during the first quarter of its fiscal year ending March 31, +2006. +Deferred Compensation Plan +In 1986, the Company adopted the Executive Deferral +Plan (the “1986 Plan”) under which certain executives were able to defer a +portion of their annual compensation into the 1986 Plan. All deferred amounts earned interest, +generally with no guaranteed rate of return. +During the year ended March 31, 2003, the Iteris +Subsidiary adopted the Deferred Compensation Plan for the sole purpose of +transferring Iteris Subsidiary common stock and cash out of the 1986 Plan. All assets of the 1986 Plan were distributed +prior to March 31, 2003. Certain of +these assets, consisting of 133,333 shares of the Iteris Subsidiary’s common +stock and $14,000 in cash, were transferred to the Deferred Compensation Plan +during the year ended March 31, 2003. +Compensation withholdings deferred under the 1986 Plan and the Deferred +Compensation Plan aggregated $0, $0 and $43,000 for the years ended March 31, +2005, 2004 and 2003, respectively. +During the year ended March 31, 2005, the Company +assumed the Deferred Compensation Plan as part of the October 2004 merger +and acquisition of the Iteris Subsidiary. In accordance with the merger (Note +3) the Company exchanged the original 133,333 shares of Iteris Subsidiary +common stock held in the Deferred Compensation Plan and an additional 21,922 +shares of the Iteris Subsidiary’s common stock subsequently purchased with +deferred wages for 310,510 shares of the Company’s common stock. All shares of Iteris Subsidiary stock held in +the plan were purchased with funds earned by the executives and deferred to the +plan at the estimated fair value and the same price that was paid by outside +investors at that time, or approximately $374,000. +At March 31, +2005, the Deferred Compensation Plan held 310,510 shares of the Company’s +common stock and $14,000 in cash, which the Company has presented as an +aggregated $772,000 deferred compensation plan liability in the accompanying consolidated +balance sheet. Changes in the value of Company common stock held by the +Deferred Compensation Plan are determined based on changes in the quoted market +price of the Company’s common stock at the close of each reporting period and +presented within operating expenses in the accompanying consolidated statements +of operations. The original $374,000 cost +basis of shares of Company common stock held in the Deferred Compensation Plan has +been recorded as a contra-equity account in the accompanying consolidated +financial statements. +8. Redeemable +Common Stock +As discussed in Note 3, the Company issued 1,219,445 Exchange Shares in +connection with the merger of the Iteris Subsidiary into the Company. Subject to certain exceptions, DCV +agreed not to sell or otherwise transfer the Exchange Shares during the year +following the Closing Date. However, +beginning on November 28, 2005, DCV may require the Company to repurchase +up to 50% of the Exchange Shares at a purchase price of $1.438 per share; and +beginning on May 28, 2007, DCV may require the Company to repurchase up to +100% of the Exchange Shares at a purchase price of $1.438 per +F-21 +share. All such rights to require the repurchase of +the Exchange Shares expire on September 28, 2007. Because this right is +outside the control of the Company, the Company has classified the $3.4 million +value of the 1,219,445 shares as redeemable common stock on the accompanying March 31, +2005, consolidated balance sheet. In addition, beginning on May 28, 2005, +DCV had the right to request registration of all 1,219,445 shares of the +Company’s common stock held as part of this exchange. In the event the Company decides not to file +a registration statement to register all such shares, DCV may require the +Company to repurchase any or all of its shares of the Company’s common stock at +a purchase price of $1.438 per share. On +February 1, 2005, DCV announced that its investment portfolio, which +included its ownership in Iteris, Inc., was sold to European-based Cipio +Partners for an undisclosed sum. All +repurchase and registration rights associated with the DCV shares inured to the +benefit of Cipio Partners. +9. Stockholders’ +Equity +Preferred Stock +The Company’s certificate of incorporation provides for the issuance of +up to 2,000,000 shares of preferred stock. +As of March 31, 2005, and 2004, there were no outstanding shares of +preferred stock, and the Company does not have any plans to issue any shares of +preferred stock. The Company’s Board of Directors +is authorized to issue from time to time such authorized but unissued shares of +preferred stock in one or more series and to fix or alter the designations, +preferences, rights and any qualifications, limitations or restrictions of the +shares of each such series, including the dividend, conversion, voting, +redemption and liquidation rights. +Common Stock and Common Stock Warrants +As discussed in Note 3, +on October 22, 2004, the Iteris Subsidiary was merged into the +Company. Also in October 2004, the +Company amended its certificate of incorporation to (a) change the voting +rights of its common stock from one-tenth to one vote per share, (b) remove +the ability to issue any further shares of Class B common stock, and (c) rename +its Class A common stock to common stock. As a result, the Company +currently has only one class of common stock outstanding, the common +stock. Previously, the Company had two +classes of common stock outstanding – the Class A common stock and the Class B +common stock. +Subject to the rights specifically granted to holders of any then +outstanding shares of the Company’s preferred stock, the Company’s common +stockholders are entitled to any dividends that may be declared by the Board of +Directors. Upon dissolution, liquidation +or winding up, holders of common stock are entitled to share ratably in net +assets after payment or provision for all liabilities and any preferential +liquidation rights of preferred stock then outstanding. Common stockholders generally do not have +preemptive or redemption rights, except for the Exchange Shares issued to DCV +in the merger of the Company and the Iteris Subsidiary (Notes 3 and 8). The rights, preferences and privileges of +holders of common stock will be subject to those of the holders of any shares +of common stock and preferred stock the Company may issue in the future. +Pursuant to the Debenture and Warrant Purchase Agreement discussed in +Note 5, each individual investor also received two warrants to purchase shares +of the Company’s common stock. For every +dollar of debenture purchased, each investor received one warrant to purchase +approximately 0.03235 shares of the Company’s common stock at an exercise price +of $3.86 per share and a second warrant to purchase approximately 0.03100 +shares of the Company’s common stock at an exercise price of $4.03 per +share. The exercise prices are subject +to certain adjustments, including adjustments for dilutive issuances. The warrants to purchase 639,347 shares of +common stock were immediately exercisable and expire on May 18, 2009. Debt +discount costs related to the fair value of the warrants issued in connection +with the convertible debentures were calculated based on the fair value of the +warrants determined using the Black-Scholes valuation model, and were +approximately $854,000 at March 31, 2005. +Significant valuation estimates used in the determination of the value +of the warrants include an expected life of five years, no dividends, a +risk-free interest rate of 4.5% and a stock volatility factor of 0.5. +Also in connection with the Debenture and Warrant Purchase Agreement, +the Company issued warrants to the investment bankers, as a commission, to +purchase 34,036 shares of its common stock at an exercise price of $3.86 per +share. The warrants were immediately exercisable and expire on May 18, +2009. The estimated fair value of these warrants of $40,000 was recorded as a +deferred financing cost and is being amortized to interest expense over the +five-year life of the debentures. Additionally, the Company incurred $621,000 +in transaction costs associated with the debenture offering, which have also +been capitalized as deferred financing costs and are being amortized to +interest expense over the five-year term of the debentures. Unamortized deferred financing costs +aggregated $568,000 at March 31, 2005, and are presented within other +assets on the accompanying consolidated balance sheet. +F-22 +During the year ended March 31, 2004, the Company issued 657,132 +shares of its Class A common stock valued at $578,000 and 89,332 shares of +its Class A common stock valued at $151,000 to settle 401(k) match +liabilities and prior trade liabilities in Company stock, respectively. +In September 2003, the Company issued 425,000 shares of its Class A +common stock, valued at $255,000, and 75,000 warrants to purchase common stock +at an exercise price of $5.00 per share, to settle liabilities related to the +sale lease-back of the Anaheim facility and the renegotiation of the related +lease. The warrants are immediately +exercisable and expire in July 2010. The fair value of these warrants was +$5,000 calculated using the Black Scholes Model. The value of the warrants was recorded as a +reduction of the deferred gain on the sale of the building. +In July 2003, the Company completed a private placement of +3,666,666 shares of its Class A common stock to seven accredited investors +for net proceeds of $1.9 million in cash. In connection with this offering, the +Company also issued warrants to purchase an additional 366,666 shares of common +stock at an exercise price of $1.50 per share. +The fair value of these warrants was $55,000 calculated using the Black +Scholes Model. The warrants are +considered a cost of raising capital and were recorded in equity as an offset +to additional paid-in capital. The +warrants expire in July 2006 and became exercisable in January 2003. +In April 2002 and February 2003, the Company sold 322,581 +shares of the Iteris Subsidiary common stock that it held at an aggregate +purchase price of $900,000 to a group of investors, which included certain +members of management of the Company and the Iteris Subsidiary. In connection with this transaction, the +Company realized a loss of $300,000 that is reflected in other income net in +the accompanying consolidated statements of operations. In February 2003, the Iteris Subsidiary +purchased back from the Company 288,500 shares of Iteris Subsidiary common +stock that the Company held. The Company +realized a loss of $310,000 on this transaction, which is reflected in other +income, net in the accompanying consolidated statements of operations. +In September 2002, the Company issued 75,000, 50,000 and 62,500 +warrants at exercise prices of $1.44, $1.68 and $1.95, respectively, in +connection with prior year fund raising activities. The warrants were +immediately exercisable and expire in August 2007. The fair value of these +warrants was $130,000 calculated using the Black Scholes Model. The warrants were considered a cost of +raising capital and were recorded in equity as an offset to additional paid-in +capital. +On August 16, 2002, the Company completed a private placement of +2,500,000 of its Class A common stock to an institutional investor for +$3.0 million in cash. The transaction, net of expenses, raised net proceeds of +approximately $2.7 million. In connection with this offering, the Company also +issued warrants to the investor to purchase up to another 1,250,000 shares at +an exercise price of $1.50 per share, and up to 1,250,000 shares at an exercise +price of $1.80 per share. The warrants are exercisable at any time by the +investor, are callable by the Company if the market price of the Company’s +common stock trades for 20 consecutive days at a price equal or greater than +two times the exercise price of the warrants, and expire in August 2007. +The fair value of these warrants was $713,000 calculated using the Black +Scholes Model. The warrants were considered a cost of raising capital and were +recorded in equity as an offset to additional paid-in capital. The proceeds +from the August 2002 transaction were used to fund general working capital +requirements. In March 2004, 1,250,000 warrants at $1.50 per share become +callable and were exercised by the holder. +The following table summarizes information regarding outstanding +warrants to purchase the Company’s common stock as of March 31, 2005: +Range of Exercise Prices +Warrants Outstanding at +March 31, 2005 +Weighted Avg. Remaining +Contractual Life +Weighted Avg. +Exercise Price +(In thousands, except per share amounts) +$1.40 to $1.95 +2,229 +2.02 +$ +1.66 +$3.00 to $4.03 +1,150 +2.94 +$ +3.56 +$5.00 to $5.26 +230 +4.66 +$ +5.18 +3,609 +2.48 +$ +2.49 +All of the warrants were exercisable at March 31, 2005. +F-23 +Common stock reserved for future issuance at March 31, 2005: +(In thousands) +Issuable under stock options plans +7,679 +Issuable upon the exercise of warrants +3,609 +11,288 +10. Associate +Benefit Plans +Stock Option Plan +The Company has adopted the 1997 Stock Incentive Plan (the “Plan”), +which provides that options for shares of the Company’s unissued common stock +may be granted to directors, associates and consultants to the Company. Options +granted enable the option holder to purchase one share of common stock at +prices which are equal to or greater than the fair market value of the shares +at the date of grant. Options expire ten years after the date of grant or 90 +days after termination of employment and generally vest ratably at the rate of +25% on each of the first four anniversaries of the grant date. In connection with the merger of the Company +and the Iteris Subsidiary, the Company assumed the outstanding options of the +Iteris Subsidiary (Note 3). +A summary of all Company stock option activity is as follows: +Year Ended March 31, +2005 +2004 +2003 +Options +Weighted +Average +Exercise +Price +Options +Weighted +Average +Exercise +Price +Options +Weighted +Average +Exercise +Price +(In thousands, except per share amounts) +Options outstanding at beginning of year +1,132 +$ +2.98 +962 +$ +3.73 +329 +$ +8.37 +Granted +163 +3.34 +230 +0.78 +659 +1.38 +Assumed in merger (Note 3) +6,133 +1.09 +— +— +— +— +Exercised +(25 +) +2.10 +— +— +— +— +Cancelled +(80 +) +1.29 +(60 +) +6.76 +(26 +) +4.29 +Options outstanding at end of year +7,323 +$ +1.42 +1,132 +$ +2.98 +962 +$ +3.73 +Exercisable at end of year +6,446 +778 +879 +Available for grant at end of year +356 +519 +689 +Weighted average fair value of options +granted +$ +1.83 +$ +0.55 +$ +0.68 +The following table summarizes information regarding the Company’s +stock options at March 31, 2005: +Options Outstanding +Options Exercisable +Range of Exercise Prices +Options Outstanding +at March 31, 2005 +Weighted Avg. +Remaining +Contractual Life +Weighted Avg. +Exercise Price +Options +Exercisable At +March 31, 2005 +Weighted Avg. +Exercise Price +(In thousands, except per share amounts) +$0.53 +to +$0.80 +1,861 +3.31 +$ +0.57 +1,861 +$ +0.57 +$0.95 +to +$1.40 +4,851 +5.39 +1.25 +4,077 +1.24 +$1.50 +to +$1.88 +171 +4.59 +1.74 +171 +1.74 +$2.28 +to +$3.20 +70 +8.22 +2.77 +70 +2.77 +$3.60 +to +$4.63 +202 +6.63 +4.09 +99 +4.59 +$5.69 +to +$8.00 +26 +3.55 +6.13 +26 +6.13 +$10.31 +to +$15.63 +142 +4.96 +12.64 +142 +12.64 +7,323 +4.89 +$ +1.42 +6,446 +$ +1.40 +Associate Incentive Programs +Under the terms of a Profit Sharing Plan, the Company contributes to a +trust fund such amounts as are determined annually by the Board of Directors. +No contributions were made during the years ended March 31, 2005, 2004 and +2003. +In May 1990, the Company adopted a 401(k) Plan as an amendment and +replacement of the former Associate Stock Purchase Plan that was an additional +feature of the Profit Sharing Plan. Under the 401(k) Plan, eligible associates +voluntarily +F-24 +contribute to the plan up to 15% of their salary +through payroll deductions. The Company matches 50% of contributions up to a +stated limit. Under the provisions of the 401(k) Plan, associates have thirteen +investment choices, one of which is the purchase of Iteris, Inc. common +stock at market price. Company matching contributions were approximately +$409,000, $403,000, and $544,000 for the years ended March 31, 2005, 2004, +and 2003, respectively. +11. Discontinued +Operations +In September 2003, the Company sold substantially all of the +assets of MAXxess to an investor group that included certain members of the +MAXxess management group. The consideration for the assets consisted of the +assumption of $2.7 million of liabilities, resulting in a net gain of $2.4 million +from the sale. +On May 9, 2003, the Company completed the sale of substantially +all of the assets of Zyfer for $2.3 million in cash plus the assumption of +certain liabilities. The asset purchase agreement provided for future incentive +payments of up to $1.0 million in each of the twelve month periods ended April 30, +2004 and 2005, based on the achievement of certain revenue goals related to the +sale of Zyfer products or the licensing of its technologies. Based on the terms of the sale agreement, +Zyfer has 60 days to provide the Company with support for the incentive +payments. In October 2004 the +Company received a payment of approximately $135,000 related to the twelve +month period ended April 30, 2004. +The Company expects to receive information for the twelve month period +ended April 30, 2005, by the end of July 2005. +In March 2003, the Company ceased the development and sale of +products of Broadcast and reduced the headcount in Broadcast to only support +the existing customer contracts for service and support through their +expiration dates. The aggregate losses recognized to write down the assets of +Broadcast to their fair value less cost to sell were approximately $3.4 +million. In addition, the Company accrued $400,000 for employees severed in March 2003 +and other direct costs to wind down the operation. +Asset write-downs and accrued costs are included in income (loss) from +discontinued operations in the years ended March 31, 2004, and 2003. The results of operations of Broadcast, Zyfer +and MAXxess for all periods presented have been reclassified and presented as +discontinued operations in the accompanying consolidated statements of +operations. Interest expense was not reclassified to discontinued operations +because the discontinuances did not eliminate any of the Company’s debt. +The net sales and income (loss) from discontinued operations are as +follows: +Year Ended March 31, +2005 +2004 +2003 +(In thousands) +Net sales +and contract revenues: +MAXxess +$ +— +$ +1,747 +$ +6,232 +Zyfer +— +— +6,487 +Broadcast +— +385 +3,599 +Total net sales and contract revenues +$ +— +$ +2,132 +$ +16,318 +Net income (loss) from discontinued +operations: +MAXxess +$ +— +$ +199 +$ +862 +Zyfer +— +— +(1,718 +) +Broadcast +— +(122 +) +(2,468 +) +— +77 +(3,324 +) +Loss recognized upon discontinuance of +operations +— +(1,226 +) +(4,909 +) +Gain on sale of assets of discontinued +operations +— +2,364 +341 +Income (loss) from discontinued operations +$ +— +$ +1,215 +$ +(7,892 +) +The Company had no assets or liabilities of discontinued operations at March 31, +2005. +12. Disposal +of Fixed Assets +After the merger of the Iteris Subsidiary +into the Company on October 2004, the Company reviewed and determined +certain corporate property and equipment would not provide value to its +on-going operations. These assets +primarily consisted of furniture and fixtures and computer equipment. Accordingly, the Company recorded a $422,000 +loss on disposal of fixed assets in the year ended March 31, 2005. +F-25 +13. Business +Segment and Geographic Information +The Company currently operates in three reportable segments: Roadway +Sensors, Automotive Sensors and Systems. +The Roadway Sensors segment includes Vantage vehicle detection systems +for traffic intersection control and certain highway traffic data +collection applications. The Automotive +Sensors segment includes AutoVue and is comprised of all activities related to +lane departure warning systems for vehicle safety. The Systems segment includes transportation +engineering and consulting services and the development of transportation +management and traveler information systems for the ITS industry. The accounting +policies of the reportable segments are the same as those described in the +summary of significant accounting policies except that certain expenses, such +as interest, amortization of certain intangibles and certain corporate expenses +are not allocated to the segments. In addition, certain assets including cash +and cash equivalents, deferred taxes and certain long-lived and intangible +assets are not allocated to the segments. +The reportable segments are each managed separately because they +manufacture and distribute distinct products or provide services with different +processes. All segment revenues are +derived from external customers. +Selected financial information for the Company’s reportable segments as +of and for the years ended March 31, 2005, 2004, and 2003 is as follows: +Roadway +Sensors +Automotive +Sensors +Systems +Total +(In thousands) +Year Ended March 31, 2005 +Product revenue from +external customers +$ +21,920 +$ +4,326 +$ +— +$ +26,246 +Service and other revenue from external +customers +— +2,816 +17,335 +20,151 +Depreciation and amortization +117 +116 +415 +648 +Allocated goodwill +8,197 +4,671 +14,906 +27,774 +Segment income +3,544 +(1,695 +) +2,313 +4,162 +Year Ended March 31, 2004 +Product revenue from external customers +$ +19,273 +$ +2,308 +$ +— +$ +21,581 +Service and other revenue from external +customers +— +1,889 +21,813 +23,702 +Depreciation and amortization +117 +116 +440 +673 +Allocated goodwill +200 +— +9,607 +9,807 +Segment income +2,629 +(2,343 +) +2,207 +2,493 +Year Ended March 31, 2003 +Product revenue from external customers +$ +17,575 +$ +1,417 +$ +— +$ +18,992 +Service and other revenue from external +customers +— +120 +22,283 +22,403 +Depreciation and amortization +133 +120 +452 +705 +Allocated goodwill +200 +— +9,607 +9,807 +Segment income (loss) +3,873 +(4,063 +) +2,302 +2,112 +The Roadway Sensors segment had two customers with combined revenue +representing 38.0% of total segment revenue for the year ended March 31, +2005; four customers with combined revenue representing 59.5% of total segment +revenue for the year ended March 31, 2004; and four customers with +combined revenue representing 49.0% of total segment revenue for the year ended +March 31, 2003. The Automotive +Sensors segment had two customers with combined revenue representing 85.2% of +total segment revenue for the year ended March 31, 2005; two customers +with combined revenue representing 85.3% of total segment revenue for the year +ended March 31, 2004; and one customer with revenue representing 60.6% of +total segment revenue for the year ended March 31, 2003. The Systems segment had one customer with +revenue representing 14.9% of total segment revenue for the year ended March 31, +2005, and one customer with revenue representing 20.0% of total segment revenue +for the year ended March 31, 2004. +In connection with the October 2004 merger of the Iteris +Subsidiary into the Company (Note 3), goodwill of $8.0 million, $4.7 million +and $5.3 million was allocated to the Roadway Sensors, Automotive Sensors and +Systems segments, respectively. This +allocation was determined based on the respective fair value of each segment as +calculated using the income approach. +F-26 +The following reconciles segment income (loss) to consolidated income +(loss) from continuing operations before income taxes and minority interest and +segment assets to consolidated assets: +March 31, +2005 +2004 +2003 +(Restated) +(In +thousands) +Segment +income +Total income for reportable segments +$ +4,162 +$ +2,493 +$ +2,112 +Unallocated amounts: +Corporate and other expenses +(1,911 +) +(444 +) +(2,789 +) +Deferred compensation +484 +(868 +) +— +Stock-based compensation +(11,777 +) +— +— +Disposal of fixed assets +(422 +) +— +— +Acquired in-process research and +development +(140 +) +— +— +Amortization of intangible assets +(114 +) +— +— +Interest expense, net +(1,178 +) +(123 +) +(761 +) +Income (loss) from continuing operations +before income taxes and minority interest +$ +(10,896 +) +$ +1,058 +$ +(1,438 +) +Assets +Total assets for reportable segments +$ +44,833 +$ +28,856 +$ +26,005 +Assets held at Corporate +1,823 +1,209 +8,837 +Total assets +$ +46,656 +$ +30,065 +$ +34,842 +The Company’s revenues from +continuing operations are generated and the Company’s assets are held +substantially in the United States. +14. Quarterly +Financial Data (Unaudited) +All quarters presented in the following schedule have been +restated for the discontinuance of MAXxess, Zyfer, and Broadcast: +Net +Sales +Gross +Profit +Income (Loss) +from +Continuing +Operations +Net Income +(loss) +Income (Loss) +per Share +from +Continuing +Operations +(In thousands, except per share amounts) +June 30, 2004 +$ +11,441 +4,949 +$ +966 +$ +966 +0.04 +September 30, 2004 +11,760 +4,695 +(4 +) +(4 +) +0.00 +December 31, 2004 +11,714 +5,044 +(12,233 +) +(12,233 +) +(0.44 +) +March 31, 2005 +11,482 +4,666 +(57 +) +(57 +) +(0.00 +) +$ +46,397 +$ +19,354 +$ +(11,328 +) +$ +(11,328 +) +$ +(0.45 +)* +June 30, 2003 +$ +11,530 +$ +4,547 +$ +(1,259 +) +$ +(1,954 +) +$ +(0.08 +) +September 30, 2003 +11,250 +4,441 +207 +2,584 +0.01 +December 31, 2003 +11,128 +4,402 +(740 +) +(740 +) +(0.04 +) +March 31, 2004 (restated see Note 1) +11,375 +4,423 +(63 +) +(530 +) +0.00 +$ +45,283 +$ +17,813 +$ +(1,855 +) +$ +(640 +) +$ +(0.09 +)* +* Annual +per share amounts may not agree to the sum of the quarterly per share amounts +due to differences between average shares outstanding during the periods. +F-27 +Schedule II +Valuation +and Qualifying Accounts (In thousands) +Description +Balance at +Beginning of +Period +Charged to +Costs and +Expenses +Charged to +Accounts +Balance at End +of Period +Year Ended March 31, 2005 +Deducted from asset accounts: +Allowance for doubtful accounts +$ +204 +$ +37 +$ +(2 +) +$ +239 +Reserve for inventory obsolescence +399 +367 +(252 +) +514 +Year Ended March 31, 2004 +Deducted from asset accounts: +Allowance for doubtful accounts +$ +156 +$ +87 +$ +(39 +) +$ +204 +Reserve for inventory obsolescence +248 +251 +(100 +) +399 +Year Ended March 31, 2003 +Deducted from asset accounts: +Allowance for doubtful accounts +$ +115 +$ +78 +$ +(37 +) +$ +156 +Reserve for inventory obsolescence +378 +— +(130 +) +248 +S-1 \ No newline at end of file diff --git a/raw/filings/0000350868/2004/0001104659-05-032468/filing_metadata.csv b/raw/filings/0000350868/2004/0001104659-05-032468/filing_metadata.csv new file mode 100644 index 0000000000000000000000000000000000000000..c8b0bb1b2f2f9ade6969b31b46b4848a239955e7 --- /dev/null +++ b/raw/filings/0000350868/2004/0001104659-05-032468/filing_metadata.csv @@ -0,0 +1,2 @@ +cik,ticker,company_name,form,filing_date,report_date,acceptance_datetime,accession_number,primary_document,primary_doc_description,size,is_xbrl,is_inline_xbrl,document_url,filing_index_url,year,fiscal_year,is_primary_filing +0000350868,ITI,"ITERIS, INC.",10-K,2005-07-14,2005-03-31,2005-07-14T21:14:05.000Z,0001104659-05-032468,a05-11244_110k.htm,10-K,3261572,0,0,https://www.sec.gov/Archives/edgar/data/350868/000110465905032468/a05-11244_110k.htm,https://www.sec.gov/Archives/edgar/data/350868/000110465905032468/,2004,2004,1 diff --git a/raw/filings/0000350868/2004/0001104659-05-032468/item1.txt b/raw/filings/0000350868/2004/0001104659-05-032468/item1.txt new file mode 100644 index 0000000000000000000000000000000000000000..253544bca1b6caf01faf5537e4ee9eeeed0f0e08 --- /dev/null +++ b/raw/filings/0000350868/2004/0001104659-05-032468/item1.txt @@ -0,0 +1,260 @@ +ITEM 1. BUSINESS +Overview +Iteris, Inc., +formerly known as Iteris Holdings, Inc., is a leading provider of outdoor +machine vision systems and sensors that optimize the flow of traffic and +enhance driver safety. Using proprietary software and Intelligent +Transportation Systems (“ITS”) industry expertise, we provide video sensor +systems, transportation management and traveler information systems and other +engineering consulting services to the ITS industry. The ITS industry is +comprised of companies applying a variety of technologies to enable the safe +and efficient movement of people and goods. We use our outdoor image +recognition software expertise to develop proprietary algorithms for video +sensor systems that improve vehicle safety and the flow of traffic. Using our +knowledge of the ITS industry, we design and implement transportation +management systems that help public agencies reduce traffic congestion and +provide greater access to traveler information. +On October 22, 2004, we completed a merger with our majority-owned +subsidiary, Iteris, Inc. (the “Iteris Subsidiary”), and officially changed our +corporate name from Iteris Holdings, Inc. to Iteris, Inc. We were originally +incorporated in Delaware in 1987 as Odetics, Inc. and in September 2003 changed +our name to Iteris Holdings, Inc. to reflect our focus on the ITS industry and our +capital structure at that time. +Our proprietary image +recognition systems include AutoVue and Vantage. AutoVue is a small windshield mounted sensor +that uses proprietary software to detect and warn drivers of unintended lane +departures. We have sold approximately 13,000 production AutoVue Lane Departure +Warning (“LDW”) systems for use on truck platforms in the European and North +American markets, and our AutoVue LDW system is currently offered as an option +on certain Mercedes, MAN, Freightliner and International trucks. We believe +that our AutoVue LDW technology is a broad sensor platform that, through +additional software development, may be expanded to incorporate additional +safety and convenience features. Vantage is a video-based vehicle sensing +system that detects vehicles on roadways, enabling more efficient traffic +management. Applications include traffic +signal operations, incident detection and data collection. +Our transportation +management systems include the design, development and implementation of our +software-based systems that integrate sensors, video surveillance, computers +and advanced communications equipment to enable public agencies to monitor, +control and direct traffic flow, assist in the quick dispatch of emergency +crews and distribute real-time information about traffic conditions. We also +offer related services that include planning and other engineering for the +implementation of transportation related communications systems, analysis and +studies related to goods movement and commercial vehicle operations, and +parking systems designs. +We currently operate in three +reportable segments: Roadway Sensors, Automotive Sensors and Systems. The Roadway +Sensors segment includes our Vantage vehicle detection systems. The Automotive Sensors segment includes our AutoVue +LDW systems for vehicle safety. The Systems segment includes transportation +engineering and consulting services, and the development of transportation +management and traveler information systems for the ITS industry. +3 +Sales, Marketing and Principal Customers +We sell our Vantage vehicle detection systems +primarily through indirect sales channels comprised of independent dealers in +the United States and Canada who sell integrated systems and related products +to the traffic management market. Our independent dealers are primarily +responsible for sales, installation and support of Vantage systems. These +dealers maintain an inventory of demonstration traffic products from various +manufacturers including our Vantage vehicle detection systems and sell directly +to government agencies and installation contractors. These dealers often have +long-term arrangements with the government agencies in their territory for the +supply of various products for the construction and renovation of traffic +intersections. We hold technical training classes for dealers and end users and +maintain a full-time staff of customer support technicians to provide technical +assistance when needed. +Our marketing strategy +for AutoVue is to establish it as the leading platform for in-vehicle video +sensing for heavy trucks and passenger cars. We sell AutoVue directly to heavy +truck manufacturers and to U.S. truck fleets. We also market to the +manufacturers of passenger automobiles through a strategic relationship with +Valeo Schalter and Sensuren GmbH (“Valeo”), an independent automotive supplier. +We market and sell our +transportation management systems and traveler information services directly to +government agencies pursuant to negotiated contracts that involve competitive +bidding and specific qualification requirements. Most of our contracts with +federal, state and municipal customers provide for cancellation or +renegotiation at the option of the customer upon reasonable notice and fees +paid for modification. We use selected members of our engineering team divided +on a regional basis to serve in sales and business development functions. We do +not engage in sales of transportation management systems and traveler +information services outside of the U.S. Sales of our transportation management +systems contracts generally involve long lead times and require extensive +specification development, evaluation and price negotiations. +Our largest customer +accounted for 12.8% of total net sales and contract revenues in the fiscal year +ended March 31, 2005 (“Fiscal 2005”). +Manufacturing and Materials +We use contract +manufacturers to build subassemblies that are used in our Vantage products. Additionally, +we procure certain components from qualified suppliers, both globally and +locally, and use multi-sourcing strategies when technically and economically +feasible to mitigate supply risk. These +subassemblies and components are delivered to our Anaheim facility where they +go through final assembly and testing prior to shipment to our customers. Our +manufacturing activities are conducted in approximately 8,000 square feet of +space at our Anaheim facility. +Production volume at our subcontractors is based upon quarterly +forecasts that we adjust on a monthly basis to control inventory. For sales of +Autovue LDW systems to the truck market, we subcontract the manufacture of our +AutoVue LDW systems to one manufacturer, and our internal processes are limited +primarily to testing and final verification. +We are currently in the process of qualifying an additional +subcontractor for the manufacture of LDW systems to mitigate production risk +and handle increased demand. For Autovue +LDW sales to the passenger car market, we anticipate that all manufacturing +will be done by Valeo; however, we plan to continue to provide engineering +support to Valeo. We currently do not +manufacture any of the hardware used in the transportation management and +traveler information systems that we design and implement. Our production +facility is currently ISO 9001 certified. +Customer +Support and Services +We provide warranty +service and support for our Vantage and AutoVue products as well as follow-up +service and support for which we charge separately. Service revenue accounted +for less than 1.0% of total net sales and contract revenues for Fiscal 2005. We believe customer support is a key +competitive factor. +Backlog +Our backlog of +unfulfilled firm orders was approximately $18.9 million as of March 31, +2005, which was comprised of $1.7 million related to Roadway Sensors, $3.4 +million related to Automotive Sensors and $13.8 million related to Systems. All backlog for Roadway Sensors and +Automotive Sensors is expected to be recognized as revenue in the fiscal year +ending March 31, 2006 (“Fiscal 2006”) while approximately 60.0% of Systems +backlog is expected to be recognized as revenue in Fiscal 2006. At March 31, 2004, we had backlog of approximately +$21.6 million, which was comprised of $4.7 million related to Roadway Sensors, +$3.9 million related to Automotive Sensors and $13.0 million related to +Systems. At March 31, +4 +2004, backlog for +Roadway Sensors and Automotive Sensors was recognized as revenue in Fiscal 2005 +while 63.8% of Systems March 31, 2004, backlog was recognized as revenue in +Fiscal 2005. Pursuant to the customary +terms of our agreements with government contractors and other customers, +customers can generally cancel or reschedule orders with little or no +penalties. Lead times for the release of purchase orders often depend upon the +scheduling and forecasting practices of our individual customers, which also +can affect the timing of the conversion of our backlog into revenues. For these +reasons, among others, our backlog at a particular date may not be indicative +of our future revenues. +Product +Development +Most of our development +activities are conducted at our principal facilities in Anaheim, California. +Our company-sponsored research and development costs and expenses were +approximately $4.2 million for Fiscal 2005, $3.9 million for the fiscal year +ended March 31, 2004 (“Fiscal 2004”), and $3.9 million for the fiscal year +ended March 31, 2003 (“Fiscal 2003”). We +expect to continue to pursue significant product development programs and incur +significant research and development expenditures. +Competition +We generally face +significant competition in each of our target markets. Increased competition +may result in price reductions, reduced gross margins and loss of market share, +any of which could have a material adverse effect on our business, financial +condition and results of operations. We believe that AutoVue is the only +commercially-available lane departure warning system used in the U.S. and in +Europe in the heavy truck market. Potential +competitors of AutoVue include Delphi Automotive Systems Corporation +domestically, NEC Corporation and Hitachi Ltd. in Japan and Robert Bosch GmbH +in Europe, as well as Siemens, Continental Tavis and Visteon, which could be +currently developing video sensor technologies for the vehicle industry that +could be used for lane departure warning systems. In the market for our Vantage +vehicle detection systems, we compete with manufacturers of other “above ground” +video camera detection systems such as Econolite Control Products, Inc., +Traficon, N.V., Quixote, and other non-intrusive detection devices including +microwave, infrared, ultrasonic and magnetic detectors, as well as +manufacturers and installers of in-pavement inductive loop products. +The transportation +management and traveler information systems market is highly fragmented and is +subject to evolving national and regional quality and safety standards. Our +competitors vary in number, scope and breadth of the products and services they +offer. Our competitors in advanced transportation management and traveler +information systems include large multi-national corporations such as +Transcore, Lockheed Martin Corporation, PB Farradyne, Inc., Kimley-Horn and +Associates, Inc. and National Engineering Technology, Inc. Our competitors in +transportation engineering, planning and design include major firms such as +Parsons Brinkerhoff, Inc. and Parsons Transportation Group, Inc., as well as +many smaller regional engineering firms. +In general, the markets +for the products and services offered by our businesses are highly competitive +and are characterized by rapidly changing technology and evolving standards. +Many of our current and prospective competitors have longer operating +histories, greater name recognition, access to larger customer bases and +significantly greater financial, technical, manufacturing, distribution and +marketing resources than us. As a result, they may be able to adapt more +quickly to new or emerging standards or technologies or to devote greater +resources to the promotion and sale of their products. It is also possible that +new competitors or alliances among competitors could emerge and rapidly acquire +significant market share. We believe that our ability to compete effectively in +our target markets will depend on a number of factors, including the success +and timing of our new product development, the compatibility of our products +with a broad range of computing systems, product quality and performance, +reliability, functionality, price, and service and technical support. Our +failure to provide services and develop and market products that compete +successfully with those of other suppliers and consultants in our target +markets would have a material adverse effect on our business, financial condition +and results of operations. +Intellectual +Property and Proprietary Rights +Our ability to compete +effectively depends in part on our ability to develop and maintain the +proprietary aspects of our technology. Our policy is to obtain appropriate +proprietary rights protection for any potentially significant new technology +acquired or developed by us. We +currently hold ten U.S. patents, which expire commencing in 2012, and have three U.S. patent applications pending, mostly relating to our +outdoor image processing techniques used in our AutoVue systems. Two of our +patents relate specifically to our AutoVue technology and provide a basis for +enhanced functionality for rain sensing and improved performance. We believe +that our other patents, while important for our technology platforms, are less +critical to our near term product strategy. We cannot assure you that any new +patents will be granted pursuant to any outstanding or subsequent applications. +In addition to patent +laws, we rely on copyright and trade secret laws to protect our proprietary +rights. We attempt to protect our trade secrets and other proprietary +information through agreements with customers and suppliers, proprietary +5 +information +agreements with our employees and consultants, and other similar measures. We +do not have any material licenses or trademarks other than those relating to +product names. We cannot be certain that we will be successful in protecting +our proprietary rights. While we believe our patents, patent applications, +software and other proprietary know-how have value, changing technology makes +our future success dependent principally upon our employees’ technical +competence and creative skills for continuing innovation. +Litigation has been +necessary in the past and may be necessary in the future to enforce our +proprietary rights, to determine the validity and scope of the proprietary +rights of others, or to defend us against claims of infringement or invalidity +by others. An adverse outcome in such litigation or similar proceedings could +subject us to significant liabilities to third parties, require disputed rights +to be licensed from others or require us to cease marketing or using certain +products, any of which could have a material adverse effect on our business, +financial condition and results of operations. In addition, the cost of +addressing any intellectual property litigation claim, both in legal fees and +expenses, as well as from the diversion of management’s resources, regardless +of whether the claim is valid, could be significant and could have a material +adverse effect on our business, financial condition and results of operations. +Employees +We refer to our employees +as associates. As of June 8, 2005, we employed an aggregate of 215 +associates, including 48 associates in general management, administration and +finance; 20 associates in sales and marketing; 113 associates in engineering +and product development; 26 associates in operations, manufacturing and +quality; and 8 associates in customer service. None of our associates are +represented by a labor union, and we have never experienced a work stoppage. +Government +Regulation +Our manufacturing +operations are subject to various federal, state and local laws and regulations, +including those restricting the discharge of materials into the environment. We +are not involved in any pending or, to our knowledge, threatened governmental +proceedings, which would require curtailment of our operations because of such +laws and regulations. We continue to expend funds in connection with our +compliance with applicable environmental regulations. These expenditures have +not, however, been significant in the past, and we do not expect any +significant expenditure in the near future. Currently, compliance with foreign +laws has not had a material impact on our business and is not expected to have +a material impact in the near future. \ No newline at end of file diff --git a/raw/filings/0000350868/2004/0001104659-05-032468/item13.txt b/raw/filings/0000350868/2004/0001104659-05-032468/item13.txt new file mode 100644 index 0000000000000000000000000000000000000000..e69de29bb2d1d6434b8b29ae775ad8c2e48c5391 diff --git a/raw/filings/0000350868/2004/0001104659-05-032468/item9a.txt b/raw/filings/0000350868/2004/0001104659-05-032468/item9a.txt new file mode 100644 index 0000000000000000000000000000000000000000..e69de29bb2d1d6434b8b29ae775ad8c2e48c5391 diff --git a/raw/filings/0000350868/2004/0001104659-05-032468/rp_note.txt b/raw/filings/0000350868/2004/0001104659-05-032468/rp_note.txt new file mode 100644 index 0000000000000000000000000000000000000000..e69de29bb2d1d6434b8b29ae775ad8c2e48c5391 diff --git a/raw/filings/0000350868/2004/0001104659-05-032468/rpt_disclosure.txt b/raw/filings/0000350868/2004/0001104659-05-032468/rpt_disclosure.txt new file mode 100644 index 0000000000000000000000000000000000000000..e69de29bb2d1d6434b8b29ae775ad8c2e48c5391 diff --git a/raw/filings/0000350868/2005/0001104659-06-044634/filing.txt b/raw/filings/0000350868/2005/0001104659-06-044634/filing.txt new file mode 100644 index 0000000000000000000000000000000000000000..ed6d1a4f0ff7dc355f8c97d06267e73809094741 --- /dev/null +++ b/raw/filings/0000350868/2005/0001104659-06-044634/filing.txt @@ -0,0 +1,6533 @@ +10-K +1 +a06-9767_110k.htm +ANNUAL REPORT PURSUANT TO SECTION 13 AND 15(D) +UNITED STATES +SECURITIES AND EXCHANGE COMMISSION +Washington, +D.C. 20549 +FORM 10-K +(Mark One) +x ANNUAL +REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT +OF 1934 +For +the fiscal year ended March 31, 2006 +OR +o TRANSITION +REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT +OF 1934 +For the transition period +from +to +Commission file number 001-08762 +ITERIS, INC. +(Exact Name of Registrant +as Specified in Its Charter) +Delaware +95-2588496 +(State or Other Jurisdiction +of Incorporation or Organization) +(I.R.S. Employer +Identification No.) +1515 +South Manchester Avenue, Anaheim, California 92802 +(Address of +Principal Executive Offices) (Zip Code) +Registrant’s +Telephone Number, Including Area Code: (714) +774-5000 +Securities +registered pursuant to Section 12(b) of the Act: +Title of each class +Name of each exchange on which registered +Common Stock, $0.10 par value +American Stock +Exchange +Securities registered pursuant to Section 12(g) of +the Act: None +Indicate by check mark if the registrant is a +well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes o No x +Indicate by check mark if the registrant is not +required to file reports pursuant to Section 13 or Section 15(d) of +the Act. Yes o No +x +Indicate by check mark whether the registrant (1) has +filed all reports required to be filed by Section 13 or 15(d) of the +Securities Exchange Act of 1934 during the preceding 12 months (or for such +shorter period that the registrant was required to file such reports), and (2) has +been subject to such filing requirements for the past 90 days. Yes x No o +Indicate by a check mark if disclosure of delinquent +filers pursuant to Item 405 of Regulation S-K is not contained herein, and will +not be contained, to the best of registrant’s knowledge, in definitive proxy or +information statements incorporated by reference in Part III of this Form 10-K +or any amendment to this Form 10-K. x +Indicate by check mark whether the registrant is a +large accelerated filer, an accelerated filer, or a non-accelerated filer. See +definition of “accelerated filer and large accelerated filer” in Rule 12b-2 +of the Exchange Act. (Check one): +Large accelerated filer o Accelerated filer o Non-accelerated filer x +Indicate by check mark whether the registrant is a +shell company (as defined in Exchange Act Rule 12b-2). Yes o No x +Based on the closing sale price of the registrant’s +common stock on September 30, 2005, the last business day of the +registrant’s most recently completed second fiscal quarter, the aggregate +market value of the voting common stock held by nonaffiliates of the registrant +was $55,322,000. For the purposes of this calculation, shares owned by officers, +directors and 10% stockholders known to the registrant have been deemed to be +owned by affiliates. This determination of affiliate status is not necessarily +a conclusive determination for other purposes. +As of June 28, 2006, there were 28,790,767 shares +of common stock outstanding. +DOCUMENTS INCORPORATED BY REFERENCE +Part III incorporates by reference certain +information from the registrant’s definitive proxy statement for the 2006 +Annual Meeting of Stockholders, which will be filed with the Securities and +Exchange Commission not later than 120 days after the end of the fiscal year +ended March 31, 2006. Except with respect to information specifically +incorporated by reference in this report, the registrant’s proxy statement is +not deemed to be filed as part hereof. +ITERIS, +INC. +ANNUAL +REPORT ON FORM 10-K +FOR THE +FISCAL YEAR ENDED MARCH 31, 2006 +TABLE OF CONTENTS +PART I +ITEM 1. +BUSINESS +ITEM 1A. +RISK +FACTORS +ITEM 1B. +UNRESOLVED STAFF COMMENTS +ITEM 2. +PROPERTIES +ITEM 3. +LEGAL +PROCEEDINGS +ITEM 4. +SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS +PART II +ITEM 5. +MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED +STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES +ITEM 6. +SELECTED CONSOLIDATED FINANCIAL DATA +ITEM 7. +MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL +CONDITION AND RESULTS OF OPERATIONS +ITEM 7A. +QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET +RISK +ITEM 8. +FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA +ITEM 9. +CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON +ACCOUNTING AND FINANCIAL DISCLOSURE +ITEM 9A. +CONTROLS AND PROCEDURES +ITEM +9B. +OTHER +INFORMATION +PART III +ITEM 10. +DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT +ITEM 11. +EXECUTIVE COMPENSATION +ITEM 12. +SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND +MANAGEMENT AND RELATED STOCKHOLDER MATTERS +ITEM 13. +CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS +ITEM 14. +PRINCIPAL ACCOUNTING FEES AND SERVICES +PART IV +ITEM 15. +EXHIBITS AND FINANCIAL STATEMENT SCHEDULES +Unless +otherwise indicated in this report, the “registrant,” “we,” “us” and “our” +collectively refers to Iteris, Inc. (formerly known as Iteris Holdings, Inc. +and Odetics, Inc.) and its former subsidiary, Meyer, Mohaddes Associates, Inc., +which was dissolved effective April 3, 2006. +AutoVue®, Iteris® and Vantage® are among the +registered trademarks of Iteris, Inc. Any other trademarks or trade names +mentioned herein are the property of their respective owners. +2 +Cautionary Statement +This report, including the following discussion and +analysis, contains forward-looking statements (within the meaning of the +Private Securities Litigation Reform Act of 1995) that are based on our current +expectations, estimates and projections about our business and our industry, +and reflect management’s beliefs and certain assumptions made by us based upon +information available to us as of the date of this report. When used in this +report and the information incorporated herein by reference, the words “expect(s),” +“feel(s),” “believe(s),” “should,” “will,” “may,” “anticipate(s),” “estimate(s)” +and similar expressions or variations of these words are intended to identify +forward-looking statements. These forward-looking statements include but are +not limited to statements regarding our anticipated sales, revenue, expenses, +profits, capital needs, competition, backlog and manufacturing capabilities, +the practical market applications, future applications and acceptance of our +products and services, the status of our facilities and product development. +These statements are not guarantees of future performance and are subject to +certain risks and uncertainties which could cause actual results to differ +materially from those projected. You should not place undue reliance on these +forward-looking statements that speak only as of the date hereof. We undertake +no obligation to republish revised forward-looking statements to reflect events +or circumstances after the date hereof or to reflect the occurrence of +unanticipated events. We encourage you to carefully review and consider the +various disclosures made by us which describe certain factors which could +affect our business, including those in “ Risk Factors” +in Item 1A of this report, before deciding to invest in our company or to +maintain or increase your investment. We undertake no obligation to revise or +update publicly any forward-looking statement for any reason. +PART I +ITEM 1. BUSINESS +Overview +Iteris, Inc., +formerly known as Iteris Holdings, Inc., is a leading provider of outdoor +machine vision systems and sensors that optimize the flow of traffic and +enhance driver safety. Using proprietary software and Intelligent +Transportation Systems (“ITS”) industry expertise, we provide video sensor systems, +transportation management and traveler information systems and other +engineering and consulting services to the ITS industry. The ITS industry is +comprised of companies applying a variety of technologies to enable the safe +and efficient movement of people and goods. We use our outdoor image +recognition software expertise to develop proprietary algorithms for video +sensor systems that improve vehicle safety and the flow of traffic. Using our +knowledge of the ITS industry, we design and implement transportation +management systems that help public agencies reduce traffic congestion and +provide greater access to traveler information. +We +were originally incorporated in Delaware in 1987 as Odetics, Inc. and in September 2003 +changed our name to Iteris Holdings, Inc. to reflect our focus on the ITS +industry and our capital structure at that time. On October 22, 2004, we +completed a merger with our majority-owned subsidiary, Iteris, Inc. (the “Iteris +Subsidiary”), and officially changed our corporate name from Iteris Holdings, Inc. +to Iteris, Inc. +Our proprietary image recognition systems include Vantage and AutoVue. Vantage +is a video vehicle detection system that detects the presence of vehicles on +roadways. Vantage systems are used at signalized intersections to enable a more +efficient allocation of green signal time and are also used for incident +detection and highway traffic data collection applications. AutoVue Lane +Departure Warning (“LDW”) systems consist of a small windshield mounted sensor +that uses proprietary software to detect and warn drivers of unintended lane +departures. To date, we and our strategic partner have sold over 50,000 +production AutoVue LDW systems for use on car and truck platforms in the North +American and European markets. We believe that our AutoVue LDW technology is a +broad sensor platform that, through additional software development, may be +expanded to incorporate additional safety and convenience features. +Our transportation +management systems business includes transportation engineering and consulting +services focused on the planning, design, development and implementation of +software-based systems that integrate sensors, video surveillance, computers +and advanced communications equipment to enable public agencies to monitor, control +and direct traffic flow, assist in the quick dispatch of emergency crews and +distribute real-time information about traffic conditions. Our services include +planning and other engineering for the implementation of transportation +infrastructure and related communications systems, analysis and study related +to goods movement and commercial vehicle operations, and parking systems +designs. +We currently +operate in three reportable segments: Roadway Sensors, Automotive Sensors and +Transportation Systems. The Roadway Sensors segment includes our Vantage +vehicle detection systems for traffic intersection control, incident +detection and certain highway traffic data collection applications. The +Automotive Sensors segment is comprised of all activities related to our +AutoVue LDW systems for vehicle safety. The Transportation Systems segment +includes transportation engineering and consulting services and the development +of transportation management and traveler +3 +information systems for +the ITS industry. See Note 13 to the accompanying consolidated financial +statements for further discussion of our operating segments. +Sales, Marketing and Principal Customers +We sell our Vantage +vehicle detection systems primarily through indirect sales channels comprised +of independent dealers in the United States and Canada who sell integrated +systems and related products to the traffic management market. Our independent +dealers are primarily responsible for sales, installation and support of +Vantage systems. These dealers maintain an inventory of demonstration traffic +products from various manufacturers including our Vantage vehicle detection +systems and sell directly to government agencies and installation contractors. +These dealers often have long-term arrangements with the government agencies in +their territory for the supply of various products for the construction and +renovation of traffic intersections. We hold technical training classes for +dealers and end users and maintain a full-time staff of customer support +technicians to provide technical assistance when needed. +Our marketing +strategy for AutoVue is to establish it as the leading platform for in-vehicle +video sensing for heavy trucks and passenger cars. We sell AutoVue LDW systems +directly to heavy truck manufacturers and to U.S. truck fleets, and our AutoVue +LDW system is currently offered as an option on certain Mercedes, MAN, +Freightliner and International trucks. We market the licensing of our LDW +technology to manufacturers of passenger automobiles through a strategic +relationship with Valeo Schalter and Sensuren GmbH (“Valeo”), an independent +automotive supplier. In connection with this marketing effort, we provide +specific contract engineering services, technical marketing and sales support +to Valeo which to date has enabled the launch of our LDW technology on three +Infiniti platforms, the FX, M and Q, where our LDW system is offered as part of +the technology option package. We plan to continue to provide technical +marketing and sales support to Valeo in our efforts to win new OEM customers +for the passenger car market as well as contract engineering services related +to the possible launch of new Infiniti platforms that include our AutoVue LDW +system. +We market and sell +our transportation management systems and traveler information services +directly to government agencies pursuant to negotiated contracts that involve +competitive bidding and specific qualification requirements. Most of our +contracts with federal, state and municipal customers provide for cancellation +or renegotiation at the option of the customer upon reasonable notice and fees +paid for modification. We use selected members of our engineering team divided +on a regional basis to serve in sales and business development functions. We do +not engage in sales of transportation management systems and traveler +information services outside of the U.S. Sales of our transportation management +systems contracts generally involve long lead times and require extensive +specification development, evaluation and price negotiations. +Our largest customer +accounted for 11.5% of total net sales and contract revenues in the fiscal year +ended March 31, 2006 (“Fiscal 2006”). +Manufacturing and Materials +We use contract +manufacturers to build subassemblies that are used in our Vantage products. +Additionally, we procure certain components from qualified suppliers, both +globally and locally, and use multi-sourcing strategies when technically and +economically feasible to mitigate supply risk. These subassemblies and +components are delivered to our Anaheim facility where they go through final +assembly and testing prior to shipment to our customers. Our manufacturing +activities are conducted in approximately 8,000 square feet of space at our +Anaheim facility. Production volume at our subcontractors is based upon +quarterly forecasts that we adjust on a monthly basis to control inventory. For +sales of AutoVue LDW systems to the truck market, we subcontract the +manufacture of our AutoVue LDW systems to two manufacturers, and our internal +processes are limited primarily to testing and final verification. For AutoVue +LDW sales to the passenger car market, we anticipate that all manufacturing +will be done by Valeo; however, we plan to continue to provide engineering +support to Valeo. We currently do not manufacture any of the hardware used in +the transportation management and traveler information systems that we design +and implement. Our production facility is currently ISO 9001 certified. +Customer Support and Services +We provide +warranty service and support for our Vantage and AutoVue products as well as +follow-up service and support for which we charge separately. Service revenue +accounted for less than 1.0% of total net sales and contract revenues for +Fiscal 2006. We believe customer support is a key competitive factor. +Backlog +Our backlog of +unfulfilled firm orders was approximately $20.3 million as of March 31, +2006, which was comprised of $1.5 million related to Roadway Sensors, $3.0 +million related to Automotive Sensors and $15.8 million related to +Transportation Systems. The backlog for Roadway Sensors and Automotive Sensors +is expected to be recognized as revenue in the fiscal year ending March 31, +2007 (“Fiscal 2007”) while approximately 84.0% of Transportation Systems +backlog is expected to be recognized as revenue in Fiscal 2007. At March 31, +2005, we had backlog of approximately $18.9 million, which was comprised of +$1.7 million related to Roadway Sensors, $3.4 million related to Automotive +Sensors and $13.8 +4 +million +related to Transportation Systems. All March 31, 2005 backlog for Roadway +Sensors and Automotive Sensors was recognized as revenue in Fiscal 2006 while +71.0% of Transportation Systems March 31, 2005 backlog was recognized as +revenue in Fiscal 2006. Pursuant to the customary terms of our agreements with +government contractors and other customers, customers can generally cancel or +reschedule orders with little or no penalties. Lead times for the release +of purchase orders often depend upon the scheduling and forecasting practices +of our individual customers, which also can affect the timing of the conversion +of our backlog into revenues. For these reasons, among others, our backlog at a +particular date may not be indicative of our future revenues. +Product Development +Most of our development activities are conducted at our principal +facilities in Anaheim, California. Our company-sponsored research and +development costs and expenses were approximately $5.1 million for Fiscal 2006, +$4.2 million for the fiscal year ended March 31, 2005 (“Fiscal 2005”), and +$3.9 million for the fiscal year ended March 31, 2004 (“Fiscal 2004”). We +expect to continue to pursue significant product development programs and incur +significant research and development expenditures. +Competition +We generally face significant competition in each of our target +markets. Increased competition may result in price reductions, reduced gross +margins and loss of market share, any of which could have a material adverse +effect on our business, financial condition and results of operations. We +believe that AutoVue is the only established commercially-available lane +departure warning system used in the U.S. and in Europe in the heavy truck +market. Potential competitors of AutoVue include Delphi Automotive Systems +Corporation domestically, NEC Corporation and Hitachi Ltd. in Japan and Robert +Bosch GmbH in Europe, as well as Siemens, Continental Tavis, Visteon and +Cognex, which could be currently developing video sensor technologies for the +vehicle industry that could be used for lane departure warning systems. In the +market for our Vantage vehicle detection systems, we compete with manufacturers +of other “above ground” video camera detection systems such as Econolite +Control Products, Inc., Traficon, N.V., Quixote, and other non-intrusive +detection devices including microwave, infrared, ultrasonic and magnetic +detectors, as well as manufacturers and installers of in-pavement inductive +loop products. +The transportation management and traveler information systems market +is highly fragmented and is subject to evolving national and regional quality +and safety standards. Our competitors vary in number, scope and breadth of the +products and services they offer. Our competitors in advanced transportation +management and traveler information systems include national corporations such +as Transcore, Siemens, PB Farradyne, Inc., Kimley-Horn and Associates, Inc. +and National Engineering Technology, Inc. Our competitors in +transportation engineering, planning and design include major firms such as +Parsons Brinkerhoff, Inc., URS, HNTB and Parsons Transportation Group, Inc., +as well as many smaller regional engineering firms. +In general, the markets for the products and services offered by our +businesses are highly competitive and are characterized by rapidly changing +technology and evolving standards. Many of our current and prospective +competitors have longer operating histories, greater name recognition, access +to larger customer bases and significantly greater financial, technical, +manufacturing, distribution and marketing resources than us. As a result, they +may be able to adapt more quickly to new or emerging standards or technologies +or to devote greater resources to the promotion and sale of their products. It +is also possible that new competitors or alliances among competitors could +emerge and rapidly acquire significant market share. We believe that our +ability to compete effectively in our target markets will depend on a number of +factors, including the success and timing of our new product development, the +compatibility of our products with a broad range of computing systems, product +quality and performance, reliability, functionality, price, and service and +technical support. Our failure to provide services and develop and market +products that compete successfully with those of other suppliers and +consultants in our target markets would have a material adverse effect on our +business, financial condition and results of operations. +Intellectual Property and Proprietary +Rights +Our ability to compete effectively depends in part on our ability to +develop and maintain the proprietary aspects of our technology. Our policy is +to obtain appropriate proprietary rights protection for any potentially +significant new technology acquired or developed by us. We currently hold ten +U.S. patents, which expire commencing in 2008, and have two U.S. +patent applications pending relating to our outdoor image processing techniques +used in our AutoVue systems. Nine of our patents relate specifically to our +AutoVue technology and provide a basis for enhanced functionality for rain +sensing and improved performance. We believe that our other patents, while +important for our technology platforms, are less critical to our near term +product strategy. We cannot assure you that any new patents will be granted +pursuant to any outstanding or subsequent applications. +5 +In addition to patent laws, we rely on copyright and trade secret laws +to protect our proprietary rights. We attempt to protect our trade secrets and +other proprietary information through agreements with customers and suppliers, +proprietary information agreements with our employees and consultants, and +other similar measures. We do not have any material licenses or trademarks +other than those relating to product names. We cannot be certain that we will +be successful in protecting our proprietary rights. While we believe our +patents, patent applications, software and other proprietary know-how have +value, changing technology makes our future success dependent principally upon +our employees’ technical competence and creative skills for continuing +innovation. +Litigation may be necessary in the future to enforce our proprietary +rights, to determine the validity and scope of the proprietary rights of +others, or to defend us against claims of infringement or invalidity by others. +An adverse outcome in such litigation or similar proceedings could subject us +to significant liabilities to third parties, require disputed rights to be +licensed from others or require us to cease marketing or using certain +products, any of which could have a material adverse effect on our business, +financial condition and results of operations. In addition, the cost of +addressing any intellectual property litigation claim, both in legal fees and +expenses, as well as from the diversion of management’s resources, regardless +of whether the claim is valid, could be significant and could have a material +adverse effect on our business, financial condition and results of operations. +Employees +We refer to our employees as associates. As of June 6, 2006, we +employed an aggregate of 219 associates, including 45 associates in general +management, administration and finance; 23 associates in sales and marketing; 117 +associates in engineering and product development; 24 associates in operations, +manufacturing and quality; and 10 associates in customer service. None of our +associates are represented by a labor union, and we have never experienced a +work stoppage. +Government Regulation +Our manufacturing operations are subject to various federal, state and +local laws and regulations, including those restricting the discharge of +materials into the environment. We are not involved in any pending or, to our +knowledge, threatened governmental proceedings, which would require curtailment +of our operations because of such laws and regulations. We continue to expend +funds in connection with our compliance with applicable environmental +regulations. These expenditures have not, however, been significant in the +past, and we do not expect any significant expenditure in the near future. +Currently, compliance with foreign laws has not had a material impact on our +business and is not expected to have a material impact in the near future. +6 +ITEM 1A. RISK FACTORS +Our +business is subject to a number of risks, some of which are discussed below. Other +risks are presented elsewhere in this report and in the information +incorporated by reference into this report. You should consider the following +risks carefully in addition to the other information contained in this report +and our other filings with the SEC, including our subsequent reports on Forms 10-Q +and 8-K, before deciding to buy, sell or hold our common stock. The risks +and uncertainties described below are not the only ones facing our company. Additional +risks and uncertainties not presently known to us or that we currently deem +immaterial may also affect our business operations. If any of these risks +actually occurs, our business, financial condition or results of operations +could be seriously harmed. In that event, the market price for our common stock +could decline and you may lose all or part of your investment. +We Have +Experienced Substantial Losses And May Continue To Experience Losses For +The Foreseeable Future. Although we had net income of $80,000 +from continuing operations in the year ended March 31, 2006, we +experienced net losses from continuing operations of $11.3 million and $1.9 +million in the years ended March 31, 2005 and 2004, respectively. While we +have divested other business units, we cannot assure you that our efforts to +downsize our operations or reduce our operating expenses will improve our +financial performance, or that we will be able to achieve profitability on a +quarterly or annual basis in the future. Most of our expenses are fixed in +advance. As such, we generally are unable to reduce our expenses significantly +in the short-term to compensate for any unexpected delay or decrease in +anticipated revenues. As a result, we may continue to experience operating +losses and net losses, which would make it difficult to fund our operations and +achieve our business plan, and could cause the market price of our common stock +to decline. +We May Need To Raise Additional Capital In +The Future, Which May Not Be Available On Terms Acceptable To Us, Or At +All. We have generated significant net losses and operating +losses in recent periods, and have experienced volatility in our cash flows +from operations ranging from positive cash flows from operations of $590,000 in +the year ended March 31, 2005 to negative cash flows from operations of $718,000 +in the year ended March 31, 2004. Additionally, we failed to meet certain +debt covenants under our credit agreement with our bank in two of our last four +fiscal quarters. Our line of credit under this credit agreement expires on July 31, +2006; and we cannot assure you that we will be able to renew this line of +credit facility on acceptable terms, in a timely manner or at all. +Although we completed a $10.1 million convertible +debenture financing and our Iteris Subsidiary closed a $5.0 million term +loan in May 2004, the majority of the proceeds from such financings were +used to purchase the Series A preferred stock of our Iteris Subsidiary +which were held by outside investors. At March 31, 2006, we had $131,000 +of cash and cash equivalents and an outstanding balance of $2.7 million on our +line of credit, which is used to fund our operations. We may need to raise +additional capital in the near future to fund our operations or to repay +indebtedness. Such additional capital may be raised through bank borrowings, or +other debt or equity financings. We cannot assure you that any additional +capital will be available on a timely basis, on acceptable terms, or at all, +and such additional financing may result in further dilution to our +stockholders. +Our capital requirements will depend on many factors, +including, but not limited to: +· market +acceptance of our products and product enhancements, and the overall level of +sales of our products; +· our +ability to control costs; +· the +supply of key components for our products; +· our +ability to generate net income; +· increased +research and development expenses; +· increased +sales and marketing expenses; +· technological +advancements and our competitors’ response to our products; +· capital +improvements to new and existing facilities and enhancements to our +infrastructure and systems; +· potential +acquisitions of businesses and product lines; +· our +relationships with customers and suppliers; +7 +· government +budgets, political agendas and other funding issues; +· our +ability to successfully negotiate credit arrangements with our bank; and +· general +economic conditions, including the effects of the current economic slowdown and +international conflicts. +If our capital requirements are materially different +from those currently planned, we may need additional capital sooner than +anticipated. If additional funds are raised through the issuance of equity or +convertible debt securities, the percentage ownership of our stockholders will +be reduced and such securities may have rights, preferences and privileges +senior to our common stock. Additional financing may not be available on +favorable terms, on a timely basis, or at all. If adequate funds are not +available or are not available on acceptable terms, we may be unable to +continue our operations as planned, develop or enhance our products, expand our +sales and marketing programs, take advantage of future opportunities or respond +to competitive pressures. +If Our +Internal Controls Over Financial Reporting Do Not Comply With The Requirements +Of The Sarbanes-Oxley Act, Our Business And Stock Price Could Be Adversely +Affected. Along with our independent registered public +accounting firm, we will be evaluating the effectiveness of our internal +controls over financial reporting to comply with Section 404 of the +Sarbanes-Oxley Act of 2002. Section 404 currently requires us to evaluate +the effectiveness of our internal controls over financial reporting at the end +of each fiscal year beginning in our fiscal year ending March 31, 2008 at +the earliest, and to include a management report assessing the effectiveness of +our internal controls over financial reporting in all annual reports beginning +with our Annual Report on Form 10-K for the fiscal year ending March 31, +2008 at the earliest. Section 404 also requires our independent accountant +to attest to, and report on, management’s assessment of our internal controls +over financial reporting. We may not be able to complete our Section 404 +compliance on a timely basis and even if we timely complete our compliance +requirements, our independent auditors may still conclude that our internal +controls over financial reporting are not effective. +Our management, including our CEO and CFO, does not +expect that our internal controls over financial reporting will prevent all +error and all fraud. A control system, no matter how well designed and +operated, can provide only reasonable, not absolute, assurance that the control +system’s objectives will be met. Further, the design of a control system must +reflect the fact that there are resource constraints, and the benefits of +controls must be considered relative to their costs. Because of the inherent +limitations in all control systems, no evaluation of controls can provide +absolute assurance that all control issues and instances of fraud, if any, +within the company have been, or will be detected. These inherent limitations +include the realities that judgments in decision-making can be faulty and that +breakdowns can occur because of simple error or mistake. Controls can also be +circumvented by the individual acts of some persons, by collusion of two or +more people, or by management override of the controls. The design of any system +of controls is based in part on certain assumptions about the likelihood of +future events, and we cannot assure you that any design will succeed in +achieving its stated goals under all potential future conditions. Over time, +our controls may become inadequate because of changes in conditions or +deterioration in the degree of compliance with policies or procedures. Because +of the inherent limitations in a cost-effective control system, misstatements +due to error or fraud may occur and not be detected. +As of March 31, 2005, we became aware of a +material weakness in our internal controls related to the accounting for the +consolidation of our deferred compensation savings plan and certain contract +administration. We cannot assure you that we or our independent registered +public accounting firm will not identify additional material weaknesses in our +internal controls. A material weakness is a control deficiency, or combination +of control deficiencies, that results in more than a remote likelihood that a +material misstatement of the annual or interim financial statements will not be +prevented or detected. Based on our evaluation, our management concluded that, +as of March 31, 2004, our internal control over financial reporting was +not effective due to the existence of one material weakness. We may experience +additional material weaknesses in the future. If our internal controls over +financial reporting are not considered adequate, we may experience a loss of +public confidence, which could have an adverse effect on our business and our +stock price. +We May Experience Production Gaps Or Delays +In The Transition To Our Next Generation LDW System And Have Exhausted +Component Supplies For Our Legacy AutoVue LDW Systems, Which Could Materially +And Adversely Impact Our Sales And Financial Results And The Ultimate +Acceptance Of AutoVue. We are in the process of transitioning +to production of a next generation LDW system and experienced a significant +decline in orders from our largest AutoVue OEM customer for the heavy truck market +as a result of this transition. Although we have qualified our next generation +system with our largest customer, we must continue to qualify the new system +with our other customers. We cannot assure you that such qualifications will be +successful or that we will not experience a decline in demand as a result of +this transition. As a result, we could experience a gap or delay in production +as we transition to this next generation system. In some cases, such gaps or +delays may be driven by customer transition issues. In addition, we have run +out of certain components used in the manufacture of our legacy AutoVue LDW +system for the heavy truck market. As such, a timely +8 +completion +of these qualifications and the successful transition will be critical to our +future success. Additionally, it is possible that we could experience +unforeseen quality control issues as we ramp up to full production of our next +generation LDW system. Should any such delay or disruption occur in +transitioning to production of our next generation LDW system, our future sales +will likely be materially and adversely affected. +We Depend On Government Contracts And +Subcontracts, And Because Many Of Our Government Contracts Are Fixed Price +Contracts, Higher Than Anticipated Costs Will Reduce Our Profit And Could +Adversely Impact Our Operating Results. A significant portion +of our sales were derived from contracts with governmental agencies, either as +a general contractor, subcontractor or supplier. Government contracts +represented approximately 38.3%, 37.4% and 48.2% of our total net sales and +contract revenues for the years ended March 31, 2006, 2005 and 2004, +respectively. We anticipate that revenue from government contracts will +continue to increase in the near future. Government business is, in general, +subject to special risks and challenges, including: +· long +purchase cycles or approval processes; +· competitive +bidding and qualification requirements; +· the +impact of international conflicts; +· performance +bond requirements; +· changes +in government policies and political agendas; +· delays +in funding, including the delays in the allocation of funds to state and local +agencies from the U.S. transportation bill; +· other +government budgetary constraints and cut-backs; and +· milestone +requirements and liquidated damage provisions for failure to meet contract +milestones +In addition, a large number of our government +contracts are fixed price contracts. As a result, we may not be able to recover +any cost overruns we may incur. These fixed price contracts require us to +estimate the total project cost based on preliminary projections of the project’s +requirements. The financial viability of any given project depends in large +part on our ability to estimate these costs accurately and complete the project +on a timely basis. In the event our costs on these projects exceed the fixed +contractual amount, we will be required to bear the excess costs. Such +additional costs would adversely affect our financial condition and results of +operations. Moreover, certain of our government contracts are subject to +termination or renegotiation at the convenience of the government, which could +result in a large decline in our net sales in any given quarter. Our inability +to address any of the foregoing concerns or the loss or renegotiation of any +material government contract could seriously harm our business, financial +condition and results of operations. +We Depend Upon Valeo To Market Our AutoVue +Technologies For The OEM Passenger Car Market. We have +granted Valeo the exclusive right to sell and manufacture our AutoVue LDW +system to the worldwide passenger car market in exchange for royalty payments +for each AutoVue unit sold. As such, the future success and broad market +acceptance of our AutoVue technologies in the passenger car market will depend +upon Valeo’s ability to manufacture, market and sell our technologies, and to +convince more OEM passenger car manufacturers to adopt our technologies. If +Valeo does not devote considerable resources and aggressively pursue opportunities, +our expansion into the passenger car market could be adversely affected. +We May Be Unable To Attract And Retain Key +Personnel, Which Could Seriously Harm Our Business. Due to +the specialized nature of our business, we are highly dependent on the +continued service of our executive officers and other key management, +engineering and technical personnel. The loss of any of our executive officers +or key members of management could adversely affect our business, financial +condition or results of operations. Our success will also depend in large part +upon our ability to continue to attract, retain and motivate qualified +engineering and other highly skilled technical personnel. In particular, the +future success of our Transportation Systems business will depend on our +ability to hire additional qualified engineers and planners. Competition for +qualified employees, particularly development engineers, is intense. We may not +be able to continue to attract and retain sufficient numbers of such highly +skilled employees. Our inability to attract and retain additional key employees +or the loss of one or more of our current key employees could adversely affect +our business, financial condition and results of operations. +We Have +Experienced Growth In Recent Periods. If We Fail To Manage Our Growth +Effectively, We May Be Unable To Execute Our Business Plan And May Experience +Future Weaknesses In Our Internal Controls. We have expanded +our overall business, particularly in our Vantage and AutoVue product lines. In +order to achieve our business +9 +objectives, we will need +to continue to expand our business and add additional qualified personnel. Such +expansion has placed and is expected to continue to place, a significant strain +on our managerial, administrative, operational, financial and other resources. If +we are unable to successfully manage our growth, our business, financial +condition and results of operations will be adversely affected. +To accommodate +this growth, we launched a new ERP system in April 2006. Accordingly, we +may experience problems commonly experienced by other companies in connection +with such implementations, including but not limited to, potential bugs in the +system, component or supply delays, training requirements and other integration +challenges and delays. Any difficulties we might experience in connection with +our new ERP system could have a material adverse effect on our financial +reporting system and internal controls. +If We Are Unable To Develop And Introduce New +Products And Product Enhancements Successfully And In A Cost-Effective And +Timely Manner, Or Are Unable To Achieve Market Acceptance Of Our New Products, +Our Operating Results Would Be Adversely Affected. We believe +our revenue growth and future operating results will depend on our ability to +complete development of new products and enhancements, introduce these products +in a timely, cost-effective manner, achieve broad market acceptance of these +products and enhancements, and reduce our product costs. We cannot guarantee +the success of these products and we may not be able to introduce any new +products or any enhancements to our existing products on a timely basis, or at +all. In addition, the introduction of any new products could adversely affect +the sales of certain of our existing products. +We believe that we must continue to make substantial +investments to support ongoing research and development in order to remain +competitive. We need to continue to develop and introduce new products that +incorporate the latest technological advancements in outdoor image processing +hardware, software and camera technologies in response to evolving customer +requirements. Our business and results of operations could be adversely +affected if we do not anticipate or respond adequately to technological developments +or changing customer requirements. We cannot assure you that any such +investments in research and development will lead to any corresponding increase +in revenue. +Market acceptance of our new products depends upon +many factors, including our ability to accurately predict market requirements +and evolving industry standards, our ability to resolve technical challenges in +a timely and cost-effective manner and achieve manufacturing efficiencies, the +perceived advantages of our new products over traditional products and the +marketing capabilities of our independent distributors and strategic partners, +including Valeo’s ability to expand sales of AutoVue in the passenger car +market. The success of our AutoVue system will also depend in part on the success +of the automotive vehicles that incorporate our technology, as well as the +success of optional equipment that OEMs bundle with our technologies. +Certain of the components used in our Vantage and +AutoVue products may need to be re-engineered in the next 18 months as the +industry is moving towards a standard of using lead-free components. We cannot +assure you as to the timing of the adoption of this new standard or our ability +to successfully redesign our products to incorporate compliant components. In addition, +if the standard is adopted earlier than anticipated we may experience a +shortage of Vantage and AutoVue products as a result of potential scarcity of +lead-free components. +Our business and +results of operations could also be seriously harmed by any significant delays +in our new product development. Certain of our new products could contain +undetected design faults and software errors or “bugs” when first released by +us, despite our testing. We may not discover these faults or errors until after +a product has been installed and used by our customers. Any faults or errors in +our existing products or in any new products may cause delays in product +introduction and shipments, require design modifications or harm customer +relationships, any of which could adversely affect our business and competitive +position. +The Markets In Which We Operate Are Highly +Competitive And Have Many More Established Competitors, Which Could Adversely +Affect Our Sales Or The Market Acceptance Of Our Products. We +compete with numerous other companies in our target markets including, but not +limited to, large, multinational corporations, which include tier one +automotive suppliers, and many smaller regional engineering firms. We expect +such competition to increase due to technological advancements, industry +consolidations and reduced barriers to entry. Increased competition is likely +to result in price reductions, reduced gross margins and loss of market share, +any of which could seriously harm our business, financial condition and results +of operations. We may experience more competition in our Vantage business in +Fiscal 2007 as the department of transportation in one of our largest sales +territories is moving to a multisource contracting environment from one in +which Iteris is the preferred supplier. In addition, one of the other +developers of LDW systems was recently acquired by a larger company. While this +developer has not been a material competitor to date, we may experience more +competition from this provider as a result of its greater access to resources +from its acquirer, and additional competitors may enter this market in the +future. +10 +Many of our competitors have far greater name +recognition and greater financial, technological, marketing and customer +service resources than we do. This may allow them to respond more quickly to +new or emerging technologies and changes in customer requirements. It may also +allow them to devote greater resources to the development, promotion, sale and +support of their products than we can. Recent consolidations of end users, +distributors and manufacturers in our target markets have exacerbated this +problem. As a result of the foregoing factors, we may not be able to compete +effectively in our target markets and competitive pressures could adversely +affect our business, financial condition and results of operations. +An Economic Slowdown And Related Uncertainties +Could Adversely Impact The Demand For Our Products. Concerns +about inflation, decreased consumer confidence, reduced corporate profits and +capital spending, and recent international conflicts and terrorist and military +actions have resulted in a downturn in worldwide economic conditions, +particularly in the United States. These unfavorable economic conditions may +have a negative impact on customer orders, cancellations and rescheduling of +backlog. In addition, recent political and social turmoil related to +international conflicts and terrorist acts can be expected to put further +pressure on economic conditions in the U.S. and worldwide. These political, +social and economic conditions make it extremely difficult for our customers, +our suppliers and us to accurately forecast and plan future business activities. +If such conditions continue or worsen, our business, financial condition and +results of operations will likely be materially and adversely affected. +We May Engage In Acquisitions Of Companies Or +Technologies That May Require Us To Undertake Significant Capital +Infusions And Could Result In Disruptions Of Our Business And Diversion Of +Resources And Management Attention. We have historically +acquired, and may in the future acquire, complementary businesses, products and +technologies. Acquisitions may require significant capital infusions and, in +general, acquisitions also involve a number of special risks, including: +· potential +disruption of our ongoing business and the diversion of our resources and +management’s attention; +· the +failure to retain or integrate key acquired personnel; +· the +challenge of assimilating diverse business cultures, and the difficulties in +integrating the operations, technologies and information system of the acquired +companies; +· increased +costs to improve managerial, operational, financial and administrative systems +and to eliminate duplicative services; +· the +incurrence of unforeseen obligations or liabilities; +· potential +impairment of relationships with employees or customers as a result of changes +in management; and +· increased +interest expense and amortization of acquired intangible assets. +Our competitors are also soliciting potential +acquisition candidates, which could both increase the price of any acquisition +targets and decrease the number of attractive companies available for +acquisition. Acquisitions may also materially and adversely affect our +operating results due to large write-offs, contingent liabilities, substantial +depreciation, deferred compensation charges or intangible asset amortization, +or other adverse tax or accounting consequences. We cannot assure you that we +will be able to identify or consummate any additional acquisitions, +successfully integrate any acquisitions or realize the benefits anticipated +from any acquisition. +Our Quarterly Operating Results Fluctuate As A +Result Of Many Factors. Therefore, We May Fail To Meet Or Exceed The +Expectations Of Securities Analysts And Investors, Which Could Cause Our Stock +Price To Decline. Our quarterly revenues and operating +results have fluctuated and are likely to continue to vary from quarter to +quarter due to a number of factors, many of which are not within our control. +Factors that could affect our revenues include, among others, the following: +· our +ability to raise additional capital; +· our +ability to control costs; +· international +conflicts and acts of terrorism; +· our +ability to develop, introduce, patent, market and gain market acceptance of new +products, applications and product enhancements in a timely manner, or at all; +11 +· market +acceptance of the products incorporating our technologies and products; +· the +size, timing, rescheduling or cancellation of significant customer orders; +· the +introduction of new products by competitors; +· the +availability and cost of components used in the manufacture of our products; +· changes +in our pricing policies and the pricing policies of our suppliers and +competitors, pricing concessions on volume sales, as well as increased price +competition in general; +· the +long lead times associated with government contracts or required by vehicle +manufacturers; +· delays +in the allocation of funds to state and local agencies from the U.S. government +transportation bill; +· our +success in expanding and implementing our sales and marketing programs; +· the +effects of technological changes in our target markets; +· our +relatively small level of backlog at any given time; +· seasonality +due to winter weather conditions; +· the +mix of our sales; +· deferrals +of customer orders in anticipation of new products, applications or product +enhancements; +· risks +and uncertainties associated with our international business; +· currency +fluctuations and our ability to get currency out of certain foreign countries; +and +· general +economic and political conditions. +Due to all of the factors listed above as well as +other unforeseen factors, our future operating results could be below the +expectations of securities analysts or investors. If that happens, the trading +price of our common stock could decline. As a result of these quarterly +variations, you should not rely on quarter-to-quarter comparisons of our +operating results as an indication of our future performance. +If We Do Not Keep Pace With Rapid Technological +Changes And Evolving Industry Standards, We Will Not Be Able To Remain +Competitive And There Will Be No Demand For Our Products. Our +markets are in general characterized by the following factors: +· rapid +technological advances; +· downward +price pressure in the marketplace as technologies mature; +· changes +in customer requirements; +· frequent +new product introductions and enhancements; and +· evolving +industry standards and changes in the regulatory environment. +Our future success will depend upon our ability to +anticipate and adapt to changes in technology and industry standards, and to +effectively develop, introduce, market and gain broad acceptance of new +products and product enhancements incorporating the latest technological +advancements. In particular, our LDW system is incorporated into automobiles +and trucks that face significant technological changes in each model year and +among different vehicle models. Accordingly, we must adapt our technology from +time to time to function with such changes. +We May Not Be Able To Adequately Protect Or +Enforce Our Intellectual Property Rights, Which Could Harm Our Competitive +Position. If we are not able to adequately protect or enforce +the proprietary aspects of our technology, competitors could be able to access +our proprietary technology and our business, financial condition and results +12 +of +operations will likely be seriously harmed. We currently attempt to protect our +technology through a combination of patent, copyright, trademark and trade +secret laws, employee and third party nondisclosure agreements and similar +means. Despite our efforts, other parties may attempt to disclose, obtain or +use our technologies or systems. Our competitors may also be able to +independently develop products that are substantially equivalent or superior to +our products or design around our patents. In addition, the laws of some +foreign countries do not protect our proprietary rights as fully as do the laws +of the United States. As a result, we may not be able to protect our +proprietary rights adequately in the United States or abroad. +Litigation may be +necessary in the future to enforce our intellectual property rights or to +determine the validity and scope of the proprietary rights of others. +Litigation may also be necessary to defend against claims of infringement or +invalidity by others. An adverse outcome in litigation or any similar +proceedings could subject us to significant liabilities to third parties, +require us to license disputed rights from others or require us to cease +marketing or using certain products or technologies. We may not be able to +obtain any licenses on terms acceptable to us, or at all. We also may have to +indemnify certain customers or strategic partners if it is determined that we +have infringed upon or misappropriated another party’s intellectual property. +Any of these results could adversely affect our business, financial condition +and results of operations. In addition, the cost of addressing any intellectual +property litigation claim, including legal fees and expenses, and the diversion +of management’s attention and resources, regardless of whether the claim is +valid, could be significant and could seriously harm our business, financial +condition and results of operations. +The Trading Price Of Our Common Stock Is Highly +Volatile. The trading price of our common stock has been +subject to wide fluctuations in the past. Since January 2000, our Class A +common stock (now known as our common stock) has traded at prices as low as +$0.45 per share and as high as $29.44 per share. The market price of our common +stock could continue to fluctuate in the future in response to various factors, +including, but not limited to: +· quarterly +variations in operating results; +· our +ability to control costs, improve cash flow and sustain profitability; +· our +ability to raise additional capital; +· shortages +announced by suppliers; +· announcements +of technological innovations or new products or applications by our +competitors, customers or us; +· transitions +to new products or product enhancements; +· acquisitions +of businesses, products or technologies; +· the +impact of any litigation; +· changes +in investor perceptions; +· government +funding, political agendas and other budgetary issues; +· changes +in earnings estimates or investment recommendations by securities analysts; and +· international +conflicts, political unrest and acts of terrorism. +The stock market in general has recently experienced +volatility, which has particularly affected the market prices of equity +securities of many technology companies. This volatility has often been unrelated +to the operating performance of these companies. These broad market +fluctuations may adversely affect the market price of our common stock. In the +past, companies that have experienced volatility in the market price of their +securities have been the subject of securities class action litigation. If we +were to become the subject of a class action lawsuit, it could result in +substantial losses and divert management’s attention and resources from other +matters. +13 +Our International Business Operations May Be +Threatened By Many Factors That Are Outside Of Our Control. We +currently market our AutoVue and Vantage products internationally and we +anticipate that our international operations will expand in the near future. +International business operations are subject to various inherent risks +including, among others: +· currency +fluctuations and restrictions; +· political, +social and economic instability; +· reduced +protection for intellectual property rights in some countries; +· unexpected +changes in regulatory requirements, tariffs and other trade barriers or +restrictions; +· the +burdens of compliance with a wide variety of foreign laws and more restrictive +labor laws and obligations; +· longer +accounts receivable payment cycles; +· difficulties +in managing and staffing international operations; +· potentially +adverse tax consequences; and +· import +and export license requirements and restrictions of the United States and each +other country in which we operate. +All of our international sales are denominated in U.S. +dollars. As a result, an increase in the relative value of the dollar could +make our products more expensive and potentially less price competitive in +international markets. We do not engage in any transactions as a hedge against +risks of loss due to foreign currency fluctuations. +Any of the factors mentioned above may adversely +affect our future international sales and, consequently, affect our business, +financial condition and operating results. Furthermore, as we increase our +international sales, our total revenues may also be affected to a greater +extent by seasonal fluctuations resulting from lower sales that typically occur +during the summer months in Europe and other parts of the world. +We Could Experience Negative Financial Impacts +Arising From Developments In Contingencies Created Under Our Previous Structure +Or By Former Subsidiaries. Although we divested ourselves of +all business units, with the exception of our Iteris business, from time to +time we could experience unforeseen developments in contingencies related to +our former subsidiaries. In particular, we are presently party to a lawsuit +brought against Mariner Networks, Inc., one of our former subsidiaries +(refer to Note 7 to the consolidated financial statements). The outcome of this +lawsuit is presently uncertain. Although we are not aware of any other material +contingencies, it is possible that other matters could be brought against us in +connection with activities related to former subsidiaries and that such matters +could materially and adversely affect our financial results and cash flows. +Some Of Our Directors, Officers And Their +Affiliates Can Control The Outcome Of Matters That Require The Approval Of Our +Stockholders, And Accordingly We Will Not Be Able To Engage In Certain +Transactions Without Their Approval. As of March 31, +2006, our officers and directors owned approximately 16% of the outstanding +shares of our common stock (and approximately 25% of our common stock when +including options, warrants and other convertible securities held by them which +are currently exercisable or convertible or will become exercisable or +convertible within 60 days after March 31, 2006). As a result of +their stock ownership, our management will be able to significantly influence +the election of our directors and the outcome of corporate actions requiring +stockholder approval, such as mergers and acquisitions, regardless of how our +other stockholders may vote. This concentration of voting control may have a +significant effect in delaying, deferring or preventing a change in our +management or change in control and may adversely affect the voting or other +rights of other holders of common stock. +Certain Anti-Takeover Provisions May Affect +The Price Of Our Common Stock And Discourage A Third Party From Acquiring Us. Certain +provisions of our certificate of incorporation and our stockholder rights plan +could make it difficult for a third party to acquire us, even though an +acquisition might be beneficial to our stockholders. Such provisions could +limit the price that investors might be willing to pay in the future for shares +of our common stock. Under the terms of our certificate of incorporation, our +Board of Directors is authorized to issue, without stockholder approval, up to +2,000,000 shares of preferred stock with voting, conversion and other rights +and preferences superior to those of our common stock. Our future issuance of +preferred stock could be used to discourage an unsolicited acquisition +proposal. In addition, in March 1998, we adopted a stockholder rights plan +and declared a dividend of preferred stock purchase rights to our stockholders. +We amended this plan in May 2004. In the event a third party acquires more +than 15% of the outstanding voting control of our company or 15% of our +outstanding common stock, the holders of these rights will be able to purchase +the junior participating preferred stock at a substantial discount off of the +then current market price. The exercise of these rights and purchase of a +significant amount of stock at below market prices could cause substantial +dilution to a particular acquirer and discourage the acquirer from pursuing our +company. The mere existence of a stockholder rights plan often delays or makes +a merger, tender offer or proxy contest more difficult. +14 +ITEM 1B. UNRESOLVED STAFF COMMENTS +Not applicable. +ITEM 2. PROPERTIES +Our headquarters and principal operations are housed in approximately +94,000 square feet of leased space located at 1515 South Manchester Boulevard +in Anaheim, California, for which we pay a monthly lease rate of $84,000. The +Anaheim facility includes our operations and administrative offices +(approximately 84,000 dedicated square feet) and the operations of our former +subsidiary, MAXxess Systems, Inc. (approximately 10,000 dedicated square +feet). The portion of the facility occupied by MAXxess is subleased at a rate +of $10,000 per month. The lease for the Anaheim facility does not contain any +renewal options and expires on October 31, 2007. +For additional information regarding our obligations under property +leases, see Note 7 of Notes to Consolidated Financial Statements, included in Part IV, +Item 15 of this Report. +ITEM 3. LEGAL PROCEEDINGS +The information set forth under Note 7 of Notes to Consolidated +Financial Statements, included in Part IV, Item 15 of this report, is +incorporated herein by reference. +ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY +HOLDERS +No matters were submitted to a vote of our security holders during the +three months ended March 31, 2006. +15 +PART II +ITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED +STOCKHOLDER MATTERS AND ISSUER +PURCHASES OF EQUITY SECURITIES +In October 2004, we amended our certificate of +incorporation to (a) change the voting rights of our Class A common +stock from one-tenth to one vote per share, (b) remove the ability to +issue any further shares of Class B common stock, and (c) rename our Class A +common stock as common stock. As a result, we currently have only one class of +common stock outstanding, the common stock. Our Class A common stock and Class B +common stock were delisted from the Nasdaq SmallCap Market in August 2003 +and April 2003, respectively, and were quoted on the OTC Bulletin Board +thereafter until December 9, 2004, when our common stock began trading on +the American Stock Exchange (“AMEX”) under the symbol “ITI.” +Class A Common Stock +Class B Common Stock +High +Low +High +Low +Fiscal +2005 +Quarter Ended June 30, 2004 +$ +4.10 +$ +2.60 +$ +3.00 +$ +3.00 +Quarter Ended September 30, 2004 +3.60 +2.85 +3.00 +3.00 +Quarter Ended December 31, 2004 +3.87 +2.90 +3.00 +3.00 +Quarter Ended March 31, 2005 +3.43 +2.30 +N/A +N/A +Fiscal +2006 +Quarter Ended June 30, 2005 +$ +2.89 +$ +2.00 +N/A +N/A +Quarter Ended September 30, 2005 +3.40 +2.57 +N/A +N/A +Quarter Ended December 31, 2005 +2.80 +2.02 +N/A +N/A +Quarter +Ended March 31, 2006 +2.80 +1.85 +N/A +N/A +On June 28, 2006, the last reported sale price of our common stock +on the AMEX was $2.20. As of June 28, 2006, we had 580 holders of record +of our common stock according to information furnished by our transfer agent. +Dividend Policy +We have never paid or declared cash dividends on our common stock, and +have no current plans to pay such dividends in the foreseeable future. We +currently intend to retain any earnings for working capital and general +corporate purposes. The payment of any future dividends will be at the +discretion of our Board of Directors and will depend upon a number of factors, +including, but not limited to, future earnings, the success of our business, +our capital requirements, our general financial condition and future prospects, +general business conditions, the consent of our lender and such other factors +as the Board of Directors may deem relevant. +16 +ITEM 6. SELECTED +CONSOLIDATED FINANCIAL DATA +The following +table sets forth selected consolidated financial data for each of the five +fiscal years ended March 31, 2006. The statement of operations and balance +sheet data for the years ended and as of March 31, 2006, 2005, 2004, 2003 +and 2002 are derived from our audited consolidated financial statements. The +accompanying consolidated financial statements have been restated to reflect +the classification and presentation of our former subsidiaries, Broadcast, Inc., +Zyfer Inc., Mariner Networks, Inc., Gyyr, Inc. and MAXxess Systems, Inc., +as discontinued operations for all periods presented. See Note 1 to the +accompanying consolidated financial statements. The following information +should be read in conjunction with “Management’s Discussion and Analysis of +Financial Condition and Results of Operations” and with our consolidated +financial statements and the related notes thereto included elsewhere in this +report. +17 +Fiscal Year Ended March 31 +2006 +2005 +2004 +2003 +2002 +(in thousands, except per share data) +Consolidated +Statement of Operations Data: +Net +sales and contract revenues: +Net sales +$ +31,156 +$ +29,062 +$ +23,470 +$ +19,112 +$ +17,104 +Contract revenues +19,330 +17,335 +21,813 +22,283 +20,205 +Total net sales and contract +revenues +50,486 +46,397 +45,283 +41,395 +37,309 +Costs +and expenses: +Cost of net sales +16,465 +15,645 +12,758 +9,366 +8,401 +Cost of contract revenues +12,395 +11,398 +14,712 +15,110 +12,043 +Selling, general and +administrative expenses +14,999 +13,964 +12,844 +14,105 +14,627 +Research and development +expenses +5,088 +4,193 +3,923 +3,908 +3,434 +Stock-based compensation +725 +11,777 +— +— +— +Amortization of intangible +assets +147 +114 +— +— +— +Deferred compensation expense +(benefit) +48 +(484 +) +868 +— +— +Disposal of fixed assets +— +422 +— +— +— +Acquired in-process research +and development +— +140 +— +— +— +Restructuring charges +— +— +— +— +1,142 +Total costs and expenses +49,867 +57,169 +45,105 +42,489 +39,647 +Income (loss) from operations +619 +(10,772 +) +178 +(1,094 +) +(2,338 +) +Non-operating +income (expense): +Other income (expense), net +35 +1,054 +1,003 +417 +(1,365 +) +Interest expense, net +(1,459 +) +(1,178 +) +(123 +) +(761 +) +(4,190 +) +Income (loss) from continuing operations before income taxes and +minority interest +(805 +) +(10,896 +) +1,058 +(1,438 +) +(7,893 +) +Income tax benefit (provision) +885 +94 +(100 +) +— +785 +Minority interest in earnings of subsidiary +— +(526 +) +(2,813 +) +(3,818 +) +(1,910 +) +Income (loss) from continuing operations +80 +(11,328 +) +(1,855 +) +(5,256 +) +(9,018 +) +Income (loss) from discontinued operations, net of taxes +— +— +1,215 +(7,892 +) +(17,120 +) +Extraordinary loss from early extinguishment of debt, net of taxes +— +— +— +— +(450 +) +Net income (loss) +$ +80 +$ +(11,328 +) +$ +(640 +) +$ +(13,148 +) +$ +(26,588 +) +Basic +earnings (loss) per share: +Continuing operations +$ +0.00 +$ +(0.45 +) +$ +(0.09 +) +$ +(0.37 +) +$ +(0.80 +) +Discontinued operations +— +— +0.06 +(0.55 +) +(1.52 +) +Extraordinary loss +— +— +— +— +(0.04 +) +Basic earnings (loss) per +share +$ +0.00 +$ +(0.45 +) +$ +(0.03 +) +$ +(0.92 +) +$ +(2.36 +) +Diluted +earnings (loss) per share: +Continuing operations +$ +0.00 +$ +(0.45 +) +$ +(0.09 +) +$ +(0.37 +) +$ +(0.80 +) +Discontinued operations +— +— +0.06 +(0.55 +) +(1.52 +) +Extraordinary loss +— +— +— +— +(0.04 +) +Diluted earnings (loss) per +share +$ +0.00 +$ +(0.45 +) +$ +(0.03 +) +$ +(0.92 +) +$ +(2.36 +) +Shares used in calculating basic earnings (loss) per share +28,182 +25,284 +19,454 +14,276 +11,267 +Shares +used in calculating diluted earnings (loss) per share +32,737 +25,284 +19,454 +14,276 +11,267 +At March 31, +2006 +2005 +2004 +2003 +2002 +(in thousands) +Consolidated +Balance Sheet Data: +Working capital (deficit) +$ +3,293 +$ +2,197 +$ +9,369 +$ +3,368 +$ +(7,349 +) +Total assets +49,633 +46,656 +30,065 +34,842 +52,238 +Long-term debt (less current portion) +11,374 +10,315 +891 +1,265 +2,042 +Accumulated deficit +(110,356 +) +(110,436 +) +(99,108 +) +(98,468 +) +(85,320 +) +Total +stockholders’ equity (deficit) +18,635 +17,462 +(1,076 +) +(5,340 +) +4,203 +18 +ITEM 7. MANAGEMENT’S +DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS +You should read the following +discussion and analysis in conjunction with our Consolidated Financial +Statements and related Notes thereto included in Part IV, Item 15 of this +report and the “Risk Factors” section in Item 1A, as well as other +cautionary statements and risks described elsewhere in this report, before +deciding to purchase, hold or sell our common stock. +Overview +We are a leading provider of outdoor machine vision systems and sensors +that optimize the flow of traffic and enhance driver safety. Using our +proprietary software and ITS industry expertise, we provide video sensor +systems, transportation management and traveler information systems and other engineering +and consulting services to the ITS industry. We use our outdoor image +recognition software expertise to develop proprietary algorithms for video +sensor systems that improve vehicle safety and the flow of traffic. Using our +knowledge of the ITS industry, we design and implement transportation +management systems that help public agencies reduce traffic congestion and +provide greater access to traveler information. +Our Vantage product is a video vehicle sensing system that detects the +presence of vehicles on roadways. Vantage systems are used at signalized +intersections to enable a more efficient allocation of green signal time and +are also used for incident detection and highway traffic data collection +applications. We sell and distribute our Vantage products primarily to +commercial customers and municipal agencies. +Our AutoVue LDW systems consist of a small windshield mounted sensor +that uses proprietary software to detect and warn drivers of unintended lane +departures. Approximately 50,000 production AutoVue LDW units have been sold +for car and truck platforms in the North American and European markets. Our +AutoVue LDW systems are currently offered as an option on certain Mercedes, +MAN, Freightliner and International trucks. In September 2003, we entered +into an agreement with Valeo, pursuant to which we granted Valeo the exclusive +right to sell and manufacture our AutoVue LDW systems to the worldwide +passenger car market in exchange for royalty payments for each AutoVue LDW unit +sold. To date, royalty payments from Valeo have not been significant. Pursuant +to this agreement, we also generate revenues from Valeo by providing specific +contract engineering services, technical marketing and sales support to Valeo +to enable the launch of our LDW technology on three Infiniti platforms, the FX, +M and Q, where the device is offered as part of the technology option package. Valeo +is currently in discussions to provide our LDW system to other passenger car +OEMs; however, we cannot assure you that such discussions will be successful. We +plan to continue to provide technical marketing and sales support to Valeo in +our efforts to win new OEM customers for the passenger car market, as well as +contract engineering services related to the possible launch of new Infiniti +platforms that include our LDW system. We believe that AutoVue is a broad +sensor platform that, through additional software development, may be expanded +to incorporate additional safety and convenience features. +Our transportation +management systems business includes transportation engineering and consulting +services focused on the planning, design, development and implementation of +software-based systems that integrate sensors, video surveillance, computers +and advanced communications equipment to enable public agencies to monitor, +control and direct traffic flow, assist in the quick dispatch of emergency +crews and distribute real-time information about traffic conditions. Our +services include planning and other engineering for the implementation of transportation +infrastructure and related communications systems, analysis and study related +to goods movement and commercial vehicle operations, and parking systems +designs. These services and systems are sold to local, state and national +transportation agencies in the United States. Our transportation management +systems business is largely dependent upon governmental funding and budgetary +issues. The Federal Highway Bill was passed in August 2005, which provides +for a significant increase in transportation funding over the next six years. Historically, +there have been significant delays between the passage of funding bills and the +allocation of related funding to specific contracts. Accordingly, while we have +seen an increase in activity following the passage of the bill, we cannot +currently predict the full impact that this bill will have on our +transportation management systems business. We anticipate that the success of +our transportation systems business will continue to be dependent in part on +government spending and the budgetary process. +We have historically operated multiple business units. During the +fiscal year ended March 31, 2003 (“Fiscal 2003”), we operated in three +business segments consisting of ITS, video products, and telecom products. The +ITS segment consisted of our current operations, which was previously conducted +by the Iteris Subsidiary. The video products segment consisted of our former +wholly-owned subsidiaries, MAXxess Systems, Inc. (“MAXxess,” previously +known as Gyyr Incorporated), which designed and manufactured security +management systems, and Broadcast, Inc. (“Broadcast”), which developed and +supplied software based systems to automate and control the multiple classes of +equipment used in broadcast studios and satellite uplink facilities. Our +telecom segment consisted of our wholly-owned subsidiary, Zyfer, Inc. (“Zyfer”), +which +19 +developed and manufactured timing and synchronization +products and which, prior to its incorporation, was operated as our +Communications division. +Beginning in +Fiscal 2003, we began divesting certain of our business units in order to +reduce our operating expenses and to focus on the operations of our Iteris +Subsidiary. These divestitures and related restructuring activities included +the following transactions: +· In March 2003, +we ceased the development and sale of any new Broadcast products and in September 2003, +we sold the balance of our Broadcast business. +· In May 2003, +we sold the assets of Zyfer for a purchase price of $2.3 million in cash and +the assumption of liabilities, plus future incentive payments based on the +revenues generated by the sale of Zyfer’s products or the license of its +technologies. In October 2004, we received an incentive payment of +$135,000 related to the twelve month period ended April 30, 2004, and in September 2005, +we received an incentive payment of $83,000 related to the twelve month period +ended April 30, 2005. +· In September 2003, +we sold substantially all of the assets of MAXxess to an investor group that +included one of our directors and certain members of the MAXxess management +group. The consideration for the sale consisted of the assumption of $2.7 +million of liabilities, resulting in a net gain of $2.3 million on this sale. +· In May 2004, +we repurchased all of the outstanding shares of Series A preferred stock +of the Iteris Subsidiary for an aggregate purchase price of approximately $17.5 +million in cash, and we purchased 548,000 shares of the Iteris Subsidiary +common stock from DaimlerChrysler Ventures GmbH (“DCV”) in consideration for +the issuance of 1.2 million shares of our common stock. We financed the +purchase price for the Iteris Subsidiary Series A preferred stock through +the issuance of convertible debentures in the original principal amount of +$10.1 million, a $5.0 million term note payable to our bank and $2.4 million in +cash. +· In June 2004, +we issued 2.6 million shares of our common stock valued at $8.6 million at the +date of issuance in exchange for an aggregate of 1.3 million shares of common +stock of the Iteris Subsidiary, which had the effect of reducing the residual +minority interest in our Iteris Subsidiary to 8.1%. +· In October 2004, +we merged the Iteris Subsidiary into us and the remaining minority interest in +the Iteris Subsidiary (consisting of 1.2 million shares of common stock of the +Iteris Subsidiary) was converted to 2.5 million shares of our common stock valued at $7.6 +million at the merger date. Immediately following the merger, we converted all +of our outstanding Class B common stock (922,000 shares) into 1.0 million +shares of our common stock (which was formerly designated as Class A +common stock). In connection with this merger, we also assumed 3.1 million +outstanding options and 327,000 warrants to purchase common stock of the Iteris +Subsidiary, which became options and warrants to purchase an aggregate of 6.1 +million and 654,000 shares, +respectively, of our common stock. +· In October 2004, +we amended our certificate of incorporation to (a) change the voting +rights of our Class A common stock from one-tenth to one vote per share, (b) remove +the ability to issue any further shares of Class B common stock, and (c) rename +our Class A common stock to common stock. As a result, we currently have +only one class of capital stock outstanding, the common stock. +Our financial +statements for all periods presented in this report have been restated to +reflect the discontinuation of the operations of Broadcast, Zyfer and MAXxess. +We currently +operate in three reportable segments: Roadway Sensors, Automotive Sensors and +Transportation Systems. The Roadway Sensors segment includes our Vantage +vehicle detection systems for traffic intersection control, incident +detection and certain highway traffic data collection applications. The +Automotive Sensors segment is comprised of all activities related to our +AutoVue LDW systems for vehicle safety. The Transportation Systems segment +includes transportation engineering and consulting services and the development +of transportation management and traveler information systems for the ITS +industry. +Critical Accounting Policies and Estimates +Management’s +Discussion and Analysis of Financial Condition and Results of Operations is +based on our consolidated financial statements included herein, which have been +prepared in accordance with generally accepted accounting principles in the +United States (“GAAP”). The preparation of these financial statements requires +management to make estimates and assumptions that affect the reported amounts +of assets and liabilities and related disclosures of contingent assets and +liabilities at the date of the financial statements and the reported amounts of +revenues and expenses during the reporting period. On an ongoing basis, we +evaluate these estimates and assumptions, including those related to the +collectibility of accounts receivable, the valuation of inventories, the +recoverability of long-lived assets and goodwill, the realizability of deferred +tax assets, and warranty reserves. We base these estimates on historical +experience and on various other factors that we believe to be reasonable under +the circumstances, the results of which form the basis for making judgments +about the carrying values of assets and liabilities that are not readily +apparent from other sources. These estimates and assumptions by their nature +involve risks and uncertainties, and may prove to be inaccurate. In the event +that any of our estimates or +20 +assumptions are +inaccurate in any material respect, it could have a material adverse effect on +our reported amounts of assets and liabilities at the date of the financial +statements and the reported amounts of revenues and expenses during the +reporting period. +The following +critical accounting policies affect our more significant judgments and +estimates used in the preparation of our consolidated financial statements. +Revenue +Recognition . We record product revenues and related costs of +sales upon transfer of title, which is generally upon shipment or, if required, +upon acceptance by the customer, provided that we believe collectibility of the +net sales amount is reasonably assured. Accordingly, at the date revenue is +recognized, the significant uncertainties concerning the sale have been +resolved. +Contract revenues +are derived primarily from long-term contracts with governmental agencies. Contract +revenues include costs incurred plus a portion of estimated fees or profits +determined using the percentage of completion method of accounting based on the +relationship of costs incurred to total estimated costs. Any anticipated losses +on contracts are charged to earnings when identified. Changes in job +performance and estimated profitability, including those arising from contract +penalty provisions and final contract settlements, may result in revisions to +recognized costs and revenues and are recognized in the period in which the +revisions are determined. Profit incentives are included in revenue when their +realization is reasonably assured. +In addition to +product and contract revenues, we derive revenue from technology access fees, +the provision of specific non-recurring contract engineering services related +to our AutoVue LDW system, and royalties related to unit sales of our AutoVue +LDW systems by our strategic partner Valeo to the passenger car market. +Technology access fee revenues are recognized evenly over the period in which +they are earned. Non-recurring contract engineering revenues are recognized in +the period in which the related services are performed. Royalty revenues are +recorded based on unit sales of our products by Valeo and are recognized in the +period in which such sales occur. Technology access fee revenues, contract +engineering revenues and royalty revenues are included in net sales in the +accompanying consolidated statements of operations. +Revenues from +follow-on service and support, for which we charge separately, are recorded in +the period in which the services are performed. +Accounts +Receivable . We estimate the collectibility of customer +receivables on an ongoing basis by periodically reviewing invoices outstanding +greater than a certain period of time. We have recorded reserves for +receivables deemed to be at risk for collection as well as a general reserve +based on our historical collections experience. A considerable amount of +judgment is required in assessing the ultimate realization of trade +receivables, including the current credit-worthiness of each customer. If the +financial condition of our customers deteriorates, resulting in an impairment +of their ability to make required payments, additional allowances may be +required that could adversely affect our operating results. +Inventory . Inventories consist of +finished goods, work-in-process and raw materials and are stated at the lower +of cost or market. We provide reserves for potentially excess and obsolete inventory. +In assessing the ultimate realization of inventories, we make judgments as to +future demand requirements and compare that with the current or committed +inventory levels. Reserves are established for inventory levels that exceed +future demand. It is possible that reserves over and above those already +established may be required in the future if market conditions for our products +deteriorate. +Goodwill . +Goodwill is tested for impairment annually in the fourth fiscal quarter at the +reporting unit level unless a change in circumstances indicates that more +frequent impairment analysis is required. Impairment, if any, is measured based +on the estimated fair value of the reporting units with the recorded goodwill. Fair +value is determined by using the income approach methodology of valuation which +utilizes discounted cash flows. Significant management judgment is required in +the forecasts of future operating results that are used in the discounted cash +flow method of valuation. In estimating future cash flows, we generally use the +financial assumptions in our current budget and our current strategic plan, +subject to modification as considered necessary, including sales and expense +growth rates and the discount rates we estimate to represent our cost of funds. +It is possible, however, that the plans and estimates used may be incorrect. If +our actual results, or the plans and estimates used in future impairment +analyses, are lower than the original estimates used to assess the +recoverability of goodwill, we could incur impairment charges. +Warranty. +Unless otherwise stated, we provide a one to three year +warranty from the original invoice date on all products, materials and +workmanship. Products sold to certain OEM customers sometimes carry longer +warranties. Defective products are either repaired or replaced, at our option, +upon meeting certain criteria. We accrue a provision for the estimated costs +that may be incurred for product warranties relating to a product as a +component of cost of sales at the time revenue for that product is recognized. The +accrued warranty provision is included within accrued expenses on the +accompanying consolidated balance sheets. Should our actual experience of +warranty returns be higher than anticipated, additional warranty reserves may +be required, which may adversely affect our operating results. +21 +Taxes. +We recorded a valuation allowance to reduce our deferred tax +assets to amounts that we believe are more likely than not to be realized. +Realization of deferred tax assets (such as net operating loss carryforwards) +is dependent on future taxable earnings and is therefore uncertain. On a +quarterly basis, we assess the likelihood that our deferred tax asset balance +will be recovered from future taxable income. To the extent we believe that +recovery is not likely, we establish a valuation allowance against our deferred +tax asset, increasing our income tax expense in the period such determination +is made. +On an interim +basis, we estimate what our anticipated annual effective tax rate will be and +record a quarterly income tax provision in accordance with this anticipated +rate. As the fiscal year progresses, we refine our estimates based upon actual +events and earnings during the year. This estimation process can result in +significant changes to our expected effective tax rate. When this occurs, we +adjust the income tax provision during the quarter in which the change in +estimate occurs so that the year-to-date provision reflects the expected annual +rate. The changes described in the preceding sentence and the recording of +valuation allowances may create fluctuations in our overall effective tax rate +from quarter to quarter. +Results +of Operations +The following table sets forth certain statement of operations data as +a percentage of total net sales and contract revenues for the periods +indicated. The following table should be read in conjunction with Management’s +Discussion and Analysis of Financial Condition and Results of Operations. +Fiscal Year Ended March 31, +2006 +2005 +2004 +Net sales and contract +revenues: +Net sales +61.7 +% +62.6 +% +51.8 +% +Contract revenues +38.3 +37.4 +48.2 +Total net sales and contract +revenues +100.0 +% +100.0 +% +100.0 +% +Costs +and expenses: +Cost of net sales +32.6 +33.7 +28.2 +Cost of contract revenues +24.6 +24.6 +32.5 +Selling, general and +administrative expenses +29.7 +30.1 +28.4 +Research and development +expenses +10.1 +9.0 +8.6 +Stock-based compensation +expense (benefit) +1.4 +25.4 +— +Amotization of intangible +assets +0.3 +0.2 +— +Deferred compensation +0.1 +(1.0 +) +1.9 +Disposal of fixed assets +— +0.9 +— +Acquired in-process research +and development +— +0.3 +— +Total costs and expenses +98.8 +123.2 +99.6 +Income (loss) from operations +1.2 +(23.2 +) +0.4 +Non-operating +income (expense): +Other income, net +0.1 +2.2 +2.2 +Interest expense, net +(2.9 +) +(2.5 +) +(0.3 +) +Loss from continuing operations before income taxes and minority +interest +(1.6 +) +(23.5 +) +2.3 +Income tax benefit (provision) +1.8 +0.2 +(0.2 +) +Minority interest in earnings of subsidiary +— +(1.1 +) +(6.2 +) +Income (loss) from continuing operations +0.2 +(24.4 +) +(4.1 +) +Income from discontinued operations, net of income taxes +— +— +2.7 +Net +income (loss) +0.2 +% +(24.4 +)% +(1.4 +)% +Years Ended March 31, 2006, 2005, and 2004 +Net Sales and Contract Revenues . Net sales +consist principally of sales of our Vantage video detection systems and AutoVue +LDW systems, as well as technology access fees, contract engineering revenue +and royalty revenue generated from AutoVue related activities. Contract revenue +consists principally of revenue derived from systems integration and ITS +consulting services with state, county and municipal agencies. We currently +have a diverse customer base with our largest customer constituting 11.5% of +total net sales and contract revenues in Fiscal 2006. Total net sales and +contract revenues increased 8.8% to $50.5 million in Fiscal 2006 compared to +$46.4 million in Fiscal 2005, and increased 2.5% in Fiscal 2005 compared to +$45.3 million in Fiscal 2004. +22 +Net sales increased 7.2% to $31.2 million in Fiscal +2006 compared to $29.1 million in Fiscal 2005, and increased 23.8% in Fiscal +2005 compared to $23.5 million in Fiscal 2004. The increase in net sales in each +of the periods reflected increased unit sales of our Vantage vehicle detection +systems and increased unit sales of our AutoVue LDW systems. Net sales from +AutoVue products and services increased 22.0% in Fiscal 2006 compared to Fiscal +2005, and represented 28.0% of our total net sales in Fiscal 2006 versus 24.6% +of our total net sales in Fiscal 2005. The increase in sales of AutoVue +products was principally related to increased unit sales of LDW systems in the +European and North American commercial heavy truck markets which increased +35.6% in Fiscal 2006 compared to Fiscal 2005. While overall unit sales of +AutoVue LDW systems increased in Fiscal 2006, AutoVue revenues in the fourth +quarter of Fiscal 2006 declined slightly primarily as a result of OEM volume +discounts provided to our largest customer and the impact of the transition to +our next generation AutoVue production unit for the heavy truck market in the +latter part of Fiscal 2006. AutoVue unit sales in Fiscal 2007 may be adversely +impacted due to slower than expected adoption rates for such next generation +production unit by our largest customer and other OEMs as well as potential +additional OEM volume discounts. +Vantage sales comprised 72.0%, 75.4% and 82.1% of net +sales in Fiscal 2006, Fiscal 2005 and Fiscal 2004, respectively. The majority +of Vantage revenues were derived from sales within North America. Vantage sales +growth was primarily due to increased market adoption of video-based detection +technologies for traffic intersection management and our ability to obtain +additional contracts with state departments of transportation. Vantage sales +growth in the fourth quarter of Fiscal 2006 was primarily the result of strong +sales in the sun-belt states and less seasonality due to more moderate winter +weather conditions in the current period. We may experience more competition in +our Vantage business in Fiscal 2007 as the department of transportation in one +of our largest sales territories is moving to a multisource contracting +environment from one in which Iteris is the preferred supplier. Additionally, +we have experienced increased lead times in procuring components, which could +adversely effect net sales in the future. +Contract revenues increased 11.5% to $19.3 million in +Fiscal 2006 compared to $17.3 million in Fiscal 2005, and decreased 20.5% in +Fiscal 2005 compared to $21.8 million in Fiscal 2004. Contract revenues reflect +a broad range of fixed price and cost plus fixed fee contracts for engineering +study and design, systems integration and system implementation. Contract +revenues are dependent upon the continued availability of funding at both the +state and federal levels from the various departments of transportation. All of +our contract revenue is currently derived from work performed in North America. +We believe the increase in Fiscal 2006 contract +revenues compared to Fiscal 2005 was largely the result of the passage of the +Federal Highway Bill in August 2005, as well as increased spending at the +state and local levels. The increase in contract revenues in Fiscal 2006 was +also due to continued growth in the California market and stronger sales in the +Eastern U.S. market. The decrease in Fiscal 2005 from Fiscal 2004 was primarily +due to budgetary constraints in both the federal and California markets, where +a significant portion of our contract revenues have been derived during the +last several years. We believe these constraints were exacerbated by the delay +in the adoption of the Federal Highway Bill. +Gross Profit . Total +gross profit increased 11.7% to $21.6 million in Fiscal 2006 compared to $19.4 +million in Fiscal 2005, and increased 8.7% from $17.8 million in Fiscal 2004 +compared to Fiscal 2005. Total gross profit as a percent of net sales and +contract revenues increased to 42.8% in Fiscal 2006 compared to 41.7% in Fiscal +2005 and 39.3% in Fiscal 2004. +Gross profit as a percentage of net sales was 47.2% in +Fiscal 2006 compared to 46.2% in Fiscal 2005 and 45.6% in Fiscal 2004. The 100 +basis point increase in gross profit in Fiscal 2006 compared to Fiscal 2005 was +primarily a result of increased margins on Roadway Sensor products due to +product improvements aimed at reducing the cost of goods sold, better overhead +absorption on higher unit sales and a change in our Roadway Sensor business +model in California to a direct sales model. +The increase in gross profit as a percent of net sales +in Fiscal 2005 compared to Fiscal 2004 was primarily a result of increased +margins on AutoVue activities due to better overhead absorption on higher unit +sales of LDW systems to the heavy truck market as well as the recognition of +technology access fee revenue and royalty revenue from Valeo, both of which +provide a 100% gross margin. These increases were somewhat offset by declining +margins related to the sales of Vantage products due to lower unit pricing on +large, high volume state contracts and increased price pressure in the +industry. +Gross profit as a percent of contract revenues +increased to 35.9% in Fiscal 2006 compared to 34.2% in Fiscal 2005 and 32.6% in +Fiscal 2004. We recognize contract revenues and related gross profit using +percentage of completion contract accounting and the underlying mix of contract +activity affects the related gross profit recognized in any given year. The +increase in Fiscal 2006 reflects a mix of higher margin contracts in Fiscal +2006 as compared to Fiscal 2005 and Fiscal 2004. +Selling, General and Administrative +Expense . Selling, general and administrative expense +increased 7.4% to $15.0 million (or 29.7% of total net sales and contract +revenues) in Fiscal 2006 compared to $14.0 million (or 30.1% of total net sales +and contract revenues) in Fiscal 2005, and increased 8.7% in Fiscal 2005 +compared to $12.8 million (or 28.4% of total net sales and contract revenues) +in Fiscal 2004. The increase in Fiscal 2006 compared to Fiscal 2005 was +principally related +23 +to additional accounting and legal fees incurred in +the first and second quarter of Fiscal 2006 related to a change in audit firms, +costs incurred in anticipation of compliance with the Sarbanes-Oxley Act of +2002, additional common area charges incurred in connection with our Anaheim headquarters +and increased outside sales commissions paid in connection with our Roadway +Sensor business due to the business model change in California. The increase in +Fiscal 2005 compared to Fiscal 2004 was principally related to $807,000 of +severance charges recorded in connection with the merger and acquisition of the +Iteris Subsidiary in October 2004, as well as increased costs to support +expanded sales and marketing efforts for our Vantage and AutoVue products in +Fiscal 2005. We are expecting the Mariner Networks, Inc. matter described in +Note 7 to the accompanying consolidated financial statements to go to +trial in the second quarter of Fiscal 2007 and, accordingly, we may experience +an increase in selling, general and administrative expenses due to increased +legal fees over the next couple quarters. +Research and Development Expense . Research +and development expense increased 21.3% to $5.1 million (or 10.1% of total net +sales and contract revenues) in Fiscal 2006 compared to $4.2 million (or 9.0% +of total net sales and contract revenues) in Fiscal 2005, and increased 6.9% in +Fiscal 2005 compared to $3.9 million (or 8.6% of total net sales and contract +revenues) in Fiscal 2004. The increase in research and development expense in +Fiscal 2006 compared to Fiscal 2005 reflects increased spending for both our +Vantage video detection products and our AutoVue LDW system for the heavy truck +market. Additional development funds were allocated to the Roadway Sensors +business to introduce new products during the current year, refresh the +existing product line and enhance cost reduction activities. Additional funds +allocated to the Automotive Sensors business were primarily used to develop the +next generation AutoVue LDW system for the heavy truck market in Europe and North +America. We anticipate incurring additional research and development expenses +in Fiscal 2007 in connection with the qualification of such systems for other +OEMs. +The +increase in research and development expense in Fiscal 2005 compared to Fiscal +2004 reflects increased spending to support the development of AutoVue +products, which was partially offset by decreased spending to support the +development of Vantage products. AutoVue product development related largely to +the development of the next generation LDW unit for the heavy truck market, +which consisted of product re-engineering and qualification of a new imager. +The increases were primarily in the areas of personnel costs and related +benefits and overhead, prototype material costs, and consulting fees. Vantage +product development primarily reflects activities for product line extensions +to support new communications platforms and to accommodate new camera designs. +For +competitive reasons, we closely guard the confidentiality of specific +development projects. +Stock-Based Compensation. On October 22, +2004, we recorded an $11.3 million charge for stock-based compensation in +connection with the assumption and exchange of vested Iteris Subsidiary stock +options for stock options immediately exercisable into our common stock. This +charge was based on the differences between the fair market value of our common +stock on the merger date and the exercise prices of the modified stock options. +Additionally, we recorded approximately $1.4 million in deferred compensation +expense related to the unvested Iteris Subsidiary stock options also assumed as +part of the merger, which will be amortized to stock-based compensation expense +as the options vest. We amortized $725,000 and $508,000 of the $1.4 million of +deferred compensation to stock-based compensation expense in Fiscal 2006 and +2005, respectively. Beginning with our fiscal quarter ending June 30, +2006, we will incur additional stock-based compensation charges in connection +with our adoption of SFAS No. 123 (revised 2004), Share-Based +Payment (“SFAS 123R”). +Deferred Compensation Expense +(Benefit). Deferred compensation expense (benefit) +represents changes in the fair value of assets, primarily shares of our common +stock, held by our deferred compensation savings plan under which certain +senior executives may defer compensation. Prior to the merger of the Iteris +Subsidiary into us in Fiscal 2005, the plan held shares of Iteris Subsidiary +common stock. In connection with the Fiscal 2005 merger of the Iteris +Subsidiary into us, shares of Iteris Subsidiary common stock held by the plan +were exchanged for shares of our common stock. Changes in the value of common +stock held by the plan resulted in an expense of $48,000 in Fiscal 2006, a +benefit of $484,000 in Fiscal 2005 and an expense of $868,000 in Fiscal 2004. No +compensation was deferred into the plan in Fiscal 2006, Fiscal 2005 and Fiscal +2004. +Disposal +of Fixed Assets. After the October 22, 2004 merger of the +Iteris Subsidiary into us, we conducted a review of our property and equipment +and determined that certain corporate property and equipment would not provide +value to our on-going operations. These assets primarily consisted of furniture +and fixtures and computer equipment. Accordingly, we recorded a $422,000 loss +on disposal of fixed assets in Fiscal 2005. No such disposals were made in +Fiscal 2006. +Other Income, Net . Other income, net +reflects the following: +Year Ended March 31, +2006 +2005 +2004 +(In thousands) +Gain on sale of +real estate +$ +— +$ +— +$ +970 +Loss on sale of +Iteris common stock +— +— +— +Gain on +settlement of lawsuit +— +949 +— +Other +35 +105 +33 +Other income, +net +$ +35 +$ +1,054 +$ +1,003 +24 +Other income, net in Fiscal 2005 +primarily reflects a $949,000 gain recognized on the settlement of litigation. We +were a beneficiary of, but not a party to, litigation between Rockwell +International and the Michigan Department of Transportation. Other income, net +in Fiscal 2004 includes a gain of $970,000 recognized on the sale and leaseback +of our Anaheim, California facility, which was consummated in May 2002. +Interest Expense, Net . Interest expense, +net reflects the net of interest expense and interest income as follows: +Year Ended March 31, +2006 +2005 +2004 +(In thousands) +Interest expense +$ +1,461 +$ +1,180 +$ +125 +Interest income +(2 +) +(2 +) +(2 +) +Interest +expense, net +$ +1,459 +$ +1,178 +$ +123 +25 +Interest expense increased 23.8% +in Fiscal 2006 compared to Fiscal 2005 and increased 844.0% in Fiscal 2005 +compared to Fiscal 2004. The increase in interest expense in Fiscal 2006 +compared to Fiscal 2005 is mainly related to an increase in the interest rate +on our line of credit and term debt as well as an increase on average borrowings +on the line. The increase in Fiscal 2005 was due to additional interest expense +incurred related to the $5.0 million term debt entered into by the Iteris +Subsidiary on May 28, 2004 (which was assumed by us in October 2004), +interest expense related to the $10.1 million convertible debentures issued by +us on May 19, 2004, the amortization of debt discounts associated with the +issuance of the convertible debentures and related warrants, and increased +borrowings on our line of credit. +Income Taxes . During Fiscal 2006, we +recognized an income tax benefit of $885,000, and at March 31, 2006, our +balance sheet included net deferred tax assets of $1.6 million. The ability to +record the deferred tax asset was based on the more likely than not criteria of +Statement of Financial Accounting Standards (“SFAS”) No. 109, Accounting for Income Taxes . During Fiscal 2005, we +recognized an income tax benefit of $94,000 and at March 31, 2005, we +recorded a net deferred tax asset of $660,000. +At March 31, +2006, we had $49.2 million of federal net operating loss carryforwards and $22.6 million +of state net operating loss carryforwards that begin to expire in 2019 and +2007, respectively. Due to changes in stock ownership, our federal net +operating loss carryforwards are subject to a Section 382 limitation +estimated at approximately $2.9 million annually which can be utilized to +offset federal consolidated taxable income. As a result of this limitation, a +portion of our carryforwards are expected to expire before becoming available +to reduce future income tax liabilities. +Although +the impact cannot be precisely determined, we believe that our net operating +loss carryforwards and the valuation allowance we have recorded against our net +deferred tax assets in our consolidated balance sheet will cause us to have +future income tax payments and income tax expense that are substantially lower +than the income tax liability and income tax expense calculated using statutory +tax rates. +Minority Interest in Earnings of Subsidiary . +Minority interest in earnings of subsidiary represents the minority +stockholders’ share of the Iteris Subsidiary’s net income or loss combined with +the accretion of the redemption preference of the Iteris Subsidiary’s Series A +preferred stock. On October 22, 2004, we completed the merger of the +Iteris Subsidiary into us. As a result of the completion of the merger in the +third quarter of Fiscal 2005, the minority interest in earnings of subsidiary +decreased from $2.8 million in Fiscal 2004 to $526,000 in Fiscal 2005, and we +did not incur any charge for minority interest during Fiscal 2006. No future +charges for minority interest are anticipated. +Income +(Loss) from Discontinued Operations, Net of Income Taxes . As +discussed in the Overview to Management’s Discussion and Analysis of Financial +Condition and Results of Operations, the results of operations related to +certain businesses discontinued by us in Fiscal 2004 are reflected as +discontinued operations in our consolidated financial statements. As of the end +of Fiscal 2004, we had completed all such restructuring activities so that we +could focus our efforts in the ITS marketplace. +Liquidity +and Capital Resources +Cash +Flows +We have +historically financed our operations with a combination of cash flows from operations, +borrowings under credit facilities and the sale of equity securities. We +currently rely on cash flows from operations and borrowings on a line of credit +facility to fund our operations, which we believe to be sufficient to fund our +operations for at least the next twelve months. However, should a shortfall +occur, we believe we could obtain additional funds through additional +borrowings or the sale of equity securities. At March 31, 2006, we had +$3.3 million in working capital, which included borrowings of $2.7 million on +our revolving line of credit and $131,000 in cash and cash equivalents. This +compares to working capital of $2.2 million at March 31, 2005, which +included borrowings of $945,000 on our revolving line of credit and $46,000 in +cash. Our operations provided $218,000 of cash during Fiscal 2006, primarily as +a result of planned decreases in inventory and the timing of payments on +accrued expenses and payables. These were partially offset by increases in +accounts receivable and net costs and estimated earnings in excess of billings +on uncompleted contracts, both as a result of sales growth. During Fiscal 2005, +our operations provided $590,000 of cash, primarily due to the receipt of +$949,000 related to a legal settlement between Rockwell International and the +Michigan Department of Transportation to which we were a third party +beneficiary. We used cash in operations of $718,000 in Fiscal 2004, which was +primarily the result of our loss from continuing operations. +Investing +activities for Fiscal 2006, Fiscal 2005 and Fiscal 2004 consisted primarily of +purchases of property and equipment, which aggregated $1.3 million, $670,000 +and $558,000, respectively. In the current fiscal year, capital expenditures +have increased significantly primarily due to hardware, software and related +labor costs to implement a new enterprise resource management system, which +will be put into use at the beginning of our next fiscal year. We expect to +continue to incur substantial additional cost, which could amount to several +hundred thousand dollars, in the next three to six months related to this new +system. Most of this cost will be in the form of training and support +activities, which will be recorded as expense when incurred. +26 +Cash provided by +financing activities was $1.1 million in Fiscal 2006, which was the result +of net borrowings of $403,000 and cash inflows of $333,000 from the exercise of +outstanding stock options and warrants to purchase our common stock. During +Fiscal 2005, financing activities used $2.5 million of cash, which was +comprised of net cash outflows of approximately $3.1 million related to the +merger activities described more fully above in the Overview to Management’s +Discussion and Analysis of Financial Condition and Results of Operations and in +Note 3 to the accompanying consolidated financial statements, partially offset +by $501,000 in proceeds from the exercise of stock options and warrants to +purchase our common stock. We generated $3.4 million in cash from financing +activities in Fiscal 2004, primarily as a result of $3.8 million raised from +the sale of our common stock and related warrants, offset by $467,000 in net +payments against borrowings. +Borrowings +The following table +summarizes our borrowings and long-term debt: +At March 31, 2006 +(In thousands) +Convertible +debentures, net +$ +9,203 +Bank term note +2,708 +Promissory note +to landlord +1,292 +Other long-term +debt +140 +Revolving line +of credit +2,662 +$ +16,005 +Effective August 1, +2005, we renewed our credit agreement with our bank. This credit agreement, +which expires on July 31, 2006, provides for borrowings of up to $5.0 +million subject to a borrowing formula based upon qualified accounts receivable +and inventories as defined in the credit agreement. At March 31, 2006, we +failed to meet a financial covenant under this agreement that limits the amount +of capital expenditures we may make in any fiscal year. On May 19, 2006, +our bank waived its right of default regarding this covenant violation for the +year ended March 31, 2006. We are currently in the process of +renegotiating this credit agreement; however, we cannot assure you that we will +be able to complete these negotiations successfully, on acceptable terms, or at +all. At March 31, 2006, we had $3.8 million available under the revolving +line of credit, of which $1.1 million was unused. Assuming the line of credit +is renewed or replaced, we believe the combination of available borrowings on +our line of credit and our internally generated cash flows will be sufficient +to enable us to execute our operating plans and meet our obligations on a +timely basis for at least the next twelve months. +Contractual +Obligations +Our contractual obligations are as follows at March 31, +2006: +Payments Due by Period +2007 +2008 +2009 +2010 +2011 +Thereafter +Total +(In thousands) +Lines of credit +$ +2,662 +$ +— +$ +— +$ +— +$ +— +$ +— +$ +2,662 +Notes payable +1,969 +1,946 +225 +— +— +— +4,140 +Convertible +debentures +— +— +— +9,850 +— +— +9,850 +Operating leases +1,305 +792 +116 +85 +43 +— +2,341 +Total +$ +5,936 +$ +2,738 +$ +341 +$ +9,935 +$ +43 +$ +— +$ +18,993 +At March 31, +2006, we had firm commitments to purchase inventory in the amount of $1.3 million +during the first and second quarters of Fiscal 2007. +Off Balance +Sheet Arrangements +In connection with the restructuring and merger +activities described in the Overview to Management’s Discussion and Analysis of +Financial Condition and Results +of Operations and in Notes 3, 5 and 9 to the accompanying consolidated +financial statements, in May 2004 we issued subordinated convertible debentures +in an aggregate original principal amount of $10.1 million. These +debentures are due in full on May 19, 2009 and are convertible into shares of +our common stock at a conversion price of $3.61 per share. At March 31, 2006, +$9.9 million of these convertible debentures remained outstanding. Because +these debentures are conventionally convertible, we have not separately +accounted for the conversion feature and, accordingly, no separate amounts are +presented in our consolidated financial statements in connection with this +conversion feature. +At March 31, 2006, outstanding warrants to purchase +1,250,000 shares of our common stock at an exercise price of $1.64 per share +and outstanding warrants to purchase an aggregate of 62,500 shares of +common stock at an exercise price of $1.95 per share are callable by us if the +market price of our common stock trades for 20 consecutive days at a price +equal to or greater than two times the exercise price of the warrants. Outstanding +w arrants to purchase an aggregate of 75,000 shares of our common +stock at an exercise price of $5.00 per share are callable by us if the market +price of our common stock trades for 20 consecutive days at a price equal +to or greater than one and a half times the exercise price of the warrants. +In +connection with the issuance of warrants to purchase 1,250,000 shares of our +common stock at $1.64 per share and 426,667 shares of our common stock at $3.00 +per share, we are a party to certain registration rights agreements that +contain provisions under which we could be subjected to liquidated damages +should we fail to maintain effective registration statements for the underlying +shares of common stock. These warrants have been accounted for within +equity in our consolidated balance sheets in accordance with EITF 00-19 Accounting for Derivative Financial Instruments Indexed to, and +Potentially Settled in, a Company’s Own Stock , and, accordingly, no +liabilities have been recorded in connection therewith. The warrants to purchase 426,667 shares of +our common stock and the related rights to liquidated damages expired +unexercised on May 31, 2006. As of the +date of this filing, no liquidated damages are payable under the provisions of +the registration rights agreements associated with these warrants. +10b5-1 Plan +In June 2006, Abbas Mohaddes, our Executive Vice +President and General Manager, entered into a 10b5-1 plan covering 200,000 +shares of our common stock. Pursuant to this plan, Mr. Mohaddes may sell up to +17,000 shares each month provided that the stock price is at least $2.50 per +share. +27 +Recent +Accounting Pronouncements +In November 2004, +the FASB issued SFAS No. 151, Inventory Costs (“SFAS +151”), which clarifies the accounting for abnormal amounts of idle facility +expense, freight, handling costs, and wasted material. SFAS 151 will be +effective for inventory costs incurred during fiscal years beginning after +June 15, 2005. We do not believe the adoption of SFAS 151 will have a +material impact on our financial statements. +On December 16, +2004, the FASB issued SFAS No. 123, which replaced SFAS No. 123, Accounting for Stock-Based Compensation (“SFAS 123”), +supersedes Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees , and amends SFAS No. 95, +Statement of Cash Flows . Generally, the +approach in SFAS 123R is similar to the approach described in SFAS 123. However, +SFAS 123R requires all share-based payments to employees, including grants of +employee stock options, to be recognized in the financial statements based on +their fair values (i.e., pro forma disclosure is no longer an alternative to +financial statement recognition). In accordance with SEC Release No. 33-8568, +SFAS 123R became effective for us on April 1, 2006. We plan to use the +modified-prospective method of recognition of compensation expense related to +share-based payments. +The adoption of the SFAS 123R fair value method +will have a significant adverse impact on our reported results of operations, +although it will have no impact on our overall financial position. The balance +of unearned stock-based compensation to be included in our fiscal years ending March 31, +2007 through 2010 related to share-based awards unvested at March 31, +2006, as previously calculated under the disclosure-only requirements of +SFAS 123, is approximately $521,000. If there are any modifications or +cancellations of the underlying unvested securities, we may be required to +accelerate, increase or cancel any remaining unearned stock-based compensation +expense. To the extent that we grant additional equity securities, our +stock-based compensation expense will be increased by the additional unearned +compensation resulting from those additional grants. Had we adopted +SFAS 123R in prior periods, the magnitude of the impact on our results of +operations would have approximated the impact of SFAS 123 assuming the +application of the Black-Scholes option pricing model as described in the +disclosure of pro forma net loss and pro forma net loss per share in +Note 1 to the accompanying consolidated financial statements. +28 +ITEM 7A. QUANTITATIVE +AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK +Our exposure to interest +rate risk is limited to our line of credit, bank term note and a promissory +note to our landlord. Our line of credit, bank term note and promissory note to +our landlord bear interest based on the prevailing prime rate (7.75% at March 31, +2006). A 10% increase in the interest rate on our line of credit, bank term +note and promissory note to our landlord (from 10.75% to 11.83% on the line of +credit, from 8.00% to 8.80% on the bank term note and from 9.75% to 10.73% on +the promissory note to our landlord) would not have a material impact on our +financial position, operating results, or cash flows. In addition, we believe +that the carrying value of our outstanding debt approximates fair value. +ITEM 8. FINANCIAL +STATEMENTS AND SUPPLEMENTARY DATA +The financial statements +and supplementary data required by Regulation S-X are included in Part IV, +Item 15 of this report. +ITEM 9. CHANGES +IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE +None. +ITEM 9A. CONTROLS AND +PROCEDURES +Evaluation of Disclosure Controls and +Procedures +As of the end of the +period covered by this report, we carried out an evaluation, under the +supervision and with the participation of our management, including our Chief +Executive Officer and our Chief Financial Officer, of the effectiveness of the +design and operation of our disclosure controls and procedures, as such term is +defined in Exchange Act Rules 13a-15(e) and 15d-15(e). Based upon that +evaluation, the Chief Executive Officer and Chief Financial Officer concluded +that our disclosure controls and procedures are effective to ensure that +information required to be disclosed by us in the reports that we file or +submit under the Exchange Act is recorded, processed, summarized and reported +within the time periods specified in the Securities and Exchange Commission’s +rules and forms and are effective in ensuring that information required to be +disclosed by us in the reports that we file or submit under the Exchange Act is +accumulated and communicated to our management, including our Chief Executive +Officer and Chief Financial Officer, as appropriate, to allow timely decisions +regarding required disclosure. In designing and evaluating the disclosure +controls and procedures, our management recognized that any controls and +procedures, no matter how well designed and operated, can provide only +reasonable assurance of achieving the desired control objectives. Our +management necessarily applied its judgment in evaluating the cost-benefit +relationship of such controls and procedures. +Changes in Internal Controls +During the most recent +completed fiscal quarter covered by this report, there has been no change in +our internal controls over financial reporting (as defined in Rules 13a-15(f) and +15d-15(f) under the Securities Exchange Act of 1934) that has +materially affected, or is reasonably likely to materially affect, our internal +controls over financial reporting. +ITEM 9B . OTHER INFORMATION +None. +29 +PART III +ITEM 10. DIRECTORS +AND EXECUTIVE OFFICERS OF THE REGISTRANT +(a) Identification of Directors. The +information under the caption “Election of Directors,” appearing in our proxy +statement for the 2006 Annual Meeting of Stockholders, is incorporated herein +by reference. +(b) Identification of Executive Officers. The +information under the caption “Executive Officers,” appearing in our proxy +statement for the 2006 Annual Meeting of Stockholders, is incorporated herein +by reference. +(c) Compliance with Section 16(a) of the +Exchange Act. The information under the caption “Section 16(a) Beneficial +Ownership Reporting Compliance” appearing in our proxy statement for the 2006 +Annual Meeting of Stockholders is incorporated herein by reference. +(d) Code of Ethics . The information under the +caption “Corporate Governance,” appearing in our proxy statement for the 2006 +Annual Meeting of Stockholders, is incorporated herein by reference. +ITEM 11. EXECUTIVE +COMPENSATION +The information +under the caption “Executive Compensation and Other Information,” appearing in +our proxy statement for the 2006 Annual Meeting of Stockholders, is +incorporated herein by reference. +ITEM +12. SECURITY +OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER +MATTERS +The information +under the captions “Equity Compensation Plans” and “Principal Stockholders and +Common Stock Ownership of Certain Beneficial Owners and Management,” appearing +in our proxy statement for the 2006 Annual Meeting of Stockholders, is incorporated +herein by reference. +ITEM +13. CERTAIN +RELATIONSHIPS AND RELATED TRANSACTIONS +The information +under the caption “Certain Transactions,” appearing in our proxy statement for +the 2006 Annual Meeting of Stockholders, is incorporated herein by reference. +ITEM +14. PRINCIPAL +ACCOUNTING FEES AND SERVICES +The information +under the caption “Fees Paid to Independent Registered Public Accounting Firm,” +appearing in our proxy statement for the 2006 Annual Meeting of Stockholders, +is incorporated herein by reference. +30 +PART IV +ITEM +15. EXHIBITS +AND FINANCIAL STATEMENT SCHEDULES +(a) Documents filed as +part of this report: +1. Financial Statements. The following +financial statements of Iteris, Inc. are included in a separate +section of this Annual Report on Form 10-K commencing on the pages referenced +below: +Report of Independent +Registered Public Accounting Firm, McGladrey & Pullen, LLP +37 +Report of Independent Registered Public Accounting +Firm, Ernst & Young LLP +38 +Consolidated +Balance Sheets as of March 31, 2006 and 2005 +39 +Consolidated Statements of Operations for the years +ended March 31, 2006, 2005 and 2004 +41 +Consolidated Statements of Stockholders’ Equity +(Deficit) for the years ended March 31, 2006, 2005 and 2004 +42 +Consolidated Statements of Cash Flows for the years +ended March 31, 2006, 2005 and 2004 +43 +Notes to Consolidated Financial Statements +44 +2. Financial +Statement Schedules . +Schedule II — Valuation +and Qualifying Accounts +62 +All other schedules have +been omitted because they are not required or the required information is +included in our consolidated financial statements and notes thereto. +3. Exhibits . +The following +exhibits are filed herewith or incorporated by reference to the location +indicated below: +Exhibit +Number +Description +Where Located +3.1 +Amended and Restated Certificate of Incorporation of +the registrant +Exhibit 3.1 to the registrant’s Current +Report on Form 8-K as filed with the SEC on October 28, 2004 +3.2 +Bylaws of the registrant, as amended +Exhibit 4.2 to the registrant’s Registration +Statement on Form S-1 (Reg. No. 033-67932) as filed +with the SEC on July 6, 1993 +3.3 +Certificates of Amendment to Bylaws of the +registrant dated April 24, 1998 and August 10, 2001 +Exhibit 3.4 to the registrant’s Annual +Report on Form 10-K/A for the year ended March 31, 2003 as +filed with the SEC on July 29, 2003 +4.1 +Specimen of common stock certificate +Exhibit 4.1 to registrant’s Registration +Statement on Form 8-A as filed with the SEC on December 8, 2004 +4.2 +Form of rights certificate for preferred stock +purchase rights +Exhibit A of Exhibit 4 to the +registrant’s Current Report on Form 8-K as filed with the SEC on +May 1, 1998 +10.1* +Profit Sharing Plan and Trust +Exhibit 10.3 to the registrant’s Amendment +No. 2 to the Registration Statement on Form S-8 (Reg. +No. 002-98656) as filed with the SEC on May 5, 1988 +31 +Exhibit +Number +Description +Where Located +10.2* +Amendment Nos. 3 and 4 to the Profit Sharing Plan +and Trust +Exhibits 4.3.1 and 4.3.2, +respectively, to Amendment No. 3 to the registrant’s Registration +Statement on Form S-3 (Reg. No. 002-86220) as filed +with the SEC on June 13, 1990 +10.3* +Form of Executive Deferral Plan between the +registrant and certain employees of the registrant +Exhibit 10.4 to the +registrant’s Annual Report on Form 10-K for the year ended March 31, +1988 +10.4 +Form of Indemnity Agreement entered into by the +registrant and certain of its officers and directors +Exhibit 19.4 to the +registrant’s Quarterly Report on Form 10-Q for the quarter ended September 30, +1988 +10.5 +Form of Indemnification Agreement entered into +by the registrant and certain of its officers and directors +Exhibit 10.5 to the +registrant’s Annual Report on Form 10-K for the year ended March 31, +2004 as filed with the SEC on June 29, 2004 +10.6* +1997 Stock Incentive Plan (as amended on May 3, +2003, as further amended on December 15, 2004) +Exhibit 10.32 to the +registrant’s Annual Report on Form 10-K for the year ended March 31, +2005 as filed with the SEC on July 14, 2005 +10.7* +Form of Notice of Grant of Stock Option for the +following executive officers: Jack Johnson, Richard D. Crawshaw, Gregory +McKhann, Francis Memole, James S. Miele and Stephen Edwin Rowe +Exhibit 99.2 to the +registrant’s Registration Statement on Form S-8 (File No. 333-30396) +as filed with the SEC on February 14, 2000 +10.8* +Form of Stock Option Agreement +Exhibit 99.3 to the +registrant’s Registration Statement on Form S-8 (File No. 333-30396) +as filed with the SEC on February 14, 2000 +10.9* +Form of Addendum to Stock Option +Agreement—Involuntary Termination Following Corporate Transaction or Change +in Control +Exhibit 99.4 to the +registrant’s Registration Statement on Form S-8 (File No. 333-30396) +as filed with the SEC on February 14, 2000 +10.10* +Form of Addendum to Stock Option +Agreement—Limited Stock Appreciation Rights +Exhibit 99.5 to the +registrant’s Registration Statement on Form S-8 (File No. 333-30396) +as filed with the SEC on February 14, 2000 +10.11* +Form of Stock Issuance Agreement +Exhibit 99.6 to the +registrant’s Registration Statement on Form S-8 (File No. 333-30396) +as filed with the SEC on February 14, 2000 +10.12* +Form of Addendum to Stock Issuance +Agreement—Involuntary Termination Following Corporate Transaction/Change in +Control +Exhibit 99.7 to the +registrant’s Registration Statement on Form S-8 (File No. 333-30396) +as filed with the SEC on February 14, 2000 +10.13* +Form of Notice of Grant of Automatic Stock +Option—Initial Grant for the following directors: Richard Char +Exhibit 99.8 to Exhibit 99.8 +to registrant’s Registration Statement on Form S-8 (File No. 333-30396) +as filed with the SEC on February 14, 2000 +10.14* +Form of Notice of Grant of Automatic Stock +Option—Annual Grant for the following directors: Kevin C. Daly, Ph.D., Gary +Hernandez, Dr. Hartmut Marwitz, Gregory A. Miner, John W. Seazholtz, Joel Slutzky, +Thomas L. Thomas and Paul E. Wright +Exhibit 99.9 to the +registrant’s Registration Statement on Form S-8 (File No. 333-30396) +as filed with the SEC on February 14, 2000 +10.15* +Form of Automatic Stock Option Agreement. +Exhibit 99.10 to the +registrant’s Registration Statement on Form S-8 (File No. 333-30396) +as filed with the SEC on February 19, 2000 +32 +Exhibit +Number +Description +Where Located +10.16 +Amended and Restated Rights Agreement, dated as of May 10, +2004, by and between the registrant and U.S. Stock Transfer Corporation, +including the exhibits thereto. +Exhibit 99.1 to the +registrant’s Registration Statement on Form 8-A/A as filed with +the SEC on June 18, 2004. +10.17 +Amended and Restated Agreement of Purchase and Sale +and Escrow Instructions, dated February 19, 2002, by and between Iteris, Inc. +and 1515 South Manchester, LLC +Exhibit 2.1 to the registrant’s +Current Report on Form 8-K as filed with the SEC on June 12, +2002 +10.18* +Change in Control Agreement dated May 8, 2003 +by and between the registrant and Gregory A. Miner +Exhibit 10.1 to the +registrant’s Quarterly Report on Form 10-Q for the quarter ended June 30, +2003 as filed with the SEC on August 14, 2003 +10.19* +Change in Control Agreement dated May 20, 2003 +by and between the registrant and Jack E. Johnson +Exhibit 10.23 to Amendment No. 1 +to the registrant’s Registration Statement on Form S-1 as filed +with the SEC on February 17, 2004 +10.20* +Iteris Inc. 1998 Stock Incentive Plan (as amended on +February 7, 2000) +Exhibit 10.24 to the +registrant’s Annual Report on Form 10-K for the year ended March 31, +2005 as filed with the SEC on July 14, 2005 +10.21* +Form of Notice of Grant, including forms of Option +Agreement and Stock Purchase Agreement for the following directors and +executive officers: Gary Hernandez, Dr. Hartmut Marwitz, Paul E. Wright, Jack +Johnson, Richard D. Crawshaw, Gregory McKhann, Francis Memole, James S. +Miele, Abbas Mohaddes and Stephen Edwin Rowe +Exhibit 99.2 to the registrant’s +Registration Statement on +Form S-8 (File No. 333-126834) as filed with the SEC on July 22, 2005 +10.22* +Form of Addendum to Stock Option Agreement +Exhibit 99.3 to the registrant’s +Registration Statement on +Form S-8 (File No. 333-126834) as filed with the SEC on July 22, 2005 +10.23* +Form of 1997 Stock Option Agreements +Exhibit 99.4 to the registrant’s +Registration Statement on +Form S-8 (File No. 333-126834) as filed with the SEC on July 22, 2005 +10.24 +Wells Fargo Bank Credit Agreement dated May 27, +2004 +Exhibit 10.25 to the +registrant’s Annual Report on Form 10-K for the year ended +March 31, 2005 as filed with the SEC on July 14, 2005 +10.25 +Wells Fargo Bank Assumption and Amendment Agreement +dated October 20, 2004 +Exhibit 10.26 to the +registrant’s Annual Report on Form 10-K for the year ended +March 31, 2005 as filed with the SEC on July 14, 2005 +10.26 +Wells Fargo Bank Revolving Line of Credit Note dated +May 27, 2004 +Exhibit 10.27 to the +registrant’s Annual Report on Form 10-K for the year ended +March 31, 2005 as filed with the SEC on July 14, 2005 +10.27 +Wells Fargo Bank Term Note dated May 27, 2004 +Exhibit 10.28 to the +registrant’s Annual Report on Form 10-K for the year ended +March 31, 2005 as filed with the SEC on July 14, 2005 +10.28 +Wells Fargo Bank Continuing Security Agreement +Rights to Payment and Inventory dated May 27, 2004 +Exhibit 10.29 to the registrant’s +Annual Report on Form 10-K for the year ended March 31, 2005 +as filed with the SEC on July 14, 2005 +10.29 +Wells Fargo Bank Security Agreement Equipment dated +May 27, 2004 +Exhibit 10.30 to the +registrant’s Annual Report on Form 10-K for the year ended +March 31, 2005 as filed with the SEC on July 14, 2005 +10.30* +Iteris, Inc. Deferred Compensation Savings Plan +and Grantor Trust +Exhibit 10.31 to the +registrant’s Annual Report on Form 10-K for the year ended +March 31, 2005 as filed with the SEC on July 14, 2005 +33 +Exhibit +Number +Description +Where Located +10.31+ +Cooperative Agreement for Development, Manufacture, +Marketing and Sale of Products to the Class 1 and Class 2 Vehicle +Markets Incorporating Iteris’ LDWS Technology (Valeo Schalter and Sensoren +GmbH) +Exhibit 10.1 to the +registrant’s Quarterly Report on Form 10-Q for the quarter ended June 30, +2004 as filed with the SEC on August 16, 2004 +10.32 +Second Amendment to Credit Agreement, dated August 1, +2005, by and between the registrant and Wells Fargo Bank, National +Association +Exhibit 10.1 to the +registrant’s Quarterly Report on Form 10-Q for the quarter ended December 31, +2005 as filed with the SEC on February 8, 2006 +10.33 +Revolving Line of Credit Note, dated August 1, +2005, by and between the registrant and Wells Fargo Bank, National +Association +Exhibit 10.2 to the +registrant’s Quarterly Report on Form 10-Q for the quarter ended December 31, +2005 as filed with the SEC on February 8, 2006 +21 +Subsidiaries of the registrant +Filed Herewith +23.1 +Consent of Independent Registered Public Accounting +Firm, McGladrey & Pullen, LLP +Filed Herewith +23.2 +Consent of Independent Registered Public Accounting +Firm, Ernst & Young, LLP +Filed Herewith +31.1 +Certification of the Chief Executive Officer +Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 +Filed Herewith +31.2 +Certification of the Chief Financial Officer +Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 +Filed Herewith +32.1 +Certification of the Chief Executive Officer +Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 +of the Sarbanes-Oxley Act of 2002 +Filed Herewith +32.2 +Certification of the Chief Financial Officer +Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 +of the Sarbanes-Oxley Act of 2002 +Filed Herewith +* Indicates a management contract or compensatory plan +or arrangement ++ Confidential treatment has been requested for +certain confidential portions of this exhibit pursuant to Rule 24b-2 +of the Securities Exchange Act of 1934, as amended. In accordance with Rule 24b-2, +these confidential portions have been omitted from the exhibit and filed +separately with the SEC. +34 +SIGNATURES +Pursuant to the requirements of Section 13 or 15(d) of +the Securities Exchange Act of 1934, the registrant has duly caused this Report +to be signed on its behalf by the undersigned, thereunto duly authorized. +ITERIS, INC. +(Registrant) +By +/s/ JACK JOHNSON +Jack Johnson +President and Chief Executive Officer +POWER OF ATTORNEY +We, the +undersigned officers and directors of Iteris, Inc., do hereby constitute +and appoint James S. Miele and Jack Johnson, and each of them, our true and +lawful attorneys-in-fact and agents, each with full power of substitution and +resubstitution, for him and in his name, place and stead, in any and all +capacities, to sign any and all amendments to this report, and to file the +same, with exhibits thereto, and other documents in connection therewith, with +the Securities and Exchange Commission, granting unto said attorneys-in-fact +and agents, and each of them, full power and authority to do and perform each +and every act and thing requisite or necessary to be done in and about the +premises, as fully to all intents and purposes as he might or could do in +person, hereby, ratifying and confirming all that each of said +attorneys-in-fact and agents, or his substitute or substitutes, may lawfully do +or cause to be done by virtue hereof. +Pursuant to the +requirements of the Securities Exchange Act of 1934, this report has been +signed below by the following persons on behalf of the registrant in the +capacities and on the dates indicated: +Signature +Title +Date +/s/ JACK JOHNSON +Director, President and Chief Executive Officer +June 29, 2006 +Jack Johnson +(principal executive officer) +/s/ JAMES S. +MIELE +Chief Financial Officer +June 29, 2006 +James S. Miele +(principal financial and accounting officer) +/s/ GREGORY A. +MINER +Chairman of the Board +June 29, 2006 +Gregory A. Miner +/s/ RICHARD CHAR +Director +June 29, 2006 +Richard Char +/s/ KEVIN C. +DALY +Director +June 29, 2006 +Kevin C. Daly, +Ph.D. +/s/ GARY +HERNANDEZ +Director +June 29, 2006 +Gary Hernandez +/s/ HARTMUT +MARWITZ +Director +June 29, 2006 +Hartmut Marwitz, +Ph.D. +/s/ JOHN +SEAZHOLTZ +Director +June 29, 2006 +John Seazholtz +/s/ JOEL SLUTZKY +Director +June 29, 2006 +Joel Slutzky +/s/ THOMAS L. +THOMAS +Director +June 29, 2006 +Thomas L. Thomas +/s/ PAUL E. +WRIGHT +Director +June 29, 2006 +Paul E. Wright +/s/ ABBAS +MOHADDES +Director, Assistant Secretary and Executive +June 29, 2006 +Abbas Mohaddes +Vice President +35 +Iteris, Inc. +Index to Consolidated +Financial Statements +Report of Independent +Registered Public Accounting Firm, McGladrey & Pullen, LLP +Report of Independent Registered Public Accounting +Firm, Ernst & Young LLP +Consolidated +Balance Sheets as of March 31, 2006 and 2005 +Consolidated Statements of Operations for the years +ended March 31, 2006, 2005, and 2004 +Consolidated Statements of Stockholders’ Equity +(Deficit) for the years ended March 31, 2006, 2005, and 2004 +Consolidated Statements of Cash Flows for the years +ended March 31, 2006, 2005, and 2004 +Notes to Consolidated Financial Statements +36 +Report +of Independent Registered Public Accounting Firm +To the Board of +Directors +Iteris, Inc. +Anaheim, California +We have audited the consolidated balance sheets of +Iteris, Inc. as of March 31, 2006 and 2005, and the related +consolidated statements of operations, stockholders’ equity (deficit) and cash +flows for the years then ended. Our audits also included the 2006 and 2005 +financial statement schedules of Iteris, Inc. listed at Item 15(a). +These financial statements and the financial statement schedules are the +responsibility of the Company’s management. Our responsibility is to express an +opinion on these financial statements and schedules based on our audits. +We conducted our audits in accordance with the +standards of the Public Company Accounting Oversight Board (United States). Those +standards require that we plan and perform the audit to obtain reasonable +assurance about whether the financial statements are free of material +misstatement. An audit includes examining, on a test basis, evidence supporting +the amounts and disclosures in the financial statements. An audit also includes +assessing the accounting principles used and significant estimates made by +management, as well as evaluating the overall financial statement presentation. +We believe that our audits provided a reasonable basis for our opinion. +In our opinion, the +consolidated financial statements referred to above present fairly, in all +material respects, the financial position of Iteris, Inc. as of March 31, +2006 and 2005, and the results of its operations and its cash flows for the +years then ended, in conformity with U.S. generally accepted accounting +principles. Also, in our opinion, the related financial statement schedules, +when considered in relation to the basic consolidated financial statements +taken as a whole, present fairly in all material respects the information set +forth therein. +/s/ McGladrey & Pullen, LLP +Irvine, California +June 28, 2006 +37 +Report of Independent Registered Public Accounting +Firm, Ernst & Young LLP +Stockholders and +Board of Directors +Iteris, Inc. +We +have audited the accompanying consolidated statements of operations, +stockholders’ equity (deficit), and cash flows for the year ended March 31, +2004. Our audit also included the financial statement schedule listed in +the index at Item 15(a). These financial statements and schedule are the +responsibility of the Company’s management. Our responsibility is to express an +opinion on these financial statements and schedule based on our audit. +We +conducted our audit in accordance with the standards of the Public Company +Accounting Oversight Board (United States). Those standards require that we +plan and perform the audit to obtain reasonable assurance about whether the +financial statements are free of material misstatement. We were not engaged to +perform an audit of the Company’s internal control over financial reporting. +Our audit included consideration of internal control over financial reporting +as a basis for designing audit procedures that are appropriate in the +circumstances, but not for the purpose of expressing an opinion on the +effectiveness of the Company’s internal control over financial reporting. +Accordingly, we express no such opinion. An audit also includes examining, on a +test basis, evidence supporting the amounts and disclosures in the financial +statements, assessing the accounting principles used and significant estimates +made by management, and evaluating the overall financial statement presentation. +We believe that our audit provides a reasonable basis for our opinion. +In our opinion, the financial statements referred to +above present fairly, in all material respects, the consolidated financial +position of Iteris, Inc. at March 31, 2004, and the consolidated results +of its operations and its cash flows for the year ended March 31, 2004, in +conformity with accounting principles generally accepted in the United States. Also, +in our opinion, the related financial statement schedule, when considered in +relation to the basic financial statements taken as a whole, presents fairly in +all material respects the information set-forth therein. +/s/ Ernst & Young LLP +Orange County, California +June 8, 2004, +except for Note 7 - Deferred Compensation Plan, as +to which the date is +July 13, 2005 +38 +Iteris, Inc. +Consolidated Balance Sheets +(In thousands) +March 31, +2006 +2005 +Assets +Current assets: +Cash and cash equivalents +$ +131 +$ +46 +Trade accounts receivable, net of allowance for +doubtful accounts of $429 and $239 at March 31, 2006 and 2005, +respectively. +11,426 +8,866 +Costs and estimated earnings in excess of billings +on uncompleted contracts +2,693 +2,086 +Deferred income taxes +790 +101 +Inventories, net of reserve for inventory +obsolescence of $592 and $514 at March 31, 2006 and 2005, respectively +2,814 +4,344 +Prepaid expenses and other current assets +368 +384 +Total current +assets +18,222 +15,827 +Property and equipment: +Leasehold improvements +112 +105 +Equipment +6,638 +5,281 +Accumulated depreciation +(4,967 +) +(4,283 +) +1,783 +1,103 +Deferred income +taxes +818 +559 +Intangible +assets, net of accumulated amortization of $261 and $114 at March 31, +2006 and 2005, respectively +551 +698 +Goodwill +27,774 +27,774 +Other assets +485 +695 +Total assets +$ +49,633 +$ +46,656 +See accompanying +notes. +39 +Iteris, Inc. +Consolidated Balance Sheets +(In +thousands, except share and per share amounts) +March 31, +2006 +2005 +Liabilities and +stockholders’ equity +Current liabilities: +Trade accounts payable +$ +3,620 +$ +3,936 +Accrued payroll and related expenses +3,481 +3,007 +Accrued liabilities +2,304 +790 +Revolving line of credit +2,662 +945 +Billings in excess of costs and estimated earnings +on uncompleted contracts +893 +944 +Current portion of long-term debt +1,969 +4,008 +Total current +liabilities +14,929 +13,630 +Non-current +payroll related liability +12 +330 +Deferred +compensation plan liability +820 +772 +Deferred gain on +sale of building +449 +733 +Long-term debt +2,171 +1,319 +Convertible +debentures, net +9,203 +8,996 +Commitments and +contingencies +Redeemable common stock +Issued and outstanding shares — 1,219,445 at +March 31, 2006 and 2005 +3,414 +3,414 +Stockholders’ equity: +Preferred stock: +Authorized +shares — 2,000,000 +Issued and outstanding — none +— +— +Common stock, +$.10 par value: +Authorized +shares — 50,000,000 +Issued and outstanding shares — 27,431,502 at +March 31, 2006 and 27,089,661 at +March 31, 2005 +2,743 +2,709 +Additional paid-in capital +126,743 +126,534 +Deferred stock-based compensation +(79 +) +(925 +) +Common stock held in trust — 310,510 shares at +March 31, 2006 and 2005 +(374 +) +(374 +) +Treasury stock — none at March 31, 2006 and 93 +shares at March 31, 2005 +— +(1 +) +Notes receivable from employees +(49 +) +(45 +) +Accumulated deficit +(110,356 +) +(110,436 +) +Accumulated other comprehensive income +7 +— +Total +stockholders’ equity +18,635 +17,462 +Total liabilities and +stockholders’ equity +$ +49,633 +$ +46,656 +See accompanying notes. +40 +Iteris, Inc. +Consolidated Statements of Operations +(In thousands, except +per share amounts) +Year Ended March 31, +2006 +2005 +2004 +Net sales and contract +revenues: +Net sales +$ +31,156 +$ +29,062 +$ +23,470 +Contract revenues +19,330 +17,335 +21,813 +Total net sales +and contract revenues +50,486 +46,397 +45,283 +Costs and expenses: +Cost of net sales +16,465 +15,645 +12,758 +Cost of contract revenues +12,395 +11,398 +14,712 +Selling, general and administrative expenses +14,999 +13,964 +12,844 +Research and development expenses +5,088 +4,193 +3,923 +Stock-based compensation +725 +11,777 +— +Amortization of intangible assets +147 +114 +— +Deferred compensation expense (benefit) +48 +(484 +) +868 +Disposal of fixed assets +— +422 +— +Acquired in-process research and development +— +140 +— +Total costs and +expenses +49,867 +57,169 +45,105 +Income (loss) +from operations +619 +(10,772 +) +178 +Non-operating income +(expense): +Other income, net +35 +1,054 +1,003 +Interest expense, net +(1,459 +) +(1,178 +) +(123 +) +Income (loss) +from continuing operations before income taxes and minority interest +(805 +) +(10,896 +) +1,058 +Income tax +benefit (provision) +885 +94 +(100 +) +Minority +interest in earnings of subsidiary +— +(526 +) +(2,813 +) +Income (loss) +from continuing operations +80 +(11,328 +) +(1,855 +) +Income from +discontinued operations, net of taxes of $0 +— +— +1,215 +Net income +(loss) +$ +80 +$ +(11,328 +) +$ +(640 +) +Basic and diluted +earnings (loss) per share: +Continuing operations +$ +0.00 +$ +(0.45 +) +$ +(0.09 +) +Discontinued operations +— +— +0.06 +Basic and +diluted earnings (loss) per share +$ +0.00 +$ +(0.45 +) +$ +(0.03 +) +Shares used in +computing basic earnings (loss) per share +28,182 +25,284 +19,454 +Shares used in +computing diluted earnings (loss) per share +32,737 +25,284 +19,454 +See accompanying notes . +41 +Iteris, Inc. +Consolidated Statements of and Stockholders’ +Equity (Deficit) +(In thousands) +Common Stock +Shares Outstanding +Class A +Shares +Class B +Shares +Amount +Additional +Paid-In +Capital +Deferred +Stock-Based +Compensation +Common +Stock +Held in +Trust +Treasury +Stock +Notes +Receivable +From +Employees +Accumulated +Deficit +Accumulated +Other +Comprehensive +Income +Total +Stockholder’s +Equity +(Deficit) +Comprehensive +Income +(Loss) +Balance at March 31, 2003 +14,081 +1,036 +$ +1,512 +$ +91,767 +$ +— +$ +— +$ +(1 +) +$ +(51 +) +$ +(98,468 +) +$ +(99 +) +$ +(5,340 +) +Issuance of Class A common stock and warrants +6,288 +— +629 +4,170 +— +— +— +— +— +— +4,799 +Conversion of Class B common stock +108 +(108 +) +— +— +— +— +— +— +— +— +— +Payments on notes receivable +— +— +— +— +— +— +— +6 +— +— +6 +Foreign currency translation adjustments +— +— +— +— +— +— +— +— +— +99 +99 +99 +Net loss +— +— +— +— +— +— +— +— +(640 +) +— +(640 +) +(640 +) +Balance at March 31, 2004 +20,477 +928 +2,141 +95,937 +— +— +(1 +) +(45 +) +(99,108 +) +— +(1,076 +) +(541 +) +Warrant exercises +402 +— +40 +344 +— +— +— +— +— +— +384 +Stock option exercises +25 +— +2 +49 +— +— +— +— +— +— +51 +Issuance of warrants in connection with convertible +debentures +— +— +— +1,101 +— +— +— +— +— +— +1,101 +Conversion of Class B common stock +1,020 +(928 +) +9 +(9 +) +— +— +— +— +— +— +— +Convertible debenture conversion to common stock +69 +— +7 +205 +— +— +— +— +— +— +212 +Issuance of common stock in connection with merger of +Iteris Subsidiary +4,787 +— +479 +14,722 +— +— +— +— +— +— +15,201 +Issuance of warrants +— +— +— +26 +— +— +— +— +— +— +26 +Assumption of Iteris subsidiary stock options and +warrants +— +— +— +13,816 +(1,433 +) +— +— +— +— +— +12,383 +Common stock held in trust +310 +— +31 +343 +— +(374 +) +— +— +— +— +— +Amortization of deferred stock-based compensation +— +— +— +508 +— +— +— +— +— +508 +Net loss +— +— +— +— +— +— +— +— +(11,328 +) +— +(11,328 +) +(11,328 +) +Balance at March 31, 2005 +27,090 +— +2,709 +126,534 +(925 +) +(374 +) +(1 +) +(45 +) +(110,436 +) +— +17,462 +(11,328 +) +Warrant exercises +98 +— +9 +28 +— +— +— +— +— +— +37 +Stock option exercises +244 +— +25 +275 +— +— +— +(4 +) +— +— +296 +Issuance of warrants +— +— +— +28 +— +— +— +— +— +— +28 +Deferred stock-based compensation, net +— +— +— +(121 +) +846 +— +— +— +— +— +725 +Retirement of treasury stock +— +— +— +(1 +) +— +— +1 +— +— +— +— +Foreign currency translation adjustments +— +— +— +— +— +— +— +— +— +7 +7 +7 +Net income +— +— +— +— +— +— +— +— +80 +— +80 +80 +Balance at March 31, 2006 +27,432 +— +$ +2,743 +$ +126,743 +$ +(79 +) +$ +(374 +) +$ +— +$ +(49 +) +$ +(110,356 +) +$ +7 +$ +18,635 +$ +87 +See accompanying notes. +42 +Iteris, Inc. +Consolidated Statements of Cash Flows +(In thousands) +Year Ended March 31, +2006 +2005 +2004 +Operating activities +Net income (loss) from +continuing operations +$ +80 +$ +(11,328 +) +$ +(1,855 +) +Net income from +discontinued operations +— +— +1,215 +Adjustments to reconcile net income (loss) to net +cash provided by (used in) operating activities: +Change in deferred tax +assets +(948 +) +(200 +) +— +Depreciation and +amortization +684 +787 +857 +Stock-based +compensation +725 +11,777 +— +Amortization of +deferred gain on sale-leaseback +(284 +) +(609 +) +(855 +) +Amortization of debt +discounts +207 +184 +— +Amortization of +intangible assets +147 +114 +— +Amortization of +deferred financing costs +138 +121 +— +Minority interest in +earnings of subsidiary +— +526 +2,813 +Loss on disposal of +assets +— +422 +— +Write-off of acquired +in-process research and development +— +140 +— +Fair value of warrants +issued for services +— +26 +— +Changes in operating assets and liabilities: +Accounts receivable +(2,560 +) +(611 +) +(88 +) +Net costs and estimated +earnings in excess of billings +(658 +) +961 +(10 +) +Inventories +1,530 +(746 +) +305 +Prepaid expenses and +other assets +109 +41 +1,454 +Deferred gain on sale +of building +— +— +(3,396 +) +Accounts payable and +accrued expenses +1,048 +(789 +) +(1,625 +) +Deferred revenue +— +(226 +) +226 +Net assets of +discontinued operations +— +— +241 +Net cash provided by +(used in) operating activities +218 +590 +(718 +) +Investing activities +Purchases of property +and equipment +(1,258 +) +(670 +) +(558 +) +Notes receivable +— +125 +— +Acquisition costs +— +(80 +) +— +Other +— +— +99 +Net cash used in +investing activities +(1,258 +) +(625 +) +(459 +) +Financing activities +Proceeds (payments) +from borrowings on lines of credit, net +1,717 +845 +(1,385 +) +Proceeds from long-term +debt +— +5,000 +918 +Payments on long-term +debt +(1,314 +) +(1,038 +) +— +Checks drawn in excess +of available bank balances +389 +268 +— +Proceeds from issuance +of convertible debentures +— +9,436 +— +Purchase of Iteris +subsidiary Series A preferred stock +— +(17,543 +) +— +Proceeds from stock +option and warrant exercises +333 +501 +— +Proceeds from issuance +of common stock and related warrants +— +— +3,813 +Payments on notes +receivable from employees +— +— +6 +Net cash provided by +(used in) financing activities +1,125 +(2,531 +) +3,352 +Increase (decrease) in +cash +85 +(2,566 +) +2,175 +Cash and cash +equivalents at beginning of year +46 +2,612 +437 +Cash and cash +equivalents at end of year +$ +131 +$ +46 +$ +2,612 +Supplemental cash flow information: +Cash paid (received) during the period: +Interest +$ +1,095 +$ +747 +$ +123 +Income taxes +(2 +) +624 +320 +Supplemental schedule of non-cash investing +and financing activities: +Property and equipment +financing +$ +127 +$ +— +$ +— +Fair value of warrants +issued in settlement of liabilities +28 +— +— +Exercises of stock +options via notes receivable from employees +4 +— +— +Retirement of treasury +stock +1 +— +— +Increase in promissory +note to landlord to settle lease obligation +— +432 +— +Acquisition of minority interest of the Iteris +subsidiary +Intangible assets +— +812 +— +Deferred tax +liabilities +— +360 +— +Goodwill +— +17,887 +— +Reduction of minority +interest +— +1,253 +— +Issuance of warrants in +connection with Debenture and Warrant Purchase Agreement +— +1,101 +— +Conversion of convertible +debt to equity +— +250 +— +Issuance of common +stock to settle liabilities +— +— +416 +Contribution of common stock to 401(k) plan to +settle employer match +— +— +578 +See accompanying notes. +43 +Iteris, Inc. +Notes to Consolidated Financial Statements +March 31, +2006 +1. Description +of Business and Summary of Significant Accounting Policies +Description +of Business +Iteris, Inc., +formerly known as Iteris Holdings, Inc. (the “Company”), is a leading provider +of outdoor machine vision systems and sensors that optimize the flow of traffic +and enhance driver safety. Using proprietary software and Intelligent +Transportation Systems (“ITS”) industry expertise, the Company provides video +sensor systems, transportation management and traveler information systems and +other engineering and consulting services to the ITS industry. The ITS industry +is comprised of companies applying a variety of technologies to enable the safe +and efficient movement of people and goods. The Company uses its outdoor image +recognition software expertise to develop proprietary algorithms for video +sensor systems that improve vehicle safety and the flow of traffic. Using its +knowledge of the ITS industry, the Company designs and implements +transportation management systems that help public agencies reduce traffic +congestion and provide greater access to traveler information. On October 22, +2004, the Company completed the merger with its majority-owned subsidiary, +Iteris, Inc. (the “Iteris Subsidiary”), and officially changed the Company’s +corporate name from Iteris Holdings, Inc. to Iteris, Inc. (Note 3). The +Company was originally incorporated in Delaware in 1987 as Odetics, Inc. +and in September 2003 changed its name to Iteris Holdings, Inc. to +reflect its focus on the ITS industry and its capital structure at that time. +Basis of +Presentation +The accompanying consolidated financial statements +include the accounts of the Company and its subsidiaries. All significant +intercompany accounts and transactions have been eliminated in consolidation. +As discussed further in Note 11, in 2003 the Company +discontinued the operations of its Broadcast, Inc. subsidiary (“Broadcast”), +its Zyfer, Inc. subsidiary (“Zyfer”), and its MAXxess Systems, Inc. +subsidiary (“MAXxess”), so that the Company could focus on its ITS business. The +results of operations for these businesses are presented as discontinued +operations in the accompanying consolidated financial statements. +Use of +Estimates +The preparation of consolidated financial statements +in conformity with accounting principles generally accepted in the United +States requires management to make certain estimates and assumptions that +affect the reported amounts of assets and liabilities and disclosures of contingent +assets and liabilities at the date of the financial statements, and reported +amounts of revenues and expenses during the reporting period. Actual results +could differ from those estimates. Significant estimates made in the +preparation of the consolidated financial statements include the allowance for +doubtful accounts, deferred tax assets, inventory and warranty reserves, costs +to complete long-term contracts, overhead rates used in cost-plus contracts, +contract reserves and estimates of future cash flows used to assess the +recoverability of long-lived assets, the valuation of equity instruments and +the realization of goodwill. +Reclassifications +Certain reclassifications +have been made to the prior year financial statements to conform to the current +year presentation. +Revenue Recognition +Product revenues and related costs of sales are +recognized upon the transfer of title, which generally occurs upon shipment or, +if required, upon acceptance by the customer, provided that the Company +believes collectibility of the net sales amount is reasonably assured. Accordingly, +at the date revenue is recognized, the significant uncertainties concerning the +sale have been resolved. +Contract revenues are derived primarily from long-term +contracts with governmental agencies. Contract revenues include costs incurred +plus a portion of estimated fees or profits determined on the percentage of +completion method of accounting based on the relationship of costs incurred to +total estimated costs. Any anticipated losses on contracts are charged to +earnings when identified. Changes in job performance and estimated +profitability, including those arising from contract penalty provisions and +final contract settlements, may result in revisions to costs and revenues and +are recognized in the period in which the revisions are determined. Profit +incentives are included in revenue when their realization is reasonably +assured. +In addition to product and contract revenue, the +Company derives revenue from technology access fees, the provision of specific +non-recurring contract engineering services and royalties. Technology access +fee revenues are recognized evenly over the period in which they are earned. Non-recurring +contract engineering revenues are recognized in the period in which the related +services are performed. Royalty revenues are recorded in the period in which +the royalty is earned, based on unit sales of the Company’s products. Technology +access fee revenues, contract engineering revenues and royalty revenues are +included in net sales in the accompanying consolidated statements of +operations. +44 +Revenues from follow-on service and support, for which +the Company charges separately, are recorded in the period in which the +services are performed. +Concentration +of Credit Risk +Accounts receivable are derived from revenues earned +from customers located throughout North America and Europe. The Company +generally does not require collateral or other security from customers. +Collectibility of receivable balances is estimated through review of invoices +outstanding greater than a certain period of time and ongoing credit +evaluations of customers’ financial condition. Reserves are maintained for +potential credit losses, and such losses have historically been within +management’s expectations. +At March 31, 2006 and 2005, accounts receivable +from governmental agencies and prime government contractors were approximately +$4.4 million and $3.5 million, respectively. No customer or government agency +had a receivable balance greater than 10% of our total net sales or contract +revenues at March 31, 2006 and 2005. +Fair +Values of Financial Instruments +The fair value of cash +and cash equivalents, receivables, inventories, accounts payable and accrued +expenses approximate carrying value because of the short period of time to +maturity. The fair value of line of credit agreements and long-term debt +approximate carrying value because the related rates of interest approximate +current market rates. The fair value of convertible debentures approximates +carrying value because the effective interest rate, taking into account +recorded debt discounts, approximates current market rates. At March 31, +2005, the fair value of redeemable common stock approximated carrying value +since these shares were not tradable in any public equity markets. At March 31, +2006, the estimated fair value of the redeemable shares was $3.2 million, based +on the closing price of the Company’s common stock on that date. +Cash and +Cash Equivalents +Cash and cash equivalents consist of cash and +short-term investments with initial maturities of ninety days or less. +Inventories +Inventories are stated at +the lower of cost or market. Cost is determined using the first-in, first-out +method. +Property +and Equipment +Property and equipment are recorded at cost and are +depreciated principally by the double declining balance method over the +estimated useful life ranging from three to eight years. Leasehold improvements are depreciated over +the term of the related lease. +Goodwill and Long-Lived Assets +In accordance with Statement of Financial Accounting +Standards (“SFAS”) No. 142, Goodwill and Intangible +Assets (“SFAS 142”), goodwill is tested for impairment at the +reporting unit level (operating segment or one level below an operating +segment) on an annual basis in the Company’s fourth fiscal quarter or more +frequently if indicators of impairment exist. The performance of the test +involves a two-step process. The first step of the impairment test involves +comparing the fair value of the Company’s reporting units with the reporting +unit’s carrying amount, including goodwill. The fair value of reporting units +is generally determined using the income approach. If the carrying amount of a +reporting unit exceeds the reporting unit’s fair value, the second step of the +goodwill impairment test is performed to determine the amount of any impairment +loss. The second step of the goodwill impairment test involves comparing the +implied fair value of the reporting unit’s goodwill with the carrying amount of +that goodwill. +The Company evaluates long-lived assets for impairment +in accordance with SFAS No. 144, “Accounting for the +Impairment or Disposal of Long-Lived Assets,” which requires +impairment evaluation on long-lived assets used in operations when indicators +of impairment are present. Reviews are performed to determine whether the +carrying value of assets is impaired, based on comparison to undiscounted +expected future cash flows. If this comparison indicates that there is +impairment, the impaired asset is written down to fair value, which is +typically calculated using discounted expected future cash flows using a +discount rate based upon the Company’s weighted average cost of capital +adjusted for risks associated with the related operations. Impairment is based +on the excess of the carrying amount over the fair value of those assets. +Income Taxes +The +Company utilizes the liability method of accounting for income taxes as set +forth in SFAS No. 109, Accounting for Income +Taxes (“SFAS 109”). Under the liability method, deferred taxes are +determined based on the temporary differences between the financial statement +and tax bases of assets and liabilities using enacted tax rates. A valuation +allowance is recorded when it is more likely than not that some of the deferred +tax assets will not be realized. See Note 6. +Stock-Based Compensation +The +Company accounts for stock-based employee compensation arrangements in +accordance with Accounting Principles Board Opinion No. 25, Accounting for Stock-Issued to Employees (“APB +25”) and related interpretations, and +45 +complies with the disclosure-only provisions of SFAS No. 123, +Accounting for Stock-Based Compensation (“SFAS +123”) and SFAS 148, Accounting for Stock-Based +Compensation — Transition and Disclosure (“SFAS 148”). Under APB 25, +compensation cost is recognized based on the difference, if any, on the date of +the grant between the fair value of the Company’s stock and the amount the +employee must pay to acquire the stock. +In +accordance with the requirements of the disclosure-only alternative of SFAS 123 +and SFAS 148, set forth below are the assumptions used and the pro forma +statement of operations data of the Company giving effect to valuing +stock-based awards to employees using the Black-Scholes option pricing model +instead of the guidelines provided by APB 25. Among other factors, the +Black-Scholes model considers the expected life of the option and the expected +volatility of the Company’s stock price in arriving at an option valuation. +The +per share fair value of stock options granted in connection with stock option +plans has been estimated with the following weighted average assumptions: +Years Ended March 31, +2006 +2005 +2004 +Dividend rate +0.0 +0.0 +0.0 +Expected life — +years +7.0 +7.0 +7.0 +Risk-free +interest rate +5.5 +4.5 +2.0 +Volatility of common +stock +0.5 +0.5 +0.4 +For purposes of pro forma disclosures, the estimated +fair value of the options is amortized to expense over the options’ vesting +period. The Company’s pro forma information follows: +Year Ended March 31, +2006 +2005 +2004 +(In thousands, except per share amounts) +Net income +(loss) — as reported +$ +80 +$ +(11,328 +) +$ +(640 +) +Add: Stock-based +compensation expense included in net income (loss) — as reported +725 +11,777 +— +Deduct: +Stock-based compensation expense determined under fair value method +(1,108 +) +(12,806 +) +(385 +) +Net loss — pro +forma +$ +(303 +) +$ +(12,357 +) +$ +(1,025 +) +Basic and +diluted income (loss) per share — as reported +$ +0.00 +$ +(0.45 +) +$ +(0.03 +) +Basic and diluted loss +per share — pro forma +$ +(0.01 +) +$ +(0.49 +) +$ +(0.05 +) +Research +and Development Expenditures +Research and development +expenditures are charged to expense in the period incurred. +Shipping +and Handling Costs +Shipping +and handling costs are included as cost of sales in the period during which the +products ship. +Advertising +Expenses +Advertising +costs are expensed in the period incurred and totaled $185,000, $112,000 and +$127,000 in the years ended March 31, 2006, 2005 and 2004, respectively. +Warranty +Unless otherwise stated, the Company provides a one to three year +warranty from the original invoice date on all products, materials, and +workmanship. Products sold to certain original equipment manufacturer (“OEM”) +customers sometimes carry longer warranties. Defective products will be either +repaired or replaced, generally at the Company’s option, upon meeting certain +criteria. The Company accrues a provision for the estimated costs that may be +incurred for product warranties relating to a product as a component of cost of +sales at the time revenue for that product is recognized. The accrued warranty +provision is included within accrued expenses on the accompanying consolidated +balance sheets. +46 +Repair +and Maintenance Costs +The +Company incurs repair and maintenance costs in the normal course of business. +Should the activity result in a permanent improvement to one of the Company’s +leased facilities, the cost is capitalized as a leasehold improvement and +amortized over its useful life or the remainder of the lease period, whichever +is shorter. Non-permanent repair and maintenance costs are charged to expense +as incurred. +Comprehensive Income +The only component of accumulated other comprehensive +income is foreign currency translation adjustments. +Recent +Accounting Pronouncements +In November 2004, the FASB issued SFAS No. 151, +Inventory Costs (“SFAS 151”), which +clarifies the accounting for abnormal amounts of idle facility expense, +freight, handling costs, and wasted material. SFAS 151 will be effective for +inventory costs incurred during fiscal years beginning after June 15, 2005. +Management does not believe the adoption of SFAS 151 will have a material +impact on the Company’s consolidated financial statements. +On December 16, +2004, the FASB issued SFAS No. 123 (revised 2004), Share-Based +Payment (“SFAS 123R”) which replaces SFAS 123, supersedes +APB 25 and amends SFAS No. 95, Statement of Cash Flows . +Generally, the approach in SFAS 123R is similar to the approach described in +SFAS 123. However, SFAS 123R requires all share-based payments to employees, +including grants of employee stock options, to be recognized in the financial +statements based on their fair values (i.e., pro forma disclosure is no longer +an alternative to financial statement recognition). In accordance with SEC +Release No. 33-8568, SFAS 123R became effective for the Company on April 1, +2006. The Company plans to use the modified-prospective method of recognition +of compensation expense related to share-based payments. +The adoption of the SFAS 123R fair value method +will have a significant adverse impact on reported results of operations, +although it will have no impact on the Company’s overall financial position. +The balance of unearned stock-based compensation to be included in the years +ending March 31, 2007 through 2010 related to share-based awards unvested +at March 31, 2006, as previously calculated under the disclosure-only +requirements of SFAS 123, is approximately $521,000. If there are any +modifications or cancellations of the underlying unvested securities, the +Company may be required to accelerate, increase or cancel any remaining +unearned stock-based compensation expense. To the extent that the Company +grants additional equity securities, stock-based compensation expense will be +increased by the additional unearned compensation resulting from those +additional grants. Had the Company adopted SFAS 123R in prior periods, the +magnitude of the impact on results of operations would have approximated the +impact of SFAS 123 assuming the application of the Black-Scholes option +pricing model as described in the disclosure above of pro forma net loss and +pro forma net loss per share. +2. Supplementary Financial Information +Inventories +The following table presents details of the Company’s +inventories: +March 31, +2006 +2005 +(In thousands) +Materials and +supplies +$ +2,258 +$ +3,204 +Work in process +217 +558 +Finished goods +339 +582 +$ +2,814 +$ +4,344 +Goodwill and Identifiable Intangible +Assets +March 31, 2006 +March 31, 2005 +Gross +Carrying +Amount +Accumulated +Amortization +Gross +Carrying +Amount +Accumulated +Amortization +(In thousands) +Intangible assets +subject to amortization: +Developed Technology +$ +495 +$ +(179 +) +$ +495 +$ +(78 +) +Patents +317 +(82 +) +317 +(36 +) +Total +$ +812 +$ +(261 +) +$ +812 +$ +(114 +) +47 +Amortization +expense for intangible assets subject to amortization was $147,000 and $114,000 +for the years ended March 31, 2006 and 2005, respectively. Future +estimated amortization expense for the next five years and thereafter is as +follows: +Year ending March 31: +(In thousands) +2007 +$ +147 +2008 +147 +2009 +147 +2010 +58 +2011 +46 +Thereafter +6 +$ +551 +At March 31, 2005, +goodwill was comprised of $18.0 million associated with the October 2004 +merger of the Iteris Subsidiary (Note 3); $9.6 million associated with the +acquisitions of the Rockwell International Transportation Systems Group, Meyer +Mohaddes Associates and the Viggen Systems Consulting Group; and $200,000 +associated with the purchase of the assets of Mil-Lektron, a complimentary +product to the Company’s Vantage video detection business. +Warranty Reserve Activity +The +following table presents activity in accrued warranty obligations: +March 31, +2006 +2005 +2004 +(In thousands) +Balance at +beginning of year +$ +326 +$ +192 +$ +256 +Additions charged to cost of sales +517 +614 +161 +Warranty claims +(324 +) +(480 +) +(225 +) +Balance at end of year +$ +519 +$ +326 +$ +192 +Earnings (Loss) Per Share +The following table sets forth the computation of +basic and diluted income (loss) per share: +Year Ended March 31, +2006 +2005 +2004 +(In thousands, except per share amounts) +Numerator: +Income (loss) from continuing operations +$ +80 +$ +(11,328 +) +$ +(1,855 +) +Income from discontinued operations +— +— +1,215 +Net income (loss) +$ +80 +$ +(11,328 +) +$ +(640 +) +Denominator: +Denominator for basic earnings (loss) per share +28,182 +25,284 +19,454 +Effect of +dilutive securities: +Stock options +3,818 +— +— +Warrants +737 +— +— +Denominator for diluted earnings (loss) per share +32,737 +25,284 +19,454 +Basic and diluted +earnings (loss) per share: +Income (loss) from continuing operations +$ +0.00 +$ +(0.45 +) +$ +(0.09 +) +Income from discontinued operations +— +— +0.06 +Net income +(loss) +$ +0.00 +$ +(0.45 +) +$ +(0.03 +) +48 +The following +shares were excluded from the computation of diluted earnings (loss) per share +as their effect would have been anti-dilutive: +Year Ended March 31, +2006 +2005 +2004 +(In thousands) +Stock options +470 +4,560 +162 +Warrants +1,265 +1,095 +64 +Convertible debentures +2,729 +2,729 +— +3. Merger +of the Company and the Iteris Subsidiary +On May 28, +2004 (the “Closing Date”), in order to simplify the Company’s capital structure +and facilitate the merger of the Iteris Subsidiary into the Company, the +Company completed the purchase of all of the outstanding shares of the Series A +preferred stock of the Iteris Subsidiary (the “Series A preferred stock”), +which were held by DaimlerChrysler Ventures GmbH (“DCV”) and Hockenheim +Investment Pte. Ltd. (“Hockenheim”), in exchange for approximately $17.5 +million in cash. In addition, the Company acquired all of the 547,893 shares of +common stock of the Iteris Subsidiary held by DCV in exchange for the issuance +of 1,219,445 shares of the Company’s Class A common stock (now known as +the Company’s common stock) which was valued at $3.4 million at the date of +issuance. The fair value of the Company’s common stock issued in the +transaction was based on the quoted market price of the Company’s stock on the OTC +Bulletin Board averaged over a five-day period. The purchase and exchange of +the shares were made pursuant to a Stock Purchase and Exchange Agreement dated March 31, +2004, by and among the Company, the Iteris Subsidiary, DCV and Hockenheim (the “Purchase +and Exchange Agreement”). +Pursuant +to the Purchase and Exchange Agreement, the Company purchased 3,124,913 shares +of the Series A preferred stock of the Iteris Subsidiary from DCV and +Hockenheim for a purchase price of $5.61 per share. The purchase price +represented the stated redemption value of the Series A preferred stock. The +purchase of the shares was financed primarily with a $10.1 million convertible +debenture financing completed in May 2004 with a group of accredited +investors, in addition to a $5.0 million senior credit facility arranged +through a bank and $2.4 million in cash (Note 5). +On June 30, +2004, the Company and certain minority stockholders of the Iteris Subsidiary +(including certain officers and directors) entered into an exchange agreement +whereby an aggregate of 1,319,541 shares of common stock of the Iteris +Subsidiary were exchanged for 2,639,082 shares of the Company’s newly issued +common stock valued at $8.6 million at the date of issuance. The fair value of +the Company’s stock issued in the transaction was based on the quoted market +price of the Company’s common stock on the OTC Bulletin Board averaged over a +five-day period. The effect of this exchange was to reduce the residual +minority interest in the Iteris Subsidiary to 8.1%. +On October 22, +2004, the Iteris Subsidiary was merged into the Company. The remaining 8.1% +minority interest in the Iteris Subsidiary (consisting of 1,228,981 shares of +common stock of the Iteris Subsidiary) was converted to 2,457,962 shares of the +Company’s common stock valued at $7.6 million at the merger date. Immediately +following the merger, the Company converted all of its outstanding Class B +common stock (921,917 shares) into 1,014,108 shares of its common stock +(formerly designated as Class A common stock). The exchange ratio used in +conversion was determined by the Company’s Board of Directors. The fair value +of the Company’s common stock issued in the transaction was based on the quoted +market price of the Company’s common stock on the OTC Bulletin Board averaged +over a five-day period. In October 2004, the Company also amended its +certificate of incorporation to (a) change the voting rights of its common +stock from one-tenth to one vote per share, (b) remove the ability to +issue any further shares of Class B common stock, and (c) rename its Class A +common stock to common stock. As a result, the Company currently has only one +class of common stock outstanding, the common stock. +In +connection with the merger, the Company assumed all outstanding options and +warrants to purchase shares of common stock of the Iteris Subsidiary that were +outstanding immediately prior to the merger, whether vested or unvested, +together with the Iteris Subsidiary’s 1998 Stock Incentive Plan. Each such +option and warrant assumed by the Company shall continue to have, and be +subject to, the same terms and conditions as were applicable immediately prior +to the merger, provided that (A) such option or warrant shall be +exercisable for that number of whole shares of the Company’s common stock equal +to the product of the number of shares of the Company’s common stock that were +issuable upon exercise of such assumed option or warrant immediately prior to +the merger multiplied by two (2) (the “Exchange Ratio”) rounded down to +the nearest whole number of shares and (B) the per share exercise price +for the shares of the Company’s common stock issuable upon exercise of such +assumed option or warrant is equal to the quotient determined by dividing the +exercise price per share at which such option or warrant was exercisable +immediately prior to the merger by the Exchange Ratio (rounded up to the +nearest whole cent). As a result, options and warrants to purchase +approximately 3.1 million shares and 327,000 shares, respectively, of +common stock of the Iteris Subsidiary assumed in the merger became options and +warrants to purchase approximately 6.1 million and 654,000 shares of +common stock of the Company, respectively. The weighted-average exercise prices +of the assumed options and warrants were $1.09 and $2.32, respectively. Stock-based +compensation expense of $11.3 million was recorded in connection with the +assumption and exchange of vested Iteris Subsidiary stock options for stock +options immediately exercisable into the Company’s common stock based on the +difference between the +49 +fair +market value of the Company’s common stock on the October 22, 2004, merger +date and the exercise price of the modified stock option. Additionally, the +Company recorded approximately $1.4 million in deferred compensation related to +the assumption of unvested stock options to purchase common stock of the Iteris +Subsidiary. Deferred compensation is being amortized to stock-based +compensation expense as the options vest; and at March 31, 2006, $79,000 +of deferred compensation remained to be amortized. The Company also recorded +$1.1 million of goodwill and additional paid-in-capital in connection with the +654,000 vested warrants assumed in the merger and acquisition of the Iteris +Subsidiary. The $1.1 million value was based on the difference between the fair +market value of the Company’s common stock on the October 22, 2004, merger +date and modified exercise price of the assumed warrant awards. +The excess of the purchase price over the +proportionate amount of minority interest acquired was allocated to acquired +intangible assets based on the estimated fair values with the residual +allocated to goodwill. Accordingly, the Company recorded goodwill of $18.0 +million, which represents the excess of the purchase price over the fair value +of the proportionate identifiable net assets acquired. The estimated fair value +of the intangible assets was determined using the income method and discounting +future expected returns. The estimated useful life for each of the acquired +intangible assets is provided below: +Patents +7 years +Developed technology +5 years +50 +The following table +summarizes fair values of the assets acquired and liabilities assumed and the +allocation of the purchase price at the date of acquisition (in thousands): +Acquisition costs: +Issuance of common stock +$ +18,617 +Assumption of Iteris Subsidiary warrants +1,114 +Purchase of Iteris Subsidiary Series A +preferred stock +17,543 +Acquisition costs +80 +Total +acquisition costs +$ +37,354 +Purchase price +allocation: +Fair value of +41% of Iteris Subsidiary +Patents +$ +318 +Developed technology +495 +Acquired in-process research and development +140 +Deferred tax liabilities +(360 +) +Reduction of minority interest +18,794 +Goodwill (not deductable for tax purposes) +17,967 +Total purchase price +allocation +$ +37,354 +On October 22, 2004, in connection with the +Company’s merger with the Iteris Subsidiary, the Chief Executive Officer of the +Iteris Subsidiary, Mr. Jack Johnson, was promoted to President and Chief +Executive Officer of the Company, replacing Mr. Gregory Miner. This merger +triggered certain obligations under the Company’s change-in-control agreement +with Mr. Miner. Accordingly, the Company recorded approximately $807,000 +in severance expense, which included $57,000 for related payroll taxes, as a +charge to operations for the year ended March 31, 2005. The severance +amount will be paid to Mr. Miner in bi-weekly installments over the next +30 months. Mr. Miner is not required to render any services to the Company +in connection with this agreement. +4. Costs and Estimated Earnings on Uncompleted +Contracts +Costs incurred, +estimated earnings and billings on uncompleted long-term contracts are as +follows: +March 31, +2006 +2005 +(In thousands) +Total estimated +contract value +$ +74,990 +$ +71,835 +Costs incurred +on uncompleted contracts +$ +18,233 +$ +16,553 +Estimated earnings +1,823 +1,655 +20,056 +18,208 +Less billings to date +(18,256 +) +(17,066 +) +$ +1,800 +$ +1,142 +Included in +accompanying consolidated balance sheets: +Costs and estimated earnings in excess of billings +on uncompleted contracts +$ +2,693 +$ +2,086 +Billings in excess of costs and estimated earnings +on uncompleted contracts +(893 +) +(944 +) +$ +1,800 +$ +1,142 +Costs and estimated earnings in excess of billings at March 31, +2006 and 2005 include $806,000 and $481,000, respectively, that were not +billable as certain milestone objectives specified in the contracts had not +been attained. Substantially all costs and estimated earnings in excess of +billings at March 31, 2006 are expected to be billed and collected during +the year ending March 31, 2007. +5. Revolving Lines of Credit and Long-Term Debt +Revolving Lines of Credit +On May 28, 2004, the Iteris Subsidiary entered +into a line of credit agreement with a bank, which expires on July 31, +2006, and provides for a maximum available credit line of $5.0 million. This +line of credit was assumed by the Company in October 2004 and amended in November 2005. +Under the terms of this agreement, the Company may borrow against its eligible +accounts receivable and the value of its eligible inventory, as defined in the +credit agreement. Interest on borrowed amounts is payable monthly at the +current stated prime rate. Additionally, the Company is obligated to pay an +unused line fee of 0.25% per annum applied to the amount by which the maximum +credit amount exceeds the average daily principal balance during the preceding +month. +There are no monthly collateral management fees and no +pre-payment or early termination fees. On March 31, 2006, the available +credit under this line of credit agreement was $3.8 million, of which $1.1 +million was unused. +51 +Long-Term +Debt +Long-term debt +consists of the following: +March 31, +2006 +2005 +(In thousands) +Convertible +debentures, net +$ +9,203 +$ +8,996 +Bank term note +2,708 +3,958 +Promissory note +to landlord +1,292 +1,292 +Other +140 +77 +13,343 +14,323 +Less current +portion +(1,969 +) +(4,008 +) +$ +11,374 +$ +10,315 +Convertible Debentures, Net. In +order to finance the purchase of the Iteris Subsidiary Series A preferred +stock (Note 3), the Company entered into a Debenture and Warrant Purchase +Agreement dated May 19, 2004 (the “Debenture and Warrant Purchase +Agreement”), with a group of accredited investors, which included certain +officers of the Company, pursuant to which the Company sold and issued +subordinated convertible debentures in the aggregate original principal amount +of $10.1 million. In connection with the issuance of the convertible +debentures, the Company issued detachable warrants to purchase an aggregate of +639,847 shares of its common stock (Note 9), the value of which was recorded as +a debt discount against the face amount of the debentures on the date of +issuance and is being amortized to interest expense over the term of the +convertible debentures. +The debentures are due in full on May 19, 2009, +provide for 6.0% annual interest, payable quarterly, and are convertible into +the Company’s common stock at an initial conversion price of $3.61 per share, +subject to certain adjustments, including adjustments for dilutive issuances. From +May 19, 2007, until May 18, 2008, the debentures may be redeemed by +the Company, at its option, at 120% of the principal amount being redeemed; and +from May 19, 2008, until the maturity date, the debentures may be redeemed +at 110% of the principal amount being redeemed. During the year ended March 31, +2005, $250,000 of convertible debentures were converted into 69,252 shares of +common stock leaving $9.9 million of the originally issued convertible +debentures outstanding at March 31, 2006 and 2005. +Bank Term Note. Concurrent +with the Company’s issuance of the convertible debentures, the Iteris +Subsidiary entered into a $5.0 million term note payable with a bank. This note +was assumed by the Company in October 2004. The proceeds from the note +were used to purchase the Series A preferred stock of the Iteris +Subsidiary (Note 3). The note is due on May 27, 2008, and provides for +monthly principal payments of approximately $104,000. Interest accrues at the +current stated prime rate plus 0.25% (8.00% at March 31, 2006). +Both the term note payable and the line of credit are +held by one bank under the same credit agreement and are secured by +substantially all of the assets of the Company. At March 31, 2006, the +Company failed to meet a financial covenant under this agreement that limits +the amount of capital expenditures the Company may make in any fiscal year. On +May 19, 2006, the bank waived its right of default regarding this covenant +violation for the year ended March 31, 2006. At March 31, 2005, the +Company failed to meet certain financial covenants under the credit agreement. On +May 12, 2005, the bank waived its right of default regarding the covenant +violations for the quarter ended March 31, 2005 only. Because at +March 31, 2005 the bank did not waive its default rights for a period of +at least twelve months, the entire balance of the bank term note is presented +as a current liability in the accompanying March 31, 2005 consolidated +balance sheet. +Promissory Note to Landlord. As +discussed further in Note 7, on July 1, 2003, the Company amended the +terms of its lease for its headquarters and entered into a $811,000 unsecured +promissory note payable to its landlord. On November 1, 2004, $432,000 was +added to the principal balance of this note to settle prior lease obligations, +bringing the total principal balance to $1.3 million. Under the terms of the +note agreement, interest is payable quarterly and accrues at a rate of prime +plus 2.0% (9.75% at March 31, 2006). Beginning on October 1, 2006, +the Company is required to make four equal quarterly payments of principal and +accrued interest. All outstanding accrued interest and principal shall be +payable in full on July 2, 2007. +Scheduled aggregate maturities of long-term debt +principal as of March 31, 2006 were as follows: +Year ending March 31, +(In thousands) +2007 +$ +1,969 +2008 +1,946 +2009 +225 +2010 +9,850 +13,990 +Less: +unamortized debt discount +(647 +) +$ +13,343 +52 +6. Income Taxes +The reconciliation of the income tax provision +(benefit) from continuing operations to taxes computed at U.S. federal +statutory rates is as follows: +Year Ended March 31, +2006 +2005 +2004 +(In thousands) +Income tax +(benefit) provision at statutory rates +$ +(284 +) +$ +(3,705 +) +$ +360 +State income +taxes net of federal benefit +(85 +) +(72 +) +20 +Change in +valuation allowance associated with federal deferred tax assets +(892 +) +(755 +) +(316 +) +Compensation +charges +222 +3,692 +— +Adjustment to +prior year deferred taxes +— +229 +— +Expiration of +unused credits +— +266 +— +AMT and foreign +taxes +46 +— +— +Other permanent +differences +108 +251 +36 +$ +(885 +) +$ +(94 +) +$ +100 +The components of deferred tax assets and liabilities +are as follows: +March 31, +2006 +2005 +(In thousands) +Deferred tax assets: +Net operating losses +$ +18,061 +$ +19,880 +Property and equipment +623 +1,695 +Credit carry forwards +1,356 +1,914 +Deferred compensation and payroll +1,770 +1,626 +Bad debt allowances and other reserves +410 +422 +Other, net +124 +204 +Total deferred +tax assets +22,344 +25,741 +Valuation +allowance +(20,516 +) +(24,417 +) +Net deferred tax +assets +1,828 +1,324 +Deferred tax +liabilities: +Capitalized interest and taxes +— +(369 +) +Acquired intangibles +(220 +) +(295 +) +Total deferred +tax liabilities +(220 +) +(664 +) +Net deferred tax +assets +$ +1,608 +660 +Current portion +of net deferred taxes +790 +101 +Long-term +portion of net deferred taxes +818 +559 +Net deferred tax assets +$ +1,608 +$ +660 +53 +The components of current and deferred federal and +state income tax benefits and provisions are as follows: +Year Ended March 31, +2006 +2005 +2004 +(In thousands) +Current income tax +(benefit) provision +Federal +$ +9 +$ +91 +$ +891 +State +3 +14 +30 +Foreign +46 +— +— +Deferred income tax +(benefit) provision +Federal +(812 +) +(75 +) +(821 +) +State +(131 +) +(124 +) +— +Net income tax +(benefit) provision +$ +(885 +) +$ +(94 +) +$ +100 +At March 31, +2006, the Company had approximately $637,000 in federal general business credit +carryforwards that begin to expire in 2007 and $709,000 in state general business +credit carryforwards that can be carried forward indefinitely. The Company had +$49.2 million of federal net operating loss carryforwards at March 31, +2006, that begin to expire in 2019 and $22.6 million of state net operating +loss carryforwards that begin to expire in 2007. +Prior +to May 28, 2004, the Iteris Subsidiary was required to file a separate +federal income tax return. On May 28, 2004, the Company acquired a greater +than 80% ownership interest in the Iteris Subsidiary. From that date forward, +income taxes are provided on a consolidated basis for federal income tax +purposes. Due to changes in stock ownership, the prior year $49.8 million of federal +net operating loss carryforwards and other federal tax attributes of the +Company are subject to a Section 382 limitation estimated at approximately +$2.9 million annually which can be utilized to offset federal consolidated +taxable income. To the extent such limitation is not exceeded in a particular +year, the excess limitation accumulates and adds to subsequent years’ +limitations. As a result of the annual limitation, a portion of the Company’s +carryforwards will expire before ultimately becoming available to reduce future +income tax liabilities. +At March 31, +2006, the Company recorded a valuation allowance against its net deferred tax +assets of approximately $20.5 million for that portion of deferred tax +assets that it is more likely than not will not be realized. In making such +determination, a review of all available positive and negative evidence was +considered, including scheduled reversal of deferred tax liabilities, potential +carryback, projected future taxable income, tax planning strategies, and recent +financial performance. Any future benefits recognized from the reduction of the +valuation allowance will result in a reduction of income tax expense. +7. Commitments +and Contingencies +Litigation +On June 29, +2004, a supplier to Mariner Networks, Inc., a former subsidiary of the +Company that was discontinued in the fiscal year ended March 31, 2002, +filed a complaint in Orange County Superior Court against the Company alleging +various breaches of written contract claims arising out of alleged purchase +orders. The plaintiff in this lawsuit seeks monetary damages aggregating +approximately $850,000 plus attorney fees and related costs. Discovery has +commenced, and a trial date has been set for July 2006. The Company +intends to vigorously defend itself against these allegations. Due to the +uncertainty of the outcome, the Company has not recorded any amounts in the +accompanying consolidated financial statements in connection with this matter; +however, should the ultimate resolution of this claim be unfavorable, it could +have an adverse material impact on the Company’s consolidated financial +position, results of operations and cash flows. +In June 2004, the Company received $949,000 as +part of a settlement between Rockwell International and the Michigan +Department of Transportation, pursuant to which the Company was a third party +beneficiary. This amount was recorded in other income in the consolidated +statement of operations for the year ended March 31, 2005. +From time to time, the +Company has been involved in litigation relating to claims arising out of its +operations in the normal course of business. The Company currently is not a +party to any legal proceedings except as described above, the adverse outcome +of which, in management’s opinion, individually or in the aggregate, would have +a material adverse effect on its consolidated results of operations, financial +position or cash flows. +Furthermore, from time to +time, the Company has experienced unforeseen developments in contingencies +related to its former subsidiaries. In addition to the lawsuit mentioned above, +the Company has been the subject of a number of routine tax audits for time +periods and jurisdictions related to the businesses of its former subsidiaries, +some of which are still in process. Although the development and ultimate +outcome of these and other unforeseen matters cannot be predicted with any +certainty, management does not believe that the Company is presently involved +in any matters related to its former +54 +subsidiaries, except as described above, that would +have a material adverse effect on the Company’s consolidated results of +operations, financial position or cash flows. +Operating Leases +In May 2002, the Company completed the sale and +leaseback of its headquarters in Anaheim, California whereby the Company +entered into a lease with an initial term of ten years. In connection with the +sale leaseback transaction, the Company originally recorded a deferred gain of +approximately $7.6 million that was being amortized against operating expenses +over the term of the initial lease. On July 1, 2003, the Company +renegotiated the terms of this lease whereby the square footage under lease was +reduced and the initial lease term of ten years was reduced to four years. As a +result of the new lease agreement, $2.5 million of restricted cash was released +to the Company and paid to the landlord, the Company entered into a promissory +note agreement with the landlord for $811,000 (Note 5), and the deferred gain +on the sale of the building was adjusted. On November 1, 2004, the Company +again amended this lease and increased the note payable to the landlord by +$432,000 as a settlement to release the Company from its obligations under the +existing lease related to the separation of buildings located at the Anaheim +facility and other facility improvements to be made at the location. The $432,000 +was recorded as a reduction of the deferred gain on the sale of the building. The +remaining deferred gain was $449,000 at March 31, 2006 which will be +amortized through October 2007. +The Company has lease commitments for facilities in +various locations throughout the United States. Future minimum rental payments +under noncancelable operating leases are as follows at March 31, 2006 (in +thousands): +2007 +$ +1,305 +2008 +792 +2009 +116 +2010 +85 +2011 +43 +$ +2,341 +Rent expense under operating leases totaled +$1,947,000, $1,722,000 and $2,241,000, respectively, for the years ended March 31, +2006, 2005 and 2004. +The Company subleases 10,000 of the 94,000 square feet +that it leases in Anaheim, California at a monthly rate of $10,000. Aggregate +future minimum rental income from this sublease agreement is $120,000 and +$70,000 for the years ending March 31, 2007 and 2008, respectively. +Inventory Purchase Commitments +At March 31, 2006, the Company had firm +commitments to purchase inventory in the amount of $1.3 million during the +first and second quarters of its fiscal year ending March 31, 2007. +Deferred Compensation Plan +In 1986, the Company adopted the Executive Deferral +Plan (the “1986 Plan”) under which certain executives were able to defer a +portion of their annual compensation into the 1986 Plan. All deferred amounts +earned interest, generally with no guaranteed rate of return. +During the year ended March 31, 2003, the Iteris +Subsidiary adopted the Deferred Compensation Plan for the sole purpose of +transferring Iteris Subsidiary common stock and cash out of the 1986 Plan. All +assets of the 1986 Plan were distributed prior to March 31, 2003. Certain +of these assets, consisting of 133,333 shares of the Iteris Subsidiary’s common +stock and $14,000 in cash, were transferred to the Deferred Compensation Plan +during the year ended March 31, 2003. No compensation withholdings were +deferred under the 1986 Plan or the Deferred Compensation Plan in the years +ended March 31, 2006, 2005 and 2004. +During the year ended March 31, 2005, the Company +assumed the Deferred Compensation Plan as part of the October 2004 merger +and acquisition of the Iteris Subsidiary. In accordance with the merger (Note +3) the Company exchanged the original 133,333 shares of Iteris Subsidiary +common stock held in the Deferred Compensation Plan and an additional 21,922 +shares of the Iteris Subsidiary’s common stock subsequently purchased with +deferred wages for 310,510 shares of the Company’s common stock. All shares of +Iteris Subsidiary stock held in the plan were purchased with funds earned by +the executives and deferred to the plan at the estimated fair value and the +same price that was paid by outside investors at that time, or approximately +$374,000. +At March 31, 2006, the Deferred Compensation Plan +held 310,510 shares of the Company’s common stock and $14,000 in cash, which +the Company has presented as an aggregated $820,000 deferred compensation plan +liability in the accompanying consolidated balance sheet. Changes in the value +of Company common stock held by the Deferred Compensation Plan are determined +based on changes in the quoted market price of the Company’s common stock at +the close of each reporting period and presented within operating expenses in the +accompanying consolidated statements of operations. The original $374,000 cost +basis of shares of Company common stock held in the Deferred Compensation Plan +has been recorded as a contra-equity account in the accompanying consolidated +financial statements. +55 +8. Redeemable +Common Stock +As discussed in Note 3, +the Company issued 1,219,445 shares of its Class A common stock (now known +as common stock) (“Exchange Shares”) in connection with the merger of the +Iteris Subsidiary into the Company. Beginning on November 28, 2005, DCV +may require the Company to repurchase up to 50% of the Exchange Shares at a +purchase price of $1.438 per share; and beginning on May 28, 2007, DCV may +require the Company to repurchase up to 100% of the Exchange Shares at a +purchase price of $1.438 per share. All such rights to require the repurchase +of the Exchange Shares expire on September 28, 2007. Because this right is +outside the control of the Company, the Company has classified the $3.4 million +value of the 1,219,445 shares as redeemable common stock on the accompanying March 31, +2006 and 2005 consolidated balance sheets. On February 1, 2005, DCV +announced that its investment portfolio, which included its ownership in Iteris, Inc., +was sold to European-based Cipio Partners for an undisclosed sum. All +repurchase rights associated with the DCV shares inured to the benefit of Cipio +Partners. +9. Stockholders’ +Equity +Preferred Stock +The Company’s certificate of incorporation provides +for the issuance of up to 2,000,000 shares of preferred stock. As of March 31, +2006 and 2005, there were no outstanding shares of preferred stock, and the +Company does not have any plans to issue any shares of preferred stock. The +Company’s Board of Directors is authorized to issue from time to time such +authorized but unissued shares of preferred stock in one or more series and to +fix or alter the designations, preferences, rights and any qualifications, +limitations or restrictions of the shares of each such series, including the +dividend, conversion, voting, redemption and liquidation rights. +Common Stock and Common Stock +Warrants +As discussed in +Note 3, on October 22, 2004, the Iteris Subsidiary was merged into the +Company. Also in October 2004, the Company amended its certificate of +incorporation to (a) change the voting rights of its Class A common +stock from one-tenth to one vote per share, (b) remove the ability to +issue any further shares of Class B common stock, and (c) rename its Class A +common stock to common stock. As a result, the Company currently has only one +class of common stock outstanding, the common stock. Previously, the Company +had two classes of common stock outstanding — the Class A common stock and +the Class B common stock. +Subject to the rights specifically granted to holders +of any then outstanding shares of the Company’s preferred stock, the Company’s +common stockholders are entitled to any dividends that may be declared by the +Board of Directors. Upon dissolution, liquidation or winding up, holders of +common stock are entitled to share ratably in net assets after payment or +provision for all liabilities and any preferential liquidation rights of +preferred stock then outstanding. Common stockholders generally do not have +preemptive or redemption rights, except for the Exchange Shares issued to DCV +in exchange for shares of the Iteris Subsidiary (Notes 3 and 8). The rights, +preferences and privileges of holders of common stock will be subject to those +of the holders of any shares of common stock and preferred stock the Company +may issue in the future. +Pursuant to the Debenture and Warrant Purchase +Agreement discussed in Note 5, each individual investor also received two +warrants to purchase shares of the Company’s common stock. For every dollar of +debenture purchased, each investor received one warrant to purchase +approximately 0.03235 shares of the Company’s common stock at an exercise price +of $3.86 per share and a second warrant to purchase approximately 0.03100 +shares of the Company’s common stock at an exercise price of $4.03 per share. The +exercise prices are subject to certain adjustments, including adjustments for +dilutive issuances. The warrants to purchase 639,847 shares of common stock +were immediately exercisable and expire on May 18, 2009. Debt discount +costs related to the fair value of the warrants issued in connection with the +convertible debentures were calculated based on the fair value of the warrants +determined using the Black-Scholes valuation model and are being amortized to +interest expense over the five-year term of the debentures. Significant +valuation estimates used in the determination of the value of the warrants +include an expected life of five years, no dividends, a risk-free interest rate +of 4.5% and a stock volatility factor of 0.5. Unamortized debt discount +aggregated $647,000 and $854,000 at March 31, 2006 and 2005, respectively, +and is presented within convertible debentures, net on the accompanying +consolidated balance sheets. +Also in connection with the Debenture and Warrant +Purchase Agreement, the Company issued warrants to the investment bankers, as a +commission, to purchase 34,036 shares of its common stock at an exercise price +of $3.86 per share. The warrants were immediately exercisable and expire on May 18, +2009. The estimated fair value of these warrants of $40,000 was recorded as a +deferred financing cost and is being amortized to interest expense over the +five-year life of the debentures. Additionally, the Company incurred $621,000 +in transaction costs associated with the debenture offering, which have also +been capitalized as deferred financing costs and are being amortized to +interest expense over the five-year term of the debentures. Unamortized +deferred financing costs aggregated $430,000 and $568,000 at March 31, +2006 and 2005, respectively, and are presented within other assets on the +accompanying consolidated balance sheets. +56 +During +the year ended March 31, 2004, the Company issued 657,132 shares of its Class A +common stock valued at $578,000 and 89,332 shares of its Class A common +stock valued at $151,000 to settle 401(k) match liabilities and prior +trade liabilities in Company stock, respectively. +In September 2003, +the Company issued 425,000 shares of its Class A common stock, valued at +$255,000, and a warrant to purchase 75,000 shares of common stock at an +exercise price of $5.00 per share, to settle liabilities related to the sale +lease-back of the Anaheim facility and the renegotiation of the related lease. The +warrant was immediately exercisable and expires in July 2010. The fair +value of the warrant was $5,000 calculated using the Black Scholes Model. The +value of the warrant was recorded as a reduction of the deferred gain on the +sale of the building. +In July 2003, +the Company completed a private placement of 3,666,666 shares of its Class A +common stock to seven accredited investors for net proceeds of $1.9 million in +cash. In connection with this offering, the Company also issued warrants to +purchase an additional 366,666 shares of common stock at an exercise price of +$1.50 per share. The fair value of these warrants was $55,000 calculated using +the Black Scholes Model. The warrants are considered a cost of raising capital +and were recorded in equity as an offset to additional paid-in capital. The +warrants expire in July 2006 and became exercisable in January 2003. +The following table summarizes information regarding +outstanding warrants to purchase the Company’s common stock as of March 31, +2006: +Range of Exercise Prices +Warrants Outstanding +at March 31, 2006 +Weighted Avg. +Remaining +Contractual Life +Weighted Avg. +Exercise Price +(In thousands, except per share amounts) +$1.40 to $1.95 +2,073 +1.11 +$ +1.58 +$3.00 to $4.03 +1,150 +1.94 +$ +3.56 +$5.00 to $5.26 +230 +3.66 +$ +5.18 +3,453 +1.56 +$ +2.48 +All +of the warrants were exercisable at March 31, 2006. Warrants to purchase an aggregate of 1,250,000 +shares of common stock at an exercise price of $1.64 per share and warrants to +purchase an aggregate of 62,500 shares of common stock at an exercise price +of $1.95 per share are callable by the Company if the market price of the +Company’s common stock trades for 20 consecutive days at a price equal to or +greater than two times the exercise price of the warrants. Warrants to purchase +an aggregate of 75,000 shares of common stock at an exercise price of +$5.00 per share are callable by the Company if the market price of the +Company’s common stock trades for 20 consecutive days at a price equal to +or greater than one and a half times the exercise price of the warrants. +In +connection with the issuance of warrants to purchase 1,250,000 shares of our +common stock at $1.64 per share and 426,667 shares of our common stock at $3.00 +per share, the Company is a party to certain registration rights agreements +that contain provisions under which the Company could be subjected to +liquidated damages should it fail to maintain effective registration statements +for the underlying shares of common stock. +These warrants have been accounted for within equity in the consolidated +balance sheets in accordance with EITF 00-19 Accounting +for Derivative Financial Instruments Indexed to, and Potentially Settled in, a +Company’s Own Stock , and, accordingly, no liabilities have been +recorded in connection therewith. As of +the March 31, 2006, no liquidated damages were payable under the provisions of +the registration rights agreements associated with these warrants. +Common +stock reserved for future issuance at March 31, 2006: +(In thousands) +Issuable under stock +options plans +7,234 +Issuable upon +the exercise of warrants +3,453 +10,687 +10. Associate Benefit Plans +Stock +Option Plan +The +Company has adopted the 1997 Stock Incentive Plan (the “Plan”), which provides +that options for shares of the Company’s unissued common stock may be granted +to directors, associates and consultants to the Company. Options granted enable +the option holder to purchase shares of the Company’s common stock at prices +which are equal to or greater than the fair market value of the shares at the +date of grant. Options expire ten years after the date of grant or 90 days +after termination of employment and generally vest ratably at the rate of 25% +on each of the first four anniversaries of the grant date. In connection with +the merger of the Company and the Iteris Subsidiary, the Company assumed the +outstanding options of the Iteris Subsidiary (Note 3). +57 +A +summary of all Company stock option activity is as follows: +Year Ended March 31, +2006 +2005 +2004 +Options +Weighted +Average +Exercise +Price +Options +Weighted +Average +Exercise +Price +Options +Weighted +Average +Exercise +Price +(In thousands, except per share amounts) +Options +outstanding at beginning of year +7,323 +$ +1.42 +1,132 +$ +2.98 +962 +$ +3.73 +Granted +168 +3.02 +163 +3.34 +230 +0.78 +Assumed in merger (Note 3) +— +— +6,133 +1.09 +— +— +Exercised +(244 +) +1.24 +(25 +) +2.10 +— +— +Cancelled +(270 +) +2.60 +(80 +) +1.29 +(60 +) +6.76 +Options +outstanding at end of year +6,977 +$ +1.42 +7,323 +$ +1.42 +1,132 +$ +2.98 +Exercisable at +end of year +6,418 +6,446 +778 +Available for +grant at end of year +257 +356 +519 +Weighted average fair +value of options granted +$ +1.77 +$ +1.83 +$ +0.55 +The following table +summarizes information regarding the Company’s stock options at March 31, 2006: +Options Outstanding +Options Exercisable +Range of Exercise Prices +Options Outstanding +at March 31, 2006 +Weighted Avg. +Remaining +Contractual Life +Weighted Avg. +Exercise Price +Options +Exercisable At +March 31, 2006 +Weighted Avg. +Exercise Price +(In thousands, except per share amounts) +$0.53 +to $ 0.80 +1,813 +2.27 +$ +0.56 +1,737 +$ +0.56 +$0.95 +to $ 1.40 +4,498 +4.36 +1.25 +4,259 +1.25 +$1.50 +to $ 2.11 +121 +3.86 +1.76 +116 +1.75 +$2.28 +to $ 3.26 +223 +8.92 +3.00 +50 +2.59 +$3.60 +to $ 4.63 +186 +5.39 +4.13 +120 +4.41 +$5.69 +to $ 8.00 +18 +2.61 +6.33 +18 +6.33 +$10.31 to $15.63 +118 +3.98 +12.67 +118 +12.67 +6,977 +3.97 +$ +1.42 +6,418 +$ +1.36 +Associate +Incentive Programs +Under +the terms of a Profit Sharing Plan, the Company contributes to a trust fund +such amounts as are determined annually by the Board of Directors. No +contributions were made during the years ended March 31, 2006, 2005 and +2004. +In May 1990, the Company adopted a 401(k) Plan +as an amendment and replacement of the former Associate Stock Purchase Plan +that was an additional feature of the Profit Sharing Plan. Under the 401(k) Plan, +eligible associates voluntarily contribute to the plan up to 15% of their +salary through payroll deductions. The Company matches 50% of contributions up +to a stated limit. Under the provisions of the 401(k) Plan, associates +have thirteen investment choices, one of which is the purchase of Iteris, Inc. +common stock at market price. Company matching contributions were approximately +$317,000, $409,000 and $403,000 for the years ended March 31, 2006, 2005, +and 2004, respectively. +58 +11. Discontinued Operations +In September 2003, the Company sold substantially +all of the assets of MAXxess to an investor group that included certain members +of the MAXxess management group. The consideration for the assets consisted of +the assumption of $2.7 million of liabilities, resulting in a net gain of $2.4 +million from the sale. +On May 9, 2003, the Company completed the sale of +substantially all of the assets of Zyfer for $2.3 million in cash plus the +assumption of certain liabilities. The asset purchase agreement provided for +future incentive payments of up to $1.0 million in each of the twelve month +periods ended April 30, 2004 and 2005, based on the achievement of certain +revenue goals related to the sale of Zyfer products or the licensing of its +technologies. Incentive payments of $83,000 and $135,000 were received in the +years ended March 31, 2006 and 2005, respectively, and are presented +within other income, net in the accompanying consolidated statements of +operations. +In March 2003, the Company ceased the development +and sale of products of Broadcast and reduced the headcount in Broadcast to +only support the existing customer contracts for service and support through +their expiration dates. +Asset write-downs and accrued costs are included in +income from discontinued operations in the year ended March 31, 2004. The +results of operations of Broadcast, Zyfer and MAXxess for all periods presented +have been reclassified and presented as discontinued operations in the +accompanying consolidated statements of operations. Interest expense was not +reclassified to discontinued operations because the discontinuances did not +eliminate any of the Company’s debt. +Net sales and +income from discontinued operations are as follows: +Year Ended March 31, +2006 +2005 +2004 +(In thousands) +Net sales and contract +revenues: +MAXxess +$ +— +$ +— +$ +1,747 +Broadcast +— +— +385 +Total net sales +and contract revenues +$ +— +$ +— +$ +2,132 +Net income (loss) from +discontinued operations: +MAXxess +$ +— +$ +— +$ +199 +Broadcast +— +— +(122 +) +— +— +77 +Loss recognized +upon discontinuance of operations +— +— +(1,226 +) +Gain on sale of +assets of discontinued operations +— +— +2,364 +Income from +discontinued operations +$ +— +$ +— +$ +1,215 +The Company had no assets +or liabilities of discontinued operations at March 31, 2006. +12. Disposal of Fixed Assets +After the merger +of the Iteris Subsidiary into the Company on October 2004, the Company +reviewed and determined certain corporate property and equipment would not +provide value to its on-going operations. These assets primarily consisted of +furniture and fixtures and computer equipment. Accordingly, the Company +recorded a $422,000 loss on disposal of fixed assets in the year ended March 31, +2005. +59 +13. Business Segment and Geographic Information +The +Company currently operates in three reportable segments: Roadway Sensors, +Automotive Sensors and Transportation Systems. The Roadway Sensors segment +includes Vantage vehicle detection systems for traffic +intersection control and certain highway traffic data collection +applications. The Automotive Sensors segment is comprised of all activities +related to AutoVue lane departure warning systems. The Transportation Systems +segment includes transportation engineering and consulting services and the +development of transportation management and traveler information systems for +the ITS industry. The accounting policies of the reportable segments are the +same as those described in the summary of significant accounting policies +except that certain expenses, such as interest, amortization of certain intangibles +and certain corporate expenses are not allocated to the segments. In addition, +certain assets including cash and cash equivalents, deferred taxes and certain +long-lived and intangible assets are not allocated to the segments. The +reportable segments are each managed separately because they manufacture and +distribute distinct products or provide services with different processes. All +segment revenues are derived from external customers. +Selected financial information for the Company’s +reportable segments as of and for the years ended March 31, 2006, 2005 and +2004 is as follows: +Roadway +Sensors +Automotive +Sensors +Transportation +Systems +Total +(In thousands) +Year Ended March 31, 2006 +Product revenue +from external customers +$ +22,446 +$ +5,865 +$ +— +$ +28,311 +Service and +other revenue from external customers +— +2,845 +19,330 +22,175 +Depreciation and +amortization +132 +189 +266 +587 +Allocated +goodwill +8,197 +4,671 +14,906 +27,774 +Segment income +3,597 +(2,375 +) +2,184 +3,406 +Year Ended March 31, 2005 +Product revenue +from external customers +$ +21,920 +$ +4,326 +$ +— +$ +26,246 +Service and +other revenue from external customers +— +2,816 +17,335 +20,151 +Depreciation and +amortization +117 +116 +415 +648 +Allocated +goodwill +8,197 +4,671 +14,906 +27,774 +Segment income +3,632 +(1,604 +) +1,531 +3,559 +Year Ended March 31, 2004 +Product revenue +from external customers +$ +19,273 +$ +2,308 +$ +— +$ +21,581 +Service and +other revenue from external customers +— +1,889 +21,813 +23,702 +Depreciation and +amortization +117 +116 +440 +673 +Allocated +goodwill +200 +— +9,607 +9,807 +Segment income +2,629 +(2,343 +) +2,207 +2,493 +The +Roadway Sensors segment had one customer with revenue representing 25.9% of +total segment revenue for the year ended March 31, 2006; two customers +with combined revenue representing 38.0% of total segment revenue for the year +ended March 31, 2005; and four customers with combined revenue representing +59.5% of total segment revenue for the year ended March 31, 2004. The +Automotive Sensors segment had two customers with combined revenue representing +70.7% of total segment revenue for the year ended March 31, 2006; two +customers with combined revenue representing 85.2% of total segment revenue for +the year ended March 31, 2005; and two customers with combined revenue +representing 85.3% of total segment revenue for the year ended March 31, +2004. The Transportation Systems segment had one customer with revenue +representing 14.9% of total segment revenue for the year ended March 31, +2005; and one customer with revenue representing 20.0% of total segment revenue +for the year ended March 31, 2004. +In +connection with the October 2004 merger of the Iteris Subsidiary into the +Company (Note 3), goodwill of $8.0 million, $4.7 million and $5.3 million was +allocated to the Roadway Sensors, Automotive Sensors and Transportation Systems +segments, respectively. This allocation was determined based on the respective +fair value of each segment as calculated using the income approach. +60 +The +following reconciles segment income to consolidated income (loss) from +continuing operations before income taxes and minority interest and segment +assets to consolidated assets: +March 31, +2006 +2005 +2004 +(In thousands) +Segment income +Total income for +reportable segments +$ +3,406 +$ +3,559 +$ +2,493 +Unallocated amounts: +Corporate and other expenses +(1,867 +) +(2,362 +) +(1,447 +) +Stock-based compensation +(725 +) +(11,777 +) +— +Amortization of intangible assets +(147 +) +(114 +) +— +Deferred compensation (expense) benefit +(48 +) +484 +(868 +) +Disposal of fixed assets +— +(422 +) +— +Acquired in-process research and development +— +(140 +) +— +Other income, net +35 +1054 +1,003 +Interest expense, net +(1,459 +) +(1,178 +) +(123 +) +Income (loss) from continuing operations before +income taxes and minority interest +$ +(805 +) +$ +(10,896 +) +$ +1,058 +Assets +Total assets for +reportable segments +$ +47,520 +$ +44,833 +$ +28,856 +Assets held at +Corporate +2,113 +1,823 +1,209 +Total assets +$ +49,633 +$ +46,656 +$ +30,065 +The Company’s revenues from continuing +operations are generated and the Company’s assets are held substantially in the +United States. +14. Quarterly Financial Data (Unaudited) +Net +Sales +Gross +Profit +Income (Loss) +from +Continuing +Operations +Net Income +(loss) +Income (Loss) +per Share +from +Continuing +Operations +(In thousands, except per share amounts) +June 30, +2005 +$ +12,079 +$ +5,434 +$ +(726 +) +$ +(726 +) +(0.03 +) +September 30, +2005 +12,715 +5,518 +(155 +) +(155 +) +(0.01 +) +December 31, +2005 +12,183 +5,021 +136 +136 +0.00 +March 31, +2006 +13,509 +5,653 +825 +825 +0.03 +$ +50,486 +$ +21,626 +$ +80 +$ +80 +$ +0.00 +* +June 30, 2004 +$ +11,441 +$ +4,949 +$ +966 +$ +966 +0.04 +September 30, +2004 +11,760 +4,695 +(4 +) +(4 +) +0.00 +December 31, +2004 +11,714 +5,044 +(12,233 +) +(12,233 +) +(0.44 +) +March 31, +2005 +11,482 +4,666 +(57 +) +(57 +) +(0.00 +) +$ +46,397 +$ +19,354 +$ +(11,328 +) +$ +(11,328 +) +$ +(0.45 +)* +* Annual per share +amounts may not agree to the sum of the quarterly per share amounts due to +differences between average shares outstanding during the periods. +61 +Schedule II +Valuation and Qualifying Accounts (In thousands) +Description +Balance at +Beginning of +Period +Charged to +Costs and +Expenses +Charged to +Accounts +Balance at End +of Period +Year Ended March 31, 2006 +Deducted from +asset accounts: +Allowance for +doubtful accounts +$ +239 +$ +275 +$ +(85 +) +$ +429 +Reserve for +inventory obsolescence +514 +312 +(234 +) +592 +Year Ended March 31, 2005 +Deducted from +asset accounts: +Allowance for +doubtful accounts +$ +204 +$ +37 +$ +(2 +) +$ +239 +Reserve for +inventory obsolescence +399 +367 +(252 +) +514 +Year Ended March 31, 2004 +Deducted from +asset accounts: +Allowance for +doubtful accounts +$ +156 +$ +87 +$ +(39 +) +$ +204 +Reserve for inventory +obsolescence +248 +251 +(100 +) +399 +62 \ No newline at end of file diff --git a/raw/filings/0000350868/2005/0001104659-06-044634/filing_metadata.csv b/raw/filings/0000350868/2005/0001104659-06-044634/filing_metadata.csv new file mode 100644 index 0000000000000000000000000000000000000000..de8b19cf5a1437b80671b468d0acb4d5b101e8f2 --- /dev/null +++ b/raw/filings/0000350868/2005/0001104659-06-044634/filing_metadata.csv @@ -0,0 +1,2 @@ +cik,ticker,company_name,form,filing_date,report_date,acceptance_datetime,accession_number,primary_document,primary_doc_description,size,is_xbrl,is_inline_xbrl,document_url,filing_index_url,year,fiscal_year,is_primary_filing +0000350868,ITI,"ITERIS, INC.",10-K,2006-06-29,2006-03-31,2006-06-29T21:19:34.000Z,0001104659-06-044634,a06-9767_110k.htm,ANNUAL REPORT PURSUANT TO SECTION 13 AND 15(D),2106773,0,0,https://www.sec.gov/Archives/edgar/data/350868/000110465906044634/a06-9767_110k.htm,https://www.sec.gov/Archives/edgar/data/350868/000110465906044634/,2005,2005,1 diff --git a/raw/filings/0000350868/2005/0001104659-06-044634/item1.txt b/raw/filings/0000350868/2005/0001104659-06-044634/item1.txt new file mode 100644 index 0000000000000000000000000000000000000000..70dac7682aa8c81bd848ad632b1f9bed1963e436 --- /dev/null +++ b/raw/filings/0000350868/2005/0001104659-06-044634/item1.txt @@ -0,0 +1,266 @@ +ITEM 1. BUSINESS +Overview +Iteris, Inc., +formerly known as Iteris Holdings, Inc., is a leading provider of outdoor +machine vision systems and sensors that optimize the flow of traffic and +enhance driver safety. Using proprietary software and Intelligent +Transportation Systems (“ITS”) industry expertise, we provide video sensor systems, +transportation management and traveler information systems and other +engineering and consulting services to the ITS industry. The ITS industry is +comprised of companies applying a variety of technologies to enable the safe +and efficient movement of people and goods. We use our outdoor image +recognition software expertise to develop proprietary algorithms for video +sensor systems that improve vehicle safety and the flow of traffic. Using our +knowledge of the ITS industry, we design and implement transportation +management systems that help public agencies reduce traffic congestion and +provide greater access to traveler information. +We +were originally incorporated in Delaware in 1987 as Odetics, Inc. and in September 2003 +changed our name to Iteris Holdings, Inc. to reflect our focus on the ITS +industry and our capital structure at that time. On October 22, 2004, we +completed a merger with our majority-owned subsidiary, Iteris, Inc. (the “Iteris +Subsidiary”), and officially changed our corporate name from Iteris Holdings, Inc. +to Iteris, Inc. +Our proprietary image recognition systems include Vantage and AutoVue. Vantage +is a video vehicle detection system that detects the presence of vehicles on +roadways. Vantage systems are used at signalized intersections to enable a more +efficient allocation of green signal time and are also used for incident +detection and highway traffic data collection applications. AutoVue Lane +Departure Warning (“LDW”) systems consist of a small windshield mounted sensor +that uses proprietary software to detect and warn drivers of unintended lane +departures. To date, we and our strategic partner have sold over 50,000 +production AutoVue LDW systems for use on car and truck platforms in the North +American and European markets. We believe that our AutoVue LDW technology is a +broad sensor platform that, through additional software development, may be +expanded to incorporate additional safety and convenience features. +Our transportation +management systems business includes transportation engineering and consulting +services focused on the planning, design, development and implementation of +software-based systems that integrate sensors, video surveillance, computers +and advanced communications equipment to enable public agencies to monitor, control +and direct traffic flow, assist in the quick dispatch of emergency crews and +distribute real-time information about traffic conditions. Our services include +planning and other engineering for the implementation of transportation +infrastructure and related communications systems, analysis and study related +to goods movement and commercial vehicle operations, and parking systems +designs. +We currently +operate in three reportable segments: Roadway Sensors, Automotive Sensors and +Transportation Systems. The Roadway Sensors segment includes our Vantage +vehicle detection systems for traffic intersection control, incident +detection and certain highway traffic data collection applications. The +Automotive Sensors segment is comprised of all activities related to our +AutoVue LDW systems for vehicle safety. The Transportation Systems segment +includes transportation engineering and consulting services and the development +of transportation management and traveler +3 +information systems for +the ITS industry. See Note 13 to the accompanying consolidated financial +statements for further discussion of our operating segments. +Sales, Marketing and Principal Customers +We sell our Vantage +vehicle detection systems primarily through indirect sales channels comprised +of independent dealers in the United States and Canada who sell integrated +systems and related products to the traffic management market. Our independent +dealers are primarily responsible for sales, installation and support of +Vantage systems. These dealers maintain an inventory of demonstration traffic +products from various manufacturers including our Vantage vehicle detection +systems and sell directly to government agencies and installation contractors. +These dealers often have long-term arrangements with the government agencies in +their territory for the supply of various products for the construction and +renovation of traffic intersections. We hold technical training classes for +dealers and end users and maintain a full-time staff of customer support +technicians to provide technical assistance when needed. +Our marketing +strategy for AutoVue is to establish it as the leading platform for in-vehicle +video sensing for heavy trucks and passenger cars. We sell AutoVue LDW systems +directly to heavy truck manufacturers and to U.S. truck fleets, and our AutoVue +LDW system is currently offered as an option on certain Mercedes, MAN, +Freightliner and International trucks. We market the licensing of our LDW +technology to manufacturers of passenger automobiles through a strategic +relationship with Valeo Schalter and Sensuren GmbH (“Valeo”), an independent +automotive supplier. In connection with this marketing effort, we provide +specific contract engineering services, technical marketing and sales support +to Valeo which to date has enabled the launch of our LDW technology on three +Infiniti platforms, the FX, M and Q, where our LDW system is offered as part of +the technology option package. We plan to continue to provide technical +marketing and sales support to Valeo in our efforts to win new OEM customers +for the passenger car market as well as contract engineering services related +to the possible launch of new Infiniti platforms that include our AutoVue LDW +system. +We market and sell +our transportation management systems and traveler information services +directly to government agencies pursuant to negotiated contracts that involve +competitive bidding and specific qualification requirements. Most of our +contracts with federal, state and municipal customers provide for cancellation +or renegotiation at the option of the customer upon reasonable notice and fees +paid for modification. We use selected members of our engineering team divided +on a regional basis to serve in sales and business development functions. We do +not engage in sales of transportation management systems and traveler +information services outside of the U.S. Sales of our transportation management +systems contracts generally involve long lead times and require extensive +specification development, evaluation and price negotiations. +Our largest customer +accounted for 11.5% of total net sales and contract revenues in the fiscal year +ended March 31, 2006 (“Fiscal 2006”). +Manufacturing and Materials +We use contract +manufacturers to build subassemblies that are used in our Vantage products. +Additionally, we procure certain components from qualified suppliers, both +globally and locally, and use multi-sourcing strategies when technically and +economically feasible to mitigate supply risk. These subassemblies and +components are delivered to our Anaheim facility where they go through final +assembly and testing prior to shipment to our customers. Our manufacturing +activities are conducted in approximately 8,000 square feet of space at our +Anaheim facility. Production volume at our subcontractors is based upon +quarterly forecasts that we adjust on a monthly basis to control inventory. For +sales of AutoVue LDW systems to the truck market, we subcontract the +manufacture of our AutoVue LDW systems to two manufacturers, and our internal +processes are limited primarily to testing and final verification. For AutoVue +LDW sales to the passenger car market, we anticipate that all manufacturing +will be done by Valeo; however, we plan to continue to provide engineering +support to Valeo. We currently do not manufacture any of the hardware used in +the transportation management and traveler information systems that we design +and implement. Our production facility is currently ISO 9001 certified. +Customer Support and Services +We provide +warranty service and support for our Vantage and AutoVue products as well as +follow-up service and support for which we charge separately. Service revenue +accounted for less than 1.0% of total net sales and contract revenues for +Fiscal 2006. We believe customer support is a key competitive factor. +Backlog +Our backlog of +unfulfilled firm orders was approximately $20.3 million as of March 31, +2006, which was comprised of $1.5 million related to Roadway Sensors, $3.0 +million related to Automotive Sensors and $15.8 million related to +Transportation Systems. The backlog for Roadway Sensors and Automotive Sensors +is expected to be recognized as revenue in the fiscal year ending March 31, +2007 (“Fiscal 2007”) while approximately 84.0% of Transportation Systems +backlog is expected to be recognized as revenue in Fiscal 2007. At March 31, +2005, we had backlog of approximately $18.9 million, which was comprised of +$1.7 million related to Roadway Sensors, $3.4 million related to Automotive +Sensors and $13.8 +4 +million +related to Transportation Systems. All March 31, 2005 backlog for Roadway +Sensors and Automotive Sensors was recognized as revenue in Fiscal 2006 while +71.0% of Transportation Systems March 31, 2005 backlog was recognized as +revenue in Fiscal 2006. Pursuant to the customary terms of our agreements with +government contractors and other customers, customers can generally cancel or +reschedule orders with little or no penalties. Lead times for the release +of purchase orders often depend upon the scheduling and forecasting practices +of our individual customers, which also can affect the timing of the conversion +of our backlog into revenues. For these reasons, among others, our backlog at a +particular date may not be indicative of our future revenues. +Product Development +Most of our development activities are conducted at our principal +facilities in Anaheim, California. Our company-sponsored research and +development costs and expenses were approximately $5.1 million for Fiscal 2006, +$4.2 million for the fiscal year ended March 31, 2005 (“Fiscal 2005”), and +$3.9 million for the fiscal year ended March 31, 2004 (“Fiscal 2004”). We +expect to continue to pursue significant product development programs and incur +significant research and development expenditures. +Competition +We generally face significant competition in each of our target +markets. Increased competition may result in price reductions, reduced gross +margins and loss of market share, any of which could have a material adverse +effect on our business, financial condition and results of operations. We +believe that AutoVue is the only established commercially-available lane +departure warning system used in the U.S. and in Europe in the heavy truck +market. Potential competitors of AutoVue include Delphi Automotive Systems +Corporation domestically, NEC Corporation and Hitachi Ltd. in Japan and Robert +Bosch GmbH in Europe, as well as Siemens, Continental Tavis, Visteon and +Cognex, which could be currently developing video sensor technologies for the +vehicle industry that could be used for lane departure warning systems. In the +market for our Vantage vehicle detection systems, we compete with manufacturers +of other “above ground” video camera detection systems such as Econolite +Control Products, Inc., Traficon, N.V., Quixote, and other non-intrusive +detection devices including microwave, infrared, ultrasonic and magnetic +detectors, as well as manufacturers and installers of in-pavement inductive +loop products. +The transportation management and traveler information systems market +is highly fragmented and is subject to evolving national and regional quality +and safety standards. Our competitors vary in number, scope and breadth of the +products and services they offer. Our competitors in advanced transportation +management and traveler information systems include national corporations such +as Transcore, Siemens, PB Farradyne, Inc., Kimley-Horn and Associates, Inc. +and National Engineering Technology, Inc. Our competitors in +transportation engineering, planning and design include major firms such as +Parsons Brinkerhoff, Inc., URS, HNTB and Parsons Transportation Group, Inc., +as well as many smaller regional engineering firms. +In general, the markets for the products and services offered by our +businesses are highly competitive and are characterized by rapidly changing +technology and evolving standards. Many of our current and prospective +competitors have longer operating histories, greater name recognition, access +to larger customer bases and significantly greater financial, technical, +manufacturing, distribution and marketing resources than us. As a result, they +may be able to adapt more quickly to new or emerging standards or technologies +or to devote greater resources to the promotion and sale of their products. It +is also possible that new competitors or alliances among competitors could +emerge and rapidly acquire significant market share. We believe that our +ability to compete effectively in our target markets will depend on a number of +factors, including the success and timing of our new product development, the +compatibility of our products with a broad range of computing systems, product +quality and performance, reliability, functionality, price, and service and +technical support. Our failure to provide services and develop and market +products that compete successfully with those of other suppliers and +consultants in our target markets would have a material adverse effect on our +business, financial condition and results of operations. +Intellectual Property and Proprietary +Rights +Our ability to compete effectively depends in part on our ability to +develop and maintain the proprietary aspects of our technology. Our policy is +to obtain appropriate proprietary rights protection for any potentially +significant new technology acquired or developed by us. We currently hold ten +U.S. patents, which expire commencing in 2008, and have two U.S. +patent applications pending relating to our outdoor image processing techniques +used in our AutoVue systems. Nine of our patents relate specifically to our +AutoVue technology and provide a basis for enhanced functionality for rain +sensing and improved performance. We believe that our other patents, while +important for our technology platforms, are less critical to our near term +product strategy. We cannot assure you that any new patents will be granted +pursuant to any outstanding or subsequent applications. +5 +In addition to patent laws, we rely on copyright and trade secret laws +to protect our proprietary rights. We attempt to protect our trade secrets and +other proprietary information through agreements with customers and suppliers, +proprietary information agreements with our employees and consultants, and +other similar measures. We do not have any material licenses or trademarks +other than those relating to product names. We cannot be certain that we will +be successful in protecting our proprietary rights. While we believe our +patents, patent applications, software and other proprietary know-how have +value, changing technology makes our future success dependent principally upon +our employees’ technical competence and creative skills for continuing +innovation. +Litigation may be necessary in the future to enforce our proprietary +rights, to determine the validity and scope of the proprietary rights of +others, or to defend us against claims of infringement or invalidity by others. +An adverse outcome in such litigation or similar proceedings could subject us +to significant liabilities to third parties, require disputed rights to be +licensed from others or require us to cease marketing or using certain +products, any of which could have a material adverse effect on our business, +financial condition and results of operations. In addition, the cost of +addressing any intellectual property litigation claim, both in legal fees and +expenses, as well as from the diversion of management’s resources, regardless +of whether the claim is valid, could be significant and could have a material +adverse effect on our business, financial condition and results of operations. +Employees +We refer to our employees as associates. As of June 6, 2006, we +employed an aggregate of 219 associates, including 45 associates in general +management, administration and finance; 23 associates in sales and marketing; 117 +associates in engineering and product development; 24 associates in operations, +manufacturing and quality; and 10 associates in customer service. None of our +associates are represented by a labor union, and we have never experienced a +work stoppage. +Government Regulation +Our manufacturing operations are subject to various federal, state and +local laws and regulations, including those restricting the discharge of +materials into the environment. We are not involved in any pending or, to our +knowledge, threatened governmental proceedings, which would require curtailment +of our operations because of such laws and regulations. We continue to expend +funds in connection with our compliance with applicable environmental +regulations. These expenditures have not, however, been significant in the +past, and we do not expect any significant expenditure in the near future. +Currently, compliance with foreign laws has not had a material impact on our +business and is not expected to have a material impact in the near future. +6 \ No newline at end of file diff --git a/raw/filings/0000350868/2005/0001104659-06-044634/item13.txt b/raw/filings/0000350868/2005/0001104659-06-044634/item13.txt new file mode 100644 index 0000000000000000000000000000000000000000..131da435a7723a764261c8e8803027c355c712d8 --- /dev/null +++ b/raw/filings/0000350868/2005/0001104659-06-044634/item13.txt @@ -0,0 +1,2 @@ +ITEM 13. +CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS \ No newline at end of file diff --git a/raw/filings/0000350868/2005/0001104659-06-044634/item9a.txt b/raw/filings/0000350868/2005/0001104659-06-044634/item9a.txt new file mode 100644 index 0000000000000000000000000000000000000000..da3cbaa762979719dd992dd7fcce3b6a0ec6e5d1 --- /dev/null +++ b/raw/filings/0000350868/2005/0001104659-06-044634/item9a.txt @@ -0,0 +1,32 @@ +ITEM 9A. CONTROLS AND +PROCEDURES +Evaluation of Disclosure Controls and +Procedures +As of the end of the +period covered by this report, we carried out an evaluation, under the +supervision and with the participation of our management, including our Chief +Executive Officer and our Chief Financial Officer, of the effectiveness of the +design and operation of our disclosure controls and procedures, as such term is +defined in Exchange Act Rules 13a-15(e) and 15d-15(e). Based upon that +evaluation, the Chief Executive Officer and Chief Financial Officer concluded +that our disclosure controls and procedures are effective to ensure that +information required to be disclosed by us in the reports that we file or +submit under the Exchange Act is recorded, processed, summarized and reported +within the time periods specified in the Securities and Exchange Commission’s +rules and forms and are effective in ensuring that information required to be +disclosed by us in the reports that we file or submit under the Exchange Act is +accumulated and communicated to our management, including our Chief Executive +Officer and Chief Financial Officer, as appropriate, to allow timely decisions +regarding required disclosure. In designing and evaluating the disclosure +controls and procedures, our management recognized that any controls and +procedures, no matter how well designed and operated, can provide only +reasonable assurance of achieving the desired control objectives. Our +management necessarily applied its judgment in evaluating the cost-benefit +relationship of such controls and procedures. +Changes in Internal Controls +During the most recent +completed fiscal quarter covered by this report, there has been no change in +our internal controls over financial reporting (as defined in Rules 13a-15(f) and +15d-15(f) under the Securities Exchange Act of 1934) that has +materially affected, or is reasonably likely to materially affect, our internal +controls over financial reporting. \ No newline at end of file diff --git a/raw/filings/0000350868/2005/0001104659-06-044634/rp_note.txt b/raw/filings/0000350868/2005/0001104659-06-044634/rp_note.txt new file mode 100644 index 0000000000000000000000000000000000000000..e69de29bb2d1d6434b8b29ae775ad8c2e48c5391 diff --git a/raw/filings/0000350868/2005/0001104659-06-044634/rpt_disclosure.txt b/raw/filings/0000350868/2005/0001104659-06-044634/rpt_disclosure.txt new file mode 100644 index 0000000000000000000000000000000000000000..e69de29bb2d1d6434b8b29ae775ad8c2e48c5391 diff --git a/raw/filings/0000350868/2007/0001104659-08-039576/filing.txt b/raw/filings/0000350868/2007/0001104659-08-039576/filing.txt new file mode 100644 index 0000000000000000000000000000000000000000..23ace636504c6122bf7a38302135c36ad8e06066 --- /dev/null +++ b/raw/filings/0000350868/2007/0001104659-08-039576/filing.txt @@ -0,0 +1,6236 @@ +10-K +1 +a08-12231_110k.htm +10-K +UNITED +STATES +SECURITIES AND EXCHANGE COMMISSION +Washington, D.C. 20549 +FORM 10-K +(Mark One) +x +ANNUAL REPORT PURSUANT TO SECTION 13 OR +15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 +For the +fiscal year ended March 31, 2008 +OR +o +TRANSITION REPORT PURSUANT TO SECTION 13 OR +15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 +For the +transition period from +to +Commission +file number 001-08762 +ITERIS, +INC. +(Exact Name of Registrant as Specified in Its Charter) +Delaware +95-2588496 +(State or Other +Jurisdiction +of Incorporation or Organization) +(I.R.S. Employer +Identification No.) +1700 +Carnegie Ave, Santa Ana, California 92705 +(Address of Principal +Executive Offices) (Zip Code) +Registrant’s Telephone +Number, Including Area Code: (949) 270-9400 +Securities registered +pursuant to Section 12(b) of the Act: +Title of each class +Name +of each exchange on which registered +Common Stock, +$0.10 par value +American Stock +Exchange +Securities registered +pursuant to Section 12(g) of the Act: None +Indicate by check mark if +the registrant is a well-known seasoned issuer, as defined in Rule 405 of +the Securities Act. +Yes o No x +Indicate by check mark if the registrant is not required to file reports +pursuant to Section 13 or Section 15(d) of the Act. Yes o No x +Indicate by check mark whether the registrant (1) has filed all +reports required to be filed by Section 13 or 15(d) of the Securities +Exchange Act of 1934 during the preceding 12 months (or for such shorter period +that the registrant was required to file such reports), and (2) has been +subject to such filing requirements for the past 90 days. Yes x No o +Indicate by a check mark if disclosure of delinquent filers pursuant to +Item 405 of Regulation S-K is not contained herein, and will not be contained, +to the best of registrant’s knowledge, in definitive proxy or information +statements incorporated by reference in Part III of this Form 10-K or +any amendment to this Form 10-K. o +Indicate by check mark +whether the registrant is a large accelerated filer, an accelerated filer, a +non-accelerated filer, or a smaller reporting company. See definitions of +“large accelerated filer,” “accelerated filer,” and “smaller reporting company” +in Rule 12b-2 of the Exchange Act. (Check one): +Large accelerated filer +o +Accelerated filer o +Non-accelerated filer o +Smaller reporting +company x +(Do not check if a +smaller reporting company) +Indicate by check mark whether the registrant is a shell company (as +defined in Exchange Act Rule 12b-2). Yes o No x +Based on the closing sale price of the registrant’s common stock on the +last business day of the registrant’s most recently completed second fiscal +quarter, the aggregate market value of the voting common stock held by +nonaffiliates of the registrant was $48,200,000. For the purposes of this +calculation, shares owned by officers, directors and 10% stockholders known to +the registrant have been deemed to be owned by affiliates. This determination +of affiliate status is not necessarily a conclusive determination for other +purposes. +As of June 10, 2008, there were 33,888,002 shares of common stock +outstanding. +DOCUMENTS INCORPORATED BY REFERENCE +Part III incorporates by reference certain information from the +registrant’s definitive proxy statement for the 2008 Annual Meeting of +Stockholders, which will be filed with the Securities and Exchange Commission +not later than 120 days after the end of the fiscal year ended March 31, +2008. Except with respect to information specifically incorporated by reference +in this report, the registrant’s proxy statement is not deemed to be filed as a +part hereof. +ITERIS, +INC. +ANNUAL +REPORT ON FORM 10-K +FOR THE +FISCAL YEAR ENDED MARCH 31, 2008 +TABLE +OF CONTENTS +PART I +3 +ITEM 1. +BUSINESS +3 +ITEM 1A. +RISK FACTORS +7 +ITEM 1B. +UNRESOLVED STAFF +COMMENTS +15 +ITEM +2. +PROPERTIES +16 +ITEM 3. +LEGAL PROCEEDINGS +16 +ITEM 4. +SUBMISSION OF +MATTERS TO A VOTE OF SECURITY HOLDERS +16 +PART II +17 +ITEM 5. +MARKET FOR +REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES +OF EQUITY SECURITIES +17 +ITEM 6. +SELECTED FINANCIAL +DATA +19 +ITEM 7. +MANAGEMENT’S +DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS +20 +ITEM 7A. +QUANTITATIVE +AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK +30 +ITEM 8. +FINANCIAL +STATEMENTS AND SUPPLEMENTARY DATA +30 +ITEM 9. +CHANGES IN AND +DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE +30 +ITEM 9A(T). +CONTROLS AND PROCEDURES +30 +ITEM 9B. +OTHER INFORMATION +31 +PART III +31 +ITEM 10. +DIRECTORS, +EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE +31 +ITEM 11. +EXECUTIVE +COMPENSATION +31 +ITEM 12. +SECURITY OWNERSHIP OF CERTAIN BENEFICIAL +OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS +31 +ITEM 13. +CERTAIN +RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE +31 +ITEM 14. +PRINCIPAL +ACCOUNTING FEES AND SERVICES +32 +PART IV +32 +ITEM 15. +EXHIBITS AND +FINANCIAL STATEMENT SCHEDULES +32 +Unless +otherwise indicated in this report, the “registrant,” “we,” “us” and “our” +collectively refers to Iteris, Inc. and its former subsidiary, Meyer, +Mohaddes Associates, Inc., which was dissolved effective April 2006. +AutoVue®, +Iteris®, Vantage® and eAccess™ are among the trademarks of Iteris, Inc. +Any other trademarks or trade names mentioned herein are the property of their +respective owners. +2 +Cautionary Statement +This +report, including the following discussion and analysis, contains +forward-looking statements (within the meaning of the Private Securities +Litigation Reform Act of 1995) that are based on our current expectations, +estimates and projections about our business and our industry, and reflect +management’s beliefs and certain assumptions made by us based upon information +available to us as of the date of this report. When used in this report and the +information incorporated herein by reference, the words “expect(s),” “feel(s),” +“believe(s),” “should,” “will,” “may,” “anticipate(s),” “estimate(s)” and +similar expressions or variations of these words are intended to identify +forward-looking statements. These forward-looking statements include but are +not limited to statements regarding our anticipated sales, revenue, expenses, +profits, capital needs, competition, backlog and manufacturing capabilities, +the practical market applications, future applications and acceptance of our +products and services, the status of our facilities and product development. +These statements are not guarantees of future performance and are subject to +certain risks and uncertainties which could cause actual results to differ +materially from those projected. You should not place undue reliance on these +forward-looking statements that speak only as of the date hereof. We undertake +no obligation to republish revised forward-looking statements to reflect events +or circumstances after the date hereof or to reflect the occurrence of unanticipated +events. We encourage you to carefully review and consider the various +disclosures made by us which describe certain factors which could affect our +business, including those in “ Risk Factors” +in Item 1A of this report, before deciding to invest in our company or to +maintain or increase your investment. We undertake no obligation to revise or +update publicly any forward-looking statement for any reason. +PART I +ITEM 1. BUSINESS +Overview +Iteris, Inc. is a +leader in the traffic management market that focuses on the development and +application of advanced technologies that reduce traffic congestion, minimize +the environmental impact of traffic congestion and improve the safety of +surface transportation systems. By combining outdoor image processing, traffic +engineering and information technology, we offer a broad range of Intelligent +Transportation Systems and driver safety solutions to customers worldwide. +Our proprietary image +recognition systems include Vantage and AutoVue. Vantage is a video vehicle detection +system that detects the presence of vehicles on roadways. Vantage systems are +used at signalized intersections to enable a more efficient allocation of green +signal time and are also used for incident detection and highway traffic data +collection applications. AutoVue Lane Departure Warning (“LDW”) systems consist +of a small windshield mounted sensor that uses proprietary software to detect +and warn drivers of unintended lane departures. To date, we and our strategic +partner have sold approximately 90,000 production AutoVue LDW systems for use +on car and truck platforms in the North American and European markets. We +believe that our AutoVue LDW technology is a broad sensor platform that, +through additional software development, may be expanded to incorporate +additional safety and convenience features. +Our transportation +management systems business includes transportation engineering and consulting +services focused on the planning, design, development and implementation of +software-based systems that integrate sensors, video surveillance, computers +and advanced communications equipment to enable public agencies to monitor, +control and direct traffic flow, assist in the quick dispatch of emergency +crews and distribute real-time information about traffic conditions. Our +services include planning, design and implementation of surface transportation +infrastructure systems. We perform +analysis and study goods movement, commercial vehicle operations, travel demand +forecasting and systems engineering, and identify mitigation measures to reduce +traffic congestion. These services and +systems are primarily sold to local, state and national transportation agencies +in the United States. Our transportation +management systems business is largely dependent upon governmental funding and +budgetary issues. The Federal Highway +Bill that was passed in August 2005 provided for a significant increase in +transportation funding over the following six years. We believe the recent expansion of our +transportation management systems business was due in part to the passage of +the Federal Highway Bill, combined with the expansion of transportation funds +at state and local agencies throughout the country. The 2005 Federal Highway Bill +is set to expire during 2009. +We currently operate in three reportable segments: +Roadway Sensors, Vehicle Sensors and Transportation Systems. The Roadway +Sensors segment includes our Vantage vehicle detection systems for traffic +intersection control, incident detection and certain highway traffic data +collection applications. The Vehicle +Sensors segment is comprised of all activities related to our AutoVue LDW +systems for vehicle safety. The Transportation Systems segment includes +transportation engineering and consulting services and the development of +transportation management and traveler information systems for the ITS +industry. See Note 12 to the +accompanying consolidated financial statements for further discussion of our +operating segments. +3 +We were originally +incorporated in Delaware in 1987. In October 2004, +we completed a merger with our majority-owned subsidiary, Iteris, Inc. +(the “Iteris Subsidiary”), and officially changed our corporate name to Iteris, Inc. +Sales, Marketing and Principal Customers +We sell our Vantage +vehicle detection systems through indirect sales channels comprised of +independent dealers in the United States and Canada who sell integrated systems +and related products to the traffic management market, as well as directly to +the traffic management market using a combination of our own sales personnel +and an outside sales organization. Our independent dealers are primarily +responsible for sales, installation and support of Vantage systems. These +dealers maintain an inventory of demonstration traffic products from various +manufacturers including our Vantage vehicle detection systems and sell directly +to government agencies and installation contractors. These dealers often have +long-term arrangements with the government agencies in their territory for the +supply of various products for the construction and renovation of traffic +intersections. We hold technical training classes for dealers and end users and +maintain a full-time staff of customer support technicians to provide technical +assistance when needed. +Our marketing strategy +for AutoVue is to establish it as the leading platform for in-vehicle video +sensing for heavy trucks and passenger cars. +We sell AutoVue LDW systems directly to heavy truck manufacturers and to +U.S. truck fleets, and our AutoVue LDW system is currently offered as an option +on certain heavy trucks, including Mercedes-Benz, MAN, Iveco, DAF, Scania, +Freightliner and FUSO, as well as Neoplan and MAN luxury bus and coach lines. +We market the licensing of our LDW technology to manufacturers of passenger +automobiles through an exclusive strategic relationship with Valeo Schalter and +Sensuren GmbH (“Valeo”), an independent automotive supplier. In connection with +this marketing effort, we provide specific contract engineering services, +technical marketing and sales support to Valeo, which to date has enabled the +launch of our LDW technology on three Infiniti car platforms. We plan to +continue to provide technical marketing and sales support to Valeo in our efforts +to win new original equipment manufacturer (“OEM”) customers for the passenger +car market as well as contract engineering services related to the possible +launch of new platforms that include our AutoVue LDW system. +We market and sell our +transportation management systems and traveler information services directly to +government agencies pursuant to negotiated contracts that involve competitive +bidding and specific qualification requirements. Most of our contracts with +federal, state and municipal customers provide for cancellation or +renegotiation at the option of the customer upon reasonable notice and fees +paid for modification. We use selected members of our engineering team divided +on a regional basis to serve in sales and business development functions. We do +not engage in sales of transportation management systems and traveler +information services outside of the U.S. Sales of our transportation management +systems contracts generally involve long lead times and require extensive +specification development, evaluation and price negotiations. +A large portion of our +revenues are derived from sales to federal, state and local government +agencies. Our largest customer accounted +for 7.3% of total net sales and contract revenues in the fiscal year ended March 31, +2008 (“Fiscal 2008”). +Manufacturing +and Materials +We use contract +manufacturers to build subassemblies that are used in our Vantage products. +Additionally, we procure certain components from qualified suppliers, both +globally and locally, and use multi-sourcing strategies when technically and +economically feasible to mitigate supply risk. These subassemblies and +components are delivered to our Santa Ana facility where they go through final +assembly and testing prior to shipment to our customers. Our manufacturing +activities are conducted in approximately 9,000 square feet of space at our +Santa Ana facility. Production volume at our subcontractors is based upon +quarterly forecasts that we adjust on a monthly basis to control inventory +levels. For sales of AutoVue LDW systems to the truck market, we subcontract +the manufacture of our AutoVue LDW systems to one primary manufacturer, and our +internal processes are limited primarily to testing and final verification. For +AutoVue LDW sales to the passenger car market, all manufacturing will be +performed by Valeo; however, we plan to continue to provide engineering support +to Valeo. We currently do not manufacture any of the hardware used in the +transportation management and traveler information systems that we design and +implement. Our production facility is currently ISO 9001 certified. +4 +Customer +Support and Services +We provide warranty service and support for our +Vantage and AutoVue products, as well as follow-up service and support for +which we charge separately. Service revenue accounted for less than 1.0% of +total net sales and contract revenues for Fiscal 2008. We believe customer +support is a key competitive factor. +Backlog +Our backlog of unfulfilled +firm orders was approximately $26.8 million as of March 31, 2008, which +was comprised of $900,000 related to Roadway Sensors, $1.3 million related to +Vehicle Sensors and $24.6 million related to Transportation Systems. +Substantially all of the backlog for Roadway Sensors and Vehicle Sensors is +expected to be recognized as revenue in the fiscal year ending March 31, +2009 (“Fiscal 2009”), while approximately 60% of Transportation Systems backlog +is expected to be recognized as revenue in Fiscal 2009. At March 31, 2007, +we had backlog of approximately $25.7 million, which was comprised of $3.5 +million related to Roadway Sensors, $2.1 million related to Vehicle Sensors and +$20.1 million related to Transportation Systems. All backlog as of March 31, +2007 for Roadway Sensors and Vehicle Sensors was recognized as revenue in +Fiscal 2008 while 45% of March 31, 2007 backlog for Transportation Systems +was recognized as revenue in Fiscal 2008. Pursuant to the customary terms of +our agreements with government contractors and other customers, customers can +generally cancel or reschedule orders with little or no penalties. Lead +times for the release of purchase orders often depend upon the scheduling and +forecasting practices of our individual customers, which also can affect the +timing of the conversion of our backlog into revenues. For these reasons, among +others, our backlog at a particular date may not be indicative of our future +revenues, in particular for Roadway Sensors and Vehicle Sensors. +Product +Development +Most of our development +activities are conducted at our principal facilities in Santa Ana, California. +Our company-sponsored research and development costs and expenses were +approximately $3.6 million for Fiscal 2008, $4.0 million for the fiscal year +ended March 31, 2007 (“Fiscal 2007”), and $5.2 million for the fiscal year +ended March 31, 2006 (“Fiscal 2006”). We expect to continue to pursue +significant product development programs and incur significant research and +development expenditures. +Competition +We generally face +significant competition in each of our target markets. Increased competition +may result in price reductions, reduced gross margins and loss of market share, +any of which could have a material adverse effect on our business, financial +condition and results of operations. While AutoVue has historically been the +only established commercially-available lane departure warning system used in +the U.S. and in Europe in the heavy truck market, we have recently experienced +increased competition from new competitors in this market. Potential +competitors of AutoVue include Delphi Automotive Systems Corporation, NEC +Corporation and Hitachi Ltd. in Japan and Robert Bosch GmbH in Europe, as well +as Siemens, Continental Tavis, Visteon and Cognex, which are currently +developing video sensor technologies for the vehicle industry that could be +used for lane departure warning systems. In the market for our Vantage vehicle +detection systems, we compete with manufacturers of other above ground video +camera detection systems such as Econolite Control Products, Inc., +Traficon, N.V., Quixote, and other non-intrusive detection devices including +microwave, infrared, ultrasonic and magnetic detectors, as well as +manufacturers and installers of in-pavement inductive loop products. +The transportation +management and traveler information systems market is highly fragmented and is +subject to evolving national and regional quality and safety standards. Our +competitors vary in number, scope and breadth of the products and services they +offer. Our competitors in advanced transportation management and traveler +information systems include national corporations such as Transcore, Siemens, +Telvent Farradyne, Kimley-Horn and Associates, Inc. and Delcan. Our +competitors in transportation engineering, planning and design include major +firms such as Parsons Brinkerhoff, Inc., URS, HNTB and Parsons +Transportation Group, Inc., as well as many smaller regional engineering +firms. +5 +In general, the markets +for the products and services we offer are highly competitive and are +characterized by rapidly changing technology and evolving standards. Many of +our current and prospective competitors have longer operating histories, +greater name recognition, access to larger customer bases and significantly +greater financial, technical, manufacturing, distribution and marketing +resources than us. As a result, they may be able to adapt more quickly to new +or emerging standards or technologies or to devote greater resources to the +promotion and sale of their products. It is also possible that new competitors +or alliances among competitors could emerge and rapidly acquire significant +market share. We believe that our ability to compete effectively in our target markets +will depend on a number of factors, including the success and timing of our new +product development, the compatibility of our products with a broad range of +computing systems, product quality and performance, reliability, functionality, +price, and service and technical support. Our failure to provide services and +develop and market products that compete successfully with those of other +suppliers and consultants in our target markets would have a material adverse +effect on our business, financial condition and results of operations. +Intellectual +Property and Proprietary Rights +Our ability to compete +effectively depends in part on our ability to develop and maintain the +proprietary aspects of our technology. Our policy is to obtain appropriate +proprietary rights protection for any potentially significant new technology +acquired or developed by us. We currently hold ten U.S. patents, which expire +commencing in 2012, and have six U.S. patent +applications pending relating to our outdoor image processing techniques used +in our AutoVue systems. Nine of our patents relate specifically to our AutoVue +technology and provide a basis for enhanced functionality for rain sensing and +improved performance. We believe that our other patents, while important for +our technology platforms, are less critical to our near term product strategy. +We cannot assure you that any new patents will be granted pursuant to any +outstanding or subsequent applications. +In addition to patent +laws, we rely on copyright and trade secret laws to protect our proprietary +rights. We attempt to protect our trade secrets and other proprietary +information through agreements with customers and suppliers, proprietary +information agreements with our employees and consultants, and other similar +measures. We do not have any material licenses or trademarks other than those +relating to product names. We cannot be certain that we will be successful in +protecting our proprietary rights. While we believe our patents, patent +applications, software and other proprietary know-how have value, changing +technology makes our future success dependent principally upon our employees’ +technical competence and creative skills for continuing innovation. +Litigation may be +necessary in the future to enforce our proprietary rights, to determine the +validity and scope of the proprietary rights of others, or to defend us against +claims of infringement or invalidity by others. An adverse outcome in such +litigation or similar proceedings could subject us to significant liabilities +to third parties, require disputed rights to be licensed from others or require +us to cease marketing or using certain products, any of which could have a +material adverse effect on our business, financial condition and results of +operations. In addition, the cost of addressing any intellectual property +litigation claim, both in legal fees and expenses, as well as from the +diversion of management’s resources, regardless of whether the claim is valid, +could be significant and could have a material adverse effect on our business, +financial condition and results of operations. +Employees +We refer to our employees +as associates. As of June 9, 2008, we employed an aggregate of 268 +associates, including 54 associates in general management, administration and finance; +34 associates in sales and marketing; 144 associates in engineering and product +development; 23 associates in operations, manufacturing and quality; and 13 +associates in customer service. None of our associates are represented by a +labor union, and we have never experienced a work stoppage. +Government +Regulation +Our manufacturing +operations are subject to various federal, state and local laws and +regulations, including those restricting the discharge of materials into the +environment. We are not involved in any pending or, to our knowledge, +threatened governmental proceedings, which would require curtailment of our +operations because of such laws and regulations. We continue to expend funds in +connection with our compliance with applicable environmental regulations. These +expenditures have not, however, been significant in the past, and we do not +expect any significant expenditure in the near future. Currently, compliance +with foreign laws has not had a material impact on our business and is not expected +to have a material impact in the near future. +6 +ITEM 1A. RISK FACTORS +Our business is subject to a number +of risks, some of which are discussed below. Other risks are presented +elsewhere in this report and in the information incorporated by reference into +this report. You should consider the following risks carefully in addition to +the other information contained in this report and our other filings with the +SEC, including our subsequent reports on Forms 10-Q and 8-K, before deciding to +buy, sell or hold our common stock. The risks and uncertainties described below +are not the only ones facing our company. Additional risks and uncertainties +not presently known to us or that we currently deem immaterial may also affect +our business operations. If any of these risks actually occurs, our business, +financial condition or results of operations could be seriously harmed. In that +event, the market price for our common stock could decline and you may lose all +or part of your investment. +We May Need +To Raise Additional Capital In The Future, Which May Not Be Available On +Terms Acceptable To Us, Or At All. Until +recently we have historically generated significant net losses and operating +losses, and have experienced volatility in our cash flows from operations +ranging from positive cash flows from operations of $7.6 million in Fiscal 2008 +to negative cash flows from operations of $2.0 million in Fiscal 2007. +Additionally, we failed to meet certain debt covenants under our prior credit +agreement during two fiscal quarters, prior to the replacement of that credit +facility in October 2006. Furthermore, as of March 31, 2008, we had +$7.8 million in subordinated convertible debentures outstanding that are due in +full in May 2009. Should the holders of the convertible debentures not +elect to convert the principal into shares of our common stock, we may need to +raise additional capital to refinance this debt. +At March 31, +2008, we had $421,000 of cash and cash equivalents and relied on our line of +credit to fund our operations. We may need to raise additional capital in the +near future to fund our operations or to repay indebtedness. Such additional +capital may be raised through bank borrowings, or other debt or equity financings. +We cannot assure you that any additional capital will be available on a timely +basis, on acceptable terms, or at all, and such additional financing may result +in further dilution to our stockholders. +Our +capital requirements will depend on many factors, including, but not limited +to: +· market +acceptance of our products and product enhancements, and the overall level of +sales of our products; +· our +ability to control costs; +· the +supply of key components for our products; +· our +ability to increase revenue and net income; +· increased +research and development expenses and sales and marketing expenses; +· our +need to respond to technological advancements and our competitors’ +introductions of new products or technologies; +· capital +improvements to new and existing facilities and enhancements to our +infrastructure and systems; +· potential +acquisitions of businesses and product lines; +· our +relationships with customers and suppliers; +· government +budgets, political agendas and other funding issues, including potential delays +in government contract awards; +· our +ability to successfully negotiate credit arrangements with our bank and repay +our subordinated convertible debentures; and +· general +economic conditions, including the effects of the current economic slowdown and +international conflicts. +7 +If our +capital requirements are materially different from those currently planned, we +may need additional capital sooner than anticipated. If additional funds are +raised through the issuance of equity or convertible debt securities, the +percentage ownership of our stockholders will be reduced and such securities +may have rights, preferences and privileges senior to our common stock. +Additional financing may not be available on favorable terms, on a timely +basis, or at all. If adequate funds are not available or are not available on +acceptable terms, we may be unable to continue our operations as planned, +develop or enhance our products, expand our sales and marketing programs, take +advantage of future opportunities or respond to competitive pressures. +We Have Historically Experienced +Substantial Losses And May Experience Losses In The Future. Although +we have achieved net income in our prior three fiscal years, we experienced a +net loss of $11.3 million in the year ended March 31, 2005 and significant +net losses in prior years. We cannot assure you that we will be able to sustain +or improve our financial performance, or that we will be able to continue to +achieve profitability on a quarterly or annual basis in the future. Most of our +expenses are fixed in advance. As such, we generally are unable to reduce our +expenses significantly in the short-term to compensate for any unexpected delay +or decrease in anticipated revenues. As a result, we may continue to experience +operating losses and net losses, which would make it difficult to fund our +operations and achieve our business plan, and could cause the market price of +our common stock to decline. +If Our Internal Controls Over +Financial Reporting Do Not Comply With The Requirements Of The Sarbanes-Oxley +Act, Our Business And Stock Price Could Be Adversely Affected. Along +with our independent registered public accounting firm, we will be evaluating +the effectiveness of our internal controls over financial reporting to comply +with Section 404 of the Sarbanes-Oxley Act of 2002. Section 404 +currently requires us to evaluate the effectiveness of our internal controls +over financial reporting at the end of each fiscal year beginning in our fiscal +year ending March 31, 2008 and to include a management report assessing +the effectiveness of our internal controls over financial reporting in all +annual reports beginning with our Annual Report on Form 10-K for the +fiscal year ending March 31, 2008. Section 404 also requires our +independent accountant to attest to, and report on, management’s assessment of +our internal controls over financial reporting beginning in our fiscal year +ending March 31, 2009. We may not be able to complete our Section 404 +compliance on a timely basis, and even if we timely complete our compliance +requirements, our independent auditors may still conclude that our internal +controls over financial reporting are not effective. +Our +management, including our CEO and CFO, does not expect that our internal +controls over financial reporting will prevent all errors and all fraud. A +control system, no matter how well designed and operated, can provide only +reasonable, not absolute, assurance that the control system’s objectives will +be met. Further, the design of a control system must reflect the fact that +there are resource constraints, and the benefits of controls must be considered +relative to their costs. Because of the inherent limitations in all control +systems, no evaluation of controls can provide absolute assurance that all +control issues and instances of fraud, if any, within Iteris have been or will +be detected. These inherent limitations include the realities that judgments in +decision-making can be faulty and that breakdowns can occur because of simple +error or mistake. Controls can also be circumvented by the individual acts of +some persons, by collusion of two or more people, or by management override of +the controls. The design of any system of controls is based in part on certain +assumptions about the likelihood of future events, and we cannot assure you +that any design will succeed in achieving its stated goals under all potential +future conditions. Over time, our controls may become inadequate because of +changes in conditions or deterioration in the degree of compliance with +policies or procedures. Because of the inherent limitations in a cost-effective +control system, misstatements due to error or fraud may occur and not be +detected. +As of +March 31, 2005, we became aware of a material weakness in our internal controls +related to the accounting for the consolidation of our deferred compensation +savings plan and certain contract administration. Based on our evaluation, our +management concluded that, as of March 31, 2004, our internal control over +financial reporting was not effective due to the existence of one material +weakness. The weakness was immediately corrected. We cannot assure you that we +or our independent registered public accounting firm will not identify +additional material weaknesses in our internal controls. A material weakness is +a control deficiency, or combination of control deficiencies, that results in +more than a remote likelihood that a material misstatement of the annual or +interim financial statements will not be prevented or detected. If our internal +controls over financial reporting are not considered adequate, we may +experience a loss of public confidence, which could have an adverse effect on +our business and our stock price. +We Depend +On Government Contracts And Subcontracts, And Because Many Of Our Government +Contracts Are Fixed Price Contracts, Higher Than Anticipated Costs Will Reduce +Our Profit And Could Adversely Impact Our Operating Results. A +significant portion of our sales are derived from contracts with governmental +agencies, either as a general contractor, subcontractor or supplier. Government +contracts represented approximately 38.1%, 37.8% and 38.3% of our total net +sales and contract revenues for the years ended March 31, 2008, 2007 and +2006, respectively. We anticipate that revenue from government contracts will +continue to remain a significant portion of our net sales and contract +revenues. Government business is, in general, subject to special risks and +challenges, including: +· long +purchase cycles or approval processes; +8 +· competitive +bidding and qualification requirements; +· the +impact of international conflicts; +· performance +bond requirements; +· changes +in government policies and political agendas; +· delays +in funding, including the delays in the allocation of funds to state and local +agencies from the U.S. federal government as a result of a reduction or a delay +in the passage of the 2005 Federal Highway Bill set to expire in 2009; +· other +government budgetary constraints and cut-backs; and +· milestone +requirements and liquidated damage provisions for failure to meet contract +milestones. +In +addition, a large number of our government contracts are fixed price contracts. +As a result, we may not be able to recover any cost overruns we may incur. +These fixed price contracts require us to estimate the total project cost based +on preliminary projections of the project’s requirements. The financial +viability of any given project depends in large part on our ability to estimate +these costs accurately and complete the project on a timely basis. In the event +our costs on these projects exceed the fixed contractual amount, we will be +required to bear the excess costs. Such additional costs would adversely affect +our financial condition and results of operations. Moreover, certain of our +government contracts are subject to termination or renegotiation at the +convenience of the government, which could result in a large decline in our net +sales and contract revenues in any given quarter. Our inability to address any +of the foregoing concerns or the loss or renegotiation of any material +government contract could seriously harm our business, financial condition and +results of operations. +New Environmental Regulations May Result In A Decline In +Our AutoVue Sales and Royalties. Environmental regulations in +Europe were modified and became effective in 2006, which required more +stringent emissions compliance in new trucks manufactured in Europe after 2006. +These regulations caused the cost of certain trucks to increase significantly +and caused a decline in new truck sales in Europe. Similar regulations were +exacted in North America that impacted diesel engines built after January 2007. +North America heavy truck sales in 2007 and the first quarter of 2008 declined +significantly as compared to the prior year, which we believe was at least in +part a result of large 2006 prebuys of heavy trucks made in anticipation of the +new North America emission standards. We +may experience a further decline in our LDW sales to truck OEMs related to +these stricter regulations. Additionally, we may experience future declines in +our LDW sales to truck OEMs as a result of future regulations such as these. +We May Experience +Production Gaps Which Could Materially And Adversely Impact Our Sales And +Financial Results And The Ultimate Acceptance Of Our Products. It +is possible that we could experience unforeseen quality control issues or part +shortages as we increase production to meet current demand for our products. We +have historically used single suppliers for certain of our components in our +AutoVue and Vantage products. Should any such delay or disruption occur, our +future sales will likely be materially and adversely affected. Additionally, we +rely heavily on select contract manufacturers to produce many of our products. +Although we believe our contract manufacturers have sufficient capacity to meet +our production schedules for the foreseeable future and we believe we could +find alternative contract manufacturing sources if necessary, we could +experience a production gap if for any reason our contract manufacturers were +unable to meet our production requirements. +We Depend +Upon Valeo To Market Our AutoVue Technologies For The OEM Passenger Car Market. +We have granted Valeo the exclusive right to sell and +manufacture our AutoVue LDW system to the worldwide passenger car market in +exchange for royalty payments for each AutoVue unit sold. As such, the future +success and broad market acceptance of our AutoVue technologies in the +passenger car market will depend upon Valeo’s ability to manufacture, market +and sell our technologies, and to convince more OEM passenger car manufacturers +to adopt our technologies. To date, we +have not generated significant royalties from Valeo’s efforts and have only +been designed into one car OEM product line. +If Valeo does not devote considerable resources and aggressively pursue +opportunities, our expansion into the passenger car market could be adversely +affected. +9 +We May Be +Unable To Attract And Retain Key Personnel, Which Could Seriously Harm Our +Business. Due to the specialized nature of our business, we +are highly dependent on the continued service of our executive officers and +other key management, engineering and technical personnel. The loss of Abbas +Mohaddes, our Chief Executive Officer, or any of the other executive officers +or key members of management could adversely affect our business, financial condition +or results of operations. Our success will also depend in large part upon our +ability to continue to attract, retain and motivate qualified engineering and +other highly skilled technical personnel. In particular, the future success of +our Transportation Systems segment will depend on our ability to hire +additional qualified engineers and planners. Competition for qualified +employees, particularly development engineers, is intense. We may not be able +to continue to attract and retain sufficient numbers of such highly skilled +employees. Our inability to attract and retain additional key employees or the +loss of one or more of our current key employees could adversely affect our +business, financial condition and results of operations. +If We Are +Unable To Develop And Introduce New Products And Product Enhancements +Successfully And In A Cost-Effective And Timely Manner, Or Are Unable To +Achieve Market Acceptance Of Our New Products, Our Operating Results Would Be +Adversely Affected. We believe our revenue growth and future +operating results will depend on our ability to complete development of new +products and enhancements, introduce these products in a timely, cost-effective +manner, achieve broad market acceptance of these products and enhancements, and +reduce our product costs. We cannot guarantee the success of these products and +we may not be able to introduce any new products or any enhancements to our +existing products on a timely basis, or at all. In addition, the introduction +of any new products could adversely affect the sales of certain of our existing +products. +We +believe that we must continue to make substantial investments to support +ongoing research and development in order to remain competitive. We need to +continue to develop and introduce new products that incorporate the latest +technological advancements in outdoor image processing hardware, software and +camera technologies in response to evolving customer requirements. We cannot +assure you that we will be able to adequately manage product transition issues. +Our business and results of operations could be adversely affected if we do not +anticipate or respond adequately to technological developments or changing +customer requirements or if we cannot adequately manage inventory issues +typically related to new product transitions and introductions. We cannot +assure you that any such investments in research and development will lead to +any corresponding increase in revenue. +Market +acceptance of our new products depends upon many factors, including our ability +to accurately predict market requirements and evolving industry standards, our +ability to resolve technical challenges in a timely and cost-effective manner, +qualify any new products with OEMs and achieve manufacturing efficiencies, the +perceived advantages of our new products over traditional products and the +marketing capabilities of our independent distributors and strategic partners, +including Valeo’s ability to expand sales of AutoVue in the passenger car +market. The success of our AutoVue system will also depend in part on the +success of the automotive vehicles that incorporate our technology, as well as +the success of optional equipment that OEMs bundle with our technologies. +Certain +of the components used in our Vantage and AutoVue products may need to be +re-engineered in the next 12 to 36 months as the industry is moving towards a +standard of using lead-free components. We cannot assure you as to the timing +of the adoption of this new standard or our ability to successfully redesign +our products to incorporate compliant components and gain market acceptance of +such redesigned products. In addition, if the standard is adopted earlier than +anticipated we may experience a shortage of Vantage and AutoVue products as a +result of potential scarcity of lead-free components. +Our +business and results of operations could also be seriously harmed by any +significant delays in our new product development. Certain of our new products +could contain undetected design faults and software errors or “bugs” when first +released by us, despite our testing. We may not discover these faults or errors +until after a product has been installed and used by our customers. Any faults +or errors in our existing products or in any new products may cause delays in +product introduction and shipments, require design modifications or harm +customer relationships, any of which could adversely affect our business and +competitive position. +The +Markets In Which We Operate Are Highly Competitive And Have Many More +Established Competitors, Which Could Adversely Affect Our Sales Or The Market +Acceptance Of Our Products. We compete with numerous other +companies in our target markets including, but not limited to, large, multinational +corporations, which include tier one automotive suppliers, and many smaller +regional engineering firms. We expect such competition to increase due to +technological advancements, industry consolidations and reduced barriers to +entry. Increased competition is likely to result in price reductions, reduced +gross margins and loss of market share, any of which could seriously harm our +business, financial condition and results of operations. In Fiscal 2007, we +began to experience more competition in our Roadway Sensors segment as the +Department of Transportation in one of our largest sales territories moved to a +multi-source contracting environment from one in which we were the sole +supplier. In addition, one of the other developers of LDW systems was +10 +acquired by a larger +company during Fiscal 2007. While this developer has not been a material +competitor to date, we may experience more competition from this provider as a +result of its greater access to resources from its acquirer, and additional +competitors may enter this market in the future. Furthermore, awareness of LDW +technology is increasing and other market players are attempting to develop +competing technologies, which may contain improvements or added features beyond +those offered by our LDW systems. Should such efforts be successful, this could +erode our ability to successfully market and sell our LDW systems to new and +existing customers. +Many +of our competitors have far greater name recognition and greater financial, +technological, marketing and customer service resources than we do. This may +allow them to respond more quickly to new or emerging technologies and changes +in customer requirements. It may also allow them to devote greater resources to +the development, promotion, sale and support of their products than we can. +Recent consolidations of end users, distributors and manufacturers in our +target markets have exacerbated this problem. As a result of the foregoing +factors, we may not be able to compete effectively in our target markets and +competitive pressures could adversely affect our business, financial condition +and results of operations. +An +Economic Slowdown Could Lead To Reduced Or Delayed Government Funding For +Transportation Infrastructure And Initiatives And Decreased Availability Of +Financial Capital For Our Customers, Causing A Decline In Our Revenues. Concerns about inflation, +decreased consumer confidence, and reduced corporate profits and capital +spending have resulted in a downturn in worldwide economic conditions, particularly +in the United States. These unfavorable economic conditions may have a negative +impact on customer orders (and also may result in decreased sales of +automobiles and trucks that incorporate our LDW systems). Such concerns may +result in cancellations and rescheduling of backlog. In addition, the recent +decline in the U.S. real estate market, particularly in new home construction, +has adversely impacted new road construction and could result in a decline in +Roadway Sensor and Vehicle Sensor net sales and Transportation Systems contract +revenues. Any of the foregoing economic conditions make it extremely difficult +for our customers, our suppliers and us to accurately forecast and plan future +business activities and could result in a decline in our net sales and contract +revenues. If such conditions continue or worsen, our business, financial +condition and results of operations could be materially and adversely affected. +The Significant Military Operations In The Middle East Or +Elsewhere May Impact Government Funding Or Consumer Spending, Causing A +Decline In Our Revenues. In the near term, the funding of +U.S. military operations in the Middle East or elsewhere may cause disruptions +in funding of government contracts. Since military operations of such magnitude +are not routinely included in U.S. defense budgets, supplemental legislative +funding actions are often required to finance such operations. Even when such +legislation is enacted, it may not be adequate for ongoing operations, causing +other government resources to be temporarily or permanently diverted. Since a +significant portion of our sales are derived from contracts with government +agencies, such diversion of funds could produce interruptions in funding or +delays in receipt of our contracts, causing disruptions and adversely effecting +our revenue and operations. +Our +Quarterly Operating Results Fluctuate As A Result Of Many Factors. Therefore, +We May Fail To Meet Or Exceed The Expectations Of Securities Analysts And +Investors, Which Could Cause Our Stock Price To Decline. Our +quarterly revenues and operating results have fluctuated and are likely to +continue to vary from quarter to quarter due to a number of factors, many of +which are not within our control. Factors that could affect our revenues include, +among others, the following: +· changes +in our pricing policies and the pricing policies of our suppliers and +competitors, pricing concessions on volume sales, as well as increased price +competition in general; +· the +long lead times associated with government contracts or required by vehicle +manufacturers; +· delays +in government contracts and funding from time to time; +· declines +in new home construction and related road construction; +· our +ability to control costs; +· our +ability to raise additional capital; +· the +mix of our products and services sold in a quarter, which mix has varied and is +expected to continue to vary from time to time; +11 +· seasonality +due to winter weather conditions; +· international +conflicts and acts of terrorism; +· our +ability to develop, introduce, patent, market and gain market acceptance of new +products, applications and product enhancements in a timely manner, or at all; +· market +acceptance of the products incorporating our technologies and products; +· the +size, timing, rescheduling or cancellation of significant customer orders; +· the +introduction of new products by competitors; +· the +availability and cost of components used in the manufacture of our products; +· our +success in expanding and implementing our sales and marketing programs; +· the +effects of technological changes in our target markets; +· the +amount of our backlog at any given time; +· the +nature of our government contracts; +· deferrals +of customer orders in anticipation of new products, applications or product +enhancements; +· risks +and uncertainties associated with our international business; +· currency +fluctuations and our ability to get currency out of certain foreign countries; +and +· general +economic and political conditions. +Due to +all of the factors listed above as well as other unforeseen factors, our future +operating results could be below the expectations of securities analysts or +investors. If that happens, the trading price of our common stock could +decline. As a result of these quarterly variations, you should not rely on +quarter-to-quarter comparisons of our operating results as an indication of our +future performance. +We May Engage +In Acquisitions Of Companies Or Technologies That May Require Us To +Undertake Significant Capital Infusions And Could Result In Disruptions Of Our +Business And Diversion Of Resources And Management Attention. We +have historically acquired, and may in the future acquire, complementary +businesses, products and technologies. Acquisitions may require significant +capital infusions and, in general, acquisitions also involve a number of +special risks, including: +· potential +disruption of our ongoing business and the diversion of our resources and +management’s attention; +· the +failure to retain or integrate key acquired personnel; +· the +challenge of assimilating diverse business cultures, and the difficulties in integrating +the operations, technologies and information system of the acquired companies; +· increased +costs to improve managerial, operational, financial and administrative systems +and to eliminate duplicative services; +· the +incurrence of unforeseen obligations or liabilities; +12 +· potential +impairment of relationships with employees or customers as a result of changes +in management; and +· increased +interest expense and amortization of acquired intangible assets. +Our +competitors are also soliciting potential acquisition candidates, which could +both increase the price of any acquisition targets and decrease the number of +attractive companies available for acquisition. Acquisitions may also +materially and adversely affect our operating results due to large write-offs, +contingent liabilities, substantial depreciation, deferred compensation charges +or intangible asset amortization, or other adverse tax or accounting +consequences. We cannot assure you that we will be able to identify or +consummate any additional acquisitions, successfully integrate any acquisitions +or realize the benefits anticipated from any acquisition. +We +Have Experienced Growth In Recent Periods. If We Fail To Manage Our Growth +Effectively, We May Be Unable To Execute Our Business Plan And May Experience +Future Weaknesses In Our Internal Controls. We have expanded +our overall business. In order to achieve our business objectives, we will need +to continue to expand our business and add additional qualified personnel. Such +expansion has placed and is expected to continue to place, a significant strain +on our managerial, administrative, operational, financial and other resources. +If we are unable to successfully manage our growth, our business, financial +condition and results of operations will be adversely affected. +If We Do +Not Keep Pace With Rapid Technological Changes And Evolving Industry Standards, +We Will Not Be Able To Remain Competitive And There Will Be No Demand For Our +Products. Our markets are in general characterized by the +following factors: +· rapid +technological advances; +· downward +price pressure in the marketplace as technologies mature; +· changes +in customer requirements; +· additional +qualification requirements related to new products or components; +· frequent +new product introductions and enhancements; +· inventory +issues related to transition to new or enhanced models; and +· evolving +industry standards and changes in the regulatory environment. +Our +future success will depend upon our ability to anticipate and adapt to changes +in technology and industry standards, and to effectively develop, introduce, +market and gain broad acceptance of new products and product enhancements +incorporating the latest technological advancements. In particular, our LDW +system is incorporated into automobiles and trucks that face significant +technological changes in each model year and among different vehicle models. +Accordingly, we must adapt our technology from time to time to function with +such changes. +We May Not +Be Able To Adequately Protect Or Enforce Our Intellectual Property Rights, +Which Could Harm Our Competitive Position. If we are not able +to adequately protect or enforce the proprietary aspects of our technology, +competitors could be able to access our proprietary technology and our +business, financial condition and results of operations will likely be +seriously harmed. We currently attempt to protect our technology through a +combination of patent, copyright, trademark and trade secret laws, employee and +third party nondisclosure agreements and similar means. Despite our efforts, +other parties may attempt to disclose, obtain or use our technologies or +systems. Our competitors may also be able to independently develop products that +are substantially equivalent or superior to our products or design around our +patents. In addition, the laws of some foreign countries do not protect our +proprietary rights as fully as do the laws of the United States. As a result, +we may not be able to protect our proprietary rights adequately in the United +States or abroad. +Litigation may be +necessary in the future to enforce our intellectual property rights or to +determine the validity and scope of the proprietary rights of others. +Litigation may also be necessary to defend against claims of infringement or +invalidity by others. An adverse outcome in litigation or any similar +proceedings could subject us to significant liabilities to third parties, +require us to license disputed rights from others or require us to cease +marketing or using certain products or +13 +technologies. We may not be able to obtain any +licenses on terms acceptable to us, or at all. We also may have to indemnify +certain customers or strategic partners if it is determined that we have +infringed upon or misappropriated another party’s intellectual property. Any of +these results could adversely affect our business, financial condition and +results of operations. In addition, the cost of addressing any intellectual +property litigation claim, including legal fees and expenses, and the diversion +of management’s attention and resources, regardless of whether the claim is +valid, could be significant and could seriously harm our business, financial +condition and results of operations. +The +Trading Price Of Our Common Stock Is Highly Volatile. The +trading price of our common stock has been subject to wide fluctuations in the +past. Since January 2000, our Class A common stock (now known as our +common stock) has traded at prices as low as $0.45 per share and as high as +$29.44 per share. The market price of our common stock could continue to +fluctuate in the future in response to various factors, including, but not +limited to: +· quarterly +variations in operating results; +· our +ability to control costs, improve cash flow and sustain profitability; +· our +ability to raise additional capital; +· shortages +announced by suppliers; +· announcements +of technological innovations or new products or applications by our +competitors, customers or us; +· transitions +to new products or product enhancements; +· acquisitions +of businesses, products or technologies; +· the +impact of any litigation; +· changes +in investor perceptions; +· government +funding, political agendas and other budgetary issues; +· changes +in earnings estimates or investment recommendations by securities analysts; and +· international +conflicts, political unrest and acts of terrorism. +The +stock market in general has from time to time experienced volatility, which has +often affected the market prices of equity securities of many technology +companies. This volatility has often been unrelated to the operating +performance of these companies. These broad market fluctuations may adversely +affect the market price of our common stock. In the past, companies that have +experienced volatility in the market price of their securities have been the +subject of securities class action litigation. If we were to become the subject +of a class action lawsuit, it could result in substantial losses and divert +management’s attention and resources from other matters. +Our +International Business Operations May Be Threatened By Many Factors That +Are Outside Of Our Control. We currently market our AutoVue +and Vantage products internationally and we anticipate that our international +operations will expand in the near future. International business operations +are subject to various inherent risks including, among others: +· currency +fluctuations and restrictions; +· political, +social and economic instability; +· longer +accounts receivable payment cycles; +· import +and export license requirements and restrictions of the United States and each +other country in which we operate; +14 +· unexpected +changes in regulatory requirements, tariffs and other trade barriers or +restrictions; +· the +burdens of compliance with a wide variety of foreign laws and more restrictive +labor laws and obligations; +· difficulties +in managing and staffing international operations; +· potentially +adverse tax consequences; and +· reduced +protection for intellectual property rights in some countries. +All of +our international sales are denominated in U.S. dollars. As a result, an +increase in the relative value of the dollar could make our products more +expensive and potentially less price competitive in international markets. We +do not engage in any transactions as a hedge against risks of loss due to foreign +currency fluctuations. +Any of +the factors mentioned above may adversely affect our future international sales +and, consequently, affect our business, financial condition and operating +results. Furthermore, as we increase our international sales, our total +revenues may also be affected to a greater extent by seasonal fluctuations +resulting from lower sales that typically occur during the summer months in +Europe and other parts of the world. +We Could +Experience Negative Financial Impacts Arising From Developments In +Contingencies Created Under Our Previous Structure Or By Former Subsidiaries. Although +we divested ourselves of all business units prior to October 2004, with +the exception of our Iteris business, from time to time we could experience +unforeseen developments in contingencies related to our former subsidiaries. +For example, in July 2006 we entered into a settlement agreement in +connection with a lawsuit brought against Mariner Networks, Inc., one of +our former subsidiaries, by one of Mariner’s suppliers, pursuant to which we +issued 88,912 shares of our common stock to this supplier (valued at $213,000 +as of the date of issuance), paid this supplier $125,000 on October 20, +2006 and are required to pay an additional $350,000 in 36 equal monthly installments +of $9,700 beginning in November 2006. Although we are not aware of any +other material contingencies, it is possible that other matters could be +brought against us in connection with activities related to former subsidiaries +and that such matters could materially and adversely affect our financial +results and cash flows. +Some Of +Our Directors, Officers And Their Affiliates Can Control The Outcome Of Matters +That Require The Approval Of Our Stockholders, And Accordingly We Will Not Be +Able To Engage In Certain Transactions Without Their Approval. As +of March 31, 2008, our officers and directors beneficially owned +approximately 11% of the outstanding shares of our common stock (and +approximately 15% of our common stock when including options, warrants and +other convertible securities held by them which are currently exercisable or +convertible or will become exercisable or convertible within 60 days after +March 31, 2008). As a result of their stock ownership, our management will +be able to influence the election of our directors and the outcome of corporate +actions requiring stockholder approval, such as mergers and acquisitions, +regardless of how our other stockholders may vote. This concentration of voting +control may have a significant effect in delaying, deferring or preventing a +change in our management or change in control and may adversely affect the +voting or other rights of other holders of common stock. +Certain +Anti-Takeover Provisions May Affect The Price Of Our Common Stock And +Discourage A Third Party From Acquiring Us. Certain +provisions of our certificate of incorporation could make it difficult for a +third party to acquire us, even though an acquisition might be beneficial to +our stockholders. Such provisions could limit the price that investors might be +willing to pay in the future for shares of our common stock. Under the terms of +our certificate of incorporation, our Board of Directors is authorized to +issue, without stockholder approval, up to 2,000,000 shares of preferred stock +with voting, conversion and other rights and preferences superior to those of +our common stock. Our future issuance of preferred stock could be used to +discourage an unsolicited acquisition proposal. +ITEM 1B. UNRESOLVED STAFF COMMENTS +Not applicable. +15 +ITEM 2. PROPERTIES +Our headquarters and +principal operations are housed in approximately 52,000 square feet of leased +space located at 1700 Carnegie Avenue, Santa Ana, California, for which we +currently pay a monthly lease rate of $102,000, exclusive of certain utility +costs. The Santa Ana facility lease expires in 2015 and contains an option to +extend the lease for an additional five years at the market rate at that time. +For additional +information regarding our obligations under property leases, see Note 6 of +Notes to Consolidated Financial Statements, included in Part IV, Item 15 +of this report. +ITEM 3. LEGAL PROCEEDINGS +The information set forth +under Note 6 of Notes to Consolidated Financial Statements, included in Part IV, +Item 15 of this report, is incorporated herein by reference. +ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY +HOLDERS +No matters were submitted +to a vote of our security holders during the three months ended March 31, +2008. +16 +PART II +ITEM 5. +MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED +STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES +Our common stock is +traded on the American Stock Exchange (“AMEX”) under the symbol “ITI”. The following table sets forth, for the +periods indicated, the high and low sales prices for our common stock as +reported by AMEX: +Common Stock +High +Low +Fiscal 2008 +Quarter Ended June 30, 2007 +$ +2.66 +$ +2.11 +Quarter Ended September 30, 2007 +2.50 +2.00 +Quarter Ended December 31, 2007 +4.20 +2.18 +Quarter Ended March 31, 2008 +4.06 +1.94 +Fiscal 2007 +Quarter Ended June 30, 2006 +$ +2.69 +$ +2.10 +Quarter Ended September 30, 2006 +2.69 +2.26 +Quarter Ended December 31, 2006 +2.69 +1.38 +Quarter Ended March 31, 2007 +2.76 +2.15 +On June 10, 2008, +the last reported sales price of our common stock on the AMEX was $2.72. As of June 10, 2008, we had 456 holders +of record of our common stock according to information furnished by our +transfer agent. +Dividend Policy +We have never paid or +declared cash dividends on our common stock, and have no current plans to pay +such dividends in the foreseeable future. We currently intend to retain any +earnings for working capital and general corporate purposes. The payment of any +future dividends will be at the discretion of our Board of Directors and will +depend upon a number of factors, including, but not limited to, future +earnings, the success of our business, our capital requirements, our general +financial condition and future prospects, general business conditions, the +consent of our lender and such other factors as the Board of Directors may deem +relevant. +17 +Stock Performance Graph +The graph below +shows the cumulative total return on investment assuming an investment of $100 +on March 31, 2003 in our common stock, the NASDAQ Stock Market Index and +the same peer group used by us last year, which is made up of the remaining +members of the index used by us in prior years, the Media General Industry +Group 836 for Diversified Electronics, which is no longer a published +index. Our common stock is currently +listed on the AMEX under the symbol “ITI” and began trading on such exchange on +December 9, 2004. Our common stock +was listed on the NASDAQ SmallCap Market (now called the NASDAQ Capital Market) +from April 2002 to August 2003 and quoted on the OTC Bulletin Board +from August 2003 to December 2004. +The total stockholder return assumes reinvestment of dividends on a +daily basis, although cash dividends have not been declared on our common +stock. The stockholder returns shown in +the following graph are not necessarily indicative of future performance. +COMPARISON OF 5 YEAR CUMULATIVE TOTAL RETURN* +Among Iteris, Inc., The NASDAQ Composite Index +And A Peer Group +* $100 invested on 3/31/03 in stock or +index-including reinvestment of dividends. Fiscal year ending March 31. +Measurement Period +2003 +2004 +2005 +2006 +2007 +2008 +Iteris, Inc. +Common Stock +100.00 +606.06 +369.70 +400.00 +348.48 +350.00 +NASDAQ Composite +100.00 +151.01 +152.38 +181.06 +189.63 +177.49 +Peer Group +100.00 +181.83 +138.87 +182.74 +186.37 +163.80 +Notwithstanding +anything to the contrary set forth in any of our previous or future filings +under the Securities Act of 1933, as amended, or the Securities Exchange Act of +1934, as amended, that might incorporate this report or future filings made by +us under those statutes, the stock performance graph is not deemed filed with +the Securities and Exchange Commission and shall not be deemed incorporated by +reference into any prior filings or into any future filings made by us under +those statutes. +18 +ITEM 6. SELECTED FINANCIAL DATA +The following table sets +forth selected consolidated financial data for each of the five fiscal years +ended March 31, 2008. The statement of operations and balance sheet data +for the years ended and as of March 31, 2008, 2007, 2006, 2005, and 2004 +are derived from our audited consolidated financial statements. The +accompanying consolidated financial statements have been restated to reflect +the classification and presentation of our former subsidiaries, Broadcast, Inc., +Zyfer Inc., and MAXxess Systems, Inc., as discontinued operations for all +periods presented. The following +information should be read in conjunction with “Management’s Discussion and +Analysis of Financial Condition and Results of Operations” and with our +consolidated financial statements and the related notes thereto included +elsewhere in this report. +Fiscal Year Ended March 31, +2008 +2007 +2006 +2005 +2004 +(in thousands, except per share data) +Consolidated Statement of Operations Data: +Net sales and contract revenues: +Net sales +$ +40,326 +$ +36,248 +$ +31,156 +$ +29,062 +$ +23,470 +Contract revenues +24,837 +22,049 +19,330 +17,335 +21,813 +Total net sales and contract revenues +65,163 +58,297 +50,486 +46,397 +45,283 +Costs of net sales and contract revenues: +Cost of net sales (a) +20,499 +19,829 +16,493 +15,925 +12,758 +Cost of contract revenues (a) +16,367 +14,460 +12,600 +13,789 +14,712 +Gross profit +28,297 +24,008 +21,393 +16,683 +17,813 +Operating expenses: +Selling, general and administrative (a) +17,289 +16,003 +15,410 +20,543 +13,712 +Research and development (a) +3,566 +4,030 +5,217 +6,236 +3,923 +Amortization of intangible assets +147 +147 +147 +114 +— +Disposal of fixed assets +— +— +— +422 +— +Acquired in-process research and development +— +— +— +140 +— +Total operating expenses +21,002 +20,180 +20,774 +27,455 +17,635 +Operating income (loss) +7,295 +3,828 +619 +(10,772 +) +178 +Non-operating income (expense): +Other income (expense), net +252 +(653 +) +35 +1,054 +1,003 +Interest expense, net +(1,284 +) +(1,600 +) +(1,459 +) +(1,178 +) +(123 +) +Income (loss) from continuing operations before income taxes and +minority interest +6,263 +1,575 +(805 +) +(10,896 +) +1,058 +Income tax benefit (provision) +5,900 +1,343 +885 +94 +(100 +) +Minority interest in earnings of subsidiary +— +— +— +(526 +) +(2,813 +) +Income (loss) from continuing operations +12,163 +2,918 +80 +(11,328 +) +(1,855 +) +Income from discontinued operations, net of taxes +— +— +— +— +1,215 +Net income (loss) +$ +12,163 +$ +2,918 +$ +80 +$ +(11,328 +) +$ +(640 +) +Basic earnings (loss) per share: +Continuing operations +$ +0.37 +$ +0.10 +$ +0.00 +$ +(0.45 +) +$ +(0.09 +) +Discontinued operations +— +— +— +— +0.06 +Basic earnings (loss) per share +$ +0.37 +$ +0.10 +$ +0.00 +$ +(0.45 +) +$ +(0.03 +) +Diluted earnings (loss) per share: +Continuing operations +$ +0.35 +$ +0.09 +$ +0.00 +$ +(0.45 +) +$ +(0.09 +) +Discontinued operations +— +— +— +— +0.06 +Diluted earnings (loss) per share +$ +0.35 +$ +0.09 +$ +0.00 +$ +(0.45 +) +$ +(0.03 +) +Shares used in calculating basic earnings (loss) per share +32,723 +29,698 +28,182 +25,284 +19,454 +Shares used in calculating diluted earnings (loss) per share +34,713 +33,348 +32,737 +25,284 +19,454 +(a) Includes stock-based compensation +expense as follows: +Cost of net sales +$ +3 +$ +13 +$ +27 +$ +280 +$ +— +Cost of contract revenues +14 +60 +205 +2,391 +— +Selling, general and administrative expense +266 +195 +364 +7,063 +— +Research and development expense +7 +20 +129 +2,043 +— +Total stock-based compensation expense +$ +290 +$ +288 +$ +725 +$ +11,777 +$ +— +19 +At March 31, +2008 +2007 +2006 +2005 +2004 +(in thousands) +Consolidated Balance Sheet Data: +Working capital +$ +14,948 +$ +6,979 +$ +3,009 +$ +2,197 +$ +9,369 +Total assets +65,645 +55,250 +49,633 +46,656 +30,065 +Long-term debt (less current portion) +7,566 +9,760 +11,374 +10,315 +891 +Accumulated deficit +(95,499 +) +(107,438 +) +(110,356 +) +(110,436 +) +(99,108 +) +Total stockholders’ equity (deficit) +43,211 +25,687 +18,635 +17,462 +(1,076 +) +ITEM +7. +MANAGEMENT’S +DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS +You +should read the following discussion and analysis in conjunction with our +Consolidated Financial Statements and related Notes thereto included in Part IV, +Item 15 of this report and the “Risk Factors” section in Item 1A, as well +as other cautionary statements and risks described elsewhere in this report, +before deciding to purchase, hold or sell our common stock. +Overview +We are a leader in the +traffic management market that focuses on the development and application of +advanced technologies that reduce traffic congestion, minimize the environmental +impact of traffic congestion and improve the safety of surface transportation +systems. By combining outdoor image processing, traffic engineering and +information technology, we offer a broad range of Intelligent Transportation +Systems and driver safety solutions to customers worldwide. +We currently operate in +three reportable segments: Roadway Sensors, Vehicle Sensors and Transportation +Systems. The Roadway Sensors segment includes our Vantage vehicle detection +systems for traffic intersection control, incident detection and certain +highway traffic data collection applications. The Vehicle Sensors segment is +comprised of all activities related to our AutoVue Lane Departure Warning +systems for vehicle safety. The Transportation Systems segment includes +transportation engineering and consulting services and the development of +transportation management and traveler information systems for the ITS +industry. +Our Vantage product is a +video vehicle detection system that detects the presence of vehicles on +roadways. Vantage systems are used at signalized intersections to enable a +traffic controller to more efficiently allocate green signal time and are also +used for incident detection and highway traffic data collection applications. +We sell and distribute our Vantage products primarily to commercial customers +and municipal agencies. +Our AutoVue LDW systems +consist of a small windshield mounted sensor that uses proprietary software to +detect and warn drivers of unintended lane departures. In excess of 90,000 +production AutoVue units have been sold for car and truck platforms in the +North American and European markets. Our AutoVue LDW systems are currently +qualified as an option on certain heavy trucks, including Mercedes-Benz, MAN, +Iveco, DAF, Scania, Freightliner and FUSO, as well as Neoplan and MAN luxury +bus and coach lines. In North America, our LDW systems are sold primarily to +truck fleets, and to date, 65 U.S. heavy truck fleets have selected our LDW +systems, representing an estimated 45,000 vehicles. +In September 2003, +we entered into an agreement with Valeo Schalter and Sensuren GmbH (“Valeo”), +pursuant to which we granted Valeo the exclusive right to sell and manufacture +our AutoVue LDW systems to the worldwide passenger car market in exchange for royalty +payments for each AutoVue LDW unit sold. To date, royalty payments from Valeo +have not been significant. Pursuant to this agreement, we also provide specific +contract engineering services, technical marketing and sales support to Valeo +to enable the incorporation of our LDW technology on three Infiniti platforms, +the FX, M and EX, where the device is offered as part of various option +packages. Valeo is currently in discussions to provide our LDW system to other +passenger car OEMs; however, we cannot assure you that such discussions will be +successful. We plan to continue to provide technical marketing and sales +support to Valeo in our efforts to win new OEM customers for the passenger car +market as well as contract engineering services related to the possible launch +of new Infiniti platforms that include our LDW system. We believe that AutoVue +is a broad sensor platform that, through additional software development, may +be expanded to incorporate additional safety and convenience features. +Our transportation +management systems business includes transportation engineering and consulting +services focused on the planning, design, development and implementation of +software-based systems that integrate sensors, video surveillance, computers +and advanced communications equipment to enable public agencies to monitor, +control and direct +20 +traffic flow, +assist in the quick dispatch of emergency crews and distribute real-time +information about traffic conditions. Our services include planning, design and +implementation of surface transportation infrastructure systems. We perform +analysis and study goods movement, commercial vehicle operations, travel demand +forecasting and systems engineering, and identify mitigation measures to reduce +traffic congestion. These services and systems are primarily sold to local, +state and national transportation agencies in the United States. Our +transportation management systems business is largely dependent upon +governmental funding and budgetary issues. The Federal Highway Bill that was +passed in August 2005 provided for a significant increase in +transportation funding over the following six years. We believe the recent +expansion of our transportation management systems business was due in part to +the passage of the Federal Highway Bill, combined with increased transportation +funds available at state and local agencies throughout the country. The 2005 +Federal Highway Bill is set to expire in 2009. It is too early to determine any +impact on future contract revenues as a result of potential delays in the +passage of future bills. +Prior to our fiscal year +ended March 31, 2004 (“Fiscal 2004”), we operated in three segments +consisting of ITS, video products and telecom products. The ITS segment +consisted of our current operations, which was previously conducted by the +Iteris Subsidiary. The video products segment included our former wholly-owned +subsidiary, MAXxess Systems, Inc. (“MAXxess”), which designed and +manufactured security management systems. +Our telecom products segment included our wholly-owned subsidiary, Zyfer, Inc. +(“Zyfer”), which developed and manufactured timing and synchronization +products. During Fiscal 2004, we +completed the divestiture of MAXxess and Zyfer and restructured our operations +to focus on the operations of our Iteris Subsidiary. Our financial statements for all periods +presented in this report have been restated to reflect the discontinuation of +the operations of MAXxess and Zyfer. +Critical +Accounting Policies and Estimates +Management’s Discussion and Analysis of Financial +Condition and Results of Operations is based on our consolidated financial +statements included herein, which have been prepared in accordance with +generally accepted accounting principles in the United States (“GAAP”). The +preparation of these financial statements requires management to make estimates +and assumptions that affect the reported amounts of assets and liabilities and +related disclosures of contingent assets and liabilities at the date of the +financial statements and the reported amounts of revenues and expenses during +the reporting period. On an ongoing basis, we evaluate these estimates and +assumptions, including those related to the collectibility of accounts +receivable, the valuation of inventories, the recoverability of long-lived +assets and goodwill, the realizability of deferred tax assets, accounting for +stock-based compensation, the valuation of equity instruments, warranty +reserves and other contingencies. We base these estimates on historical +experience and on various other factors that we believe to be reasonable under +the circumstances, the results of which form the basis for making judgments +about the carrying values of assets and liabilities that are not readily +apparent from other sources. These estimates and assumptions by their nature +involve risks and uncertainties, and may prove to be inaccurate. In the event +that any of our estimates or assumptions are inaccurate in any material +respect, it could have a material adverse effect on our reported amounts of +assets and liabilities at the date of the financial statements and the reported +amounts of revenues and expenses during the reporting period. +The following critical accounting policies affect our +more significant judgments and estimates used in the preparation of our +consolidated financial statements. +Revenue Recognition. We record +product revenues and related costs of sales upon transfer of title, which is +generally upon shipment or, if required, upon acceptance by the customer, +provided that we believe collectibility of the net sales amount is reasonably +assured. Accordingly, at the date +revenue is recognized, the significant uncertainties concerning the sale have +been resolved. +Contract revenues are derived primarily from long-term +contracts with governmental agencies. Contract revenues include costs incurred +plus a portion of estimated fees or profits determined using the percentage of +completion method of accounting based on the relationship of costs incurred to +total estimated costs. Any anticipated losses on contracts are charged to +earnings when identified. Changes in job performance and estimated +profitability, including those arising from contract penalty provisions and +final contract settlements, may result in revisions to recognized costs and +revenues and are recognized in the period in which the revisions are +determined. Profit incentives are included in revenue when their realization is +reasonably assured. +In addition to +product and contract revenues, we derive revenue from technology access fees, +the provision of specific non-recurring contract engineering services to our +strategic partner, Valeo, related to our AutoVue LDW systems, and royalties +earned on unit sales of our AutoVue LDW systems by Valeo to the passenger car +market. Technology access fee revenues are recognized evenly over the period in +which they are earned. Non-recurring contract engineering revenues are +21 +recognized in the period in which the related services +are performed. Royalty revenues are recorded based on unit sales of our +products by Valeo and are recognized in the period in which such sales occur. +Technology access fee revenues, non-recurring contract engineering revenues and +royalty revenues are included in net sales. +Revenues from follow-on service and support, for which +we generally charge separately, are recorded in the period in which the +services are performed. +Accounts Receivable. We estimate +the collectibility of customer receivables on an ongoing basis by periodically +reviewing invoices outstanding greater than a certain period of time. We record +reserves for receivables deemed to be at risk for collection as well as a +general reserve based on our historical collections experience. A considerable +amount of judgment is required in assessing the ultimate realization of trade +receivables, including the current credit-worthiness of each customer. If the +financial condition of our customers deteriorates, resulting in an impairment +of their ability to make required payments, additional allowances may be +required that could adversely affect our operating results. +Inventory. Inventories consist of +finished goods, work-in-process and raw materials and are stated at the lower +of cost or market. We provide reserves for potentially excess and obsolete +inventory. In assessing the ultimate realization of inventories, we make +judgments as to future demand requirements and compare that with the current or +committed inventory levels. Reserves are established for inventory levels that +exceed anticipated future demand. It is possible that reserves over and above +those already established may be required in the future if market conditions +for our products deteriorate. +Goodwill. Goodwill is tested for +impairment annually in our fourth fiscal quarter at the reporting unit level +unless a change in circumstances indicates that more frequent impairment +analysis is required. Impairment, if any, is measured based on the estimated +fair value of the reporting units with the recorded goodwill. Fair value is +determined by using the income approach methodology of valuation which utilizes +discounted cash flows. Significant management judgment is required in the +forecasts of future operating results that are used in the discounted cash flow +method of valuation. In estimating future cash flows, we generally use the +financial assumptions in our current budget and our current strategic plan, +subject to modification as considered necessary, including sales and expense +growth rates and the discount rates we estimate to represent our cost of funds. +It is possible, however, that the plans and estimates used may be incorrect. If +our actual results, or the plans and estimates used in future impairment +analyses, are lower than the original estimates used to assess the +recoverability of goodwill, we could incur impairment charges. +Warranty. We generally provide a +one to three year warranty from the original invoice date on all products, materials +and workmanship. Defective products are either repaired or replaced, at our +option, upon meeting certain criteria. We accrue a provision for the estimated +costs that may be incurred for product warranties relating to a product as a +component of cost of sales at the time revenue for that product is recognized. +The accrued warranty provision is included within accrued expenses on the +accompanying consolidated balance sheets. Should our actual experience of +warranty returns be higher than anticipated, additional warranty reserves may +be required, which may adversely affect our operating results. +Income Taxes. We recorded a +valuation allowance to reduce our deferred tax assets to amounts that we +believe are more likely than not to be realized. Realization of deferred tax +assets (such as net operating loss carryforwards) is dependent on future +taxable earnings and is therefore uncertain. On a quarterly basis, we assess +the likelihood that our deferred tax asset balance will be recovered from +future taxable income. To the extent we believe that recovery is not likely, we +establish a valuation allowance against our deferred tax asset, increasing our +income tax expense in the period such determination is made. +On an interim basis, we estimate what our anticipated +annual effective tax rate will be and record a quarterly income tax provision +in accordance with this anticipated rate. As the fiscal year progresses, we +refine our estimates based upon actual events and earnings during the year. +This estimation process can result in significant changes to our expected +effective tax rate. When this occurs, we adjust the income tax provision during +the quarter in which the change in estimate occurs so that the year-to-date +provision reflects the expected annual rate. The changes described in the +preceding sentence and adjustments to our valuation allowance may create +fluctuations in our overall effective tax rate from quarter to quarter. +Effective April 1, 2007, we adopted the +provisions of Financial Accounting Standards Board Interpretation No. 48, Accounting for Uncertainty in Income Taxes – an Interpretation of FASB +Statement No. 109 (“FIN 48”), which applies to all tax +positions accounted for under Statement of Financial Accounting Standards (“SFAS”) +No. 109, Accounting for Income Taxes (“SFAS +109”). FIN 48 clarifies the accounting +for uncertainty in income taxes by establishing minimum standards for the +recognition and measurement of tax positions taken or expected to be taken in a +tax return. Under the requirements of +22 +FIN 48, we must review all of our tax positions and +make a determination as to whether our position is more-likely-than-not to be +sustained upon examination by regulatory authorities. If a tax position meets +the more-likely-than-not standard, then the related tax benefit is measured +based on a cumulative probability analysis of the amount that is +more-likely-than-not to be realized upon ultimate settlement or disposition of +the underlying issue. +Stock-Based Compensation . We adopted SFAS No. 123 (revised 2004), Share-Based Payment (“SFAS 123R”), effective April 1, +2006. Prior to April 1, 2006, we +followed the disclosure-only provisions of SFAS No. 123, Accounting for Stock-Based Compensation (“SFAS 123”), as +amended by SFAS No. 148, Accounting for Stock-Based +Compensation — Transition and Disclosure , and, accordingly, +accounted for our stock-based compensation plans using the intrinsic value +method under Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees (“APB 25”), and +related interpretations. +SFAS 123R requires all +stock-based payments, including grants of employee stock options, to be +recognized in the statement of operations as an expense, based on their grant +date fair values with such fair values amortized over the requisite service +period. We elected to utilize the +modified prospective method for the transition to SFAS 123R. Under the modified +prospective method, SFAS 123R applies to all awards granted or modified after +the date of adoption. In addition, under the modified prospective method, +compensation expense will be recognized for all stock-based compensation awards +granted prior to but not yet vested as of April 1, 2006, based on +grant-date fair values estimated in accordance with the original provisions of +SFAS 123. +In implementing SFAS +123R, we have used the Black-Scholes-Merton (“BSM”) option-pricing formula to +estimate the fair value of stock-based awards granted subsequent to April 1, +2006. Our assumptions under the BSM +formula include the following: expected +volatilities are based on the historical volatility of our stock price, the +expected life of options is derived based on the historical life of our +options, and the risk-free rate for periods within the expected life of the +option is based on the U.S. Treasury interest rates in effect at the time of +grant. Additionally, SFAS 123 did not +require the estimation of forfeitures in the calculation of stock compensation +expense; however, SFAS 123R does require such estimation and upon adoption of +SFAS 123R, we changed our methodology to include an estimate of +forfeitures. Future stock-based +compensation expense in any particular quarter or year could be affected by +changes in our assumptions or changes in market conditions. +23 +Results +of Operations +The following table sets +forth certain statement of operations data as a percentage of total net sales +and contract revenues for the periods indicated. The following table should be +read in conjunction with Management’s Discussion and Analysis of Financial +Condition and Results of Operations. +Fiscal Year Ended March 31, +2008 +2007 +2006 +Net sales and +contract revenues: +Net sales +61.9 +% +62.2 +% +61.7 +% +Contract revenues +38.1 +37.8 +38.3 +Total net sales and contract revenues +100.0 +% +100.0 +% +100.0 +% +Costs of net +sales and contract revenues: +Cost of net sales (a) +31.5 +34.0 +32.7 +Cost of contract revenues (a) +25.1 +24.8 +24.9 +Gross profit +43.4 +41.2 +42.4 +Operating expenses: +Selling, general and administrative (a) +26.5 +27.4 +30.5 +Research and development (a) +5.5 +6.9 +10.3 +Amortization of intangible assets +0.2 +0.3 +0.3 +Total operating expenses +32.2 +34.6 +41.1 +Operating income +11.2 +6.6 +1.2 +Non-operating income (expense): +Other income (expense), net +0.4 +(1.1 +) +0.1 +Interest expense, net +(2.0 +) +(2.7 +) +(2.9 +) +Income (loss) before income taxes +9.6 +2.7 +(1.6 +) +Income tax benefit +9.1 +2.3 +1.8 +Net income +18.7 +% +5.0 +% +0.2 +% +(a) Includes +stock-based compensation expense as a percent of total net sales and contract +revenues as follows: +Cost of net sales +0.0 +% +0.0 +% +0.1 +% +Cost of contract revenues +0.0 +0.1 +0.4 +Selling, general and administrative expense +0.4 +0.3 +0.7 +Research and development expense +0.0 +0.0 +0.3 +Total stock-based compensation expense +0.4 +% +0.5 +% +1.4 +% +Analysis +of Fiscal 2008, Fiscal 2007 and Fiscal 2006 Results of Operations +Net +Sales and Contract Revenues . Net sales are comprised of +Roadway Sensors sales, which are derived from sales of our Vantage video +detection systems, and Vehicle Sensors sales, which are derived from sales of +AutoVue LDW systems, technology access fees, contract engineering revenue and +royalty revenue generated from AutoVue related activities. Contract +revenues consist entirely of Transportation Systems contract revenues, which +are generated from systems integration and ITS consulting services primarily +with federal, state, county and municipal agencies. We currently have a diverse +customer base with our largest customer constituting 7.3% of total net sales +and contract revenues in Fiscal 2008. Total net sales and contract revenues +increased 11.8% to $65.2 million in Fiscal 2008 compared to $58.3 million in +Fiscal 2007, and increased 15.5% in Fiscal 2007 from $50.5 million in Fiscal +2006. +Net sales increased 11.3% +to $40.3 million in Fiscal 2008 compared to $36.2 million in Fiscal 2007, and +increased 16.3% in Fiscal 2007 compared to $31.2 million in Fiscal 2006. The +increase in net sales in each of the periods reflected increased unit sales in +both Roadway Sensors and Vehicle Sensors. +Roadway Sensors +net sales comprised 70.6%, 75.2% and 72.0% of net sales in Fiscal 2008, Fiscal +2007 and Fiscal 2006, respectively, and increased 4.4% to $28.5 million in +Fiscal 2008 compared to $27.3 million in Fiscal 2007 and increased 21.5% in +Fiscal 2007 compared to $22.4 million in Fiscal 2006. The majority of Roadway +24 +Sensors net sales were +derived from sales within North America. +The Fiscal 2008 and Fiscal 2007 increases primarily reflect the +continued adoption of video vehicle detection technology, such as the +technology offered by our Vantage line of products, both domestically and +internationally. Fiscal 2008 sales +growth was not as strong as sales growth in Fiscal 2007 due primarily to lower +sales volumes in Texas as a result of local budgetary issues, a trend that we +expect to continue for at least the next few fiscal quarters. We continue to believe that the current +increased rate of adoption has to some extent been due to increased government +spending on traffic initiatives, which we believe has been at least partially +made possible by the passage of the Federal Highway Bill in August 2005, +as well as expanded sales and marketing efforts, particularly in North America. +The 2005 Federal Highway Bill is set to expire in 2009. Although we are not aware of any imminent +changes in government spending patterns, it is possible that, as a result of +softening macroeconomic conditions in the U.S. and the decline in the new +housing market, government funding for certain traffic initiatives and roadway +improvement projects could be delayed or diverted to focus on other budgetary +needs. Should this occur, future +domestic Roadway Sensors net sales may be adversely affected. +Net sales from +Vehicle Sensors products and services increased 32.1% in Fiscal 2008 to $11.9 +million compared to $9.0 million in Fiscal 2007 and increased 3.2% in Fiscal +2007 compared to $8.7 million in Fiscal 2006. +The largest element of Vehicle Sensors net sales was sales of our LDW +systems to the heavy truck market, which aggregated $10.0 million in Fiscal +2008, $6.4 million in Fiscal 2007 and $5.9 million in Fiscal 2006. The increase in Fiscal 2008 net sales of +Vehicle Sensors products was primarily a result of increased unit sales of our +LDW systems to European and Asian OEMs. The increase in Fiscal 2007 net +sales of Vehicle Sensors products was primarily related to increased unit sales +of LDW systems in the North American commercial heavy truck market, partially +offset by OEM volume discounts provided to our largest customer and the impact +of the transition to our next generation AutoVue LDW systems for the heavy +truck market in the latter part of Fiscal 2006. +Although we have +experienced an overall increase in unit sales of our AutoVue LDW systems in +recent fiscal years, in Fiscal 2008, we began to experience softness in LDW +unit sales to the North American truck market as a result of an overall decline +in new truck sales in the U.S. driven largely by the general slowdown in the +U.S. housing market and overall economy. +We expect flat or declining LDW unit sales in the North American market +over at least the next several fiscal quarters due to these macroeconomic +conditions. We have not experienced the +same decline in net sales to our European and Asian OEM customers; however, a +slowdown in international truck sales could lead to similar sluggishness in LDW +unit sales internationally. Vehicle +Sensors unit sales in Fiscal 2009 and beyond could also be adversely impacted +by slower than expected adoption rates of our LDW system by European and Asian +OEMs and North American heavy truck fleets, as well as potential additional OEM +volume discounts resulting from increased price competition as new competitors +have entered this market. Additionally, +recent environmental regulations in Europe and North America have substantially +increased the cost of new commercial trucks, which could impact future truck +sales volumes and, ultimately, unit sales of our LDW systems. +Also included in +Vehicle Sensors net sales are revenues from contract engineering services, +technology access fees and royalty revenues in the passenger car market that +are derived from our strategic relationship with Valeo, which aggregated $1.9 +million, $2.6 million and $2.8 million in Fiscal 2008, Fiscal 2007 and Fiscal +2006, respectively. Such revenues were +lower in Fiscal 2008 as compared to Fiscal 2007 and Fiscal 2006 as a result of +technology access fee revenue of $500,000 that was recognized in Fiscal 2007 +and Fiscal 2006. Royalty revenues from +Valeo for sales of our LDW systems for the passenger car market were relatively +insignificant in Fiscal 2008, Fiscal 2007 and Fiscal 2006. Our LDW systems are now offered as an option +on three Infiniti models. While Valeo is +currently in discussions to offer our LDW systems on other passenger car +platforms, we cannot assure you that Valeo will be successful in these efforts. +Contract revenues +increased 12.6% to $24.8 million in Fiscal 2008 compared to $22.0 million in +Fiscal 2007 and increased 14.1% in Fiscal 2007 compared to $19.3 million in +Fiscal 2006. Contract revenues are +dependent upon the continued availability of funding at both the state and +federal levels from the various departments of transportation. The Fiscal 2008 and Fiscal 2007 increases in +contract revenues were largely due to increased funding at the federal, state +and local levels throughout the country, as well as new contract awards. In response to the growth in our Transportation +Systems segment, we increased our Transportation Systems staff by 21% in Fiscal +2008 and 16% in Fiscal 2007. We expect +to continue to increase our Transportation Systems staff in Fiscal 2009. We believe the ability of our Transportation +Systems business to grow and successfully win and service new contracts will be +highly dependent upon our continued success in recruiting and retaining +qualified personnel. All of our contract +revenues are derived from work performed in North America under a broad range +of fixed price and cost plus fixed fee contracts. +25 +Gross +Profit . Total gross profit increased 17.9% to $28.3 million +in Fiscal 2008 compared to $24.0 million in Fiscal 2007, and increased 12.2% in +Fiscal 2007 compared to $21.4 million in Fiscal 2006. Total gross profit as a percent of net sales +and contract revenues increased to 43.4% in Fiscal 2008 compared to 41.2% in +Fiscal 2007 and decreased in Fiscal 2007 from 42.4% in Fiscal 2006. +Gross profit as a +percentage of net sales was 49.2% in Fiscal 2008 compared to 45.3% in Fiscal +2007 and 47.1% in Fiscal 2006. The +increase in gross profit as a percentage of net sales in Fiscal 2008 was a +result of a favorable sales mix in terms of both geography and product mix, as +well as improved production efficiencies. +Gross profit as a percentage of net sales also improved in Fiscal 2008 +through the expansion of our Vehicle Sensors customer base, which helped +mitigate the impact of lower contractual pricing to our largest European +customer. The decrease in gross profit +as a percentage of net sales in Fiscal 2007 compared to Fiscal 2006 was +primarily due to volume discounts given to our largest Vehicle Sensors product +customer, as well as an overall decline in unit volumes to this customer. Fiscal 2007 gross profit as a percentage of +net sales in our Roadway Sensors division was relatively consistent with Fiscal +2006 gross profit as a percentage of net sales. +Gross profit as a percentage of net sales can fluctuate in any specific +quarter or year based on customer and product mix, as well as possible shifts +of engineering resources from development activities to sustaining activities, +which we record as cost of goods sold. +Gross profit as a percent of net sales has fluctuated over the last five +years from a low of 45.2% in Fiscal 2005 to a high of 49.2% in Fiscal 2008. +Gross profit as a +percentage of contract revenues decreased to 34.1% in Fiscal 2008 compared to +34.4% in Fiscal 2007 and decreased from 34.8% in Fiscal 2006. We recognize +contract revenues and related gross profit using percentage of completion +contract accounting and the underlying mix of contract activity affects the +related gross profit recognized in any given period. The decreases in gross profit as a percent of +contract revenues in Fiscal 2008 compared to Fiscal 2007, and in Fiscal 2007 +compared to Fiscal 2006 reflect a contract mix weighted more toward lower +margin contracts in those periods. Lower +margin contracts generally have a higher proportion of sub-consulting revenues +associated with them. +Selling, +General and Administrative Expense . Selling, general and +administrative expense increased 8.0% to $17.3 million (or 26.5% of total net +sales and contract revenues) in Fiscal 2008 compared to $16.0 million (or 27.4% +of total net sales and contract revenues) in Fiscal 2007, and increased 3.8% in +Fiscal 2007 compared to $15.4 million (or 30.5% of total net sales and contract +revenues) in Fiscal 2006. The increase +in selling, general and administrative expense in Fiscal 2008 compared to +Fiscal 2007 was largely attributable to higher commissions and selling expenses +driven by sales growth in our Roadway Sensors segment, as well as general and +administrative expenses incurred related to our efforts to comply with the +internal control attestation requirements of the Sarbanes-Oxley Act. In Fiscal 2009, we expect to continue to +experience increased selling, general and administrative expenses as we pursue +further sales growth. Furthermore, we +expect to experience further increases in general and administrative expenses +as we continue our efforts to comply with the internal control attestation +requirements of the Sarbanes-Oxley Act. +The increase in selling, +general and administrative expense in Fiscal 2007 compared to Fiscal 2006 was +mainly a result of higher commissions associated with increased Roadway Sensors +net sales and increased sales and marketing activities in our Transportation +Systems segment. Additionally, selling, +general and administrative expense included legal expenses associated with the +settlement of litigation described in Note 6 of Notes to Consolidated Financial +Statements, a severance accrual of approximately $300,000 associated with the +departure of our former Chief Executive Officer in March 2007 and $180,000 +related to the write-off of past-due accounts receivable related to rent and +other services provided to our former subsidiary, MAXxess (Note 6 of Notes to +Consolidated Financial Statements). No +further expense is expected to be incurred in connection with the aforementioned +lawsuit or the severance arrangement with our former Chief Executive +Officer. We have written off all +balances receivable from MAXxess based on our accounts receivable accounting +policy, but will continue to work with MAXxess to attempt to collect amounts +due to us. Certain members of our Board +of Directors are part of MAXxess management and ownership. +Research +and Development Expense . Research and development expense +decreased 11.5% to $3.6 million (or 5.5% of total net sales and contract +revenues) in Fiscal 2008 compared to $4.0 million (or 6.9% of total net sales +and contract revenues) in Fiscal 2007, and decreased 22.8% in Fiscal 2007 +compared to $5.2 million (or 10.3% of total net sales and contract revenues) in +Fiscal 2006. The decrease in research +and development expense in Fiscal 2008 compared to Fiscal 2007 was primarily +due to reduced research and development activities in Vehicle Sensors as many +of our significant truck OEM customers now have production LDW units that only +require minimal further development and the majority of our passenger car +research and development efforts are funded by our strategic partner, +Valeo. This decreased spending was +partially offset by increased research and development spending in Roadway +Sensors. We believe research and +development activities are crucial to our ability to continue to be a leader in +our markets, and we expect our Fiscal 2009 research and development +expenditures to increase from Fiscal 2008 levels. +26 +The decrease in research +and development expense in Fiscal 2007 compared to Fiscal 2006 was largely a +result of higher than anticipated costs in Fiscal 2006 in Vehicle Sensors as we +expended significant development resources in qualifying the next generation +LDW system with our largest customer, as well as several other heavy truck OEMs. +Additionally, in Fiscal 2007, there was a shift in engineering resources from +research and development activities to product support activities as a result +of new product introductions and improvements in Roadway Sensors. Costs associated with product support +activities are included in cost of net sales rather than research and +development expense. +For competitive reasons, +we closely guard the confidentiality of specific development projects. +Other +Income (Expense), Net . Other income (expense), net reflects +the following: +Year Ended March 31, +2008 +2007 +2006 +(In thousands) +Gain on early +extinguishment of debt +$ +224 +$ +— +$ +— +Settlement of +lawsuits +— +(635 +) +— +Other +28 +(18 +) +35 +Other income +(expense), net +$ +252 +$ +(653 +) +$ +35 +Other +income (expense), net in Fiscal 2008 primarily reflects the gain of $224,000 we +recognized in connection with the early retirement of $2.1 million of +convertible debentures, which is discussed in Note 4 of Notes to Consolidated +Financial Statements. Other income +(expense), net in Fiscal 2007 primarily reflects $635,000 of expense recorded +in connection with the settlement of litigation in July 2006, which is +discussed in Note 6 of Notes to Consolidated Financial Statements. +Interest +Expense, Net . Interest expense, net reflects the net of +interest expense and interest income as follows: +Year Ended March 31, +2008 +2007 +2006 +(In thousands) +Interest expense +$ +(1,285 +) +$ +(1,601 +) +$ +(1,461 +) +Interest income +1 +1 +2 +Interest +expense, net +$ +(1,284 +) +$ +(1,600 +) +$ +(1,459 +) +Interest +expense, net decreased 19.8% in Fiscal 2008 compared to Fiscal 2007 and +increased 9.7% in Fiscal 2007 compared to Fiscal 2006. The decrease in interest expense in Fiscal +2008 compared to Fiscal 2007 was primarily due to a lower level of borrowings +as well as a lower interest rate on our line of credit, which bears interest at +a rate indexed to the prime rate. The +increase in interest expense in Fiscal 2007 compared to Fiscal 2006 was mainly +related to the October 2006 refinancing of our bank term note and line of +credit with a new bank, which resulted in a slightly higher interest rate on +our bank borrowings. +Income +Taxes . During Fiscal 2008, we recognized an income tax +benefit of $5.9 million and at March 31, 2008 our consolidated balance +sheet included net deferred tax assets of $10.3 million. The ability to record the deferred tax asset +was based on the more likely than not criteria of SFAS No. 109, Accounting for Income Taxes . +During Fiscal 2007, we recognized an income tax benefit of $1.3 million +and at March 31, 2007, our consolidated balance sheet included net +deferred tax assets of $3.0 million. The +income tax benefits recorded in Fiscal 2008, Fiscal 2007 and Fiscal 2006 were +primarily the result of a decrease in the valuation allowance recorded against +our deferred tax assets as a result of changes in estimates of the future +realizability of these assets. In the +future, we may continue to record similar adjustments to our deferred tax asset +valuation allowance as our estimates are updated. We anticipate this will cause our future +overall effective tax rate in any given period to fluctuate from prior +effective tax rates and statutory tax rates. +At March 31, 2008, +we had $44.7 million of federal net operating loss carryforwards and +$16.6 million of state net operating loss carryforwards that begin to +expire in 2019 and 2013, respectively. Due to changes in stock ownership, our +federal net operating loss carryforwards are subject to a Section 382 +limitation estimated at approximately $7.8 million annually which can be +utilized to offset federal consolidated taxable income. Although the impact cannot be precisely +determined, we believe that our net operating loss carryforwards and the +valuation allowance we have recorded against our net deferred tax assets in our +consolidated balance sheets will cause us to have future income tax payments and +income tax expense that are substantially lower than the income tax liability +and income tax expense calculated using statutory tax rates. +27 +In Fiscal 2008, we +adopted FIN 48. See Notes 1 and 5 of +Notes to Consolidated Financial Statements for further discussion regarding our +implementation of FIN 48. +Stock-Based +Compensation Expense . +In Fiscal 2007, we adopted SFAS 123R using the modified prospective +approach. Stock-based compensation +expense remained relatively consistent in Fiscal 2008 and Fiscal 2007 at +$290,000 and $288,000, respectively. See +Notes 1 and 9 of Notes to Consolidated Financial Statements for additional +discussion regarding our implementation of SFAS 123R. +Liquidity +and Capital Resources +Cash Flows +We have historically financed our operations with a +combination of cash flows from operations, borrowings under credit facilities +and the sale of equity securities. We currently rely on cash flows from +operations and borrowings on a line of credit facility to fund our operations, +which we believe to be sufficient to fund our operations for at least the next +twelve months. At March 31, 2008, +we had $14.9 million in working capital, which included no borrowings on our +$10.0 million line of credit and $421,000 in cash and cash equivalents, as +compared to working capital of $7.0 million at March 31, 2007, which +included borrowings of $4.0 million on our line of credit and $35,000 in cash +and cash equivalents. Our operations +provided $7.6 million of cash during Fiscal 2008, primarily as a result of net +income adjusted for non-cash items within the statement of operations. During Fiscal 2007, our operations used $2.0 +million of cash, primarily as a result of investments in inventory due to sales +growth and longer lead times in procuring certain components, and an increased +level of net costs and estimated earnings in excess of billings due to sales +growth and the timing of invoicing on contracts in our Transportation Systems +segment. These were partially offset by +net income of $2.9 million. During +Fiscal 2006, our operations provided $218,000 of cash, primarily as a result of +planned decreases in inventory and the timing of payments on accrued expenses and +payables, which were partially offset by increases in accounts receivable and +net costs and estimated earnings in excess of billings on uncompleted +contracts, both as a result of sales growth. +Investing activities for Fiscal 2008, Fiscal 2007 and +Fiscal 2006 consisted primarily of purchases of property and equipment, which +aggregated $739,000, $488,000 and $1.3 million, respectively. In Fiscal 2006, capital expenditures were +higher primarily due to hardware, software and related labor costs to implement +a new enterprise resource management system, which was placed in service at the +beginning of Fiscal 2007. +Cash used in financing activities was $6.5 million in +Fiscal 2008, which was the net result of net payments on borrowings of $8.0 +million offset by cash inflows of $1.5 million from the exercise of outstanding +stock options and warrants to purchase our common stock. During Fiscal 2007, financing activities +provided $2.4 million of cash, which was the net result of net payments on +borrowings of $1.2 million, offset by cash inflows of $3.6 million from the +exercise of outstanding stock options and warrants to purchase our common +stock. As discussed in Note 8 of Notes +to Consolidated Financial Statements, approximately $2.0 million of the $3.6 +million in proceeds from the exercise of stock options and warrants was raised +through the exercise of outstanding warrants to purchase an aggregate of +1,250,000 shares of our common stock. +During Fiscal 2006, financing activities provided $1.1 million of cash +as a result of net borrowings of $792,000 and cash inflows of $333,000 from the +exercise of outstanding stock options and warrants to purchase our common +stock. +Borrowings +The following table +summarizes our borrowings and long-term debt: +At March 31, 2008 +(In thousands) +Convertible debentures, +net +$ +7,566 +Bank term note +210 +Other +34 +$ +7,810 +In October 2006, +we entered into a two-year credit facility with a bank which includes our line +of credit and bank term note. The credit facility provides for line of credit +borrowings of up to $10.0 million against our eligible accounts +28 +receivable and inventory, as defined in the credit agreement. The term +note provided for monthly principal payments of approximately $104,000 and +matured in May 2008. The interest rate on the line of credit is the +current stated prime rate plus 1.00%, and the interest rate on the bank term +note was fixed at an annual rate of 8.75%. We are obligated to pay an unused +line fee of 0.25% per annum applied to the amount by which the maximum credit +amount exceeds the average daily principal balance during the preceding month. +The credit facility also requires $2,000 in monthly collateral management fees +and includes an early termination fee equal to 1% of the total facility. The +credit facility is secured by substantially all of our assets. At March 31, +2008, we had $8.6 million available under our credit facility, all of which was +unused. +Contractual Obligations +Our contractual +obligations were as follows at March 31, 2008: +Payments Due by Period +2009 +2010 +2011 +2012 +2013 +Thereafter +Total +(In thousands) +Notes payable +$ +244 +$ +— +$ +— +$ +— +$ +— +$ +— +$ +244 +Convertible +debentures +— +7,750 +— +— +— +— +7,750 +Operating leases +1,594 +1,431 +1,366 +1,332 +1,363 +2,460 +9,546 +Total +$ +1,838 +$ +9,181 +$ +1,366 +$ +1,332 +$ +1,363 +$ +2,460 +$ +17,540 +At March 31, 2008, +we had firm commitments to purchase inventory in the amount of $2.3 million +during the first and second quarters of Fiscal 2009. +Off +Balance Sheet Arrangements +In May 2004, we issued +subordinated convertible debentures in an aggregate original principal amount +of $10.1 million. These debentures are due in full on May 19, 2009 +and are convertible into shares of our common stock at a conversion price of +$3.61 per share. At March 31, 2008, convertible debentures in an aggregate +principal amount of $7.8 million remained outstanding. Because these debentures +are conventionally convertible, we have not separately accounted for the +conversion feature and, accordingly, no separate amounts are presented in our +consolidated financial statements in connection with this conversion feature. +At March 31, 2008, +outstanding warrants to purchase an aggregate of 246,250 shares of our +common stock at an exercise price of $3.25 per share are callable by us if the +market price of our common stock trades for 20 consecutive days at a price +equal to or greater than two times the exercise price of the warrants. Outstanding +w arrants to purchase an aggregate of 75,000 shares of our common +stock at an exercise price of $5.00 per share are callable by us if the market +price of our common stock trades for 20 consecutive days at a price equal to or +greater than one and a half times the exercise price of the warrants. +In connection with the +issuance of warrants to purchase 246,250 shares of our common stock at $3.25 +per share, we are a party to a registration rights agreement that contains +provisions under which we could be subjected to liquidated damages should we +fail to maintain effective registration statements for the shares of common +stock issuable upon exercise of certain underlying warrants. These warrants +have been accounted for within equity in our consolidated balance sheets in +accordance with EITF Issue No. 00-19, Accounting for Derivative +Financial Instruments Indexed to, and Potentially Settled in, a Company’s Own +Stock , and, accordingly, no liabilities have been recorded in +connection therewith. As of the date of this filing, no liquidated damages are +payable under the provisions of the registration rights agreement associated +with these warrants. +Recent +Accounting Pronouncements +In September 2006, +the FASB issued SFAS No. 157, Fair Value Measurements +(“SFAS 157”), which defines fair value, establishes a framework for measuring +fair value, and expands disclosure about fair value measurements. SFAS 157 does +not require any new fair value measurements; rather it specifies valuation +methods to be applied when fair value measurements are required under existing +or future accounting pronouncements. SFAS 157 is effective for fiscal years +beginning after November 15, 2007, and interim periods within those fiscal +years. In February 2008 the FASB issued FSP 157-2, Effective +Date of FASB Statement No. 157 , which delays +the effective date of SFAS 157 for non-financial assets and liabilities to +fiscal years beginning after November 15, 2008. Generally, this statement will +be applied prospectively. We are currently evaluating the impact of SFAS 157 +and expect to adopt SFAS 157 in the first quarter of our fiscal year ending March 31, +2009. +29 +In February 2007, +the FASB issued SFAS No. 159, The Fair Value Option for +Financial Assets and Financial Liabilities — Including an Amendment of FASB +Statement No. 115 (“SFAS 159”). SFAS 159 permits entities to +choose to measure many financial instruments and certain other items at fair +value. Unrealized gains and losses on items for which the fair value option has +been elected will be recognized in earnings at each subsequent reporting date. +SFAS 159 is effective for financial statements issued for fiscal years +beginning after November 15, 2007. +We are evaluating the impact that the adoption of SFAS 159 will have on +our results of operations and financial condition and expect to adopt SFAS 159 +in our fiscal year ending March 31, 2009. +Seasonality +We have historically +experienced seasonality, particularly with respect to our Roadway Sensors net +sales in the third and fourth fiscal quarters due to a reduction in road +construction and repairs during the winter months due to inclement weather +conditions. +ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES +ABOUT MARKET RISK +Our exposure to interest +rate risk is limited to our line of credit. Our line of credit bears interest +based on the prevailing prime rate (5.25% at March 31, 2008). We do not believe that a 10% increase in the +interest rate on our line of credit (from 6.25% to 6.88%) would have a material +impact on our financial position, operating results or cash flows. In addition, +we believe that the carrying value of our outstanding debt approximates fair +value. +ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY +DATA +The financial statements +and supplementary data required by Regulation S-X are included in Part IV, +Item 15 of this report. +ITEM 9. CHANGES IN AND DISAGREEMENTS WITH +ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE +None. +ITEM 9A(T). CONTROLS AND PROCEDURES +(a) Evaluation of disclosure controls and +procedures. In accordance with Rule 13a-15(b) of +the Securities Exchange Act of 1934, as of the end of the period covered by +this Annual Report on Form 10-K, the Company’s management evaluated, with +the participation of the Company’s President and Chief Executive Officer and +the Chief Financial Officer, the effectiveness of the design and operation of +the Company’s disclosure controls and procedures (as defined in Rule 13a-15(e) under +the Exchange Act). Based upon their evaluation of these disclosure controls and +procedures, the President and Chief Executive Officer and the Chief Financial +Officer have concluded that the disclosure controls and procedures were +effective as of the date of such evaluation in ensuring that information +required to be disclosed in the Company’s Exchange Act reports is (1) recorded, +processed, summarized and reported in a timely manner, and (2) accumulated +and communicated to management, including the Company’s President and Chief +Executive Officer and the Chief Financial Officer, as appropriate, to allow +timely decisions regarding required disclosure. +(b) +Changes in internal control. There was no change in the Company’s +internal control over financial reporting that occurred during the period +covered by this Annual Report on Form 10-K that has materially affected, +or is reasonably likely to materially affect, the Company’s internal control +over financial reporting. +Management’s Report on Internal +Control Over Financial Reporting +Management of the Company +is responsible for establishing and maintaining adequate internal control over +financial reporting. Our internal control system was designed to provide +reasonable assurance to management and the board of directors regarding the +effectiveness of our internal control processes over the preparation and fair +presentation of published financial statements. +All internal +control systems, no matter how well designed, have inherent limitations. +Therefore, even those systems determined effective can provide only reasonable +assurance with respect to financial statement preparation and presentation. +30 +We have assessed +the effectiveness of our internal controls over financial reporting as of March 31, +2008. In making this assessment, we used the criteria set forth by the +Committee of Sponsoring Organizations of the Treadway Commission (COSO) in +Internal Control—Integrated Framework. Based on our assessment, we believe +that, as of March 31, 2008, our internal control over financial reporting +is effective based on those criteria. +This annual report +does not include an attestation report of the Company’s independent registered +public accounting firm regarding internal control over financial reporting. +Management’s report was not subject to attestation by the Company’s independent +registered public accounting firm pursuant to the rules of the Securities +and Exchange Commission that permit the Company to provide only management’s +report in this annual report. +ITEM 9B . OTHER INFORMATION +On June 11, 2008, we +entered into a change in control agreement with James Miele, our Chief +Financial Officer. Pursuant to the terms +of the agreement, in the event of an Involuntary Termination (as defined in the +agreement) of Mr. Miele’s employment in connection with or within twelve +months after a change in control, Mr. Miele will be entitled to receive a +lump sum severance payment of up to one year’s base pay and 50% of his target +bonus for the year. In addition, Mr. Miele +will be entitled to receive reimbursement for the cost of COBRA coverage for a +period of up to one year following the termination of his employment. The agreement terminates on the fifth +anniversary of the date of the agreement, unless earlier terminated in +accordance therewith. +PART III +ITEM 10. DIRECTORS, +EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE +(a) Identification of Directors. The +information under the caption “Election of Directors,” appearing in our proxy +statement for the 2008 Annual Meeting of Stockholders, is incorporated herein +by reference. +(b) Identification of Executive Officers. The +information under the caption “Executive Compensation and Other Information - +Executive Officers,” appearing in our proxy statement for the 2008 Annual +Meeting of Stockholders, is incorporated herein by reference. +(c) Compliance with Section 16(a) of the +Exchange Act. The information under the caption “Section 16(a) Beneficial +Ownership Reporting Compliance” appearing in our proxy statement for the 2008 +Annual Meeting of Stockholders is incorporated herein by reference. +(d) Corporate Governance . +The information under the caption “Corporate Governance,” appearing in our proxy +statement for the 2008 Annual Meeting of Stockholders, is incorporated herein +by reference. +(e) Audit Committee . +The information under the caption “Board Meetings and Committees – Audit +Committee,” appearing in our proxy statement for the 2008 Annual Meeting of +Stockholders, is incorporated herein by reference. +ITEM 11. EXECUTIVE +COMPENSATION +The information under the +caption “Executive Compensation and Other Information,” appearing in our proxy +statement for the 2008 Annual Meeting of Stockholders, is incorporated herein +by reference. +ITEM 12 . SECURITY +OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER +MATTERS +The information under the +captions “Equity Compensation Plans” and “Principal Stockholders and Common +Stock Ownership of Certain Beneficial Owners and Management,” appearing in our +proxy statement for the 2008 Annual Meeting of Stockholders, is incorporated +herein by reference. +ITEM 13. CERTAIN RELATIONSHIPS AND RELATED +TRANSACTIONS, AND DIRECTOR INDEPENDENCE +The information under the +captions “Corporate Governance – Director Independence” and “Certain +Transactions,” appearing in our proxy statement for the 2008 Annual Meeting of +Stockholders, is incorporated herein by reference. +31 +ITEM 14. PRINCIPAL ACCOUNTING FEES AND SERVICES +The information under the +caption “Fees Paid to Independent Registered Public Accounting Firm,” appearing +in our proxy statement for the 2008 Annual Meeting of Stockholders, is +incorporated herein by reference. +PART IV +ITEM 15. EXHIBITS AND FINANCIAL STATEMENT +SCHEDULES +(a) Documents +filed as part of this report: +1. Financial Statements. The following +financial statements of Iteris, Inc. are included in a separate +section of this Annual Report on Form 10-K commencing on the pages referenced +below: +Report of Independent +Registered Public Accounting Firm +40 +Consolidated +Balance Sheets as of March 31, 2008 and 2007 +41 +Consolidated Statements of Operations for the years +ended March 31, 2008, 2007 and 2006 +43 +Consolidated Statements of Stockholders’ Equity and +Comprehensive Income for the years ended March 31, 2008, 2007 and 2006 +44 +Consolidated Statements of Cash Flows for the years +ended March 31, 2008, 2007 and 2006 +45 +Notes to Consolidated Financial Statements +46 +2. Financial Statement Schedules . +Schedule II — Valuation +and Qualifying Accounts +63 +All other schedules have been omitted because they are +not required or the required information is included in our consolidated +financial statements and notes thereto. +3. Exhibits . +The following exhibits are filed herewith or +incorporated by reference to the location indicated below: +Exhibit +Number +Description +Where Located +3.1 +Amended and Restated Certificate of Incorporation of +the registrant +Exhibit 3.1 to the registrant’s Current +Report on Form 8-K as filed with the SEC on October 28, 2004 +3.2 +Certificate of Amendment to Amended and Restated +Certificate of Incorporation effective September 26, 2007 +Exhibit 3.2 to the registrant’s Quarterly +Report on Form 10-Q for the quarter ended September 30, 2007 as +filed with the SEC on November 13, 2007 +3.3 +Bylaws of the registrant, as amended +Exhibit 4.2 to the registrant’s Registration +Statement on Form S-1 (Reg. No. 033-67932) as filed with the SEC on +July 6, 1993 +3.4 +Certificates of Amendment to Bylaws of the +registrant dated April 24, 1998 and August 10, 2001 +Exhibit 3.4 to the registrant’s Annual +Report on Form 10-K/A for the year ended March 31, 2003 as filed +with the SEC on July 29, 2003 +3.5 +Certificate of Amendment to Bylaws of registrant +dated September 9, 2004 +Exhibit 3.1 to the registrant’s Quarterly +Report on Form 10-Q for the quarter ended September 30, 2004 as +filed with the SEC on November 15, 2004 +32 +Exhibit +Number +Description +Where Located +3.6 +Certificate of Amendment to Bylaws of registrant +effective September 16, 2005 +Exhibit 3.5 to the registrant’s Annual +Report on Form 10-K for the year ended March 31, 2007 +3.7 +Certificate of Amendment to Bylaws of registrant +effective December 7, 2007 +Exhibit 3.1 to the registrant’s Current +Report on Form 8-K as filed with the SEC on December 13, 2007 +4.1 +Specimen of common stock certificate +Exhibit 4.1 to registrant’s Registration +Statement on Form 8-A as filed with the SEC on December 8, 2004 +4.2 +Amended and Restated Rights Agreement, dated as of +May 10, 2004, by and between the registrant and U.S. Stock Transfer +Corporation, including exhibits thereto +Exhibit 99.1 to the registrant’s +Registration Statement on Form 8-A/A as field with the SEC on +June 18, 2004 +10.1* +Profit Sharing Plan and Trust +Exhibit 10.3 to the registrant’s Amendment +No. 2 to the Registration Statement on Form S-8 (Reg. +No. 002-98656) as filed with the SEC on May 5, 1988 +10.2* +Amendment Nos. 3 and 4 to the Profit Sharing Plan +and Trust +Exhibits 4.3.1 and 4.3.2, respectively, to +Amendment No. 3 to the registrant’s Registration Statement on +Form S-3 (Reg. No. 002-86220) as filed with the SEC on +June 13, 1990 +10.3* +Form of Executive Deferral Plan between the +registrant and certain employees of the registrant +Exhibit 10.4 to the registrant’s Annual +Report on Form 10-K for the year ended March 31, 1988 +10.4 +Form of Indemnity Agreement entered into by the +registrant and certain of its officers and directors +Exhibit 19.4 to the registrant’s Quarterly +Report on Form 10-Q for the quarter ended September 30, 1988 +10.5 +Form of Indemnification Agreement entered into +by the registrant and certain of its officers and directors +Exhibit 10.5 to the registrant’s Annual +Report on Form 10-K for the year ended March 31, 2004 as filed with +the SEC on June 29, 2004 +10.6* +1997 Stock Incentive Plan (as amended on May 3, +2003, as further amended on December 15, 2004) +Exhibit 10.32 to the registrant’s Annual +Report on Form 10-K for the year ended March 31, 2005 as filed with +the SEC on July 14, 2005 +10.7* +Form of Notice of Grant of Stock Option +Exhibit 99.2 to the registrant’s +Registration Statement on Form S-8 (File No. 333-30396) as filed +with the SEC on February 14, 2000 +10.8* +Form of Stock Option Agreement +Exhibit 99.3 to the registrant’s +Registration Statement on Form S-8 (File No. 333-30396) as filed +with the SEC on February 14, 2000 +10.9* +Form of Addendum to Stock Option +Agreement—Involuntary Termination Following Corporate Transaction or Change +in Control +Exhibit 99.4 to the registrant’s Registration +Statement on Form S-8 (File No. 333-30396) as filed with the SEC on +February 14, 2000 +10.10* +Form of Addendum to Stock Option +Agreement—Limited Stock Appreciation Rights +Exhibit 99.5 to the registrant’s +Registration Statement on Form S-8 (File No. 333-30396) as filed +with the SEC on February 14, 2000 +33 +Exhibit +Number +Description +Where Located +10.11* +Form of Stock Issuance Agreement +Exhibit 99.6 to the registrant’s +Registration Statement on Form S-8 (File No. 333-30396) as filed +with the SEC on February 14, 2000 +10.12* +Form of Addendum to Stock Issuance +Agreement—Involuntary Termination Following Corporate Transaction/Change in +Control +Exhibit 99.7 to the registrant’s +Registration Statement on Form S-8 (File No. 333-30396) as filed +with the SEC on February 14, 2000 +10.13* +Form of Notice of Grant of Automatic Stock +Option—Initial Grant +Exhibit 99.8 to Exhibit 99.8 to +registrant’s Registration Statement on Form S-8 (File +No. 333-30396) as filed with the SEC on February 14, 2000 +10.14* +Form of Notice of Grant of Automatic Stock +Option—Annual Grant +Exhibit 99.9 to the registrant’s +Registration Statement on Form S-8 (File No. 333-30396) as filed +with the SEC on February 14, 2000 +10.15* +Form of Automatic Stock Option Agreement. +Exhibit 99.10 to the registrant’s +Registration Statement on Form S-8 (File No. 333-30396) as filed +with the SEC on February 19, 2000 +10.16 +Amended and Restated Agreement of Purchase and Sale +and Escrow Instructions, dated February 19, 2002, by and between +Iteris, Inc. and 1515 South Manchester, LLC +Exhibit 2.1 to the +registrant’s Current Report on Form 8-K as filed with the SEC on +June 12, 2002 +10.17* +Change in Control Agreement dated May 8, 2003 +by and between the registrant and Gregory A. Miner +Exhibit 10.1 to the +registrant’s Quarterly Report on Form 10-Q for the quarter ended +June 30, 2003 as filed with the SEC on August 14, 2003 +10.18* +Change in Control Agreement dated May 20, 2003 +by and between the registrant and Jack E. Johnson +Exhibit 10.23 to Amendment +No. 1 to the registrant’s Registration Statement on Form S-1 as +filed with the SEC on February 17, 2004 +10.19* +Iteris Inc. 1998 Stock Incentive Plan (as amended on +February 7, 2000) +Exhibit 10.24 to the +registrant’s Annual Report on Form 10-K for the year ended +March 31, 2005 as filed with the SEC on July 14, 2005 +10.20* +Form of Notice of Grant, including forms of +Option Agreement and Stock Purchase Agreement for the following directors and +executive officers: Gary Hernandez, Dr. Hartmut Marwitz, Paul E. Wright, +Jack Johnson, Richard D. Crawshaw, Gregory McKhann, Francis Memole, James S. +Miele, Abbas Mohaddes and Stephen Edwin Rowe +Exhibit 99.2 to the +registrant’s Registration Statement on Form S-8 (File +No. 333-126834) as filed with the SEC on July 22, 2005 +10.21* +Form of Addendum to Stock Option Agreement +Exhibit 99.3 to the +registrant’s Registration Statement on Form S-8 (File +No. 333-126834) as filed with the SEC on July 22, 2005 +10.22* +Form of 1997 Stock Option Agreements +Exhibit 99.4 to the +registrant’s Registration Statement on Form S-8 (File +No. 333-126834) as filed with the SEC on July 22, 2005 +10.23* +Iteris, Inc. Deferred Compensation Savings Plan +and Grantor Trust +Exhibit 10.31 to the +registrant’s Annual Report on Form 10-K for the year ended +March 31, 2005 as filed with the SEC on July 14, 2005 +34 +Exhibit +Number +Description +Where Located +10.24+ +Cooperative Agreement for Development, Manufacture, +Marketing and Sale of Products to the Class 1 and Class 2 Vehicle +Markets Incorporating Iteris’ LDWS Technology (Valeo Schalter and Sensoren +GmbH) +Exhibit 10.1 to the +registrant’s Quarterly Report on Form 10-Q for the quarter ended +June 30, 2004 as filed with the SEC on August 16, 2004 +10.25 +Warrant Exercise Agreement dated September 27, +2006 by and among the registrant and Special Situations Fund III QP, L.P., +Special Situations Fund III, L.P., Special Situations Cayman Fund, L.P. and +Special Situations Private Equity Fund, L.P. +Exhibit 10.1 to the +registrant’s Quarterly Report on Form 10-Q for the quarter ended +September 30, 2006 as filed with the SEC on November 14, 2006. +10.26 +Registration Rights Agreement dated +September 28, 2006 by and among the registrant and Special Situations +Fund III QP, L.P., Special Situations Fund III, L.P., Special Situations +Cayman Fund, L.P. and Special Situations Private Equity Fund, L.P. +Exhibit 10.2 to the +registrant’s Quarterly Report on Form 10-Q for the quarter ended +September 30, 2006 as filed with the SEC on November 14, 2006. +10.27+ +National Intelligent Transportation Systems (ITS) +Architecture Evolution and Support Award/Contract effective as of +October 1, 2006 by and between the registrant and the Federal Highway +Administration +Exhibit 10.3 to the +registrant’s Quarterly Report on Form 10-Q for the quarter ended +September 30, 2006 as filed with the SEC on November 14, 2006. +10.28 +Loan and Security Agreement effective as of +October 16, 2006 by and between the registrant and Silicon Valley Bank +Exhibit 10.4 to the +registrant’s Quarterly Report on Form 10-Q for the quarter ended +September 30, 2006 as filed with the SEC on November 14, 2006. +10.29 +Intellectual Property Security Agreement dated +October 9, 2006 by and between the registrant and Silicon Valley Bank +Exhibit 10.5 to the registrant’s Quarterly +Report on Form 10-Q for the quarter ended September 30, 2006 as +filed with the SEC on November 14, 2006. +10.30+ +Settlement Agreement, effective August 15, +2006, by and between the registrant and Delta Networks, Inc. +Exhibit 10.1 to the registrant’s Current +Report on Form 8-K as filed with the SEC on August 21, 2006 +10.31* +Offer letter effective February 28, 2007 by and +between the registrant and Abbas Mohaddes +Exhibit 10.1 to the registrant’s Current +Report on Form 8-K as filed with the SEC on March 6, 2007 +10.32* +Separation Agreement and Release of Claims dated +March 1, 2007 by and between the registrant and Jack Johnson +Exhibit 10.2 to the registrant’s Current +Report on Form 8-K as filed with the SEC on March 6, 2007 +10.33 +Sublease Agreement, dated September 30, 2003, +by and between Odetics, Inc. and Maij, Inc. +Exhibit 10.1 to the registrant’s Quarterly +Report on Form 10-Q as filed with the SEC on August 14, 2007 +10.34 +Office Lease Agreement, dated May 24, 2007, by +and between Crown Carnegie Associates, LLC and Iteris, Inc. +Exhibit 10.2 to the registrant’s Quarterly +Report on Form 10-Q as filed with the SEC on August 14, 2007 +10.35 +Termination Agreement, dated May 30, 2007, by +and among Transportation Planning Group, Inc., Abbas Mohaddes and +Iteris, Inc. +Exhibit 10.3 to the registrant’s Quarterly +Report on Form 10-Q as filed with the SEC on August 14, 2007 +35 +Exhibit +Number +Description +Where Located +10.36* +2007 Omnibus Incentive Plan and forms of agreements +Appendix A to the registrant’s Definitive Proxy +Statement on Schedule 14A as filed with the SEC on August 10, 2007 +10.37 +Amendment to Loan and Security Agreement, dated +October 17, 2007, by and between Silicon Valley Bank and +Iteris, Inc. +Exhibit 10.1 to the registrant’s Current +Report on Form 8-K as filed with the SEC on October 23, 2007 +10.38 +Debenture Redemption Agreement, dated +February 11, 2008, by and among Potomac Capital Partners, LP, Potomac +Capital International Ltd. and Iteris, Inc. +Exhibit 10.1 to the +registrant’s Current Report on Form 8-K as filed with the SEC on +February 15, 2008 +10.39 +Debenture Redemption Agreement, dated +February 27, 2008, by and between Gruber & McBaine +International and Iteris, Inc. +Exhibit 10.1 to the +registrant’s Current Report on Form 8-K as filed with the SEC on +February 29, 2008 +10.40 +Debenture Redemption Agreement, dated +February 27, 2008, by and between Lagunitas Partners, LP and +Iteris, Inc. +Exhibit 10.2 to the +registrant’s Current Report on Form 8-K as filed with the SEC on +February 29, 2008 +10.41 +Debenture Redemption Agreement, dated +February 27, 2008, by and between Jon D. and Linda W. Gruber Trust and +Iteris, Inc. +Exhibit 10.3 to the +registrant’s Current Report on Form 8-K as filed with the SEC on +February 29, 2008 +10.42* +Change in Control Agreement dated June 11, 2008 +by and between James S. Miele and Iteris, Inc. +Filed Herewith +21 +Subsidiaries of the registrant +Filed Herewith +23 +Consent of Independent Registered Public Accounting +Firm +Filed Herewith +31.1 +Certification of the Chief Executive Officer +Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 +Filed Herewith +31.2 +Certification of the Chief Financial Officer +Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 +Filed Herewith +32.1 +Certification of the Chief Executive Officer +Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to +Section 906 of the Sarbanes-Oxley Act of 2002 +Filed Herewith +32.2 +Certification of the Chief Financial Officer +Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to +Section 906 of the Sarbanes-Oxley Act of 2002 +Filed Herewith +* Indicates a management contract or compensatory plan +or arrangement ++ Confidential treatment has been requested for +certain confidential portions of this exhibit pursuant to Rule 24b-2 of +the Securities Exchange Act of 1934, as amended. In accordance with Rule 24b-2, +these confidential portions have been omitted from the exhibit and filed +separately with the SEC. +36 +SIGNATURES +Pursuant to the +requirements of Section 13 or 15(d) of the Securities Exchange Act of +1934, the registrant has duly caused this report to be signed on its behalf by +the undersigned, thereunto duly authorized. +ITERIS, INC. +(Registrant) +By +/s/ ABBAS MOHADDES +Abbas Mohaddes +President and Chief Executive Officer +37 +POWER OF ATTORNEY +We, the undersigned +officers and directors of Iteris, Inc., do hereby constitute and appoint +James S. Miele and Abbas Mohaddes, and each of them, our true and lawful +attorneys-in-fact and agents, each with full power of substitution and +resubstitution, for him and in his name, place and stead, in any and all +capacities, to sign any and all amendments to this report, and to file the +same, with exhibits thereto, and other documents in connection therewith, with +the Securities and Exchange Commission, granting unto said attorneys-in-fact +and agents, and each of them, full power and authority to do and perform each +and every act and thing requisite or necessary to be done in and about the +premises, as fully to all intents and purposes as he might or could do in +person, hereby, ratifying and confirming all that each of said +attorneys-in-fact and agents, or his substitute or substitutes, may lawfully do +or cause to be done by virtue hereof. +Pursuant to the +requirements of the Securities Exchange Act of 1934, this report has been +signed below by the following persons on behalf of the registrant in the +capacities and on the dates indicated: +Signature +Title +Date +/s/ ABBAS +MOHADDES +Director, President and Chief Executive Officer +June 11, 2008 +Abbas Mohaddes +(principal executive officer) +/s/ JAMES S. +MIELE +Chief Financial Officer +June 11, 2008 +James S. Miele +(principal financial and accounting officer) +/s/ GREGORY A. +MINER +Chairman of the Board +June 11, 2008 +Gregory A. Miner +/s/ RICHARD CHAR +Director +June 11, 2008 +Richard Char +/s/ KEVIN C. DALY +Director +June 11, 2008 +Kevin C. Daly, +Ph.D. +/s/ JOHN +SEAZHOLTZ +Director +June 11, 2008 +John Seazholtz +/s/ JOEL SLUTZKY +Director +June 11, 2008 +Joel Slutzky +/s/ THOMAS L. +THOMAS +Director +June 11, 2008 +Thomas L. Thomas +38 +Iteris, Inc. +Index to Consolidated Financial Statements +Report of Independent Registered Public Accounting +Firm +40 +Consolidated Balance Sheets as of March 31, 2008 +and 2007 +41 +Consolidated Statements of Operations for the years +ended March 31, 2008, 2007, and 2006 +43 +Consolidated Statements of Stockholders’ Equity and +Comprehensive Income for the years ended March 31, 2008, 2007, and 2006 +44 +Consolidated Statements of Cash Flows for the years +ended March 31, 2008, 2007, and 2006 +45 +Notes to Consolidated Financial Statements +46 +39 +Report +of Independent Registered Public Accounting Firm +To the Board of Directors +and Stockholders +Iteris, Inc. +We have audited the +consolidated balance sheets of Iteris, Inc. as of March 31, 2008 and +2007, and the related consolidated statements of operations, stockholders’ +equity and comprehensive income and cash flows for each of the three years in +the period ended March 31, 2008. +Our audits also included the financial statement schedules of Iteris, Inc. +listed in Item 15(a). These financial +statements and financial statement schedules are the responsibility of the +Company’s management. Our responsibility +is to express an opinion on these financial statements and schedules based on +our audits. +We conducted our audits +in accordance with the standards of the Public Company Accounting Oversight +Board (United States). Those standards +require that we plan and perform the audit to obtain reasonable assurance about +whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, +evidence supporting the amounts and disclosures in the financial +statements. An audit also includes +assessing the accounting principles used and significant estimates made by +management, as well as evaluating the overall financial statement +presentation. We believe that our audits +provide a reasonable basis for our opinion. +In our opinion, the +consolidated financial statements referred to above present fairly, in all +material respects, the financial position of Iteris, Inc. as of March 31, +2008 and 2007, and the results of its operations and its cash flows for each of +the three years in the period ended March 31, 2008, in conformity with +U.S. generally accepted accounting principles. +Also, in our opinion, the related financial statement schedule, when +considered in relation to the basic consolidated financial statements taken as +a whole, presents fairly in all material respects the information set forth +therein. +As discussed in Note 1 to +the consolidated financial statements, effective April 1, 2007 the Company +changed its method of accounting for uncertainty in income taxes, and effective +April 1, 2006 the Company changed its method of accounting for stock-based +compensation. +We were not engaged to +examine management’s assertion about the effectiveness of Iteris, Inc.’s +internal control over financial reporting as of March 31, 2008 included in +the accompanying Management’s Report On Internal Control Over Financial +Reporting and, accordingly, we do not express an opinion thereon. +/s/ McGladrey & Pullen, LLP +Irvine, California +June 11, 2008 +40 +Iteris, Inc. +Consolidated Balance Sheets +(In thousands) +March 31, +2008 +2007 +Assets +Current assets: +Cash and cash +equivalents +$ +421 +$ +35 +Trade accounts +receivable, net of allowance for doubtful accounts of $1,020 and $664 at +March 31, 2008 and 2007, respectively +13,108 +11,493 +Costs and estimated +earnings in excess of billings on uncompleted contracts +5,351 +3,689 +Deferred income +taxes +2,541 +494 +Inventories, net +of reserve for inventory obsolescence of $819 and $844 at March 31, 2008 +and 2007, respectively +4,226 +6,379 +Prepaid expenses +and other current assets +371 +385 +Total current +assets +26,018 +22,475 +Property and +equipment: +Leasehold +improvements +1,915 +112 +Equipment +7,356 +6,830 +Accumulated +depreciation +(5,804 +) +(5,230 +) +3,467 +1,712 +Deferred income +taxes +7,807 +2,533 +Intangible +assets, net of accumulated amortization of $555 and $408 at March 31, +2008 and 2007, respectively +257 +404 +Goodwill +27,774 +27,774 +Other assets +322 +352 +Total assets +$ +65,645 +$ +55,250 +See accompanying +notes. +41 +Iteris, Inc. +Consolidated +Balance Sheets +(In thousands, except per share +amounts) +March 31, +2008 +2007 +Liabilities and +stockholders’ equity +Current +liabilities: +Trade accounts +payable +$ +3,902 +$ +3,542 +Accrued payroll +and related expenses +3,825 +3,527 +Accrued +liabilities +1,973 +1,618 +Revolving line +of credit +— +4,015 +Billings in +excess of costs and estimated earnings on uncompleted contracts +1,126 +847 +Current portion +of long-term debt +244 +1,947 +Total current +liabilities +11,070 +15,496 +Deferred rent +1,956 +— +Unrecognized tax +benefits +1,381 +— +Deferred +compensation plan liability +391 +730 +Other +non-current liabilities +70 +163 +Long-term debt +7,566 +9,760 +Commitments and +contingencies +Redeemable +common stock +Issued and +outstanding shares — none at March 31, 2008 and 1,219 at March 31, +2007 +— +3,414 +Stockholders’ +equity: +Preferred stock, +$1.00 par value: +Authorized +shares — 2,000 +Issued and +outstanding shares — none +— +— +Common stock, +$.10 par value: +Authorized +shares — 70,000 at March 31, 2008 and 50,000 at March 31, 2007 +Issued and +outstanding shares — 33,420 at March 31, 2008 and 30,601 at +March 31, 2007 +3,342 +3,060 +Additional +paid-in capital +135,516 +130,425 +Common stock +held in trust — 167 shares at March 31, 2008 and 311 shares at +March 31, 2007 +(202 +) +(374 +) +Notes receivable +from employees +— +(5 +) +Accumulated +deficit +(95,499 +) +(107,438 +) +Accumulated +other comprehensive income +54 +19 +Total +stockholders’ equity +43,211 +25,687 +Total +liabilities and stockholders’ equity +$ +65,645 +$ +55,250 +See accompanying notes. +42 +Iteris, Inc. +Consolidated +Statements of Operations +(In thousands, except per share amounts) +Year Ended March 31, +2008 +2007 +2006 +Net sales and +contract revenues: +Net sales +$ +40,326 +$ +36,248 +$ +31,156 +Contract +revenues +24,837 +22,049 +19,330 +Total net sales +and contract revenues +65,163 +58,297 +50,486 +Costs of net +sales and contract revenues: +Cost of net +sales (a) +20,499 +19,829 +16,493 +Cost of contract +revenues (a) +16,367 +14,460 +12,600 +Gross profit +28,297 +24,008 +21,393 +Operating +expenses: +Selling, general +and administrative (a) +17,289 +16,003 +15,410 +Research and +development (a) +3,566 +4,030 +5,217 +Amortization of +intangible assets +147 +147 +147 +Total operating +expenses +21,002 +20,180 +20,774 +Operating income +7,295 +3,828 +619 +Non-operating +income (expense): +Other income +(expense), net +252 +(653 +) +35 +Interest +expense, net +(1,284 +) +(1,600 +) +(1,459 +) +Income (loss) +before income taxes +6,263 +1,575 +(805 +) +Income tax +benefit +5,900 +1,343 +885 +Net income +$ +12,163 +$ +2,918 +$ +80 +Earnings per +share: +Basic +$ +0.37 +$ +0.10 +$ +0.00 +Diluted +$ +0.35 +$ +0.09 +$ +0.00 +Weighted average +shares outstanding: +Basic +32,723 +29,698 +28,182 +Diluted +34,713 +33,348 +32,737 +(a) Includes stock-based compensation expense as follows: +Cost of net +sales +$ +3 +$ +13 +$ +27 +Cost of contract +revenues +14 +60 +205 +Selling, general +and administrative expense +266 +195 +364 +Research and +development expense +7 +20 +129 +Total +stock-based compensation expense +$ +290 +$ +288 +$ +725 +See accompanying notes . +43 +Iteris, Inc. +Consolidated Statements of Stockholders’ Equity and +Comprehensive Income +(In thousands) +Common +Stock +Shares +Outstanding +Amount +Additional +Paid-In +Capital +Common +Stock +Held in +Trust +Treasury +Stock +Notes +Receivable +From +Employees +Accumulated +Deficit +Accumulated +Other +Comprehensive +Income +Total +Stockholder’s +Equity +Comprehensive +Income +Balance at +March 31, 2005 +27,090 +$ +2,709 +$ +125,609 +$ +(374 +) +$ +(1 +) +$ +(45 +) +$ +(110,436 +) +$ +— +$ +17,462 +Warrant exercises +98 +9 +28 +— +— +— +— +— +37 +Stock option +exercises +244 +25 +275 +— +— +(4 +) +— +— +296 +Issuance of +warrants +— +— +28 +— +— +— +— +— +28 +Stock-based +compensation +— +— +725 +— +— +— +— +— +725 +Retirement of +treasury stock +— +— +(1 +) +— +1 +— +— +— +— +Foreign currency +translation +— +— +— +— +— +— +— +7 +7 +$ +7 +Net income +— +— +— +— +— +— +80 +— +80 +80 +Balance at +March 31, 2006 +27,432 +2,743 +126,664 +(374 +) +— +(49 +) +(110,356 +) +7 +18,635 +$ +87 +Warrant exercises +1,706 +170 +2,265 +— +— +— +— +— +2,435 +Stock option +exercises +1,374 +138 +982 +— +— +— +— +— +1,120 +Issuance of +warrants +— +— +22 +— +— +— +— +— +22 +Stock-based +compensation +— +— +288 +— +— +— +— +— +288 +Issuance of +common stock in connection with legal settlement +89 +9 +204 +— +— +— +— +— +213 +Repayment of +notes receivable from employees +— +— +— +— +— +44 +— +— +44 +Foreign currency +translation +— +— +— +— +— +— +— +12 +12 +$ +12 +Net income +— +— +— +— +— +— +2,918 +— +2,918 +2,918 +Balance at +March 31, 2007 +30,601 +3,060 +130,425 +(374 +) +— +(5 +) +(107,438 +) +19 +25,687 +$ +2,930 +Conversion of +redeemable common stock to common stock +1,219 +122 +3,292 +— +— +— +— +— +3,414 +Stock option +exercises +1,515 +151 +1,223 +— +— +— +— +— +1,374 +Warrant exercises +85 +9 +113 +— +— +— +— +— +122 +Stock-based +compensation +— +— +290 +— +— +— +— +— +290 +Issuance of +shares held in trust +— +— +178 +172 +— +— +— +— +350 +Write-off of +notes receivable from employees +— +— +(5 +) +— +— +5 +— +— +— +Cumulative effect +of adoption of FIN 48 +— +— +— +— +— +— +(224 +) +— +(224 +) +Foreign currency +translation +— +— +— +— +— +— +— +35 +35 +$ +35 +Net income +— +— +— +— +— +— +12,163 +— +12,163 +12,163 +Balance at +March 31, 2008 +33,420 +$ +3,342 +$ +135,516 +$ +(202 +) +$ +— +$ +— +$ +(95,499 +) +$ +54 +$ +43,211 +$ +12,198 +See accompanying notes. +44 +Iteris, Inc. +Consolidated Statements of Cash Flows +(In thousands) +Year Ended March 31, +2008 +2007 +2006 +Operating +activities +Net income +$ +12,163 +$ +2,918 +$ +80 +Adjustments to +reconcile net income to net cash provided by (used in) operating activities: +Change in +deferred tax assets +(7,321 +) +(1,419 +) +(948 +) +Depreciation of +property and equipment +756 +559 +684 +Stock-based compensation +290 +288 +725 +Gain on early +extinguishment of debt +(224 +) +— +— +Amortization of +debt discounts +201 +207 +207 +Amortization of +deferred financing costs +135 +137 +138 +Amortization of +deferred gain on sale-leaseback +(165 +) +(284 +) +(284 +) +Amortization of +intangible assets +147 +147 +147 +Issuance of +common stock in connection with legal settlement +— +213 +— +Fair value of +warrants issued for services +— +22 +— +Changes in +operating assets and liabilities: +Accounts +receivable +(1,615 +) +(67 +) +(2,560 +) +Net costs and +estimated earnings in excess of billings +(1,383 +) +(1,042 +) +(658 +) +Inventories +2,153 +(3,565 +) +1,530 +Prepaid expenses +and other assets +(77 +) +19 +109 +Accounts payable +and accrued expenses +2,519 +(182 +) +1,048 +Net cash +provided by (used in) operating activities +7,579 +(2,049 +) +218 +Investing +activities +Purchases of +property and equipment +(739 +) +(488 +) +(1,258 +) +Financing +activities +(Payments on) +proceeds from borrowings on lines of credit, net +(4,015 +) +1,353 +1,717 +Payments on +long-term debt +(3,838 +) +(1,843 +) +(1,314 +) +Credit facility +commitment fees +(50 +) +(40 +) +— +Checks drawn in +excess of available bank balances +(47 +) +(628 +) +389 +Proceeds from +stock option and warrant exercises +1,496 +3,555 +333 +Proceeds from +notes receivable from employees +— +44 +— +Net cash +provided by (used in) financing activities +(6,454 +) +2,441 +1,125 +Increase +(decrease) in cash +386 +(96 +) +85 +Cash and cash +equivalents at beginning of year +35 +131 +46 +Cash and cash +equivalents at end of year +$ +421 +$ +35 +$ +131 +Supplemental +cash flow information: +Cash paid +(received) during the period: +Interest +$ +1,008 +$ +1,263 +$ +1,095 +Income taxes +24 +39 +(2 +) +Supplemental +schedule of non-cash investing and financing activities: +Conversion of +redeemable common stock to common stock +$ +3,414 +$ +— +$ +— +Lease incentives +in connection with new headquarters lease +1,772 +— +— +Fair value of +common stock issued in settlement of liabilities +350 +— +— +Write-off of +notes receivable from employees +(5 +) +— +— +Property and +equipment financing +— +— +127 +Fair value of +warrants issued in settlement of liabilities +— +— +28 +Exercises of +stock options via notes receivable from employees +— +— +4 +Retirement of +treasury stock +— +— +1 +See accompanying notes. +45 +Iteris, Inc. +Notes to Consolidated Financial Statements +March 31, +2008 +1. Description +of Business and Summary of Significant Accounting Policies +Description +of Business +Iteris, Inc. (the “Company”) +is a leader in the traffic management market and focuses on the development and +application of advanced technologies that reduce traffic congestion, minimize +the environmental impact of traffic congestion and improve the safety of +surface transportation systems. By +combining outdoor image processing, traffic engineering and information +technology, the Company offers a broad range of Intelligent Transportation +Systems and driver safety solutions to customers worldwide. The Company was originally incorporated in +Delaware in 1987. In October 2004, +the Company completed a merger with its majority-owned subsidiary, Iteris, Inc. +(the “Iteris Subsidiary”), and officially changed its corporate name to Iteris, Inc. +Basis +of Presentation +The accompanying consolidated financial statements include the accounts +of the Company and its subsidiaries. All significant intercompany accounts and +transactions have been eliminated in consolidation. +Use +of Estimates +The preparation of consolidated financial statements in conformity with +accounting principles generally accepted in the United States requires +management to make certain estimates and assumptions that affect the reported +amounts of assets and liabilities and disclosures of contingent assets and +liabilities at the date of the financial statements, and reported amounts of +revenues and expenses during the reporting period. Actual results could differ +from those estimates. Significant estimates made in the preparation of the +consolidated financial statements include the allowance for doubtful accounts, +deferred tax assets, inventory and warranty reserves, costs to complete +long-term contracts, overhead rates used in cost-plus contracts, contract +reserves, the valuation of equity instruments and estimates of future cash +flows used to assess the recoverability of long-lived assets and the +realization of goodwill. +Reclassifications +Certain reclassifications +have been made to the prior year financial statements to conform to the current +year presentation. +Revenue +Recognition +Product revenues and related costs of sales are recognized upon the +transfer of title, which generally occurs upon shipment or, if required, upon acceptance +by the customer, provided that the Company believes collectibility of the net +sales amount is reasonably assured. Accordingly, at the date revenue is +recognized, the significant uncertainties concerning the sale have been +resolved. +Contract revenues are derived primarily from long-term contracts with +governmental agencies. Contract revenues include costs incurred plus a portion +of estimated fees or profits determined on the percentage of completion method +of accounting based on the relationship of costs incurred to total estimated +costs. Any anticipated losses on contracts are charged to earnings when +identified. Changes in job performance and estimated profitability, including +those arising from contract penalty provisions and final contract settlements, +may result in revisions to costs and revenues and are recognized in the period +in which the revisions are determined. Profit incentives are included in +revenue when their realization is reasonably assured. +46 +In addition to product and contract revenue, the Company derives +revenue from technology access fees, the provision of specific non-recurring +contract engineering services and royalties. Technology access fee revenues are +recognized evenly over the period in which they are earned. Non-recurring +contract engineering revenues are recognized in the period in which the related +services are performed. Royalty revenues are recorded in the period in which +the royalty is earned, based on unit sales of the Company’s products. +Technology access fee revenues, contract engineering revenues and royalty +revenues are included in net sales in the accompanying consolidated statements +of operations. +Revenues from follow-on service and support, for which the Company +charges separately, are recorded in the period in which the services are +performed. +Concentration +of Credit Risk +Accounts receivable are derived from revenues earned from customers +located throughout North America and Europe. The Company generally does not +require collateral or other security from customers. Collectibility of +receivable balances is estimated through review of invoices outstanding greater +than a certain period of time and ongoing credit evaluations of customers’ +financial condition. Reserves are maintained for potential credit losses, and +such losses have historically been within management’s expectations. +At March 31, 2008 and 2007, accounts receivable from governmental +agencies and prime government contractors were approximately $6.4 million and +$5.2 million, respectively. No customer or government agency had a receivable +balance at March 31, 2008 or 2007 greater than 10% of our total net sales +and contract revenues for the years ended March 31, 2008 and 2007. +Fair +Values of Financial Instruments +The fair value of cash +and cash equivalents, receivables, inventories, accounts payable and accrued +expenses approximate carrying value because of the short period of time to +maturity. The fair value of line of credit agreements and long-term debt +approximate carrying value because the related rates of interest approximate +current market rates. The fair value of convertible debentures approximates +carrying value because the effective interest rate, taking into account +recorded debt discounts, approximates current market rates. At March 31, +2007, the fair value of redeemable common stock was $2.8 million, based on the +closing price of the Company’s common stock on that date. +Cash and +Cash Equivalents +Cash and cash equivalents consist of cash and short-term investments +with initial maturities of ninety days or less. +Inventories +Inventories are stated at +the lower of cost or market. Cost is determined using the first-in, first-out +method. +Property +and Equipment +Property and equipment +are recorded at cost and are depreciated over the estimated useful life ranging +from three to eight years. Leasehold +improvements are depreciated over the term of the related lease or the +estimated useful life of the improvement, whichever is shorter. Beginning April 1, 2006, the Company +began depreciating property and equipment using the straight-line method of +depreciation, which the Company believes more closely approximates the usage of +the underlying assets, which generally provide value evenly throughout the +estimated life. Prior to this date, the +Company used the double declining balance method of depreciation. As a result of this change in estimate, +depreciation expense declined by $455,000 for the year ended March 31, +2007, resulting in a $0.02 per share impact on basic and diluted earnings per +share. +Goodwill +and Long-Lived Assets +In accordance with +Statement of Financial Accounting Standards (“SFAS”) No. 142, Goodwill and Intangible Assets (“SFAS 142”), goodwill is +tested for impairment on an annual basis in the Company’s fourth fiscal quarter +or more frequently if indicators of impairment exist, of which none have been +identified. The performance of the test +involves a two-step process. The first +step of the impairment test involves comparing the fair value of the Company’s +reporting units with each respective reporting unit’s carrying amount, +including goodwill. The Company +determines the fair value of reporting units using the income approach. If the carrying amount of a reporting unit +exceeds the reporting unit’s fair value, the second step of the goodwill +impairment test is performed to determine the amount of any impairment +loss. The second step of the goodwill +impairment test involves comparing the implied fair value of the reporting unit’s +goodwill with the carrying amount of that goodwill. +47 +The Company evaluates +long-lived assets for impairment in accordance with SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets , +which requires impairment evaluation on long-lived assets used in operations +when indicators of impairment are present. +Reviews are performed to determine whether the carrying value of assets +is impaired, based on a comparison to undiscounted expected future cash +flows. If this comparison indicates that +there is impairment, the impaired asset is written down to fair value, which is +typically calculated using discounted expected future cash flows and a discount +rate based upon the Company’s weighted average cost of capital adjusted for +risks associated with the related operations. +Impairment is based on the excess of the carrying amount over the fair +value of those assets. +Income +Taxes +The Company utilizes the +liability method of accounting for income taxes as set forth in SFAS No. 109, +Accounting for Income Taxes (“SFAS 109”). Under the liability method, deferred taxes +are determined based on the temporary differences between the financial +statement and tax bases of assets and liabilities using enacted tax rates. A valuation allowance is recorded when it is +more likely than not that all or a portion of the deferred tax assets will not +be realized. See Note 5. +On April 1, 2007, +the Company adopted the provisions of Financial Accounting Standards Board (“FASB”) +Interpretation No. 48, Accounting for Uncertainty +in Income Taxes – an Interpretation of FASB Statement No. 109 (“FIN 48”). +FIN 48 clarifies the accounting for uncertainty in income taxes by +establishing minimum standards for the recognition and measurement of tax +positions taken or expected to be taken in a tax return. Under the requirements +of FIN 48, the Company must review all of its tax positions and make a +determination as to whether its position is more-likely-than-not to be +sustained upon examination by regulatory authorities. If a tax position meets +the more-likely-than-not standard, then the related tax benefit is measured +based on a cumulative probability analysis of the amount that is +more-likely-than-not to be realized upon ultimate settlement or disposition of +the underlying issue. +The Company recognized +the cumulative impact of the adoption of FIN 48 as a $224,000 increase to its +liability for unrecognized tax benefits with a corresponding increase to its +accumulated deficit balance as of April 1, 2007. As of April 1, 2007 +and March 31, 2008, the Company’s gross unrecognized tax benefits were +$185,000 and $1.4 million, respectively, of which $78,000 and $88,000, +respectively, if recognized, would affect the Company’s effective tax rate. The +gross unrecognized tax benefits differ from the amount that would affect the +Company’s effective tax rate due primarily to the impact of the valuation +allowance on such differences. +The Company’s continuing +practice is to recognize interest and/or penalties related to income tax +matters in income tax expense. As of March 31, +2008 and April 1, 2007, the Company had accrued cumulatively $21,000 and +$39,000 respectively, for the payment of interest and penalties. +A reconciliation of the +beginning and ending balances of the total amounts of gross unrecognized tax +benefits is as follows (in thousands): +Gross +unrecognized tax benefits at April 1, 2007 +$ +185 +Increases in tax +positions for prior year +1,160 +Decrease in tax +positions for prior year +(147 +) +Increase in tax +positions for current year +327 +Decrease in tax +positions for current year +— +Settlements +— +Lapse in statute +of limitation +(136 +) +Gross +unrecognized tax benefits at March 31, 2008 +$ +1,389 +During the next twelve +months, it is reasonably possible that, as a result of the expiration of the +statute of limitations, the Company may decrease the amount of its gross +unrecognized tax benefits by approximately $408,000. The gross unrecognized tax +benefits subject to potential decrease involve various timing differences. +48 +The Company is subject to +taxation in the United States and various states. The Company is subject to U.S. federal tax +examination for fiscal tax years ended March 31, 2005 and state as well as +local income tax examination for fiscal tax years ended March 31, 2004. +Stock-Based Compensation +Effective April 1, 2006, the Company adopted SFAS No. 123 +(revised 2004), Share-Based Payment (“SFAS 123R”), +which replaced SFAS No. 123, Accounting for Stock-Based +Compensation (“SFAS 123”), superseded Accounting Principles Board +Opinion No. 25, Accounting for Stock +Issued to Employees (“APB 25”), and amended SFAS No. 95, Statement of Cash Flows . +Prior to April 1, 2006, the Company followed the disclosure-only +provisions of SFAS 123, as amended by SFAS No. 148, Accounting +for Stock-Based Compensation – Transition and Disclosure , and, accordingly, accounted for its stock-based +compensation plans using the intrinsic value method under APB 25 and related +interpretations. +SFAS 123R requires all stock-based payments, including grants of +employee stock options, to be recognized in the statement of operations as an +expense, based on their grant date fair values with such fair values amortized +over the requisite service period. The +Company elected to use the modified prospective transition method for +transition to SFAS 123R. Under the +modified prospective method, SFAS 123R applies to all awards granted or +modified after the date of adoption. In +addition, under the modified prospective method, compensation expense will be +recognized for all stock-based compensation awards granted prior to but not yet +vested as of April 1, 2006, based on grant-date fair values estimated in +accordance with the original provisions of SFAS 123. Accordingly, prior period amounts presented +herein have not been restated to reflect the adoption of SFAS 123R. +The fair value +concepts were not changed significantly as a result of implementing SFAS 123R; +however, in adopting SFAS 123R, companies must choose among alternative +valuation models and amortization assumptions. After assessing alternative +valuation models and amortization assumptions, the Company continued to use +both the Black-Scholes-Merton (“BSM”) option-pricing formula and straight-line +amortization of compensation expense over the requisite service period of stock +option grants. The Company will +reconsider use of this model if additional information becomes available in the +future that indicates another model would be more appropriate, or if grants +issued in future periods have characteristics that cannot be reasonably +estimated using this model. SFAS 123 did +not require the estimation of forfeitures in the calculation of stock +compensation expense; however, SFAS 123R does require such estimation and upon +adoption of SFAS 123R, the Company changed its methodology to include an +estimate of forfeitures. +In addition, in +accordance with SFAS 123R, SFAS 109 and EITF Topic D-32, Intraperiod Tax Allocation of the Tax Effect of +Pretax Income from Continuing Operations , the Company has elected to +recognize excess income tax benefits from stock option exercises in additional +paid-in capital only if an incremental income tax benefit would be realized +after considering all other tax attributes presently available to the Company. +The Company measures the tax benefit associated with excess tax deductions +related to stock-based compensation expense by multiplying the excess tax +deductions by the statutory tax rates. +The following +table illustrates the effect on net income and earnings per share for the year +ended March 31, 2006 as if the Company had applied the fair value +recognition provisions of SFAS 123R to options granted under the Company’s +stock option plans. For purposes of this +pro forma disclosure, the fair value of the options was estimated using the BSM +option-pricing formula and amortized on a straight-line basis to expense over +the options’ vesting period: +49 +Year Ended March 31, +2006 +(In thousands, except +per share amounts) +Net income — as +reported +$ +80 +Add: Stock-based +compensation expense included in net income — as reported +725 +Deduct: Total +stock-based compensation expense determined under fair value based method for +all awards +(1,108 +) +Net loss — pro forma +$ +(303 +) +Basic and diluted +earnings per share — as reported +$ +0.00 +Basic and diluted loss +per share — pro forma +$ +(0.01 +) +Research and Development +Expenditures +Research and +development expenditures are charged to expense in the period incurred. +Shipping +and Handling Costs +Shipping and +handling costs are included as cost of sales in the period during which the +products ship. +Sales Taxes +Sales taxes are +presented on a net basis (excluded from net sales and contract revenues) in the +consolidated statements of operations. +Advertising +Expenses +Advertising costs +are expensed in the period incurred and totaled $172,000, $152,000, and +$185,000 in the years ended March 31, 2008, 2007 and 2006, respectively. +Warranty +The Company generally +provides a one to three year warranty from the original invoice date on all +products, materials and workmanship. +Products sold to certain original equipment manufacturer (“OEM”) customers +sometimes carry longer warranties. Defective products will be either repaired +or replaced, generally at the Company’s option, upon meeting certain criteria. +The Company accrues a provision for the estimated costs that may be incurred +for product warranties relating to a product as a component of cost of sales at +the time revenue for that product is recognized. The accrued warranty provision is included +within accrued expenses on the accompanying consolidated balance sheets. +Repair and Maintenance Costs +The Company incurs +repair and maintenance costs in the normal course of business. Should the +activity result in a permanent improvement to one of the Company’s leased +facilities, the cost is capitalized as a leasehold improvement and amortized +over its useful life or the remainder of the lease period, whichever is +shorter. Non-permanent repair and maintenance costs are charged to expense as +incurred. +Comprehensive +Income +The only component of +accumulated other comprehensive income is foreign currency translation +adjustments. +Recent Accounting Pronouncements +In September 2006, +the FASB issued SFAS No. 157, Fair Value Measurements +(“SFAS 157”), which defines fair value, establishes a framework for measuring +fair value, and expands disclosure about fair value measurements. SFAS 157 does +not require any new fair value measurements; rather it specifies valuation +methods to be applied when fair value measurements are required under existing +or future accounting pronouncements. SFAS 157 is effective for fiscal years +beginning after November 15, 2007 and interim periods within those fiscal +years. In February 2008 the FASB issued FSP 157-2, Effective +Date of FASB Statement No. 157 , which delays the effective date of +SFAS 157 for non-financial assets and liabilities to fiscal years beginning +after November 15, 2008. Generally, this statement will be applied +prospectively. The Company is currently evaluating the impact of SFAS 157 and +expects to adopt SFAS 157 in the first quarter of its fiscal year ending March 31, +2009. +50 +In February 2007, +the FASB issued SFAS No. 159, The Fair Value Option for +Financial Assets and Financial Liabilities — Including an Amendment of FASB +Statement No. 115 (“SFAS 159”). SFAS 159 permits entities to +choose to measure many financial instruments and certain other items at fair +value. Unrealized gains and losses on items for which the fair value option has +been elected will be recognized in earnings at each subsequent reporting date. SFAS +159 is effective for financial statements issued for fiscal years beginning +after November 15, 2007. The Company is evaluating the impact that the +adoption of SFAS 159 will have on its results of operations and financial +condition and expects to adopt SFAS 159 in its fiscal year ending March 31, +2009. +2. Supplementary +Financial Information +Inventories +The following +table presents details regarding the Company’s inventories: +March 31, +2008 +2007 +(In thousands) +Materials +and supplies +$ +3,031 +$ +4,705 +Work +in process +345 +366 +Finished +goods +850 +1,308 +$ +4,226 +$ +6,379 +Goodwill +and Intangible Assets +March 31, 2008 +March 31, 2007 +Gross +Carrying +Amount +Accumulated +Amortization +Gross +Carrying +Amount +Accumulated +Amortization +(In thousands) +Intangible +assets subject to amortization: +Developed +Technology +$ +495 +$ +(381 +) +$ +495 +$ +(280 +) +Patents +317 +(174 +) +317 +(128 +) +Total +$ +812 +$ +(555 +) +$ +812 +$ +(408 +) +Amortization expense for intangible assets subject to +amortization was $147,000 for the years ended March 31, 2008, 2007 and +2006. Future estimated amortization expense is as follows: +Year Ending March 31: +(In thousands) +2009 +$ +147 +2010 +58 +2011 +46 +2012 +6 +$ +257 +At March 31, 2008, goodwill was comprised of +$18.0 million associated with the October 2004 merger of the Iteris +Subsidiary (Note 1); $9.6 million associated with the acquisitions of the +Rockwell International Transportation Systems Group, Meyer Mohaddes Associates +and the Viggen Systems Consulting Group; and $200,000 associated with the +purchase of the assets of +Mil-Lektron, a complementary product to the Company’s Vantage video detection +business. +51 +Warranty +Reserve Activity +The +following table presents activity in accrued warranty obligations: +Year Ended March 31, +2008 +2007 +2006 +(In thousands) +Balance +at beginning of year +$ +520 +$ +519 +$ +326 +Additions +charged to cost of sales +347 +630 +517 +Warranty +claims +(373 +) +(629 +) +(324 +) +Balance +at end of year +$ +494 +$ +520 +$ +519 +Earnings +Per Share +The following +table sets forth the computation of basic and diluted income per share: +Year Ended March 31, +2008 +2007 +2006 +(In thousands, except per share amounts) +Numerator: +Net +income +$ +12,163 +$ +2,918 +$ +80 +Denominator: +Weighted +average common shares used in basic computation +32,723 +29,698 +28,182 +Dilutive +stock options +1,973 +3,346 +3,818 +Dilutive +warrants +17 +304 +737 +Weighted +average common shares used in dilutive computation +34,713 +33,348 +32,737 +Earnings +per share: +Basic +$ +0.37 +$ +0.10 +$ +0.00 +Diluted +$ +0.35 +$ +0.09 +$ +0.00 +The following shares were excluded from the +computation of diluted earnings per share as their effect would have been +anti-dilutive: +Year Ended March 31, +2008 +2007 +2006 +(In thousands) +Stock +options +520 +582 +470 +Warrants +1,170 +1,240 +1,265 +Convertible +debentures +2,661 +2,729 +2,729 +3. Costs +and Estimated Earnings on Uncompleted Contracts +Costs incurred, +estimated earnings and billings on uncompleted long-term contracts are as +follows: +52 +March 31, +2008 +2007 +(In thousands) +Total +estimated contract value +$ +77,557 +$ +74,794 +Costs +incurred on uncompleted contracts +$ +23,415 +$ +20,688 +Estimated +earnings +2,342 +2,069 +25,757 +22,757 +Less +billings to date +(21,532 +) +(19,915 +) +$ +4,225 +$ +2,842 +Included +in accompanying consolidated balance sheets: +Costs +and estimated earnings in excess of billings on uncompleted contracts +$ +5,351 +$ +3,689 +Billings +in excess of costs and estimated earnings on uncompleted contracts +(1,126 +) +(847 +) +$ +4,225 +$ +2,842 +Costs and +estimated earnings in excess of billings at March 31, 2008 and 2007 +include $828,000 and $786,000, respectively, that were not billable as certain +milestone objectives specified in the contracts had not been attained. +Substantially all costs and estimated earnings in excess of billings at March 31, +2008 are expected to be billed and collected during the year ending March 31, +2009. +4. Revolving +Line of Credit and Long-Term Debt +Revolving Line of Credit +In October 2006, the +Company entered into a new two-year credit facility with a bank. At March 31, 2008, the facility provided +line of credit borrowings of up to $10.0 million. Under the credit facility, the Company may +borrow against its eligible accounts receivable and eligible inventory, as +defined in the credit agreement. +Interest on borrowed amounts under the line of credit is payable monthly +at the current stated prime rate plus 1.00% (6.25% at March 31, +2008). Additionally, the Company is +obligated to pay an unused line fee of 0.25% per annum applied to the amount by +which the maximum credit amount exceeds the average daily principal balance +during the preceding month. The credit facility requires $2,000 in monthly +collateral management fees and includes an early termination fee equal to 2% of +the total facility during the first year of the agreement and 1% of the total +facility in the second year of the agreement. +Additionally, the Company paid commitment fees of $40,000 in October 2006 +and $50,000 in October 2007. The credit facility is secured by +substantially all of the assets of the Company. +On March 31, 2008, +the available credit under the credit facility was $8.6 million, all of which +was unused. +Long-Term Debt +The Company’s +long-term debt consists of the following: +March 31, +2008 +2007 +(In thousands) +Convertible +debentures, net +$ +7,566 +$ +9,410 +Bank +term note +210 +1,573 +Promissory +note to landlord +— +646 +Other +34 +78 +7,810 +11,707 +Less +current portion +(244 +) +(1,947 +) +$ +7,566 +$ +9,760 +53 +Convertible +Debentures, Net. In May 2004, the Company sold and +issued subordinated convertible debentures in the aggregate original principal +amount of $10.1 million. In connection +with the issuance of these debentures, the Company issued detachable warrants +to purchase an aggregate of 639,847 shares of its common stock, the value of +which was recorded as a debt discount against the face amount of the debentures +on the date of issuance and is being amortized to interest expense over the +term of the convertible debentures. +The debentures are +due in full on May 19, 2009, provide for 6.0% annual interest, payable +quarterly, and are convertible at the holder’s option into the Company’s common +stock at an initial conversion price of $3.61 per share, subject to certain +adjustments, including adjustments for dilutive issuances. From May 19, +2008, until the maturity date, the Company may redeem the debentures at 110% of +the principal amount. +During the year +ended March 31, 2008, the Company paid $1.8 million to retire $2.1 million +of convertible debentures early. In +connection with this early retirement, the Company recorded a gain of $224,000, +which is included within other income in the accompanying consolidated +statement of operations for the year ended March 31, 2008. Additionally, $250,000 of convertible +debentures were previously converted into 69,252 shares of common stock. At March 31, 2008, $7.8 million of the +originally issued convertible debentures remained outstanding. +Bank Term Note. In +October 2004, the Company entered into a $5.0 million term note payable +with a bank. The note was due on May 27, +2008, and provided for monthly principal payments of approximately +$104,000. In October 2006, the term +note was assumed by the Company’s new bank as part of the Company’s new credit +facility. The new term note was also due +on May 27, 2008 and provided for monthly principal payments of +approximately $104,000. Interest accrued +under the new term note at an annual rate of 8.75%. The final payment against this term note was +made in June 2008. +Promissory Note to Landlord. The +Company had an unsecured promissory note payable to the landlord of its +previous headquarters. Under the terms +of the note agreement, interest was payable quarterly and accrued at a rate of +prime plus 2.0%. In October 2006, January 2007, +April 2007 and July 2007, the Company made required quarterly +principal payments of $323,000. As of March 31, +2008, all principal and interest under this note was paid in full. +Scheduled +aggregate maturities of long-term debt principal as of March 31, 2008 were +as follows: +Year Ending March 31, +(In thousands) +2009 +$ +244 +2010 +7,750 +7,994 +Less: +unamortized debt discount +(184 +) +$ +7,810 +5. Income +Taxes +The reconciliation +of the Company’s income tax benefit to taxes computed at U.S. federal statutory +rates is as follows: +Year Ended March 31, +2008 +2007 +2006 +(In thousands) +Income +tax (benefit) provision at statutory rates +$ +2,131 +$ +536 +$ +(284 +) +State +income taxes net of federal benefit +(675 +) +(147 +) +(85 +) +Change +in valuation allowance associated with federal deferred tax assets +(7,558 +) +(1,895 +) +(892 +) +Compensation +charges +194 +— +222 +Unrecognized +tax benefits +(133 +) +— +— +AMT +and foreign taxes +40 +24 +46 +Other +permanent differences +101 +139 +108 +Income +tax benefit +$ +(5,900 +) +$ +(1,343 +) +$ +(885 +) +54 +The components of +deferred tax assets and liabilities are as follows: +March 31, +2008 +2007 +(In thousands) +Deferred +tax assets: +Net +operating losses +$ +16,777 +$ +18,806 +Credit +carry forwards +164 +1,401 +Deferred +compensation and payroll +1,359 +2,032 +Bad +debt allowances and other reserves +601 +524 +Acquired +intangibles +— +67 +Other, +net +167 +— +Total +deferred tax assets +19,068 +22,830 +Valuation +allowance +(7,887 +) +(19,543 +) +Net +deferred tax assets +11,181 +3,287 +Deferred +tax liabilities: +Other, +Net +(490 +) +(135 +) +Property +and equipment +(160 +) +(125 +) +Acquired +intangibles +(183 +) +— +Total +deferred tax liabilities +(833 +) +(260 +) +Net +deferred tax assets +$ +10,348 +$ +3,027 +Current +portion of net deferred taxes +$ +2,541 +$ +494 +Long-term +portion of net deferred taxes +7,807 +2,533 +Net +deferred tax assets +$ +10,348 +$ +3,027 +The components of current +and deferred federal and state income tax benefits and provisions are as +follows: +Year Ended March 31, +2008 +2007 +2006 +(In thousands) +Current +income tax provision +Federal +$ +94 +$ +25 +$ +9 +State +40 +32 +3 +Foreign +40 +24 +46 +Deferred +income tax benefit +Federal +(5,011 +) +(1,170 +) +(812 +) +State +(1,063 +) +(254 +) +(131 +) +Net +income tax benefit +$ +(5,900 +) +$ +(1,343 +) +$ +(885 +) +At March 31, +2008, the Company had approximately $581,000 in federal general business credit +carryforwards that begin to expire in 2014 and $818,000 in state general +business credit carryforwards that can be carried forward indefinitely. The +Company had $44.7 million of federal net operating loss carryforwards at March 31, +2008 that begin to expire in 2019 and $16.6 million of state net operating loss +carryforwards that begin to expire in 2013. +Prior to May 28, +2004, the Iteris Subsidiary was required to file a separate federal income tax +return. On May 28, 2004, the Company acquired a greater than 80% ownership +interest in the Iteris Subsidiary. From that date forward, income taxes are +provided on a consolidated basis for federal income tax purposes. Due to +changes in stock ownership, the prior year $49.8 million of federal net +operating loss carryforwards and other federal tax attributes of the Company +are subject to a Section 382 limitation estimated at approximately $7.8 +million annually which can be utilized to offset federal consolidated taxable +income. To the extent such limitation is not exceeded in a particular year, the +excess limitation accumulates and adds to subsequent years’ limitations. +As a result of +SFAS 123R, our deferred tax assets at March 31, 2008 do not include $1.9 +million of excess tax benefits from employee stock option exercises that are a +component of our net operating loss carryforwards. Stockholders’ equity will be +increased by $1.9 million if and when such excess tax benefits are ultimately +realized. +55 +At March 31, +2008, the Company recorded a valuation allowance against its net deferred tax +assets of approximately +$7.9 million for that portion of deferred tax assets that it is more likely +than not will not be realized. In making such determination, a review of all +available positive and negative evidence was considered, including scheduled +reversal of deferred tax liabilities, potential carryback, projected future +taxable income, tax planning strategies, and recent financial performance. Any +future benefits recognized from the reduction of the valuation allowance will +result in a reduction of income tax expense. +Unremitted +earnings of the Company’s foreign subsidiary have been included in the +consolidated financial statements without giving effect to the United States +taxes that may be payable on distribution to the United States because it is +not anticipated that such earnings will be remitted to the United States. If remitted, the additional United States +taxes would not be material. +6. Commitments +and Contingencies +Litigation +On June 29, 2004, a +supplier to Mariner Networks, Inc., a former subsidiary of the Company +that was discontinued in the fiscal year ended March 31, 2002, filed a +complaint in Orange County Superior Court against the Company alleging various +breaches of written contract claims arising out of alleged purchase +orders. On July 20, 2006, the +Company entered into a settlement agreement in connection with this +matter. The dispute was settled in full +for $688,000 payable as follows: (i) the +Company issued 88,912 shares of the Company’s common stock on August 18, +2006 valued at $213,000 based on the closing sales price of the Company’s +common stock on the date of issuance; (ii) the Company made a cash payment +of $125,000 on October 20, 2006; and (iii) the Company is obligated +to pay $350,000 in cash in equal monthly installments of $9,700 over three +years beginning in November 2006. +In connection with this settlement, the Company recorded a charge of +$635,000, representing the fair value of the settlement, within other expense +in the accompanying consolidated statement of operations for the year ended March 31, +2007. +From time to time, the +Company has been involved in litigation relating to claims arising out of its +operations in the normal course of business. The Company currently is not a +party to any legal proceedings, the adverse outcome of which, in management’s +opinion, individually or in the aggregate, would have a material adverse effect +on its consolidated results of operations, financial position or cash flows. +Furthermore, from time to +time, the Company has experienced unforeseen developments in contingencies +related to its former subsidiaries. For +example, the Company has been the subject of a number of routine tax audits for +time periods and jurisdictions related to the businesses of its former +subsidiaries, some of which are still in process. Although the development and ultimate outcome +of these and other unforeseen matters cannot be predicted with any certainty, +management does not believe that the Company is presently involved in any +matters related to its former subsidiaries that would have a material adverse +effect on the Company’s consolidated results of operations, financial position +or cash flows. +Operating Leases +In May 2007, +the Company entered into an agreement to lease 52,000 square feet of space in +Santa Ana, California for a term of 88 months. In September 2007, the +Company relocated its headquarters and principal operations into this space. +The monthly lease rate is $102,000 during the first year of the lease and +increases each year thereafter, up to a maximum of $120,000 during the last +year of the lease. The lease may be extended for a period of five years, at the +option of the Company, at a lease rate to be based on the market lease rate for +comparable property determined as of the commencement date of the extension +period. Additionally, the lease agreement provides for $1.8 million in +incentives in the form of tenant improvement allowances, which the Company +recorded as deferred rent and capitalized leasehold improvements in its +consolidated balance sheet. The deferred +rent amount will reduce future rent expense over the term of the lease, and the +capitalized leasehold improvements amount will be depreciated over the initial +term of the lease (the estimated useful life of the related leasehold +improvements). +The Company has +lease commitments for facilities in various locations throughout the United +States. Future minimum rental payments under +these noncancelable operating leases at March 31, 2008 were as follows: +56 +Fiscal Year Ending March 31, +(In thousands) +2009 +$ +1,594 +2010 +1,431 +2011 +1,366 +2012 +1,332 +2013 +1,363 +Thereafter +2,460 +Total +$ +9,546 +Rent expense +totaled $2.1 million, $2.2 million and $1.9 million, respectively, for the +years ended March 31, 2008, 2007 and 2006. +The Company +previously had recorded on its consolidated balance sheet a deferred gain +related to the May 2002 sale and leaseback of its prior headquarters in +Anaheim, California. The deferred gain +was amortized over the term of the underlying lease, which terminated in September 2007, +and resulted in a realized gain of $165,000 in the fiscal year ended March 31, +2008 and $284,000 in the fiscal years ended March 31, 2007 and 2006. +The Company +previously subleased office space to MAXxess Systems, Inc. (“MAXxess”), a +former subsidiary of the Company that was sold by the Company in September 2003 +and is currently owned by an investor group that includes two of the Company’s +directors, one of which is the Chief Executive Officer of MAXxess. At March 31, +2008, MAXxess owed the Company an aggregate of $274,000 related to this +sublease, which terminated in September 2007, and certain related +ancillary services that were provided by the Company to MAXxess. Although the Company has fully reserved for +amounts owed to it by MAXxess under the terms of this sublease, the Company +intends to pursue full payment of any and all amounts due from MAXxess. +Inventory Purchase Commitments +At March 31, +2008, the Company had firm commitments to purchase inventory in the amount of +$2.3 million during the first and second quarters of its fiscal year ending March 31, +2009. +Deferred +Compensation Plan +In 1986, the Company +adopted the Executive Deferral Plan (the “1986 Plan”) under which certain +executives were able to defer a portion of their annual compensation into the +1986 Plan. All deferred amounts earned interest, generally with no guaranteed +rate of return. During the year ended March 31, +2003, the Company adopted the Deferred Compensation Plan, and all assets of the +1986 Plan were transferred into the Deferred Compensation Plan. No compensation withholdings were deferred +under the 1986 Plan or the Deferred Compensation Plan in the years ended March 31, +2008, 2007 and 2006. +At March 31, +2008, the Deferred Compensation Plan held 167,177 shares of the Company’s +common stock and $5,000 in cash, which the Company has presented as an +aggregated $391,000 deferred compensation plan liability in the accompanying +consolidated balance sheet. At March 31, 2007, the Deferred Compensation +Plan held 310,510 shares of the Company’s common stock and $15,000 in +cash. Changes in the value of Company +common stock held by the Deferred Compensation Plan are determined based on +changes in the quoted market price of the Company’s common stock at the close +of each reporting period and presented within operating expenses in the accompanying +consolidated statements of operations. As a result of such changes in the value +of Company common stock, the Company recorded expense of $21,000, a benefit of +$91,000 and expense of $48,000 in the years ended March 31, 2008, 2007 and +2006, respectively. The original +$202,000 cost basis of shares of Company common stock held in the Deferred +Compensation Plan at March 31, 2008 has been recorded as a contra-equity +account in the accompanying consolidated financial statements. On June 3, 2008, substantially all of the +remaining assets of the Deferred Compensation Plan were distributed. +7. Redeemable +Common Stock +In connection with the +merger of the Iteris Subsidiary into the Company (Note 1) in May 2004, the +Company acquired 547,893 shares of common stock of the Iteris Subsidiary in +exchange for the issuance of 1,219,445 shares of the Company’s common stock, +which was valued at $3.4 million at the date of issuance. Beginning on May 28, +2007, the holder of these shares had the right to require the Company to +repurchase up to 100% of the shares at a purchase price of $1.438 per share. +57 +All such rights to +require the repurchase of these shares expired on September 28, 2007. +Because these rights were outside of the control of the Company, the Company +previously had classified the $3.4 million value of the 1,219,445 shares as +redeemable common stock on its consolidated balance sheet. Upon the expiration +of these rights, the Company reclassified $122,000 to common stock, +representing the par value of the shares, and $3.3 million to additional +paid-in capital on its consolidated balance sheet. +8. Stockholders’ +Equity +Preferred Stock +The Company’s +certificate of incorporation provides for the issuance of up to 2,000,000 +shares of preferred stock. As of March 31, 2008 and 2007, there were no +outstanding shares of preferred stock, and the Company does not have any plans +to issue any shares of preferred stock. The Company’s Board of Directors is +authorized to issue from time to time such authorized but unissued shares of +preferred stock in one or more series and to fix or alter the designations, +preferences, rights and any qualifications, limitations or restrictions of the +shares of each such series, including the dividend, conversion, voting, +redemption and liquidation rights. +Common Stock and Common Stock +Warrants +On September 28, +2006, the Company issued warrants to purchase an aggregate 246,250 shares of +common stock at an exercise price of $3.25 with a five-year life to an existing +shareholder in exchange for the early exercise of 1,250,000 outstanding +warrants with an exercise price of $1.61. +The new warrants were immediately exercisable and are callable by the Company +if the market price of the Company’s common stock trades for 20 consecutive +days at a price greater than or equal to two times the exercise price of the +warrants. The fair value of the new +warrants was $320,000 calculated using the Black-Scholes-Merton (“BSM”) +option-pricing formula. The warrants +were considered a cost of raising capital and were recorded in equity. +In connection with the +issuance of the new warrants, the Company is party to a registration rights +agreement that contains provisions under which the Company could be subjected +to liquidated damages should it fail to maintain effective registration +statements for the shares of common stock issuable upon exercise of the +warrants. These warrants have been +accounted for within equity in the consolidated balance sheets as of March 31, +2008 and 2007 in accordance with EITF Issue No. 00-19 Accounting +for Derivative Financial Instruments Indexed to, and Potentially Settled in, a +Company’s Own Stock , and, accordingly, no liabilities have been +recorded in connection therewith. As of March 31, +2008, no liquidated damages were payable under the provisions of the +registration rights agreement associated with these warrants. +The following +table summarizes information regarding outstanding warrants to purchase the +Company’s common stock as of March 31, 2008: +Range of Exercise Prices +Warrants Outstanding +at March 31, 2008 +Weighted Average +Remaining +Contractual Life +(Years) +Weighted Average +Exercise Price +(In thousands, except per share amounts) +$1.42 +15 +5.42 +$ +1.42 +$3.25 +246 +2.91 +$ +3.25 +$3.61 to $4.03 +674 +1.13 +$ +3.93 +$5.00 to $5.26 +230 +1.66 +$ +5.18 +1,165 +1.67 +$ +4.00 +All of the +warrants were exercisable at March 31, 2008. Warrants to purchase an aggregate of +246,260 shares of common stock at an exercise price of $3.25 per share are +callable by the Company if the market price of the Company’s common stock +trades for 20 consecutive days at a price equal to or greater than two times +the exercise price of the warrants. Warrants to purchase an aggregate of +75,000 shares of common stock at an exercise price of $5.00 per share are +callable by the Company if the market price of the Company’s common stock +trades for 20 consecutive days at a price equal to or greater than one and +a half times the exercise price of the warrants. +58 +Common stock reserved for +future issuance at March 31, 2008: +(In thousands) +Issuable +under stock options plans +4,985 +Issuable +upon the exercise of warrants +1,165 +6,150 +9. Associate +Benefit Plans +Stock +Option Plan +On September 21, +2007, the Company’s stockholders approved the 2007 Omnibus Incentive Plan (the “2007 +Plan”), which provides that options to purchase shares of the Company’s +unissued common stock may be granted to employees, officers, consultants and +directors to the Company at exercise prices which are equal to or greater than +the fair market value of the Company’s common stock on the date of grant. +Options expire no more than ten years after the date of grant and generally +vest at the rate of 25% on each of the first four anniversaries of the grant +date. The 2007 Plan also allows for the issuance of stock appreciation rights, +restricted stock, restricted stock units and other stock-based awards based on +the value of the Company’s common stock. New shares are issued to satisfy stock +option exercises and share issuances under the 2007 Plan. As of March 31, +2008, options to purchase an aggregate of 389,000 shares of common stock were +outstanding under the 2007 Plan. +The Company’s 1997 Stock +Incentive Plan (the “1997 Plan”) terminated in September 2007; however, +all stock options outstanding under the 1997 Plan will remain outstanding +pursuant to the terms of such stock options. As of March 31, 2008, options +to purchase 1.4 million shares of the Company’s common stock were outstanding +under the 1997 Plan. +In connection with the +merger of the Company and the Iteris Subsidiary (Note 1), the Company assumed +the 1998 Stock Incentive Plan of the Iteris Subsidiary (the “1998 Plan”) and +all outstanding options granted thereunder. As of March 31, 2008, options +to purchase 2.7 million shares of the Company’s common stock were outstanding +under the 1998 Plan. No further options may be granted under the 1998 Plan. +Certain options granted +under the 2007 Plan, the 1997 Plan and the 1998 Plan (collectively, the “Plans”) +provide for accelerated vesting of unvested options in the event of a change in +control under certain circumstances. These change-in-control provisions meet +the criteria of a performance condition under SFAS 123R. +A summary of activity in +the Plans for the year ended March 31, 2008 is as follows: +Options +Weighted +Average +Exercise +Price +Weighted +Average +Remaining Contractual +Life (Years) +Aggregate +Intrinsic Value +(In thousands, except per share amounts) +Options outstanding at +March 31, 2007 +5,818 +$1.60 +3.4 +Granted +389 +$2.38 +N/A +Exercised +(1,515 +) +$0.90 +N/A +Forfeited +(53 +) +$2.92 +N/A +Expired +(115 +) +$3.90 +N/A +Options outstanding at +March 31, 2008 +4,524 +$1.83 +3.7 +$3,761 +Vested and expected to +vest at March 31, 2008 +4,400 +$1.81 +3.6 +$3,759 +Options exercisable at +March 31, 2008 +3,875 +$1.72 +2.8 +$3,750 +Options exercisable at +March 31, 2008 pursuant to a change-in-control +4,524 +$1.83 +3.7 +$3,761 +At March 31, 2008, +there were 461,000 shares of common stock available for grant under the 2007 +Plan. +For the years ended March 31, +2008, 2007 and 2006, the Company received $1.4 million, $1.1 million and +$296,000, respectively, in cash from the exercise of stock options. +59 +Stock-Based Compensation Expense +Total stock-based +compensation expense for the years ended March 31, 2008, 2007 and 2006 was +$290,000, $288,000, and $725,000, respectively. +No income tax benefit was realized from activity in the Plans during the +years ended March 31, 2008, 2007 and 2006. +The fair value of +each stock-based award is estimated on the grant date using the BSM +option-pricing formula. Expected volatility is based on the historical +volatility of the Company’s stock price. The expected life of options granted +subsequent to the adoption of SFAS 123R is derived based on the historical life +of the Company’s options. The risk-free +interest rate for periods within the expected life of the option is based on +the U.S. Treasury interest rates in effect at the time of grant. The grant date +fair value of options granted was estimated using the following weighted-average +assumptions: +Year Ended March 31, +2008 +2007 +2006 +Dividend +yield +0.0 +% +0.0 +% +0.0 +% +Expected +life — years +7.0 +7.0 +7.0 +Risk-free +interest rate +3.8 +% +4.7 +% +5.5 +% +Expected +volatility of common stock +0.8 +0.9 +0.5 +A summary of the grant +date fair value and intrinsic value information is as follows: +Year Ended March 31, +2008 +2007 +2006 +(In thousands, except per share amounts) +Weighted +average grant date fair value per share of options granted +$ +1.83 +$ +1.92 +$ +1.77 +Intrinsic +value of options exercised +$ +2,555 +$ +2,288 +$ +295 +At March 31, 2008, +there was $1.2 million of total unrecognized compensation expense related to +unvested stock options. This expense is +expected to be recognized over a weighted-average period of approximately 3.5 +years. +Associate Incentive Programs +Under the terms of +a Profit Sharing Plan, the Company may contribute to a trust fund such amounts +as are determined annually by the Board of Directors. No contributions were +made during the years ended March 31, 2008, 2007 and 2006. +In May 1990, +the Company adopted a 401(k) Plan as an amendment and replacement of the +former Associate Stock Purchase Plan that was an additional feature of the +Profit Sharing Plan. Under the 401(k) Plan, eligible associates +voluntarily contribute to the plan, up to IRS maximums, through payroll +deductions. The Company matches up to 90% of contributions, based on years of +service, up to a stated limit. Under the provisions of the 401(k) Plan, +associates have various investment choices, one of which is the purchase of +Iteris, Inc. common stock at market price. Company matching contributions +were approximately $401,000, $480,000, and $317,000 and for the years ended March 31, +2008, 2007, and 2006, respectively. +10. Business +Segment and Geographic Information +The Company +currently operates in three reportable segments: Roadway Sensors, Vehicle +Sensors and Transportation Systems. The Roadway Sensors segment includes +Vantage vehicle detection systems for traffic intersection control and +certain highway traffic data collection applications. The Vehicle Sensors +segment is comprised of all activities related to AutoVue lane departure +warning systems. The Transportation Systems segment includes transportation +engineering and consulting services and the development of transportation +management and traveler information systems for the ITS industry. The +accounting policies of the reportable segments are the same as those described +in the summary of significant accounting policies. Prior to April 1, 2007, certain +expenses, such as interest, amortization of certain intangibles and certain +corporate expenses were not allocated to the segments. Beginning April 1, +2007, the Company increased the portion of its corporate expenses that it +allocates to its segments such that substantially all corporate expenses are +allocated. Interest, amortization of +certain intangibles and certain corporate expenses are still not allocated to +the segments. The reportable segments are each managed separately because they +manufacture and distribute distinct products or provide services with different +processes. All segment revenues are derived from external customers. +60 +Selected financial +information for the Company’s reportable segments as of and for the years ended +March 31, 2008, 2007 and 2006 is as follows: +Roadway +Sensors +Vehicle +Sensors +Transportation +Systems +Total +(In thousands) +Year Ended March 31, 2008 +Product +revenue from external customers +$ +28,452 +$ +10,016 +$ +— +$ +38,468 +Service +and other revenue from external customers +— +1,858 +24,837 +26,695 +Stock-based +compensation +18 +45 +27 +90 +Depreciation +107 +130 +147 +384 +Allocated +goodwill +8,197 +4,671 +14,906 +27,774 +Segment +income +5,062 +552 +2,094 +7,708 +Year Ended March 31, 2007 +Product +revenue from external customers +$ +27,261 +$ +6,408 +$ +— +$ +33,669 +Service +and other revenue from external customers +— +2,579 +22,049 +24,628 +Stock-based +compensation +37 +54 +78 +169 +Depreciation +82 +138 +126 +346 +Allocated +goodwill +8,197 +4,671 +14,906 +27,774 +Segment +income (loss) +6,035 +(2,625 +) +2,551 +5,961 +Year Ended March 31, 2006 +Product +revenue from external customers +$ +22,446 +$ +5,865 +$ +— +$ +28,311 +Service +and other revenue from external customers +— +2,845 +19,330 +22,175 +Stock-based +compensation +177 +101 +342 +620 +Depreciation +132 +189 +266 +587 +Allocated +goodwill +8,197 +4,671 +14,906 +27,774 +Segment +income (loss) +3,420 +(2,476 +) +1,842 +2,786 +The Roadway +Sensors segment had one customer with combined revenue representing 16.9% of +total segment revenue for the year ended March 31, 2008; one customer with +revenue representing 26.5% of total segment revenue for the year ended March 31, +2007; and one customer with revenue representing 25.9% of total segment revenue +for the year ended March 31, 2006. The Vehicle Sensors segment had three +customers with combined revenue representing 60.9% of total segment revenue for +the year ended March 31, 2008; three customers with combined revenue +representing 64.2% of total segment revenue for the year ended March 31, +2007; and two customers with combined revenue representing 70.7% of total +segment revenue for the year ended March 31, 2006. The Transportation +Systems segment had one customer with revenue representing 13.3% of total +segment revenue for the year ended March 31, 2007. +61 +The following +reconciles segment income to consolidated income (loss) before income taxes and +segment assets to consolidated assets: +March 31, +2008 +2007 +2006 +(In thousands) +Segment +income +Total +income for reportable segments +$ +7,708 +$ +5,961 +$ +2,786 +Unallocated +amounts: +Corporate +and other expenses +(266 +) +(1,986 +) +(2,020 +) +Amortization +of intangible assets +(147 +) +(147 +) +(147 +) +Other +income (expense), net +252 +(653 +) +35 +Interest +expense, net +(1,284 +) +(1,600 +) +(1,459 +) +Income +(loss) before income taxes +$ +6,263 +$ +1,575 +$ +(805 +) +The Company’s revenues are generated and the +Company’s assets are held substantially in the United States. +11. Quarterly Financial Data +(Unaudited) +Total Net +Sales and +Contract +Revenues +Gross +Profit +Net +Income +Basic +Earnings +per Share +Diluted +Earnings +per Share +(In thousands, except per share amounts) +June 30, +2007 +$ +15,757 +$ +7,094 +$ +1,096 +$ +0.03 +$ +0.03 +September 30, +2007 +16,976 +7,262 +2,170 +0.07 +0.06 +December 31, +2007 +15,363 +6,500 +954 +0.03 +0.03 +March 31, +2008 +17,067 +7,441 +7,943 +0.24 +0.23 +$ +65,163 +$ +28,297 +$ +12,163 +$ +0.37 +* +$ +0.35 +* +June 30, +2006 +$ +13,816 +$ +5,719 +$ +279 +$ +0.01 +$ +0.01 +September 30, +2006 +14,466 +5,957 +732 +0.03 +0.02 +December 31, +2006 +14,488 +5,676 +310 +0.01 +0.01 +March 31, +2007 +15,527 +6,656 +1,597 +0.05 +0.05 +$ +58,297 +$ +24,008 +$ +2,918 +$ +0.10 +* +$ +0.09 +* +* Annual per share +amounts may not agree to the sum of the quarterly per share amounts due to +differences between average shares outstanding during the periods. +62 +Schedule II +Valuation +and Qualifying Accounts (In thousands) +Description +Balance at +Beginning of +Period +Charged to +Costs and +Expenses +Charged to +Accounts +Balance at End +of Period +Year Ended March 31, 2008 +Deducted +from asset accounts: +Allowance +for doubtful accounts +$ +664 +$ +360 +$ +(4 +) +$ +1,020 +Reserve +for inventory obsolescence +844 +576 +(601 +) +819 +Year Ended March 31, 2007 +Deducted +from asset accounts: +Allowance +for doubtful accounts +$ +429 +$ +220 +$ +15 +$ +664 +Reserve +for inventory obsolescence +592 +420 +(168 +) +844 +Year Ended March 31, 2006 +Deducted +from asset accounts: +Allowance +for doubtful accounts +$ +239 +$ +275 +$ +(85 +) +$ +429 +Reserve +for inventory obsolescence +514 +312 +(234 +) +592 +63 \ No newline at end of file diff --git a/raw/filings/0000350868/2007/0001104659-08-039576/filing_metadata.csv b/raw/filings/0000350868/2007/0001104659-08-039576/filing_metadata.csv new file mode 100644 index 0000000000000000000000000000000000000000..357c645a6d3dfd2c9635f2b7b29ba48580a9a163 --- /dev/null +++ b/raw/filings/0000350868/2007/0001104659-08-039576/filing_metadata.csv @@ -0,0 +1,2 @@ +cik,ticker,company_name,form,filing_date,report_date,acceptance_datetime,accession_number,primary_document,primary_doc_description,size,is_xbrl,is_inline_xbrl,document_url,filing_index_url,year,fiscal_year,is_primary_filing +0000350868,ITI,"ITERIS, INC.",10-K,2008-06-12,2008-03-31,2008-06-12T20:23:02.000Z,0001104659-08-039576,a08-12231_110k.htm,10-K,2116871,0,0,https://www.sec.gov/Archives/edgar/data/350868/000110465908039576/a08-12231_110k.htm,https://www.sec.gov/Archives/edgar/data/350868/000110465908039576/,2007,2007,1 diff --git a/raw/filings/0000350868/2007/0001104659-08-039576/item1.txt b/raw/filings/0000350868/2007/0001104659-08-039576/item1.txt new file mode 100644 index 0000000000000000000000000000000000000000..11f8666efb8afff98fe4f74d11e30c72320c0b0f --- /dev/null +++ b/raw/filings/0000350868/2007/0001104659-08-039576/item1.txt @@ -0,0 +1,281 @@ +ITEM 1. BUSINESS +Overview +Iteris, Inc. is a +leader in the traffic management market that focuses on the development and +application of advanced technologies that reduce traffic congestion, minimize +the environmental impact of traffic congestion and improve the safety of +surface transportation systems. By combining outdoor image processing, traffic +engineering and information technology, we offer a broad range of Intelligent +Transportation Systems and driver safety solutions to customers worldwide. +Our proprietary image +recognition systems include Vantage and AutoVue. Vantage is a video vehicle detection +system that detects the presence of vehicles on roadways. Vantage systems are +used at signalized intersections to enable a more efficient allocation of green +signal time and are also used for incident detection and highway traffic data +collection applications. AutoVue Lane Departure Warning (“LDW”) systems consist +of a small windshield mounted sensor that uses proprietary software to detect +and warn drivers of unintended lane departures. To date, we and our strategic +partner have sold approximately 90,000 production AutoVue LDW systems for use +on car and truck platforms in the North American and European markets. We +believe that our AutoVue LDW technology is a broad sensor platform that, +through additional software development, may be expanded to incorporate +additional safety and convenience features. +Our transportation +management systems business includes transportation engineering and consulting +services focused on the planning, design, development and implementation of +software-based systems that integrate sensors, video surveillance, computers +and advanced communications equipment to enable public agencies to monitor, +control and direct traffic flow, assist in the quick dispatch of emergency +crews and distribute real-time information about traffic conditions. Our +services include planning, design and implementation of surface transportation +infrastructure systems. We perform +analysis and study goods movement, commercial vehicle operations, travel demand +forecasting and systems engineering, and identify mitigation measures to reduce +traffic congestion. These services and +systems are primarily sold to local, state and national transportation agencies +in the United States. Our transportation +management systems business is largely dependent upon governmental funding and +budgetary issues. The Federal Highway +Bill that was passed in August 2005 provided for a significant increase in +transportation funding over the following six years. We believe the recent expansion of our +transportation management systems business was due in part to the passage of +the Federal Highway Bill, combined with the expansion of transportation funds +at state and local agencies throughout the country. The 2005 Federal Highway Bill +is set to expire during 2009. +We currently operate in three reportable segments: +Roadway Sensors, Vehicle Sensors and Transportation Systems. The Roadway +Sensors segment includes our Vantage vehicle detection systems for traffic +intersection control, incident detection and certain highway traffic data +collection applications. The Vehicle +Sensors segment is comprised of all activities related to our AutoVue LDW +systems for vehicle safety. The Transportation Systems segment includes +transportation engineering and consulting services and the development of +transportation management and traveler information systems for the ITS +industry. See Note 12 to the +accompanying consolidated financial statements for further discussion of our +operating segments. +3 +We were originally +incorporated in Delaware in 1987. In October 2004, +we completed a merger with our majority-owned subsidiary, Iteris, Inc. +(the “Iteris Subsidiary”), and officially changed our corporate name to Iteris, Inc. +Sales, Marketing and Principal Customers +We sell our Vantage +vehicle detection systems through indirect sales channels comprised of +independent dealers in the United States and Canada who sell integrated systems +and related products to the traffic management market, as well as directly to +the traffic management market using a combination of our own sales personnel +and an outside sales organization. Our independent dealers are primarily +responsible for sales, installation and support of Vantage systems. These +dealers maintain an inventory of demonstration traffic products from various +manufacturers including our Vantage vehicle detection systems and sell directly +to government agencies and installation contractors. These dealers often have +long-term arrangements with the government agencies in their territory for the +supply of various products for the construction and renovation of traffic +intersections. We hold technical training classes for dealers and end users and +maintain a full-time staff of customer support technicians to provide technical +assistance when needed. +Our marketing strategy +for AutoVue is to establish it as the leading platform for in-vehicle video +sensing for heavy trucks and passenger cars. +We sell AutoVue LDW systems directly to heavy truck manufacturers and to +U.S. truck fleets, and our AutoVue LDW system is currently offered as an option +on certain heavy trucks, including Mercedes-Benz, MAN, Iveco, DAF, Scania, +Freightliner and FUSO, as well as Neoplan and MAN luxury bus and coach lines. +We market the licensing of our LDW technology to manufacturers of passenger +automobiles through an exclusive strategic relationship with Valeo Schalter and +Sensuren GmbH (“Valeo”), an independent automotive supplier. In connection with +this marketing effort, we provide specific contract engineering services, +technical marketing and sales support to Valeo, which to date has enabled the +launch of our LDW technology on three Infiniti car platforms. We plan to +continue to provide technical marketing and sales support to Valeo in our efforts +to win new original equipment manufacturer (“OEM”) customers for the passenger +car market as well as contract engineering services related to the possible +launch of new platforms that include our AutoVue LDW system. +We market and sell our +transportation management systems and traveler information services directly to +government agencies pursuant to negotiated contracts that involve competitive +bidding and specific qualification requirements. Most of our contracts with +federal, state and municipal customers provide for cancellation or +renegotiation at the option of the customer upon reasonable notice and fees +paid for modification. We use selected members of our engineering team divided +on a regional basis to serve in sales and business development functions. We do +not engage in sales of transportation management systems and traveler +information services outside of the U.S. Sales of our transportation management +systems contracts generally involve long lead times and require extensive +specification development, evaluation and price negotiations. +A large portion of our +revenues are derived from sales to federal, state and local government +agencies. Our largest customer accounted +for 7.3% of total net sales and contract revenues in the fiscal year ended March 31, +2008 (“Fiscal 2008”). +Manufacturing +and Materials +We use contract +manufacturers to build subassemblies that are used in our Vantage products. +Additionally, we procure certain components from qualified suppliers, both +globally and locally, and use multi-sourcing strategies when technically and +economically feasible to mitigate supply risk. These subassemblies and +components are delivered to our Santa Ana facility where they go through final +assembly and testing prior to shipment to our customers. Our manufacturing +activities are conducted in approximately 9,000 square feet of space at our +Santa Ana facility. Production volume at our subcontractors is based upon +quarterly forecasts that we adjust on a monthly basis to control inventory +levels. For sales of AutoVue LDW systems to the truck market, we subcontract +the manufacture of our AutoVue LDW systems to one primary manufacturer, and our +internal processes are limited primarily to testing and final verification. For +AutoVue LDW sales to the passenger car market, all manufacturing will be +performed by Valeo; however, we plan to continue to provide engineering support +to Valeo. We currently do not manufacture any of the hardware used in the +transportation management and traveler information systems that we design and +implement. Our production facility is currently ISO 9001 certified. +4 +Customer +Support and Services +We provide warranty service and support for our +Vantage and AutoVue products, as well as follow-up service and support for +which we charge separately. Service revenue accounted for less than 1.0% of +total net sales and contract revenues for Fiscal 2008. We believe customer +support is a key competitive factor. +Backlog +Our backlog of unfulfilled +firm orders was approximately $26.8 million as of March 31, 2008, which +was comprised of $900,000 related to Roadway Sensors, $1.3 million related to +Vehicle Sensors and $24.6 million related to Transportation Systems. +Substantially all of the backlog for Roadway Sensors and Vehicle Sensors is +expected to be recognized as revenue in the fiscal year ending March 31, +2009 (“Fiscal 2009”), while approximately 60% of Transportation Systems backlog +is expected to be recognized as revenue in Fiscal 2009. At March 31, 2007, +we had backlog of approximately $25.7 million, which was comprised of $3.5 +million related to Roadway Sensors, $2.1 million related to Vehicle Sensors and +$20.1 million related to Transportation Systems. All backlog as of March 31, +2007 for Roadway Sensors and Vehicle Sensors was recognized as revenue in +Fiscal 2008 while 45% of March 31, 2007 backlog for Transportation Systems +was recognized as revenue in Fiscal 2008. Pursuant to the customary terms of +our agreements with government contractors and other customers, customers can +generally cancel or reschedule orders with little or no penalties. Lead +times for the release of purchase orders often depend upon the scheduling and +forecasting practices of our individual customers, which also can affect the +timing of the conversion of our backlog into revenues. For these reasons, among +others, our backlog at a particular date may not be indicative of our future +revenues, in particular for Roadway Sensors and Vehicle Sensors. +Product +Development +Most of our development +activities are conducted at our principal facilities in Santa Ana, California. +Our company-sponsored research and development costs and expenses were +approximately $3.6 million for Fiscal 2008, $4.0 million for the fiscal year +ended March 31, 2007 (“Fiscal 2007”), and $5.2 million for the fiscal year +ended March 31, 2006 (“Fiscal 2006”). We expect to continue to pursue +significant product development programs and incur significant research and +development expenditures. +Competition +We generally face +significant competition in each of our target markets. Increased competition +may result in price reductions, reduced gross margins and loss of market share, +any of which could have a material adverse effect on our business, financial +condition and results of operations. While AutoVue has historically been the +only established commercially-available lane departure warning system used in +the U.S. and in Europe in the heavy truck market, we have recently experienced +increased competition from new competitors in this market. Potential +competitors of AutoVue include Delphi Automotive Systems Corporation, NEC +Corporation and Hitachi Ltd. in Japan and Robert Bosch GmbH in Europe, as well +as Siemens, Continental Tavis, Visteon and Cognex, which are currently +developing video sensor technologies for the vehicle industry that could be +used for lane departure warning systems. In the market for our Vantage vehicle +detection systems, we compete with manufacturers of other above ground video +camera detection systems such as Econolite Control Products, Inc., +Traficon, N.V., Quixote, and other non-intrusive detection devices including +microwave, infrared, ultrasonic and magnetic detectors, as well as +manufacturers and installers of in-pavement inductive loop products. +The transportation +management and traveler information systems market is highly fragmented and is +subject to evolving national and regional quality and safety standards. Our +competitors vary in number, scope and breadth of the products and services they +offer. Our competitors in advanced transportation management and traveler +information systems include national corporations such as Transcore, Siemens, +Telvent Farradyne, Kimley-Horn and Associates, Inc. and Delcan. Our +competitors in transportation engineering, planning and design include major +firms such as Parsons Brinkerhoff, Inc., URS, HNTB and Parsons +Transportation Group, Inc., as well as many smaller regional engineering +firms. +5 +In general, the markets +for the products and services we offer are highly competitive and are +characterized by rapidly changing technology and evolving standards. Many of +our current and prospective competitors have longer operating histories, +greater name recognition, access to larger customer bases and significantly +greater financial, technical, manufacturing, distribution and marketing +resources than us. As a result, they may be able to adapt more quickly to new +or emerging standards or technologies or to devote greater resources to the +promotion and sale of their products. It is also possible that new competitors +or alliances among competitors could emerge and rapidly acquire significant +market share. We believe that our ability to compete effectively in our target markets +will depend on a number of factors, including the success and timing of our new +product development, the compatibility of our products with a broad range of +computing systems, product quality and performance, reliability, functionality, +price, and service and technical support. Our failure to provide services and +develop and market products that compete successfully with those of other +suppliers and consultants in our target markets would have a material adverse +effect on our business, financial condition and results of operations. +Intellectual +Property and Proprietary Rights +Our ability to compete +effectively depends in part on our ability to develop and maintain the +proprietary aspects of our technology. Our policy is to obtain appropriate +proprietary rights protection for any potentially significant new technology +acquired or developed by us. We currently hold ten U.S. patents, which expire +commencing in 2012, and have six U.S. patent +applications pending relating to our outdoor image processing techniques used +in our AutoVue systems. Nine of our patents relate specifically to our AutoVue +technology and provide a basis for enhanced functionality for rain sensing and +improved performance. We believe that our other patents, while important for +our technology platforms, are less critical to our near term product strategy. +We cannot assure you that any new patents will be granted pursuant to any +outstanding or subsequent applications. +In addition to patent +laws, we rely on copyright and trade secret laws to protect our proprietary +rights. We attempt to protect our trade secrets and other proprietary +information through agreements with customers and suppliers, proprietary +information agreements with our employees and consultants, and other similar +measures. We do not have any material licenses or trademarks other than those +relating to product names. We cannot be certain that we will be successful in +protecting our proprietary rights. While we believe our patents, patent +applications, software and other proprietary know-how have value, changing +technology makes our future success dependent principally upon our employees’ +technical competence and creative skills for continuing innovation. +Litigation may be +necessary in the future to enforce our proprietary rights, to determine the +validity and scope of the proprietary rights of others, or to defend us against +claims of infringement or invalidity by others. An adverse outcome in such +litigation or similar proceedings could subject us to significant liabilities +to third parties, require disputed rights to be licensed from others or require +us to cease marketing or using certain products, any of which could have a +material adverse effect on our business, financial condition and results of +operations. In addition, the cost of addressing any intellectual property +litigation claim, both in legal fees and expenses, as well as from the +diversion of management’s resources, regardless of whether the claim is valid, +could be significant and could have a material adverse effect on our business, +financial condition and results of operations. +Employees +We refer to our employees +as associates. As of June 9, 2008, we employed an aggregate of 268 +associates, including 54 associates in general management, administration and finance; +34 associates in sales and marketing; 144 associates in engineering and product +development; 23 associates in operations, manufacturing and quality; and 13 +associates in customer service. None of our associates are represented by a +labor union, and we have never experienced a work stoppage. +Government +Regulation +Our manufacturing +operations are subject to various federal, state and local laws and +regulations, including those restricting the discharge of materials into the +environment. We are not involved in any pending or, to our knowledge, +threatened governmental proceedings, which would require curtailment of our +operations because of such laws and regulations. We continue to expend funds in +connection with our compliance with applicable environmental regulations. These +expenditures have not, however, been significant in the past, and we do not +expect any significant expenditure in the near future. Currently, compliance +with foreign laws has not had a material impact on our business and is not expected +to have a material impact in the near future. +6 \ No newline at end of file diff --git a/raw/filings/0000350868/2007/0001104659-08-039576/item13.txt b/raw/filings/0000350868/2007/0001104659-08-039576/item13.txt new file mode 100644 index 0000000000000000000000000000000000000000..c01996db219b9d50919913f7b9d322381f70e56f --- /dev/null +++ b/raw/filings/0000350868/2007/0001104659-08-039576/item13.txt @@ -0,0 +1,7 @@ +ITEM 13. CERTAIN RELATIONSHIPS AND RELATED +TRANSACTIONS, AND DIRECTOR INDEPENDENCE +The information under the +captions “Corporate Governance – Director Independence” and “Certain +Transactions,” appearing in our proxy statement for the 2008 Annual Meeting of +Stockholders, is incorporated herein by reference. +31 \ No newline at end of file diff --git a/raw/filings/0000350868/2007/0001104659-08-039576/item9a.txt b/raw/filings/0000350868/2007/0001104659-08-039576/item9a.txt new file mode 100644 index 0000000000000000000000000000000000000000..952b048d94a02dc72f735d8b4e465233cdd3739d --- /dev/null +++ b/raw/filings/0000350868/2007/0001104659-08-039576/item9a.txt @@ -0,0 +1,50 @@ +ITEM 9A(T). CONTROLS AND PROCEDURES +(a) Evaluation of disclosure controls and +procedures. In accordance with Rule 13a-15(b) of +the Securities Exchange Act of 1934, as of the end of the period covered by +this Annual Report on Form 10-K, the Company’s management evaluated, with +the participation of the Company’s President and Chief Executive Officer and +the Chief Financial Officer, the effectiveness of the design and operation of +the Company’s disclosure controls and procedures (as defined in Rule 13a-15(e) under +the Exchange Act). Based upon their evaluation of these disclosure controls and +procedures, the President and Chief Executive Officer and the Chief Financial +Officer have concluded that the disclosure controls and procedures were +effective as of the date of such evaluation in ensuring that information +required to be disclosed in the Company’s Exchange Act reports is (1) recorded, +processed, summarized and reported in a timely manner, and (2) accumulated +and communicated to management, including the Company’s President and Chief +Executive Officer and the Chief Financial Officer, as appropriate, to allow +timely decisions regarding required disclosure. +(b) +Changes in internal control. There was no change in the Company’s +internal control over financial reporting that occurred during the period +covered by this Annual Report on Form 10-K that has materially affected, +or is reasonably likely to materially affect, the Company’s internal control +over financial reporting. +Management’s Report on Internal +Control Over Financial Reporting +Management of the Company +is responsible for establishing and maintaining adequate internal control over +financial reporting. Our internal control system was designed to provide +reasonable assurance to management and the board of directors regarding the +effectiveness of our internal control processes over the preparation and fair +presentation of published financial statements. +All internal +control systems, no matter how well designed, have inherent limitations. +Therefore, even those systems determined effective can provide only reasonable +assurance with respect to financial statement preparation and presentation. +30 +We have assessed +the effectiveness of our internal controls over financial reporting as of March 31, +2008. In making this assessment, we used the criteria set forth by the +Committee of Sponsoring Organizations of the Treadway Commission (COSO) in +Internal Control—Integrated Framework. Based on our assessment, we believe +that, as of March 31, 2008, our internal control over financial reporting +is effective based on those criteria. +This annual report +does not include an attestation report of the Company’s independent registered +public accounting firm regarding internal control over financial reporting. +Management’s report was not subject to attestation by the Company’s independent +registered public accounting firm pursuant to the rules of the Securities +and Exchange Commission that permit the Company to provide only management’s +report in this annual report. \ No newline at end of file diff --git a/raw/filings/0000350868/2007/0001104659-08-039576/rp_note.txt b/raw/filings/0000350868/2007/0001104659-08-039576/rp_note.txt new file mode 100644 index 0000000000000000000000000000000000000000..e69de29bb2d1d6434b8b29ae775ad8c2e48c5391 diff --git a/raw/filings/0000350868/2007/0001104659-08-039576/rpt_disclosure.txt b/raw/filings/0000350868/2007/0001104659-08-039576/rpt_disclosure.txt new file mode 100644 index 0000000000000000000000000000000000000000..e69de29bb2d1d6434b8b29ae775ad8c2e48c5391 diff --git a/raw/filings/0000350868/2010/0001104659-11-032666/filing.txt b/raw/filings/0000350868/2010/0001104659-11-032666/filing.txt new file mode 100644 index 0000000000000000000000000000000000000000..9e47693932bc03aaaf33268049e3d49160f0f1d2 --- /dev/null +++ b/raw/filings/0000350868/2010/0001104659-11-032666/filing.txt @@ -0,0 +1,3404 @@ +10-K +1 +a11-12868_110k.htm +10-K +Table of Contents +UNITED STATES +SECURITIES AND EXCHANGE COMMISSION +Washington, D.C. 20549 +FORM 10-K +(Mark One) +x ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 +For the fiscal year ended March 31, 2011 +OR +o TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 +For the transition period from to +Commission file number 001-08762 +ITERIS, INC. +(Exact Name of Registrant as Specified in Its Charter) +Delaware +95-2588496 +(State or Other Jurisdiction +of Incorporation or Organization) +(I.R.S. Employer +Identification No.) +1700 Carnegie Ave., Santa Ana, California 92705 +(Address of Principal Executive Offices) (Zip Code) +Registrant’s Telephone Number, Including Area Code: (949) 270-9400 +Securities registered pursuant to Section 12(b) of the Act: +Title of each class +Name of each exchange on which registered +Common Stock, $0.10 par value +NYSE Amex +Securities registered pursuant to Section 12(g) of the Act: None +Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes o No x +Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes o No x +Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No o +Indicate by a check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. o +Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes o No o +Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See definitions of “large accelerated filer,” “accelerated filer,” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one): +Large accelerated filer o +Accelerated filer o +Non-accelerated filer o +Smaller reporting company x +(Do not check if a smaller reporting company) +Indicate by check mark whether the registrant is a shell company (as defined in Exchange Act Rule 12b-2). Yes o No x +Based on the closing sale price of the registrant’s common stock on the last business day of the registrant’s most recently completed second fiscal quarter, the aggregate market value of the voting common stock held by nonaffiliates of the registrant was approximately $33,247,000. For the purposes of this calculation, shares owned by officers, directors and 10% stockholders known to the registrant have been deemed to be owned by affiliates. This determination of affiliate status is not necessarily a conclusive determination for other purposes. +As of May 20, 2011, there were 34,365,743 shares of our common stock outstanding. +DOCUMENTS INCORPORATED BY REFERENCE +Part III incorporates by reference certain information from the registrant’s definitive proxy statement for the 2011 Annual Meeting of Stockholders, which will be filed with the Securities and Exchange Commission not later than 120 days after the end of the fiscal year ended March 31, 2011. Except with respect to information specifically incorporated by reference in this report, the registrant’s proxy statement is not deemed to be filed as a part hereof. +Table of Contents +ITERIS, INC. +ANNUAL REPORT ON FORM 10-K +FOR THE FISCAL YEAR ENDED MARCH 31, 2011 +TABLE OF CO NTENTS +PART I +ITEM 1. +BUSINESS +2 +ITEM 1A. +RISK FACTORS +7 +ITEM 1B. +UNRESOLVED STAFF COMMENTS +16 +ITEM 2. +PROPERTIES +16 +ITEM 3. +LEGAL PROCEEDINGS +16 +ITEM 4. +(REMOVED AND RESERVED) +16 +PART II +17 +ITEM 5. +MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES +17 +ITEM 6. +SELECTED FINANCIAL DATA +17 +ITEM 7. +MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS +17 +ITEM 7A. +QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK +32 +ITEM 8. +FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA +32 +ITEM 9. +CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE +32 +ITEM 9A. +CONTROLS AND PROCEDURES +32 +ITEM 9B. +OTHER INFORMATION +33 +PART III +33 +ITEM 10. +DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE +33 +ITEM 11. +EXECUTIVE COMPENSATION +33 +ITEM 12. +SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS +33 +ITEM 13. +CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE +33 +ITEM 14. +PRINCIPAL ACCOUNTING FEES AND SERVICES +34 +PART IV +34 +ITEM 15. +EXHIBITS, FINANCIAL STATEMENT SCHEDULES +34 +Unless otherwise indicated in this report, the “Company,” “we,” “us” and “our” refer to Iteris, Inc. and our wholly-owned subsidiaries. +AutoVue ® , Iteris ® , Vantage ® , VantageView™, VersiCam™, SafetyDirect™ and Abacus™ are among the trademarks of Iteris, Inc. Any other trademarks or trade names mentioned herein are the property of their respective owners. +1 +Table of Contents +Cautionary Statement +This report, including the following discussion and analysis, contains forward-looking statements (within the meaning of the Private Securities Litigation Reform Act of 1995) that are based on our current expectations, estimates and projections about our business and our industry, and reflect management’s beliefs and certain assumptions made by us based upon information available to us as of the date of this report. When used in this report and the information incorporated herein by reference, the words “expect(s),” “feel(s),” “believe(s),” “should,” “would,” “could,” “may,” “anticipate(s),” “estimate(s)” and similar expressions or variations of these words are intended to identify forward-looking statements. These forward-looking statements include but are not limited to statements regarding our anticipated sales, revenue, expenses, profits, capital needs, competition, backlog and manufacturing capabilities, the practical market applications, future applications and acceptance of our products and services, the status of our facilities and product development. These statements are not guarantees of future performance and are subject to certain risks and uncertainties which could cause actual results to differ materially from those projected. You should not place undue reliance on these forward-looking statements that speak only as of the date hereof. We undertake no obligation to republish revised forward-looking statements to reflect events or circumstances after the date hereof or to reflect the occurrence of unanticipated events. We encourage you to carefully review and consider the various disclosures made by us which describe certain factors which could affect our business, including those in “ Risk Factors” in Item 1A of this report, before deciding to invest in our company or to maintain or increase your investment. We undertake no obligation to revise or update publicly any forward-looking statement for any reason. +PART I +ITEM 1. BUSINESS +Overview +We are a leader in the traffic management market focused on the development and application of advanced technologies that reduce traffic congestion and improve the safety of surface transportation systems infrastructure. Additionally, we believe that our products and services, in conjunction with sound traffic management, minimize the environmental impact of traffic congestion. By combining outdoor image processing, traffic engineering and information technology, we offer a broad range of Intelligent Transportation Systems (“ITS”) and driver safety solutions to customers worldwide. +We were originally incorporated in Delaware in 1987. Our principal executive offices are located at 1700 Carnegie Avenue, Santa Ana, California 92705, and our telephone number at that location is (949) 270-9400. Our Internet website address is www.iteris.com. Our annual reports on Form 10-K, quarterly reports on Form 10-Q and current reports on Form 8-K, together with amendments to these reports, are available on the “Investors” section of our website, free of charge, as soon as reasonably practicable after such material is electronically filed with, or furnished to, the Securities and Exchange Commission (“SEC”). The inclusion of our website address in this report does not include or incorporate by reference into this report any information on our website. +Products and Services +We currently operate in four reportable segments: Roadway Sensors, Vehicle Sensors, Transportation Systems and Environmental Technology. The Roadway Sensors segment includes, among other products, our Vantage, Versicam and Pico vehicle detection systems for traffic intersection control, incident detection and certain highway traffic data collection applications. The Vehicle Sensors segment includes our lane departure warning (“LDW”) products, including our AutoVue LDW system, and is comprised of all activities related to in-vehicle safety. The Transportation Systems segment includes transportation engineering and consulting services, and the development of transportation management and traveler information systems for the ITS industry. The Environmental Technology segment was created in connection with our acquisition of Meridian Environmental Technology, Inc. (“MET”) in January 2011, and specializes in 511 advanced traveler information systems by offering a unique range of customer-specific environmental and operational forecasting products and services, as well as Maintenance Decision Support System (“MDSS”) management tools that allow users to create solutions to meet roadway maintenance decision needs. See Note 11 of Notes to Consolidated Financial Statements, included in Part IV, Item 15 of this report, for further details on our reportable segments. +Roadway Sensors. Our Roadway Sensors segment product line uses advanced image processing technology to capture and analyze video images through sophisticated algorithms, enabling vehicle detection and transmission of both video images and data using a wide range of communication technologies. Our Vantage video detection systems detect vehicle presence, count, speed, occupancy and other traffic data used in traffic management systems. Our Vantage systems give traffic managers the ability to mitigate roadway congestion by modifying traffic signal timing or detecting incidents quickly. Our VantageView software supplements our Vantage video detection systems by providing an integrated platform to manage and “see” video detection assets remotely over a network connection. Vantage video detection systems have been deployed by hundreds of agencies and are currently sold through a network of independent dealers in the United States (“U.S.”), Asia, Latin America, Europe and the Middle East. +2 +Table of Contents +VersiCam, our integrated camera and processor video detection system, is a cost-efficient video detection system for smaller intersections that require only a few detection points. Pico is a compact video detection system that delivers superior vehicle detection in a small and economical framework, and was developed primarily to address international video detection needs. We anticipate that future growth domestically and internationally, particularly in developing countries, will be dependent in part on the continued adoption of above-ground video detection technologies, instead of in-pavement loop technology, to manage traffic. +Our Roadway Sensors product line also includes the Abacus family of products, which has been designed with a blend of artificial intelligence and video detection algorithms that allow either fixed or pan-tilt-zoom cameras to be used for data collection and incident detection. Our Abacus products take advantage of the large number of existing installed closed-circuit television video feeds monitoring roadways, tunnels and bridges and at signalized intersections. This flexibility of using a broad range of cameras with an appropriate perspective allows for accurate data collection without the set-up and calibration required with other systems. +We have historically experienced seasonality, particularly with respect to our Roadway Sensors net sales in the third and fourth fiscal quarters due to a reduction in road construction and repairs during the winter months due to inclement weather conditions. +Vehicle Sensors. Our Vehicle Sensors segment addresses the leading causes of roadway fatalities: lane change, roadway departure and rear-end collision accidents. Early estimates by the NHTSA of U.S. motor vehicle traffic fatalities in 2010 were approximately 33,000. +We developed the world’s first production LDW system and offer a proven system that is available as an original equipment manufacturer (“OEM”) and aftermarket option on heavy trucks worldwide and as an option in certain passenger cars. Our LDW products utilize video detection technology to detect when a vehicle begins to drift toward an unintended lane change. When this occurs, the system automatically emits a distinctive rumble strip or other audible warning sound, alerting the driver to make a correction. Through March 31, 2011, we have sold slightly more than 91,000 LDW systems into the heavy truck market in Europe, North America and Asia. Our LDW systems are standard on certain FUSO heavy truck models, and are currently qualified as an option on certain heavy trucks, including Mercedes-Benz, MAN, Iveco, DAF, Scania and Freightliner, as well as EvoBus, Neoplan and VanHool luxury bus and coach lines. In North America, our LDW systems are sold both as factory-installed OEM options, as well as directly to truck fleets as a retrofit installation. +In 2009, the European Union (“EU”) introduced a mandate, which is expected to be finalized and approved sometime in 2011, that sets better standards to improve road safety in Europe. The new mandated rules for safety technology are expected to include systems such as electronic stability control, advanced emergency braking and LDW systems to be compulsory on heavy-duty trucks and buses to further reduce accident risks. LDW systems are expected to be mandatory in Europe on all new heavy truck models beginning in 2013. Additionally, by 2015, every new truck produced will be required to have LDW systems. We believe that in order for the EU mandate for active safety systems to have a positive impact on our sales, we need to establish long-term supplier agreements with our European OEM heavy truck customers. To date we have agreements to supply certain of our European heavy truck customers through 2014, and are currently working on agreements with certain other heavy truck OEMs and our existing customer base to extend contracts further in the future in order to meet the anticipated increase in demand. However, we cannot assure you that our efforts will be successful or that the expected increase in demand will occur. We believe that the expected EU mandate for LDW and other active safety systems, and an increasing general awareness of the potential benefits of LDW, helps validate the long-term market opportunity for LDW systems in commercial vehicles. Additionally, in North America we plan to develop partnerships with other manufacturers and suppliers of safety devices for heavy trucks to jointly sell our LDW systems and provide our SafetyDirect software tool to North American trucking fleets. +For the passenger car market, we have exclusively licensed our LDW technology to our strategic partner, Valeo Schalter and Sensoren GmbH (“Valeo”), resulting in sales to date through March 31, 2011 of approximately 108,000 LDW systems for passenger cars. We and our partner have recently experienced a greater degree of competition in the passenger car market as several passenger car OEMs have introduced vehicle platforms with competing LDW systems. However, Valeo continues to pursue opportunities in the passenger car market. +In addition to our LDW systems, our Vehicle Sensors portfolio includes radar-based Forward Collision Warning (“FCW”) and Blind Spot Warning (“BSW”) systems for the North American truck market. We offer the FCW and BSW features through the resale of Delphi’s radar based systems, for which we are the exclusive North American dealer. Our portfolio also includes our internally-developed SafetyDirect software system, which can provide a single point of access to monitor and synchronize driver performance data on braking, stability control, following distances, and lane departure warnings for individual drivers as well as entire fleets. SafetyDirect uses information transmitted from the vehicle by the fleet’s onboard mobile communications system to provide fleet operators with a comprehensive view of the entire fleet, as well as the ability to drill down to detailed information on individual drivers and events. These products, together with our LDW products, combine to create a broad suite of active safety driver assistance features designed to help reduce the number of motor vehicle crashes and the severity of crash-related injuries. +3 +Table of Contents +Additionally, in collaboration with Audiovox Electronics Corporation, during the fiscal year ended March 31, 2011 (“Fiscal 2011”), we developed and introduced an Advanced Driver Assistance System for the consumer automobile aftermarket. The new system provides consumers an opportunity to benefit from life-saving features that were previously only available on new premium cars or commercial Class 8 trucks, and incorporates our LDW and FCW systems developed for the OEM market. We anticipate the system to be available in the marketplace by the end of our fiscal year ending March 31, 2012. +Transportation Systems. Our Transportation Systems segment includes transportation engineering and consulting services focused on the planning, design, development and implementation of software-based systems that integrate sensors, video surveillance, computers and advanced communications equipment to enable public agencies to monitor, control and direct traffic flow, assist in the quick dispatch of emergency crews and distribute real-time information about traffic conditions. Our services include transportation and ITS planning, design and implementation of surface transportation infrastructure systems. We perform analysis and study goods movement, commercial vehicle operations, travel demand forecasting and systems engineering, and identify mitigation measures to reduce traffic congestion. These services and systems have historically been primarily sold to local, state and national transportation agencies in the U.S.; however, during the last two years, we have been awarded several contracts in the United Arab Emirates, and plan to continue to pursue additional international opportunities in the Middle East and other regions. Our Transportation Systems segment is largely dependent upon governmental funding, and is affected by federal, state and local budgetary issues. +Environmental Technology. In January 2011, we acquired MET, a privately-held company based in Grand Forks, North Dakota. MET specializes in 511 advanced traveler information systems by offering a unique range of customer-specific environmental and operational forecasting products and services. MET utilizes certain internally developed systems and tools as the model for the 511 National Guidelines, and currently delivers a combination of customized route-specific surface weather, travel times and road condition reports statewide across various states in the U.S. MET also provides MDSS management tools that allow users to create solutions to meet roadway maintenance decision needs. MDSS provides detailed and accurate information at the route level that enables the efficient maintenance of roads and highways while optimizing resource use and reducing costs. +Sales, Marketing and Principal Customers +We sell our Roadway Sensors products through indirect sales channels comprised of a strong network of independent dealers in the U.S. and certain foreign locations, who sell integrated systems and related products to the traffic management market, as well as directly to the traffic management market using a combination of our own sales personnel and an outside sales organization. Our independent dealers are well-trained in, and primarily responsible for, sales, installation, set-up and support of our products, and maintain an inventory of demonstration traffic products from various manufacturers, including our vehicle detection systems, and sell directly to government agencies and installation contractors. These dealers often have long-term arrangements with local government agencies in their respective territories for the supply of various products for the construction and renovation of traffic intersections, and are generally well-known suppliers of high-quality ITS products to the traffic management market. We periodically hold technical training classes for our dealers and end users and maintain a full-time expert staff of customer support technicians throughout the U.S. to provide technical assistance when needed. When appropriate, we have the ability to modify or make changes to our dealer network to best suit the needs of the market and our customer base. In the states where we sell directly, we use our own expert staff to sell, oversee installations and set-up issues and support our products. +Our marketing strategy for our Vehicle Sensors segment is to establish our LDW products as the leading platform for in-vehicle video sensing for heavy trucks and passenger cars. We sell LDW systems directly to heavy truck manufacturers and to U.S. truck fleets. We market the licensing of our LDW technology to manufacturers of passenger automobiles through an exclusive strategic relationship with Valeo. In connection with this marketing effort, we provide specific contract engineering services, technical marketing and sales support to Valeo, which to date has enabled the launch of our LDW technology on four Infiniti car platforms. We plan to continue to provide technical marketing and sales support to Valeo in our efforts to win new OEM customers for the passenger car market, as well as contract engineering services related to the possible launch of new platforms that include our LDW system. +With respect to the Vehicle Sensors segment, during Fiscal 2011, we also entered into a strategic alliance with MeritorWabco for integration, marketing and sales of our SafetyDirect system. This alliance provides us access to the North American sales force of MeritorWabco and Meritor, and provides the market with a leading comprehensive safety system for heavy trucks available today. +We market and sell our Transportation Systems and Environmental Technology services directly to government agencies pursuant to negotiated contracts that involve competitive bidding and specific qualification requirements. Most of our contracts are with federal, state and municipal customers and generally provide for cancellation or renegotiation at the option of the customer upon reasonable notice and fees paid for modification. We generally use selected members of our engineering, science and information technology teams on a regional basis to serve in sales and business development functions. Our contracts generally involve long lead times and require extensive specification development, evaluation and price negotiations. +4 +Table of Contents +A large portion of our revenues are derived from sales to federal, state and local government agencies. We currently have a diverse customer base with no individual customer representing greater than 10% of our total net sales and contract revenues in Fiscal 2011, or in the fiscal years ended March 31, 2010 (“Fiscal 2010”) and March 31, 2009 (“Fiscal 2009”). Also refer to Note 11 of Notes to Consolidated Financial Statements, included in Part IV, Item 15 of this report. +Manufacturing and Materials +We use contract manufacturers to build subassemblies that are used in our sensors products. Additionally, we procure certain components from qualified suppliers, both globally and locally, and generally use multi-sourcing strategies when technically and economically feasible to mitigate supply risk. These subassemblies and components are delivered to our Santa Ana, California facility where they go through final assembly and testing prior to shipment to our customers. Certain of our key suppliers include CTS Electronics Manufacturing Solutions, Inc., Total Electronics LLC, Sony Electronics, Inc. and LG Electronics, Inc. Our manufacturing activities are conducted in approximately 9,000 square feet of space at our Santa Ana facility. Production volume at our subcontractors is based upon quarterly forecasts that we generally adjust on a monthly basis to control inventory levels. For LDW products sales to the passenger car market, all manufacturing has been and is expected to be performed by Valeo; however, we plan to continue to provide engineering support to Valeo. We typically do not manufacture any of the hardware used in the transportation management and traveler information systems that we design and implement. Our production facility is currently ISO 9001 certified. +Customer Support and Services +We provide warranty service and support for our products, as well as follow-up service and support for which we charge separately. Such service revenue was not a material portion of our total net sales and contract revenues for each of Fiscal 2011, 2010 and 2009. We believe customer support is a key competitive factor. +Backlog +Our total backlog of unfulfilled firm orders was approximately $32.8 million as of March 31, 2011, which was comprised of $2.7 million related to Roadway Sensors, $1.0 million related to Vehicle Sensors, $25.5 million related to Transportation Systems and $3.6 million related to Environmental Technology. Substantially all of the backlog for Roadway Sensors and Vehicle Sensors is expected to be recognized as revenue in the fiscal year ending March 31, 2012. We have historically recognized in the subsequent fiscal year between 50% to 70% of our Transportation Systems backlog at the fiscal year end, and currently expect that trend to continue for the near future. +At March 31, 2010, we had backlog of approximately $30.6 million, which was comprised of $1.6 million related to Roadway Sensors, $600,000 related to Vehicle Sensors and $28.4 million related to Transportation Systems. +The timing and realization of our backlog is subject to the inherent uncertainties of doing business with federal, state and local governments, particularly in view of budgetary constraints, cut-backs and other delays or reallocations of funding that these entities typically face. +Pursuant to the customary terms of our agreements with government contractors and other customers, customers can generally cancel or reschedule orders with little or no penalties. Lead times for the release of purchase orders often depend upon the scheduling and forecasting practices of our individual customers, which also can affect the timing of the conversion of our backlog into revenues. For these reasons, among others, our backlog at a particular date may not be indicative of our future revenues, in particular for our Roadway Sensors and Vehicle Sensors segments. +Product Development +Most of our product development activities are conducted at our principal facilities in Santa Ana. Our research and development costs and expenses were approximately $3.8 million for Fiscal 2011, $3.7 million for Fiscal 2010 and $4.0 million for Fiscal 2009. We expect to continue to pursue various product development programs and incur research and development expenditures in future periods. +We believe our engineering and product development capabilities are a competitive strength. We strive to continue to develop new products to meet the needs of the ever-changing ITS market as well as enhance and refine our existing product lines. Within the last 12 to 24 months we have introduced our VersiCam and VersiCam wireless products, Pico, our new RZ-4 Advanced camera, and our RZ-4 Advanced Wide Dynamic Range camera, which significantly improves video detection performance in certain +5 +Table of Contents +harsh lighting conditions. We have also introduced our Abacus and VantageView software products. We believe that developing new offerings across our segments and enhancing, refining and marketing our existing products is a key component of strong organic growth and profitability. +Competition +We generally face significant competition in each of our target markets. Increased competition may result in price reductions, reduced gross margins and loss of market share, any of which could have a material adverse effect on our business, financial condition and results of operations. +In the market for our Roadway Sensors vehicle detection products, we compete with manufacturers and distributors of other above ground video camera detection systems such as Peek Traffic Corporation, Wavetronix LLC, Econolite Control Products, Inc., Traficon, N.V., Image Sensing Systems, Inc. and other non-intrusive detection devices, including microwave, infrared, ultrasonic and magnetic detectors, as well as manufacturers and installers of in-pavement inductive loop products, which have historically, and currently continue to be, the predominant detection system in this market. +In the market for our Vehicle Sensors systems, we believe that, as a result of the expected 2013 European mandate for LDW and other active safety systems and an increase in overall awareness of the potential benefits of LDW, we anticipate we will experience an even higher degree of competition from a variety of tier-one OEM suppliers and other potential market entrants worldwide. Additionally, we and our strategic partner (Valeo) have recently experienced a greater degree of competition in the passenger car market as several passenger car OEMs have introduced vehicle platforms with competing LDW systems. We consider competitors in this market to include Delphi Automotive Systems Corporation, DENSO and Hitachi Ltd. in Japan, Robert Bosch GmbH in Europe, Continental, TRW, MobilEye and Takata, all of which currently have developed or are developing video sensor technologies for the vehicle industry that could be used for lane departure warning systems. +The markets in which our Transportation Systems and Environmental Technology segments operate are highly fragmented and are subject to evolving national and regional quality, operations and safety standards. Our competitors vary in number, scope and breadth of the products and services they offer. Our competitors in advanced Transportation Systems include national corporations such as Transcore, Siemens, Telvent Farradyne, Kimley-Horn and Associates, Inc., Delcan, Atkins and Open Roads. Our competitors in transportation engineering, planning and design include major firms such as Parsons Brinkerhoff, Inc., URS, HNTB and Parsons Transportation Group, Inc., as well as many smaller regional engineering firms. Additionally, key competitors pertaining to the road weather portion or our Environmental Technology segment include Telvent DTN, Mixon-Hill and Cambridge Systematics. +In general, the markets for the products and services we offer are highly competitive and are characterized by rapidly changing technology and evolving standards. Many of our current and prospective competitors have longer operating histories, greater name recognition, access to larger customer bases and significantly greater financial, technical, manufacturing, distribution and marketing resources than us. As a result, they may be able to adapt more quickly to new or emerging standards or technologies or to devote greater resources to the promotion and sale of their products. It is also possible that new competitors or alliances among competitors could emerge and rapidly acquire significant market share. We believe that our ability to compete effectively in our target markets will depend on a number of factors, including the success and timing of our new product development, the compatibility of our products with a broad range of computing systems, product quality and performance, reliability, functionality, price and service and technical support. Our failure to provide services and develop and market products that compete successfully with those of other suppliers and consultants in our target markets would have a material adverse effect on our business, financial condition and results of operations. +Intellectual Property and Proprietary Rights +Our ability to compete effectively depends in part on our ability to develop and maintain the proprietary aspects of our technology. Our policy is to obtain appropriate proprietary rights protection for any potentially significant new technology acquired or developed by us. We currently hold eleven U.S. patents, two foreign patents, one pending U.S. patent and three pending foreign patents. Eight U.S. patents, two foreign patents, one pending U.S. patent, and one pending foreign patent relate specifically to our Vehicle Sensors technology and provide a basis for enhanced functionality and improved performance. Three U.S. patents and two pending foreign patents relate specifically to our Roadway Sensors technology. One of these U.S. patents and the two pending foreign patents are for an Electronic Traffic Monitor related to our Abacus product in the Roadway Sensors segment. We cannot assure you that any new patents will be granted pursuant to these or subsequent applications. +In addition to patent laws, we rely on copyright and trade secret laws to protect our proprietary rights. We attempt to protect our trade secrets and other proprietary information through agreements with customers and suppliers, proprietary information agreements with our employees and consultants, and other similar measures. We do not have any material licenses or trademarks other +6 +Table of Contents +than those relating to product names. We cannot be certain that we will be successful in protecting our proprietary rights. While we believe our patents, patent applications, software and other proprietary know-how have value, changing technology makes our future success dependent principally upon our employees’ technical competence and creative skills for continuing innovation. +Litigation may be necessary in the future to enforce our proprietary rights, to determine the validity and scope of the proprietary rights of others, or to defend us against claims of infringement or invalidity by others. An adverse outcome in such litigation or similar proceedings could subject us to significant liabilities to third parties, require disputed rights to be licensed from others or require us to cease marketing or using certain products, any of which could have a material adverse effect on our business, financial condition and results of operations. In addition, the cost of addressing any intellectual property litigation claim, both in legal fees and expenses, as well as from the diversion of management’s resources, regardless of whether the claim is valid, could be significant and could have a material adverse effect on our business, financial condition and results of operations. +Employees +We refer to our employees as associates. As of May 2, 2011, we employed an aggregate of 276 associates, including 55 associates in general management, administration and finance; 30 associates in sales and marketing; 162 associates in engineering and product development; 18 associates in operations, manufacturing and quality; and 11 associates in customer service. None of our associates are represented by a labor union, and we have never experienced a work stoppage. We believe our relations with our associates are good. +Government Regulation +Our manufacturing operations are subject to various federal, state and local laws and regulations, including those restricting the discharge of materials into the environment. We are not involved in any pending or, to our knowledge, threatened governmental proceedings, which would require curtailment of our operations because of such laws and regulations. We continue to expend funds in connection with our compliance with applicable environmental regulations. These expenditures have not, however, been significant in the past, and we do not expect any significant expenditure in the near future. Currently, compliance with foreign laws has not had a material impact on our business and is not expected to have a material impact in the near future. +ITEM 1A. RISK FACTORS +Our business is subject to a number of risks, some of which are discussed below. Other risks are presented elsewhere in this report and in the information incorporated by reference into this report. You should consider the following risks carefully in addition to the other information contained in this report and our other filings with the SEC, including our subsequent reports on Forms 10-Q and 8-K, before deciding to buy, sell or hold our common stock. The risks and uncertainties described below are not the only ones facing our company. Additional risks and uncertainties not presently known to us or that we currently deem immaterial may also affect our business operations. If any of these risks actually occurs, our business, financial condition, or results of operations could be seriously harmed. In that event, the market price for our common stock could decline and you may lose all or part of your investment. +The economic slowdown has reduced and delayed government funding for transportation infrastructure projects and initiatives, decreased availability of financial capital for our customers and adversely impacted real estate development, all of which have adversely impacted our net sales and contract revenues. Decreased consumer spending, the failure of certain financial institutions and businesses, concerns about the availability and cost of credit, and reduced corporate profits and capital spending have resulted in a downturn in worldwide economic conditions, as well as budgetary shortfalls increasingly present at all levels of government. These unfavorable economic conditions are having a negative impact on customer orders and government funding of infrastructure projects incorporating our products and services. Such factors have and may continue to result in cancellations and rescheduling of backlog and customer orders. In addition, the recent decline in the U.S. real estate market, particularly in new home and commercial construction, has adversely impacted new road construction, and in the prior fiscal year, resulted in flat or declining Roadway Sensor and Vehicle Sensor net sales and adverse effects on Transportation Systems contract revenues. Any of the foregoing economic conditions may adversely affect our net sales and contract revenues in future periods and make it extremely difficult for our customers, our suppliers and us to accurately forecast and plan future business activities. Additionally, there continues to be uncertainties regarding the impact of the federal stimulus package and the fact that the accessibility of funds is taking longer than originally anticipated, as well as a delay in the passage of a new Federal Highway Bill. If such conditions continue or worsen, our business, financial condition and results of operations could be materially and adversely affected. +Because we depend on government contracts and subcontracts, we face additional risks related to contracting with federal, state and local governments, including budgetary issues and fixed price contracts. A significant portion of our sales are derived from contracts with governmental agencies, either as a general contractor, subcontractor or supplier. We anticipate that +7 +Table of Contents +revenue from government contracts will continue to remain a significant portion of our net sales and contract revenues. Government business is, in general, subject to special risks and challenges, including: +· delays in funding, including delays in the allocation of funds to state and local agencies from the U.S. federal government as a result of the expiration of the 2005 Federal Highway Bill on October 31, 2009, as well as delays or reductions in stimulus funds and other state and local funding dedicated for transportation projects; +· other government budgetary constraints, cut-backs, delays or reallocation of government funding; +· performance bond requirements; +· long purchase cycles or approval processes; +· competitive bidding and qualification requirements; +· changes in government policies and political agendas; +· milestone requirements and liquidated damage provisions for failure to meet contract milestones; and +· international conflicts or other military operations that could cause the temporary or permanent diversion of government funding from transportation or other infrastructure projects. +Governmental budgets and plans are subject to change without warning. Certain risks of selling to governmental entities include dependence on appropriations and administrative allocation of funds, changes in governmental procurement legislation and regulations and other policies that may reflect political developments or agendas, significant changes in contract scheduling, intense competition for government business and termination of purchase decisions for the convenience of the governmental entity. Substantial delays in purchase decisions by governmental entities, and the current constraints on government budgets at the federal, state and local level, could cause our net sales and contract revenues and income to drop substantially or to fluctuate significantly between fiscal periods. +In addition, a large number of our government contracts are fixed price contracts. As a result, we may not be able to recover any cost overruns we may incur. These fixed price contracts require us to estimate the total project cost based on preliminary projections of the project’s requirements. The financial viability of any given project depends in large part on our ability to estimate these costs accurately and complete the project on a timely basis. In the event our costs on these projects exceed the fixed contractual amount, we will be required to bear the excess costs. Such additional costs would adversely affect our financial condition and results of operations. Moreover, certain of our government contracts are subject to termination or renegotiation at the convenience of the government, which could result in a large decline in our net sales and contract revenues in any given period. Our inability to address any of the foregoing concerns or the loss or renegotiation of any material government contract could seriously harm our business, financial condition and results of operations. +California state budgetary constraints may have a material adverse impact on us. The state of California has experienced, and is continuing to experience, a significant budget shortfall and other related budgetary issues and constraints. The state of California has historically been and is considered to be a key geographic region for our Roadway Sensors and Transportation Systems segments. Ongoing uncertainty as to the timing and accessibility of budgetary funding, changes in state funding allocations to local agencies and municipalities, or other delays in purchasing for, or commencement of, transportation projects have had and may continue to have a negative impact on our net sales and contract revenues and our income. +The markets in which we operate are highly competitive and have many more established competitors, which could adversely affect our sales or the market acceptance of our products. We compete with numerous other companies in our target markets including, but not limited to, large, multinational corporations, which include tier-one automotive suppliers, and many smaller regional engineering firms. +In the Vehicle Sensors segment, we believe that as a result of the expected 2013 European mandate for LDW and other active safety systems and an increase in overall awareness of the potential benefits of LDW, we will experience an even higher degree of competition from a variety of tier-one OEM suppliers and other potential market entrants worldwide. We also expect such competition to increase due to technological advancements, industry consolidations and reduced barriers to entry. Increased competition is likely to result in a loss of market share, price reductions and reduced gross margins, any of which could seriously harm our business, financial condition and results of operations. Additionally, awareness of LDW technology is increasing and other market players have +8 +Table of Contents +developed competing technologies, which may contain improvements or added features beyond those offered by our LDW systems. Additionally, from time to time, we may be required to re-compete for LDW business from our main customer base of heavy truck OEMs. These OEMs could make a supplier change based on price, product performance or available features. Should our competition be successful, this could adversely affect our ability to successfully market and sell our LDW systems to new and existing customers. +We compete with existing, well-established companies in our Roadway Sensors segment, both domestically and abroad. Certain technological barriers to entry make it difficult for new competitors to enter the market with competing video or other technologies; however, we are aware of new market entrants from time to time. Increased competition could result in loss of market share, price reductions and reduced gross margins, any of which could seriously harm our business, financial condition and results of operations. +The Transportation Systems and Environmental Technology markets are highly fragmented and are subject to evolving national and regional quality and safety standards. Our competitors vary in size, number, scope and breadth of the products and services they offer, and include large multi-national engineering firms and smaller local regional firms. +In all of our segments, many of our competitors have far greater name recognition and greater financial, technological, marketing, and customer service resources than we do. This may allow them to respond more quickly to new or emerging technologies and changes in customer requirements. It may also allow them to devote greater resources to the development, promotion, sale and support of their products than we can. Recent consolidations of end users, distributors and manufacturers in our target markets have exacerbated this problem. As a result of the foregoing factors, we may not be able to compete effectively in our target markets and competitive pressures could adversely affect our business, financial condition and results of operations. +We may engage in acquisitions of companies or technologies that may require us to undertake significant capital infusions and could result in disruptions of our business and diversion of resources and management attention. In January 2011, we completed the acquisition of Meridian Environmental Technology, Inc. We also completed the acquisition of certain assets of Hamilton Signal, Inc. in April 2009. We have in the past acquired, and may in the future acquire, additional complementary businesses, products, and technologies. Acquisitions may require significant capital infusions and, in general, acquisitions also involve a number of special risks, including: +· potential disruption of our ongoing business and the diversion of our resources and management’s attention; +· the failure to retain or integrate key acquired personnel; +· the challenge of assimilating diverse business cultures, and the difficulties in integrating the operations, technologies and information system of the acquired companies; +· increased costs to improve managerial, operational, financial and administrative systems and to eliminate duplicative services; +· the incurrence of unforeseen obligations or liabilities; +· potential impairment of relationships with employees or customers as a result of changes in management; and +· increased interest expense and amortization of acquired intangible assets. +Our competitors are also soliciting potential acquisition candidates, which could both increase the price of any acquisition targets and decrease the number of attractive companies available for acquisition. Acquisitions may also materially and adversely affect our operating results due to large write-offs, contingent liabilities, substantial depreciation, deferred compensation charges or intangible asset amortization, or other adverse tax or accounting consequences. We cannot assure you that we will be able to identify or consummate any additional acquisitions, successfully integrate any acquisitions or realize the benefits anticipated from any acquisition. +We may be unable to attract and retain key personnel, which could seriously harm our business. Due to the specialized nature of our business, we are highly dependent on the continued service of our executive officers and other key management, engineering and technical personnel. The loss of any of our officers, or any of our other executives or key members of management could adversely affect our business, financial condition, or results of operations. Our success will also depend in large part upon our ability to continue to attract, retain and motivate qualified engineering and other highly skilled technical personnel. In particular, the future success of our Transportation Systems segment will depend on our ability to hire additional qualified engineers and planners. Competition for qualified employees, particularly development engineers, is intense. We may not be able to continue to attract and +9 +Table of Contents +retain sufficient numbers of such highly skilled employees. Our inability to attract and retain additional key employees or the loss of one or more of our current key employees could adversely affect our business, financial condition and results of operations. +Our profitability could be adversely affected if we are not able to maintain adequate utilization of our Transportation Systems workforce. The cost of providing our Transportation Systems engineering and consulting services, including the extent to which we utilize our workforce, affects our profitability. The rate at which we utilize our workforce is affected by a number of factors, including: +· our ability to transition employees from completed projects to new assignments and to hire and assimilate new employees; +· our ability to forecast demand for our services and thereby maintain an appropriate headcount in our various regions; +· our need to devote time and resources to training, business development, professional development and other non-chargeable activities; and +· our ability to match the skill sets of our employees to the needs of the marketplace. +Our use of the percentage of completion method of accounting for our contract revenues could result in a reduction or reversal of previously recorded revenues and profits. A significant portion of our total net sales and contract revenues are measured and recognized using the percentage of completion method of accounting. Our use of this accounting method results in recognition of revenues and profits ratably over the life of a contract, based generally on the proportion of costs incurred to date to total costs expected to be incurred for the entire project. The effects of revisions to revenues and estimated costs are recorded when the amounts are known or can be reasonably estimated. Such revisions could occur in any period and their effects could be material. Although we have historically made reasonably reliable estimates of the progress towards completion of long-term engineering, program management, construction management or construction contracts, the uncertainties inherent in the estimating process make it possible for actual costs to vary materially from estimates, including reductions or reversals of previously recorded revenues and profits. +Our failure to successfully bid on new contracts and renew existing contracts could reduce our revenues and profits. Our business depends on our ability to successfully bid on new contracts and renew existing contracts with private and public sector customers. Contract proposals and negotiations are complex and frequently involve a lengthy bidding and selection process, which are affected by a number of factors, such as market conditions, financing arrangements and required governmental approvals. For example, a customer may require us to provide a surety bond or letter of credit to protect the client should we fail to perform under the terms of the contract. If negative market conditions continue, or if we fail to secure adequate financing arrangements or the required governmental approval or fail to meet other required conditions, we may not be able to pursue particular projects, which could reduce or eliminate our profitability. +We may experience production gaps that could materially and adversely impact our sales and financial results and the ultimate acceptance of our products. It is possible that we could experience unforeseen quality control issues or part shortages as we adjust production to meet current demand for our products. We have historically used single suppliers for certain significant components in our products. Should any such delay or disruption occur, or should a key supplier discontinue operations because of the current economic climate, our future sales will likely be materially and adversely affected. Additionally, we rely heavily on select contract manufacturers to produce many of our products and do not have any long-term contracts to guarantee supply of such products. Although we believe our contract manufacturers have sufficient capacity to meet our production schedules for the foreseeable future and we believe we could find alternative contract manufacturing sources for many of our products, if necessary, we could experience a production gap if for any reason our contract manufacturers were unable to meet our production requirements and our cost of goods sold could increase, adversely affecting our margins. In particular, while we have not to date experienced a material adverse impact due to the earthquake, tsunami and resulting damage to Japan’s infrastructure, we could experience supply chain interruptions for products sourced from Japan. +If we are unable to develop and introduce new products and product enhancements successfully and in a cost-effective and timely manner, or are unable to achieve market acceptance of our new products, our operating results would be adversely affected. We believe our revenue growth and future operating results will depend on our ability to complete development of new products and enhancements, introduce these products in a timely, cost-effective manner, achieve broad market acceptance of these products and enhancements, and reduce our production costs. We cannot guarantee the success of these products, and we may not be able to introduce any new products or any enhancements to our existing products on a timely basis, or at all. In addition, the introduction of any new products could adversely affect the sales of certain of our existing products. +10 +Table of Contents +We believe that we must continue to make substantial investments to support ongoing research and development in order to remain competitive. We need to continue to develop and introduce new products that incorporate the latest technological advancements in outdoor image processing hardware, software and camera technologies in response to evolving customer requirements. We cannot assure you that we will be able to adequately manage product transition issues. Our business and results of operations could be adversely affected if we do not anticipate or respond adequately to technological developments or changing customer requirements or if we cannot adequately manage inventory issues typically related to new product transitions and introductions. We cannot assure you that any such investments in research and development will lead to any corresponding increase in revenue. +Market acceptance of our new products depends upon many factors, including our ability to accurately predict market requirements and evolving industry standards, our ability to resolve technical challenges in a timely and cost-effective manner, our ability to qualify any new products with OEMs and achieve manufacturing efficiencies, the perceived advantages of our new products over traditional products and the marketing capabilities of our independent distributors and strategic partners, including Valeo’s ability to expand sales of LDW systems in the passenger car market. The success of our LDW system will also depend in part on the success of the automotive vehicles that incorporate our technology, as well as the success of optional equipment that OEMs bundle with our technologies. +Our business and results of operations could also be seriously harmed by any significant delays in our new product development. Certain of our new products could contain undetected design faults and software errors or “bugs” when first released by us, despite our testing. We may not discover these faults or errors until after a product has been installed and used by our customers. Any faults or errors in our existing products or in any new products may cause delays in product introduction and shipments, require design modifications or harm customer relationships, any of which could adversely affect our business and competitive position. +New environmental regulations may result in a decline in our Vehicle Sensors net sales. From time to time, environmental regulations are enacted, which can significantly increase the cost of manufacturing new vehicles as well as the cost of maintaining existing vehicles and truck fleets. As a result, we could experience a decline in sales of our Vehicle Sensors products as truck and vehicle manufacturers and fleet operators attempt to control their costs. +We depend upon Valeo to market our LDW technologies for the OEM passenger car market. We have granted Valeo the exclusive right to sell and manufacture our LDW system to the worldwide passenger car market in exchange for royalty payments for each LDW unit sold. As such, the future success and broad market acceptance of our technologies in the passenger car market will depend upon Valeo’s ability to manufacture, market and sell our technologies, and to convince more OEM passenger car manufacturers to adopt our technologies. To date, we have not generated significant royalties from Valeo’s efforts and have only been designed into one passenger car OEM product line. If Valeo does not devote considerable resources and aggressively pursue opportunities, our expansion into the passenger car market, and our related revenues from contract engineering services and royalty revenues, could be adversely affected or not materialize as originally anticipated. +If we do not keep pace with rapid technological changes and evolving industry standards, we will not be able to remain competitive and there will be no demand for our products. Our markets are in general characterized by the following factors: +· rapid technological advances; +· downward price pressures in the marketplace as technologies mature; +· changes in customer requirements; +· additional qualification requirements related to new products or components; +· frequent new product introductions and enhancements; +· inventory issues related to transition to new or enhanced models; and +· evolving industry standards and changes in the regulatory environment. +Our future success will depend upon our ability to anticipate and adapt to changes in technology and industry standards, and to effectively develop, introduce, market and gain broad acceptance of new products and product enhancements incorporating the latest technological advancements. In particular, our LDW systems are incorporated into automobiles and trucks that face significant +11 +Table of Contents +technological changes in each model year and among different vehicle models. Accordingly, we must adapt our technology from time to time to function with such changes. +Our international business operations may be threatened by many factors that are outside of our control. While we historically have had limited international sales and operations experience, we began work on our first overseas contracts in the United Arab Emirates in Fiscal 2010. We plan to expand our international efforts in the future with respect to all three of our segments, but cannot assure you that we will be successful in those efforts. International operations subject us to various inherent risks including, among others: +· currency fluctuations and restrictions; +· political, social and economic instability, as well as international conflicts and acts of terrorism; +· longer accounts receivable payment cycles; +· import and export license requirements and restrictions of the U. S. and each other country in which we operate; +· unexpected changes in regulatory requirements, tariffs and other trade barriers or restrictions; +· the burdens of compliance with a wide variety of foreign laws and more restrictive labor laws and obligations; +· difficulties in managing and staffing international operations; +· potentially adverse tax consequences; and +· reduced protection for intellectual property rights in some countries. +Substantially all of our international sales are denominated in U.S. dollars. As a result, an increase in the relative value of the dollar could make our products more expensive and potentially less price competitive in international markets. We do not currently engage in any transactions as a hedge against risks of loss due to foreign currency fluctuations. +Any of the factors mentioned above may adversely affect our future international sales and, consequently, affect our business, financial condition and operating results. Additionally, as we pursue the expansion of our international business, certain fixed and other overhead costs could outpace our revenues, thus adversely affecting our results of operations. We may likewise face local competitors in certain international markets who are more established, have greater economies of scale and stronger customer relationships. Furthermore, as we increase our international sales, our total revenues may also be affected to a greater extent by seasonal fluctuations resulting from lower sales that typically occur during the summer months in Europe and other parts of the world. +If our internal controls over financial reporting do not comply with the requirements of the Sarbanes-Oxley Act, our business and stock price could be adversely affected. Section 404 of the Sarbanes-Oxley Act of 2002 currently requires us to evaluate the effectiveness of our internal controls over financial reporting at the end of each fiscal year and to include a management report assessing the effectiveness of our internal controls over financial reporting in all annual reports. +As a smaller reporting company, for our fiscal year ended March 31, 2011, we were exempt from the auditor attestation requirement over our internal control over financial reporting; however, to the extent we do not qualify as a non-accelerated filer or smaller reporting Company in subsequent fiscal years, we will be subject to the auditor attestation requirement under Section 404(b) of the Sarbanes-Oxley Act. In such an event, we may not be able to complete the work required for such attestation on a timely basis, and even if we timely complete such requirements, our independent registered public accounting firm may still conclude that our internal controls over financial reporting are not effective. +Our management, including our CEO and CFO, does not expect that our internal controls over financial reporting will prevent all errors and all fraud. A control system, no matter how well designed and operated, can provide only reasonable, not absolute, assurance that the control system’s objectives will be met. Further, the design of a control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within Iteris have been or will be detected. These inherent limitations include the realities that judgments in decision-making can be faulty and that breakdowns can occur because of simple errors or mistakes. Controls can also be circumvented by the individual acts of some persons, by collusion of two or more people, or by management override of the controls. The design of any system of controls is based in part on certain assumptions about the likelihood of future events, and we cannot assure you that any design will succeed in achieving its stated goals under all potential future conditions. Over time, our controls may become inadequate +12 +Table of Contents +because of changes in conditions or deterioration in the degree of compliance with policies or procedures. Because of the inherent limitations in a cost-effective control system, misstatements due to error or fraud may occur and not be detected. +Our quarterly operating results fluctuate as a result of many factors. Therefore, we may fail to meet or exceed the expectations of securities analysts and investors, which could cause our stock price to decline. Our quarterly revenues and operating results have fluctuated and are likely to continue to vary from quarter to quarter due to a number of factors, many of which are not within our control. Factors that could affect our revenues include, among others, the following: +· delays in government contracts and funding from time to time and budgetary constraints at the federal, state and local levels; +· our ability to access stimulus funding, funding from a new Federal Highway Bill or other funding; +· declines in new home and commercial real estate construction and related road and other infrastructure construction; +· changes in our pricing policies and the pricing policies of our suppliers and competitors, pricing concessions on volume sales, as well as increased price competition in general; +· the long lead times associated with government contracts or required by vehicle manufacturers; +· the size, timing, rescheduling or cancellation of significant customer orders; +· our ability to control costs; +· our ability to raise additional capital; +· the mix of our products and services sold in a quarter, which mix has varied and is expected to continue to vary from time to time; +· seasonality due to winter weather conditions; +· our ability to develop, introduce, patent, market and gain market acceptance of new products, applications and product enhancements in a timely manner, or at all; +· market acceptance of the products incorporating our technologies and products; +· the introduction of new products by competitors; +· the availability and cost of components used in the manufacture of our products; +· our success in expanding and implementing our sales and marketing programs; +· the effects of technological changes in our target markets; +· the amount of our backlog at any given time; +· the nature of our government contracts; +· deferrals of customer orders in anticipation of new products, applications or product enhancements; +· risks and uncertainties associated with our international business; +· currency fluctuations and our ability to get currency out of certain foreign countries; +· general economic and political conditions; +· international conflicts and acts of terrorism; and +· other factors beyond our control, including but not limited, to the impact on our future revenues as a result of the recent earthquake, tsunami and related events in Japan. +13 +Table of Contents +Due to all of the factors listed above as well as other unforeseen factors, our future operating results could be below the expectations of securities analysts or investors. If that happens, the trading price of our common stock could decline. As a result of these quarterly variations, you should not rely on quarter-to-quarter comparisons of our operating results as an indication of our future performance. +As compared to recent prior fiscal years, we experienced declining or flat net sales and contract revenues in our two most recently completed fiscal years. If we fail to manage this decline effectively, we may be unable to execute our business plan and may experience future weaknesses in our operating results. Based on our business objectives, and in order to achieve future growth, we will need to continue to add additional qualified personnel, and invest in additional research and development and sales and marketing activities, which could lead to increases in our expenses and further declines in our operating results. In addition, our past expansion has placed, and future expansion is expected to place, a significant strain on our managerial, administrative, operational, financial and other resources. If we are unable to manage these activities or any unexpected revenue declines successfully, our growth, our business, our financial condition and our results of operations could continue to be adversely affected. +We may not be able to adequately protect or enforce our intellectual property rights, which could harm our competitive position. If we are not able to adequately protect or enforce the proprietary aspects of our technology, competitors could be able to access our proprietary technology and our business, financial condition and results of operations will likely be seriously harmed. We currently attempt to protect our technology through a combination of patent, copyright, trademark and trade secret laws, employee and third party nondisclosure agreements and similar means. Despite our efforts, other parties may attempt to disclose, obtain or use our technologies or systems. Our competitors may also be able to independently develop products that are substantially equivalent or superior to our products or design around our patents. In addition, the laws of some foreign countries do not protect our proprietary rights as fully as do the laws of the U. S. As a result, we may not be able to protect our proprietary rights adequately in the U.S. or abroad. +Litigation may be necessary in the future to enforce our intellectual property rights or to determine the validity and scope of the proprietary rights of others. Litigation may also be necessary to defend against claims of infringement or invalidity by others. An adverse outcome in litigation or any similar proceedings could subject us to significant liabilities to third parties, require us to license disputed rights from others or require us to cease marketing or using certain products or technologies. We may not be able to obtain any licenses on terms acceptable to us, or at all. We also may have to indemnify certain customers or strategic partners if it is determined that we have infringed upon or misappropriated another party’s intellectual property. Any of these results could adversely affect our business, financial condition and results of operations. In addition, the cost of addressing any intellectual property litigation claim, including legal fees and expenses, and the diversion of management’s attention and resources, regardless of whether the claim is valid, could be significant and could seriously harm our business, financial condition and results of operations. +We may need to raise additional capital in the future, which may not be available on terms acceptable to us, or at all. We have historically experienced volatility in our earnings and cash flows from operations from year to year. Although we have a $12.0 million revolving line of credit, should we have an event of default, which includes, among other things, a failure to meet certain financial covenants and a material adverse change in the business, the bank could choose to limit or take away our ability to borrow these or any funds. Should this occur, or if the credit markets further tighten or our business declines, we may need or choose to raise additional capital to repay indebtedness, pursue acquisitions or expand our operations. Such additional capital may be raised through bank borrowings, or other debt or equity financings. We cannot assure you that any additional capital will be available on a timely basis, on acceptable terms, or at all, and such additional financing may result in further dilution to our stockholders. +Our capital requirements will depend on many factors, including, but not limited to: +· market acceptance of our products and product enhancements, and the overall level of sales of our products; +· our ability to control costs; +· the supply of key components for our products; +· our ability to increase revenue and net income; +· increased research and development expenses and sales and marketing expenses; +14 +Table of Contents +· our need to respond to technological advancements and our competitors’ introductions of new products or technologies; +· capital improvements to new and existing facilities and enhancements to our infrastructure and systems; +· potential acquisitions of businesses and product lines; +· our relationships with customers and suppliers; +· government budgets, political agendas and other funding issues, including potential delays in government contract awards; +· our ability to successfully negotiate credit arrangements with our bank and the state of the financial markets, in general; and +· general economic conditions, including the effects of the current economic slowdown and international conflicts. +If our capital requirements are materially different from those currently planned, we may need additional capital sooner than anticipated. If additional funds are raised through the issuance of equity or convertible debt securities, the percentage ownership of our stockholders will be reduced and such securities may have rights, preferences and privileges senior to our common stock. Additional equity or debt financing may not be available on favorable terms, on a timely basis, or at all. If adequate funds are not available or are not available on acceptable terms, we may be unable to continue our operations as planned, develop or enhance our products, expand our sales and marketing programs, take advantage of future opportunities or respond to competitive pressures. +We may be unable to maintain profitability on a quarterly or annual basis. We cannot assure you that we will be able to sustain or improve our financial performance, or that we will be able to continue to achieve profitability on a quarterly or annual basis in the future. Our ability to maintain profitability in future periods could be impacted by budgetary constraints, government and political agendas, economic instability and other items that are not in our control. Most of our expenses are fixed in advance. As such, we generally are unable to reduce our expenses significantly in the short-term to compensate for any unexpected delay or decrease in anticipated revenues. As a result, we may experience operating losses and net losses in the future, which would make it difficult to fund our operations and achieve our business plan, and could cause the market price of our common stock to decline. +The trading price of our common stock is highly volatile. The trading price of our common stock has been subject to wide fluctuations in the past. Since April 2008, our Class A common stock (now known as our common stock) has traded at closing prices as low as $0.98 per share and as high as $2.98 per share. The market price of our common stock could continue to fluctuate in the future in response to various factors, including, but not limited to: +· quarterly variations in operating results; +· our ability to control costs, improve cash flow and sustain profitability; +· our ability to raise additional capital; +· shortages announced by suppliers; +· announcements of technological innovations or new products or applications by our competitors, customers or us; +· transitions to new products or product enhancements; +· acquisitions of businesses, products or technologies; +· the impact of any litigation; +· changes in investor perceptions; +· government funding, political agendas and other budgetary constraints; +· changes in earnings estimates or investment recommendations by securities analysts; and +· international conflicts, political unrest and acts of terrorism. +15 +Table of Contents +The stock market in general has from time to time experienced volatility, which has often affected the market prices of equity securities of many technology companies. This volatility has often been unrelated to the operating performance of these companies. These broad market fluctuations may adversely affect the market price of our common stock. In the past, companies that have experienced volatility in the market price of their securities have been the subject of securities class action litigation. If we were to become the subject of a class action lawsuit, it could result in substantial losses and divert management’s attention and resources from other matters. +Certain provisions of our charter documents may discourage a third party from acquiring us and may adversely affect the price of our common stock. Certain provisions of our certificate of incorporation could make it difficult for a third party to acquire us, even though an acquisition might be beneficial to our stockholders. Such provisions could limit the price that investors might be willing to pay in the future for shares of our common stock. Under the terms of our certificate of incorporation, our Board of Directors is authorized to issue, without stockholder approval, up to 2,000,000 shares of preferred stock with voting, conversion and other rights and preferences superior to those of our common stock. In August 2009, we adopted a stockholder rights plan and declared a dividend of preferred stock purchase rights to our stockholders. Generally, the stockholder rights plan provides that if a person or group acquires 15% or more of our common stock, subject to certain exceptions and under certain circumstances, the rights may be exchanged by us for common stock or the holders of the rights, other than the acquiring person or group, could acquire additional shares of our capital stock at a discount off of the then current market price. Such exchanges or exercise of rights could cause substantial dilution to a particular acquirer and discourage the acquirer from pursuing our company. The mere existence of a stockholder rights plan often delays or makes a merger, tender offer or proxy contest more difficult. +ITEM 1B. UNRESOLVED STAFF COMMENTS +None. +ITEM 2. PROPERTIES +Our headquarters and principal operations are housed in approximately 52,000 square feet of leased office, manufacturing and warehouse space located in Santa Ana, California. This facility lease expires in 2015 and contains an option to extend the lease for an additional five years at the market rate at that time. +For additional information regarding our obligations under property leases, see Note 8 of Notes to Consolidated Financial Statements, included in Part IV, Item 15 of this report. +ITEM 3. LEGAL PROCEEDINGS +The information set forth under the heading “Litigation and Other Contingencies” under Note 8 of Notes to Consolidated Financial Statements, included in Part IV, Item 15 of this report, is incorporated herein by reference. +ITEM 4. (REMOVED AND RESERVED) +16 +Table of Contents +PART II +ITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES +Market Information and Holders +Our common stock is traded on the NYSE Amex under the symbol “ITI.” The following table sets forth, for the periods indicated, the highest and lowest closing prices for our common stock as reported by NYSE Amex: +High +Low +Fiscal 2011 +Quarter Ended June 30, 2010 +$ +2.09 +$ +1.35 +Quarter Ended September 30, 2010 +1.56 +1.28 +Quarter Ended December 31, 2010 +1.86 +1.35 +Quarter Ended March 31, 2011 +1.77 +1.41 +Fiscal 2010 +Quarter Ended June 30, 2009 +$ +1.45 +$ +1.14 +Quarter Ended September 30, 2009 +1.73 +1.15 +Quarter Ended December 31, 2009 +1.60 +1.37 +Quarter Ended March 31, 2010 +2.04 +1.31 +On May 20, 2011, the last reported sales price of our common stock on the NYSE Amex was $1.31. As of May 20, 2011, we had 405 holders of record of our common stock according to information furnished by our transfer agent. +Dividend Policy +We have never paid or declared cash dividends on our common stock, and have no current plans to pay such dividends in the foreseeable future. We currently intend to retain any earnings for working capital and general corporate purposes. The payment of any future dividends will be at the discretion of our Board of Directors and will depend upon a number of factors, including, but not limited to, future earnings, the success of our business, our capital requirements, our general financial condition and future prospects, general business conditions, the consent of our lender and such other factors as the Board of Directors may deem relevant. +ITEM 6. SELECTED FINANCIAL DATA +As a smaller reporting company, we are not required to make any disclosure pursuant to this Item 6. +ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS +You should read the following discussion and analysis in conjunction with our Consolidated Financial Statements and related Notes thereto included in Part IV, Item 15 of this report and the “Risk Factors” section in Item 1A, as well as other cautionary statements and risks described elsewhere in this report, before deciding to purchase, hold or sell our common stock. +Overview +General. We are a leader in the traffic management market focused on the development and application of advanced technologies that reduce traffic congestion and improve the safety of surface transportation systems infrastructure. Additionally, we believe our products and services, in conjunction with sound traffic management, minimize the environmental impact of traffic congestion. By combining outdoor image processing, traffic engineering and information technology, we offer a broad range of Intelligent Transportation Systems and driver safety solutions to customers in U.S. and internationally. +Acquisitions. In January 2011, we acquired all of the capital stock of Meridian Environmental Technology, Inc. for an initial cash payment of approximately $1.6 million. We also agreed to pay up to $1 million on each of the first two anniversaries of the closing of the acquisition, as well as up to an additional $2 million under a 24-month earn-out provision. +In April 2009, we completed the acquisition of certain assets of Hamilton Signal, which included the Abacus system, for an aggregate purchase price of approximately $518,000. +Refer to Note 3 of Notes to Consolidated Financial Statements, included in Part IV, Item 15 of this report for additional discussion regarding the above acquisitions. +Business Segments. We currently operate in four reportable segments: Roadway Sensors, Vehicle Sensors, Transportation Systems and Environmental Technology. +17 +Table of Contents +Roadway Sensors +Our Roadway Sensors segment product line uses advanced image processing technology to capture and analyze video images through sophisticated algorithms, enabling vehicle detection and transmission of both video images and data using various communication technologies. +· Our Vantage video detection systems detect vehicle presence at intersections, as well as vehicle count, speed and other traffic data used in traffic management systems. Our Vantage systems give traffic managers the ability to mitigate roadway congestion by modifying traffic signal timing or detecting incidents quickly. Our VantageView software supplements our Vantage video detection systems by providing an integrated platform to manage and “see” video detection assets remotely over a network connection. +· VersiCam, our integrated camera and processor video detection system, is a cost-efficient video detection system for smaller intersections that require only a few detection points. +· Pico, our compact video detection system, was developed primarily to address international video detection needs, and was designed for easy installation and configuration. +· Our Abacus products take advantage of the large number of existing installed closed-circuit television video feeds monitoring roadways, signalized intersections, tunnels and bridges to allow for data collection and incident detection without the set-up and calibration generally required with other systems. +We believe that future growth domestically and internationally, particularly in developing countries, will be dependent in part on the continued adoption of above-ground video detection technologies, instead of traditional in-pavement loop technology, to manage traffic. +Vehicle Sensors +Our Vehicle Sensors segment addresses the leading cause of roadway fatalities: lane change, roadway departure and rear-end collision accidents. We developed the world’s first production LDW system and offer a proven system that is available as an OEM and aftermarket option on heavy trucks worldwide and as an option in certain passenger cars. Our LDW products utilize video detection images to detect when a vehicle begins to drift toward an unintended lane change. When this occurs, the unit automatically emits a distinctive rumble strip or other audible warning sound, alerting the driver to make a correction. We believe that, as a result of the expected 2013 European Union mandate for LDW and other active safety systems and an general increase in awareness of the potential benefits of LDW, we will experience an even higher degree of competition from a variety of tier-one OEM suppliers and other potential market entrants worldwide. While we believe that this increased competition validates the long-term market opportunity for LDW systems in commercial vehicles, it could also adversely affect our future LDW sales and margins. We are currently working with our European OEM customer base to establish long-term supply agreements that extend through 2013 and beyond in order to meet the anticipated increase in demand; however, we cannot assure you that our efforts will be successful or that the increase in demand will occur. We have entered into an exclusive license of our LDW technology to our strategic partner, Valeo, for the passenger car market. Recently, we and our partner have experienced a greater degree of competition in the passenger car market, as several passenger car OEMs have introduced vehicle platforms with competing LDW systems. However, Valeo continues to pursue opportunities in the passenger car market. +In addition to our LDW systems, our Vehicle Sensors portfolio includes radar-based Forward Collision Warning and Blind Spot Warning systems for the North American truck market, and our SafetyDirect product, a system that reports driver performance data captured by our LDW system, and has the ability to relay this data directly to fleet operators through integration with the truck’s existing fleet communications system. We expect future revenues generated by our SafetyDirect product will be based on a subscription model, whereby we charge our customers a monthly fee based on the number of vehicles equipped with the product. We offer the FCW and BSW features through the resale of Delphi’s radar-based systems, for which we are the exclusive North American dealer, while SafetyDirect was internally developed. These products, together with our LDW products, combine to create a suite of active safety driver assistance features focused on reducing the number of motor vehicle crashes and the severity of crash-related injuries. +Transportation Systems +Our Transportation Systems segment includes transportation engineering and consulting services focused on the planning, design, development and implementation of software-based systems that integrate sensors, video surveillance, computers, and advanced communications equipment to enable public agencies to monitor, control and direct traffic flow, assist in the quick dispatch of emergency crews and distribute real-time information about traffic conditions. Our services include planning, design and +18 +Table of Contents +implementation of surface transportation infrastructure systems. We perform analysis and study goods movement, commercial vehicle operations, travel demand forecasting and systems engineering, and identify mitigation measures to reduce traffic congestion. Historically, these services and systems have primarily been sold to local, state and national transportation agencies in the U.S. under a broad range of fixed price and cost plus fixed fee contracts; however, in Fiscal 2010, we began work on our first two overseas contract awards and plan to pursue additional international opportunities for our Transportation Systems segment. +Our Transportation Systems segment is largely dependent upon governmental funding and is affected by state and local budgetary issues. We believe the overall expansion of our Transportation Systems segment in the future will at least in part be dependent on the passage of a new Federal Highway Bill, which Congress is currently working on. We anticipate continued delays in the enactment of such a new bill, and until such time as a bill becomes law, the allotment of transportation funds in federal, state and local budgets may be uncertain. We believe that prolonged uncertainty has adversely impacted, and may continue to adversely impact, our net sales and contract revenues and our overall financial performance in future periods. +Environmental Technology +Our Environmental Technology segment is comprised of the activities of MET, which we acquired in January 2011. This segment specializes in 511 advanced traveler information systems by offering a unique range of customer-specific environmental and operational forecasting products and services. It also utilizes certain internally developed systems and tools as the model for the 511 National Guidelines, and currently delivers a combination of customized route-specific surface weather, travel times and road condition reports statewide across various states in the U.S. We also provide Maintenance Decision Support System (MDSS) management tools that allow users to create solutions to meet roadway maintenance decision needs. MDSS provides detailed and accurate information at the route level that enables the efficient maintenance of roads and highways while optimizing resource use and reducing costs. +Business. Given the current ongoing uncertainties regarding global economic conditions, we continue to remain cautious about our overall business. Since the end users of a majority of our products and services are governmental entities, we are negatively affected by the budgetary issues and delays in purchasing decisions that many municipalities and other state and local agencies continue to face. Spending for new roadways, new systems to address traffic congestion and other transportation infrastructure improvements has been delayed or eliminated in some instances. However, we believe that the need to rebuild and modernize aging transportation infrastructure will continue, and in addition to funds available through recent federal stimulus packages and federal highway bills, there exist various other funding mechanisms that support transportation infrastructure and related projects. These include bonds, dedicated sales and gas tax measures and other alternative funding sources. +We believe the overall ongoing unfavorable economic environment has negatively affected, and may continue to negatively affect, our financial results for the foreseeable future. Additionally, our ability to accurately forecast our future financial performance and other business trends may be impaired. +Critical Accounting Policies and Estimates +Management’s Discussion and Analysis of Financial Condition and Results of Operations is based on our consolidated financial statements included herein, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and related disclosures of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. On an ongoing basis, we evaluate these estimates and assumptions, including those related to the collectibility of accounts receivable, the valuation of inventories, the recoverability of long-lived assets and goodwill, the realizability of deferred tax assets, accounting for stock-based compensation, the valuation of equity instruments, warranty reserves and other contingencies. We base these estimates on historical experience and on various other factors that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. These estimates and assumptions by their nature involve risks and uncertainties, and may prove to be inaccurate. In the event that any of our estimates or assumptions are inaccurate in any material respect, it could have a material adverse effect on our reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. +The following critical accounting policies affect our more significant judgments and estimates used in the preparation of our consolidated financial statements. +Revenue Recognition. Product revenues and related costs of sales are recognized when all of the following criteria are met: (i) persuasive evidence of an arrangement exists, (ii) delivery has occurred, (iii) the price to the customer is fixed or determinable and (iv) collection of the receivable is reasonably assured. These criteria are typically met at the time of product shipment, but in certain +19 +Table of Contents +circumstances, may not be met until receipt or acceptance by the customer. Accordingly, at the date revenue is recognized, the significant obligations or uncertainties concerning the sale have been resolved. +We recognize revenue from the sale of deliverables that are part of a multiple-element arrangement in accordance with applicable accounting guidance that establishes a selling price hierarchy permitting the use of an estimated selling price to determine the allocation of arrangement consideration to a deliverable in a multiple-element arrangement where neither vendor specific objective evidence (“VSOE”) nor third-party evidence (“TPE”) of fair value is available for that deliverable. In the absence of VSOE or TPE of the standalone selling price for one or more delivered or undelivered elements that have stand-alone value in a multiple-element arrangement, we are required to estimate the selling prices of those elements. Overall arrangement consideration is allocated to each element (both delivered and undelivered items) based on their relative selling prices, regardless of whether those selling prices are evidenced by VSOE or TPE or are based on our estimated selling prices. +We account for multiple-element arrangements that consist only of software and software-related services in accordance with industry-specific accounting guidance for software and software-related transactions. For such transactions, revenue on arrangements that include multiple elements is allocated to each element based on the relative fair value of each element, and fair value is determined by VSOE. If we cannot objectively determine the fair value of any undelivered element included in such multiple-element arrangements and the only undelivered element is post-contract customer support or maintenance, and VSOE of the fair value of such support or maintenance does not exist, revenue from the entire arrangement is recognized ratably over the support period. When the fair value of a delivered element has not been established, but VSOE of fair value exists for the undelivered elements, we use the residual method to recognize revenue if the fair value of all undelivered elements is determinable. Under the residual method, the fair value of the undelivered elements is deferred and the remaining portion of the arrangement fee is allocated to the delivered elements and is recognized as revenue. +We also derive revenue from the provision of specific non-recurring contract engineering services to our strategic partner, Valeo, related to our LDW systems, and royalties earned on unit sales of our LDW systems by Valeo to the passenger car market. Non-recurring contract engineering revenues are recognized in the period in which the related services are performed. Royalty revenues are recorded based on unit sales of our products by Valeo and are recognized in the period in which such sales occur. Non-recurring contract engineering revenues and royalty revenues are included in our net sales. +Revenues from follow-on service and support, for which we generally charge separately, are recorded in the period in which the services are performed and are included in our net sales. +Contract Revenues +Contract revenues are derived primarily from long-term contracts with governmental agencies. The majority of our contract revenues are recognized using the percentage of completion method of accounting. Under this method, revenue is recognized as contract performance progresses, and is based on the relationship of costs incurred to total estimated costs. We generally utilize a cost-to-cost approach in applying the percentage of completion method, whereby revenue is earned in proportion to total costs incurred, divided by total costs expected to be incurred. Costs are generally determined from actual hours of labor effort expended. Direct non-labor costs are charged as incurred plus any mark-up permitted under the contract. Certain of our contract revenues are recognized as services are performed and amounts are earned, which is measured by time incurred or other contractual milestones or output measure. Contract revenues accounted for in this manner generally relate to certain cost-plus fixed fee or time-and-materials contracts for which no specific maximum contract values are stipulated. +Any anticipated losses on contracts are charged to operations when identified. Changes in job performance and estimated profitability, including those arising from contract penalty provisions and final contract settlements, may result in revisions to recognized costs and revenues and are recognized in the period in which the revisions are determined. Profit incentives are included in revenue when their realization is reasonably assured. Under the percentage of completion method, recognition of profit is dependent upon the accuracy of a variety of estimates, including engineering progress, materials quantities, and achievement of milestones, incentives, penalty provisions, labor productivity, cost estimates and others. Such estimates are based on various professional judgments we make with respect to those factors and are subject to change as the project proceeds and new information becomes available. We have a history of making reasonably dependable estimates of the extent of progress towards completion and contract completion costs on our long-term contracts. However, due to uncertainties inherent in the estimation process, it is possible that actual completion costs may vary from our estimates. +Substantially all of our contracts are of the following types: +Cost-Plus Fixed Fee. Under cost-plus fixed fee contracts, we charge our customers for our costs, including both direct and indirect costs, plus a fixed negotiated fee. +20 +Table of Contents +Fixed-Price. Under fixed-price contracts, our customers pay us an agreed fixed amount negotiated in advance for a specified scope of work. Prior to completion, our recognized profit margins on any fixed price contract depend on the accuracy of our estimates and will increase to the extent that our current estimates of aggregate actual costs are below amounts previously estimated. Conversely, if our current estimated costs exceed prior estimates, our profit margins will decrease and we may realize a loss on a project. +Time-and-Materials. Under our time-and-materials contracts, we negotiate hourly billing rates and charge our customers based on the actual time that we spend on a project. In addition, customers reimburse us for our actual out-of-pocket costs of materials and other direct incidental expenditures that we incur in connection with our performance under the contract. The majority of our time-and-material contracts are subject to maximum contract values and, accordingly, revenues under these contracts are generally recognized under the percentage-of-completion method. +Accounts Receivable. We estimate the collectibility of customer receivables on an ongoing basis by reviewing invoices outstanding greater than a certain period of time. We record an allowance for doubtful accounts for specific receivables deemed to be at risk for collection as well as a general allowance based on our historical collections experience. Considerable judgment is required in assessing and estimating the ultimate realization of trade receivables, including the current credit-worthiness of each customer. If the financial condition of our customers deteriorates, resulting in an impairment of their ability to make required payments, additional allowances may be required that could adversely affect our operating results. +Inventories. Inventories consist of finished goods, work-in-process and raw materials and are stated at the lower of cost or market. We write down the carrying value of our inventories to net realizable value for estimated excess and obsolete inventories in an amount equal to the difference between the cost of the inventories and their estimated realizable value. These estimates are based on management’s judgments and assumptions as to future demand requirements and our evaluation of market conditions. Demand for our products may fluctuate significantly over time, and actual demand and market conditions may be more or less favorable than those projected by management. In the event that actual demand is lower than originally projected, additional inventory write-downs may be required. Estimated inventory write-downs, once established, are not reversed until the related inventory has been sold or scrapped, so if actual market conditions are more favorable in the fiscal periods subsequent to those in which we record significant write-downs, we may have higher gross margins when products are sold. +Acquisitions and Intangible Assets. The accounting for acquisitions requires extensive use of estimates and judgments to measure the fair value of identifiable tangible and intangible assets acquired and liabilities assumed. Additionally, we must determine whether an acquired entity is considered to be a business or a set of net assets, because the excess of the purchase price over the fair value of net assets can only be recognized as goodwill in a business combination in accordance with relevant accounting guidance. +Our intangible assets are amortized over the estimated useful life of the asset. We periodically evaluate the recoverability of the intangible assets and consider any changes in circumstances that would indicate that the carrying amount of an asset may not be recoverable. Any material changes in circumstances, such as significant decreases in revenue or the operating results of one or more of our operating segments, could require future write-downs of our intangible assets. +Goodwill. Goodwill is recorded as the difference, if any, between the aggregate consideration paid for an acquisition and the fair value of the acquired net tangible and intangible assets. Goodwill is tested for impairment annually in our fourth fiscal quarter at the reporting unit level unless a change in circumstances indicates that an interim impairment analysis is required. We have determined that our reporting units for purposes of testing for goodwill impairment are identical to our reportable segments for financial reporting purposes. Impairment, if any, is measured based on the estimated fair value of the reporting units with the recorded goodwill. The fair value of our reporting units is determined by using the income approach methodology of valuation which utilizes discounted cash flows. The estimated fair value of our reporting units also includes a control premium, which is the amount that a buyer is willing to pay over the current market price of a company as indicated by the traded price per share (i.e., market capitalization), in order to acquire a controlling interest. Significant management judgment is required in the forecasts of future operating results that are used in the discounted cash flow method of valuation. In estimating future cash flows, we generally use the financial assumptions in our current budget and our current strategic plan, subject to modification as considered necessary, including sales and expense growth rates and the discount rates we estimate to represent our cost of funds. It is possible, however, that the plans may change and the estimates used may prove to be inaccurate. In the future, the value of goodwill attributable to each of our reporting units could be adversely impacted by, among other factors, declines in our financial results or market capitalization for an extended period of time or our failure to meet financial performance projections included in our forecasts of future operating results. +Warranty. We generally provide a one to three year warranty from the original invoice date on all products, materials and workmanship. Defective products are either repaired or replaced, at our option, upon meeting certain criteria. We accrue a provision for the estimated costs that may be incurred for product warranties relating to a product as a component of cost of sales at the time revenue for that product is recognized. The accrued warranty provision is included within accrued expenses in the accompanying +21 +Table of Contents +consolidated balance sheets. Should our actual experience of warranty returns be higher than anticipated, additional warranty reserves may be required, which would adversely affect our product gross profit and our operating results. +Income Taxes. On a quarterly basis, we assess the likelihood that our deferred tax asset balance will be recovered from future taxable income. Realization of deferred tax assets (such as net operating loss carryforwards) is dependent on future taxable earnings and is therefore uncertain. To the extent we believe that recovery is not likely, we establish a valuation allowance to reduce our deferred tax assets to amounts that we believe are more likely than not to be realized, which increases our income tax expense in the period such determination is made. +On an interim basis, we estimate what our anticipated annual effective tax rate will be, while also separately considering applicable discrete and other non-recurring items, and record a quarterly income tax provision in accordance with this anticipated rate. As the fiscal year progresses, we refine our estimates based upon actual events and financial results during the year. This estimation process can result in significant changes to our expected effective tax rate. When this occurs, we adjust our income tax provision during the quarter in which our estimates are refined so that the year-to-date provision reflects the expected annual effective tax rate. These changes, along with adjustments to our deferred taxes, among others, may create fluctuations in our overall effective tax rate from quarter to quarter. +Applicable accounting guidance requires that we review all of our tax positions and make a determination as to whether each position is more-likely-than-not to be sustained upon examination by regulatory authorities. If a tax position meets the more-likely-than-not standard, then the related tax benefit is measured based on a cumulative probability analysis of the amount that is more-likely-than-not to be realized upon effective settlement or disposition of the underlying issue. +The application of tax laws and regulations is subject to legal and factual interpretation, judgment and uncertainty. Tax laws and regulations themselves are subject to change as a result of changes in fiscal policy, changes in legislation, the evolution of regulations and court rulings. Therefore, the actual liability for U.S. or foreign taxes may be materially different from our estimates, which could result in the need to record additional tax liabilities or potentially reverse previously recorded tax liabilities. +Stock-Based Compensation . We record stock-based compensation in the statement of operations as an expense, based on the estimated grant date fair value of our stock-based awards, whereby such fair values are amortized over the requisite service period. Our stock-based awards are currently comprised of common stock options and restricted stock units. The fair value of our common stock option awards is estimated on the grant date using the Black-Scholes-Merton (“BSM”) option-pricing formula. While utilizing this model meets established requirements, the estimated fair values generated by it may not be indicative of the actual fair values of our common stock option awards as it does not consider certain factors important to those awards to employees, such as continued employment and periodic vesting requirements as well as limited transferability. Our assumptions under the BSM formula include the following: (i) expected volatilities are based on the historical volatility of our stock price, (ii) the expected life of options is derived based on the historical life of our options, (iii) the risk-free rate for periods within the expected life of the option is based on the U.S. Treasury interest rates in effect at the time of grant and (iv) the dividend yield assumption is based on our history and expectation of dividend payouts. The fair value of our restricted stock units is based on the closing market price of our common stock on the grant date. We include an estimate of forfeitures in the calculation of stock-based compensation expense. Future stock-based compensation expense in any particular quarter or year could be affected by changes in our assumptions, changes in market conditions, or to the extent that we grant additional stock-based awards. Additionally, if there are any modifications or cancellations of the underlying unvested stock-based awards, we may be required to accelerate, increase or cancel any remaining unearned stock-based compensation expense. +Recent Accounting Pronouncements +Refer to Note 1 of Notes to Consolidated Financial Statements, included in Part IV, Item 15 of this report for a discussion of recent accounting pronouncements. +22 +Table of Contents +Results of Operations +The following table sets forth certain statement of operations data as a percentage of total net sales and contract revenues for the periods indicated. The following table should be read in conjunction with Management’s Discussion and Analysis of Financial Condition and Results of Operations. +Year Ended March 31, +2011 +2010 +2009 +Net sales and contract revenues: +Net sales +60.0 +% +54.5 +% +55.4 +% +Contract revenues +40.0 +45.5 +44.6 +Total net sales and contract revenues +100.0 +% +100.0 +% +100.0 +% +Costs of net sales and contract revenues: +Cost of net sales +30.1 +28.4 +29.3 +Cost of contract revenues +26.3 +30.0 +30.4 +Gross profit +43.6 +41.6 +40.3 +Operating expenses: +Selling, general and administrative +31.4 +29.3 +26.0 +Research and development +6.3 +6.3 +5.8 +Impairment of goodwill +13.4 +— +— +Amortization of intangible assets +0.4 +0.3 +0.2 +Change in fair value of contingent acquisition consideration +0.1 +— +— +Total operating expenses +51.6 +35.9 +32.0 +Operating income (loss) +(7.9 +) +5.7 +8.2 +Non-operating income (expense): +Other income, net +0.0 +0.1 +0.2 +Interest expense, net +(0.3 +) +(0.5 +) +(0.9 +) +Income (loss) before income taxes +(8.2 +) +5.3 +7.5 +Benefit (provision) for income taxes +(0.6 +) +(1.5 +) +7.6 +Net income (loss) +(8.8 +)% +3.8 +% +15.1 +% +Analysis of Fiscal 2011, Fiscal 2010 and Fiscal 2009 Results of Operations +Net Sales and Contract Revenues . Net sales are comprised of product sales from our Roadway Sensors and Vehicle Sensors segments, as well as contract engineering revenue and royalty revenue generated from our Vehicle Sensors segment. Contract revenues consist of revenues derived from our Transportation Systems and Environmental Technology segments. +23 +Table of Contents +The following tables present details of our net sales and contract revenues for Fiscal 2011 compared to Fiscal 2010, and Fiscal 2010 compared to Fiscal 2009: +Fiscal +Fiscal +Increase +% +2011 +2010 +(Decrease) +Change +(In thousands, except percentages) +Roadway Sensors +$ +28,208 +$ +25,341 +$ +2,867 +11.3 +% +Vehicle Sensors +7,477 +6,309 +1,168 +18.5 +Net sales +35,685 +31,650 +4,035 +12.7 +Contract revenues +23,758 +26,413 +(2,655 +) +(10.1 +) +Total net sales and contract revenues +$ +59,443 +$ +58,063 +$ +1,380 +2.4 +Fiscal +Fiscal +% +2010 +2009 +Decrease +Change +(In thousands, except percentages) +Roadway Sensors +$ +25,341 +$ +27,197 +$ +(1,856 +) +(6.8 +)% +Vehicle Sensors +6,309 +11,230 +(4,921 +) +(43.8 +) +Net sales +31,650 +38,427 +(6,777 +) +(17.6 +) +Contract revenues +26,413 +30,932 +(4,519 +) +(14.6 +) +Total net sales and contract revenues +$ +58,063 +$ +69,359 +$ +(11,296 +) +(16.3 +) +We currently have a diverse customer base with no individual customer representing greater than 10% of our total annual net sales and contract revenues for Fiscal 2011, Fiscal 2010 or Fiscal 2009. +Roadway Sensors +The increase in Roadway Sensors net sales for Fiscal 2011 as compared to Fiscal 2010 were driven by higher unit sales domestically from both our direct sales and dealer markets, which was offset in part by lower prices due to competitive pressures. In the current fiscal year, we also saw particular strength, both domestically and internationally, in certain of our newer product lines which were introduced within the last 12 to 18 months. Additionally, we believe we have recently gained market share as a result of these new product introductions. However, we cannot assure you that these new products will continue to gain market share or new products we develop in the future will be as successful. Net sales for Fiscal 2010 declined when compared to Fiscal 2009 mainly due to the effects of reduced and delayed spending on infrastructure projects, in part due to the decline in commercial and residential construction as well as state and local government budgetary pressures, and increased competition in the market. +Vehicle Sensors +Vehicle Sensors net sales were primarily made up of sales of our LDW systems to the heavy truck market, which aggregated approximately $6.9 million in Fiscal 2011, $5.6 million in Fiscal 2010 and $9.9 million in Fiscal 2009. As compared to Fiscal 2010, during Fiscal 2011 we saw relatively higher unit sales of our LDW products to each of our key markets, particularly to our foreign OEM heavy truck customers in Japan and Europe, as well as our domestic truck fleet customers. In the fourth quarter of Fiscal 2011, we experienced slightly lower total unit shipments to Japan, as compared to recent prior quarters, which we believe was partially attributable to the crisis caused by the earthquake and tsunami that occurred in that region in March 2011. In the near term, we remain uncertain as to whether our sales volumes to this region will be adversely impacted as a result of the crisis. Our Fiscal 2010 net sales were significantly lower when compared to Fiscal 2009 levels, as we saw a substantial slowdown in overall LDW unit shipments to each of our key markets, which began in the fourth quarter of Fiscal 2009. We believe this was driven largely by the weakness in the U.S. and worldwide economy at that time, in which there was a significant decline in new heavy truck sales in general. Although we have experienced improvements in our sales in the current year, we remain cautious in our outlook for the upcoming year. We anticipate that Vehicle Sensors unit sales in future periods could be adversely impacted by, among other factors, slower than expected adoption rates of our LDW system across each of our target markets and the continuing uncertainty in the global economic environment. Additionally, future unit sales of LDW systems and unit pricing could be adversely impacted as a result of increased competition in this market. +Also included in Vehicle Sensors net sales are revenues from contract engineering services and royalty revenues in the passenger car market that are derived from our strategic relationship with Valeo, which aggregated approximately $568,000, $685,000 and $1.3 million for the fiscal years ended March 31, 2011, 2010 and 2009, respectively. We have experienced year-over-year decreases in contract engineering services provided to Valeo as the pertinent engineering development activities have generally reached maturity for the related vehicle platforms that currently incorporate our LDW system. During the current fiscal year, the +24 +Table of Contents +decrease in contract engineering services provided was partially offset by an increase in our royalty revenues. Our LDW systems are currently offered as an option on four Infiniti models. While Valeo is promoting our LDW systems to other passenger car OEMs, we cannot assure you that Valeo will be successful in these efforts. +Contract Revenues +Contract revenues are derived from our Transportation Systems segment, and upon our acquisition of MET in January 2011, also include the revenues from our Environmental Technology segment. Our contract revenues are primarily dependent upon the continued availability of funding at both the state and federal levels from the various departments of transportation. Our Fiscal 2011 contract revenues include approximately $1.5 million of revenues attributable to MET. Our Transportation Systems contract revenues have sequentially decreased over the last two fiscal years primarily as a result of the ongoing weakness in the markets this segment serves, which has been aggravated by the general lengthening of the overall sales cycle, from the bid and proposal process, to the signing of a contract and commencement of work on a project. Government budgeting constraints and funding delays or reductions on various existing contracts, particularly in the Southeast region of the U.S., also contributed to the sequential declines in our revenues. Our private planning group, which focuses on private development consulting, has likewise experienced particular weakness over the last two years. The decrease in our Fiscal 2010 revenues, as compared to Fiscal 2009, was also partially attributable to the timing differences on certain of our larger contracts, which contained a higher amount of sub-consultant revenue in Fiscal 2009, but such contracts were mostly completed by the end of Fiscal 2009 and were not replaced with similar contracts in Fiscal 2010. +Going forward, we plan to continue to pursue large contracts that may contain significant sub-consulting content, which will likely contribute to variability in the timing and amount of our contract revenues from period to period. We also intend to continue to expand our foreign operations by pursuing additional international opportunities in the Middle East and other regions. Among other factors, we believe the ability of both our Transportation Systems and Environmental Technology segments to grow and successfully win and service new contracts will be highly dependent upon our continued success in recruiting and retaining qualified personnel. +Gross Profit . The following tables present details of our gross profit for Fiscal 2011 compared to Fiscal 2010, and Fiscal 2010 compared to Fiscal 2009: +Fiscal +Fiscal +% +2011 +2010 +Decrease +Change +(In thousands, except percentages) +Total gross profit +$ +25,941 +$ +24,159 +$ +1,782 +7.4 +% +Total gross profit as a % of total net sales and contract revenues +43.6 +% +41.6 +% +Gross profit as a % of net sales +49.9 +% +47.9 +% +Gross profit as a % of contract revenues +34.2 +% +34.1 +% +Fiscal +Fiscal +% +2010 +2009 +Decrease +Change +(In thousands, except percentages) +Total gross profit +$ +24,159 +$ +27,919 +$ +(3,760 +) +(13.5 +)% +Total gross profit as a % of total net sales and contract revenues +41.6 +% +40.3 +% +Gross profit as a % of net sales +47.9 +% +47.1 +% +Gross profit as a % of contract revenues +34.1 +% +31.8 +% +Our total gross profit as a percent of total net sales and contract revenues increased in Fiscal 2011 compared to Fiscal 2010 primarily as a result of our product and service mix. In Fiscal 2011, our net sales, which are substantially comprised of product sales, represented approximately 60% of our total net sales and contract revenues as compared to 55% in Fiscal 2010. Our net sales generally carry higher margins than our contract revenues derived primarily from our consulting services. Our total gross profit as a percent of total net sales and contract revenues for Fiscal 2010 increased slightly compared to Fiscal 2009 primarily due to higher margins from our net sales, particularly Roadway Sensors, as we realized cost savings due to lower costs of materials driven by improvements in our supply chain management. The increase from Fiscal 2009 to Fiscal 2010 was also attributable, to a lesser extent, to the improvement in our Transportation Systems margins in Fiscal 2010, as discussed further below. +The increase in gross profit as a percent of sales (“gross margin”) in Fiscal 2011 as compared to Fiscal 2010 was primarily a result of higher overall net sales and margins in Roadway Sensors during the current year. Such higher margins were largely driven by +25 +Table of Contents +our customer mix and lower costs for certain key materials. We generally enjoy higher gross margins on direct sales as compared to dealer and aftermarket sales. In Vehicle Sensors, we also experienced a significant improvement in our year over year gross margins as a result of (i) higher product sales levels in the current year which provided for improved overhead absorption and (ii) higher royalty revenues from Valeo. The slight increase in gross margin in Fiscal 2010 as compared to Fiscal 2009 was due to certain materials cost savings, as discussed above, and a favorable customer mix weighted more toward direct sales. This increase was partially offset during Fiscal 2010 by decreased gross margins in Vehicle Sensors, which was largely driven by lower overhead absorption due to the decline in sales as compared to Fiscal 2009, along with an increase in certain estimates for additional excess and obsolete inventory provisions in Fiscal 2010. Gross profit as a percentage of net sales can fluctuate in any specific quarter or year based on, among other factors, customer and product mix, competitive pricing requirements, product warranty costs and provisions for excess and obsolete inventories, as well as possible shifts of engineering resources from development activities to sustaining activities, which we record as cost of goods sold. +We recognize the majority of our contract revenues and related gross profit using percentage of completion contract accounting, and the underlying mix of contract activity affects the related gross profit recognized in any given period. Gross profit as percent of contract revenues in Fiscal 2011 were highly consistent with those of Fiscal 2010. The increase in gross profit as a percent of contract revenues in Fiscal 2010 compared to Fiscal 2009 was primarily due to a contract mix weighted more toward higher margin contracts in Fiscal 2010. Our higher margin contracts often contain a comparatively lower proportion of sub-consulting revenues associated with them. We expect the variability and timing of contract mix and related sub-consulting content in our Transportation Systems and Environmental Technology segments in future periods, as well as factors such as paid holidays and our ability to efficiently utilize our workforce, will cause fluctuations in our margins from contract revenues from period to period. +Selling, General and Administrative Expense +The following table presents selling, general and administrative expense for Fiscal 2011 and Fiscal 2010: +Fiscal 2011 +Fiscal 2010 +% of Net +% of Net +Sales and +Sales and +Contract +Contract +Increase +% +Amount +Revenues +Amount +Revenues +(Decrease) +Change +(In thousands, except percentages) +Salary and personnel-related +$ +13,040 +21.9 +% +$ +11,262 +19.4 +% +$ +1,778 +15.8 +% +Facilities, insurance and supplies +2,329 +3.9 +2,444 +4.2 +(115 +) +(4.7 +) +Travel and conferences +1,590 +2.7 +1,488 +2.6 +102 +6.9 +Professional and outside services +1,378 +2.3 +1,038 +1.8 +340 +32.8 +Other +317 +0.5 +772 +1.3 +(455 +) +(58.9 +) +Selling, general and administrative +$ +18,654 +31.4 +% +$ +17,004 +29.3 +% +$ +1,650 +9.7 +The increase in selling, general and administrative expenses in Fiscal 2011 as compared to Fiscal 2010 was primarily due to (i) higher selling and commission-related expenses for our Roadway Sensors and Vehicle Sensors segments, as total net sales for both segments increased approximately 11% and 19%, respectively, from Fiscal 2010 levels, (ii) higher salary and headcount-related expenses as we have added certain key sales and marketing personnel in all of our business segments, including as a result of the acquisition of MET in January 2011, (iii) additional consulting and outside services expenses in the Vehicle Sensors segment related to market research and certain other sales and marketing activities and (iv) additional legal and professional services related to our acquisition of MET, along with various other corporate initiatives. We also saw a shift from cost of sales to sales and marketing of certain of our headcount expenses in our Transportation Systems segment in the current year commensurate with the overall decline in this segment’s revenues and the reallocation of existing personnel in an effort to expand our contract backlog and increase contract revenues. However, we cannot assure you that our efforts will be successful. Additionally, during Fiscal 2011, we realized approximately $250,000 in reversals of certain previously recorded bad debt expense (included in the “Other” category in the table above) as a result of collecting certain large accounts receivable balances. In prior periods, we had recorded an estimated allowance for doubtful accounts against these receivables given the uncertainty of collection at that time. In the future, our operating results in any given period may be favorably or adversely impacted as a result of our estimates of the realization of our accounts receivable. +26 +Table of Contents +The following table presents selling, general and administrative expense for Fiscal 2010 and 2009: +Fiscal 2010 +Fiscal 2009 +% of Net +% of Net +Sales and +Sales and +Contract +Contract +Increase +% +Amount +Revenues +Amount +Revenues +(Decrease) +Change +(In thousands, except percentages) +Salary and personnel-related +$ +11,262 +19.4 +% +$ +11,949 +17.2 +% +$ +(687 +) +(5.7 +)% +Facilities, insurance and supplies +2,444 +4.2 +2,378 +3.4 +66 +2.8 +Travel and conferences +1,488 +2.6 +1,563 +2.3 +(75 +) +(4.8 +) +Professional and outside services +1,038 +1.8 +1,302 +1.9 +(264 +) +(20.3 +) +Other +772 +1.3 +843 +1.2 +(71 +) +(8.4 +) +Selling, general and administrative +$ +17,004 +29.3 +% +$ +18,035 +26.0 +% +$ +(1,031 +) +(5.7 +) +The decrease in selling, general and administrative expenses in Fiscal 2010 as compared to Fiscal 2009 was primarily due to (i) our overall reduction in headcount during Fiscal 2010; (ii) lower accruals for bonuses and other incentive compensation primarily due to lower sales and operating profit in Fiscal 2010; and (iii) the suspension of our matching contributions under our 401(k) plan effective July 1, 2009. We also reduced our professional and outside services expenses during Fiscal 2010 primarily through our efforts to conserve costs and scale back our usage of such services, along with various efficiencies gained in our internal control assessment and other financial reporting obligations. +Research and Development Expense +The following table presents research and development expense for Fiscal 2011 and Fiscal 2010: +Fiscal 2011 +Fiscal 2010 +% of Net +% of Net +Sales and +Sales and +Contract +Contract +Increase +% +Amount +Revenues +Amount +Revenues +(Decrease) +Change +(In thousands, except percentages) +Salary and personnel-related +$ +2,381 +4.0 +% +$ +2,655 +4.6 +% +$ +(274 +) +(10.3 +)% +Facilties, development and supplies +1,173 +2.0 +883 +1.5 +290 +32.8 +Other +208 +0.3 +140 +0.2 +68 +48.6 +Research and development +$ +3,762 +6.3 +% +$ +3,678 +6.3 +% +$ +84 +2.3 +Research and development expenses for Fiscal 2011 were generally consistent, in total, with those of Fiscal 2010. During Fiscal 2011, we incurred certain additional external costs primarily for development and related activities associated with our Vehicle Sensors segment. As compared to the prior year, the increase in these costs was largely offset by lower personnel-related expenses. We believe research and development activities are crucial to our ability to continue to be a leader in our markets. +27 +Table of Contents +The following table presents research and development expense for Fiscal 2010 and 2009: +Fiscal 2010 +Fiscal 2009 +% of Net +% of Net +Sales and +Sales and +Contract +Contract +% +Amount +Revenues +Amount +Revenues +Decrease +Change +(In thousands, except percentages) +Salary and personnel-related +$ +2,655 +4.6 +% +$ +2,748 +4.0 +% +$ +(93 +) +(3.4 +)% +Facilties, development and supplies +883 +1.5 +1,018 +1.5 +(135 +) +(13.3 +) +Other +140 +0.2 +264 +0.4 +(124 +) +(47.0 +) +Research and development +$ +3,678 +6.3 +% +$ +4,030 +5.8 +% +$ +(352 +) +(8.7 +) +The decrease in research and development expense in Fiscal 2010 compared to Fiscal 2009 was primarily due to lower overall engineering headcount and a more efficient engineering structure as we shifted our focus to new product development from a historical focus on new customer qualification and manufacturing support. +Impairment of Goodwill. We performed annual impairment assessments of the carrying value of goodwill for the fiscal years ended March 31, 2010 and 2009. Based on these assessments, we determined that no impairment as of either of these dates was indicated as the estimated fair value of each reporting unit exceeded its respective carrying value. +As of September 30, 2010, we performed the first step in the impairment analysis of the carrying value of goodwill for all reporting units primarily due to the decline in our stock price and market capitalization since our fiscal year ended March 31, 2010 and the ongoing weakness in the economic environment. This analysis did not result in any impairment charges during the quarter ended September 30, 2010. +During the quarter ended December 31, 2010, due primarily to lower than expected operating results in our Transportation Systems reporting unit, as well as ongoing weakness specifically in the Transportation Systems markets, we determined it was necessary to perform another interim test of impairment of the carrying value of goodwill in our Transportation Systems reporting unit as of December 31, 2010. In performing the first step in this analysis, we estimated the fair value of our Transportation Systems reporting unit using the income approach. As of December 31, 2010, we determined that the carrying value of our Transportation Systems reporting unit exceeded its estimated fair value, and accordingly, we performed the second step of the impairment analysis to estimate the implied fair value of the goodwill of this reporting unit. +The implied fair value of goodwill was determined in the same manner utilized to estimate the amount of goodwill recognized in a business combination. To determine this value, we estimated the fair value of the assets and liabilities, including certain intangible assets, to be allocated to the Transportation Systems reporting unit as of December 31, 2010. The implied fair value of goodwill was measured as the difference between the estimated fair value of the reporting unit over the estimated fair value amounts of its assets and liabilities. The impairment loss for the Transportation Systems reporting unit was measured by the amount the carrying value of its goodwill exceeded the implied fair value of the goodwill. Accordingly, in order to write down Transportation Systems goodwill with a carrying value of $14.9 million to its implied fair value of $6.9 million, we recorded an impairment charge of $8.0 million in the three months ended December 31, 2010. +We estimated the fair value of the Transportation Systems reporting unit using the income approach, which was based on management’s business plans and financial projections for the next five years, along with a perpetual growth rate thereafter of approximately 4%. The analysis also used a weighted average discount rate of approximately 14%, which we believe reflects our cost of capital, slightly adjusted for increased market risk. +Our Transportation Systems segment has recently been adversely impacted by, among other factors, (i) continued delays in government spending and resolution of budgetary issues, (ii) longer than expected lead times in bidding, successfully winning and commencing work on new contracts, and renewing existing contracts, and (iii) the ongoing weakness in the macroeconomic environment and the longer than expected economic recovery. +28 +Table of Contents +Subsequent to the interim impairment test as of December 31, 2010 described above, we performed our annual impairment assessment of the carrying value of goodwill as of March 31, 2011. Based on this assessment, we determined that no impairment as of this date was indicated, as the estimated fair value of each of our reporting units exceeded its respective carrying value. At March 31, 2011, our Roadway Sensors, Vehicle Sensors, Transportation Systems and Environmental Technology reporting units had goodwill balances of $8.2 million, $4.7 million, $7.2 million and $1.2 million, respectively. We believe we have no goodwill at risk, as the estimated fair values of our Roadway Sensors, Vehicle Sensors and Transportations Systems reporting units significantly exceeded their carrying values at March 31, 2011. The fair value of our Environment Technology reporting unit at March 31, 2011 approximated its carrying value given that the acquisition of MET occurred in January 2011. If our actual financial results, or the plans and estimates used in future goodwill impairment analyses, are lower than the original estimates used to assess for impairment of our goodwill, we could incur future goodwill impairment charges. +Interest Expense, Net +Net interest expense was $152,000, $264,000 and $646,000 in Fiscal 2011, 2010 and 2009, respectively. The sequential decreases were primarily due to our lower overall level of borrowings, as we continue to make monthly principal payments on our term note. See “Liquidity and Capital Resources” below for additional details on our borrowings. +Income Taxes +The following table presents our benefit (provision) for income taxes for Fiscal 2011, Fiscal 2010 and Fiscal 2009: +Year Ended March 31, +2011 +2010 +2009 +(In thousands, except percentages) +Benefit (provision) for income taxes +$ +(353 +) +$ +(895 +) +$ +5,297 +Effective tax rate +7.3 +% +28.9 +% +(102.3 +)% +Our effective tax rate for Fiscal 2011 was impacted unfavorably by a portion of the charge recorded for the impairment of goodwill, amounting to approximately $2.2 million, for which there is no corresponding tax basis. This unfavorable impact was partially offset by the impact of the recognition of approximately $327,000 of previously unrecognized tax benefits during the year due to expiration of certain federal and state statutes in various jurisdictions. Our effective tax rate for Fiscal 2010 was favorably impacted by the recognition of approximately $414,000 of unrecognized tax benefits during the year due to the expiration of certain federal and state statutes in various jurisdictions. The income tax benefit recorded in Fiscal 2009 was primarily the result of a decrease in the valuation allowance recorded against our deferred tax assets as a result of changes in estimates of the future realizability of these assets. +As of March 31, 2011 and 2010, respectively, we determined that it was more likely than not that our deferred tax assets will be realized. Accordingly, no valuation allowance has been recorded against our deferred tax assets as of either such dates. In making our determination as to the realizability of our deferred tax assets, we reviewed all available positive and negative evidence, including reversal of deferred tax liabilities, potential carrybacks, projected future taxable income, tax planning strategies and recent financial performance. +As we update our estimates in future periods, adjustments to our deferred tax asset and valuation allowance may be necessary. We anticipate this will cause our future overall effective tax rate in any given period to fluctuate from prior effective tax rates and statutory tax rates. We utilize the liability method of accounting for income taxes. We record net deferred tax assets to the extent that we believe these assets will more likely than not be realized. In making such determination, we consider all available positive and negative evidence, including, but not limited to, scheduled reversals of deferred tax liabilities, projected future taxable income, tax planning strategies and recent financial performance. +At March 31, 2011, we had $35.7 million of federal net operating loss carryforwards and $18.6 million of state net operating loss carryforwards that begin to expire in 2019 and 2017, respectively. Due to changes in stock ownership, our federal net operating loss carryforwards and other federal attributes are subject to a Section 382 annual limitation. Although the impact cannot be precisely determined at this time, we believe that our net operating loss carryforwards will cause us to have future income tax payments that are substantially lower than the income tax liability calculated using statutory tax rates. +29 +Table of Contents +Liquidity and Capital Resources +Cash Flows +We have historically financed our operations with a combination of cash flows from operations, borrowings under credit facilities and the sale of equity securities. We currently rely on cash flows from operations and the availability of borrowings on a line of credit facility to fund our operations, which we believe to be sufficient to fund our operations for at least the next twelve months. However, we may need or choose to raise additional capital to fund potential future acquisitions and our future growth. We may raise such funds by selling equity or debt securities to the public or to selected investors, or by borrowing money from financial institutions. If we raise additional funds by issuing equity or convertible debt securities, our existing stockholders may experience significant dilution and any equity securities that may be issued may have rights senior to our existing stockholders. +At March 31, 2011, we had $19.9 million in working capital, which included no borrowings on our $12.0 million line of credit and $11.8 million in cash and cash equivalents. This compares to working capital of $22.6 million at March 31, 2010, which included no borrowings on our line of credit and $10.4 million in cash and cash equivalents. +The following table summarizes our cash flows for Fiscal 2011, Fiscal 2010 and Fiscal 2009: +Year Ended March 31, +2011 +2010 +2009 +(In thousands) +Net cash provided by (used in): +Operating activities +$ +5,346 +$ +6,484 +$ +6,390 +Investing activities +(1,530 +) +(594 +) +(795 +) +Financing activities +(2,403 +) +(1,857 +) +413 +Operating Activities. Cash provided by our operations in Fiscal 2011 was the result of (i) $9.9 million in non-cash items within the statement of operations, primarily $8.0 million for the impairment of goodwill, depreciation expense of $1.0 million and stock-based compensation expense of $382,000; and (ii) $614,000 in positive cash flows resulting from changes in our operating assets and liabilities during the year, all of which was partially offset by our net loss of $5.2 million for the year. +Our inventories increased approximately $953,000, or 35%, from March 31, 2010 to March 31, 2011 as we have built up certain inventories on hand to meet anticipated increases in our product net sales in both Roadway Sensors and Vehicle Sensors. In the future, our inventory levels are likely to continue to be determined based upon, among other factors, the level of purchase orders we receive from our customers, the stage at which our products are in their respective product life cycles, and competitive situations in the marketplace. We attempt to balance such considerations against risk of obsolescence and potentially excess inventory levels. +The increase in accounts payable by approximately $920,000 from March 31, 2010 to March 31, 2011 was driven by our increased inventory levels and the general timing of payments to vendors. +Cash provided by our operations in Fiscal 2010 was primarily the result of (i) our Fiscal 2010 net income of $2.2 million; (ii) $2.5 million in non-cash items within the statement of operations, primarily consisting of adjustments to our deferred tax assets of $1.0 million, depreciation expense of $986,000 and stock-based compensation expense of $375,000; and (iii) $1.7 million in cash resulting from changes in our operating assets and liabilities during the year. +Cash provided by our operations in Fiscal 2009 was primarily the result of our Fiscal 2009 net income of $10.5 million adjusted for $3.7 million of net non-cash items within the statement of operations, which was comprised primarily of adjustments to our deferred tax balances of $5.4 million, offset slightly by depreciation expense of $1.0 million and stock-based compensation, amortization and other items totaling $642,000. +Investing Activities. Cash used in our investing activities for Fiscal 2011 consisted of (i) $1.1 million used for the acquisition of MET and purchases of property and equipment of $414,000. In April 2011, we made an additional payment of $137,000 related to the MET acquisition. For further information on our acquisitions, refer to Note 3 of Notes to Consolidated Financial Statements included in Part IV, Item 15 of this report. Our investing activities for Fiscal 2010 consisted of purchases of property and equipment of +30 +Table of Contents +$294,000, as well as $300,000 representing the initial payment for the acquisition of certain assets of Hamilton Signal, Inc. Cash used in investing activities for Fiscal 2009 consisted of purchases of certain property and equipment of $795,000. +Financing Activities. Net cash used in financing activities during Fiscal 2011 primarily consisted of $2.4 million in payments on our long-term debt and $106,000 for the first anniversary payment for the Hamilton Signal acquisition. In April 2011, we made our final payment of $112,000 for the Hamilton Signal acquisition. Net cash used in financing activities during Fiscal 2010 consisted of net payments on our long-term debt of $2.0 million. The net payments on our long-term debt during Fiscal 2010 were partially offset by $143,000 in proceeds received from the exercise of outstanding stock options to purchase shares of our common stock. Net cash provided by financing activities in Fiscal 2009 was the result of $939,000 in cash inflows from the exercise of stock options to purchase our common stock, partially offset by net payments on our borrowings of $526,000. +Borrowings +In October 2008, we entered into a $19.5 million credit facility with California Bank & Trust (the “Bank”), which provided for a two-year revolving line of credit with borrowings of up to $12.0 million and a $7.5 million 48-month term note (discussed below). In September 2010, we entered into a modification agreement with the Bank to extend the expiration date of our revolving line of credit to October 1, 2012. Interest on borrowed amounts under the revolving line of credit are payable monthly at a rate equal to the current stated prime rate (3.25% at March 31, 2011) up to the current stated prime rate plus 0.50%, depending on aggregate deposit balances maintained at the bank in relation to the total loan commitment under the credit facility. We are obligated to pay an unused line fee of 0.25% per annum applied to the average unused portion of the revolving line of credit during the preceding month. The revolving line of credit does not contain any early termination fees and is secured by substantially all of our assets. As of March 31, 2011, no amounts were outstanding under the revolving line of credit portion of the facility. Availability under this line of credit may be reduced or otherwise limited as a result of our obligations to comply with certain financial covenants, as described further below. +As of March 31, 2011, we had outstanding borrowings of approximately $3.0 million under the term note included in our credit facility. Principal payments under this term note are required to be repaid in 48 monthly installments of $152,000 commencing on June 1, 2009. Additionally, beginning on November 1, 2009, and on November 1 of each year thereafter, we are required to repay additional principal of up to $500,000, calculated based on certain financial measures, as further defined in the loan agreement. These additional principal payments effectively reduce the total number of monthly installments necessary to repay the term note. To date, we have made additional principal payments of $500,000 on each of November 1, 2010 and 2009. Interest on the term note is payable monthly at a rate equal to the current stated prime rate plus 0.50% up to the current stated prime rate plus 1.00%, depending on aggregate deposit balances maintained at the bank in relation to the total loan commitment under the credit facility. The term note contains no early termination fees and, along with our revolving line of credit discussed above, is secured by substantially all of our assets. +In connection with our credit facility and loan agreement with the Bank, we are also required to comply with certain quarterly financial covenants. These include achieving ratios for working capital and debt service, as well as maintaining a level of profitability, all of which are further defined in the agreement. While we believe we are currently in compliance with all such financial covenants, we cannot assure you that we will not violate one or more covenants in the future. If we were to be in violation of covenants under this agreement, our lender could choose to accelerate payment on all outstanding loan balances and pursue its security interest in our assets. In this event, we cannot assure you that we would be able to quickly obtain equivalent or suitable replacement financing on acceptable terms, on a timely basis, or at all. If we were not able to secure alternative sources of financing, such acceleration would have a material adverse impact on our business and financial condition. +Off Balance Sheet Arrangements +Other than our operating leases, which are further described at Note 8 of Notes to Consolidated Financial Statements, included in Part IV, Item 15 of this report, we do not believe we have any other material off balance sheet arrangements at March 31, 2011. +Seasonality +We have historically experienced seasonality, particularly with respect to our Roadway Sensors net sales in the third and fourth fiscal quarters due to a reduction in road construction and repairs during the winter months due to inclement weather conditions. +31 +Table of Contents +ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK +Interest Rate Risk +Our exposure to interest rate risk is limited to our line of credit and our bank term note. Our line of credit bears interest equal to the prevailing prime rate (3.25% at March 31, 2011) plus 0% to 1.0%. We do not believe that a 10% increase in the interest rate on our line of credit or term note would have a material impact on our financial position, operating results or cash flows. In addition, we believe that the carrying value of our outstanding debt under our credit facility approximates fair value. +Foreign Currency Risk +To date, a small portion of our net sales have been denominated in Euros. Gains or losses from foreign currency remeasurement are included in “other income, net” in our consolidated financial statements and to date have not been significant. We do not believe we are currently exposed to any material risk of loss from currency exchange fluctuations. We do not currently purchase derivative financial instruments to hedge foreign currency exchange risk, but may do so in the future. +ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA +The financial statements and supplementary data required by Regulation S-X are included in Part IV, Item 15 of this report. +ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE +None. +ITEM 9A. CONTROLS AND PROCEDURES +(a) Evaluation of disclosure controls and procedures. In accordance with Rule 13a-15(b) of the Securities Exchange Act of 1934, as of the end of the period covered by this Annual Report on Form 10-K, management evaluated, with the participation of the our President and Chief Executive Officer and the Chief Financial Officer, the effectiveness of the design and operation of our disclosure controls and procedures (as defined in Rule 13a-15(e) under the Exchange Act). Based upon their evaluation of these disclosure controls and procedures, the President and Chief Executive Officer and the Chief Financial Officer have concluded that our disclosure controls and procedures were effective as of the date of such evaluation in ensuring that information required to be disclosed in our Exchange Act reports is (1) recorded, processed, summarized and reported in a timely manner, and (2) accumulated and communicated to management, including the Company’s President and Chief Executive Officer and the Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure. +(b) Changes in internal control. There was no change in our internal control over financial reporting that occurred during the period covered by this Annual Report on Form 10-K that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting. +Inherent Limitations on Internal Control +A control system, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. Further, the benefits of controls must be considered relative to their costs. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of management override or improper acts, if any, have been detected. These inherent limitations include the realities that judgments in decision making can be faulty, and that breakdowns can occur because of simple errors. Additionally, controls can be circumvented by the individual acts of some persons, by collusion of two or more people, or by management override of the control. The design of any system of controls is also based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions. Because of the inherent limitations in a cost-effective control system, misstatements due to management override, error or improper acts may occur and not be detected. Any resulting misstatement or loss may have an adverse and material effect on our business, financial condition and results of operations. +32 +Table of Contents +Management’s Report on Internal Control Over Financial Reporting +Our management is responsible for establishing and maintaining adequate internal control over financial reporting. Our internal control system was designed to provide reasonable assurance to management and the board of directors regarding the effectiveness of our internal control processes over the preparation and fair presentation of published financial statements. +We have assessed the effectiveness of our internal controls over financial reporting as of March 31, 2011. In making this assessment, we used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (“COSO”) in Internal Control—Integrated Framework. Based on our assessment, we believe that, as of March 31, 2011, our internal control over financial reporting is effective based on those criteria. +This annual report does not include an attestation report of our independent registered public accounting firm regarding internal control over financial reporting. Management’s report was not subject to attestation by our independent registered public accounting firm pursuant to the rules of the SEC applicable to smaller reporting companies. +ITEM 9B . OTHER INFORMATION +In February 2011, three of our executive officers, Abbas Mohaddes, James Miele and Greg McKhann, entered into stock selling plans pursuant to Rule 10b5-1 promulgated under the Securities Exchange Act of 1934, as amended. All of such plans only cover shares of the Company’s common stock issuable upon exercise of stock options that expire on September 26, 2011. Mr. Mohaddes’ plan covers the sale of up to an aggregate of 210,000 shares, with initial sales under the plan commencing on June 8, 2011. Mr. Miele’s plan covers the sale of up to an aggregate of 40,000 shares, with initial sales commencing on June 6, 2011. Mr. McKhann’s plan covers the sale of up to an aggregate of 96,000 shares, with initial sales commencing on June 8, 2011. Shares covered by the above-described 10b5-1 plans will be sold if the market price per share of our common stock reaches the amounts designated in the applicable plan. +PART III +ITEM 10. DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE +(a) Identification of Directors. The information under the caption “Election of Directors,” appearing in our proxy statement for the 2011 Annual Meeting of Stockholders, is incorporated herein by reference. +(b) Identification of Executive Officers. The information under the caption “Executive Compensation and Other Information - Executive Officers,” appearing in our proxy statement for the 2011 Annual Meeting of Stockholders, is incorporated herein by reference. +(c) Compliance with Section 16(a) of the Exchange Act. The information under the caption “Section 16(a) Beneficial Ownership Reporting Compliance,” appearing in our proxy statement for the 2011 Annual Meeting of Stockholders, is incorporated herein by reference. +(d) Corporate Governance . The information under the caption “Corporate Governance,” appearing in our proxy statement for the 2011 Annual Meeting of Stockholders, is incorporated herein by reference. +(e) Audit Committee . The information under the caption “Board Meetings and Committees — Audit Committee,” appearing in our proxy statement for the 2011 Annual Meeting of Stockholders, is incorporated herein by reference. +ITEM 11. EXECUTIVE COMPENSATION +The information under the caption “Executive Compensation and Other Information,” appearing in our proxy statement for the 2011 Annual Meeting of Stockholders, is incorporated herein by reference. +ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS +The information under the captions “Equity Compensation Plans” and “Principal Stockholders and Common Stock Ownership of Certain Beneficial Owners and Management,” appearing in our proxy statement for the 2011 Annual Meeting of Stockholders, is incorporated herein by reference. +ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE +The information under the captions “Corporate Governance — Director Independence” and “Certain Transactions,” appearing in our proxy statement for the 2011 Annual Meeting of Stockholders, is incorporated herein by reference. +33 +Table of Contents +ITEM 14. PRINCIPAL ACCOUNTING FEES AND SERVICES +The information under the caption “Fees Paid to Independent Registered Public Accounting Firm,” appearing in our proxy statement for the 2011 Annual Meeting of Stockholders, is incorporated herein by reference. +PART IV +ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES +(a) Documents filed as part of this report: +1. Financial Statements. The following financial statements of Iteris, Inc. are included in a separate section of this Annual Report on Form 10-K commencing on the pages referenced below: +Report of Independent Registered Public Accounting Firm +38 +Consolidated Balance Sheets as of March 31, 2011 and 2010 +39 +Consolidated Statements of Operations for the years ended March 31, 2011, 2010 and 2009 +40 +Consolidated Statements of Stockholders’ Equity and Comprehensive Income for the years ended March 31, 2011, 2010 and 2009 +41 +Consolidated Statements of Cash Flows for the years ended March 31, 2011, 2010 and 2009 +42 +Notes to Consolidated Financial Statements +43 +2. Exhibits . +The exhibits listed on the accompanying index to exhibits immediately following the financial statements are filed as part of, or hereby incorporated by reference into, this report. +34 +Table of Contents +SIGNATURES +Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. +Dated: June 1, 2011 +ITERIS, INC. +(Registrant) +By +/S/ ABBAS MOHADDES +Abbas Mohaddes +Chief Executive Officer +(Principal Executive Officer) +35 +Table of Contents +POWER OF ATTORNEY +We, the undersigned officers and directors of Iteris, Inc., do hereby constitute and appoint James S. Miele and Abbas Mohaddes, and each of them, our true and lawful attorneys-in-fact and agents, each with full power of substitution and resubstitution, for him and in his name, place and stead, in any and all capacities, to sign any and all amendments to this report, and to file the same, with exhibits thereto, and other documents in connection therewith, with the Securities and Exchange Commission, granting unto said attorneys-in-fact and agents, and each of them, full power and authority to do and perform each and every act and thing requisite or necessary to be done in and about the premises, as fully to all intents and purposes as he might or could do in person, hereby, ratifying and confirming all that each of said attorneys-in-fact and agents, or his substitute or substitutes, may lawfully do or cause to be done by virtue hereof. +Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant in the capacities and on the dates indicated: +Signature +Title +Date +/s/ ABBAS MOHADDES +Director, President and Chief Executive Officer +June 1, 2011 +Abbas Mohaddes +(principal executive officer) +/s/ JAMES S. MIELE +Chief Financial Officer +June 1, 2011 +James S. Miele +(principal financial and accounting officer) +/s/ GREGORY A. MINER +Chairman of the Board +June 1, 2011 +Gregory A. Miner +/s/ RICHARD CHAR +Director +June 1, 2011 +Richard Char +/s/ KEVIN C. DALY +Director +June 1, 2011 +Kevin C. Daly, Ph.D. +/s/ JOHN SEAZHOLTZ +Director +June 1, 2011 +John Seazholtz +/s/ JOEL SLUTZKY +Director +June 1, 2011 +Joel Slutzky +/s/ THOMAS L. THOMAS +Director +June 1, 2011 +Thomas L. Thomas +/s/ MIKEL WILLIAMS +Director +June 1, 2011 +Mikel Williams +36 +Table of Contents +Iteris, Inc. +Index to Consolidated Financial Statements +Report of Independent Registered Public Accounting Firm +38 +Consolidated Balance Sheets as of March 31, 2011 and 2010 +39 +Consolidated Statements of Operations for the years ended March 31, 2011, 2010 and 2009 +40 +Consolidated Statements of Stockholders’ Equity and Comprehensive Income for the years ended March 31, 2011, 2010 and 2009 +41 +Consolidated Statements of Cash Flows for the years ended March 31, 2011, 2010 and 2009 +42 +Notes to Consolidated Financial Statements +43 +37 +Table of Contents +Report of Independent Registered Public Accounting Firm +To the Board of Directors and Stockholders +Iteris, Inc. +We have audited the accompanying consolidated balance sheets of Iteris, Inc. and subsidiaries as of March 31, 2011 and 2010, and the related consolidated statements of operations, stockholders’ equity and comprehensive income (loss), and cash flows for each of the three years in the period ended March 31, 2011. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits. +We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. The Company is not required to have, nor were we engaged to perform an audit of its internal control over financial reporting. Our audit included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. +In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Iteris, Inc. and subsidiaries as of March 31, 2011 and 2010, and the results of their operations and their cash flows for each of the three years in the period ended March 31, 2011, in conformity with U.S. generally accepted accounting principles. +/s/ McGladrey & Pullen, LLP +Irvine, California +June 1, 2011 +38 +Table of Contents +Iteris, Inc. +Consolidated Balance Sheets +(In thousands, except par value) +March 31, +2011 +2010 +Assets +Current assets: +Cash and cash equivalents +$ +11,818 +$ +10,405 +Trade accounts receivable, net of allowance for doubtful accounts of $387 and $768 at March 31, 2011 and 2010, respectively +10,941 +11,311 +Costs in excess of billings on uncompleted contracts +4,070 +3,871 +Inventories +3,680 +2,727 +Deferred income taxes +2,927 +4,993 +Prepaid expenses and other current assets +432 +623 +Total current assets +33,868 +33,930 +Property and equipment, net +2,607 +2,550 +Deferred income taxes +10,807 +9,739 +Intangible assets, net +1,850 +452 +Goodwill +21,270 +27,791 +Other assets +203 +200 +Total assets +$ +70,605 +$ +74,662 +Liabilities and stockholders’ equity +Current liabilities: +Trade accounts payable +$ +3,412 +$ +2,492 +Accrued payroll and related expenses +3,538 +2,709 +Accrued liabilities +3,387 +1,748 +Billings in excess of costs and estimated earnings on uncompleted contracts +1,335 +2,105 +Current portion of long-term debt +2,324 +2,324 +Total current liabilities +13,996 +11,378 +Long-term debt +640 +2,969 +Deferred rent +1,058 +1,386 +Unrecognized tax benefits +587 +751 +Other non-current liabilities +1,028 +112 +Total liabilities +17,309 +16,596 +Commitments and contingencies +Stockholders’ equity: +Preferred stock, $1.00 par value: +Authorized shares - 2,000 +Issued and outstanding shares - none +— +— +Common stock. $0.10 par value: +Authorized shares - 70,000 at March 31, 2011 and 2010 +Issued and outstanding shares - 34,364 at March 31, 2011 and 34,318 at March 31, 2010 +3,436 +3,432 +Additional paid-in capital +137,938 +137,503 +Accumulated deficit +(88,078 +) +(82,869 +) +Total stockholders’ equity +53,296 +58,066 +Total liabilities and stockholders’ equity +$ +70,605 +$ +74,662 +See accompanying notes. +39 +Table of Contents +Iteris, Inc. +Consolidated Statements of Operations +(In thousands, except per share amounts) +Year Ended March 31, +2011 +2010 +2009 +Net sales and contract revenues: +Net sales +$ +35,685 +$ +31,650 +$ +38,427 +Contract revenues +23,758 +26,413 +30,932 +Total net sales and contract revenues +59,443 +58,063 +69,359 +Costs of net sales and contract revenues: +Cost of net sales +17,867 +16,505 +20,346 +Cost of contract revenues +15,635 +17,399 +21,094 +Gross profit +25,941 +24,159 +27,919 +Operating expenses: +Selling, general and administrative +18,654 +17,004 +18,035 +Research and development +3,762 +3,678 +4,030 +Impairment of goodwill +7,970 +— +— +Amortization of intangible assets +222 +159 +147 +Change in fair value of contingent acquisition consideration +55 +— +— +Total operating expenses +30,663 +20,841 +22,212 +Operating income (loss) +(4,722 +) +3,318 +5,707 +Non-operating income (expense): +Other income, net +18 +44 +116 +Interest expense, net +(152 +) +(264 +) +(646 +) +Income (loss) before income taxes +(4,856 +) +3,098 +5,177 +Benefit (provision) for income taxes +(353 +) +(895 +) +5,297 +Net income (loss) +$ +(5,209 +) +$ +2,203 +$ +10,474 +Net income (loss) per share: +Basic +$ +(0.15 +) +$ +0.06 +$ +0.31 +Diluted +$ +(0.15 +) +$ +0.06 +$ +0.30 +Weighted-average shares outstanding: +Basic +34,335 +34,249 +33,964 +Diluted +34,335 +34,435 +34,638 +See accompanying notes. +40 +Table of Contents +Iteris, Inc. +Consolidated Statements of Stockholders’ Equity and Comprehensive Income (loss) +(In thousands) +Common +Accumulated +Additional +Stock +Other +Total +Common Stock +Paid-In +Held in +Accumulated +Comprehensive +Stockholders’ +Shares +Amount +Capital +Trust +Deficit +Income (Loss) +Equity +Balance at March 31, 2008 +33,420 +$ +3,342 +$ +135,516 +$ +(202 +) +$ +(95,499 +) +$ +54 +$ +43,211 +Stock option exercises +785 +78 +861 +— +— +— +939 +Stock-based compensation +— +— +364 +— +— +— +364 +Issuance of shares held in trust +— +— +256 +171 +— +— +427 +Components of comprehensive income: +Foreign currency translation +— +— +— +— +— +(57 +) +(57 +) +Net income +— +— +— +— +10,474 +— +10,474 +Comprehensive income +— +— +— +— +— +— +10,417 +Balance at March 31, 2009 +34,205 +3,420 +136,997 +(31 +) +(85,025 +) +(3 +) +55,358 +Cumulative effect of adoption of change in accounting for warrants +— +— +— +— +(47 +) +— +(47 +) +Stock option exercises +113 +12 +131 +— +— +— +143 +Stock-based compensation +— +— +375 +— +— +— +375 +Issuance of shares held in trust +— +— +— +31 +— +— +31 +Components of comprehensive income: +Foreign currency translation +— +— +— +— +— +3 +3 +Net income +— +— +— +— +2,203 +— +2,203 +Comprehensive income +— +— +— +— +— +— +2,206 +Balance at March 31, 2010 +34,318 +3,432 +137,503 +— +(82,869 +) +— +58,066 +Stock option exercises +46 +4 +53 +— +— +— +57 +Stock-based compensation +— +— +382 +— +— +— +382 +Net loss and comprehensive loss +— +— +— +— +(5,209 +) +— +(5,209 +) +Balance at March 31, 2011 +34,364 +$ +3,436 +$ +137,938 +$ +— +$ +(88,078 +) +$ +— +$ +53,296 +See accompanying notes. +41 +Table of Contents +Iteris, Inc. +Consolidated Statements of Cash Flows +(In thousands) +Year Ended March 31, +2011 +2010 +2009 +Cash flows from operating activities +Net income (loss) +$ +(5,209 +) +$ +2,203 +$ +10,474 +Adjustments to reconcile net income (loss) to net cash provided by operating activities: +Deferred income taxes +273 +1,014 +(5,398 +) +Depreciation of property and equipment +1,030 +986 +1,018 +Stock-based compensation +382 +375 +364 +Impairment of goodwill +7,970 +— +— +Amortization of intangible assets +222 +159 +147 +Change in fair value of contingent acquisition consideration +55 +— +— +Loss on disposal of equipment +9 +— +— +Gain on early extinguishment of debt +— +— +(50 +) +Amortization of debt discounts +— +— +109 +Amortization of deferred financing costs +— +— +72 +Changes in operating assets and liabilities, net of effects of business combinations: +Accounts receivable +1,052 +1,137 +660 +Net costs and estimated earnings in excess of billings +(501 +) +917 +1,542 +Inventories +(953 +) +2,954 +(1,455 +) +Prepaid expenses and other assets +211 +(350 +) +97 +Accounts payable and accrued expenses +805 +(2,911 +) +(1,190 +) +Net cash provided by operating activities +5,346 +6,484 +6,390 +Cash flows from investing activities +Purchases of property and equipment +(414 +) +(294 +) +(795 +) +Net cash paid for business combinations +(1,116 +) +(300 +) +— +Net cash used in investing activities +(1,530 +) +(594 +) +(795 +) +Cash flows from financing activities +Payments on long-term debt +(2,354 +) +(2,750 +) +(7,069 +) +Borrowings on long-term debt +— +750 +6,543 +Deferred payment for prior business combination +(106 +) +— +— +Proceeds from stock option exercises +57 +143 +939 +Net cash provided by (used in) financing activities +(2,403 +) +(1,857 +) +413 +Effect of exchange rate changes on cash +— +— +(57 +) +Increase in cash and cash equivalents +1,413 +4,033 +5,951 +Cash and cash equivalents at beginning of year +10,405 +6,372 +421 +Cash and cash equivalents at end of year +$ +11,818 +$ +10,405 +$ +6,372 +Supplemental cash flow information: +Cash paid during the year for: +Interest +$ +200 +$ +306 +$ +545 +Income taxes +455 +159 +462 +Supplemental schedule of non-cash investing and financing activities: +Liabilities incurred for business combinations +$ +2,610 +$ +218 +$ +— +Fair value of common stock issued in settlement of liabilities +— +31 +427 +See accompanying notes. +42 +Table of Contents +Iteris, Inc. +Notes to Consolidated Financial Statements +March 31, 2011 +1. Description of Business and Summary of Significant Accounting Policies +Description of Business +Iteris, Inc. (including our subsidiary, referred to collectively in these consolidated financial statements as “Iteris,” “the Company,” “we,” “our” and “us”) is a leader in the traffic management market focused on the development and application of advanced technologies that reduce traffic congestion, minimize the environmental impact of traffic congestion and improve the safety of surface transportation systems infrastructure. By combining outdoor image processing, traffic engineering and information technology, we offer a broad range of Intelligent Transportation Systems (“ITS”) and driver safety solutions to customers worldwide. Iteris was originally incorporated in Delaware in 1987. +Basis of Presentation +Our consolidated financial statements include the accounts of Iteris and our subsidiaries. All significant intercompany accounts and transactions have been eliminated in consolidation. +Use of Estimates +The preparation of consolidated financial statements in conformity with accounting principles generally accepted in the United States requires our management to make certain estimates and assumptions that affect the reported amounts of assets and liabilities and disclosures of contingent assets and liabilities at the date of the financial statements, and reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Significant estimates made in the preparation of the consolidated financial statements include the allowance for doubtful accounts, projections of taxable income used to assess realizability of deferred tax assets, inventory and warranty reserves, costs to complete long-term contracts, indirect cost rates used in cost-plus contracts, contract reserves, the valuation of purchased intangible asset and goodwill, the valuation of debt and equity instruments and estimates of future cash flows used to assess the recoverability of long-lived assets and the impairment of goodwill. +Revenue Recognition +Net Sales +Product revenues and related costs of sales are recognized when all of the following criteria are met: (i) persuasive evidence of an arrangement exists, (ii) delivery has occurred, (iii) the price to the customer is fixed or determinable, and (iv) collection of the receivable is reasonably assured. These criteria are typically met at the time of product shipment, but in certain circumstances, may not be met until receipt or acceptance by the customer. Accordingly, at the date revenue is recognized, the significant obligations or uncertainties concerning the sale have been resolved. +We recognize revenue from the sale of deliverables that are part of a multiple-element arrangement in accordance with applicable accounting guidance that establishes a selling price hierarchy permitting the use of an estimated selling price to determine the allocation of arrangement consideration to a deliverable in a multiple-element arrangement where neither vendor specific objective evidence (“VSOE”) nor third-party evidence (“TPE”) of fair value is available for that deliverable. In the absence of VSOE or TPE of the standalone selling price for one or more delivered or undelivered elements in a multiple-element arrangement, we are required to estimate the selling prices of those elements. Overall arrangement consideration is allocated to each element (both delivered and undelivered items) that has stand-alone value based on their relative selling prices, regardless of whether those selling prices are evidenced by VSOE or TPE or are based on our estimated selling prices. +We account for multiple-element arrangements that consist only of software and software-related services in accordance with applicable accounting guidance for software and software-related transactions. For such transactions, revenue on arrangements that include multiple elements is allocated to each element based on the relative fair value of each element, and fair value is determined by VSOE. If we cannot objectively determine the fair value of any undelivered element included in such multiple-element arrangements and the only undelivered element is post-contract customer support or maintenance, and VSOE of the fair value of such support or maintenance does not exist, revenue from the entire arrangement is recognized ratably over the support period. When the fair value of a delivered element has not been established, but VSOE of fair value exists for the undelivered elements, we use the residual method to recognize revenue if the fair value of all undelivered elements is determinable. Under the residual method, the fair value of the +43 +Table of Contents +undelivered elements is deferred and the remaining portion of the arrangement fee is allocated to the delivered elements and is recognized as revenue. +We also derive revenue from the provision of specific non-recurring contract engineering services and royalties. Non-recurring contract engineering revenues are recognized in the period in which the related services are performed. Royalty revenues are recorded in the period in which the royalty is earned based on unit sales of certain of our products. Non-recurring contract engineering and royalty revenues are included in net sales in the accompanying consolidated statements of operations and totaled $568,000, $685,000 and $1.3 million for the fiscal years ending March 31, 2011, 2010 and 2009, respectively. +Contract Revenues +Contract revenues are derived primarily from long-term contracts with governmental agencies. The majority of our contract revenues are recognized using the percentage of completion method of accounting, whereby costs incurred plus a portion of estimated fees or profits are determined based on the relationship of costs incurred to total estimated costs. Any anticipated losses on contracts are charged to earnings when identified. Changes in job performance and estimated profitability, including those arising from contract penalty provisions and final contract settlements, may result in revisions to costs and revenues and are recognized in the period in which the revisions are determined. Profit incentives are included in revenue when their realization is reasonably assured. Certain of our contract revenues are recognized as services are performed and amounts are earned, which is measured by time incurred or other contractual milestones or output measure. Contract revenues accounted for in this manner generally relate to certain cost-plus fixed fee or time-and-materials contracts for which no specific maximum contract values are stipulated. +Costs in Excess of Billings on Uncompleted Contracts +Costs in excess of billings on uncompleted contracts in the accompanying consolidated balance sheets represent unbilled amounts earned and reimbursable under services sales arrangements. At any given period-end, a large portion of the balance in this account represents the accumulation of labor, materials and other costs that have not been billed due to timing, whereby the accumulation of each month’s costs and earnings are not administratively billed until the subsequent month. Also included in this account are amounts that become billable according to contract terms, which usually consider the passage of time, achievement of milestones or completion of the project. Generally, such unbilled amounts will be billed and collected within the next twelve months. +Costs in excess of billings on uncompleted contracts at March 31, 2011 and 2010 include $400,000 and $635,000, respectively, which were not billable as certain milestone objectives specified in the contracts had not been attained. Substantially all costs and estimated earnings in excess of billings at March 31, 2011 are expected to be billed and collected during the fiscal year ending March 31, 2012. +Billings in Excess of Costs and Estimated Earnings on Uncompleted Contracts +Billings in excess of costs and estimated earnings on uncompleted contracts in the accompanying consolidated balance sheets is comprised of cash collected from customers and billings to customers on contracts in advance of work performed, advance payments negotiated as a contract condition, estimated losses on uncompleted contracts, project-related legal liabilities and other project-related reserves. The majority of the unearned amounts are expected to be earned within the next twelve months. +We record provisions for estimated losses on uncompleted contracts in the period in which such losses become known. The cumulative effects of revisions to contract revenues and estimated completion costs are recorded in the accounting period in which the amounts become evident and can be reasonably estimated. These revisions can include such items as the effects of change orders and claims, warranty claims, liquidated damages or other contractual penalties, adjustments for audit findings on United States (“U.S.”) or other government contracts and contract closeout settlements. +Foreign Currency +We have determined that the functional currency of our subsidiary in Europe is the U.S. dollar. Local currency financial statements are remeasured into U.S. dollars at the exchange rate in effect as of the balance sheet date for monetary assets and liabilities and the historical exchange rate for nonmonetary assets and liabilities. Revenues and expenses are remeasured using the average exchange rate for the period, except items related to nonmonetary assets and liabilities, which are remeasured using historical exchange rates. Remeasurement gains and losses are reported in “other income, net” in the consolidated statements of operations. +44 +Table of Contents +Concentration of Credit Risk +Financial instruments that potentially subject us to a concentration of credit risk consist principally of cash and cash equivalents and trade accounts receivable. +Cash and cash equivalents consist primarily of demand deposits and money market funds maintained with several financial institutions. Deposits held with banks may exceed the amount of insurance provided on such deposits. Generally, these deposits may be redeemed upon demand and are maintained with high credit quality financial institutions and therefore have minimal credit risk. +Our accounts receivable are primarily derived from revenues earned from customers located throughout North America, as well as in Europe, Asia, and South America. We generally do not require collateral or other security from customers. We maintain an allowance for doubtful accounts for potential credit losses, which losses have historically been within management’s expectations. +Fair Values of Financial Instruments +The fair value of cash and cash equivalents, receivables, accounts payable and accrued expenses approximate carrying value because of the short period of time to maturity. The fair value of line of credit agreements and long-term debt approximate carrying value because the related effective rates of interest approximate current market rates available to us for debt with similar terms and similar remaining maturities. +Cash and Cash Equivalents +Cash and cash equivalents consist of cash and short-term investments with initial maturities of ninety days or less. +Allowance for Doubtful Accounts +The collectability of our accounts receivable is evaluated through review of invoices outstanding greater than a certain period of time and ongoing credit evaluations of our customers’ financial condition. In cases where we are aware of circumstances that may impair a specific customer’s ability to meet its financial obligations subsequent to the original sale, we will record an allowance against amounts due, and thereby reduce the net recognized receivable to the amount we reasonably believe will be collected. We also maintain an allowance based on our historical collections experience. When we determine that collection is not likely, we write off accounts receivable against the allowance for doubtful accounts. +Inventories +Inventories are stated at the lower of cost or market. Cost is determined using the first-in, first-out method. +Property and Equipment +Property and equipment are recorded at cost and are depreciated using the straight-line method over the estimated useful life ranging from three to eight years. Leasehold improvements are depreciated over the term of the related lease or the estimated useful life of the improvement, whichever is shorter. +Goodwill and Long-Lived Assets +Goodwill is tested for impairment on an annual basis in our fourth fiscal quarter or more frequently if indicators of impairment exist. The performance of the test involves a two-step process. The first step of the impairment test involves comparing the fair value of our reporting units with each respective reporting unit’s carrying amount, including goodwill. We determine the fair value of reporting units using the income approach with a reconciliation of the total reporting unit fair value to our total market capitalization. If the carrying amount of a reporting unit exceeds the reporting unit’s fair value, the second step of the goodwill impairment test is performed to determine the amount of any impairment loss. The second step of the goodwill impairment test involves comparing the implied fair value of the reporting unit’s goodwill with the carrying amount of that goodwill and an impairment charge is recorded for any excess carrying amount over fair value. We performed annual impairment assessments of the carrying value of goodwill for each of the fiscal years ended March 31, 2011, 2010 and 2009. Based on these assessments, we determined that no impairment as of each of these dates was indicated as the estimated fair value of each of our reporting units exceeded its respective carrying value. We monitor the indicators for goodwill impairment testing between annual tests. Certain adverse business conditions impacting one or more reporting units would cause us to test goodwill for impairment on an interim basis. Refer to Note 4 for additional discussion regarding our interim goodwill impairment analyses during the fiscal year ended March 31, 2011. +45 +Table of Contents +We also evaluate long-lived assets for impairment which requires impairment evaluation on long-lived assets used in operations when indicators of impairment are present. Reviews are performed to determine whether the carrying value of assets is impaired, based on a comparison of undiscounted expected future cash flows to the carrying value of the related net assets. If this comparison indicates that there is impairment, the impaired asset is written down to fair value, which is typically calculated using discounted expected future cash flows and a discount rate based upon our weighted average cost of capital adjusted for risks associated with the related operations. Impairment is based on the excess of the carrying amount over the fair value of those assets. +Income Taxes +We utilize the liability method of accounting for income taxes, whereby deferred taxes are determined based on the temporary differences between the financial statement and tax bases of assets and liabilities using enacted tax rates. A valuation allowance is recorded when it is more likely than not that all or a portion of the deferred tax assets will not be realized. +We must review all of our tax positions and make a determination as to whether each position is more-likely-than-not to be sustained upon examination by taxing authorities. If a tax position meets the more-likely-than-not standard, then the related tax benefit is measured based on a cumulative probability analysis of the amount that is more-likely-than-not to be realized upon effective settlement or disposition of the underlying issue. +Stock-Based Compensation +We record stock-based compensation in the consolidated statements of operations as an expense, based on the grant date fair values of our stock-based awards, whereby such fair values are amortized over the requisite service period. The fair value of our common stock option awards is estimated on the grant date using the Black-Scholes-Merton (“BSM”) option-pricing formula, which considers, among other factors, the expected life of the award and the expected volatility of our stock price. The fair value of our restricted stock units is based on the closing market price of our common stock on the date of grant. +Research and Development Expenditures +Research and development expenditures are charged to expense in the period incurred. +Shipping and Handling Costs +Shipping and handling costs are included as cost of sales in the period during which the products ship. +Sales Taxes +Sales taxes are presented on a net basis (excluded from net sales and contract revenues) in the consolidated statements of operations. +Advertising Expenses +Advertising costs are expensed in the period incurred and totaled $224,000, $153,000 and $202,000 in the fiscal years ended March 31, 2011, 2010 and 2009, respectively. +Warranty +We generally provide a one to three year warranty from the original invoice date on all products, materials and workmanship. Products sold to various original equipment manufacturer (“OEM”) customers sometimes carry longer warranties. Defective products will be either repaired or replaced, usually at our option, upon meeting certain criteria. We accrue a provision for the estimated costs that may be incurred for product warranties relating to a product as a component of cost of sales at the time revenue for that product is recognized. The accrued warranty reserve is included within accrued liabilities in the accompanying consolidated balance sheets. +Repair and Maintenance Costs +We incur repair and maintenance costs in the normal course of business. Should the activity result in a permanent improvement to one of our leased facilities, the cost is capitalized as a leasehold improvement and amortized over its useful life or the remainder of the lease period, whichever is shorter. Non-permanent repair and maintenance costs are charged to expense as incurred. +46 +Table of Contents +Recent Accounting Pronouncements +In October 2009, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) No. 2009-13, Multiple-Deliverable Revenue Arrangements (“ASU 2009-13”), which amends the existing multiple-element revenue arrangements guidance currently included in Accounting Standards Codification (“ASC”) 605-25, Revenue Recognition — Multiple Element Arrangements . ASU 2009-13 provides for two significant changes to the existing multiple-element revenue arrangements guidance. The first relates to the determination of when a delivered item included in a multiple-element arrangement may be treated as a separate unit of accounting. The second change modifies the manner in which the transaction consideration is allocated across the separately identified deliverables. We adopted the amendments prescribed by ASU 2009-13 for our fiscal year beginning April 1, 2010 and such adoption did not have a material impact on our consolidated financial statements. +In October 2009, the FASB issued ASU No. 2009-14, Certain Revenue Arrangements That Include Software Elements (“ASU 2009-14”), which amends and modifies the scope of ASC 985-605, Software — Revenue Recognition , such that many sales transactions of tangible products that include software and other related transactions will fall outside its scope. We adopted the amendments prescribed by ASU 2009-14 for our fiscal year beginning April 1, 2010 and such adoption did not have a material impact on our consolidated financial statements. +In December 2010, the FASB issued ASU No. 2010-29, Disclosures of Supplementary Pro Forma Information for Business Combinations (“ASU 2010-29”), which amends certain existing, and adds additional, pro forma disclosure requirements for public companies under ASC 805, Business Combinations . We expect to adopt the amendments prescribed in ASU 2010-29 for business combinations for which the acquisition date is after our fiscal year beginning April 1, 2011. We do not expect such adoption to have a material impact on our consolidated financial statements. +In May 2011, the FASB issued ASU No. 2011-04, Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRSs (“ASU 2011-04”), which amends ASC 820, Fair Value Measurements . ASU 2011-04 aims to eliminate certain differences that existed between U.S. and international fair value accounting concepts, and also clarifies existing guidance in U.S. GAAP. Additionally, among other disclosures, the ASU requires certain new quantitative and qualitative disclosures regarding unobservable fair value measurements. We will be required to adopt the amendments prescribed by ASU 2011-04 for our fiscal year beginning April 1, 2012. We have not yet evaluated the impact of adoption on our consolidated financial statements. +2. Supplementary Financial Information +Inventories +The following table presents details regarding our inventories: +March 31, +2011 +2010 +(In thousands) +Materials and supplies +$ +2,668 +$ +2,292 +Work in process +128 +49 +Finished goods +884 +386 +$ +3,680 +$ +2,727 +Property and Equipment +The following table presents details of our property and equipment: +March 31, +2011 +2010 +(In thousands) +Equipment +$ +9,357 +$ +8,334 +Leasehold improvements +1,985 +1,940 +Accumulated depreciation +(8,735 +) +(7,724 +) +$ +2,607 +$ +2,550 +47 +Table of Contents +Intangible Assets +The following table presents details regarding our intangible assets: +March 31, 2011 +March 31, 2010 +Gross +Carrying +Amount +Accumulated +Amortization +Gross +Carrying +Amount +Accumulated +Amortization +(In thousands) +Developed technology +$ +1,566 +$ +(719 +) +$ +996 +$ +(595 +) +Patents +317 +(312 +) +317 +(266 +) +Customer contracts / relationships +500 +(21 +) +— +— +Other +550 +(31 +) +— +— +Total +$ +2,933 +$ +(1,083 +) +$ +1,313 +$ +(861 +) +Amortization expense for intangible assets subject to amortization was $222,000, $159,000, and $147,000 for the fiscal years ended March 31, 2011, 2010 and 2009, respectively. We do not have any intangible assets with indefinite useful lives. Future estimated amortization expense is as follows: +Year Ending March 31 +(In thousands) +2012 +$ +410 +2013 +404 +2014 +387 +2015 +237 +2016 +229 +Thereafter +183 +$ +1,850 +Refer to Note 3 for additional information regarding intangible assets acquired during the fiscal years ended March 31, 2011 and 2010. If we acquire additional intangible assets in future periods, our amortization expense will increase. +Goodwill +The following table presents the activity related to the carrying value of our goodwill by reportable segment for the fiscal year ended March 31, 2011: +Roadway +Sensors +Vehicle +Sensors +Transportation +Systems +Environmental +Technology +Total +(In thousands) +Beginning balance - April 1, 2010 +Goodwill +$ +8,214 +$ +4,671 +$ +14,906 +$ +— +$ +27,791 +Accumulated impairment losses +— +— +— +— +— +8,214 +4,671 +14,906 +— +27,791 +Acquisition of Meridian Environmental Technology, Inc. (Note 3) +— +— +219 +1,230 +1,449 +Impairment of Transportation Systems goodwill (Note 4) +— +— +(7,970 +) +— +(7,970 +) +Ending balance - March 31, 2011 +Goodwill +8,214 +4,671 +15,125 +1,230 +29,240 +Accumulated impairment losses +— +— +(7,970 +) +— +(7,970 +) +$ +8,214 +$ +4,671 +$ +7,155 +$ +1,230 +$ +21,270 +Refer to Note 11 for additional information on our reportable segments. +48 +Table of Contents +Warranty Reserve Activity +The following table presents activity with respect to the warranty reserve: +Year Ended March 31, +2011 +2010 +2009 +(In thousands) +Balance at beginning of year +$ +468 +$ +582 +$ +494 +Additions charged to cost of sales +130 +221 +342 +Warranty claims +(213 +) +(335 +) +(254 +) +Balance at end of year +$ +385 +$ +468 +$ +582 +Net Income (Loss) Per Share +The following table sets forth the computation of basic and diluted net income (loss) per share: +Year Ended March 31, +2011 +2010 +2009 +(In thousands, except per share amounts) +Numerator: +Net income (loss) +$ +(5,209 +) +$ +2,203 +$ +10,474 +Denominator: +Weighted average common shares used in basic computation +34,335 +34,249 +33,964 +Dilutive stock options +— +185 +671 +Dilutive warrants +— +1 +3 +Weighted average common shares used in diluted computation +34,335 +34,435 +34,638 +Net income (loss) per share: +Basic +$ +(0.15 +) +$ +0.06 +$ +0.31 +Diluted +$ +(0.15 +) +$ +0.06 +$ +0.30 +The following instruments were excluded for purposes of calculating weighted average common share equivalents in the computation of diluted net income (loss) per share as their effect would have been anti-dilutive: +Year Ended March 31, +2011 +2010 +2009 +(In thousands) +Stock options +1,467 +1,790 +1,518 +Warrants +272 +371 +1,158 +Restricted stock units +54 +— +— +Convertible debentures +— +— +1,281 +3. Acquisitions +Meridian Environmental Technology, Inc. +In January 2011, we acquired all of the capital stock of Meridian Environmental Technology, Inc. (“MET”), a privately-held company based in Grand Forks, North Dakota. MET specializes in 511 advanced traveler information systems, as well as Maintenance Decision Support System management tools that allow users to create solutions to meet roadway maintenance decision needs. Our primary reasons for the acquisition were (i) to enhance our ability to provide travelers and traffic management authorities with more accurate and real-time information and network performance management tools and (ii) to provide Iteris with key capabilities in the emerging performance measurement and management market. +Our consolidated financial statements for the fiscal year ended March 31, 2011 include the results of operations of MET commencing as of the acquisition date. On the acquisition date, we paid approximately $1.5 million in cash, exclusive of $369,000 of +49 +Table of Contents +cash acquired. In April 2011, we paid another $137,000 in cash as a result of certain post-closing adjustments. We also agreed to pay up to $1 million on each of the first two anniversaries of the acquisition date, subject to adjustments related to the retention of various key employees and certain other adjustments as further defined in the agreement. Additionally, we may pay up to an additional $1 million per year for two years pursuant to an earn-out provision, based on revenue and operating income achieved from MET’s operations during the twelve months ending December 31, 2011 and 2012. The potential outcomes pertaining to these contingent consideration payments range from zero to approximately $4.0 million. Acquisition-related costs were not significant and are included in selling, general and administrative expenses in the accompanying consolidated statement of operations for the year ended March 31, 2011. +Acquisition Accounting +We have accounted for this acquisition as a business combination in accordance with applicable accounting guidance. We measured the fair value of the consideration transferred (including contingent consideration) to determine the purchase price of the acquisition. We allocated the fair value of consideration transferred to tangible assets acquired, liabilities assumed and identifiable intangible assets acquired based on their estimated fair values at the acquisition date. +The acquisition is recorded as follows (in thousands): +Fair value of consideration transferred: +Cash paid on or shortly after acquisition date +$ +1,622 +Estimated fair value of contingent consideration +2,473 +Total +4,095 +Allocation: +Cash +(369 +) +Accounts receivable +(682 +) +Other tangible current assets +(491 +) +Property and equipment +(682 +) +Liabilities +1,198 +Purchased intangible assets +(1,620 +) +Goodwill +$ +1,449 +The excess of the fair value of the business over the aggregate fair values of identifiable assets acquired and liabilities assumed was recorded as goodwill. The primary factor that resulted in the recognition of goodwill was the acquisition of MET’s assembled workforce, which is not a separately identifiable intangible asset. Additionally, we allocated approximately $219,000 of the goodwill to our Transportation Systems segment based on estimated expected synergies resulting from the acquisition. The goodwill is not expected to be deductible for income tax purposes. +Purchased Intangible Assets +The following table presents details of the intangible assets acquired: +Estimated +Useful Life +Amount +(In years) +(In thousands) +Developed technology +6 +$ +570 +Customer contracts / relationships +6 +500 +Other purchased intangible assets +3 - 7 +550 +$ +1,620 +Supplemental Pro Forma Data (Unaudited) +The unaudited pro forma data below presents selected details of our results of operations as if the acquisition of MET had occurred on April 1, 2009 (the beginning of Fiscal 2010). The following data includes the amortization of purchased intangible assets. +50 +Table of Contents +This pro forma data is presented for informational purposes only and does not purport to be indicative of the results of future operations or the results that would have occurred had the acquisition taken place on April 1, 2009. +Year Ended March 31, +2011 +2010 +(In thousands, except per share data) +Pro forma net sales and contract revenues +$ +63,643 +$ +63,248 +Pro forma net income (loss) +$ +(5,344 +) +$ +2,402 +Pro forma net income (loss) per share - basis +$ +(0.16 +) +$ +0.07 +Pro forma net income (loss) per share - diluted +$ +(0.16 +) +$ +0.07 +Hamilton Signal, Inc. +In April 2009, we completed the acquisition of certain assets of Hamilton Signal, Inc., a privately-held developer of video processing algorithms enabling state and local governments to conduct real-time analysis on fixed and pan-tilt-zoom camera feeds. Our primary reasons for the acquisition were to expand our product portfolio in the traffic management market and to incorporate enhanced functionality into and complement our Roadway Sensors technologies. +The total purchase consideration was approximately $518,000, for which we paid $300,000 in cash upon execution of the purchase agreement, and for which, pursuant to the purchase agreement, we paid an additional $106,000 on the first anniversary of the acquisition date and paid $112,000 on the second anniversary of the acquisition date. Pursuant to the purchase agreement, the seller became an employee of Iteris and is eligible to receive compensation based on future net sales of certain products during the three-year period ending March 31, 2012, subject to continued employment and other limitations. +We accounted for this acquisition as a business combination in accordance with applicable accounting guidance. We estimated the fair value of the assets acquired to allocate the purchase price, which is summarized as follows (in thousands): +Developed technology +$ +501 +Goodwill +17 +$ +518 +The purchased developed technology was determined to have an estimated useful life of five years. +Our consolidated financial statements for the fiscal years ended March 31, 2011 and 2010 include the results of operations of Hamilton Signal commencing as of the acquisition date. Disclosures required for material business combinations have been limited due to the immateriality of the acquisition of Hamilton Signal to our consolidated financial statements. No supplemental pro forma information is presented for the acquisition due to the immaterial effect of the acquisition on our results of operations. +4. Impairment of Goodwill +As discussed in Note 1, goodwill is tested for impairment on an annual basis in our fourth fiscal quarter or more frequently if indicators of impairment exist. +As of September 30, 2010, we performed the first step in the impairment analysis of the carrying value of goodwill for all reporting units primarily due to the decline in our stock price and market capitalization since our fiscal year ended March 31, 2010 and the ongoing weakness in the current economic environment. This analysis did not result in any impairment charges during the quarter ended September 30, 2010. +During the quarter ended December 31, 2010, due primarily to lower than expected operating results in our Transportation Systems reporting unit, as well as ongoing weakness specifically in the Transportation Systems markets, we determined it was necessary to perform another interim test of impairment of the carrying value of goodwill in our Transportation Systems reporting unit as of December 31, 2010. In performing the first step in this analysis, we estimated the fair value of our Transportation Systems reporting unit using the income approach. As of December 31, 2010, we determined that the carrying value of our Transportation Systems reporting unit exceeded its estimated fair value, and accordingly, we performed the second step of the impairment analysis to estimate the implied fair value of the goodwill of this reporting unit. +51 +Table of Contents +The implied fair value of goodwill was determined in the same manner utilized to estimate the amount of goodwill recognized in a business combination. To determine this value, we estimated the fair value of the assets and liabilities, including certain intangible assets, to be allocated to the Transportation Systems reporting unit as of December 31, 2010. The implied fair value of goodwill was measured as the difference between the estimated fair value of the reporting unit over the estimated fair value amounts of its assets and liabilities. The impairment loss for the Transportation Systems reporting unit was measured by the amount the carrying value of its goodwill exceeded the implied fair value of the goodwill. Accordingly, in order to write down Transportation Systems goodwill with a carrying value of $14.9 million to its implied fair value of $6.9 million, we recorded an impairment charge of $8.0 million in the three months ended December 31, 2010. +We estimated the fair value of the Transportation Systems reporting unit using the income approach, which was based on management’s business plans and financial projections for the next five years, along with a perpetual growth rate thereafter of approximately 4%. The analysis also used a weighted average discount rate of approximately 14%, which we believe reflects our cost of capital, slightly adjusted for increased market risk. +5. Fair Value Measurements +We measure fair value as the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. Fair value measurements are based on a three-tier hierarchy that prioritizes the inputs used to measure fair value. These tiers include: Level 1, defined as observable inputs such as quoted prices in active markets for identical assets and liabilities; Level 2, defined as observable inputs other than Level 1 prices such as quoted prices for similar assets or liabilities or prices quoted in inactive markets; and Level 3, defined as unobservable inputs that are significant to the fair value of the asset or liability, and for which little or no market data exists, therefore requiring management to utilize its own assumptions to provide its best estimate of what market participants would use in valuing the asset or liability. +The liability for the estimated fair value of the contingent consideration in connection with the MET acquisition (see Note 3) was determined using Level 3 inputs based on a probabilistic calculation whereby we assigned estimated probabilities to achieving the earn-out targets and then discounted the total contingent consideration to net present value. The following table reconciles this liability measured at fair value on a recurring basis for the fiscal year ended March 31, 2011 (in thousands): +Balance at April 1, 2010 +$ +— +Fair value of liability assumed at acquisition date +2,473 +Change in fair value included in net loss +55 +Balance at March 31, 2011 +$ +2,528 +The current and non-current portions of the liability are included within accrued liabilities and other non-current liabilities, respectively, in the accompanying consolidated balance sheet as of March 31, 2011. The change in the estimated fair value of the liability for the fiscal year ended March 31, 2011 is included as part of operating expenses in the accompanying consolidated statement of operations. +Other than the above, we did not have any material financial assets or liabilities measured at fair value on a recurring basis using Level 3 inputs as of March 31, 2011. +Our non-financial assets, such as goodwill, intangible assets and property and equipment, are measured at fair value on a non-recurring basis, generally when there is a transaction involving those assets such as a purchase transaction, a business combination or an adjustment for impairment. See Notes 3 and 4 above for further discussion regarding certain of our intangible assets and goodwill balances (including goodwill impairment) that were measured at fair value, using certain Level 3 inputs, during the fiscal year ended March 31, 2011 and 2010. +6. Revolving Line of Credit and Long-Term Debt +Revolving Line of Credit +In October 2008, we entered into a new $19.5 million credit facility with California Bank & Trust (“CB&T”). This credit facility provided for a two-year revolving line of credit with borrowings of up to $12.0 million and a $7.5 million 48-month term note (discussed below). Interest on borrowed amounts under the revolving line of credit are payable monthly at a rate equal to the current stated prime rate (3.25% at March 31, 2011) up to the current stated prime rate plus 0.50%, depending on aggregate deposit balances maintained at the bank in relation to the total loan commitment under the credit facility. We are obligated to pay an unused line fee of +52 +Table of Contents +0.25% per annum applied to the average unused portion of the revolving line of credit during the preceding month. The revolving line of credit does not contain any early termination fees and is secured by substantially all of our assets. As of March 31, 2011, no amounts were borrowed under the revolving line of credit portion of the facility. Availability under this line of credit may be reduced or otherwise limited as a result of our obligations to comply with certain financial covenants. In September 2010, we entered into a modification agreement with CB&T to extend the expiration date of our revolving line of credit to October 1, 2012. +Long-Term Debt +Our long-term debt consists of the following: +March 31, +2011 +2010 +(In thousands) +Bank term note +$ +2,964 +$ +5,293 +Less current portion +(2,324 +) +(2,324 +) +$ +640 +$ +2,969 +Scheduled aggregate maturities of long-term debt principal as of March 31, 2011 were as follows: +Year Ending March 31 +(In thousands) +2012 +$ +2,324 +2013 +640 +$ +2,964 +Bank Term Note. As part of our credit facility described above, we were permitted to borrow up to $7.5 million in the form of a 48-month term note. As of March 31, 2011, we had outstanding borrowings of approximately $3.0 million under the term note. Principal payments under this term note are required to be repaid in 48 monthly installments of $152,000 commencing on June 1, 2009. Additionally, beginning on November 1, 2009, and on November 1 of each year thereafter, we are required to repay additional principal of up to $500,000, calculated based on certain financial measures, as further defined in the agreement. These additional principal payments effectively reduce the total number of monthly installments necessary to repay the term note. As of March 31, 2011 and 2010, an additional $500,000 was included as of each date in the current portion of the term note within the accompanying consolidated balance sheets, representing the amount we estimate will be due on November 1, 2011 and the amount paid on November 1, 2010. Interest on the term note is payable monthly at a rate equal to the current stated prime rate plus 0.50% up to the current stated prime rate plus 1.00%, depending on aggregate deposit balances maintained at the bank in relation to the total loan commitment under the credit facility. The term note contains no early termination fees and, along with the revolving line of credit under the same credit agreement, is secured by substantially all of our assets. +Convertible Debentures, Net. In May 2004, we sold and issued subordinated convertible debentures in the aggregate original principal amount of $10.1 million. In connection with the issuance of the debentures, we issued warrants to purchase an aggregate of 639,847 shares of our common stock, the value of which was recorded as a debt discount against the face amount of the debentures on the date of issuance and has been amortized to interest expense over the term of the convertible debentures. The debentures were due in full on May 19, 2009, provided for 6.0% annual interest, payable quarterly, and were convertible into our common stock at an initial conversion price of $3.61 per share, subject to certain adjustments, including adjustments for dilutive issuances. From May 19, 2008 until the maturity date, we were permitted to redeem the debentures at 110% of the principal amount. During the period that the debentures were outstanding, $250,000 of debentures were converted into 69,252 shares of our common stock. +During the fiscal year ended March 31, 2009, at the holders’ request, we early-retired approximately $7.0 million of outstanding convertible debentures, and realized a net gain of approximately $50,000. For this retirement we used $300,000 of our cash and financed $6.5 million under our bank term note, which is described above under the caption “Bank Term Note.” The net gain was recorded within “other income, net” within the accompanying consolidated statement of operations. During the fiscal year ended March 31, 2010, we retired the remaining $750,000 of convertible debentures. The retirement was financed under our bank term note. No convertible debentures remained outstanding as of March 31, 2011 and 2010. +53 +Table of Contents +7. Income Taxes +For financial reporting purposes, income (loss) before income taxes includes the following components: +Year Ended March 31, +2011 +2010 +2009 +(In thousands) +United States +$ +(4,694 +) +$ +3,177 +$ +4,927 +Foreign +(162 +) +(79 +) +250 +$ +(4,856 +) +$ +3,098 +$ +5,177 +The reconciliation of our income tax provision (benefit) to taxes computed at U.S. federal statutory rates is as follows: +Year Ended March 31, +2011 +2010 +2009 +(In thousands) +Income tax provision (benefit) at statutory rates +$ +(1,651 +) +$ +1,053 +$ +1,761 +State income taxes net of federal benefit +192 +183 +57 +Change in valuation allowance associated with federal deferred tax assets +— +— +(6,915 +) +Goodwill impairment charge +2,044 +— +— +Stock-based compensation charge +99 +(12 +) +(4 +) +Unrecognized tax benefits +(288 +) +(362 +) +(290 +) +Other +(43 +) +33 +94 +Provision (benefit) for income taxes +$ +353 +$ +895 +$ +(5,297 +) +The components of deferred tax assets and liabilities are as follows: +March 31, +2011 +2010 +(In thousands) +Deferred tax assets: +Net operating losses +$ +12,315 +$ +13,273 +Credit carry forwards +319 +272 +Deferred compensation and payroll +823 +691 +Bad debt allowance and other reserves +763 +796 +Property and equipment +— +42 +Other, net +252 +167 +Total deferred tax assets +14,472 +15,241 +Deferred tax liabilities: +Property and equipment +(66 +) +— +Deferred rent +(145 +) +Acquired intangibles +(527 +) +(509 +) +Total deferred tax liabilities +(738 +) +(509 +) +Net deferred tax assets +$ +13,734 +$ +14,732 +54 +Table of Contents +The components of current and deferred federal and state income tax provisions and (benefits) are as follows: +Year Ended March 31, +2011 +2010 +2009 +(In thousands) +Current income tax provision (benefit): +Federal +$ +(183 +) +$ +(234 +) +$ +(200 +) +State +264 +126 +223 +Foreign +(2 +) +(11 +) +78 +Deferred income tax provision (benefit): +Federal +322 +862 +(5,261 +) +State +(48 +) +152 +(137 +) +Net income tax provision (benefit) +$ +353 +$ +895 +$ +(5,297 +) +At March 31, 2011, we had approximately $301,000 in federal alternative minimum tax credit carryforwards that can be carried forward indefinitely. We had $35.7 million of federal net operating loss carryforwards at March 31, 2011 that begin to expire in 2019. We also had $18.6 million of state net operating loss carryforwards at March 31, 2011, of which, $10.2 million are scheduled to expire in 2017, $7.9 million are scheduled to expire in 2018 and $420,000 are scheduled to expire in 2019. +Due to changes in stock ownership, our federal net operating loss carryforwards of approximately $35.7 million and other federal attributes are subject to a Section 382 annual limitation. +Our deferred tax assets at March 31, 2011 do not include $2.4 million of excess tax benefits from employee stock option exercises that are a component of our net operating loss carryforwards. If and when such excess tax benefits are realized, stockholders’ equity will be adjusted. +As of March 31, 2011 and 2010, we determined that it was more likely than not that our deferred tax assets will be realized. Accordingly, no valuation allowance has been recorded against our deferred tax assets as of either such dates. In making our determination as to the realizability of our deferred tax assets, we reviewed all available positive and negative evidence, including reversal of deferred tax liabilities, potential carrybacks, projected future taxable income, tax planning strategies and recent financial performance. +Unremitted earnings of our foreign subsidiary have been included in the consolidated financial statements without giving effect to the U.S. taxes that may be payable on distribution to the U.S. because it is not anticipated that such earnings will be remitted to the U.S. If remitted, the additional U.S. taxes would not be material. +Unrecognized Tax Benefits +As of March 31, 2011 and 2010, our gross unrecognized tax benefits were $1.9 million and $2.1 million, respectively, of which $1.5 million and $1.7 million, respectively, if recognized, would affect our effective tax rate. +We recognize interest and/or penalties related to income tax matters in income tax expense. As of March 31, 2011 and 2010, we had accrued cumulatively $45,000 and $40,000, respectively, for the payment of potential interest and penalties. +55 +Table of Contents +A reconciliation of the beginning and ending balances of the total amounts of gross unrecognized tax benefits is as follows (in thousands): +Gross unrecognized tax benefits at March 31, 2008 +$ +2,788 +Increases in tax positions for prior year +155 +Decreases in tax positions for prior year +(36 +) +Increases in tax positions for current year +22 +Lapse in statute of limitations +(404 +) +Gross unrecognized tax benefits at March 31, 2009 +2,525 +Increases in tax positions for prior year +93 +Decreases in tax positions for current year +(51 +) +Lapse in statute of limitations +(414 +) +Gross unrecognized tax benefits at March 31, 2010 +2,153 +Increases in tax positions for prior year +121 +Decreases in tax positions for prior year +(15 +) +Increases in tax positions for current year +17 +Settlements +(8 +) +Lapse in statute of limitations +(327 +) +Gross unrecognized tax benefits at March 31, 2011 +$ +1,941 +We anticipate a decrease in gross unrecognized tax benefits of approximately $343,000 within the next twelve months based on federal and state statute expirations in various jurisdictions. +We are subject to taxation in the U.S. and various states. We are subject to U.S. federal tax examination for fiscal tax years ended March 31, 2008 or later, and state and local income tax examination for fiscal tax years ended March 31, 2007 or later. +8. Commitments and Contingencies +Litigation and Other Contingencies +From time to time, we have been involved in litigation relating to claims arising out of our operations in the normal course of business. We currently are not a party to any legal proceedings, the adverse outcome of which, in management’s opinion, individually or in the aggregate, would have a material adverse effect on our consolidated results of operations, financial position or cash flows. +Operating Leases +In May 2007, we entered into an agreement to lease 52,000 square feet of office space in Santa Ana, California for a term of 88 months. In September 2007, we relocated our headquarters and principal operations into this space. The monthly lease rate was $102,000 during the first year of the lease and increases each year thereafter, up to a maximum of $120,000 during the last year of the lease. The lease may be extended for a period of five years, at our option, at a lease rate to be based on the market lease rate for comparable property determined as of the commencement date of the extension period. Additionally, the lease agreement provided for $1.8 million in incentives in the form of tenant improvement allowances, which we recorded as deferred rent and capitalized leasehold improvements in our consolidated balance sheet. The deferred rent amount reduces monthly rent expense over the term of the lease, and the capitalized leasehold improvements amount are being depreciated over the initial term of the lease (the estimated useful life of the related leasehold improvements). +56 +Table of Contents +We have lease commitments for facilities in various locations throughout the U.S. as well as certain other equipment. Future minimum rental payments under these noncancelable operating leases at March 31, 2011 were as follows: +Year Ending March 31 +(In thousands) +2012 +$ +2,025 +2013 +1,898 +2014 +1,803 +2015 +1,350 +2016 +235 +Thereafter +514 +$ +7,825 +Rent expense totaled $1.9 million, $1.9 million and $1.8 million for the fiscal years ended March 31, 2011, 2010 and 2009, respectively. +Related Party Transaction +We previously subleased office space to MAXxess Systems, Inc. (“MAXxess”), one of our former subsidiaries that we sold in September 2003. MAXxess is currently owned by an investor group that includes two of our directors, one of whom is the Chief Executive Officer of MAXxess. The sublease terminated in September 2007, at which time MAXxess owed us an aggregate of $274,000 related to this sublease and certain related ancillary services that we provided to MAXxess. We have previously fully reserved for amounts owed to us by MAXxess under the terms of this sublease. In August 2009, MAXxess executed a promissory note payable to Iteris for $274,000. The promissory note bears interest at a rate of 6% per annum, compounded annually, with accrued interest to be paid annually on the first business day of each calendar year. Payments under the note may be made in bona fide services rendered by MAXxess to Iteris to the extent such services and amounts are pre-approved in writing by us. All amounts outstanding under the note will become due and payable on the earliest of (i) August 10, 2014, (ii) a change of control in MAXxess, or (iii) a financing by MAXxess resulting in gross proceeds of at least $10 million. As of March 31, 2011, approximately $16,000 of accrued interest along with the entire $274,000 principal balance was outstanding and payable to Iteris, all of which remains fully reserved. +Inventory Purchase Commitments +At March 31, 2011, we had firm commitments to purchase approximately $3.5 million of inventory, primarily during the first and second quarters of our fiscal year ending March 31, 2012. +9. Stockholders’ Equity +Preferred Stock +Our certificate of incorporation provides for the issuance of up to 2,000,000 shares of preferred stock. As of March 31, 2011 and 2010, there were no outstanding shares of preferred stock, and we do not currently have plans to issue any shares of preferred stock. +In August 2009, our Board of Directors adopted a stockholder rights plan, which calls for preferred stock purchase rights (each, a “Right”) to be distributed, as a dividend, at the rate of one Right for each share of common stock held as of September 3, 2009. Each Right will entitle holders of common stock to buy one one-thousandth of one share of Series A Junior Participating Preferred Stock of Iteris. A further description and terms of the Rights are set forth in the Rights Agreement dated August 20, 2009 by and between Iteris and Computershare Trust Company, N.A., as rights agent. In connection with the stockholder rights plan, our Board of Directors approved the adoption of a Certificate of Designations, which created the Series A Junior Participating Preferred Stock, and likewise authorized the filing of a Certification of Elimination to eliminate the two series of junior participating preferred stock, which were originally created in April 1998 in connection with our previous stockholder rights plan which expired in 2008. +Our Board of Directors is authorized to issue from time to time such authorized but unissued shares of preferred stock in one or more series and to fix or alter the designations, preferences, rights and any qualifications, limitations or restrictions of the shares of each such series, including the dividend, conversion, voting, redemption and liquidation rights. +57 +Table of Contents +Common Stock Warrants +A summary of activity with respect to our common stock warrants for the fiscal year ended March 31, 2011 is as follows: +Warrants +Weighted +Average +Exercise +Price Per +Share +Remaining +Contractual +Life +(In thousands) +(Years) +Warrants outstanding at March 31, 2010 +336 +$ +3.56 +Warrants expired +(321 +) +3.66 +Warrants outstanding at March 31, 2011 +15 +$ +1.42 +2.4 +The warrants outstanding at March 31, 2011 are fully exercisable. +In connection with our adoption of certain provisions of accounting for derivatives, which became effective for us on April 1, 2009, we determined that certain outstanding warrants to purchase shares of our common stock contained provisions that provide for a possible future adjustment to either the exercise price and/or number of shares to be issued upon exercise. As such, beginning April 1, 2009, we began recognizing these warrants as liabilities at their respective estimated fair values on each reporting date. The cumulative effect of the change in accounting for these warrants of $47,000 was recognized as an adjustment to the opening balance of accumulated deficit at April 1, 2009. The amounts recognized in the consolidated balance sheet as a result of our adoption on April 1, 2009 were determined based on the amounts that would have been recognized if this accounting treatment had been applied from the issuance date of the warrants. As of March 31, 2011, all such warrants had expired unexercised, and thus there was no remaining liability recorded on our consolidated balance sheet at that date. We estimated the fair value of these warrants using the BSM option-pricing formula. The change in the estimated fair value of the warrants for the fiscal years ended March 31, 2011 and 2010 is included in “other income, net” in the accompanying consolidated statements of operations. +Common Stock Reserved for Future Issuance +The following summarizes common stock reserved for future issuance at March 31, 2011: +Number of Shares +(In thousands) +Stock options outstanding +3,111 +RSUs outstanding +214 +Authorized for future issuance under stock incentive plans +652 +Warrants oustanding +15 +3,992 +10. Employee Benefit Plans +Stock Incentive Plans +In September 2007, our stockholders approved the 2007 Omnibus Incentive Plan (the “2007 Plan”), which provides that options to purchase shares of our unissued common stock may be granted to our employees, officers, consultants and directors at exercise prices which are equal to or greater than the market value of our common stock on the date of grant. Options expire no more than ten years after the date of grant and generally vest at the rate of 25% on each of the first four anniversaries of the grant date. The 2007 Plan also allows for the issuance of stock appreciation rights, restricted stock, restricted stock units (“RSUs”) and other stock-based awards based on the value of our common stock. New shares are issued to satisfy stock option exercises and share issuances under the 2007 Plan. In September 2009, our stockholders approved an amendment to increase the number of shares of our common stock authorized and reserved for issuance under the 2007 Plan by 800,000 shares to a total of 1,650,000 shares. At March 31, 2011, there were approximately 652,000 shares of common stock available for grant under this plan. As of March 31, 2011, options to purchase approximately 785,000 shares of common stock, as well as 214,000 RSUs, were outstanding under the 2007 Plan. +Our 1997 Stock Incentive Plan (the “1997 Plan”) terminated in September 2007; however, all stock options outstanding under the 1997 Plan remain outstanding pursuant to the terms of such stock options. As of March 31, 2011, options to purchase approximately 1.1 million shares of our common stock were outstanding under the 1997 Plan. No further options or other stock-based awards may be granted under the 1997 Plan. +58 +Table of Contents +In connection with our merger with the Iteris Subsidiary in 2004, we assumed the 1998 Stock Incentive Plan (the “1998 Plan”) of the Iteris Subsidiary and all outstanding options granted thereunder. As of March 31, 2011, options to purchase approximately 1.2 million shares of our common stock were outstanding under the 1998 Plan. No further options or other stock-based awards may be granted under the 1998 Plan. +Certain options granted under the 2007 Plan, the 1997 Plan and the 1998 Plan (collectively, the “Plans”) and the RSUs granted under the 2007 Plan provide for accelerated vesting of unvested options in the event of a change in control under certain circumstances. +Stock Options +A summary of activity in the Plans with respect to our stock options for the fiscal year ended March 31, 2011 is as follows: +Options +Weighted +Average +Exercise +Price Per +Share +Weigthed +Average +Remaining +Contractual +Life +Aggregate +Intrinsic +Value +(In thousands) +(Years) +(In thousands) +Options outstanding at March 31, 2010 +3,218 +$ +1.77 +Granted +30 +1.45 +Exercised +(46 +) +1.25 +Forfeited +(11 +) +1.71 +Expired +(80 +) +8.99 +Options outstanding at March 31, 2011 +3,111 +$ +1.59 +3.1 +$ +402 +Options exercisable at March 31, 2011 +2,701 +$ +1.58 +2.4 +$ +394 +Vested and expected to vest at March 31, 2011 +3,065 +$ +1.59 +3.1 +$ +401 +Options exercisable at March 31, 2011 pursuant to a change-in-control +3,111 +$ +1.59 +3.1 +$ +402 +Included in the options outstanding at March 31, 2011 are vested options to purchase 721,000 shares of our common stock with an exercise price per share of $1.19, which are scheduled to expire in September 2011 unless exercised prior to that date. +Restricted Stock Units +In August 2010, we granted 214,000 RSUs under the 2007 Plan to certain employees of Iteris, all of which were unvested and outstanding as of March 31, 2011. These RSUs are stock awards that entitle the holder to receive shares of our common stock upon vesting. The RSUs vest at the rate of 25% per year beginning in August 2011. The fair value per share of these RSUs was $1.48, determined based on the closing market price of our common stock on the grant date. Other than the above, there are no other RSUs outstanding at March 31, 2011. +Stock-Based Compensation +The following table presents stock-based compensation expense that is included in each functional line item on our consolidated statements of operations: +Year Ended March 31, +2011 +2010 +2009 +(In thousands) +Cost of net sales +$ +11 +$ +9 +$ +9 +Cost of contract revenues +36 +39 +38 +Selling, general and administrative expense +300 +300 +297 +Research and development expense +35 +27 +20 +$ +382 +$ +375 +$ +364 +At March 31, 2011, there was approximately $611,000 of unrecognized compensation expense related to unvested stock options and RSUs. This expense is currently expected to be recognized over a weighted average period of approximately 2.6 years. If there are any modifications or cancellations of the underlying unvested awards, we may be required to accelerate, increase or cancel +59 +Table of Contents +any remaining unearned stock-based compensation expense. Future stock-based compensation expense and unearned stock-based compensation will increase to the extent that we grant additional stock options, RSUs or other stock-based awards. +The grant date fair value of stock options granted was estimated using the following weighted-average assumptions: +Year Ended March 31, +2011 +2010 +2009 +Expected life - years +7.0 +7.0 +7.0 +Risk-free interest rate +2.1 +% +3.2 +% +3.3 +% +Expected volatility of common stock +58 +% +74 +% +75 +% +Dividend yield +— +% +— +% +— +% +A summary of certain fair value and intrinsic value information pertaining to our stock options is as follows: +Year Ended March 31, +2011 +2010 +2009 +(In thousands, except per share amounts) +Weighted average grant date fair value per share of options granted +$ +0.86 +$ +1.01 +$ +1.50 +Intrinsic value of options exercised +$ +23 +$ +28 +$ +771 +Employee Incentive Programs +Under the terms of a Profit Sharing Plan, we may contribute to a trust fund such amounts as are determined annually by the Board of Directors. No contributions were made during the years ended March 31, 2011, 2010 and 2009. +We sponsor a defined contribution 401(k) Plan, adopted in 1990, under which eligible associates voluntarily contribute to the plan, up to IRS maximums, through payroll deductions. Under the provisions of the 401(k) Plan, associates have various investment choices, one of which is the purchase of Iteris common stock at market price. We match up to 90% of contributions, based on years of service, up to a stated limit. From July 1, 2009 through March 31, 2010, we temporarily suspended our matching contributions to the 401(k) Plan. Beginning in April 2010, we reinstituted certain limited matching contributions to the 401(k) Plan. Our matching contributions were approximately $491,000, $220,000 and $753,000 for the fiscal years ended March 31, 2011, 2010 and 2009, respectively. +11. Business Segments, Significant Customer and Geographic Information +We currently operate in four reportable segments: Roadway Sensors, Vehicle Sensors, Transportation Systems and Environmental Technology. The Roadway Sensors segment includes our Vantage and VersiCam vehicle detection systems for traffic intersection control, incident detection and certain highway traffic data collection applications. This segment also includes our Pico compact video detection system, which was designed primarily to respond to international video detection needs. The Vehicle Sensors segment includes our lane departure warning products and is comprised of all of our activities related to vehicle safety. The Transportation Systems segment includes transportation engineering and consulting services and the development of transportation management and traveler information systems for the ITS industry. The Environmental Technology segment represents the operations of MET (Note 3) and specializes in 511 advanced traveler information systems by offering a unique range of customer-specific environmental and operational forecasting products and services, as well as Maintenance Decision Support System management tools that allow users to create solutions to meet roadway maintenance decision needs. +The accounting policies of our reportable segments are the same as those described in the summary of significant accounting policies (Note 1). Certain corporate expenses, including interest and amortization of intangible assets, are not allocated to the segments. The reportable segments are each managed separately because they manufacture and distribute distinct products or provide services with different processes. All segment revenues are derived from external customers. Segment assets are not disclosed because the discrete financial information provided to and reviewed by our chief executive officer, who is our chief operating decision maker, does not separately identify segment assets. +60 +Table of Contents +Selected financial information for our reportable segments for the fiscal years ended March 31, 2011, 2010 and 2009 is as follows: +Roadway +Sensors +Vehicle +Sensors +Transportation +Systems +Environmental +Technology +Total +(In thousands) +Year Ended March 31, 2011 +Product revenue +$ +28,208 +$ +6,909 +$ +— +$ +— +$ +35,117 +Service and other revenue +— +568 +22,301 +1,457 +24,326 +Depreciation +217 +83 +191 +59 +550 +Impairment of goodwill +— +— +7,970 +— +7,970 +Segment income (loss) +3,942 +(691 +) +(7,618 +) +77 +(4,290 +) +Year Ended March 31, 2010 +Product revenue +$ +25,341 +$ +5,624 +$ +— +$ +— +$ +30,965 +Service and other revenue +— +685 +26,413 +— +27,098 +Depreciation +234 +83 +221 +— +538 +Segment income (loss) +3,158 +(894 +) +1,445 +— +3,709 +Year Ended March 31, 2009 +Product revenue +$ +27,197 +$ +9,913 +$ +— +$ +— +$ +37,110 +Service and other revenue +— +1,317 +30,932 +— +32,249 +Depreciation +198 +137 +249 +— +584 +Segment income +3,415 +569 +2,216 +— +6,200 +The following reconciles segment income (loss) to consolidated income (loss) before income taxes: +Year Ended March 31, +2011 +2010 +2009 +(In thousands) +Segment income (loss): +Total income (loss) from reportable segments +$ +(4,290 +) +$ +3,709 +$ +6,200 +Unallocated amounts: +Corporate and other expenses +(155 +) +(232 +) +(346 +) +Amortization of intangible assets +(222 +) +(159 +) +(147 +) +Change in fair value of contingent acquisition consideration +(55 +) +— +— +Other income, net +18 +44 +116 +Interest expense, net +(152 +) +(264 +) +(646 +) +Income (loss) before income taxes +$ +(4,856 +) +$ +3,098 +$ +5,177 +Significant Customer and Geographic Information +No single customer accounted for more than 10% of our total net sales and contract revenues for each of the fiscal years ended March 31, 2011, 2010 and 2009. +No individual customer or government agency had a receivable balance at March 31, 2011 or 2010 greater than 10% of our total trade accounts receivable balances as of March 31, 2011 and 2010, respectively. +The following table sets forth the percentages of our total net sales and contract revenues, by geographic region, derived from shipments to, or contract, service and other revenues from external customers located outside the U.S.: +Year Ended March 31, +2011 +2010 +2009 +Europe +5 +% +4 +% +9 +% +Asia +5 +2 +3 +Other +3 +2 +3 +13 +% +8 +% +15 +% +Substantially all of our long-lived assets are held in the U.S. +61 +Table of Contents +12. Quarterly Financial Data (Unaudited) +Quarter Ended: +Total Net +Sales and +Contract +Revenues +Gross +Profit +Net +Income +(Loss) +Basic Net +Income +(Loss) per +Share +Diluted Net +Income +(Loss) per +Share +(In thousands, except per share amounts) +June 30, 2010 +$ +15,674 +$ +7,017 +$ +797 +$ +0.02 +$ +0.02 +September 30, 2010 +14,086 +6,301 +542 +0.02 +0.02 +December 31, 2010 +14,032 +5,751 +(7,027 +) +(0.20 +) +(0.20 +) +March 31, 2011 +15,651 +6,872 +479 +0.01 +0.01 +$ +59,443 +$ +25,941 +$ +(5,209 +) +$ +(0.15 +)* +$ +(0.15 +)* +June 30, 2009 +$ +14,634 +$ +5,582 +$ +144 +$ +0.00 +$ +0.00 +September 30, 2009 +14,865 +6,570 +543 +0.02 +0.02 +December 31, 2009 +13,577 +5,535 +709 +0.02 +0.02 +March 31, 2010 +14,987 +6,472 +807 +0.02 +0.02 +$ +58,063 +$ +24,159 +$ +2,203 +$ +0.06 +* +$ +0.06 +* +* Annual per share amounts may not agree to the sum of the quarterly per share amounts due to differences between average shares outstanding during the periods. +62 +Table of Contents +Exhibit Index +Exhibit +Number +Description +Where Located +2.1+ +Stock Purchase Agreement dated December 23, 2010 by and among Iteris, Inc., Meridian Environmental Technology, Inc., the shareholders of MET and Kathy J. Osborne as the Shareholders Representative +Exhibit 2.1 to the registrant’s Quarterly Report on Form 10-Q for the quarter ended December 31, 2010 as filed with the SEC on February 14, 2011 +3.1 +Restated Certificate of Incorporation of the registrant +Exhibit 3.1 to the registrant’s Quarterly Report on Form 10-Q for the quarter ended September 30, 2009 as filed with the SEC on October 30, 2009 +3.2 +Certificate of Designations of Series A Junior Participating Preferred Stock +Exhibit 3.2 to the registrant’s Quarterly Report on Form 10-Q for the quarter ended September 30, 2009 as filed with the SEC on October 30, 2009 +3.3 +Bylaws of the registrant, as amended +Exhibit 4.2 to the registrant’s Registration Statement on Form S-1 (Reg. No. 033-67932) as filed with the SEC on July 6, 1993 +3.4 +Certificates of Amendment to Bylaws of the registrant dated April 24, 1998 and August 10, 2001 +Exhibit 3.4 to the registrant’s Annual Report on Form 10-K/A for the year ended March 31, 2003 as filed with the SEC on July 29, 2003 +3.5 +Certificate of Amendment to Bylaws of registrant dated September 9, 2004 +Exhibit 3.1 to the registrant’s Quarterly Report on Form 10-Q for the quarter ended September 30, 2004 as filed with the SEC on November 15, 2004 +3.6 +Certificate of Amendment to Bylaws of registrant effective September 16, 2005 +Exhibit 3.5 to the registrant’s Annual Report on Form 10-K for the year ended March 31, 2007 +3.7 +Certificate of Amendment to Bylaws of registrant effective December 7, 2007 +Exhibit 3.1 to the registrant’s Current Report on Form 8-K as filed with the SEC on December 13, 2007 +3.8 +Certificate of Amendment to Bylaws of registrant, effective August 20, 2009 +Exhibit 3.3 to the registrant’s Current Report on Form 8-K as filed with the SEC on August 21, 2009 +4.1 +Specimen of common stock certificate +Exhibit 4.1 to registrant’s Registration Statement on Form 8-A as filed with the SEC on December 8, 2004 +4.2 +Rights Agreement dated August 20, 2009 between the registrant and Computershare Trust Company, N.A., which includes the form of Certificate of Designations for the Series A Junior Participating Preferred Stock, the form of Right Certificate, and Summary of Rights to Purchase Preferred Stock as exhibits thereto +Exhibit 4.1 to the registrant’s Current Report on Form 8-K as filed with the SEC on August 21, 2009 +10.1 +Form of Indemnity Agreement entered into by the registrant and certain of its officers and directors +Exhibit 19.4 to the registrant’s Quarterly Report on Form 10-Q for the quarter ended September 30, 1988 +10.2 +Form of Indemnification Agreement entered into by the registrant and certain of its officers and directors +Exhibit 10.5 to the registrant’s Annual Report on Form 10-K for the year ended March 31, 2004 as filed with the SEC on June 29, 2004 +10.3* +1997 Stock Incentive Plan (the “1997 Plan”) as amended on May 3, 2003, as further amended on December 15, 2004 +Exhibit 10.32 to the registrant’s Annual Report on Form 10-K for the year ended March 31, 2005 as filed with the SEC on July 14, 2005 +63 +Table of Contents +10.4* +Form of Notice of Grant of Stock Option for 1997 Plan +Exhibit 99.2 to the registrant’s Registration Statement on Form S-8 (File No. 333-30396) as filed with the SEC on February 14, 2000 +10.5* +Form of Stock Option Agreement for the 1997 Plan +Exhibit 99.3 to the registrant’s Registration Statement on Form S-8 (File No. 333-30396) as filed with the SEC on February 14, 2000 +10.6* +Form of Addendum to Stock Option Agreement for 1997 Plan—Involuntary Termination Following Corporate Transaction or Change in Control +Exhibit 99.4 to the registrant’s Registration Statement on Form S-8 (File No. 333-30396) as filed with the SEC on February 14, 2000 +10.7* +Form of Addendum to Stock Option Agreement for 1997 Plan—Limited Stock Appreciation Rights +Exhibit 99.5 to the registrant’s Registration Statement on Form S-8 (File No. 333-30396) as filed with the SEC on February 14, 2000 +10.8* +Form of Stock Issuance Agreement for 1997 Plan +Exhibit 99.6 to the registrant’s Registration Statement on Form S-8 (File No. 333-30396) as filed with the SEC on February 14, 2000 +10.9* +Form of Addendum to Stock Issuance Agreement for 1997 Plan—Involuntary Termination Following Corporate Transaction/Change in Control +Exhibit 99.7 to the registrant’s Registration Statement on Form S-8 (File No. 333-30396) as filed with the SEC on February 14, 2000 +10.10* +Form of Notice of Grant of Automatic Stock Option for 1997 Plan—Initial Grant +Exhibit 99.8 to Exhibit 99.8 to registrant’s Registration Statement on Form S-8 (File No. 333-30396) as filed with the SEC on February 14, 2000 +10.11* +Form of Notice of Grant of Automatic Stock Option for 1997 Plan—Annual Grant +Exhibit 99.9 to the registrant’s Registration Statement on Form S-8 (File No. 333-30396) as filed with the SEC on February 14, 2000 +10.12* +Form of Automatic Stock Option Agreement for 1997 Plan +Exhibit 99.10 to the registrant’s Registration Statement on Form S-8 (File No. 333-30396) as filed with the SEC on February 19, 2000 +10.13* +Iteris Inc. 1998 Stock Incentive Plan (as amended on February 7, 2000) (“1998 Plan”) +Exhibit 10.24 to the registrant’s Annual Report on Form 10-K for the year ended March 31, 2005 as filed with the SEC on July 14, 2005 +10.14* +Form of Notice of Grant for 1998 Plan, including forms of Option Agreement and Stock Purchase Agreement for the following directors and executive officers: Gregory McKhann, James S. Miele and Abbas Mohaddes +Exhibit 99.2 to the registrant’s Registration Statement on Form S-8 (File No. 333-126834) as filed with the SEC on July 22, 2005 +10.15* +Form of Addendum to Stock Option Agreement for 1998 Plan +Exhibit 99.3 to the registrant’s Registration Statement on Form S-8 (File No. 333-126834) as filed with the SEC on July 22, 2005 +10.16* +Form of 1997 Stock Option Agreements +Exhibit 99.4 to the registrant’s Registration Statement on Form S-8 (File No. 333-126834) as filed with the SEC on July 22, 2005 +10.17* +Iteris, Inc. Deferred Compensation Savings Plan and Grantor Trust +Exhibit 10.31 to the registrant’s Annual Report on Form 10-K for the year ended March 31, 2005 as filed with the SEC on July 14, 2005 +64 +Table of Contents +10.18+ +Cooperative Agreement for Development, Manufacture, Marketing and Sale of Products to the Class 1 and Class 2 Vehicle Markets Incorporating Iteris’ LDWS Technology (Valeo Schalter and Sensoren GmbH) +Exhibit 10.1 to the registrant’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2004 as filed with the SEC on August 16, 2004 +10.19 +Warrant Exercise Agreement dated September 27, 2006 by and among the registrant and Special Situations Fund III QP, L.P., Special Situations Fund III, L.P., Special Situations Cayman Fund, L.P. and Special Situations Private Equity Fund, L.P. +Exhibit 10.1 to the registrant’s Quarterly Report on Form 10-Q for the quarter ended September 30, 2006 as filed with the SEC on November 14, 2006. +10.20 +Registration Rights Agreement dated September 28, 2006 by and among the registrant and Special Situations Fund III QP, L.P., Special Situations Fund III, L.P., Special Situations Cayman Fund, L.P. and Special Situations Private Equity Fund, L.P. +Exhibit 10.2 to the registrant’s Quarterly Report on Form 10-Q for the quarter ended September 30, 2006 as filed with the SEC on November 14, 2006. +10.21+ +National Intelligent Transportation Systems (ITS) Architecture Evolution and Support Award/Contract effective as of October 1, 2006 by and between the registrant and the Federal Highway Administration +Exhibit 10.3 to the registrant’s Quarterly Report on Form 10-Q for the quarter ended September 30, 2006 as filed with the SEC on November 14, 2006. +10.22 +Sublease Agreement, dated September 30, 2003, by and between Odetics, Inc. and Maij, Inc. +Exhibit 10.1 to the registrant’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2007 as filed with the SEC on August 14, 2007 +10.23 +Office Lease Agreement, dated May 24, 2007, by and between Crown Carnegie Associates, LLC and Iteris, Inc. +Exhibit 10.2 to the registrant’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2007 as filed with the SEC on August 14, 2007 +10.24* +2007 Omnibus Incentive Plan and forms of agreements +Appendix A to the registrant’s Definitive Proxy Statement on Schedule 14A as filed with the SEC on August 10, 2007 +10.25 +Debenture Redemption Agreement, dated February 11, 2008, by and among Potomac Capital Partners, LP, Potomac Capital International Ltd. and Iteris, Inc. +Exhibit 10.1 to the registrant’s Current Report on Form 8-K as filed with the SEC on February 15, 2008 +10.26* +Change in Control Agreement dated June 11, 2008 by and between James S. Miele and Iteris, Inc. +Exhibit 10.42 to the registrant’s Annual Report on Form 10-K for the year ended March 31, 2008 as filed with the SEC on June 12, 2008 +10.27 +Amended and Restated Loan and Security Agreement dated February 4, 2009 by and between California Bank & Trust and the registrant +Exhibit 10.1 to the registrant’s Quarterly Report on Form 10-Q for the quarter ended December 31, 2008 as filed with the SEC on February 13, 2009 +10.28 +Unsecured Promissory Note dated August 10, 2009 executed by MAXxess Systems, Inc. +Exhibit 10.1 to the registrant’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2009 as filed with the SEC on August 11, 2009 +10.29* +Letter Agreement dated July 27, 2010 by and between the registrant and Abbas Mohaddes +Exhibit 10.1 to the registrant’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2010 as filed with the SEC on July 28, 2010 +10.30* +Change in Control Agreement dated July 27, 2010 by and between the registrant and Abbas Mohaddes +Exhibit 10.2 to the registrant’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2010 as filed with the SEC on July 28, 2010 +65 +Table of Contents +10.31 +Form of Restricted Stock Unit Award Agreement under the 2007 Omnibus Incentive Plan +Exhibit 10.3 to the registrant’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2010 as filed with the SEC on July 28, 2010 +10.32 +Modification Agreement dated September 30, 2010 by and between Iteris, Inc. and California Bank & Trust +Exhibit 10.1 to the registrant’s Current Report on Form 8-K as filed with the SEC on October 6, 2010 +21 +Subsidiaries of the registrant +Filed Herewith +23 +Consent of Independent Registered Public Accounting Firm +Filed Herewith +24 +Power of Attorney +Filed Herewith (included on the Signature page) +31.1 +Certification of the Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 +Filed Herewith +31.2 +Certification of the Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 +Filed Herewith +32.1 +Certification of the Chief Executive Officer Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 +Filed Herewith +32.2 +Certification of the Chief Financial Officer Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 +Filed Herewith +* Indicates a management contract or compensatory plan or arrangement ++ Confidential treatment has been requested for certain confidential portions of this exhibit pursuant to Rule 24b-2 of the Securities Exchange Act of 1934, as amended. In accordance with Rule 24b-2, these confidential portions have been omitted from the exhibit and filed separately with the SEC. +66 \ No newline at end of file diff --git a/raw/filings/0000350868/2010/0001104659-11-032666/filing_metadata.csv b/raw/filings/0000350868/2010/0001104659-11-032666/filing_metadata.csv new file mode 100644 index 0000000000000000000000000000000000000000..30a9ceb365eefec3b6f665f439942815ec46176b --- /dev/null +++ b/raw/filings/0000350868/2010/0001104659-11-032666/filing_metadata.csv @@ -0,0 +1,2 @@ +cik,ticker,company_name,form,filing_date,report_date,acceptance_datetime,accession_number,primary_document,primary_doc_description,size,is_xbrl,is_inline_xbrl,document_url,filing_index_url,year,fiscal_year,is_primary_filing +0000350868,ITI,"ITERIS, INC.",10-K,2011-06-01,2011-03-31,2011-06-01T20:54:15.000Z,0001104659-11-032666,a11-12868_110k.htm,10-K,1973325,0,0,https://www.sec.gov/Archives/edgar/data/350868/000110465911032666/a11-12868_110k.htm,https://www.sec.gov/Archives/edgar/data/350868/000110465911032666/,2010,2010,1 diff --git a/raw/filings/0000350868/2010/0001104659-11-032666/item1.txt b/raw/filings/0000350868/2010/0001104659-11-032666/item1.txt new file mode 100644 index 0000000000000000000000000000000000000000..ee60e41bb7471bbc63f4dbddc0d7c2544b496d52 --- /dev/null +++ b/raw/filings/0000350868/2010/0001104659-11-032666/item1.txt @@ -0,0 +1,62 @@ +ITEM 1. BUSINESS +Overview +We are a leader in the traffic management market focused on the development and application of advanced technologies that reduce traffic congestion and improve the safety of surface transportation systems infrastructure. Additionally, we believe that our products and services, in conjunction with sound traffic management, minimize the environmental impact of traffic congestion. By combining outdoor image processing, traffic engineering and information technology, we offer a broad range of Intelligent Transportation Systems (“ITS”) and driver safety solutions to customers worldwide. +We were originally incorporated in Delaware in 1987. Our principal executive offices are located at 1700 Carnegie Avenue, Santa Ana, California 92705, and our telephone number at that location is (949) 270-9400. Our Internet website address is www.iteris.com. Our annual reports on Form 10-K, quarterly reports on Form 10-Q and current reports on Form 8-K, together with amendments to these reports, are available on the “Investors” section of our website, free of charge, as soon as reasonably practicable after such material is electronically filed with, or furnished to, the Securities and Exchange Commission (“SEC”). The inclusion of our website address in this report does not include or incorporate by reference into this report any information on our website. +Products and Services +We currently operate in four reportable segments: Roadway Sensors, Vehicle Sensors, Transportation Systems and Environmental Technology. The Roadway Sensors segment includes, among other products, our Vantage, Versicam and Pico vehicle detection systems for traffic intersection control, incident detection and certain highway traffic data collection applications. The Vehicle Sensors segment includes our lane departure warning (“LDW”) products, including our AutoVue LDW system, and is comprised of all activities related to in-vehicle safety. The Transportation Systems segment includes transportation engineering and consulting services, and the development of transportation management and traveler information systems for the ITS industry. The Environmental Technology segment was created in connection with our acquisition of Meridian Environmental Technology, Inc. (“MET”) in January 2011, and specializes in 511 advanced traveler information systems by offering a unique range of customer-specific environmental and operational forecasting products and services, as well as Maintenance Decision Support System (“MDSS”) management tools that allow users to create solutions to meet roadway maintenance decision needs. See Note 11 of Notes to Consolidated Financial Statements, included in Part IV, Item 15 of this report, for further details on our reportable segments. +Roadway Sensors. Our Roadway Sensors segment product line uses advanced image processing technology to capture and analyze video images through sophisticated algorithms, enabling vehicle detection and transmission of both video images and data using a wide range of communication technologies. Our Vantage video detection systems detect vehicle presence, count, speed, occupancy and other traffic data used in traffic management systems. Our Vantage systems give traffic managers the ability to mitigate roadway congestion by modifying traffic signal timing or detecting incidents quickly. Our VantageView software supplements our Vantage video detection systems by providing an integrated platform to manage and “see” video detection assets remotely over a network connection. Vantage video detection systems have been deployed by hundreds of agencies and are currently sold through a network of independent dealers in the United States (“U.S.”), Asia, Latin America, Europe and the Middle East. +2 +Table of Contents +VersiCam, our integrated camera and processor video detection system, is a cost-efficient video detection system for smaller intersections that require only a few detection points. Pico is a compact video detection system that delivers superior vehicle detection in a small and economical framework, and was developed primarily to address international video detection needs. We anticipate that future growth domestically and internationally, particularly in developing countries, will be dependent in part on the continued adoption of above-ground video detection technologies, instead of in-pavement loop technology, to manage traffic. +Our Roadway Sensors product line also includes the Abacus family of products, which has been designed with a blend of artificial intelligence and video detection algorithms that allow either fixed or pan-tilt-zoom cameras to be used for data collection and incident detection. Our Abacus products take advantage of the large number of existing installed closed-circuit television video feeds monitoring roadways, tunnels and bridges and at signalized intersections. This flexibility of using a broad range of cameras with an appropriate perspective allows for accurate data collection without the set-up and calibration required with other systems. +We have historically experienced seasonality, particularly with respect to our Roadway Sensors net sales in the third and fourth fiscal quarters due to a reduction in road construction and repairs during the winter months due to inclement weather conditions. +Vehicle Sensors. Our Vehicle Sensors segment addresses the leading causes of roadway fatalities: lane change, roadway departure and rear-end collision accidents. Early estimates by the NHTSA of U.S. motor vehicle traffic fatalities in 2010 were approximately 33,000. +We developed the world’s first production LDW system and offer a proven system that is available as an original equipment manufacturer (“OEM”) and aftermarket option on heavy trucks worldwide and as an option in certain passenger cars. Our LDW products utilize video detection technology to detect when a vehicle begins to drift toward an unintended lane change. When this occurs, the system automatically emits a distinctive rumble strip or other audible warning sound, alerting the driver to make a correction. Through March 31, 2011, we have sold slightly more than 91,000 LDW systems into the heavy truck market in Europe, North America and Asia. Our LDW systems are standard on certain FUSO heavy truck models, and are currently qualified as an option on certain heavy trucks, including Mercedes-Benz, MAN, Iveco, DAF, Scania and Freightliner, as well as EvoBus, Neoplan and VanHool luxury bus and coach lines. In North America, our LDW systems are sold both as factory-installed OEM options, as well as directly to truck fleets as a retrofit installation. +In 2009, the European Union (“EU”) introduced a mandate, which is expected to be finalized and approved sometime in 2011, that sets better standards to improve road safety in Europe. The new mandated rules for safety technology are expected to include systems such as electronic stability control, advanced emergency braking and LDW systems to be compulsory on heavy-duty trucks and buses to further reduce accident risks. LDW systems are expected to be mandatory in Europe on all new heavy truck models beginning in 2013. Additionally, by 2015, every new truck produced will be required to have LDW systems. We believe that in order for the EU mandate for active safety systems to have a positive impact on our sales, we need to establish long-term supplier agreements with our European OEM heavy truck customers. To date we have agreements to supply certain of our European heavy truck customers through 2014, and are currently working on agreements with certain other heavy truck OEMs and our existing customer base to extend contracts further in the future in order to meet the anticipated increase in demand. However, we cannot assure you that our efforts will be successful or that the expected increase in demand will occur. We believe that the expected EU mandate for LDW and other active safety systems, and an increasing general awareness of the potential benefits of LDW, helps validate the long-term market opportunity for LDW systems in commercial vehicles. Additionally, in North America we plan to develop partnerships with other manufacturers and suppliers of safety devices for heavy trucks to jointly sell our LDW systems and provide our SafetyDirect software tool to North American trucking fleets. +For the passenger car market, we have exclusively licensed our LDW technology to our strategic partner, Valeo Schalter and Sensoren GmbH (“Valeo”), resulting in sales to date through March 31, 2011 of approximately 108,000 LDW systems for passenger cars. We and our partner have recently experienced a greater degree of competition in the passenger car market as several passenger car OEMs have introduced vehicle platforms with competing LDW systems. However, Valeo continues to pursue opportunities in the passenger car market. +In addition to our LDW systems, our Vehicle Sensors portfolio includes radar-based Forward Collision Warning (“FCW”) and Blind Spot Warning (“BSW”) systems for the North American truck market. We offer the FCW and BSW features through the resale of Delphi’s radar based systems, for which we are the exclusive North American dealer. Our portfolio also includes our internally-developed SafetyDirect software system, which can provide a single point of access to monitor and synchronize driver performance data on braking, stability control, following distances, and lane departure warnings for individual drivers as well as entire fleets. SafetyDirect uses information transmitted from the vehicle by the fleet’s onboard mobile communications system to provide fleet operators with a comprehensive view of the entire fleet, as well as the ability to drill down to detailed information on individual drivers and events. These products, together with our LDW products, combine to create a broad suite of active safety driver assistance features designed to help reduce the number of motor vehicle crashes and the severity of crash-related injuries. +3 +Table of Contents +Additionally, in collaboration with Audiovox Electronics Corporation, during the fiscal year ended March 31, 2011 (“Fiscal 2011”), we developed and introduced an Advanced Driver Assistance System for the consumer automobile aftermarket. The new system provides consumers an opportunity to benefit from life-saving features that were previously only available on new premium cars or commercial Class 8 trucks, and incorporates our LDW and FCW systems developed for the OEM market. We anticipate the system to be available in the marketplace by the end of our fiscal year ending March 31, 2012. +Transportation Systems. Our Transportation Systems segment includes transportation engineering and consulting services focused on the planning, design, development and implementation of software-based systems that integrate sensors, video surveillance, computers and advanced communications equipment to enable public agencies to monitor, control and direct traffic flow, assist in the quick dispatch of emergency crews and distribute real-time information about traffic conditions. Our services include transportation and ITS planning, design and implementation of surface transportation infrastructure systems. We perform analysis and study goods movement, commercial vehicle operations, travel demand forecasting and systems engineering, and identify mitigation measures to reduce traffic congestion. These services and systems have historically been primarily sold to local, state and national transportation agencies in the U.S.; however, during the last two years, we have been awarded several contracts in the United Arab Emirates, and plan to continue to pursue additional international opportunities in the Middle East and other regions. Our Transportation Systems segment is largely dependent upon governmental funding, and is affected by federal, state and local budgetary issues. +Environmental Technology. In January 2011, we acquired MET, a privately-held company based in Grand Forks, North Dakota. MET specializes in 511 advanced traveler information systems by offering a unique range of customer-specific environmental and operational forecasting products and services. MET utilizes certain internally developed systems and tools as the model for the 511 National Guidelines, and currently delivers a combination of customized route-specific surface weather, travel times and road condition reports statewide across various states in the U.S. MET also provides MDSS management tools that allow users to create solutions to meet roadway maintenance decision needs. MDSS provides detailed and accurate information at the route level that enables the efficient maintenance of roads and highways while optimizing resource use and reducing costs. +Sales, Marketing and Principal Customers +We sell our Roadway Sensors products through indirect sales channels comprised of a strong network of independent dealers in the U.S. and certain foreign locations, who sell integrated systems and related products to the traffic management market, as well as directly to the traffic management market using a combination of our own sales personnel and an outside sales organization. Our independent dealers are well-trained in, and primarily responsible for, sales, installation, set-up and support of our products, and maintain an inventory of demonstration traffic products from various manufacturers, including our vehicle detection systems, and sell directly to government agencies and installation contractors. These dealers often have long-term arrangements with local government agencies in their respective territories for the supply of various products for the construction and renovation of traffic intersections, and are generally well-known suppliers of high-quality ITS products to the traffic management market. We periodically hold technical training classes for our dealers and end users and maintain a full-time expert staff of customer support technicians throughout the U.S. to provide technical assistance when needed. When appropriate, we have the ability to modify or make changes to our dealer network to best suit the needs of the market and our customer base. In the states where we sell directly, we use our own expert staff to sell, oversee installations and set-up issues and support our products. +Our marketing strategy for our Vehicle Sensors segment is to establish our LDW products as the leading platform for in-vehicle video sensing for heavy trucks and passenger cars. We sell LDW systems directly to heavy truck manufacturers and to U.S. truck fleets. We market the licensing of our LDW technology to manufacturers of passenger automobiles through an exclusive strategic relationship with Valeo. In connection with this marketing effort, we provide specific contract engineering services, technical marketing and sales support to Valeo, which to date has enabled the launch of our LDW technology on four Infiniti car platforms. We plan to continue to provide technical marketing and sales support to Valeo in our efforts to win new OEM customers for the passenger car market, as well as contract engineering services related to the possible launch of new platforms that include our LDW system. +With respect to the Vehicle Sensors segment, during Fiscal 2011, we also entered into a strategic alliance with MeritorWabco for integration, marketing and sales of our SafetyDirect system. This alliance provides us access to the North American sales force of MeritorWabco and Meritor, and provides the market with a leading comprehensive safety system for heavy trucks available today. +We market and sell our Transportation Systems and Environmental Technology services directly to government agencies pursuant to negotiated contracts that involve competitive bidding and specific qualification requirements. Most of our contracts are with federal, state and municipal customers and generally provide for cancellation or renegotiation at the option of the customer upon reasonable notice and fees paid for modification. We generally use selected members of our engineering, science and information technology teams on a regional basis to serve in sales and business development functions. Our contracts generally involve long lead times and require extensive specification development, evaluation and price negotiations. +4 +Table of Contents +A large portion of our revenues are derived from sales to federal, state and local government agencies. We currently have a diverse customer base with no individual customer representing greater than 10% of our total net sales and contract revenues in Fiscal 2011, or in the fiscal years ended March 31, 2010 (“Fiscal 2010”) and March 31, 2009 (“Fiscal 2009”). Also refer to Note 11 of Notes to Consolidated Financial Statements, included in Part IV, Item 15 of this report. +Manufacturing and Materials +We use contract manufacturers to build subassemblies that are used in our sensors products. Additionally, we procure certain components from qualified suppliers, both globally and locally, and generally use multi-sourcing strategies when technically and economically feasible to mitigate supply risk. These subassemblies and components are delivered to our Santa Ana, California facility where they go through final assembly and testing prior to shipment to our customers. Certain of our key suppliers include CTS Electronics Manufacturing Solutions, Inc., Total Electronics LLC, Sony Electronics, Inc. and LG Electronics, Inc. Our manufacturing activities are conducted in approximately 9,000 square feet of space at our Santa Ana facility. Production volume at our subcontractors is based upon quarterly forecasts that we generally adjust on a monthly basis to control inventory levels. For LDW products sales to the passenger car market, all manufacturing has been and is expected to be performed by Valeo; however, we plan to continue to provide engineering support to Valeo. We typically do not manufacture any of the hardware used in the transportation management and traveler information systems that we design and implement. Our production facility is currently ISO 9001 certified. +Customer Support and Services +We provide warranty service and support for our products, as well as follow-up service and support for which we charge separately. Such service revenue was not a material portion of our total net sales and contract revenues for each of Fiscal 2011, 2010 and 2009. We believe customer support is a key competitive factor. +Backlog +Our total backlog of unfulfilled firm orders was approximately $32.8 million as of March 31, 2011, which was comprised of $2.7 million related to Roadway Sensors, $1.0 million related to Vehicle Sensors, $25.5 million related to Transportation Systems and $3.6 million related to Environmental Technology. Substantially all of the backlog for Roadway Sensors and Vehicle Sensors is expected to be recognized as revenue in the fiscal year ending March 31, 2012. We have historically recognized in the subsequent fiscal year between 50% to 70% of our Transportation Systems backlog at the fiscal year end, and currently expect that trend to continue for the near future. +At March 31, 2010, we had backlog of approximately $30.6 million, which was comprised of $1.6 million related to Roadway Sensors, $600,000 related to Vehicle Sensors and $28.4 million related to Transportation Systems. +The timing and realization of our backlog is subject to the inherent uncertainties of doing business with federal, state and local governments, particularly in view of budgetary constraints, cut-backs and other delays or reallocations of funding that these entities typically face. +Pursuant to the customary terms of our agreements with government contractors and other customers, customers can generally cancel or reschedule orders with little or no penalties. Lead times for the release of purchase orders often depend upon the scheduling and forecasting practices of our individual customers, which also can affect the timing of the conversion of our backlog into revenues. For these reasons, among others, our backlog at a particular date may not be indicative of our future revenues, in particular for our Roadway Sensors and Vehicle Sensors segments. +Product Development +Most of our product development activities are conducted at our principal facilities in Santa Ana. Our research and development costs and expenses were approximately $3.8 million for Fiscal 2011, $3.7 million for Fiscal 2010 and $4.0 million for Fiscal 2009. We expect to continue to pursue various product development programs and incur research and development expenditures in future periods. +We believe our engineering and product development capabilities are a competitive strength. We strive to continue to develop new products to meet the needs of the ever-changing ITS market as well as enhance and refine our existing product lines. Within the last 12 to 24 months we have introduced our VersiCam and VersiCam wireless products, Pico, our new RZ-4 Advanced camera, and our RZ-4 Advanced Wide Dynamic Range camera, which significantly improves video detection performance in certain +5 +Table of Contents +harsh lighting conditions. We have also introduced our Abacus and VantageView software products. We believe that developing new offerings across our segments and enhancing, refining and marketing our existing products is a key component of strong organic growth and profitability. +Competition +We generally face significant competition in each of our target markets. Increased competition may result in price reductions, reduced gross margins and loss of market share, any of which could have a material adverse effect on our business, financial condition and results of operations. +In the market for our Roadway Sensors vehicle detection products, we compete with manufacturers and distributors of other above ground video camera detection systems such as Peek Traffic Corporation, Wavetronix LLC, Econolite Control Products, Inc., Traficon, N.V., Image Sensing Systems, Inc. and other non-intrusive detection devices, including microwave, infrared, ultrasonic and magnetic detectors, as well as manufacturers and installers of in-pavement inductive loop products, which have historically, and currently continue to be, the predominant detection system in this market. +In the market for our Vehicle Sensors systems, we believe that, as a result of the expected 2013 European mandate for LDW and other active safety systems and an increase in overall awareness of the potential benefits of LDW, we anticipate we will experience an even higher degree of competition from a variety of tier-one OEM suppliers and other potential market entrants worldwide. Additionally, we and our strategic partner (Valeo) have recently experienced a greater degree of competition in the passenger car market as several passenger car OEMs have introduced vehicle platforms with competing LDW systems. We consider competitors in this market to include Delphi Automotive Systems Corporation, DENSO and Hitachi Ltd. in Japan, Robert Bosch GmbH in Europe, Continental, TRW, MobilEye and Takata, all of which currently have developed or are developing video sensor technologies for the vehicle industry that could be used for lane departure warning systems. +The markets in which our Transportation Systems and Environmental Technology segments operate are highly fragmented and are subject to evolving national and regional quality, operations and safety standards. Our competitors vary in number, scope and breadth of the products and services they offer. Our competitors in advanced Transportation Systems include national corporations such as Transcore, Siemens, Telvent Farradyne, Kimley-Horn and Associates, Inc., Delcan, Atkins and Open Roads. Our competitors in transportation engineering, planning and design include major firms such as Parsons Brinkerhoff, Inc., URS, HNTB and Parsons Transportation Group, Inc., as well as many smaller regional engineering firms. Additionally, key competitors pertaining to the road weather portion or our Environmental Technology segment include Telvent DTN, Mixon-Hill and Cambridge Systematics. +In general, the markets for the products and services we offer are highly competitive and are characterized by rapidly changing technology and evolving standards. Many of our current and prospective competitors have longer operating histories, greater name recognition, access to larger customer bases and significantly greater financial, technical, manufacturing, distribution and marketing resources than us. As a result, they may be able to adapt more quickly to new or emerging standards or technologies or to devote greater resources to the promotion and sale of their products. It is also possible that new competitors or alliances among competitors could emerge and rapidly acquire significant market share. We believe that our ability to compete effectively in our target markets will depend on a number of factors, including the success and timing of our new product development, the compatibility of our products with a broad range of computing systems, product quality and performance, reliability, functionality, price and service and technical support. Our failure to provide services and develop and market products that compete successfully with those of other suppliers and consultants in our target markets would have a material adverse effect on our business, financial condition and results of operations. +Intellectual Property and Proprietary Rights +Our ability to compete effectively depends in part on our ability to develop and maintain the proprietary aspects of our technology. Our policy is to obtain appropriate proprietary rights protection for any potentially significant new technology acquired or developed by us. We currently hold eleven U.S. patents, two foreign patents, one pending U.S. patent and three pending foreign patents. Eight U.S. patents, two foreign patents, one pending U.S. patent, and one pending foreign patent relate specifically to our Vehicle Sensors technology and provide a basis for enhanced functionality and improved performance. Three U.S. patents and two pending foreign patents relate specifically to our Roadway Sensors technology. One of these U.S. patents and the two pending foreign patents are for an Electronic Traffic Monitor related to our Abacus product in the Roadway Sensors segment. We cannot assure you that any new patents will be granted pursuant to these or subsequent applications. +In addition to patent laws, we rely on copyright and trade secret laws to protect our proprietary rights. We attempt to protect our trade secrets and other proprietary information through agreements with customers and suppliers, proprietary information agreements with our employees and consultants, and other similar measures. We do not have any material licenses or trademarks other +6 +Table of Contents +than those relating to product names. We cannot be certain that we will be successful in protecting our proprietary rights. While we believe our patents, patent applications, software and other proprietary know-how have value, changing technology makes our future success dependent principally upon our employees’ technical competence and creative skills for continuing innovation. +Litigation may be necessary in the future to enforce our proprietary rights, to determine the validity and scope of the proprietary rights of others, or to defend us against claims of infringement or invalidity by others. An adverse outcome in such litigation or similar proceedings could subject us to significant liabilities to third parties, require disputed rights to be licensed from others or require us to cease marketing or using certain products, any of which could have a material adverse effect on our business, financial condition and results of operations. In addition, the cost of addressing any intellectual property litigation claim, both in legal fees and expenses, as well as from the diversion of management’s resources, regardless of whether the claim is valid, could be significant and could have a material adverse effect on our business, financial condition and results of operations. +Employees +We refer to our employees as associates. As of May 2, 2011, we employed an aggregate of 276 associates, including 55 associates in general management, administration and finance; 30 associates in sales and marketing; 162 associates in engineering and product development; 18 associates in operations, manufacturing and quality; and 11 associates in customer service. None of our associates are represented by a labor union, and we have never experienced a work stoppage. We believe our relations with our associates are good. +Government Regulation +Our manufacturing operations are subject to various federal, state and local laws and regulations, including those restricting the discharge of materials into the environment. We are not involved in any pending or, to our knowledge, threatened governmental proceedings, which would require curtailment of our operations because of such laws and regulations. We continue to expend funds in connection with our compliance with applicable environmental regulations. These expenditures have not, however, been significant in the past, and we do not expect any significant expenditure in the near future. Currently, compliance with foreign laws has not had a material impact on our business and is not expected to have a material impact in the near future. \ No newline at end of file diff --git a/raw/filings/0000350868/2010/0001104659-11-032666/item13.txt b/raw/filings/0000350868/2010/0001104659-11-032666/item13.txt new file mode 100644 index 0000000000000000000000000000000000000000..a0ff4cb34ce9db49433f1084de30e89fd1b30b81 --- /dev/null +++ b/raw/filings/0000350868/2010/0001104659-11-032666/item13.txt @@ -0,0 +1,4 @@ +ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE +The information under the captions “Corporate Governance — Director Independence” and “Certain Transactions,” appearing in our proxy statement for the 2011 Annual Meeting of Stockholders, is incorporated herein by reference. +33 +Table of Contents \ No newline at end of file diff --git a/raw/filings/0000350868/2010/0001104659-11-032666/item9a.txt b/raw/filings/0000350868/2010/0001104659-11-032666/item9a.txt new file mode 100644 index 0000000000000000000000000000000000000000..99812794e8aeb2420f05071d4167403f76bbf63e --- /dev/null +++ b/raw/filings/0000350868/2010/0001104659-11-032666/item9a.txt @@ -0,0 +1,11 @@ +ITEM 9A. CONTROLS AND PROCEDURES +(a) Evaluation of disclosure controls and procedures. In accordance with Rule 13a-15(b) of the Securities Exchange Act of 1934, as of the end of the period covered by this Annual Report on Form 10-K, management evaluated, with the participation of the our President and Chief Executive Officer and the Chief Financial Officer, the effectiveness of the design and operation of our disclosure controls and procedures (as defined in Rule 13a-15(e) under the Exchange Act). Based upon their evaluation of these disclosure controls and procedures, the President and Chief Executive Officer and the Chief Financial Officer have concluded that our disclosure controls and procedures were effective as of the date of such evaluation in ensuring that information required to be disclosed in our Exchange Act reports is (1) recorded, processed, summarized and reported in a timely manner, and (2) accumulated and communicated to management, including the Company’s President and Chief Executive Officer and the Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure. +(b) Changes in internal control. There was no change in our internal control over financial reporting that occurred during the period covered by this Annual Report on Form 10-K that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting. +Inherent Limitations on Internal Control +A control system, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. Further, the benefits of controls must be considered relative to their costs. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of management override or improper acts, if any, have been detected. These inherent limitations include the realities that judgments in decision making can be faulty, and that breakdowns can occur because of simple errors. Additionally, controls can be circumvented by the individual acts of some persons, by collusion of two or more people, or by management override of the control. The design of any system of controls is also based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions. Because of the inherent limitations in a cost-effective control system, misstatements due to management override, error or improper acts may occur and not be detected. Any resulting misstatement or loss may have an adverse and material effect on our business, financial condition and results of operations. +32 +Table of Contents +Management’s Report on Internal Control Over Financial Reporting +Our management is responsible for establishing and maintaining adequate internal control over financial reporting. Our internal control system was designed to provide reasonable assurance to management and the board of directors regarding the effectiveness of our internal control processes over the preparation and fair presentation of published financial statements. +We have assessed the effectiveness of our internal controls over financial reporting as of March 31, 2011. In making this assessment, we used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (“COSO”) in Internal Control—Integrated Framework. Based on our assessment, we believe that, as of March 31, 2011, our internal control over financial reporting is effective based on those criteria. +This annual report does not include an attestation report of our independent registered public accounting firm regarding internal control over financial reporting. Management’s report was not subject to attestation by our independent registered public accounting firm pursuant to the rules of the SEC applicable to smaller reporting companies. \ No newline at end of file diff --git a/raw/filings/0000350868/2010/0001104659-11-032666/rp_note.txt b/raw/filings/0000350868/2010/0001104659-11-032666/rp_note.txt new file mode 100644 index 0000000000000000000000000000000000000000..e69de29bb2d1d6434b8b29ae775ad8c2e48c5391 diff --git a/raw/filings/0000350868/2010/0001104659-11-032666/rpt_disclosure.txt b/raw/filings/0000350868/2010/0001104659-11-032666/rpt_disclosure.txt new file mode 100644 index 0000000000000000000000000000000000000000..e69de29bb2d1d6434b8b29ae775ad8c2e48c5391 diff --git a/raw/filings/0000350868/2011/0001104659-12-042848/filing.txt b/raw/filings/0000350868/2011/0001104659-12-042848/filing.txt new file mode 100644 index 0000000000000000000000000000000000000000..031f3d09fb96c955d99aba283766eb5c6b3cb728 --- /dev/null +++ b/raw/filings/0000350868/2011/0001104659-12-042848/filing.txt @@ -0,0 +1,3446 @@ +10-K +1 +a12-5241_110k.htm +10-K +Table of Contents +UNITED STATES +SECURITIES AND EXCHANGE COMMISSION +Washington, D.C. 20549 +FORM 10-K +(Mark One) +x ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 +For the fiscal year ended March 31, 2012 +OR +o TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 +For the transition period from to +Commission file number 001-08762 +ITERIS, INC. +(Exact Name of Registrant as Specified in Its Charter) +Delaware +95-2588496 +(State or Other Jurisdiction +of Incorporation or Organization) +(I.R.S. Employer +Identification No.) +1700 Carnegie Ave., Santa Ana, California 92705 +(Address of Principal Executive Offices) (Zip Code) +Registrant’s Telephone Number, Including Area Code: (949) 270-9400 +Securities registered pursuant to Section 12(b) of the Act: +Title of each class +Name of each exchange on which registered +Common Stock, $0.10 par value +NYSE Amex +Securities registered pursuant to Section 12(g) of the Act: None +Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes o No x +Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes o No x +Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No o +Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes x No o +Indicate by a check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. x +Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See definitions of “large accelerated filer,” “accelerated filer,” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one): +Large accelerated filer o +Accelerated filer o +Non-accelerated filer o +Smaller reporting company x +(Do not check if a smaller reporting company) +Indicate by check mark whether the registrant is a shell company (as defined in Exchange Act Rule 12b-2). Yes o No x +Based on the closing sale price of the registrant’s common stock on the last business day of the registrant’s most recently completed second fiscal quarter, the aggregate market value of the voting common stock held by nonaffiliates of the registrant was approximately $33,247,000. For the purposes of this calculation, shares owned by officers, directors and 10% stockholders known to the registrant have been deemed to be owned by affiliates. This determination of affiliate status is not necessarily a conclusive determination for other purposes. +As of June 1, 2012, there were 33,998,351 shares of our common stock outstanding. +DOCUMENTS INCORPORATED BY REFERENCE +Part III incorporates by reference certain information from the registrant’s definitive proxy statement for the 2012 Annual Meeting of Stockholders, which will be filed with the Securities and Exchange Commission not later than 120 days after the end of the fiscal year ended March 31, 2012. Except with respect to information specifically incorporated by reference in this report, the registrant’s proxy statement is not deemed to be filed as a part hereof. +Table of Contents +ITERIS, INC. +ANNUAL REPORT ON FORM 10-K +FOR THE FISCAL YEAR ENDED MARCH 31, 2012 +TABLE OF CONTENTS +PART I +ITEM 1. +BUSINESS +2 +ITEM 1A. +RISK FACTORS +6 +ITEM 1B. +UNRESOLVED STAFF COMMENTS +14 +ITEM 2. +PROPERTIES +15 +ITEM 3. +LEGAL PROCEEDINGS +15 +ITEM 4. +MINE SAFETY DISCLOSURES +15 +PART II +ITEM 5. +MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES +16 +ITEM 6. +SELECTED FINANCIAL DATA +17 +ITEM 7. +MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS +17 +ITEM 7A. +QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK +29 +ITEM 8. +FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA +29 +ITEM 9. +CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE +29 +ITEM 9A. +CONTROLS AND PROCEDURES +29 +ITEM 9B. +OTHER INFORMATION +30 +PART III +ITEM 10. +DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE +30 +ITEM 11. +EXECUTIVE COMPENSATION +30 +ITEM 12. +SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS +31 +ITEM 13. +CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE +31 +ITEM 14. +PRINCIPAL ACCOUNTING FEES AND SERVICES +31 +PART IV +ITEM 15. +EXHIBITS, FINANCIAL STATEMENT SCHEDULES +31 +Unless otherwise indicated in this report, the “Company,” “we,” “us” and “our” refer to Iteris, Inc. and our wholly-owned subsidiaries. +Iteris®, Vantage®, Abacus®, VantageView™, VersiCam™, Pico™, RZ-4™, Vantage Vector™, iPerform™ and IterisPeMS™ are among the trademarks of Iteris, Inc. Any other trademarks or trade names mentioned herein are the property of their respective owners. +1 +Table of Contents +Cautionary Statement +This report, including the following discussion and analysis, contains forward-looking statements (within the meaning of the Private Securities Litigation Reform Act of 1995) that are based on our current expectations, estimates and projections about our business and our industry, and reflect management’s beliefs and certain assumptions made by us based upon information available to us as of the date of this report. When used in this report and the information incorporated herein by reference, the words “expect(s),” “feel(s),” “believe(s),” “should,” “would,” “could,” “may,” “anticipate(s),” “estimate(s)” and similar expressions or variations of these words are intended to identify forward-looking statements. These forward-looking statements include but are not limited to statements regarding our anticipated future sales, revenue and operating results, expansion plans, market share, capital needs, competition, backlog and manufacturing capabilities, acceptance of our products and services, and the impact of recent accounting pronouncements. These statements are not guarantees of future performance and are subject to certain risks and uncertainties which could cause actual results to differ materially from those projected. You should not place undue reliance on these forward-looking statements that speak only as of the date hereof. We undertake no obligation to republish revised forward-looking statements to reflect events or circumstances after the date hereof or to reflect the occurrence of unanticipated events. We encourage you to carefully review and consider the various disclosures made by us which describe certain factors which could affect our business, including those in “ Risk Factors” in Item 1A of this report, before deciding to invest in our company or to maintain or increase your investment. We undertake no obligation to revise or update publicly any forward-looking statement for any reason. +PART I +ITEM 1. BUSINESS +Overview +We are a leading provider of intelligent information solutions to the traffic management market. We are focused on the development and application of advanced technologies and software-based information systems that reduce traffic congestion, provide measurement, management and predictive traffic analytics and improve the safety of surface transportation systems infrastructure. We believe that our products, services and solutions, in conjunction with sound traffic management, minimize the environmental impact of traffic congestion. By combining our image processing, traffic engineering, information technology, and other products and services, we offer a broad range of Intelligent Transportation Systems (“ITS”) solutions to customers worldwide. +We were originally incorporated in Delaware in 1987. Our principal executive offices are located at 1700 Carnegie Avenue, Santa Ana, California 92705, and our telephone number at that location is (949) 270-9400. Our Internet website address is www.iteris.com. Our annual reports on Form 10-K, quarterly reports on Form 10-Q and current reports on Form 8-K, together with amendments to these reports, are available on the “Investors” section of our website, free of charge, as soon as reasonably practicable after such material is electronically filed with, or furnished to, the Securities and Exchange Commission (“SEC”). The inclusion of our website address in this report does not include or incorporate by reference into this report any information on our website. +Sale of Vehicle Sensors +On July 29, 2011, we completed the sale of substantially all of the assets used in connection with our Vehicle Sensors segment to Bendix Commercial Vehicle Systems LLC (“Bendix”), a member of Knorr-Bremse Group, pursuant to an Asset Purchase Agreement signed on July 25, 2011 (the “Asset Sale”). Upon closing, Bendix paid us $14 million in cash, subject to a $2 million holdback and adjustments based upon the working capital of the Vehicle Sensors segment at closing, and Bendix assumed certain specified obligations and liabilities of the Vehicle Sensors segment. We are entitled to additional consideration in the form of certain performance and royalty-related earn-outs. As a result of the Asset Sale, we no longer operate in the Vehicle Sensors segment and we determined that the Vehicle Sensors segment, which previously constituted one of our operating segments, qualifies as a discontinued operation. Refer to Note 3 of Notes to Consolidated Financial Statements, included in Part IV, Item 15 of this report for additional discussion on this transaction. The applicable financial results of the Vehicle Sensors segment through the closing of the Asset Sale have been reported as a discontinued operation for all periods presented. +Products and Services +As a result of the sale of Vehicle Sensors in July 2011, and a reevaluation and reorganization of our operating segments in the first quarter of the fiscal year ended March 31, 2012, we currently operate in two reportable segments: Roadway Sensors and Transportation Systems. The Roadway Sensors segment includes, among other products, our Vantage, Versicam, Pico, Vantage Vector and Abacus vehicle detection systems for traffic intersection control, incident detection and certain highway traffic data collection applications. The Transportation Systems segment includes transportation engineering and consulting services, and the development of transportation management and traveler information systems for the ITS industry. See Note 13 of Notes to Consolidated Financial Statements, included in Part IV, Item 15 of this report, for further details on our reportable segments. +2 +Table of Contents +Roadway Sensors +Our Roadway Sensors segment product line uses advanced image processing technology to capture and analyze video images through sophisticated algorithms, enabling vehicle detection and transmission of both video images and data using various communication technologies. +· Our Vantage video detection systems detect vehicle presence at intersections, as well as vehicle count, speed and other traffic data used in traffic management systems. Our Vantage systems give traffic managers the ability to mitigate roadway congestion by modifying traffic signal timing or detecting incidents quickly. Our VantageView software supplements our Vantage video detection systems by providing an integrated platform to manage and “see” video detection assets remotely over a network connection. +· Our Vantage Vector product is an all-in-one vehicle detection sensor with a wide range of capabilities: stop bar detection, advanced-zone detection, and sensing that enables advanced safety and adaptive control applications. It includes all the proven benefits of Iteris video detection, including high accuracy, high availability remote viewing of video images, no trenching or pavement cutting for installation, bicycle detection capability and high precision for dilemma zone detection by integrating the video field-of-view with radar sensing. Enhanced information includes the number of vehicles, speed, and distance in user configurable zones that can be used for special applications. +· VersiCam, our integrated camera and processor video detection system, is a cost-efficient video detection system for smaller intersections that require only a few detection points. +· Pico, our compact video detection system, was developed primarily to address international video detection needs, and was designed for easy installation and configuration. +· Our Abacus products take advantage of the large number of existing installed closed-circuit television video feeds designed to monitor roadways, signalized intersections, tunnels and bridges to allow for data collection and incident detection without the set-up and calibration generally required with other systems. +We believe that future growth domestically and internationally, particularly in developing countries, will be dependent in part on the continued adoption of above-ground video detection technologies, instead of traditional in-pavement loop technology, to manage traffic. +We have historically experienced seasonality, particularly with respect to our Roadway Sensors net sales in our third and fourth fiscal quarters due to a reduction in road construction and repairs during the winter months due to inclement weather conditions. +Transportation Systems +Our Transportation Systems segment includes transportation engineering and consulting services focused on the planning, design, development and implementation of software-based systems that integrate sensors, video surveillance, computers, and advanced communications equipment to enable public agencies to monitor, control and direct traffic flow, assist in the quick dispatch of emergency crews and distribute real-time information about traffic conditions. Our services include planning, design and implementation of surface transportation infrastructure systems. We perform analysis and study goods movement, study commercial vehicle operations, provide travel demand forecasting and systems engineering, and identify mitigation measures to reduce traffic congestion. This segment also includes the activities of Meridian Environmental Technology, Inc. (“MET”), which we acquired in January 2011, and which specializes in 511 advanced traveler information systems as well as Maintenance Decision Support System (“MDSS”) management tools that allow users to create solutions to meet roadway maintenance decision needs. The operations of Berkeley Transportation Systems, Inc. (“BTS”), which we acquired in November 2011, are also included in this segment. BTS specializes in transportation performance measurement and its Performance Measurement System leverages its real-time data collection, diagnostic, fusion and warehousing platform to aggregate and compute performance measures. +Our Transportation Systems segment is largely dependent upon governmental funding and is affected by state and local budgetary issues. We believe the overall expansion of our Transportation Systems segment in the future will at least in part be dependent on the passage of a new Federal Highway Bill. Congress is currently working on such a bill. The previous Federal Highway Bill expired in October 2009 but the funding levels under the expired bill have continued through a series of short-term extensions, the most recent of which extends funding through the end of June 2012. Continued delays in the enactment of such a new Federal Highway Bill, and until such time as a bill becomes law, will prolong the uncertainty regarding the allotment of transportation funds in federal, state and local budgets. We believe that prolonged uncertainty has adversely impacted, and may continue to adversely impact, our net sales and contract revenues and our overall financial performance in future periods. +With the addition of MET in January 2011, we have experienced seasonality particularly related to certain MDSS services in our first and second fiscal quarters mainly because MDSS services are generally not required in the summer months. +3 +Table of Contents +During the fiscal year ended March 31, 2012 (“Fiscal 2012”), we began the development of IterisPeMS. IterisPeMS is an advanced, real-time data collection, diagnostic, fusion and warehousing software platform used to aggregate and compute performance measures across multiple transportation modes, including travel time, travel time variability, delay and lost throughput. This information can then be analyzed by traffic professionals to measure how a transportation network is performing and identity potential areas of improvement. IterisPeMS is also capable of providing users with easy-to-use visualization and animation features for both historical and predictive traffic conditions. Costs incurred during Fiscal 2012, which include research and development expense as well as sales and marketing expenditures were not allocated to either of the Roadway Sensors or Transportation Systems segments as this project was deemed to be a corporate level development. +Sales, Marketing and Principal Customers +We sell our Roadway Sensors products through indirect sales channels comprised of a network of independent dealers in the U.S. and certain foreign locations, who sell integrated systems and related products to the traffic management market, as well as directly to the traffic management market using a combination of our own sales personnel and an outside sales organization. Our independent dealers are trained in, and primarily responsible for, sales, installation, set-up and support of our products, and maintain an inventory of demonstration traffic products from various manufacturers and sell directly to government agencies and installation contractors. These dealers often have long-term arrangements with local government agencies in their respective territories for the supply of various products for the construction and renovation of traffic intersections, and are generally well-known suppliers of high-quality ITS products to the traffic management market. We periodically hold technical training classes for our dealers and end users and maintain a full-time staff of customer support technicians throughout the U.S. to provide technical assistance when needed. When appropriate, we have the ability to modify or make changes to our dealer network to accommodate the needs of the market and our customer base. In the states where we sell directly, we use our own staff to sell, oversee installations and set-up issues and support our products. +We market and sell our Transportation Systems services directly to government agencies pursuant to negotiated contracts that involve competitive bidding and specific qualification requirements. Most of our contracts are with federal, state and municipal customers and generally provide for cancellation or renegotiation at the option of the customer upon reasonable notice and fees paid for modification. We generally use selected members of our engineering, science and information technology teams on a regional basis to serve in sales and business development functions. Our contracts generally involve long lead times and require extensive specification development, evaluation and price negotiations. +A large portion of our revenues are derived from sales to federal, state and local government agencies. We currently have a diverse customer base, and no individual customer represented greater than 10% of our total net sales and contract revenues in Fiscal 2012 and in the fiscal years ended March 31, 2011 (“Fiscal 2011”) and March 31, 2010 (“Fiscal 2010”). Also refer to Note 13 of Notes to Consolidated Financial Statements, included in Part IV, Item 15 of this report. +Manufacturing and Materials +We use contract manufacturers to build subassemblies that are used in our roadway sensors products. Additionally, we procure certain components from qualified suppliers, both globally and locally, and generally use multi-sourcing strategies when technically and economically feasible to mitigate supply risk. These subassemblies and components are delivered to our Santa Ana, California facility where they go through final assembly and testing prior to shipment to our customers. Our key suppliers include CTS Electronics Manufacturing Solutions, Inc., Total Electronics LLC, Sony Electronics, Inc. and LG Electronics, Inc. Our manufacturing activities are conducted in approximately 9,000 square feet of space at our Santa Ana facility. Production volume at our subcontractors is based upon quarterly forecasts that we generally adjust on a monthly basis to control inventory levels. We typically do not manufacture any of the hardware used in the transportation management and traveler information systems that we design and implement. Our production facility is currently ISO 9001 certified. +Customer Support and Services +We provide warranty service and support for our products, as well as follow-up service and support for which we charge separately. Such service revenue was not a material portion of our total net sales and contract revenues for each of Fiscal 2012, Fiscal 2011 and Fiscal 2010. We believe customer support is a key competitive factor. +Backlog +Our total backlog of unfulfilled firm orders was approximately $35.0 million as of March 31, 2012, which was comprised of $3.2 million related to Roadway Sensors and $31.8 million related to Transportation Systems. Substantially the entire backlog for Roadway Sensors is expected to be recognized as revenue in the fiscal year ending March 31, 2013. We have historically recognized between 50% to 70% of our Transportation Systems backlog as of the end of a fiscal year in the subsequent fiscal year, and currently expect that trend to continue for the near future. +4 +Table of Contents +At March 31, 2011, we had backlog of approximately $28.2 million, which was comprised of $2.7 million related to Roadway Sensors and $25.5 million related to Transportation Systems. +The timing and realization of our backlog is subject to the inherent uncertainties of doing business with federal, state and local governments, particularly in view of budgetary constraints, cut-backs and other delays or reallocations of funding that these entities typically face. +Pursuant to the customary terms of our agreements with government contractors and other customers, customers can generally cancel or reschedule orders with little or no penalties. Lead times for the release of purchase orders often depend upon the scheduling and forecasting practices of our individual customers, which also can affect the timing of the conversion of our backlog into revenues. For these reasons, among others, our backlog at a particular date may not be indicative of our future revenues, in particular for our Roadway Sensors segment. +Product Development +Most of our product development activities are conducted at our principal facilities in Santa Ana, California. Our research and development costs and expenses were approximately $3.2 million for Fiscal 2012, $2.4 million for Fiscal 2011 and $2.6 million for Fiscal 2010. We expect to continue to pursue various product development programs and incur research and development expenditures in future periods. +We believe our engineering and product development capabilities are a competitive strength. We strive to continue to develop new products to meet the needs of the ever-changing ITS market as well as enhance and refine our existing product lines. Within the last four fiscal years, our Roadway Sensors segment has introduced our VersiCam and VersiCam wireless products, Pico, RZ-4 Advanced camera and our RZ-4 Advanced Wide Dynamic Range camera, which significantly improve video detection performance in certain harsh lighting conditions, and within the last fiscal year, Vantage Vector. We have also upgraded our Abacus and VantageView software products within the last fiscal year. Additionally, during Fiscal 2012, we began development of our IterisPeMS Performance Measurement System. We plan to continue this development effort in our fiscal year ending March 31, 2013. We believe that developing new offerings across our segments and enhancing, refining and marketing our existing products is a key component of strong organic growth and profitability. +Competition +We generally face significant competition in each of our target markets. Increased competition may result in price reductions, reduced gross margins and loss of market share, any of which could have a material adverse effect on our business, financial condition and results of operations. +In the market for our Roadway Sensors vehicle detection products, we compete with manufacturers and distributors of other above ground video camera detection systems and other non-intrusive detection devices, including microwave, infrared, ultrasonic and magnetic detectors, as well as manufacturers and installers of in-pavement inductive loop products, which have historically, and currently continue to be, the predominant detection system in this market. +The markets in which our Transportation Systems segment operates is highly fragmented and subject to evolving national and regional quality, operations and safety standards. Our competitors vary in number, scope and breadth of the products and services they offer. Our competitors in advanced Transportation Systems include national corporations. Our competitors in transportation engineering, planning and design include major regional firms, as well as many smaller local engineering firms. +In general, the markets for the products and services we offer are highly competitive and are characterized by rapidly changing technology and evolving standards. Many of our current and prospective competitors have longer operating histories, greater name recognition, access to larger customer bases and significantly greater financial, technical, manufacturing, distribution and marketing resources than us. As a result, they may be able to adapt more quickly to new or emerging standards or technologies or to devote greater resources to the promotion and sale of their products. It is also possible that new competitors or alliances among competitors could emerge and rapidly acquire significant market share. We believe that our ability to compete effectively in our target markets will depend on a number of factors, including the success and timing of our new product development, the compatibility of our products with a broad range of computing systems, product quality and performance, reliability, functionality, price and service and technical support. Our failure to provide services and develop and market products that compete successfully with those of other suppliers and consultants in our target markets would have a material adverse effect on our business, financial condition and results of operations. +5 +Table of Contents +Intellectual Property and Proprietary Rights +Our ability to compete effectively depends in part on our ability to develop and maintain the proprietary aspects of our technology. Our policy is to obtain appropriate proprietary rights protection for any potentially significant new technology acquired or developed by us. We currently hold five U.S. patents, three pending foreign patents and two provisional patents. One U.S. patent, which expires in May 2019, is for general technology related to CMOS sensors. Four U.S. patents, which expire between 2013 and 2029, two pending foreign patents and two provisional patents relate specifically to our Roadway Sensors technology. One of these U.S. patents and the two pending foreign patents are for an Electronic Traffic Monitor related to our Abacus product in the Roadway Sensors segment. We cannot be certain that any new patents will be granted pursuant to these or subsequent applications. As a result of the Asset Sale, certain patents were transferred to Bendix. We believe these patents were specific to that segment and the transfer of ownership does not impair our proprietary rights related to our current product and service offerings. +In addition to patent laws, we rely on copyright and trade secret laws to protect our proprietary rights. We attempt to protect our trade secrets and other proprietary information through agreements with customers and suppliers, proprietary information agreements with our employees and consultants, and other similar measures. We do not have any material licenses or trademarks other than those relating to product names. We cannot be certain that we will be successful in protecting our proprietary rights. While we believe our patents, patent applications, software and other proprietary know-how have value; changing technology makes our future success dependent principally upon our employees’ technical competence and creative skills for continuing innovation. +Litigation may be necessary in the future to enforce our proprietary rights, to determine the validity and scope of the proprietary rights of others, or to defend us against claims of infringement or invalidity by others. An adverse outcome in such litigation or similar proceedings could subject us to significant liabilities to third parties, require disputed rights to be licensed from others or require us to cease marketing or using certain products, any of which could have a material adverse effect on our business, financial condition and results of operations. In addition, the cost of addressing any intellectual property litigation claim, both in legal fees and expenses, as well as from the diversion of management’s resources, regardless of whether the claim is valid, could be significant and could have a material adverse effect on our business, financial condition and results of operations. +Employees +We refer to our employees as associates. As of March 31, 2012, we employed an aggregate of 264 full-time associates, including 57 associates in general management, administration and finance; 19 associates in sales and marketing; 160 associates in engineering and product development; 15 associates in operations, manufacturing and quality; and 13 associates in customer service. None of our associates are represented by a labor union, and we have never experienced a work stoppage. We believe our relations with our associates are good. +Government Regulation +Our manufacturing operations are subject to various federal, state and local laws and regulations, including those restricting the discharge of materials into the environment. We are not involved in any pending or, to our knowledge, threatened governmental proceedings, which would require curtailment of our operations because of such laws and regulations. We continue to expend funds in connection with our compliance with applicable environmental regulations. These expenditures have not, however, been significant in the past, and we do not expect any significant expenditure in the near future. Currently, compliance with foreign laws has not had a material impact on our business and is not expected to have a material impact in the near future. +ITEM 1A. RISK FACTORS +Our business is subject to a number of risks, some of which are discussed below. Other risks are presented elsewhere in this report and in the information incorporated by reference into this report. You should consider the following risks carefully in addition to the other information contained in this report and our other filings with the SEC, including our subsequent reports on Forms 10-Q and 8-K, before deciding to buy, sell or hold our common stock. The risks and uncertainties described below are not the only ones facing our company. Additional risks and uncertainties not presently known to us or that we currently deem immaterial may also affect our business operations. If any of these risks actually occurs, our business, financial condition, or results of operations could be seriously harmed. In that event, the market price for our common stock could decline and you may lose all or part of your investment. +The economic slowdown has reduced and delayed government funding for transportation infrastructure projects and initiatives, decreased availability of financial capital for our customers and adversely impacted real estate development, all of which have adversely impacted our net sales and contract revenues. Decreased consumer spending, the failure of certain financial institutions and businesses, concerns about the availability and cost of credit, and reduced corporate profits and capital spending have resulted in a downturn in worldwide economic conditions, as well as budgetary shortfalls at all levels of government. These unfavorable economic conditions are having a negative impact on customer orders and government funding of infrastructure projects +6 +Table of Contents +incorporating our products and services. Such factors have and may continue to result in delays, cancellations and rescheduling of backlog and customer orders. In addition, the decline in the U.S. real estate market, particularly in new home and commercial construction, has adversely impacted new road construction and has had and may continue to have adverse effects on Transportation Systems contract revenues and Roadway Sensors net sales. Any of the foregoing economic conditions may adversely affect our net sales and contract revenues in future periods and make it extremely difficult for our customers, our suppliers and us to accurately forecast and plan future business activities. Additionally, there continues to be uncertainty regarding allotment of government funds due to delays in the passage of a new Federal Highway Bill, which has adversely impacted, and may continue to adversely impact, our net sales and contract revenues and overall financial performance in future periods. The previous Federal Highway Bill expired in October 2009 but the funding levels under the previous bill have been continued through a series of short-term extensions, the most recent of which extends funding through the end of June 2012. If the conditions above continue or worsen, or delays in the passage of a new Federal Highway Bill continue, our business, financial condition and results of operations could be materially and adversely affected. +Because we depend on government contracts and subcontracts, we face additional risks related to contracting with federal, state and local governments, including budgetary issues and fixed price contracts. A significant portion of our net sales and contract revenues are derived from contracts with governmental agencies, either as a general contractor, subcontractor or supplier. We anticipate that revenue from government contracts will continue to remain a significant portion of our net sales and contract revenues. Government business is, in general, subject to special risks and challenges, including: +· delays in funding and uncertainty regarding the allocation of funds to state and local agencies from the U.S. federal government as a result of delays in the passage of a new Federal Highway Bill, as well as delays or reductions in other state and local funding dedicated for transportation projects; +· other government budgetary constraints, cut-backs, delays or reallocation of government funding; +· performance bond requirements; +· long purchase cycles or approval processes; +· competitive bidding and qualification requirements; +· changes in government policies and political agendas; +· milestone requirements and liquidated damage provisions for failure to meet contract milestones; and +· international conflicts or other military operations that could cause the temporary or permanent diversion of government funding from transportation or other infrastructure projects. +Governmental budgets and plans are subject to change without warning. Certain risks of selling to governmental entities include dependence on appropriations and administrative allocation of funds, changes in governmental procurement legislation and regulations and other policies that may reflect political developments or agendas, significant changes in contract scheduling, intense competition for government business and termination of purchase decisions for the convenience of the governmental entity. Substantial delays in purchase decisions by governmental entities, and the current constraints on government budgets at the federal, state and local level, could cause our net sales and contract revenues and income to drop substantially or to fluctuate significantly between fiscal periods. +In addition, a number of our government contracts are fixed price contracts. As a result, we may not be able to recover any cost overruns we may incur. These fixed price contracts require us to estimate the total project cost based on preliminary projections of the project’s requirements. The financial viability of any given project depends in large part on our ability to estimate these costs accurately and complete the project on a timely basis. In the event our costs on these projects exceed the fixed contractual amount, we will be required to bear the excess costs. Such additional costs would adversely affect our financial condition and results of operations. Moreover, certain of our government contracts are subject to termination or renegotiation at the convenience of the government, which could result in a large decline in our net sales and contract revenues in any given period. Our inability to address any of the foregoing concerns or the loss or renegotiation of any material government contract could seriously harm our business, financial condition and results of operations. +California state budgetary constraints may have a material adverse impact on us. The state of California has experienced, and is continuing to experience, a significant budget shortfall and other related budgetary issues and constraints. The state of California has historically been and is considered to be a key geographic region for our Roadway Sensors and Transportation Systems segments. Ongoing uncertainty as to the timing and accessibility of budgetary funding, changes in state funding allocations to local agencies and municipalities, or other delays in purchasing for, or commencement of, transportation projects have had and may continue to have a negative impact on our net sales and contract revenues and our income. +7 +Table of Contents +If we do not keep pace with rapid technological changes and evolving industry standards, we will not be able to remain competitive and there will be no demand for our products. Our markets are in general characterized by the following factors: +· rapid technological advances; +· downward price pressures in the marketplace as technologies mature; +· changes in customer requirements; +· additional qualification requirements related to new products or components; +· frequent new product introductions and enhancements; +· inventory issues related to transition to new or enhanced models; and +· evolving industry standards and changes in the regulatory environment. +Our future success will depend upon our ability to anticipate and adapt to changes in technology and industry standards, and to effectively develop, introduce, market and gain broad acceptance of new products and product enhancements incorporating the latest technological advancements. +The markets in which we operate are highly competitive and have many more established competitors, which could adversely affect our net sales and contract revenues or the market acceptance of our products. We compete with numerous other companies in our target markets including, but not limited to, large, multinational corporations and many smaller regional engineering firms. +We compete with existing, well-established companies in our Roadway Sensors segment, both domestically and abroad. Certain technological barriers to entry make it difficult for new competitors to enter the market with competing video or other technologies; however, we are aware of new market entrants from time to time. Increased competition could result in loss of market share, price reductions and reduced gross margins, any of which could seriously harm our business, financial condition and results of operations. +The Transportation Systems market is highly fragmented and is subject to evolving national and regional quality and safety standards. Our competitors vary in size, number, scope and breadth of the products and services they offer, and include large multi-national engineering firms and smaller local regional firms. +In both of our segments, many of our competitors have far greater name recognition and greater financial, technological, marketing, and customer service resources than we do. This may allow them to respond more quickly to new or emerging technologies and changes in customer requirements. It may also allow them to devote greater resources to the development, promotion, sale and support of their products than we can. Consolidations of end users, distributors and manufacturers in our target markets exacerbate this problem. As a result of the foregoing factors, we may not be able to compete effectively in our target markets and competitive pressures could adversely affect our business, financial condition and results of operations. +We may engage in acquisitions of companies or technologies that may require us to undertake significant capital infusions and could result in disruptions of our business and diversion of resources and management attention. We have completed three acquisitions since April 2009 and, in the future, we may acquire additional complementary businesses, products, and technologies. Acquisitions may require significant capital infusions and, in general, acquisitions also involve a number of special risks, including: +· potential disruption of our ongoing business and the diversion of our resources and management’s attention; +· the failure to retain or integrate key acquired personnel; +· the challenge of assimilating diverse business cultures, and the difficulties in integrating the operations, technologies and information system of the acquired companies; +· increased costs to improve managerial, operational, financial and administrative systems and to eliminate duplicative services; +8 +Table of Contents +· the incurrence of unforeseen obligations or liabilities; +· potential impairment of relationships with employees or customers as a result of changes in management; and +· increased interest expense and amortization of acquired intangible assets, as well as unanticipated accounting charges. +Our competitors are also soliciting potential acquisition candidates, which could both increase the price of any acquisition targets and decrease the number of attractive companies available for acquisition. Acquisitions may also materially and adversely affect our operating results due to large write-offs, contingent liabilities, substantial depreciation, deferred compensation charges or intangible asset amortization, or other adverse tax or accounting consequences. We cannot assure you that we will be able to identify or consummate any additional acquisitions, successfully integrate any acquisitions or realize the benefits anticipated from any acquisition. +We may be unable to attract and retain key personnel, which could seriously harm our business. Due to the specialized nature of our business, we are highly dependent on the continued service of our executive officers and other key management, engineering and technical personnel. The loss of any of our officers, or any of our other executives or key members of management could adversely affect our business, financial condition, or results of operations. Our success will also depend in large part upon our ability to continue to attract, retain and motivate qualified engineering and other highly skilled technical personnel. In particular, the future success of our Transportation Systems segment will depend on our ability to hire additional qualified engineers and planners. Competition for qualified employees, particularly development engineers, is intense. We may not be able to continue to attract and retain sufficient numbers of such highly skilled employees. Our inability to attract and retain additional key employees or the loss of one or more of our current key employees could adversely affect our business, financial condition and results of operations. +Our profitability could be adversely affected if we are not able to maintain adequate utilization of our Transportation Systems workforce. The cost of providing our Transportation Systems engineering and consulting services, including the extent to which we utilize our workforce, affects our profitability. The rate at which we utilize our workforce is affected by a number of factors, including: +· our ability to transition employees from completed projects to new assignments and to hire and assimilate new employees; +· our ability to forecast demand for our services and thereby maintain an appropriate headcount in our various regions; +· our need to devote time and resources to training, business development, professional development and other non-chargeable activities; and +· our ability to match the skill sets of our employees to the needs of the marketplace. +Our use of the percentage of completion method of accounting for our contract revenues could result in a reduction or reversal of previously recorded revenues and profits. A significant portion of contract revenues are measured and recognized using the percentage of completion method of accounting. Our use of this accounting method results in recognition of revenues and profits ratably over the life of a contract, based generally on the proportion of costs incurred to date to total costs expected to be incurred for the entire project. The effects of revisions to revenues and estimated costs are recorded when the amounts are known or can be reasonably estimated. Such revisions could occur in any period and their effects could be material. Although we have historically made reasonably reliable estimates of the progress towards completion of long-term engineering, program management, construction management or construction contracts, the uncertainties inherent in the estimating process make it possible for actual costs to vary materially from estimates, including reductions or reversals of previously recorded revenues and profits. +Our failure to successfully bid on new contracts and renew existing contracts could reduce our revenues and profits. Our business depends on our ability to successfully bid on new contracts and renew existing contracts with private and public sector customers. Contract proposals and negotiations are complex and frequently involve a lengthy bidding and selection process, which are affected by a number of factors, such as market conditions, financing arrangements and required governmental approvals. For example, a customer may require us to provide a surety bond or letter of credit to protect the client should we fail to perform under the terms of the contract. If negative market conditions continue, or if we fail to secure adequate financing arrangements or the required governmental approval or fail to meet other required conditions, we may not be able to pursue particular projects, which could reduce or eliminate our profitability. +We may experience production gaps that could materially and adversely impact our sales and financial results and the ultimate acceptance of our products. It is possible that we could experience unforeseen quality control issues or part shortages as we adjust production to meet current demand for our products. We have historically used single suppliers for certain significant components in our products. Should any such delay or disruption occur, or should a key supplier discontinue operations because of the +9 +Table of Contents +current economic climate, our future sales will likely be materially and adversely affected. Additionally, we rely heavily on select contract manufacturers to produce many of our products and do not have any long-term contracts to guarantee supply of such products. Although we believe our contract manufacturers have sufficient capacity to meet our production schedules for the foreseeable future and we believe we could find alternative contract manufacturing sources for many of our products, if necessary, we could experience a production gap if for any reason our contract manufacturers were unable to meet our production requirements and our cost of goods sold could increase, adversely affecting our margins. +If we are unable to develop and introduce new products and product enhancements successfully and in a cost-effective and timely manner, or are unable to achieve market acceptance of our new products, our operating results would be adversely affected. We believe our revenue growth and future operating results will depend on our ability to complete development of new products and enhancements, introduce these products in a timely, cost-effective manner, achieve broad market acceptance of these products and enhancements, and reduce our production costs. We cannot guarantee the success of these products, and we may not be able to introduce any new products or any enhancements to our existing products on a timely basis, or at all. In addition, the introduction of any new products could adversely affect the sales of certain of our existing products. +We believe that we must continue to make substantial investments to support ongoing research and development in order to remain competitive. We need to continue to develop and introduce new products that incorporate the latest technological advancements in outdoor image processing hardware, software and camera technologies in response to evolving customer requirements. We cannot assure you that we will be able to adequately manage product transition issues. Our business and results of operations could be adversely affected if we do not anticipate or respond adequately to technological developments or changing customer requirements or if we cannot adequately manage inventory issues typically related to new product transitions and introductions. We cannot assure you that any such investments in research and development will lead to any corresponding increase in revenue. +Our business and results of operations could also be seriously harmed by any significant delays in our new product development. Certain of our new products could contain undetected design faults and software errors or “bugs” when first released by us, despite our testing. We may not discover these faults or errors until after a product has been installed and used by our customers. Any faults or errors in our existing products or in any new products may cause delays in product introduction and shipments, require design modifications or harm customer relationships, any of which could adversely affect our business and competitive position. +Our international business operations may be threatened by many factors that are outside of our control. While we historically have had limited international sales, contract revenues and operations experience, we began work on our first overseas contracts in the United Arab Emirates in the fiscal year ended March 31, 2010. We plan to expand our international efforts in the future with respect to all of our segments, but cannot assure you that we will be successful in those efforts. International operations subject us to various inherent risks including, among others: +· currency fluctuations and restrictions; +· political, social and economic instability, as well as international conflicts and acts of terrorism; +· longer accounts receivable payment cycles; +· import and export license requirements and restrictions of the U.S. and each other country in which we operate; +· unexpected changes in regulatory requirements, tariffs and other trade barriers or restrictions; +· the burdens of compliance with a wide variety of foreign laws and more restrictive labor laws and obligations; +· difficulties in managing and staffing international operations; +· potentially adverse tax consequences; and +· reduced protection for intellectual property rights in some countries. +Substantially all of our international sales are denominated in U.S. dollars. As a result, an increase in the relative value of the dollar could make our products more expensive and potentially less price competitive in international markets. We do not currently engage in any transactions as a hedge against risks of loss due to foreign currency fluctuations. +10 +Table of Contents +Any of the factors mentioned above may adversely affect our future international sales and contract revenues and, consequently, affect our business, financial condition and operating results. Additionally, as we pursue the expansion of our international business, certain fixed and other overhead costs could outpace our revenues, thus adversely affecting our results of operations. We may likewise face local competitors in certain international markets who are more established, have greater economies of scale and stronger customer relationships. Furthermore, as we increase our international sales, our total revenues may also be affected to a greater extent by seasonal fluctuations resulting from lower sales that typically occur during the summer months in Europe and other parts of the world. +If our internal controls over financial reporting do not comply with the requirements of the Sarbanes-Oxley Act, our business and stock price could be adversely affected. Section 404 of the Sarbanes-Oxley Act of 2002 currently requires us to evaluate the effectiveness of our internal controls over financial reporting at the end of each fiscal year and to include a management report assessing the effectiveness of our internal controls over financial reporting in all annual reports. As a smaller reporting company, for our fiscal year ended March 31, 2012, we are exempt from the auditor attestation requirement over our internal control over financial reporting; however, to the extent we do not qualify as a non-accelerated filer or smaller reporting company in subsequent fiscal years, we will be subject to the auditor attestation requirement under Section 404(b) of the Sarbanes-Oxley Act. In such an event, we may not be able to complete the work required for such attestation on a timely basis and, even if we timely complete such requirements, our independent registered public accounting firm may still conclude that our internal controls over financial reporting are not effective. +Our management, including our CEO and CFO, does not expect that our internal controls over financial reporting will prevent all errors and all fraud. A control system, no matter how well designed and operated, can provide only reasonable, not absolute, assurance that the control system’s objectives will be met. Further, the design of a control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within Iteris have been or will be detected. These inherent limitations include the realities that judgments in decision-making can be faulty and that breakdowns can occur because of simple errors or mistakes. Controls can also be circumvented by the individual acts of some persons, by collusion of two or more people, or by management override of the controls. The design of any system of controls is based in part on certain assumptions about the likelihood of future events, and we cannot assure you that any design will succeed in achieving its stated goals under all potential future conditions. Over time, our controls may become inadequate because of changes in conditions or deterioration in the degree of compliance with policies or procedures. Because of the inherent limitations in a cost-effective control system, misstatements due to error or fraud may occur and not be detected. +Our quarterly operating results fluctuate as a result of many factors. Therefore, we may fail to meet or exceed the expectations of securities analysts and investors, which could cause our stock price to decline. Our quarterly revenues and operating results have fluctuated and are likely to continue to vary from quarter to quarter due to a number of factors, many of which are not within our control. Factors that could affect our revenues include, among others, the following: +· delays in government contracts and funding from time to time and budgetary constraints at the federal, state and local levels; +· our ability to access stimulus funding, funding from a new Federal Highway Bill or other funding; +· declines in new home and commercial real estate construction and related road and other infrastructure construction; +· changes in our pricing policies and the pricing policies of our suppliers and competitors, pricing concessions on volume sales, as well as increased price competition in general; +· the long lead times associated with government contracts; +· the size, timing, rescheduling or cancellation of significant customer orders; +· our ability to control costs; +· our ability to raise additional capital; +· the mix of our products and services sold in a quarter, which has varied and is expected to continue to vary from time to time; +· seasonality due to winter weather conditions; +· seasonality with respect to revenues from our MDSS and related weather forecasting services due to the decrease in revenues generated for such services during the spring and summer time periods; +11 +Table of Contents +· our ability to develop, introduce, patent, market and gain market acceptance of new products, applications and product enhancements in a timely manner, or at all; +· market acceptance of the products incorporating our technologies and products; +· the introduction of new products by competitors; +· the availability and cost of components used in the manufacture of our products; +· our success in expanding and implementing our sales and marketing programs; +· the effects of technological changes in our target markets; +· the amount of our backlog at any given time; +· the nature of our government contracts; +· deferrals of customer orders in anticipation of new products, applications or product enhancements; +· risks and uncertainties associated with our international business; +· currency fluctuations and our ability to get currency out of certain foreign countries; +· general economic and political conditions; +· international conflicts and acts of terrorism; and +· other factors beyond our control, including but not limited to, natural disasters such as the earthquake, tsunami and related events in Japan. +Due to all of the factors listed above as well as other unforeseen factors, our future operating results could be below the expectations of securities analysts or investors. If that happens, the trading price of our common stock could decline. As a result of these quarterly variations, you should not rely on quarter-to-quarter comparisons of our operating results as an indication of our future performance. +We experienced declining or flat net sales and contract revenues in recent years. If we fail to manage this decline effectively, we may be unable to execute our business plan and may experience future weaknesses in our operating results. Based on our business objectives, and in order to achieve future growth, we will need to continue to add additional qualified personnel, and invest in additional research and development and sales and marketing activities, which could lead to increases in our expenses and future declines in our operating results. In addition, our past expansion has placed, and future expansion is expected to place, a significant strain on our managerial, administrative, operational, financial and other resources. If we are unable to manage these activities or any revenue declines successfully, our growth, our business, our financial condition and our results of operations could continue to be adversely affected. +We may not be able to adequately protect or enforce our intellectual property rights, which could harm our competitive position. If we are not able to adequately protect or enforce the proprietary aspects of our technology, competitors could be able to access our proprietary technology and our business, financial condition and results of operations will likely be seriously harmed. We currently attempt to protect our technology through a combination of patent, copyright, trademark and trade secret laws, employee and third party nondisclosure agreements and similar means. Despite our efforts, other parties may attempt to disclose, obtain or use our technologies or systems. Our competitors may also be able to independently develop products that are substantially equivalent or superior to our products or design around our patents. In addition, the laws of some foreign countries do not protect our proprietary rights as fully as do the laws of the U.S. As a result, we may not be able to protect our proprietary rights adequately in the U.S. or abroad. +Litigation may be necessary in the future to enforce our intellectual property rights or to determine the validity and scope of the proprietary rights of others. Litigation may also be necessary to defend against claims of infringement or invalidity by others. An adverse outcome in litigation or any similar proceedings could subject us to significant liabilities to third parties, require us to license disputed rights from others or require us to cease marketing or using certain products or technologies. We may not be able to obtain any licenses on terms acceptable to us, or at all. We also may have to indemnify certain customers or strategic partners if it is determined that we have infringed upon or misappropriated another party’s intellectual property. Any of these results could adversely affect our business, financial condition and results of operations. In addition, the cost of addressing any intellectual property litigation claim, including legal fees and expenses, and the diversion of management’s attention and resources, regardless of whether the claim is valid, could be significant and could seriously harm our business, financial condition and results of operations. +12 +Table of Contents +We may be subject to traffic related litigation . The traffic industry in general can be subject to litigation claims due to the nature of personal injuries that result from traffic accidents. As a provider of traffic engineering services, products and solutions, we have been and could in the future be subject to litigation for traffic related accidents from time to time even if our products or services had nothing to do with the particular accident. While we carry insurance against such claims, if the damages in any given action were high or we were subject to multiple lawsuits, the damages and costs could exceed the limits of our insurance coverage. If we were required to pay substantial damages as a result of these lawsuits, it may harm our business and financial condition. Even defending against unsuccessful claims could cause us to incur significant expenses and result in a diversion of management’s attention. +We may need to raise additional capital in the future, which may not be available on terms acceptable to us, or at all. We have historically experienced volatility in our earnings and cash flows from operations from year to year. Although we have a $12.0 million revolving line of credit, should we have an event of default, which includes, among other things, a failure to meet certain financial covenants and a material adverse change in the business, the bank could choose to limit or take away our ability to borrow these or any funds. Should this occur, or if the credit markets further tighten or our business declines, we may need or choose to raise additional capital to repay indebtedness, pursue acquisitions or expand our operations. Such additional capital may be raised through bank borrowings, or other debt or equity financings. We cannot assure you that any additional capital will be available on a timely basis, on acceptable terms, or at all, and such additional financing may result in further dilution to our stockholders. +Our capital requirements will depend on many factors, including, but not limited to: +· market acceptance of our products and product enhancements, and the overall level of sales of our products; +· our ability to control costs; +· the supply of key components for our products; +· our ability to increase revenue and net income; +· increased research and development expenses and sales and marketing expenses; +· our need to respond to technological advancements and our competitors’ introductions of new products or technologies; +· capital improvements to new and existing facilities and enhancements to our infrastructure and systems; +· potential acquisitions of businesses and product lines; +· our relationships with customers and suppliers; +· government budgets, political agendas and other funding issues, including potential delays in government contract awards; +· our ability to successfully negotiate credit arrangements with our bank and the state of the financial markets, in general; and +· general economic conditions, including the effects of the current economic slowdown and international conflicts. +If our capital requirements are materially different from those currently planned, we may need additional capital sooner than anticipated. If additional funds are raised through the issuance of equity or convertible debt securities, the percentage ownership of our stockholders will be reduced and such securities may have rights, preferences and privileges senior to our common stock. Additional equity or debt financing may not be available on favorable terms, on a timely basis, or at all. If adequate funds are not available or are not available on acceptable terms, we may be unable to continue our operations as planned, develop or enhance our products, expand our sales and marketing programs, take advantage of future opportunities or respond to competitive pressures. +We may be unable to maintain profitability on a quarterly or annual basis. We cannot assure you that we will be able to sustain or improve our financial performance, or that we will be able to continue to achieve profitability on a quarterly or annual basis in the future. Our ability to maintain profitability in future periods could be impacted by budgetary constraints, government and political agendas, economic instability and other items that are not in our control. Most of our expenses are fixed in advance. As such, we generally are unable to reduce our expenses significantly in the short-term to compensate for any unexpected delay or decrease in anticipated revenues. As a result, we may experience operating losses and net losses in the future, which would make it difficult to fund our operations and achieve our business plan, and could cause the market price of our common stock to decline. +13 +Table of Contents +The trading price of our common stock is highly volatile. The trading price of our common stock has been subject to wide fluctuations in the past. Since April 2008, our common stock has traded at closing prices as low as $0.90 per share and as high as $2.98 per share. The market price of our common stock could continue to fluctuate in the future in response to various factors, including, but not limited to: +· quarterly variations in operating results; +· our ability to control costs, improve cash flow and sustain profitability; +· our ability to raise additional capital; +· shortages announced by suppliers; +· announcements of technological innovations or new products or applications by our competitors, customers or us; +· transitions to new products or product enhancements; +· acquisitions of businesses, products or technologies; +· the impact of any litigation; +· changes in investor perceptions; +· government funding, political agendas and other budgetary constraints; +· changes in earnings estimates or investment recommendations by securities analysts; and +· international conflicts, political unrest and acts of terrorism. +The stock market in general has from time to time experienced volatility, which has often affected the market prices of equity securities of many technology companies. This volatility has often been unrelated to the operating performance of these companies. These broad market fluctuations may adversely affect the market price of our common stock. In the past, companies that have experienced volatility in the market price of their securities have been the subject of securities class action litigation. If we were to become the subject of a class action lawsuit, it could result in substantial losses and divert management’s attention and resources from other matters. +Certain provisions of our charter documents may discourage a third party from acquiring us and may adversely affect the price of our common stock. Certain provisions of our certificate of incorporation could make it difficult for a third party to acquire us, even though an acquisition might be beneficial to our stockholders. Such provisions could limit the price that investors might be willing to pay in the future for shares of our common stock. Under the terms of our certificate of incorporation, our Board of Directors is authorized to issue, without stockholder approval, up to 2,000,000 shares of preferred stock with voting, conversion and other rights and preferences superior to those of our common stock. In August 2009, we adopted a new stockholder rights plan and declared a dividend of preferred stock purchase rights to our stockholders. Generally, the stockholder rights plan provides that if a person or group acquires 15% or more of our common stock, subject to certain exceptions and under certain circumstances, the rights may be exchanged by us for common stock or the holders of the rights, other than the acquiring person or group, could acquire additional shares of our capital stock at a discount off of the then current market price. Such exchanges or exercise of rights could cause substantial dilution to a particular acquirer and discourage the acquirer from pursuing our company. The mere existence of a stockholder rights plan often delays or makes a merger, tender offer or proxy contest more difficult. +ITEM 1B. UNRESOLVED STAFF COMMENTS +None. +14 +Table of Contents +ITEM 2. PROPERTIES +Our headquarters and principal operations are housed in approximately 52,000 square feet of leased office, manufacturing and warehouse space located in Santa Ana, California. This facility lease expires in 2015 and contains an option to extend the lease for an additional five years at the market rate at that time. +For additional information regarding our obligations under property leases, see Note 9 of Notes to Consolidated Financial Statements, included in Part IV, Item 15 of this report. +ITEM 3. LEGAL PROCEEDINGS +The information set forth under the heading “Litigation and Other Contingencies” under Note 9 of Notes to Consolidated Financial Statements, included in Part IV, Item 15 of this report, is incorporated herein by reference. +ITEM 4. MINE SAFETY DISCLOSURES +Not applicable. +15 +Table of Contents +PART II +ITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES +Market Information and Holders +Our common stock is traded on the NYSE Amex under the symbol “ITI.” The following table sets forth, for the periods indicated, the highest and lowest sales prices for our common stock as reported by NYSE Amex: +High +Low +Fiscal 2012 +Quarter Ended June 30, 2011 +$ +1.58 +$ +1.22 +Quarter Ended September 30, 2011 +1.35 +0.90 +Quarter Ended December 31, 2011 +1.39 +1.08 +Quarter Ended March 31, 2012 +1.58 +1.31 +Fiscal 2011 +Quarter Ended June 30, 2010 +$ +2.25 +$ +1.26 +Quarter Ended September 30, 2010 +1.78 +1.25 +Quarter Ended December 31, 2010 +1.93 +1.33 +Quarter Ended March 31, 2011 +1.92 +1.35 +On June 1, 2012, the last reported sales price of our common stock on the NYSE Amex was $1.42. As of June 1, 2012, we had 425 holders of record of our common stock according to information furnished by our transfer agent. +Dividend Policy +We have never paid or declared cash dividends on our common stock, and have no current plans to pay such dividends in the foreseeable future. We currently intend to retain any earnings for working capital and general corporate purposes. The payment of any future dividends will be at the discretion of our Board of Directors and will depend upon a number of factors, including, but not limited to, future earnings, the success of our business, our capital requirements, our general financial condition and future prospects, general business conditions, the consent of our lender and such other factors as the Board of Directors may deem relevant. +Issuer Purchases of Equity Securities +On August 22, 2011, our Board of Directors approved a stock repurchase program. Under the program, we may acquire up to $3 million of our outstanding common stock from time to time until August 2012. Purchases may be made in the open market (including pursuant to Rule 10b5-1 trading plans), in privately negotiated transactions or in block purchases, depending on market conditions, share price and other factors. The table below details our common stock repurchases during the fourth quarter of Fiscal 2012. All repurchased shares have been retired and resumed their status as authorized and unissued shares of our common stock. +Issuer Purchases of Equity Securities +Period +Total Number +of Shares +Purchased +Average +Price Paid +per Share +Total Number of +Shares +Purchased as +Part of Publicly +Announced Plans +or Programs +Maximum Number +(or Approximate +Dollar Value) of +Shares that May Yet +Be Purchased Under +the Plans or +Programs +Jan 1 to Jan 31, 2012 +— +$ +— +— +Feb 1 to Feb 29, 2012 +239,273 +1.48 +239,273 +Mar 1 to Mar 31, 2012 +— +— +— +Total +239,273 +$ +1.48 +239,273 +$ +2,239,470 +16 +Table of Contents +ITEM 6. SELECTED FINANCIAL DATA +As a smaller reporting company, we are not required to make any disclosure pursuant to this Item 6. +ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS +You should read the following discussion and analysis in conjunction with our Consolidated Financial Statements and related Notes thereto included in Part IV, Item 15 of this report and the “Risk Factors” section in Item 1A, as well as other cautionary statements and risks described elsewhere in this report, before deciding to purchase, hold or sell our common stock. +Overview +General. We are a leading provider of intelligent information solutions to the traffic management market. We are focused on the development and application of advanced technologies and software-based information systems that reduce traffic congestion, provide measurement, management and predictive traffic analytics and improve the safety of surface transportation systems infrastructure. Additionally, we believe that our products, services and solutions, in conjunction with sound traffic management, minimize the environmental impact of traffic congestion. By combining image processing, traffic engineering, information technology and other products and services, we offer a broad range of ITS solutions to customers worldwide. +Acquisitions. In November 2011, we acquired all of the outstanding capital stock of Berkeley Transportation Systems, Inc. (“BTS”), a privately-held company based in Berkeley, California which specializes in transportation performance measurement. On or shortly after the acquisition date, we paid a total of approximately $840,000 in cash. Additionally, we are scheduled to pay up to a total of $1.5 million within 36 months after the acquisition date pursuant to holdback, deferred payment and earn-out provisions. +In January 2011, we acquired all of the capital stock of Meridian Environmental Technology, Inc. (“MET”) for an initial cash payment of approximately $1.6 million. MET specializes in 511 advanced traveler information systems and offers Maintenance Decision Support System (“MDSS”) management tools that allow users to create solutions to meet roadway maintenance decision needs. We also agreed to pay up to $1 million on each of the first two anniversaries of the closing of the acquisition, as well as up to an additional $2 million under a 24-month earn-out provision. In January 2012, we made a cash payment of approximately $668,000 of the first deferred payment to the shareholders of MET and held back $250,000 in accordance with certain provisions of the purchase agreement. We expect the contingencies related to the $250,000 holdback to be resolved sometime in the first fiscal quarter of the fiscal year ending March 31, 2013, at which time we may or may not release the holdback. Additionally, no amounts were earned by the MET shareholders related to the first year earn-out provision. +In April 2009, we completed the acquisition of certain assets of Hamilton Signal, Inc., which included the Abacus system, for an aggregate purchase price of approximately $518,000 in cash. +Refer to Note 4 of Notes to Consolidated Financial Statements, included in Part IV, Item 15 of this report, for additional discussion on these acquisitions. +Sale of Vehicle Sensors . On July 29, 2011, we completed the sale of substantially all of our assets used in connection with our Vehicle Sensors segment to Bendix pursuant to an Asset Purchase Agreement signed on July 25, 2011 (the “Asset Sale”). Upon closing, Bendix paid us $14 million in cash, subject to a $2 million holdback and adjustments based upon the working capital of the Vehicle Sensors segment at closing, and Bendix assumed certain specified obligations and liabilities of the Vehicle Sensors segment. We are entitled to additional consideration in the form of certain performance and royalty-related earn-outs. As a result of the Asset Sale, we no longer operate in the Vehicle Sensors segment. Refer to Note 3 of Notes to Consolidated Financial Statements, included in Part IV, Item 15 of this report, for additional discussion on this transaction. +Business Segments. Subsequent to the Asset Sale, we now operate in two reportable segments: Roadway Sensors and Transportation Systems. +Roadway Sensors +The Roadway Sensors segment includes, among other products, our Vantage, Versicam, Pico, Vantage Vector and Abacus vehicle detection systems for traffic intersection control, incident detection and certain highway traffic data collection applications. +17 +Table of Contents +Transportation Systems +The Transportation Systems segment includes transportation engineering and consulting services and the development of transportation management and traveler information systems for the ITS industry. This segment includes the operations of MET, which specializes in 511 advanced traveler information systems and offers MDSS management tools that allow users to create solutions to meet roadway maintenance decision needs. Also included in this segment are the operations of BTS, which specializes in transportation performance measurement. +Business. Given the current ongoing uncertainties regarding global economic conditions, we continue to remain cautious about our overall business. We believe the overall ongoing unfavorable economic environment has negatively affected, and may continue to negatively affect, our financial results for the foreseeable future, and may impair our ability to accurately forecast our future financial performance and other business trends. In addition, since the end users of a majority of our products and services are governmental entities, we have been, and may continue to be, negatively affected by the budgetary issues and delays in purchasing decisions that many municipalities and other state and local agencies continue to face. Spending for new roadways, new systems to address traffic congestion and other transportation infrastructure improvements has been delayed or eliminated in some instances. However, we believe the need to rebuild and modernize aging transportation infrastructure will continue, and in addition to funds available through recent federal stimulus packages and federal highway bills, there exist various other funding mechanisms that support transportation infrastructure and related projects. These include bonds, dedicated sales and gas tax measures and other alternative funding sources. +Critical Accounting Policies and Estimates +Management’s Discussion and Analysis of Financial Condition and Results of Operations is based on our consolidated financial statements included herein, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and related disclosures of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. On an ongoing basis, we evaluate these estimates and assumptions, including those related to the collectability of accounts receivable, the valuation of inventories, the recoverability of long-lived assets and goodwill, the realizability of deferred tax assets, accounting for stock-based compensation, the valuation of equity instruments, warranty reserves and other contingencies. We base these estimates on historical experience and on various other factors that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. These estimates and assumptions by their nature involve risks and uncertainties, and may prove to be inaccurate. In the event that any of our estimates or assumptions are inaccurate in any material respect, it could have a material adverse effect on our reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. +The following critical accounting policies affect our more significant judgments and estimates used in the preparation of our consolidated financial statements. +Revenue Recognition. Product revenues and related costs of sales are recognized when all of the following criteria are met: (i) persuasive evidence of an arrangement exists, (ii) delivery has occurred, (iii) the price to the customer is fixed or determinable and (iv) collection of the receivable is reasonably assured. These criteria are typically met at the time of product shipment, but in certain circumstances, may not be met until receipt or acceptance by the customer. Accordingly, at the date revenue is recognized, the significant obligations or uncertainties concerning the sale have been resolved. +We recognize revenue from the sale of deliverables that are part of a multiple-element arrangement in accordance with applicable accounting guidance that establishes a relative selling price hierarchy permitting the use of an estimated selling price to determine the allocation of arrangement consideration to a deliverable in a multiple-element arrangement where neither vendor specific objective evidence (“VSOE”) nor third-party evidence (“TPE”) of fair value is available for that deliverable. In the absence of VSOE or TPE of the standalone selling price for one or more delivered or undelivered elements that have stand alone value in a multiple-element arrangement, we are required to estimate the selling prices of those elements. Overall arrangement consideration is allocated to each element (both delivered and undelivered items) based on their relative selling prices, regardless of whether those selling prices are evidenced by VSOE or TPE or are based on our estimated selling prices. +We account for multiple-element arrangements that consist only of software and software-related services in accordance with industry-specific accounting guidance for software and software-related transactions. For such transactions, revenue on arrangements that include multiple elements is allocated to each element based on the relative fair value of each element, and fair value is determined by VSOE. If we cannot objectively determine the fair value of any undelivered element included in such multiple-element arrangements and the only undelivered element is post-contract customer support or maintenance, and VSOE of the fair value of such support or maintenance does not exist, revenue from the entire arrangement is recognized ratably over the support period. When the +18 +Table of Contents +fair value of a delivered element has not been established but VSOE of fair value exists for the undelivered elements, we use the residual method to recognize revenue if the fair value of all undelivered elements is determinable. Under the residual method, the fair value of the undelivered elements is deferred and the remaining portion of the arrangement fee is allocated to the delivered elements and is recognized as revenue. +Revenues from follow-on service and support, for which we generally charge separately, are recorded in the period in which the services are performed and are included in our net sales. +Contract Revenues +Contract revenues are derived primarily from long-term contracts with governmental agencies. When appropriate, contract revenues are recognized using the percentage of completion method of accounting. Under this method, revenue is recognized as contract performance progresses, and is based on the relationship of costs incurred to total estimated costs. We generally utilize a cost-to-cost approach in applying the percentage of completion method, whereby revenue is earned in proportion to total costs incurred, divided by total costs expected to be incurred. Costs are generally determined from actual hours of labor effort expended. Direct non-labor costs are charged as incurred plus any mark-up permitted under the contract. Certain of our contract revenues are recognized as services are performed and amounts are earned, which is measured by time incurred or other contractual milestones or output measures. Contract revenues accounted for in this manner generally relate to certain cost-plus fixed fee or time-and-materials contracts for which no specific maximum contract values are stipulated. +Any anticipated losses on contracts are charged to operations when identified. Changes in job performance and estimated profitability, including those arising from contract penalty provisions and final contract settlements, may result in revisions to recognized costs and revenues and are recognized in the period in which the revisions are determined. Profit incentives are included in contract revenues when their realization is reasonably assured. Under the percentage of completion method, recognition of profit is dependent upon the accuracy of a variety of estimates, including engineering progress, materials quantities, and achievement of milestones, incentives, penalty provisions, labor productivity, cost estimates and others. Such estimates are based on various professional judgments we make with respect to those factors and are subject to change as the project proceeds and new information becomes available. We have a history of making reasonably dependable estimates of the extent of progress towards completion and contract completion costs on our long-term contracts. However, due to uncertainties inherent in the estimation process, it is possible that actual completion costs may vary from our estimates. To the extent there are material differences between our estimates and our actual results, our future results of operations will be affected. +Substantially all of our contracts are of the following types: +Cost-Plus Fixed Fee. Under cost-plus fixed fee contracts, we charge our customers for our costs, including both direct and indirect costs, plus a fixed negotiated fee. +Fixed-Price. Under fixed-price contracts, our customers pay us an agreed fixed amount negotiated in advance for a specified scope of work. Prior to completion, our recognized profit margins on any fixed price contract depend on the accuracy of our estimates and will increase to the extent that our current estimates of aggregate actual costs are below amounts previously estimated. Conversely, if our current estimated costs exceed prior estimates, our profit margins will decrease and we may realize a loss on a project. +Time-and-Materials. Under our time-and-materials contracts, we negotiate hourly billing rates and charge our customers based on the actual time that we spend on a project. In addition, customers reimburse us for our actual out-of-pocket costs of materials and other direct incidental expenditures incurred in connection with our performance under the contract. The majority of our time-and-material contracts are subject to maximum contract values and, accordingly, revenues under these contracts are generally recognized under the percentage of completion method. +Accounts Receivable. We estimate the collectability of customer receivables on an ongoing basis by reviewing invoices outstanding greater than a certain period of time. We record an allowance for doubtful accounts for specific receivables deemed to be at risk for collection as well as a general allowance based on our historical collections experience. Considerable judgment is required in assessing and estimating the ultimate realization of trade receivables, including the current credit-worthiness of each customer. If the financial condition of our customers deteriorates, resulting in an impairment of their ability to make required payments, additional allowances may be required that could adversely affect our operating results. +Inventories. Inventories consist of finished goods, work-in-process and raw materials and are stated at the lower of cost or market. We write down the carrying value of our inventories to net realizable value for estimated excess and obsolete inventories in an amount equal to the difference between the cost of the inventories and their estimated realizable value. These estimates are based on management’s judgments and assumptions as to future demand requirements and our evaluation of market conditions. Demand for our +19 +Table of Contents +products may fluctuate significantly over time, and actual demand and market conditions may be more or less favorable than those projected by management. In the event that actual demand is lower than originally projected, additional inventory write-downs may be required. Estimated inventory write-downs, once established, are not reversed until the related inventory has been sold or scrapped, so if actual market conditions are more favorable in the fiscal periods subsequent to those in which we record significant write-downs, we may have higher gross margins when products are sold. +Goodwill and Other Long-Lived Assets. Goodwill is recorded as the difference, if any, between the aggregate consideration paid for an acquisition and the fair value of the acquired net tangible and intangible assets. Other long-lived assets primarily represent purchased intangible assets including developed technology, customer relationships, trade names and patents. We currently amortize our intangible assets with definitive lives over periods ranging from one to seven years using a method that reflects the pattern in which the economic benefits of the intangible asset are consumed or otherwise used or, if that pattern cannot be reliably determined, using a straight-line amortization method over the estimated useful life of the asset. +We evaluate goodwill on an annual basis in our fourth fiscal quarter or more frequently if we believe indicators of impairment exist. We have determined that our reporting units for purposes of testing for goodwill impairment are identical to our reportable segments for financial reporting purposes. In Fiscal 2012, we early adopted the new provisions issued by the Financial Accounting Standard Board (“FASB”) that are intended to simplify goodwill impairment testing. This guidance permits us to first assess qualitative factors to determine whether it is more likely than not that the fair value of a reporting unit is less than its carrying amount. If we conclude that it is more likely than not that the fair value of a reporting unit is less than its carrying amount, we conduct a two-step goodwill impairment test. The first step of the impairment test involves comparing the fair values of the applicable reporting units with their carrying values. We determine the fair values of our reporting units using the income valuation approach, as well as other generally accepted valuation methodologies. If the carrying amount of a reporting unit exceeds the reporting unit’s fair value, we perform the second step of the goodwill impairment test. The second step of the goodwill impairment test involves comparing the implied fair value of the affected reporting unit’s goodwill with the carrying value of that goodwill. The amount by which the carrying value of the goodwill exceeds its implied fair value, if any, is recognized as an impairment loss. +We test long-lived assets and purchased intangible assets (other than goodwill) for impairment if we believe indicators of impairment exist. We determine whether the carrying value of an asset or asset group is recoverable, based on comparisons to undiscounted expected future cash flows the asset are expected to generate. If an asset is not recoverable, we record an impairment loss equal to the amount by which the carrying value of the asset exceeds its fair value. We primarily use the income valuation approach to determine the fair value of our long lived assets and purchased intangible assets. +Warranty. We generally provide a one to three year warranty from the original invoice date on all products, materials and workmanship. Defective products are either repaired or replaced, at our option, upon meeting certain criteria. We accrue a provision for the estimated costs that may be incurred for product warranties relating to a product as a component of cost of sales at the time revenue for that product is recognized. The accrued warranty provision is included within accrued expenses in the accompanying consolidated balance sheets. Should our actual experience of warranty returns be higher than anticipated, additional warranty reserves may be required, which would adversely affect our product gross profit and our operating results. +Income Taxes. We utilize the asset and liability method of accounting for income taxes, under which deferred taxes are determined based on the temporary differences between the financial statement and tax basis of assets and liabilities using tax rates expected to be in effect during the years in which the basis differences reverse. A valuation allowance is recorded when it is more-likely-than-not that some or all of the deferred tax assets will not be realized, which increases our income tax expense in the period such determination is made. +On an interim basis, we estimate what our anticipated annual effective tax rate will be, while also separately considering applicable discrete and other non-recurring items, and record a quarterly income tax provision in accordance with this anticipated rate. As the fiscal year progresses, we refine our estimates based upon actual events and financial results during the year. This estimation process can result in significant changes to our expected effective tax rate. When this occurs, we adjust our income tax provision during the quarter in which our estimates are refined so that the year-to-date provision reflects the expected annual effective tax rate. These changes, along with adjustments to our deferred taxes, among others, may create fluctuations in our overall effective tax rate from quarter to quarter. +Income tax positions must meet a more-likely-than-not recognition threshold to be recognized. Income tax positions that previously failed to meet the more-likely-than-not threshold are recognized in the first subsequent financial reporting period in which that threshold is met. Previously recognized tax positions that no longer meet the more-likely-than-not threshold are derecognized in the first subsequent financial reporting period in which that threshold is no longer met. +20 +Table of Contents +The application of tax laws and regulations is subject to legal and factual interpretation, judgment and uncertainty. Tax laws and regulations themselves are subject to change as a result of changes in fiscal policy, changes in legislation, the evolution of regulations and court rulings. Therefore, the actual liability for U.S. or foreign taxes may be materially different from our estimates, which could result in the need to record additional tax liabilities or potentially reverse previously recorded tax liabilities. +Stock-Based Compensation . We record stock-based compensation in the statements of operations as an expense, based on the estimated grant date fair value of our stock-based awards, whereby such fair values are amortized over the requisite service period. Our stock-based awards are currently comprised of common stock options and restricted stock units. The fair value of our common stock option awards is estimated on the grant date using the Black-Scholes-Merton option-pricing formula. While utilizing this model meets established requirements, the estimated fair values generated by it may not be indicative of the actual fair values of our common stock option awards as it does not consider certain factors important to those awards to employees, such as continued employment and periodic vesting requirements as well as limited transferability. The fair value of our restricted stock units is based on the closing market price of our common stock on the grant date. If there are any modifications or cancellations of the underlying unvested stock-based awards, we may be required to accelerate, increase or cancel any remaining unearned stock-based compensation expense. +Recent Accounting Pronouncements +Refer to Note 1 of Notes to Consolidated Financial Statements, included in Part IV, Item 15 of this report, for a discussion of recent accounting pronouncements. +Results of Operations +The following table sets forth certain statement of operations data as a percentage of total net sales and contract revenues for the periods indicated. +Year Ended March 31, +2012 +2011 +2010 +Net sales and contract revenues: +Net sales +47.4 +% +54.3 +% +49.0 +% +Contract revenues +52.6 +45.7 +51.0 +Total net sales and contract revenues +100.0 +% +100.0 +% +100.0 +% +Costs of net sales and contract revenues: +Cost of net sales +22.9 +25.9 +23.8 +Cost of contract revenues +37.6 +30.1 +33.6 +Gross profit +39.5 +44.0 +42.6 +Operating expenses: +Selling, general and administrative +30.8 +32.7 +30.4 +Research and development +5.4 +4.7 +5.1 +Amortization of intangible assets +0.9 +0.3 +0.2 +Change in fair value of contingent acquisition consideration +(1.1 +) +0.1 +0.0 +Impairment of goodwill +0.0 +15.3 +0.0 +Total operating expenses +36.0 +53.1 +35.7 +Operating income (loss) +3.5 +(9.1 +) +6.9 +Non-operating income (expense): +Other income, net +0.0 +0.0 +0.1 +Interest expense, net +(0.1 +) +(0.3 +) +(0.5 +) +Income (loss) from continuing operations before income taxes +3.4 +(9.4 +) +6.5 +Provision for income taxes +(1.1 +) +(0.5 +) +(1.9 +) +Income (loss) from continuing operations +2.3 +(9.9 +) +4.6 +Gain on sale of discontinued operation, net of tax +2.0 +0.0 +0.0 +Income (loss) from discontinued operation, net of tax +0.0 +(0.1 +) +(0.4 +) +Net income (loss) +4.3 +% +(10.0 +)% +4.2 +% +21 +Table of Contents +Analysis of Fiscal 2012, Fiscal 2011 and Fiscal 2010 Results of Operations +Net Sales and Contract Revenues . Net sales are comprised of sales from our Roadway Sensors segment. Contract revenues consist of revenues from our Transportation Systems segment. +The following tables present details of our net sales and contract revenues for Fiscal 2012 compared to Fiscal 2011, and Fiscal 2011 compared to Fiscal 2010: +Year Ended March 31, +Increase +% +2012 +2011 +(Decrease) +Change +(In thousands, except percentages) +Net sales +$ +27,679 +$ +28,208 +$ +(529 +) +(1.9 +)% +Contract revenues +30,727 +23,758 +6,969 +29.3 +Total net sales and contract revenues +$ +58,406 +$ +51,966 +$ +6,440 +12.4 +Year Ended March 31, +Increase +% +2011 +2010 +(Decrease) +Change +(In thousands, except percentages) +Net sales +$ +28,208 +$ +25,341 +$ +2,867 +11.3 +% +Contract revenues +23,758 +26,413 +(2,655 +) +(10.1 +) +Total net sales and contract revenues +$ +51,966 +$ +51,754 +$ +212 +0.4 +We currently have a diverse customer base, and no individual customer represented greater than 10% of our total a net sales and contract revenues for Fiscal 2012, Fiscal 2011 or Fiscal 2010. +Net Sales +Net sales of Roadway Sensors products in Fiscal 2012 were marginally lower compared to Fiscal 2011 due primarily to certain international customer orders in Fiscal 2011 which did not recur in the current year. We believe we continued to gain domestic market share in Fiscal 2012, mainly as a result of new product introductions and other competitive advantages; however, our gains in market share were offset in part by lower prices due to competitive pressures. The increase in Roadway Sensors net sales in Fiscal 2011, as compared to Fiscal 2010, were driven by higher unit sales domestically from both our direct sales and dealer markets, which was offset in part by lower prices due to competitive pressures. We also saw particular strength, both domestically and internationally, in certain of our newer product lines which were introduced within the previous two fiscal years. Additionally, we believe we gained market share as a result of these new product introductions. +Contract Revenues +Our contract revenues are primarily dependent upon the continued availability of funding at the local, state and federal levels from the various agencies and departments of transportation. Contract revenues in Fiscal 2012 increased compared to Fiscal 2011 in part due to several significant project wins in the last two quarters of Fiscal 2012. Additionally in Fiscal 2012, we recognized $5.1 million and $936,000 of total contract revenues derived from our acquisitions of MET and BTS, respectively, which contributed to the overall increase. In Fiscal 2012, the Transportation System segment continued to experience similar general lengthening of overall sales cycles, government budget constraints and funding delays and/or reductions on various existing contracts that existed in Fiscal 2011. Our Transportation Systems contract revenues decreased in Fiscal 2011 compared to Fiscal 2010 primarily as a result of the ongoing weakness in the markets this segment serves, which has been aggravated by the general lengthening of the overall sales cycle, from the bid and proposal process, to the signing of a contract and commencement of work on a project. Government budgeting constraints and funding delays or reductions on various existing contracts, particularly in the Southeast region of the U.S., also contributed to the decline in our contract revenues. Our private planning group, which focuses on private development consulting, has likewise experienced particular weakness. Additionally, our Fiscal 2011 contract revenues included approximately $1.5 million of revenues attributable to MET, which we acquired in January 2011. +Going forward, we plan to continue to pursue larger contracts that may contain significant sub-consulting content, which will likely contribute to variability in the timing and amount of our contract revenues and margins from period to period. We also intend to continue to expand our foreign operations by pursuing additional international opportunities in the Middle East and other regions. Among other factors, we believe the ability of our Transportation Systems segment to grow and successfully win and service new contracts will be highly dependent upon our continued success in recruiting and retaining qualified personnel, as well as upon the passage of a new Federal Highway Bill and other government funding initiatives in the markets we serve. +22 +Table of Contents +Gross Profit . The following tables present details of our gross profit for Fiscal 2012 compared to Fiscal 2011, and Fiscal 2011 compared to Fiscal 2010: +Year Ended March 31, +% +2012 +2011 +Increase +Change +(In thousands, except percentages) +Total gross profit +$ +23,071 +$ +22,884 +$ +187 +0.8 +% +Total gross profit as a % of total net sales and contract revenues +39.5 +% +44.0 +% +Gross profit as a % of net sales +51.6 +% +52.3 +% +Gross profit as a % of contract revenues +28.6 +% +34.2 +% +Year Ended March 31, +% +2011 +2010 +Increase +Change +(In thousands, except percentages) +Total gross profit +$ +22,884 +$ +22,042 +$ +842 +3.8 +% +Total gross profit as a % of total net sales and contract revenues +44.0 +% +42.6 +% +Gross profit as a % of net sales +52.3 +% +51.4 +% +Gross profit as a % of contract revenues +34.2 +% +34.1 +% +Our total gross profit as a percentage of total net sales and contract revenues decreased in Fiscal 2012 compared to Fiscal 2011 primarily as a result of our product and service mix, whereby Transportation Systems consulting revenues (discussed below) significantly increased as percentage of the total. Our net sales (derived from our Roadway Sensors segment) represented approximately 47% of our total net sales and contract revenues in Fiscal 2012 compared to 54% in Fiscal 2011. Our net sales generally carry higher margins than our contract revenues, which are derived primarily from our consulting services. Our total gross profit as a percent of total net sales and contract revenues increased in Fiscal 2011 compared to Fiscal 2010 primarily as a result of our product and service mix. In Fiscal 2011, our net sales represented approximately 54% of our total net sales and contract revenues as compared to 49% in Fiscal 2010. +The decrease in gross profit as a percent of net sales in Fiscal 2012 as compared to Fiscal 2011 was primarily a result of sales mix as well as certain manufacturing overhead costs previously absorbed by sales of Vehicle Sensors products. The Vehicle Sensors segment was divested in July 2011. Our gross margin on net sales can fluctuate in any specific quarter or year based on, among other factors, customer and product mix, competitive pricing requirements, product warranty costs and provisions for excess and obsolete inventories, as well as shifts of engineering resources from development activities to sustaining activities, which we record as cost of goods sold. +The increase in gross margin on net sales in Fiscal 2011 as compared to Fiscal 2010 was primarily a result of higher overall net sales and higher margins in Roadway Sensors during Fiscal 2011. Such higher margins were largely driven by our customer mix and lower costs for certain key materials. We generally enjoy higher gross margins on direct product sales as compared to sales throgh our dealer channel. +We recognize contract revenues and related gross profit using percentage of completion contract accounting when appropriate, while certain of our contract revenues are recognized as services are performed and amounts are earned, which is measured by time incurred or other contractual milestones or output measures. Therefore, the underlying mix of contract activity can affect the related gross profit recognized in any given period. Gross profit as a percent of contract revenues in Fiscal 2012 was lower than in Fiscal 2011 primarily due to the overall mix of contract revenues which in the current year contained a significant proportion of lower-margin sub-consulting content as well as lower margins stemming from seasonality due to the decrease in revenues from certain of our MDSS and weather forecasting services in the spring and summer time periods. Gross profit as percent of contract revenues in Fiscal 2011 were highly consistent with those of Fiscal 2010. We expect the variability and timing of contract mix and related sub-consulting content in our Transportation Systems segment in future periods, as well as factors such as paid holidays and our ability to efficiently utilize our workforce, will cause fluctuations in our margins from contract revenues from period to period. +23 +Table of Contents +Selling, General and Administrative Expense +The following table presents selling, general and administrative expense for Fiscal 2012 and Fiscal 2011: +Year Ended March 31, +2012 +2011 +% of Net +% of Net +Sales and +Sales and +Contract +Contract +Increase +% +Amount +Revenues +Amount +Revenues +(Decrease) +Change +(In thousands, except percentages) +Salary and personnel-related +$ +12,434 +21.3 +% +$ +11,952 +23.0 +% +$ +482 +4.0 +% +Facilities, insurance and supplies +1,853 +3.2 +1,379 +2.7 +474 +34.4 +Travel and conferences +1,568 +2.7 +1,205 +2.3 +363 +30.1 +Professional and outside services +1,778 +3.0 +2,150 +4.1 +(372 +) +(17.3 +) +Other +353 +0.6 +295 +0.6 +58 +19.7 +Selling, general and administrative +$ +17,986 +30.8 +% +$ +16,981 +32.7 +% +$ +1,005 +5.9 +The increase in selling, general and administrative expenses in Fiscal 2012 as compared to Fiscal 2011 was primarily due to (i) higher salary, travel and headcount-related expenses as we added certain key sales and marketing personnel, (ii) added personnel as well as facilities and other related operating costs as a result of the MET and BTS acquisitions, (iii) legal and professional services related to the sale of our Vehicle Sensors segment and (iv) certain other corporate initiatives related to the development of our performance measurement software. +The following table presents selling, general and administrative expense for Fiscal 2011 and 2010: +Year Ended March 31, +2011 +2010 +% of Net +% of Net +Sales and +Sales and +Contract +Contract +Increase +% +Amount +Revenues +Amount +Revenues +(Decrease) +Change +(In thousands, except percentages) +Salary and personnel-related +$ +11,952 +23.0 +% +$ +10,496 +20.3 +% +$ +1,456 +13.9 +% +Facilities, insurance and supplies +1,379 +2.7 +1,320 +2.6 +59 +4.5 +Travel and conferences +1,205 +2.3 +908 +1.8 +297 +32.7 +Professional and outside services +2,150 +4.1 +2,280 +4.4 +(130 +) +(5.7 +) +Other +295 +0.6 +706 +1.4 +(411 +) +(58.2 +) +Selling, general and administrative +$ +16,981 +32.7 +% +$ +15,710 +30.5 +% +$ +1,271 +8.1 +The increase in selling, general and administrative expenses in Fiscal 2011 as compared to Fiscal 2010 was primarily due to (i) higher selling and commission-related expenses for our Roadway Sensors segment, as total net sales increased approximately 11% from Fiscal 2010 levels, (ii) higher salary and headcount-related expenses as we have added certain key sales and marketing personnel in all of our business segments, including as a result of the acquisition of MET in January 2011, and (iii) additional legal and professional services related to our acquisition of MET, along with various other corporate initiatives. We also saw a shift from cost of sales to sales and marketing of certain of our headcount expenses in our Transportation Systems segment in Fiscal 2011 commensurate with the overall decline in this segment’s revenues and the reallocation of existing personnel in an effort to expand our contract backlog and increase contract revenues. Additionally, during Fiscal 2011, we realized approximately $250,000 in reversals of certain previously recorded bad debt expense (included in the “Other” category in the table above) as a result of collecting certain large accounts receivable balances. In prior periods, we had recorded an estimated allowance for doubtful accounts against these receivables given the uncertainty of collection at that time. In the future, our operating results in any given period may be favorably or adversely impacted as a result of our estimates of the realization of our accounts receivable. +24 +Table of Contents +Research and Development Expense +The following table presents research and development expense for Fiscal 2012 and Fiscal 2011: +Year Ended March 31, +2012 +2011 +% of Net +% of Net +Sales and +Sales and +Contract +Contract +Increase +% +Amount +Revenues +Amount +Revenues +(Decrease) +Change +(In thousands, except percentages) +Salary and personnel-related +$ +2,153 +3.7 +% +$ +1,736 +3.3 +% +$ +417 +24.0 +% +Facilities, development and supplies +792 +1.3 +557 +1.1 +235 +42.2 +Other +238 +0.4 +151 +0.3 +87 +57.6 +Research and development +$ +3,183 +5.4 +% +$ +2,444 +4.7 +% +$ +739 +30.2 +Research and development expenses for Fiscal 2012 were higher than Fiscal 2011 primarily due to (i) the allocation of additional resources to various development projects in our Roadway Sensors segment, including our Vantage Vector vehicle detection sensor, (ii) development costs related to our IterisPeMS information management solution, and (iii) additional headcount and other expenses in Fiscal 2012 related to the MET and BTS acquisitions. +The following table presents research and development expense for Fiscal 2011 and 2010: +Year Ended March 31, +2011 +2010 +% of Net +% of Net +Sales and +Sales and +Contract +Contract +Increase +% +Amount +Revenues +Amount +Revenues +(Decrease) +Change +(In thousands, except percentages) +Salary and personnel-related +$ +1,736 +3.3 +% +$ +1,857 +3.6 +% +$ +(121 +) +(6.5 +)% +Facilities, development and supplies +557 +1.1 +692 +1.3 +(135 +) +(19.5 +) +Other +151 +0.3 +96 +0.2 +55 +57.3 +Research and development +$ +2,444 +4.7 +% +$ +2,645 +5.1 +% +$ +(201 +) +(7.6 +) +Research and development expenses for Fiscal 2011 were generally consistent, in total, with those of Fiscal 2010. We believe research and development activities are crucial to our ability to continue to be a leader in our markets. +Impairment of Goodwill +In Fiscal 2012, we early adopted the new provisions issued by the FASB that are intended to simplify goodwill impairment testing. The updated guidance permits us to first assess qualitative factors to determine whether it is more likely than not that the fair value of a reporting unit is less than its carrying amount. If we conclude that it is more likely than not that the fair value of a reporting unit is less than its carrying amount, we conduct a two-step goodwill impairment test. We performed the annual impairment assessment of the carrying value of goodwill for Fiscal 2012 in the fourth fiscal quarter. Based on our assessments, we determined that no impairment was indicated as the estimated fair value of each reporting unit exceeded its respective carrying value. +During Fiscal 2011, due primarily to lower than expected operating results in our Transportation Systems reporting unit, as well as ongoing weakness specifically in the Transportation Systems markets, we determined it was necessary to perform an interim test of impairment of the carrying value of goodwill in our Transportation Systems reporting unit as of December 31, 2010. In performing the first step in this analysis, we estimated the fair value of our Transportation Systems reporting unit using the income approach. As of December 31, 2010, we determined that the carrying value of our Transportation Systems reporting unit exceeded its estimated fair value and, accordingly, we performed the second step of the impairment analysis to estimate the implied fair value of the goodwill of this reporting unit. +25 +Table of Contents +The implied fair value of goodwill was determined in the same manner utilized to estimate the amount of goodwill recognized in a business combination. To determine this value, we estimated the fair value of the assets and liabilities, including certain intangible assets, to be allocated to the Transportation Systems reporting unit as of December 31, 2010. The implied fair value of goodwill was measured as the difference between the estimated fair value of the reporting unit over the estimated fair value amounts of its assets and liabilities. The impairment loss for the Transportation Systems reporting unit was measured by the amount the carrying value of its goodwill exceeded the implied fair value of the goodwill. Accordingly, in order to write down Transportation Systems goodwill with a carrying value of $14.9 million to its implied fair value of $6.9 million, we recorded an impairment charge of $8.0 million in the three months ended December 31, 2010, the third quarter of Fiscal 2011. +As a result of the impairment charge taken in Fiscal 2011, we believe we have no goodwill at risk, as the estimated fair values of our Roadway Sensors and Transportations Systems reporting units significantly exceeded their carrying values at March 31, 2012. If our actual financial results, or the plans and estimates used in future goodwill impairment analyses, are lower than the original estimates used to assess for impairment of our goodwill, we could incur future goodwill impairment charges. +Interest Expense, Net +Net interest expense was approximately $72,000, $152,000 and $264,000 in Fiscal 2012, Fiscal 2011 and Fiscal 2010, respectively. The sequential decreases were primarily due to our lower overall level of borrowings, as we continue to make monthly principal payments on our term note. See “Liquidity and Capital Resources” below for additional details on our borrowings. +Income Taxes +The following table presents our provision for income taxes for Fiscal 2012, Fiscal 2011 and Fiscal 2010: +Year Ended March 31, +2012 +2011 +2010 +(In thousands, except percentages) +Provision for income taxes +$ +643 +$ +278 +$ +960 +Effective tax rate +33.0 +% +-5.7 +% +28.6 +% +Our effective tax rate for Fiscal 2012 was favorably impacted by the recognition of approximately $276,000 of previously unrecognized tax benefits during the year due to the expiration of statutes limitation in various jurisdictions, by the recognition of tax credits of approximately $246,000 for research and development activities, and by approximately $211,000 of tax benefit from non-taxable favorable fair value adjustments recognized for financial statement purposes. These favorable impacts were partially offset by the impact of recognizing approximately $466,000 of expense upon the expiration of a state net operating loss, net of federal benefit. Our effective tax rate for Fiscal 2011 was impacted unfavorably by a portion of the charge recorded for the impairment of goodwill, amounting to approximately $2.2 million, for which there is no corresponding tax basis. This unfavorable impact was partially offset by the impact of the recognition of approximately $327,000 of previously unrecognized tax benefits during the year due to expiration of certain federal and state statutes in various jurisdictions. Our effective tax rate for Fiscal 2010 was favorably impacted by the recognition of approximately $414,000 of unrecognized tax benefits during the year due to the expiration of certain federal and state statutes in various jurisdictions. +As of March 31, 2012 and 2011, respectively, we determined that it was more likely than not that our deferred tax assets will be realized. Accordingly, no valuation allowance has been recorded against our deferred tax assets as of either such dates. In making our determination as to the realizability of our deferred tax assets, we reviewed all available positive and negative evidence, including reversal of deferred tax liabilities, potential carrybacks, projected future taxable income, tax planning strategies and recent financial performance. +As we update our estimates in future periods, adjustments to our deferred tax asset and valuation allowance may be necessary. We anticipate this will cause our future overall effective tax rate in any given period to fluctuate from prior effective tax rates and statutory tax rates. We utilize the liability method of accounting for income taxes. We record net deferred tax assets to the extent that we believe these assets will more likely than not be realized. In making such determination, we consider all available positive and negative evidence, including, but not limited to, scheduled reversals of deferred tax liabilities, projected future taxable income, tax planning strategies and recent financial performance. +26 +Table of Contents +At March 31, 2012, we had $25.0 million of federal net operating loss carryforwards and $10.9 million of state net operating loss carryforwards that begin to expire in 2021 and 2014, respectively. Although the impact cannot be precisely determined at this time, we believe that our net operating loss carryforwards will cause us to have future income tax payments that are substantially lower than the income tax liability calculated using statutory tax rates. Due to changes in stock ownership, our federal net operating loss carryforwards and other federal attributes are subject to a Section 382 annual limitation. +Liquidity and Capital Resources +Cash Flows +We have historically financed our operations with a combination of cash flows from operations, borrowings under credit facilities and the sale of equity securities. We currently rely on cash flows from operations and the availability of borrowings on a line of credit facility to fund our operations, which we believe to be sufficient to fund our operations for at least the next twelve months. However, we may need or choose to raise additional capital to fund potential future acquisitions and our future growth. We may raise such funds by selling equity or debt securities to the public or to selected investors or by borrowing money from financial institutions. If we raise additional funds by issuing equity or convertible debt securities, our existing stockholders may experience significant dilution and any equity securities that may be issued may have rights senior to our existing stockholders. +At March 31, 2012, we had $28.4 million in working capital, which included no borrowings on our $12.0 million line of credit and $18.7 million in cash and cash equivalents. This compares to working capital of $24.8 million at March 31, 2011, which included no borrowings on our line of credit and $11.8 million in cash and cash equivalents. +The following table summarizes our cash flows for Fiscal 2012, Fiscal 2011 and Fiscal 2010: +Year Ended March 31, +2012 +2011 +2010 +(In thousands) +Net cash provided by (used in): +Operating activities +$ +668 +$ +5,346 +$ +6,484 +Investing activities +10,002 +(1,530 +) +(594 +) +Financing activities +(3,787 +) +(2,403 +) +(1,857 +) +Operating Activities. Cash provided by our operations in Fiscal 2012 was the result of (i) adding back to net income $907,000 of depreciation expense, $331,000 of stock-based compensation expense, $504,000 of amortization expense and $286,000 of deferred tax assets, (ii) deducting from net income $619,000 in changes in the fair value of contingent consideration related to our recent acquisition of MET and BTS and $1.2 million for the gain on sale of Vehicle Sensors and (iii) $2.1 million in negative cash flows resulting from changes in our operating assets and liabilities during Fiscal 2012, all of which was partially offset by our net income of $2.5 million for such fiscal year. +Our accounts receivable and net costs and estimated earnings in excess of billings increased approximately $3.0 million, or 22%, during Fiscal 2012 mainly as a result of a 12% year-over-year increase in net sales and contract revenues as well as the timing of collection on certain receivables. In the future, our accounts receivable and net costs and estimated earnings in excess of billings accounts are likely to be determined based upon, among other factors, increases or decreases in net sales and contract revenues, the timing of collections of existing receivables and our ability to timely bill billings in excess of costs amounts. We try to offset significant increases in accounts receivables through increased and focused collection efforts; however, we cannot assure you that our efforts will be successful. +The increase in accounts payable by approximately $1.1 million during Fiscal 2012 was largely driven by the general timing of payments to vendors and sub-consultants. +Cash provided by our operations in Fiscal 2011 was the result of (i) $9.9 million in non-cash items within the statement of operations, primarily $8.0 million for the impairment of goodwill, depreciation expense of $1.0 million and stock-based compensation expense of $382,000; and (ii) $614,000 in positive cash flows resulting from changes in our operating assets and liabilities during Fiscal 2011, all of which was partially offset by our net loss of $5.2 million for such fiscal year. +Our inventories increased approximately $953,000, or 35%, during Fiscal 2011 as we built up certain inventories on hand in Fiscal 2011 to meet anticipated increases in our product net sales in our the Roadway Sensors segment. In the future, our inventory levels are likely to continue to be determined based upon, among other factors, the level of purchase orders we receive from our customers, the stage at which our products are in their respective product life cycles, and competitive situations in the marketplace. We attempt to balance such considerations against risk of obsolescence and potentially excess inventory levels. +27 +Table of Contents +The increase in accounts payable by approximately $920,000 from March 31, 2010 to March 31, 2011 was primarily driven by our increased inventory levels and the general timing of payments to vendors. +Cash provided by our operations in Fiscal 2010 was primarily the result of (i) our Fiscal 2010 net income of $2.2 million; (ii) $2.5 million in non-cash items within the statement of operations, primarily consisting of adjustments to our deferred tax assets of $1.0 million, depreciation expense of $986,000 and stock-based compensation expense of $375,000; and (iii) $1.7 million in cash resulting from changes in our operating assets and liabilities during the year. +Investing Activities. Cash provided by our investing activities for Fiscal 2012 consisted of (i) $11.4 million in proceeds from the sale of the Vehicle Sensors segment, (ii) $1.0 million used for the acquisition of MET and BTS, which consisted of $840,000 for the initial purchase of BTS and $129,000 related to purchase price adjustments for the purchase of MET, (iii) purchases of property and equipment of $337,000 and (iv) capitalized software of $138,000 related to IterisPeMS. Cash used in our investing activities for Fiscal 2011 consisted of $1.1 million used for the acquisition of MET and purchases of property and equipment of $414,000. Our investing activities for Fiscal 2010 consisted of purchases of property and equipment of $294,000, as well as $300,000 representing the initial payment for the acquisition of certain assets of Hamilton Signal, Inc. For further information on our acquisitions, refer to Note 4 of Notes to Consolidated Financial Statements included in Part IV, Item 15 of this report. +Financing Activities. Net cash used in our financing activities during Fiscal 2012 primarily consisted of $2.3 million in payments on our long-term debt, which consists of a bank term note, $112,000 for the second anniversary payment for the Hamilton Signal acquisition, $676,000 related to the first year deferred payment to MET and $754,000 used to repurchase our common stock under our stock repurchase program announced in August 2011. Net cash used in our financing activities during Fiscal 2011 primarily consisted of $2.4 million in payments on our term note and $106,000 for the first anniversary payment for the Hamilton Signal acquisition. Net cash used in our financing activities during Fiscal 2010 consisted of net payments on our term note of $2.0 million. The net payments on our term note during Fiscal 2010 were partially offset by $143,000 in proceeds received from the exercise in Fiscal 2010 of outstanding stock options to purchase shares of our common stock. +Borrowings +In October 2008, we entered into a $19.5 million credit facility with California Bank & Trust (the “Bank”), which provided for a two-year revolving line of credit with borrowings of up to $12.0 million and a $7.5 million term note (discussed below). In September 2010, we entered into a modification agreement with the Bank to extend the expiration date of our revolving line of credit to October 1, 2012. Interest on borrowed amounts under the revolving line of credit are payable monthly at a rate equal to the current stated prime rate (3.25% at March 31, 2012) up to the current stated prime rate plus 0.50%, depending on aggregate deposit balances maintained at the bank in relation to the total loan commitment under the credit facility. We are obligated to pay an unused line fee of 0.25% per annum applied to the average unused portion of the revolving line of credit during the preceding month. The revolving line of credit does not contain any early termination fees and is secured by substantially all of our assets. As of March 31, 2012, no amounts were outstanding under the revolving line of credit portion of the facility. Availability under this line of credit may be reduced or otherwise limited as a result of our obligations to comply with certain financial covenants, as described further below. +As of March 31, 2012, we had outstanding borrowings of approximately $634,000 under our bank term note, which expires on May 1, 2013. Principal payments under this term note are required to be repaid in monthly installments of $152,000. Additionally, beginning on November 1, 2009, and on November 1 of each year thereafter, we are required to repay additional principal of up to $500,000, calculated based on certain financial measures, as further defined in the loan agreement. These additional principal payments effectively reduce the total number of monthly installments necessary to repay the term note. To date, we have made additional principal payments of $500,000 on each of November 1, 2011, 2010 and 2009. Interest on the term note is payable monthly at a rate equal to the current stated prime rate plus 0.50% up to the current stated prime rate plus 1.00%, depending on aggregate deposit balances maintained at the bank in relation to the total loan commitment under the credit facility. The term note contains no early termination fees and, along with our revolving line of credit discussed above, is secured by substantially all of our assets. We currently expect the remaining outstanding balance of the term note will be paid off in full by June 30, 2012. +In connection with our credit facility and loan agreement with the Bank, we are also required to comply with certain quarterly financial covenants. These include achieving ratios for working capital and debt service, as well as maintaining a level of profitability, all of which are further defined in the agreement. While we believe we are currently in compliance with all such financial covenants, we cannot assure you that we will not violate one or more covenants in the future. If we were to be in violation of covenants under this agreement, our lender could choose to accelerate payment on all outstanding loan balances and pursue its security interest in our assets. In this event, we cannot assure you that we would be able to quickly obtain equivalent or suitable replacement financing on acceptable terms, on a timely basis, or at all. If we were not able to secure alternative sources of financing, such acceleration would have a material adverse impact on our business and financial condition. +28 +Table of Contents +Off-Balance Sheet Arrangements +Other than our operating leases, which are further described at Note 9 of Notes to Consolidated Financial Statements, included in Part IV, Item 15 of this report, we do not believe we have any other material off-balance sheet arrangements at March 31, 2012. +Seasonality +We have historically experienced seasonality, particularly with respect to our Roadway Sensors net sales in our third and fourth fiscal quarters due to a reduction in road construction and repairs during the winter months due to inclement weather conditions. With the addition of MET in January 2011, we have also experienced seasonality related to certain MDSS services in our first and second fiscal quarters mainly because these services are generally not required in the summer months. +ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK +Interest Rate Risk +Our exposure to interest rate risk is limited to our line of credit and our bank term note. Our line of credit bears interest equal to the prevailing prime rate (3.25% at March 31, 2012) plus 0% to 1.0%. We do not believe that a 10% increase in the interest rate on our line of credit or term note would have a material impact on our financial position, operating results or cash flows. In addition, we believe that the carrying value of our outstanding debt under our credit facility approximates fair value. +ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA +The financial statements and supplementary data required by Regulation S-X are included in Part IV, Item 15 of this report. +ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE +None. +ITEM 9A. CONTROLS AND PROCEDURES +(a) Evaluation of disclosure controls and procedures. In accordance with Rule 13a-15(b) of the Securities Exchange Act of 1934, as of the end of the period covered by this Annual Report on Form 10-K, management evaluated, with the participation of the our President and Chief Executive Officer and the Chief Financial Officer, the effectiveness of the design and operation of our disclosure controls and procedures (as defined in Rule 13a-15(e) under the Exchange Act). Based upon their evaluation of these disclosure controls and procedures, the President and Chief Executive Officer and the Chief Financial Officer have concluded that our disclosure controls and procedures were effective as of the date of such evaluation in ensuring that information required to be disclosed in our Exchange Act reports is (1) recorded, processed, summarized and reported in a timely manner, and (2) accumulated and communicated to management, including the Company’s President and Chief Executive Officer and the Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure. +(b) Changes in internal control. There was no change in our internal control over financial reporting that occurred during the fourth quarter of Fiscal 2012 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting. +Inherent Limitations on Internal Control +A control system, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. Further, the benefits of controls must be considered relative to their costs. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of management override or improper acts, if any, have been detected. These inherent limitations include the realities that judgments in decision making can be faulty, and that breakdowns can occur because of simple errors. Additionally, controls can be circumvented by the individual acts of some persons, by collusion of two or more people, or by management override of the control. The design of any system of controls is also based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions. Because of the inherent limitations in a cost-effective control system, misstatements due to management override, error or improper acts may occur and not be detected. Any resulting misstatement or loss may have an adverse and material effect on our business, financial condition and results of operations. +29 +Table of Contents +Management’s Report on Internal Control Over Financial Reporting +Our management is responsible for establishing and maintaining adequate internal control over financial reporting. Our internal control system was designed to provide reasonable assurance to management and our Board of Directors regarding the effectiveness of our internal control processes over the preparation and fair presentation of published financial statements. +We have assessed the effectiveness of our internal controls over financial reporting as of March 31, 2012. In making this assessment, we used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (“COSO”) in Internal Control—Integrated Framework. Based on our assessment, we believe that, as of March 31, 2012, our internal control over financial reporting is effective based on those criteria. +This annual report does not include an attestation report of our independent registered public accounting firm regarding internal control over financial reporting. Management’s report was not subject to attestation by our independent registered public accounting firm pursuant to the rules of the SEC applicable to smaller reporting companies. +ITEM 9B . OTHER INFORMATION +None. +PART III +ITEM 10. DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE +(a) Identification of Directors. The information under the caption “Election of Directors,” appearing in our proxy statement for the 2012 Annual Meeting of Stockholders, is incorporated herein by reference. +(b) Identification of Executive Officers. The information under the caption “Executive Compensation and Other Information - Executive Officers,” appearing in our proxy statement for the 2012 Annual Meeting of Stockholders, is incorporated herein by reference. +(c) Compliance with Section 16(a) of the Exchange Act. The information under the caption “Section 16(a) Beneficial Ownership Reporting Compliance,” appearing in our proxy statement for the 2012 Annual Meeting of Stockholders, is incorporated herein by reference. +(d) Corporate Governance . The information under the caption “Corporate Governance,” appearing in our proxy statement for the 2012 Annual Meeting of Stockholders, is incorporated herein by reference. +(e) Audit Committee . The information under the caption “Board Meetings and Committees — Audit Committee,” appearing in our proxy statement for the 2012 Annual Meeting of Stockholders, is incorporated herein by reference. +ITEM 11. EXECUTIVE COMPENSATION +The information under the caption “Executive Compensation and Other Information,” appearing in our proxy statement for the 2012 Annual Meeting of Stockholders, is incorporated herein by reference. +30 +Table of Contents +ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS +The information under the captions “Equity Compensation Plans” and “Principal Stockholders and Common Stock Ownership of Certain Beneficial Owners and Management,” appearing in our proxy statement for the 2012 Annual Meeting of Stockholders, is incorporated herein by reference. +ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE +The information under the captions “Corporate Governance — Director Independence” and “Certain Transactions,” appearing in our proxy statement for the 2012 Annual Meeting of Stockholders, is incorporated herein by reference. +ITEM 14. PRINCIPAL ACCOUNTING FEES AND SERVICES +The information under the caption “Fees Paid to Independent Registered Public Accounting Firm,” appearing in our proxy statement for the 2012 Annual Meeting of Stockholders, is incorporated herein by reference. +PART IV +ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES +(a) Documents filed as part of this report: +1. Financial Statements. The following financial statements of Iteris, Inc. are included in a separate section of this Annual Report on Form 10-K commencing on the pages referenced below: +Report of Independent Registered Public Accounting Firm +34 +Consolidated Balance Sheets as of March 31, 2012 and 2011 +35 +Consolidated Statements of Operations for the fiscal years ended March 31, 2012, 2011 and 2010 +36 +Consolidated Statements of Stockholders’ Equity and Comprehensive Income (Loss) for the fiscal years ended March 31, 2012, 2011 and 2010 +37 +Consolidated Statements of Cash Flows for the fiscal years ended March 31, 2012, 2011 and 2010 +38 +Notes to Consolidated Financial Statements +39 +2. Exhibits . +The exhibits listed on the accompanying Exhibit Index immediately following the financial statements are filed as part of, or hereby incorporated by reference into, this report. +31 +Table of Contents +SIGNATURES +Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. +Dated: June 11, 2012 +ITERIS, INC. +(Registrant) +By +/S/ ABBAS MOHADDES +Abbas Mohaddes +Chief Executive Officer +(Principal Executive Officer) +POWER OF ATTORNEY +We, the undersigned officers and directors of Iteris, Inc., do hereby constitute and appoint James S. Miele and Abbas Mohaddes, and each of them, our true and lawful attorneys-in-fact and agents, each with full power of substitution and resubstitution, for him and in his name, place and stead, in any and all capacities, to sign any and all amendments to this report, and to file the same, with exhibits thereto, and other documents in connection therewith, with the Securities and Exchange Commission, granting unto said attorneys-in-fact and agents, and each of them, full power and authority to do and perform each and every act and thing requisite or necessary to be done in and about the premises, as fully to all intents and purposes as he might or could do in person, hereby, ratifying and confirming all that each of said attorneys-in-fact and agents, or his substitute or substitutes, may lawfully do or cause to be done by virtue hereof. +Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant in the capacities and on the dates indicated: +Signature +Title +Date +/s/ ABBAS MOHADDES +Director, President and Chief Executive Officer +June 11, 2012 +Abbas Mohaddes +(principal executive officer) +/s/ JAMES S. MIELE +Chief Financial Officer +June 11, 2012 +James S. Miele +(principal financial and accounting officer) +/s/ GREGORY A. MINER +Chairman of the Board +June 11, 2012 +Gregory A. Miner +/s/ RICHARD CHAR +Director +June 11, 2012 +Richard Char +/s/ KEVIN C. DALY +Director +June 11, 2012 +Kevin C. Daly, Ph.D. +/s/ JOEL SLUTZKY +Director +June 11, 2012 +Joel Slutzky +/s/ THOMAS L. THOMAS +Director +June 11, 2012 +Thomas L. Thomas +/s/ MIKEL WILLIAMS +Director +June 11, 2012 +Mikel Williams +32 +Table of Contents +Iteris, Inc. +Index to Consolidated Financial Statements +Report of Independent Registered Public Accounting Firm +34 +Consolidated Balance Sheets as of March 31, 2012 and 2011 +35 +Consolidated Statements of Operations for the fiscal years ended March 31, 2012, 2011 and 2010 +36 +Consolidated Statements of Stockholders’ Equity and Comprehensive Income (Loss) for the fiscal years ended March 31, 2012, 2011 and 2010 +37 +Consolidated Statements of Cash Flows for the fiscal years ended March 31, 2012, 2011 and 2010 +38 +Notes to Consolidated Financial Statements +39 +33 +Table of Contents +Report of Independent Registered Public Accounting Firm +To the Board of Directors and Stockholders +Iteris, Inc. +We have audited the accompanying consolidated balance sheets of Iteris, Inc. and subsidiaries as of March 31, 2012 and 2011, and the related consolidated statements of operations, stockholders’ equity and comprehensive income (loss), and cash flows for each of the three years in the period ended March 31, 2012. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits. +We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. Our audits included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. +In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Iteris, Inc. and subsidiaries as of March 31, 2012 and 2011, and the results of their operations and their cash flows for each of the three years in the period ended March 31, 2012, in conformity with U.S. generally accepted accounting principles. +/s/ McGladrey LLP +Irvine, California +June 11, 2012 +34 +Table of Contents +Iteris, Inc. +Consolidated Balance Sheets +(In thousands, except par value) +March 31, +2012 +2011 +Assets +Current assets: +Cash and cash equivalents +$ +18,701 +$ +11,818 +Trade accounts receivable, net of allowance for doubtful accounts of $379 and $385 at March 31, 2012 and 2011, respectively +11,081 +9,419 +Costs in excess of billings on uncompleted contracts +5,360 +4,070 +Inventories +2,454 +2,392 +Deferred income taxes +2,904 +2,967 +Prepaid expenses and other current assets +425 +392 +Assets of discontinued operation +— +7,672 +Total current assets +40,925 +38,730 +Property and equipment, net +1,948 +2,461 +Deferred income taxes +6,761 +10,807 +Intangible assets, net +2,578 +1,845 +Goodwill +17,318 +16,522 +Other assets +210 +203 +Total assets +$ +69,740 +$ +70,568 +Liabilities and stockholders’ equity +Current liabilities: +Trade accounts payable +$ +4,044 +$ +2,985 +Accrued payroll and related expenses +3,398 +3,523 +Accrued liabilities +2,942 +3,181 +Billings in excess of costs and estimated earnings on uncompleted contracts +1,542 +1,335 +Current portion of long-term debt +634 +2,324 +Current liabilities of discontinued operation +— +611 +Total current liabilities +12,560 +13,959 +Long-term debt +— +640 +Deferred rent +700 +1,058 +Unrecognized tax benefits +351 +587 +Other non-current liabilities +657 +1,028 +Total liabilities +14,268 +17,272 +Commitments and contingencies +Stockholders’ equity: +Preferred stock, $1.00 par value: +Authorized shares - 2,000 +Issued and outstanding shares - none +— +— +Common stock, $0.10 par value: +Authorized shares - 70,000 at March 31, 2012 and 2011 +Issued and outstanding shares - 33,909 at March 31, 2012 and 34,364 at March 31, 2011 +3,391 +3,436 +Additional paid-in capital +137,645 +137,938 +Accumulated deficit +(85,564 +) +(88,078 +) +Total stockholders’ equity +55,472 +53,296 +Total liabilities and stockholders’ equity +$ +69,740 +$ +70,568 +See accompanying notes. +35 +Table of Contents +Iteris, Inc. +Consolidated Statements of Operations +(In thousands, except per share amounts) +Year Ended March 31, +2012 +2011 +2010 +Net sales and contract revenues: +Net sales +$ +27,679 +$ +28,208 +$ +25,341 +Contract revenues +30,727 +23,758 +26,413 +Total net sales and contract revenues +58,406 +51,966 +51,754 +Costs of net sales and contract revenues: +Cost of net sales +13,393 +13,447 +12,313 +Cost of contract revenues +21,942 +15,635 +17,399 +Gross profit +23,071 +22,884 +22,042 +Operating expenses: +Selling, general and administrative +17,986 +16,981 +15,709 +Research and development +3,183 +2,444 +2,646 +Amortization of intangible assets +504 +176 +113 +Change in fair value of contingent acquisition consideration +(619 +) +55 +— +Impairment of goodwill +— +7,970 +— +Total operating expenses +21,054 +27,626 +18,468 +Operating income (loss) +2,017 +(4,742 +) +3,574 +Non-operating income (expense): +Other income, net +4 +18 +44 +Interest expense, net +(72 +) +(152 +) +(264 +) +Income (loss) from continuing operations before income taxes +1,949 +(4,876 +) +3,354 +Provision for income taxes +(643 +) +(278 +) +(960 +) +Income (loss) from continuing operations +1,306 +(5,154 +) +2,394 +Gain on sale of discontinued operation, net of tax +1,180 +— +— +Income (loss) from discontinued operation, net of tax +28 +(55 +) +(191 +) +Net income (loss) +$ +2,514 +$ +(5,209 +) +$ +2,203 +Income (loss) per share from continuing operations - basic and diluted +$ +0.04 +$ +(0.15 +) +$ +0.07 +Gain per share from sale of discontinued operation - basic and diluted +$ +0.03 +$ +0.00 +$ +0.00 +Income (loss) per share from discontinued operation - basic and diluted +$ +0.00 +$ +0.00 +$ +(0.01 +) +Net income (loss) per share - basic and diluted +$ +0.07 +$ +(0.15 +) +$ +0.06 +Shares used in basic per share calculations +34,259 +34,335 +34,249 +Shares used in diluted per share calculations +34,380 +34,335 +34,435 +See accompanying notes. +36 +Table of Contents +Iteris, Inc. +Consolidated Statements of Stockholders’ Equity and Comprehensive Income (Loss) +(In thousands) +Common +Accumulated +Additional +Stock +Other +Total +Common Stock +Paid-In +Held in +Accumulated +Comprehensive +Stockholders’ +Shares +Amount +Capital +Trust +Deficit +Income (Loss) +Equity +Balance at March 31, 2009 +34,205 +$ +3,420 +$ +136,997 +$ +(31 +) +$ +(85,025 +) +$ +(3 +) +$ +55,358 +Cumulative effect of adoption of change in accounting for warrants +— +— +— +— +(47 +) +— +(47 +) +Stock option exercises +113 +12 +131 +— +— +— +143 +Stock-based compensation +— +— +375 +— +— +— +375 +Issuance of shares held in trust +— +— +— +31 +— +— +31 +Components of comprehensive income: +Foreign currency translation +— +— +— +— +— +3 +3 +Net income +— +— +— +— +2,203 +— +2,203 +Comprehensive income +— +— +— +— +— +— +2,206 +Balance at March 31, 2010 +34,318 +3,432 +137,503 +— +(82,869 +) +— +58,066 +Stock option exercises +46 +4 +53 +— +— +— +57 +Stock-based compensation +— +— +382 +— +— +— +382 +Net loss and comprehensive loss +— +— +— +— +(5,209 +) +— +(5,209 +) +Balance at March 31, 2011 +34,364 +3,436 +137,938 +— +(88,078 +) +— +53,296 +Stock option exercises +68 +8 +77 +— +— +— +85 +Stock-based compensation +— +— +331 +— +— +— +331 +Issuance of shares pursuant to vesting of restricted stock units +51 +5 +(5 +) +— +— +— +— +Repurchases of common stock +(574 +) +(58 +) +(696 +) +— +— +— +(754 +) +Net income and comprehensive income +— +— +— +— +2,514 +— +2,514 +Balance at March 31, 2012 +33,909 +$ +3,391 +$ +137,645 +$ +— +$ +(85,564 +) +$ +— +$ +55,472 +See accompanying notes. +37 +Table of Contents +Iteris, Inc. +Consolidated Statements of Cash Flows +(In thousands) +Year Ended March 31, +2012 +2011 +2010 +Cash flows from operating activities +Net income (loss) +$ +2,514 +$ +(5,209 +) +$ +2,203 +Adjustments to reconcile net income (loss) to net cash provided by operating activities: +Deferred income taxes +286 +273 +1,014 +Depreciation of property and equipment +907 +1,030 +986 +Stock-based compensation +331 +382 +375 +Impairment of goodwill +— +7,970 +— +Amortization of intangible assets +504 +222 +159 +Change in fair value of contingent acquisition consideration +(619 +) +55 +— +Loss on disposal of equipment +1 +9 +— +Gain on sale of Vehicle Sensors +(1,180 +) +— +— +Changes in operating assets and liabilities, net of effects of acquisitions and sale of Vehicle Sensors: +Accounts receivable +(1,826 +) +1,052 +1,137 +Net costs and estimated earnings in excess of billings +(902 +) +(501 +) +917 +Inventories +79 +(953 +) +2,954 +Prepaid expenses and other assets +284 +211 +(350 +) +Accounts payable and accrued expenses +289 +805 +(2,911 +) +Net cash provided by operating activities +668 +5,346 +6,484 +Cash flows from investing activities +Purchases of property and equipment +(337 +) +(414 +) +(294 +) +Capitalized software +(138 +) +— +— +Net cash paid for acquisitions +(969 +) +(1,116 +) +(300 +) +Net proceeds from sale of Vehicle Sensors +11,446 +— +— +Net cash provided by (used in) investing activities +10,002 +(1,530 +) +(594 +) +Cash flows from financing activities +Payments on long-term debt +(2,330 +) +(2,354 +) +(2,750 +) +Borrowings on long-term debt +— +— +750 +Repurchases of common stock +(754 +) +— +— +Deferred payment for prior business combinations +(788 +) +(106 +) +— +Proceeds from stock option exercises +85 +57 +143 +Net cash used in financing activities +(3,787 +) +(2,403 +) +(1,857 +) +Increase in cash and cash equivalents +6,883 +1,413 +4,033 +Cash and cash equivalents at beginning of year +11,818 +10,405 +6,372 +Cash and cash equivalents at end of year +$ +18,701 +$ +11,818 +$ +10,405 +Supplemental cash flow information: +Cash paid during the year for: +Interest +$ +111 +$ +200 +$ +306 +Income taxes +439 +455 +159 +Supplemental schedule of non-cash investing and financing activities: +Liabilities incurred for business combinations +$ +971 +$ +2,610 +$ +218 +Issuance of common stock for vested restricted stock units +5 +— +— +Fair value of common stock issued in settlement of liabilities +— +— +31 +See accompanying notes. +38 +Table of Contents +Iteris, Inc. +Notes to Consolidated Financial Statements +March 31, 2012 +1. Description of Business and Summary of Significant Accounting Policies +Description of Business +Iteris, Inc. (referred to collectively with our subsidiaries in these consolidated financial statements as “Iteris,” the “Company,” “we,” “our” and “us”) is a leading provider of intelligent information solutions to the traffic management market. We are focused on the development and application of advanced technologies and software-based information systems that reduce traffic congestion, provide measurement, management and predictive traffic analytics and improve the safety of surface transportation systems infrastructure. We believe that our products, services and solutions, in conjunction with sound traffic management, minimize the environmental impact of traffic congestion. By combining image processing, traffic engineering, information technology, and other products and services, we offer a broad range of Intelligent Transportation Systems (“ITS”) solutions to customers worldwide. Iteris was originally incorporated in Delaware in 1987. +Basis of Presentation +Our consolidated financial statements include the accounts of Iteris and our subsidiaries and have been prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”). All significant intercompany accounts and transactions have been eliminated in consolidation. +The results of continuing operations for all periods presented in the consolidated financial statements exclude the financial impact of discontinued operations. See Note 3, “Sale of Vehicle Sensors”, for further discussion related to discontinued operations presentation. +Use of Estimates +The preparation of consolidated financial statements in conformity with GAAP requires our management to make certain estimates and assumptions that affect the reported amounts of assets and liabilities and disclosures of contingent assets and liabilities at the date of the financial statements, and reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Significant estimates made in the preparation of the consolidated financial statements include the allowance for doubtful accounts, projections of taxable income used to assess realizability of deferred tax assets, inventory and warranty reserves, costs to complete long-term contracts, indirect cost rates used in cost-plus contracts, contract reserves, the valuation of purchased intangible asset and goodwill, the valuation of debt and equity instruments and estimates of future cash flows used to assess the recoverability of long-lived assets and the impairment of goodwill. +Revenue Recognition +Net Sales +Product revenues and related costs of sales are recognized when all of the following criteria are met: (i) persuasive evidence of an arrangement exists, (ii) delivery has occurred, (iii) the price to the customer is fixed or determinable, and (iv) collection of the receivable is reasonably assured. These criteria are typically met at the time of product shipment, but in certain circumstances, may not be met until receipt or acceptance by the customer. Accordingly, at the date revenue is recognized, the significant obligations or uncertainties concerning the sale have been resolved. +We recognize revenue from the sale of deliverables that are part of a multiple-element arrangement in accordance with applicable accounting guidance that establishes a relative selling price hierarchy permitting the use of an estimated selling price to determine the allocation of arrangement consideration to a deliverable in a multiple-element arrangement where neither vendor specific objective evidence (“VSOE”) nor third-party evidence (“TPE”) of fair value is available for that deliverable. In the absence of VSOE or TPE of the standalone selling price for one or more delivered or undelivered elements in a multiple-element arrangement, we are required to estimate the selling prices of those elements. Overall arrangement consideration is allocated to each element (both delivered and undelivered items) that has stand-alone value based on their relative selling prices, regardless of whether those selling prices are evidenced by VSOE or TPE or are based on our estimated selling prices. +39 +Table of Contents +We account for multiple-element arrangements that consist only of software and software-related services in accordance with applicable accounting guidance for software and software-related transactions. For such transactions, revenue on arrangements that include multiple elements is allocated to each element based on the relative fair value of each element, and fair value is determined by VSOE. If we cannot objectively determine the fair value of any undelivered element included in such multiple-element arrangements and the only undelivered element is post-contract customer support or maintenance, and VSOE of the fair value of such support or maintenance does not exist, revenue from the entire arrangement is recognized ratably over the support period. When the fair value of a delivered element has not been established but VSOE of fair value exists for the undelivered elements, we use the residual method to recognize revenue if the fair value of all undelivered elements is determinable. Under the residual method, the fair value of the undelivered elements is deferred and the remaining portion of the arrangement fee is allocated to the delivered elements and is recognized as revenue. +Contract Revenues +Contract revenues are derived primarily from long-term contracts with governmental agencies. When appropriate, contract revenues are recognized using the percentage of completion method of accounting, whereby revenue is recognized as contract performance progresses and is determined based on the relationship of costs incurred to total estimated costs. Any anticipated losses on contracts are charged to earnings when identified. Changes in job performance and estimated profitability, including those arising from contract penalty provisions and final contract settlements, may result in revisions to costs and revenues and are recognized in the period in which the revisions are determined. Profit incentives are included in contract revenues when their realization is reasonably assured. Certain of our contract revenues are recognized as services are performed and amounts are earned, which is measured by time incurred or other contractual milestones or output measures. Contract revenues accounted for in this manner generally relate to certain cost-plus fixed fee or time-and-materials contracts for which no specific maximum contract values are stipulated. +Costs in Excess of Billings on Uncompleted Contracts +Costs in excess of billings on uncompleted contracts in the accompanying consolidated balance sheets represent unbilled amounts earned and reimbursable under services sales arrangements. At any given period-end, a large portion of the balance in this account represents the accumulation of labor, materials and other costs that have not been billed due to timing, whereby the accumulation of each month’s costs and earnings are not administratively billed until the subsequent month. Also included in this account are amounts that will become billable according to contract terms, which usually require the consideration of the passage of time, achievement of milestones or completion of the project. Such unbilled amounts are expected to be billed and collected within the next twelve months. +Costs in excess of billings on uncompleted contracts at March 31, 2012 and 2011 include approximately $944,000 and $400,000, respectively, which were not billable because certain milestone objectives specified in the contracts had not been attained. The costs and estimated earnings in excess of billings at March 31, 2012 are expected to be billed and collected during the fiscal year ending March 31, 2013. +Billings in Excess of Costs and Estimated Earnings on Uncompleted Contracts +Billings in excess of costs and estimated earnings on uncompleted contracts in the accompanying consolidated balance sheets is comprised of cash collected from customers and billings to customers on contracts in advance of work performed, advance payments negotiated as a contract condition, estimated losses on uncompleted contracts, project-related legal liabilities and other project-related reserves. The unearned amounts are expected to be earned within the next twelve months. +We record provisions for estimated losses on uncompleted contracts in the period in which such losses become known. The cumulative effects of revisions to contract revenues and estimated completion costs are recorded in the accounting period in which the amounts become evident and can be reasonably estimated. These revisions can include such items as the effects of change orders and claims, warranty claims, liquidated damages or other contractual penalties, adjustments for audit findings on contract closeout settlements. +Concentration of Credit Risk +Financial instruments that potentially subject us to a concentration of credit risk consist principally of cash and cash equivalents and trade accounts receivable. +Cash and cash equivalents consist primarily of demand deposits and money market funds maintained with several financial institutions. Deposits held with banks may exceed the amount of insurance provided on such deposits. Generally, these deposits may be redeemed upon demand and are maintained with high credit quality financial institutions and therefore are believed to have minimal credit risk. +Our accounts receivable are primarily derived from billings with customers located throughout North America, as well as in Europe, Asia and South America. We generally do not require collateral or other security from customers. We maintain an allowance for doubtful accounts for potential credit losses, which losses have historically been within management’s expectations. +40 +Table of Contents +Fair Values of Financial Instruments +The fair value of cash and cash equivalents, receivables, accounts payable and accrued expenses approximate carrying value because of the short period of time to maturity. The fair value of line of credit agreements and long-term debt approximate carrying value because the related effective rates of interest approximate current market rates available to us for debt with similar terms and similar remaining maturities. +Cash and Cash Equivalents +Cash and cash equivalents consist of cash and short-term investments with initial maturities of ninety days or less. +Allowance for Doubtful Accounts +The collectability of our accounts receivable is evaluated through review of invoices outstanding greater than a certain period of time and ongoing credit evaluations of our customers’ financial condition. In cases where we are aware of circumstances that may impair a specific customer’s ability to meet its financial obligations subsequent to the original sale, we will record an allowance against amounts due, and thereby reduce the net recognized receivable to the amount we reasonably believe will be collected. We also maintain an allowance based on our historical collections experience. When we determine that collection is not likely, we write off accounts receivable against the allowance for doubtful accounts. +Inventories +Inventories are stated at the lower of cost or market. Cost is determined using the first-in, first-out method. +Property and Equipment +Property and equipment are recorded at cost and are depreciated using the straight-line method over the estimated useful life ranging from three to eight years. Leasehold improvements are depreciated over the term of the related lease or the estimated useful life of the improvement, whichever is shorter. +Goodwill and Long-Lived Assets +We evaluate goodwill on an annual basis in our fourth fiscal quarter or more frequently if we believe indicators of impairment exist. We have determined that our reporting units for purposes of testing for goodwill impairment are identical to our reportable segments for financial reporting purposes. In the fiscal year ended March 31, 2012 (“Fiscal 2012”) we early adopted the new provisions issued by the Financial Accounting Standards Board (“FASB”) that are intended to simplify goodwill impairment testing. This guidance permits us to first assess qualitative factors to determine whether it is more likely than not that the fair value of a reporting unit is less than its carrying amount. If we conclude that it is more likely than not that the fair value of a reporting unit is less than its carrying amount, we conduct a two-step goodwill impairment test. The first step of the impairment test involves comparing the fair values of the applicable reporting units with their carrying values. We determine the fair values of our reporting units using the income valuation approach, as well as other generally accepted valuation methodologies. If the carrying amount of a reporting unit exceeds the reporting unit’s fair value, we perform the second step of the goodwill impairment test. The second step of the goodwill impairment test involves comparing the implied fair value of the affected reporting unit’s goodwill with the carrying value of that goodwill. The amount by which the carrying value of the goodwill exceeds its implied fair value, if any, is recognized as an impairment loss. We performed an annual impairment assessment of the carrying value of goodwill for each of the fiscal years ended March 31, 2012, 2011 and 2010. Based on these assessments, we determined that no impairment as of each of these dates was indicated as the estimated fair value of each of our reporting units exceeded its respective carrying value. We monitor the indicators for goodwill impairment testing between annual tests. Certain adverse business conditions impacting one or more reporting units would cause us to test goodwill for impairment on an interim basis. Refer to Note 5 for additional discussion regarding our interim goodwill impairment analyses during Fiscal 2012 and the fiscal year ended March 31, 2011 (“Fiscal 2011”). +We test long-lived assets and purchased intangible assets (other than goodwill) for impairment if we believe indicators of impairment exist. We determine whether the carrying value of an asset or asset group is recoverable, based on comparisons to undiscounted expected future cash flows the asset are expected to generate. If an asset is not recoverable, we record an impairment loss equal to the amount by which the carrying value of the asset exceeds its fair value. We primarily use the income valuation approach to determine the fair value of our long lived assets and purchased intangible assets. +41 +Table of Contents +Income Taxes +We utilize the asset and liability method of accounting for income taxes, under which deferred taxes are determined based on the temporary differences between the financial statement and tax basis of assets and liabilities using tax rates expected to be in effect during the years in which the basis differences reverse. A valuation allowance is recorded when it is more-likely-than-not that some or all of the deferred tax assets will not be realized, which increases our income tax expense in the period such determination is made. +Income tax positions must meet a more-likely-than-not recognition threshold to be recognized. Income tax positions that previously failed to meet the more-likely-than-not threshold are recognized in the first subsequent financial reporting period in which that threshold is met. Previously recognized tax positions that no longer meet the more-likely-than-not threshold are derecognized in the first subsequent financial reporting period in which that threshold is no longer met. +Stock-Based Compensation +We record stock-based compensation in the consolidated statement of operations as an expense, based on the estimated grant date fair value of our stock-based awards, whereby such fair values are amortized over the requisite service period. Our stock-based awards are currently comprised of common stock options and restricted stock units. The fair value of our common stock option awards is estimated on the grant date using the Black-Scholes-Merton (“BSM”) option-pricing formula. While utilizing this model meets established requirements, the estimated fair values generated by it may not be indicative of the actual fair values of our common stock option awards as it does not consider certain factors important to those awards to employees, such as continued employment and periodic vesting requirements as well as limited transferability. The fair value of our restricted stock units is based on the closing market price of our common stock on the grant date. If there are any modifications or cancellations of the underlying unvested stock-based awards, we may be required to accelerate, increase or cancel any remaining unearned stock-based compensation expense. +Research and Development Expenditures +Research and development expenditures are charged to expense in the period incurred. +Shipping and Handling Costs +Shipping and handling costs are included as cost of sales in the period during which the products ship. +Sales Taxes +Sales taxes are presented on a net basis (excluded from net sales and contract revenues) in the consolidated statements of operations. +Advertising Expenses +Advertising costs are expensed in the period incurred and totaled $187,000, $224,000 and $153,000 in the fiscal years ended March 31, 2012, 2011 and 2010, respectively. +Warranty +We generally provide a one to three year warranty from the original invoice date on all products, materials and workmanship. Products sold to various original equipment manufacturer customers sometimes carry longer warranties. Defective products will be either repaired or replaced, usually at our option, upon meeting certain criteria. We accrue a provision for the estimated costs that may be incurred for product warranties relating to a product as a component of cost of sales at the time revenue for that product is recognized. The accrued warranty reserve is included within accrued liabilities in the accompanying consolidated balance sheets. +Repair and Maintenance Costs +We incur repair and maintenance costs in the normal course of business. Should the repair or maintenance result in a permanent improvement to one of our leased facilities, the cost is capitalized as a leasehold improvement and amortized over its useful life or the remainder of the lease period, whichever is shorter. Non-permanent repair and maintenance costs are charged to expense as incurred. +42 +Table of Contents +Recent Accounting Pronouncements +In May 2011, the FASB issued Accounting Standards Update (“ASU”) No. 2011-04, Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRSs (“ASU 2011-04”), which amends Accounting Standards Codification 820, Fair Value Measurements . ASU 2011-04 aims to eliminate certain differences that existed between U.S. and international fair value accounting concepts, and also clarifies existing guidance under GAAP. Additionally, among other disclosures, this ASU requires certain new quantitative and qualitative disclosures regarding unobservable fair value measurements. We will be required to adopt the amendments prescribed by ASU 2011-04 for our fiscal year ending March 31, 2013. We do not expect that the adoption of ASU 2011-04 will have a material impact on our consolidated financial statements. +In June 2011, the FASB issued ASU No. 2011-05, Presentation of Comprehensive Income (“ASU 2011-05”). ASU 2011-05 requires the presentation of comprehensive income, the components of net income and the components of other comprehensive income either in a single continuous statement of comprehensive income or in two separate but consecutive statements. The new standard also requires presentation of adjustments for items that are reclassified from other comprehensive income to net income in the statement where the components of net income and the components of other comprehensive income are presented; however, in December 2011, the FASB issued ASU No. 2011-12, Deferral of the Effective Date for Amendments to the Presentation of Reclassifications of Items Out of Accumulated Other Comprehensive Income in Accounting Standards Update No. 2011-05 , which deferred this requirement, and the FASB plans to reconsider it during the first half of calendar 2012. The amendments prescribed by ASU 2011-05 are currently scheduled to become effective on a retrospective basis for financial statements issued for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2011. Early adoption is permitted. We do not expect that the adoption of ASU 2011-05 will have a material impact on our consolidated financial statements. +In September 2011, the FASB issued ASU No. 2011-08, Testing for Goodwill Impairment (“ASU 2011-08”). With respect to performing their required annual test for goodwill impairment, ASU 2011-08 gives companies the option to first perform a qualitative assessment to determine whether it is more likely than not that the fair value of a reporting unit is less than its carrying amount. If a company concludes that this is the case, it must perform the two-step test in accordance with previously existing guidance. Otherwise, a company can skip the two-step test. ASU 2011-08 is effective for fiscal years beginning after December 15, 2011. Early adoption is permitted and we chose to adopt ASU 2011-05 in Fiscal 2012, which did not result in a material impact on our consolidated financial statements. +2. Supplementary Financial Information +Inventories +The following table presents details regarding our inventories: +March 31, +2012 +2011 +(In thousands) +Materials and supplies +$ +1,513 +$ +1,734 +Work in process +98 +84 +Finished goods +843 +574 +$ +2,454 +$ +2,392 +Property and Equipment +The following table presents details of our property and equipment: +March 31, +2012 +2011 +(In thousands) +Equipment +$ +5,545 +$ +8,101 +Leasehold improvements +1,946 +1,985 +Accumulated depreciation +(5,543 +) +(7,625 +) +$ +1,948 +$ +2,461 +43 +Table of Contents +Intangible Assets +The following table presents details regarding our intangible assets: +March 31, +2012 +2011 +Gross +Carrying +Amount +Accumulated +Amortization +Gross +Carrying +Amount +Accumulated +Amortization +(In thousands) +Technology +$ +1,856 +$ +(935 +) +$ +1,566 +$ +(719 +) +Customer contracts / relationships +750 +(122 +) +500 +(21 +) +Other +1,110 +(219 +) +550 +(31 +) +Capitalized software development costs +138 +— +— +— +Total +$ +3,854 +$ +(1,276 +) +$ +2,616 +$ +(771 +) +Amortization expense for intangible assets subject to amortization was approximately $504,000, $176,000 and $113,000 for the fiscal years ended March 31, 2012, 2011 and 2010, respectively. +In Fiscal 2012, we capitalized approximately $138,000 of internal costs incurred in developing software products to be sold. These costs related to the internal development of our performance measurement software offerings. +We do not have any intangible assets with indefinite useful lives. Future estimated amortization expense is as follows: +Year Ending March 31, +(In thousands) +2013 +$ +644 +2014 +627 +2015 +431 +2016 +360 +2017 +378 +Thereafter +— +$ +2,440 +Refer to Note 4 for additional information regarding intangible assets acquired during the last three fiscal years. If we acquire additional intangible assets in future periods, our amortization expense will increase. +Goodwill +The following table presents the activity related to the carrying value of our goodwill by reportable segment for Fiscal 2011 and Fiscal 2012: +Roadway +Sensors +Transportation +Systems +Total +(In thousands) +Balance - March 31, 2010 +Goodwill +$ +8,214 +$ +14,906 +$ +23,120 +Accumulated impairment losses +— +— +— +8,214 +14,906 +23,120 +Acquisition of Meridian Environmental Technology, Inc. (Note 4) +— +1,372 +1,372 +Impairment loss +— +(7,970 +) +(7,970 +) +Balance - March 31, 2011 +Goodwill +8,214 +16,278 +24,492 +Accumulated impairment losses +— +(7,970 +) +(7,970 +) +8,214 +8,308 +16,522 +Acquisition of Berkeley Transportation Systems, Inc. (Note 4) +— +796 +796 +Balance - March 31, 2012 +Goodwill +8,214 +17,074 +25,288 +Accumulated impairment losses +— +(7,970 +) +(7,970 +) +$ +8,214 +$ +9,104 +$ +17,318 +44 +Table of Contents +The measurement period adjustments in the table above are due primarily to certain income tax-related adjustments pertaining to our acquisition of Meridian Environmental Technology, Inc. in January 2011 (see Note 4). +Warranty Reserve Activity +The following table presents activity with respect to the warranty reserve: +Year Ended March 31, +2012 +2011 +2010 +(In thousands) +Balance at beginning of fiscal year +$ +279 +$ +297 +$ +247 +Additions charged to cost of sales +86 +137 +218 +Warranty claims +(134 +) +(155 +) +(168 +) +Balance at end of fiscal year +$ +231 +$ +279 +$ +297 +Earnings Per Share +The following table sets forth the computation of basic and diluted income (loss) from continuing operations per share: +Year Ended March 31, +2012 +2011 +2010 +(In thousands, except per share amounts) +Numerator: +Income (loss) from continuing operations +$ +1,306 +$ +(5,154 +) +$ +2,394 +Denominator: +Weighted average common shares used in basic computation +34,259 +34,335 +34,249 +Dilutive stock options +96 +— +185 +Dilutive restricted stock units +25 +— +— +Dilutive warrants +— +— +1 +Weighted average common shares used in diluted computation +34,380 +34,335 +34,435 +Income (loss) from continuing operations per share: +Basic +$ +0.04 +$ +(0.15 +) +$ +0.07 +Diluted +$ +0.04 +$ +(0.15 +) +$ +0.07 +The following instruments were excluded for purposes of calculating weighted average common share equivalents in the computation of diluted income (loss) from continuing operations per share as their effect would have been anti-dilutive: +Year Ended March 31, +2012 +2011 +2010 +(In thousands) +Stock options +1,840 +1,467 +1,790 +Restricted stock units +— +54 +— +Warrants +15 +272 +371 +3. Sale of Vehicle Sensors +On July 29, 2011, we completed the sale of substantially all of our assets used in connection with our Vehicle Sensors segment to Bendix Commercial Vehicle Systems LLC (“Bendix”), a member of Knorr-Bremse Group, pursuant to an Asset Purchase Agreement (the “Agreement”) signed on July 25, 2011 (the “Asset Sale”). +Under the terms of the Agreement, upon the closing of the Asset Sale, Bendix paid us $14 million in cash, subject to a $2 million holdback and adjustments based upon the working capital of the Vehicle Sensors segment at closing, and Bendix assumed certain specified obligations and liabilities of the Vehicle Sensors segment. We are entitled to additional consideration in the form of the following performance and royalty-related earn-outs: Bendix is obligated to pay us an amount in cash equal to (i) 85% of revenue +45 +Table of Contents +associated with royalties received under our license and distribution agreements with Audiovox Electronics Corporation and Valeo Schalter and Sensoren GmbH through December 31, 2017 and (ii) 30% of the amount, if any, by which the amount of revenue generated from the sale of our lane departure warning systems exceeds Bendix’s projection for such revenue for the two years following closing, each subject to certain reductions and limitations set forth in the Agreement. +Upon the closing of the Asset Sale and resolution of working capital adjustments (as described above), we recorded aggregate proceeds received of approximately $12.0 million. Legal and other professional fees of approximately $0.6 million that were directly related to the sale transaction were offset against the proceeds to calculate net proceeds from the Asset Sale of approximately $11.4 million. +The following table summarizes the assets and liabilities of the Vehicle Sensors segment as of the closing date of the Asset Sale (in thousands): +Cash +$ +105 +Accounts receivable +1,850 +Inventories +1,147 +Other current assets +31 +Property and equipment, net +133 +Goodwill +4,671 +Total assets +7,937 +Current liabilities +(691 +) +Net assets +$ +7,246 +In comparing the above net assets to the net proceeds received, we recorded a gain on the Asset Sale of $4.3 million, or $1.2 million after tax, in the accompanying consolidated statements of operations for Fiscal 2012. The effective tax rate applicable to the gain was impacted by goodwill of $4.7 million for which there is no corresponding tax basis. We also recorded a gain on the sale of approximately $189,000, or $129,000 after tax, related to certain performance and royalty-related earn-outs (as described above) that were achieved through December 31, 2011. +In accordance with applicable accounting guidance, we determined that the Vehicle Sensors segment, which constituted one of our operating segments, qualified as a discontinued operation. The applicable financial results of the Vehicle Sensors segment have been reported as a discontinued operation in the consolidated statements of operations for all periods presented. For the fiscal years ended March 31, 2012, 2011 and 2010, Vehicle Sensors net sales classified as part of discontinued operation was $3.2 million, $7.5 million and $6.3 million, respectively. We have elected not to allocate any interest expense to the discontinued operation. Additionally, the applicable net assets of the Vehicle Sensors segment are separately presented as assets and liabilities of discontinued operation in the accompanying consolidated balance sheet as of March 31, 2011. +We entered into a short-term transitional services agreement with Bendix that terminated at the end of February 2012, pursuant to which we provided them certain ongoing logistical and administrative support services. Bendix paid us a fixed monthly amount for such support services, and also paid us an hourly amount for providing certain development-related services during the transition period. +4. Acquisitions +Berkeley Transportation Systems, Inc. +In November 2011, we acquired all of the outstanding capital stock of Berkeley Transportation Systems, Inc. (“BTS”). BTS was a privately-held company based in Berkeley, California, which specializes in transportation performance measurement. BTS’ Performance Measurement System leverages its real-time data collection, diagnostic, fusion and warehousing platform to aggregate and compute performance measures. This information is used to analyze how a transportation system is performing based on pre-determined measures of effectiveness such as stops, delays and travel time. Our primary reasons for the acquisition were to add key technologies to complement our iPerform solution and strengthen our performance measurement and management initiative as a whole. +Our consolidated financial statements for Fiscal 2012 include the results of operations of BTS commencing as of the acquisition date. BTS contributed approximately $936,000 of Contract Revenues and approximately $38,000 of operating income since the acquisition date included in the consolidated statement of operations for Fiscal 2012. On or shortly after the acquisition date, we paid a total of approximately $840,000 in cash to BTS. Additionally, we are also scheduled to pay (i) up to $250,000 at the 24-month anniversary of the closing of the acquisition, pursuant to a holdback provision, (ii) up to $500,000 at the 36-month anniversary of the closing of the acquisition, pursuant to a deferred payment provision, and (iii) up to $750,000 pursuant to an earn-out provision based on revenue and operating income achieved from BTS’ operations during the 18 months ending June 30, 2013. Our potential obligation pertaining to the various contingent consideration payments ranges from zero to $1.5 million. Acquisition-related costs were not significant and are included in selling, general and administrative expenses in the accompanying consolidated statement of operations for Fiscal 2012. +46 +Table of Contents +Acquisition Accounting +We have accounted for the acquisition of BTS as a business combination in accordance with applicable accounting guidance. We measured the fair value of the consideration transferred (including contingent consideration) to determine the purchase price of the acquisition. We allocated the fair value of consideration transferred to tangible assets acquired, liabilities assumed and identifiable intangible assets acquired based on their estimated fair values at the acquisition date. +The BTS acquisition is recorded as follows (in thousands): +Fair value of consideration transferred: +Cash paid on or shortly after acquisition date +$ +840 +Estimated fair value of contingent consideration +971 +Total +1,811 +Allocation: +Accounts receivable +(164 +) +Other tangible assets +(375 +) +Purchased intangible assets +(1,100 +) +Liabilities +624 +Goodwill +$ +796 +The excess of the fair value of the BTS business over the aggregate fair values of identifiable assets acquired and liabilities assumed was recorded as goodwill. The primary factor that resulted in the recognition of goodwill was the acquisition of BTS’ assembled workforce, which is not a separately identifiable intangible asset. The goodwill is not expected to be deductible for income tax purposes. +Purchased Intangible Assets +The following table presents details of the intangible assets acquired from BTS: +Estimated +Useful Life +Amount +(In years) +(In thousands) +Backlog +3 +$ +330 +Technology +6 +290 +Customer contracts / relationships +6 +250 +Other purchased intangible assets +5 - 7 +230 +$ +1,100 +Meridian Environmental Technology, Inc. +In January 2011, we acquired all of the capital stock of Meridian Environmental Technology, Inc. (“MET”), a privately-held company based in Grand Forks, North Dakota. MET specializes in 511 advanced traveler information systems, as well as Maintenance Decision Support System management tools that allow users to create solutions to meet roadway maintenance decision needs. Our primary reasons for the acquisition were (i) to enhance our ability to provide travelers and traffic management authorities with more accurate and real-time information and network performance management tools and (ii) to provide Iteris with key capabilities in the emerging performance measurement and management market. From the date of acquisition through the end of Fiscal 2011, MET contributed approximately $1.5 million of Contract Revenues and approximately $77,000 of operating income included in the consolidated statement of operations for Fiscal 2011. +Our consolidated financial statements for the fiscal years ended March 31, 2012 and 2011 include the results of operations of MET commencing as of the acquisition date. On or shortly after the acquisition date, we paid approximately $1.6 million in cash, exclusive of $369,000 of cash acquired. We also agreed to pay up to $1 million on each of the first two anniversaries of the acquisition date, subject to adjustments related to the retention of various key employees and certain other adjustments as further defined in the agreement. Additionally, we agreed to pay up to an additional $1 million per year for two years pursuant to an earn-out provision, based on revenue and operating income achieved from MET’s operations during the twelve months ending December 31, 2011 and 2012. Acquisition-related costs were not significant and are included in selling, general and administrative expenses in the accompanying consolidated statement of operations for Fiscal 2011. In January 2012, we made a cash payment of approximately $676,000 related to the first deferred payment to the shareholders of MET and held back $250,000 in +47 +Table of Contents +accordance with certain provisions of the purchase agreement. We expect the contingencies related to the hold-back to be resolved sometime in the first fiscal quarter of the fiscal year ending March 31, 2013 at which time we may or may not release the hold-back. No amounts were earned by the shareholders of MET related to the first year earn-out provision. As a result of the first year deferred payment and that no amounts were earned related to the first year earn-out provision, the potential outcomes pertaining to the remaining contingent consideration payments at March 31, 2012 range from zero to approximately $1.8 million. +Acquisition Accounting +We have accounted for the acquisition of MET as a business combination in accordance with applicable accounting guidance. We measured the fair value of the consideration transferred (including contingent consideration) to determine the purchase price of the acquisition. We allocated the fair value of consideration transferred to tangible assets acquired, liabilities assumed and identifiable intangible assets acquired based on their estimated fair values at the acquisition date. +The acquisition is recorded as follows (in thousands): +Fair value of consideration transferred: +Cash paid on or shortly after acquisition date +$ +1,622 +Estimated fair value of contingent consideration +2,473 +Total +4,095 +Allocation: +Cash +(369 +) +Accounts receivable +(682 +) +Other tangible current assets +(531 +) +Property and equipment +(682 +) +Purchased intangible assets +(1,620 +) +Liabilities +1,161 +Goodwill +$ +1,372 +The excess of the fair value of the business over the aggregate fair values of identifiable assets acquired and liabilities assumed was recorded as goodwill. The primary factor that resulted in the recognition of goodwill was the acquisition of MET’s assembled workforce, which is not a separately identifiable intangible asset. The goodwill is not expected to be deductible for income tax purposes. +Purchased Intangible Assets +The following table presents details of the intangible assets acquired from MET: +Estimated +Useful Life +Amount +(In years) +(In thousands) +Technology +6 +$ +570 +Customer contracts / relationships +6 +500 +Other purchased intangible assets +3 - 7 +550 +$ +1,620 +48 +Table of Contents +Supplemental Pro Forma Data (Unaudited) +The unaudited pro forma data below presents selected details of our results of operations as if the acquisition of BTS had occurred on April 1, 2010 (the beginning of Fiscal 2011). The following data includes the amortization of purchased intangible assets. This pro forma data is presented for informational purposes only and does not purport to be indicative of the results of future operations or the results that would have occurred had the acquisition taken place on April 1, 2010. +Year Ended March 31, +2012 +2011 +(In thousands, except per share data) +Pro forma net sales and contract revenues +$ +59,553 +$ +53,722 +Pro forma net income (loss) +$ +2,383 +$ +(5,433 +) +Pro forma net income (loss) per share - basic and diluted +$ +0.07 +$ +(0.16 +) +Hamilton Signal, Inc. +In April 2009, we completed the acquisition of certain assets of Hamilton Signal, Inc., a privately-held developer of video processing algorithms enabling state and local governments to conduct real-time analysis on fixed and pan-tilt-zoom camera feeds. Our primary reasons for the acquisition were to expand our product portfolio in the traffic management market and to integrate enhanced functionality into and complement our Roadway Sensors technologies. +The total purchase consideration was approximately $518,000, of which we paid $300,000 in cash upon execution of the purchase agreement and of which, pursuant to the purchase agreement, we paid $106,000 on the first anniversary of the acquisition date and $112,000 on the second anniversary of the acquisition date. Pursuant to the purchase agreement, the selling stockholder became an employee of Iteris and was eligible to receive compensation based on net sales of certain products during the three-year period ended March 31, 2012, subject to continued employment and other limitations. +We accounted for this acquisition as a business combination in accordance with applicable accounting guidance. We estimated the fair value of the assets acquired to allocate the purchase price, which is summarized as follows (in thousands): +Developed technology +$ +501 +Goodwill +17 +$ +518 +The purchased developed technology was determined to have an estimated useful life of five years. +Our consolidated financial statements for the fiscal years ended March 31, 2012, 2011 and 2010 include the results of operations of Hamilton Signal commencing as of the acquisition date. Disclosures required for material business combinations have been limited due to the immateriality of the acquisition of Hamilton Signal to our consolidated financial statements. +5. Impairment of Goodwill +As discussed in Note 1, goodwill is tested for impairment on an annual basis in our fourth fiscal quarter or more frequently if indicators of impairment exist. +In Fiscal 2012, we early adopted the new provisions issued by the FASB that are intended to simplify goodwill impairment testing. The updated guidance permits us to first assess qualitative factors to determine whether it is more likely than not that the fair value of a reporting unit is less than its carrying amount. If we conclude that it is more likely than not that the fair value of a reporting units is less than its carrying amount, we conduct a two-step goodwill impairment test. Based on our qualitative assessment for Fiscal 2012, we concluded that it is not more likely than not that the fair value of our reporting units are less than their carrying amount and therefore, we did not perform a two-step goodwill impairment test. +In Fiscal 2011, during the quarter ended December 31, 2010, due primarily to lower than expected operating results in our Transportation Systems reporting unit, as well as ongoing weakness specifically in the Transportation Systems markets, we performed an interim test of impairment of the carrying value of goodwill in our Transportation Systems reporting unit as of December 31, 2010. In performing the first step in this analysis, we estimated the fair value of our Transportation Systems reporting unit using the income approach. As of December 31, 2010, we determined that the carrying value of our Transportation Systems reporting unit exceeded its estimated fair value and, accordingly, we performed the second step of the impairment analysis to estimate the implied fair value of the goodwill of this reporting unit. +The implied fair value of goodwill was determined in the same manner utilized to estimate the amount of goodwill recognized in a business combination. To determine this value, we estimated the fair value of the assets and liabilities, including certain intangible assets, to be allocated to the Transportation Systems reporting unit as of December 31, 2010. The implied fair value of goodwill was measured as the difference between the estimated fair value of the reporting unit over the estimated fair value amounts of its assets and liabilities. The impairment loss for the Transportation Systems reporting unit was measured by the amount the carrying value of its goodwill exceeded the implied fair value of the goodwill. Accordingly, in order to write down Transportation Systems goodwill with a carrying value of $14.9 million to its implied fair value of $6.9 million, we recorded an impairment charge of $8.0 million in the three months ended December 31, 2010. +49 +Table of Contents +We estimated the fair value of the Transportation Systems reporting unit using the income approach, which was based on management’s business plans and financial projections for the next five years, along with a perpetual growth rate thereafter of approximately 4%. The analysis also used a weighted average discount rate of approximately 14%, which we believe reflects our cost of capital, slightly adjusted for increased market risk. +6. Fair Value Measurements +We measure fair value as the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. Fair value measurements are based on a three-tier hierarchy that prioritizes the inputs used to measure fair value. These tiers include: Level 1, defined as observable inputs such as quoted prices in active markets for identical assets and liabilities; Level 2, defined as observable inputs other than Level 1 prices such as quoted prices for similar assets or liabilities or prices quoted in inactive markets; and Level 3, defined as unobservable inputs that are significant to the fair value of the asset or liability, and for which little or no market data exists, therefore requiring management to utilize its own assumptions to provide its best estimate of what market participants would use in valuing the asset or liability. +The liability for the estimated fair value of the contingent consideration in connection with our acquisitions of MET and BTS was determined using Level 3 inputs based on a probabilistic calculation whereby we assigned estimated probabilities to achieving the earn-out targets and then discounted the total contingent consideration to net present value. The following table reconciles this liability measured at fair value on a recurring basis for Fiscal 2012 (in thousands): +Balance at March 31, 2011 +$ +2,528 +Fair value of BTS contingent consideration assumed at acquisition date +971 +Deferred payments made to MET shareholders +(676 +) +Change in fair value included in net income +(619 +) +Balance at March 31, 2012 +$ +2,204 +The change in the estimated fair value of this liability during the current fiscal year resulted primarily from payments to the shareholders of MET related to the first year deferred payment and revisions to our estimates regarding both the probability of achieving certain earn-out targets and the amounts of certain future deferred payments. +The current portions of the liability at March 31, 2012 and 2011 were $1.6 million and $1.5 million, respectively, and were included within accrued liabilities in the accompanying consolidated balance sheets. The remaining non-current portions of the liability are included within non-current liabilities in the accompanying consolidated balance sheets. +Other than the above, we did not have any material financial assets or liabilities measured at fair value on a recurring basis using Level 3 inputs as of March 31, 2012. +Our non-financial assets, such as goodwill, intangible assets and property and equipment, are measured at fair value on a non-recurring basis, generally when there is a transaction involving those assets such as a purchase transaction, a business combination or an adjustment for impairment. See Notes 4 and 5 above for further discussion regarding certain of our intangible assets and goodwill balances (including goodwill impairment) that were measured at fair value, using certain Level 3 inputs, during the fiscal years ended March 31, 2012 and 2011. +7. Revolving Line of Credit and Long-Term Debt +Revolving Line of Credit +In October 2008, we entered into a $19.5 million credit facility with California Bank & Trust (“CB&T”). This credit facility provided for a two-year revolving line of credit with borrowings of up to $12.0 million and a $7.5 million 48-month term note (discussed below). Interest on borrowed amounts under the revolving line of credit are payable monthly at a rate equal to the current stated prime rate (3.25% at March 31, 2012) up to the current stated prime rate plus 0.50%, depending on aggregate deposit balances maintained at the bank in relation to the total loan commitment under the credit facility. We are obligated to pay an unused line fee of 0.25% per annum applied to the average unused portion of the revolving line of credit during the preceding month. The revolving line of credit does not contain any early termination fees and is secured by substantially all of our assets. As of March 31, 2012, no amounts were borrowed under the revolving line of credit portion of the facility. Availability under this line of credit may be reduced or otherwise limited as a result of our obligations to comply with certain financial covenants. In September 2010, we entered into a modification agreement with CB&T to extend the expiration date of our revolving line of credit to October 1, 2012. +50 +Table of Contents +Long-Term Debt — Bank Term Note +As of March 31, 2012, we had outstanding borrowings of approximately $634,000 under the term note with our bank referenced above, which expires on May 1, 2013. Principal payments under this term note are required to be repaid in monthly installments of $152,000. Additionally, beginning on November 1, 2009, and on November 1 of each year thereafter, we are required to repay additional principal of up to $500,000, calculated based on certain financial measures, as further defined in the loan agreement. These additional principal payments effectively reduce the total number of monthly installments necessary to repay the term note. To date, we have made additional principal payments of $500,000 on each of November 1, 2011, 2010 and 2009. Interest on the term note is payable monthly at a rate equal to the current stated prime rate plus 0.50% up to the current stated prime rate plus 1.00%, depending on aggregate deposit balances maintained at the bank in relation to the total loan commitment under the credit facility. The term note contains no early termination fees and, along with the revolving line of credit under the same credit agreement, is secured by substantially all of our assets. We currently expect the remaining outstanding balance of this term note will be repaid in full by June 2012. +8. Income Taxes: +The reconciliation of our income tax provision (benefit) to taxes computed at U.S. federal statutory rates is as follows: +Year Ended March 31, +2012 +2011 +2010 +(In thousands) +Income tax provision (benefit) at statutory rates +$ +663 +$ +(1,658 +) +$ +1,140 +State income taxes net of federal benefit +562 +189 +192 +Impairment charges +— +2,044 +— +Research credits +(246 +) +— +— +Change in fair value of contingent acquisition consideration +(211 +) +— +— +Compensation charges +59 +94 +(12 +) +Unrecognized tax benefits +(276 +) +(288 +) +(362 +) +Other +92 +(103 +) +2 +Provision for income taxes +$ +643 +$ +278 +$ +960 +The components of deferred tax assets and liabilities are as follows: +March 31, +2012 +2011 +(In thousands) +Deferred tax assets: +Net operating losses +$ +8,246 +$ +12,315 +Credit carry forwards +773 +319 +Deferred compensation and payroll +941 +823 +Bad debt allowance and other reserves +433 +763 +Deferred rent +435 +— +Other, net +300 +252 +Total deferred tax assets +11,128 +14,472 +Deferred tax liabilities: +Property and equipment +(517 +) +(66 +) +Deferred rent +— +(145 +) +Acquired intangibles +(754 +) +(527 +) +Goodwill +(193 +) +— +Total deferred tax liabilities +(1,464 +) +(738 +) +Net deferred tax assets +$ +9,664 +$ +13,734 +51 +Table of Contents +The components of current and deferred federal and state income tax provisions and (benefits) are as follows: +Year Ended March 31, +2012 +2011 +2010 +(In thousands) +Current income tax provision (benefit): +Federal +$ +(221 +) +$ +(186 +) +$ +(234 +) +State +208 +264 +127 +Deferred income tax provision (benefit): +Federal +12 +251 +903 +State +644 +(51 +) +164 +Net income tax provision (benefit) +$ +643 +$ +278 +$ +960 +At March 31, 2012, we had approximately $525,000 in federal alternative minimum tax credit carryforwards that can be carried forward indefinitely. We had $25.0 million of federal net operating loss carryforwards at March 31, 2012 that begin to expire in 2021. We also had $10.9 million of state net operating loss carryforwards at March 31, 2012, of which $420,000 are scheduled to expire in 2014, $10.2 million are scheduled to expire in 2015 and $298,000 are scheduled to expire in 2031. +Due to changes in stock ownership, our federal net operating loss carryforwards of approximately $25.0 million as of March 31, 2012 and other federal attributes are subject to an annual limitation under Section 382 of the Internal Revenue Code. As of March 31, 2012, based on the cumulative amount of tax attributes that have become available under the limitation imposed by Section 382, all of our net operating losses are now fully available for use. Our deferred tax assets at March 31, 2012 do not include approximately $901,000 of excess tax benefits from employee stock option exercises that are a component of our net operating loss carryforwards. If and when such excess tax benefits are realized, stockholders’ equity will be adjusted. +As of March 31, 2012 and 2011, we determined that it was more likely than not that our deferred tax assets will be realized. Accordingly, no valuation allowance has been recorded against our deferred tax assets as of either such dates. In making our determination as to the realizability of our deferred tax assets, we reviewed all available positive and negative evidence, including reversal of deferred tax liabilities, potential carrybacks, projected future taxable income, tax planning strategies and recent financial performance. +Unrecognized Tax Benefits +As of March 31, 2012 and 2011, our gross unrecognized tax benefits were $1.7 million and $1.9 million, respectively, of which $1.3 million and $1.5 million, respectively, if recognized, would affect our effective tax rate. +We recognize interest and/or penalties related to income tax matters in income tax expense. As of March 31, 2012 and 2011, we had accrued cumulatively $56,000 and $45,000, respectively, for the payment of potential interest and penalties. +A reconciliation of the beginning and ending balances of the total amounts of gross unrecognized tax benefits is as follows: +Year Ended March 31, +2012 +2011 +2010 +(In thousands) +Gross unrecognized tax benefits at beginning of year +$ +1,941 +$ +2,153 +$ +2,525 +Increases for tax positions taken in prior years +97 +121 +93 +Decreases for tax positions taken in prior years +(10 +) +(15 +) +— +Increases for tax positions taken in the current year +20 +17 +— +Decreases for tax positions taken in the current year +— +— +(51 +) +Settlement with taxing authorities +— +(8 +) +— +Lapse in statute of limitations +(356 +) +(327 +) +(414 +) +Gross unrecognized tax benefits at March 31 +$ +1,692 +$ +1,941 +$ +2,153 +We anticipate a decrease in gross unrecognized tax benefits of approximately $60,000 within the next twelve months based on federal and state statute expirations in various jurisdictions. +We are subject to taxation in the U.S. and various states. We are subject to U.S. federal tax examination for fiscal tax years ended March 31, 2009 or later, and state and local income tax examination for fiscal tax years ended March 31, 2008 or later. +52 +Table of Contents +9. Commitments and Contingencies +Litigation and Other Contingencies +From time to time, we have been involved in litigation relating to claims arising out of our operations in the normal course of business. We currently are not a party to any legal proceedings, the adverse outcome of which, in management’s opinion, individually or in the aggregate, would have a material adverse effect on our consolidated results of operations, financial position or cash flows. +Operating Leases +In May 2007, we entered into an agreement to lease 52,000 square feet of office space in Santa Ana, California for a term of 88 months. In September 2007, we relocated our headquarters and principal operations into this space. The monthly lease rate was $102,000 during the first year of the lease and increases each year thereafter, up to a maximum of $120,000 during the last year of the lease. The lease may be extended for a period of five years, at our option, at a lease rate to be based on the market lease rate for comparable property determined as of the commencement date of the extension period. Additionally, the lease agreement provided for $1.8 million in incentives in the form of tenant improvement allowances, which we recorded as deferred rent and capitalized leasehold improvements in our consolidated balance sheet. The deferred rent amount reduces monthly rent expense over the term of the lease, and the capitalized leasehold improvements amount are being depreciated over the initial term of the lease (the estimated useful life of the related leasehold improvements). +We have lease commitments for facilities in various locations throughout the U.S., as well as for certain equipment. Future minimum rental payments under these non-cancelable operating leases at March 31, 2012 were as follows: +Year Ending March 31, +(In thousands) +2013 +$ +2,111 +2014 +1,905 +2015 +1,430 +2016 +280 +2017 +175 +Thereafter +339 +$ +6,240 +Rent expense totaled $1.9 million for each of the fiscal years ended March 31, 2012, 2011 and 2010, respectively. +Related Party Transaction +We previously subleased office space to MAXxess Systems, Inc. (“MAXxess”), one of our former subsidiaries that we sold in September 2003. MAXxess is currently owned by an investor group that includes two of our directors, one of whom is the former Chief Executive Officer of MAXxess. The sublease terminated in September 2007, at which time MAXxess owed us an aggregate of $274,000 related to this sublease and certain ancillary corporate services that we provided to MAXxess. We have previously fully reserved for amounts owed to us by MAXxess under the terms of this sublease. In August 2009, MAXxess executed a promissory note payable to Iteris in the original principal amount of $274,000. The promissory note bears interest at a rate of 6% per annum, compounded annually, with accrued interest to be paid annually on the first business day of each calendar year. Payments under the note may be made in bona fide services rendered by MAXxess to Iteris to the extent such services and amounts are pre-approved in writing by us. All amounts outstanding under the note will become due and payable on the earliest of (i) August 10, 2014, (ii) a change of control in MAXxess, or (iii) a financing by MAXxess resulting in gross proceeds of at least $10 million. As of March 31, 2012, approximately $259,000 of the original principal balance is outstanding and payable to Iteris, all of which remains fully reserved. +Inventory Purchase Commitments +At March 31, 2012, we had firm commitments to purchase approximately $2.5 million of inventory, which are expected to occur primarily during the first and second quarters of our fiscal year ending March 31, 2013. +53 +Table of Contents +10. Stockholders’ Equity +Preferred Stock +Our certificate of incorporation provides for the issuance of up to 2,000,000 shares of preferred stock. Our Board of Directors is authorized to issue from time to time such authorized but unissued shares of preferred stock in one or more series and to fix or alter the designations, preferences, rights and any qualifications, limitations or restrictions of the shares of each such series, including the dividend, conversion, voting, redemption and liquidation rights. As of March 31, 2012 and 2011, there were no outstanding shares of preferred stock, and we do not currently have plans to issue any shares of preferred stock. +In August 2009, our Board of Directors adopted a stockholder rights plan, which calls for preferred stock purchase rights (each, a “Right”) to be distributed, as a dividend, at the rate of one Right for each share of common stock held as of September 3, 2009. Each Right will entitle holders of common stock to buy one one-thousandth of one share of Series A Junior Participating Preferred Stock of Iteris. A further description and terms of the Rights are set forth in the Rights Agreement dated August 20, 2009 by and between Iteris and Computershare Trust Company, N.A., as rights agent. In connection with the stockholder rights plan, our Board of Directors approved the adoption of a Certificate of Designations, which created the Series A Junior Participating Preferred Stock, and likewise authorized the filing of a Certification of Elimination to eliminate the two series of junior participating preferred stock, which were originally created in April 1998 in connection with our previous stockholder rights plan which expired in 2008. +Common Stock Warrants +As of March 31, 2012, we had outstanding fully exercisable warrants to purchase 15,000 shares of our common stock. These warrants have an exercise price per share of $1.42 and a remaining contractual life of 1.4 years. There was no activity with respect to these or any other warrants during Fiscal 2012. +In connection with our adoption of certain provisions of accounting for derivatives, which became effective for us on April 1, 2009, we determined that certain outstanding warrants to purchase shares of our common stock contained provisions that provide for a possible future adjustment to either the exercise price and/or number of shares to be issued upon exercise. As such, beginning April 1, 2009, we began recognizing these warrants as liabilities at their respective estimated fair values on each reporting date. The cumulative effect of the change in accounting for these warrants of $47,000 was recognized as an adjustment to the opening balance of accumulated deficit at April 1, 2009. The amounts recognized in the consolidated balance sheet as a result of our adoption on April 1, 2009 were determined based on the amounts that would have been recognized if this accounting treatment had been applied from the issuance date of the warrants. By March 31, 2011, all such warrants had expired unexercised, and thus there was no remaining liability recorded on our consolidated balance sheet at that date or thereafter. We estimated the fair value of these warrants using the BSM option-pricing formula. The change in the estimated fair value of the warrants for the fiscal years ended March 31, 2011 and 2010 is included in “other income, net” in the accompanying consolidated statements of operations. +Common Stock Reserved for Future Issuance +The following summarizes common stock reserved for future issuance at March 31, 2012: +Number of Shares +(In thousands) +Stock options outstanding +2,493 +Restricted stock units outstanding +235 +Authorized for future issuance under stock incentive plans +335 +Warrants outstanding +15 +3,078 +11. Employee Benefit Plans +Stock Incentive Plans +In September 2007, our stockholders approved the 2007 Omnibus Incentive Plan (the “2007 Plan”), which provides that options to purchase shares of our unissued common stock may be granted to our employees, officers, consultants and directors at exercise prices which are equal to or greater than the market value of our common stock on the date of grant. Options expire no more than ten years after the date of grant and generally vest at the rate of 25% on each of the first four anniversaries of the grant date. The 2007 Plan also allows for the issuance of stock appreciation rights, restricted stock, restricted stock units (“RSUs”) and other stock-based awards based on the value of our common stock. New shares are issued to satisfy stock option exercises and share issuances +54 +Table of Contents +under the 2007 Plan. In September 2009, our stockholders approved an amendment to increase the number of shares of our common stock authorized and reserved for issuance under the 2007 Plan by 800,000 shares to a total of 1,650,000 shares. At March 31, 2012, there were approximately 335,000 shares of common stock available for grant under this plan. As of March 31, 2012, options to purchase approximately 1,022,000 shares of common stock, as well as 235,000 RSUs, were outstanding under the 2007 Plan. +Our 1997 Stock Incentive Plan (the “1997 Plan”) terminated in September 2007; however, all stock options outstanding under the 1997 Plan remain outstanding pursuant to the terms of such stock options. As of March 31, 2012, options to purchase approximately 1,061,000 shares of our common stock were outstanding under the 1997 Plan. No further options or other stock-based awards may be granted under the 1997 Plan. +In connection with our merger with our Iteris, Inc. subsidiary (the “Iteris Subsidiary”) in 2004, we assumed the 1998 Stock Incentive Plan (the “1998 Plan”) of the Iteris Subsidiary and all outstanding options granted thereunder. As of March 31, 2012, options to purchase approximately 410,000 shares of our common stock were outstanding under the 1998 Plan. No further options or other stock-based awards may be granted under the 1998 Plan. +Certain options granted under the 2007 Plan, the 1997 Plan and the 1998 Plan (collectively, the “Plans”) and the RSUs granted under the 2007 Plan provide for accelerated vesting of unvested options in the event of a change in control under certain circumstances. +Stock Options +A summary of activity in the Plans with respect to our stock options for Fiscal 2012 is as follows: +Options +Weighted +Average +Exercise +Price Per +Share +Weighted +Average +Remaining +Contractual +Life +Aggregate +Intrinsic +Value +(In thousands) +(Years) +(In thousands) +Options outstanding at March 31, 2011 +3,111 +$ +1.59 +Granted +315 +1.13 +Exercised +(68 +) +1.24 +Forfeited +(31 +) +1.54 +Expired +(834 +) +1.30 +Options outstanding at March 31, 2012 +2,493 +$ +1.64 +3.8 +$ +393 +Options exercisable at March 31, 2012 +1,986 +$ +1.73 +2.5 +$ +267 +Vested and expected to vest at March 31, 2012 +2,431 +$ +1.65 +3.6 +$ +374 +Options exercisable at March 31, 2012 pursuant to a change-in-control +2,493 +$ +1.64 +3.8 +$ +393 +Restricted Stock Units +In August 2010, we began granting RSUs under the 2007 Plan to certain of our employees. RSUs awards are stock-based awards that entitle the holder to receive one share of our common stock for each RSU upon vesting. RSUs vest at the rate of 25% on each of the first four anniversaries of the grant date provided that the holder remains in service (as defined by the 2007 Plan) as of the vesting date. The fair value per RSU is determined based on the closing market price of our common stock on the grant date. +55 +Table of Contents +A summary of activity with respect to our RSUs for Fiscal 2012 is as follows: +# of Shares +Weighted +Average +Price Per +Share +Weighted +Average +Remaining +Life +Aggregate +Intrinsic +Value +(In thousands) +(Years) +(In thousands) +RSUs outstanding at March 31, 2011 +214 +$ +1.48 +Granted +100 +1.10 +Vested +(51 +) +1.48 +Forfeited +(28 +) +1.48 +RSUs outstanding at March 31, 2012 +235 +$ +1.32 +2.8 +$ +40 +Expected to vest at March 31, 2012 +198 +$ +1.32 +2.8 +$ +33 +Common stock issuable (for RSUs) at March 31, 2012 upon a change-in-control +235 +$ +1.32 +2.8 +$ +40 +Stock-Based Compensation +The following table presents stock-based compensation expense that is included in each functional line item in our consolidated statements of operations: +Year Ended March 31, +2012 +2011 +2010 +(In thousands) +Cost of net sales +$ +16 +$ +11 +$ +9 +Cost of contract revenues +29 +36 +39 +Selling, general and administrative expense +249 +280 +288 +Research and development expense +31 +25 +21 +Income from discontinued operation, net of tax +6 +30 +18 +Total stock-based compensation +$ +331 +$ +382 +$ +375 +At March 31, 2012, there was approximately $475,000 of unrecognized compensation expense related to unvested stock options and RSUs. This expense is currently expected to be recognized over a weighted average period of approximately 2.5 years. If there are any modifications or cancellations of the underlying unvested awards, we may be required to accelerate, increase or cancel any remaining unearned stock-based compensation expense. Future stock-based compensation expense and unearned stock-based compensation will increase to the extent that we grant additional stock options, RSUs or other stock-based awards. +The grant date fair value of stock options granted was estimated using the following weighted-average assumptions: +Year Ended March 31, +2012 +2011 +2010 +Expected life - years +7.0 +7.0 +7.0 +Risk-free interest rate +1.6 +% +2.1 +% +3.2 +% +Expected volatility of common stock +52 +% +58 +% +74 +% +Dividend yield +— +% +— +% +— +% +A summary of certain fair value and intrinsic value information pertaining to our stock options is as follows: +Year Ended March 31, +2012 +2011 +2010 +(In thousands, except per share amounts) +Weighted average grant date fair value per share of options granted +$ +0.61 +$ +0.86 +$ +1.01 +Intrinsic value of options exercised +$ +7 +$ +23 +$ +28 +56 +Table of Contents +Employee Incentive Programs +Under the terms of a Profit Sharing Plan, we may contribute to a trust fund such amounts as determined annually by the Board of Directors. No contributions were made during the fiscal years ended March 31, 2012, 2011 and 2010. +We sponsor a defined contribution 401(k) Plan, adopted in 1990, under which eligible associates voluntarily contribute to the plan, up to IRS maximums, through payroll deductions. Under the provisions of the 401(k) Plan, associates have various investment choices, one of which is the purchase of Iteris common stock at market price. We match up to 90% of contributions, based on years of service, up to a stated limit. From July 1, 2009 through March 31, 2010, we temporarily suspended our matching contributions to the 401(k) Plan. Beginning in April 2010, we reinstituted certain limited matching contributions to the 401(k) Plan. Our matching contributions under the 401(k) Plan were approximately $475,000, $491,000 and $220,000 for the fiscal years ended March 31, 2012, 2011 and 2010, respectively. +12. Stock Repurchase Program +In August 2011, our Board of Directors approved a stock repurchase program pursuant to which we may acquire up to $3 million of our outstanding common stock from time to time until August 2012. Under the program, we may repurchase shares in open-market and privately negotiated transactions and block trades and pursuant to a 10b5-1 trading plan during our closed trading windows. There is no guarantee as to the exact number of shares that will be repurchased. We may modify, terminate or extend the repurchase program at any time without prior notice. From inception of this program through March 31, 2012, we repurchased approximately 573,558 shares of our common stock at an average price per share of $1.31. All repurchased shares have been retired and resumed their status as authorized and unissued shares of our common stock. +13. Business Segments, Significant Customer and Geographic Information +Business Segments +As a result of the sale of substantially all of the assets used in connection with our Vehicle Sensors segment to Bendix in July 2011 (see Note 3), along with a reevaluation and reorganization of our operating segments in the first quarter of our fiscal year ended March 31, 2012, we now operate in two reportable segments: Roadway Sensors and Transportation Systems. +The Roadway Sensors segment includes, among other products, our Vantage, Versicam, Pico, Vantage Vector and Abacus vehicle detection systems for traffic intersection control, incident detection and certain highway traffic data collection applications. +The Transportation Systems segment includes transportation engineering and consulting services and the development of transportation management and traveler information systems for the ITS industry. This segment includes the operations of MET, which specializes in 511 advanced traveler information systems and offers Maintenance Decision Support System management tools that allow users to create solutions to meet roadway maintenance decision needs. Also included in this segment are the operations of BTS, which specializes in transportation performance measurement. +The accounting policies of our reportable segments are the same as those described in the summary of significant accounting policies (Note 1). Certain corporate expenses, including interest and amortization of intangible assets, are not allocated to the segments. Unallocated corporate expenses in the current fiscal year also include costs related to the sale of our Vehicle Sensors segment and certain other corporate initiatives, as well as costs related to our recently announced iPerform information management solution. The reportable segments are each managed separately because they manufacture and distribute distinct products or provide services with different processes. All reported segment revenues are derived from external customers. +57 +Table of Contents +Selected financial information for our reportable segments for the fiscal years ended March 31, 2012, 2011 and 2010 is as follows: +Roadway +Sensors +Transportation +Systems +Total +(In thousands) +Year Ended March 31, 2012 +Product revenue +$ +27,679 +$ +— +$ +27,679 +Service and other revenue +— +30,727 +30,727 +Depreciation +194 +393 +587 +Segment income +2,826 +1,284 +4,110 +Year Ended March 31, 2011 +Product revenue +$ +28,208 +$ +— +$ +28,208 +Service and other revenue +— +23,758 +23,758 +Depreciation +217 +250 +467 +Impairment of goodwill +— +7,970 +7,970 +Segment income (loss) +3,942 +(7,540 +) +(3,598 +) +Year Ended March 31, 2010 +Product revenue +$ +25,341 +$ +— +$ +25,341 +Service and other revenue +— +26,413 +26,413 +Depreciation +234 +221 +455 +Segment income +3,158 +1,445 +4,603 +The following table reconciles total segment income (loss) to consolidated income (loss) from continuing operations before income taxes: +Year Ended March 31, +2012 +2011 +2010 +Segment income (loss): +Total income (loss) from reportable segments +$ +4,110 +$ +(3,598 +) +$ +4,603 +Unallocated amounts: +Corporate and other expenses +(2,208 +) +(913 +) +(916 +) +Amortization of intangible assets +(504 +) +(176 +) +(113 +) +Change in fair value of contingent acquisition consideration +619 +(55 +) +— +Other income, net +4 +18 +44 +Interest expense, net +(72 +) +(152 +) +(264 +) +Income (loss) from continuing operations before income taxes +$ +1,949 +$ +(4,876 +) +$ +3,354 +Fiscal 2012 corporate and other expense includes legal and accounting expenses related to the sale of the Vehicle Sensors segment in July 2011 as well as certain other costs incurred in connection with the development of IterisPeMS and certain corporate general and administrative expenses allocated to the Vehicle Sensors segment in prior fiscal years. +Significant Customer and Geographic Information +No single customer accounted for more than 10% of our total net sales and contract revenues for each of the fiscal years ended March 31, 2012, 2011 and 2010. +No individual customer or government agency had a receivable balance at March 31, 2012 or 2011 greater than 10% of our total trade accounts receivable balances as of March 31, 2012 and 2011, respectively. +58 +Table of Contents +The following table sets forth the percentages of our total net sales and contract revenues, by geographic region, derived from shipments to, or contract, service and other revenues from, external customers located outside the U.S.: +Year Ended March 31, +2012 +2011 +2010 +Europe +— +% +5 +% +4 +% +Asia +1 +5 +2 +Other +1 +3 +2 +2 +% +13 +% +8 +% +Substantially all of our long-lived assets are held in the U.S. +14. Quarterly Financial Data (Unaudited) +Quarter Ended: +Total Net +Sales and +Contract +Revenues +Gross +Profit +Net +Income +(Loss) +Basic Net +Income +(Loss) per +Share +Diluted Net +Income +(Loss) per +Share +(In thousands, except per share amounts) +June 30, 2011 +$ +13,892 +$ +5,869 +$ +97 +$ +0.00 +$ +0.00 +September 30, 2011 +14,393 +6,005 +1,310 +0.04 +0.04 +December 31, 2011 +14,881 +5,464 +747 +0.02 +0.02 +March 31, 2012 +15,240 +5,733 +360 +0.01 +0.01 +$ +58,406 +$ +23,071 +$ +2,514 +$ +0.07 +* +$ +0.07 +* +June 30, 2010 +$ +13,905 +$ +6,257 +$ +797 +0.02 +0.02 +September 30, 2010 +12,466 +5,675 +542 +0.02 +0.02 +December 31, 2010 +11,953 +4,894 +(7,027 +) +(0.20 +) +(0.20 +) +March 31, 2011 +13,642 +6,058 +479 +0.01 +0.01 +$ +51,966 +$ +22,884 +$ +(5,209 +) +$ +(0.15 +)* +$ +(0.15 +)* +* Annual per share amounts may not agree to the sum of the quarterly per share amounts due to differences between average shares outstanding during the periods. +59 +Table of Contents +Exhibit Index +Exhibit +Number +Description +Reference +2.1+ +Stock Purchase Agreement dated December 23, 2010 by and among Iteris, Inc., Meridian Environmental Technology, Inc., (“MET”) the shareholders of MET and Kathy J. Osborne as the Shareholders Representative +Exhibit 2.1 to the registrant’s Quarterly Report on Form 10-Q for the quarter ended December 31, 2010 as filed with the SEC on February 14, 2011 +2.2+ +Asset Purchase Agreement by and between Iteris, Inc. and Bendix Commercial Vehicle Systems LLC, dated as of July 25, 2011 +Exhibit 2.1 to the registrant’s Current Report on Form 8-K/A as filed with the SEC on November 1, 2011 +3.1 +Restated Certificate of Incorporation of the registrant +Exhibit 3.1 to the registrant’s Quarterly Report on Form 10-Q for the quarter ended September 30, 2009 as filed with the SEC on October 30, 2009 +3.2 +Certificate of Designations of Series A Junior Participating Preferred Stock +Exhibit 3.2 to the registrant’s Quarterly Report on Form 10-Q for the quarter ended September 30, 2009 as filed with the SEC on October 30, 2009 +3.3 +Bylaws of the registrant, as amended +Exhibit 4.2 to the registrant’s Registration Statement on Form S-1 (Reg. No. 033-67932) as filed with the SEC on July 6, 1993 +3.4 +Certificates of Amendment to Bylaws of the registrant dated April 24, 1998 and August 10, 2001 +Exhibit 3.4 to the registrant’s Annual Report on Form 10-K/A for the year ended March 31, 2003 as filed with the SEC on July 29, 2003 +3.5 +Certificate of Amendment to Bylaws of registrant dated September 9, 2004 +Exhibit 3.1 to the registrant’s Quarterly Report on Form 10-Q for the quarter ended September 30, 2004 as filed with the SEC on November 15, 2004 +3.6 +Certificate of Amendment to Bylaws of registrant effective September 16, 2005 +Exhibit 3.5 to the registrant’s Annual Report on Form 10-K for the year ended March 31, 2007 +3.7 +Certificate of Amendment to Bylaws of registrant effective December 7, 2007 +Exhibit 3.1 to the registrant’s Current Report on Form 8-K as filed with the SEC on December 13, 2007 +3.8 +Certificate of Amendment to Bylaws of registrant, effective August 20, 2009 +Exhibit 3.3 to the registrant’s Current Report on Form 8-K as filed with the SEC on August 21, 2009 +4.1 +Specimen of common stock certificate +Exhibit 4.1 to registrant’s Registration Statement on Form 8-A as filed with the SEC on December 8, 2004 +4.2 +Rights Agreement dated August 20, 2009 between the registrant and Computershare Trust Company, N.A., which includes the form of Certificate of Designations for the Series A Junior Participating Preferred Stock, the form of Right Certificate, and Summary of Rights to Purchase Preferred Stock as exhibits thereto +Exhibit 4.1 to the registrant’s Current Report on Form 8-K as filed with the SEC on August 21, 2009 +10.1 +Form of Indemnity Agreement entered into by the registrant and certain of its officers and directors +Exhibit 19.4 to the registrant’s Quarterly Report on Form 10-Q for the quarter ended September 30, 1988 +10.2 +Form of Indemnification Agreement entered into by the registrant and certain of its officers and directors +Exhibit 10.5 to the registrant’s Annual Report on Form 10-K for the year ended March 31, 2004 as filed with the SEC on June 29, 2004 +60 +Table of Contents +10.3* +1997 Stock Incentive Plan (the “1997 Plan”) as amended on May 3, 2003, as further amended on December 15, 2004 +Exhibit 10.32 to the registrant’s Annual Report on Form 10-K for the year ended March 31, 2005 as filed with the SEC on July 14, 2005 +10.4* +Form of Notice of Grant of Stock Option for 1997 Plan +Exhibit 99.2 to the registrant’s Registration Statement on Form S-8 (File No. 333-30396) as filed with the SEC on February 14, 2000 +10.5* +Form of Stock Option Agreement for the 1997 Plan +Exhibit 99.3 to the registrant’s Registration Statement on Form S-8 (File No. 333-30396) as filed with the SEC on February 14, 2000 +10.6* +Form of Addendum to Stock Option Agreement for 1997 Plan—Involuntary Termination Following Corporate Transaction or Change in Control +Exhibit 99.4 to the registrant’s Registration Statement on Form S-8 (File No. 333-30396) as filed with the SEC on February 14, 2000 +10.7* +Form of Addendum to Stock Option Agreement for 1997 Plan—Limited Stock Appreciation Rights +Exhibit 99.5 to the registrant’s Registration Statement on Form S-8 (File No. 333-30396) as filed with the SEC on February 14, 2000 +10.8* +Form of Stock Issuance Agreement for 1997 Plan +Exhibit 99.6 to the registrant’s Registration Statement on Form S-8 (File No. 333-30396) as filed with the SEC on February 14, 2000 +10.9* +Form of Addendum to Stock Issuance Agreement for 1997 Plan—Involuntary Termination Following Corporate Transaction/Change in Control +Exhibit 99.7 to the registrant’s Registration Statement on Form S-8 (File No. 333-30396) as filed with the SEC on February 14, 2000 +10.10* +Form of Notice of Grant of Automatic Stock Option for 1997 Plan—Initial Grant +Exhibit 99.8 to Exhibit 99.8 to registrant’s Registration Statement on Form S-8 (File No. 333-30396) as filed with the SEC on February 14, 2000 +10.11* +Form of Notice of Grant of Automatic Stock Option for 1997 Plan—Annual Grant +Exhibit 99.9 to the registrant’s Registration Statement on Form S-8 (File No. 333-30396) as filed with the SEC on February 14, 2000 +10.12* +Form of Automatic Stock Option Agreement for 1997 Plan +Exhibit 99.10 to the registrant’s Registration Statement on Form S-8 (File No. 333-30396) as filed with the SEC on February 19, 2000 +10.13* +Iteris Inc. 1998 Stock Incentive Plan (as amended on February 7, 2000) (“1998 Plan”) +Exhibit 10.24 to the registrant’s Annual Report on Form 10-K for the year ended March 31, 2005 as filed with the SEC on July 14, 2005 +10.14* +Form of Notice of Grant for 1998 Plan, including forms of Option Agreement and Stock Purchase Agreement for the following directors and executive officers: Gregory McKhann, James S. Miele and Abbas Mohaddes +Exhibit 99.2 to the registrant’s Registration Statement on Form S-8 (File No. 333-126834) as filed with the SEC on July 22, 2005 +10.15* +Form of Addendum to Stock Option Agreement for 1998 Plan +Exhibit 99.3 to the registrant’s Registration Statement on Form S-8 (File No. 333-126834) as filed with the SEC on July 22, 2005 +10.16* +Form of 1997 Stock Option Agreements +Exhibit 99.4 to the registrant’s Registration Statement on Form S-8 (File No. 333-126834) as filed with the SEC on July 22, 2005 +61 +Table of Contents +10.17 +Sublease Agreement, dated September 30, 2003, by and between Odetics, Inc. and Maij, Inc. +Exhibit 10.1 to the registrant’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2007 as filed with the SEC on August 14, 2007 +10.18 +Office Lease Agreement, dated May 24, 2007, by and between Crown Carnegie Associates, LLC and Iteris, Inc. +Exhibit 10.2 to the registrant’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2007 as filed with the SEC on August 14, 2007 +10.19* +2007 Omnibus Incentive Plan +Filed herewith +10.20* +Forms of Stock Option Agreements under the 2007 Omnibus Incentive Plan +Filed herewith +10.21* +Change in Control Agreement dated June 11, 2008 by and between James S. Miele and Iteris, Inc. +Exhibit 10.42 to the registrant’s Annual Report on Form 10-K for the year ended March 31, 2008 as filed with the SEC on June 12, 2008 +10.22 +Amended and Restated Loan and Security Agreement dated February 4, 2009 by and between California Bank & Trust and the registrant +Exhibit 10.1 to the registrant’s Quarterly Report on Form 10-Q for the quarter ended December 31, 2008 as filed with the SEC on February 13, 2009 +10.23 +Unsecured Promissory Note dated August 10, 2009 executed by MAXxess Systems, Inc. +Exhibit 10.1 to the registrant’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2009 as filed with the SEC on August 11, 2009 +10.24* +Letter Agreement dated July 27, 2010 by and between the registrant and Abbas Mohaddes +Exhibit 10.1 to the registrant’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2010 as filed with the SEC on July 28, 2010 +10.25* +Change in Control Agreement dated July 27, 2010 by and between the registrant and Abbas Mohaddes +Exhibit 10.2 to the registrant’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2010 as filed with the SEC on July 28, 2010 +62 +Table of Contents +10.26* +Form of Restricted Stock Unit Award Agreement under the 2007 Omnibus Incentive Plan +Exhibit 10.3 to the registrant’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2010 as filed with the SEC on July 28, 2010 +10.27 +Modification Agreement dated September 30, 2010 by and between Iteris, Inc. and California Bank & Trust +Exhibit 10.1 to the registrant’s Current Report on Form 8-K as filed with the SEC on October 6, 2010 +21 +Subsidiaries of the registrant +Filed herewith +23 +Consent of Independent Registered Public Accounting Firm +Filed herewith +24 +Power of Attorney +Filed herewith (included on the Signature page) +31.1 +Certification of the Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 +Filed herewith +31.2 +Certification of the Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 +Filed herewith +32.1 +Certification of the Chief Executive Officer Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 +Filed herewith +32.2 +Certification of the Chief Financial Officer Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 +Filed herewith +101.INS# +XBRL Instance Document +Filed herewith +101.SCH# +XBRL Taxonomy Extension Schema Document +Filed herewith +101.CAL# +XBRL Taxonomy Extension Calculation Linkbase Document +Filed herewith +101.LAB# +XBRL Taxonomy Extension Label Linkbase Document +Filed herewith +101.PRE# +XBRL Taxonomy Extension Presentation Linkbase Document +Filed herewith +101.DEF# +XBRL Taxonomy Definition Presentation Linkbase Document +Filed herewith +* Indicates a management contract or compensatory plan or arrangement ++ Confidential treatment has been requested for certain confidential portions of this exhibit pursuant to Rule 24b-2 of the Securities Exchange Act of 1934, as amended. In accordance with Rule 24b-2, these confidential portions have been omitted from the exhibit and filed separately with the SEC. +# Pursuant to Rule 406T of Regulation S-T, these interactive data files i) are not deemed filed or part of a registration statement or prospectus for purposes of Sections 11 or 12 of the Securities Act of 1933, are not deemed filed for purposes of Section 18 of the Securities Exchange Act of 1934, irrespective of any general incorporation language included in any such filings, and otherwise are not subject to liability under these sections; and ii) are deemed to have complied with Rule 405 of Regulation S-T (“Rule 405”) and are not subject to liability under the anti-fraud provisions of the Section 17(a)(1) of the Securities Act of 1933, Section 10(b) of the Securities Exchange Act of 1934 or under any other liability provision if we have made a good faith attempt to comply with Rule 405 and, after we become aware that the interactive data files fail to comply with Rule 405, we promptly amend the interactive data files. +63 \ No newline at end of file diff --git a/raw/filings/0000350868/2011/0001104659-12-042848/filing_metadata.csv b/raw/filings/0000350868/2011/0001104659-12-042848/filing_metadata.csv new file mode 100644 index 0000000000000000000000000000000000000000..ba7f0868210e64048f21a05697cc86aea288e48d --- /dev/null +++ b/raw/filings/0000350868/2011/0001104659-12-042848/filing_metadata.csv @@ -0,0 +1,2 @@ +cik,ticker,company_name,form,filing_date,report_date,acceptance_datetime,accession_number,primary_document,primary_doc_description,size,is_xbrl,is_inline_xbrl,document_url,filing_index_url,year,fiscal_year,is_primary_filing +0000350868,ITI,"ITERIS, INC.",10-K,2012-06-11,2012-03-31,2012-06-11T21:00:27.000Z,0001104659-12-042848,a12-5241_110k.htm,10-K,6576764,1,0,https://www.sec.gov/Archives/edgar/data/350868/000110465912042848/a12-5241_110k.htm,https://www.sec.gov/Archives/edgar/data/350868/000110465912042848/,2011,2011,1 diff --git a/raw/filings/0000350868/2011/0001104659-12-042848/item1.txt b/raw/filings/0000350868/2011/0001104659-12-042848/item1.txt new file mode 100644 index 0000000000000000000000000000000000000000..8b7f3cef9c8256f373c32017f240a6d4dc9c7bc7 --- /dev/null +++ b/raw/filings/0000350868/2011/0001104659-12-042848/item1.txt @@ -0,0 +1,59 @@ +ITEM 1. BUSINESS +Overview +We are a leading provider of intelligent information solutions to the traffic management market. We are focused on the development and application of advanced technologies and software-based information systems that reduce traffic congestion, provide measurement, management and predictive traffic analytics and improve the safety of surface transportation systems infrastructure. We believe that our products, services and solutions, in conjunction with sound traffic management, minimize the environmental impact of traffic congestion. By combining our image processing, traffic engineering, information technology, and other products and services, we offer a broad range of Intelligent Transportation Systems (“ITS”) solutions to customers worldwide. +We were originally incorporated in Delaware in 1987. Our principal executive offices are located at 1700 Carnegie Avenue, Santa Ana, California 92705, and our telephone number at that location is (949) 270-9400. Our Internet website address is www.iteris.com. Our annual reports on Form 10-K, quarterly reports on Form 10-Q and current reports on Form 8-K, together with amendments to these reports, are available on the “Investors” section of our website, free of charge, as soon as reasonably practicable after such material is electronically filed with, or furnished to, the Securities and Exchange Commission (“SEC”). The inclusion of our website address in this report does not include or incorporate by reference into this report any information on our website. +Sale of Vehicle Sensors +On July 29, 2011, we completed the sale of substantially all of the assets used in connection with our Vehicle Sensors segment to Bendix Commercial Vehicle Systems LLC (“Bendix”), a member of Knorr-Bremse Group, pursuant to an Asset Purchase Agreement signed on July 25, 2011 (the “Asset Sale”). Upon closing, Bendix paid us $14 million in cash, subject to a $2 million holdback and adjustments based upon the working capital of the Vehicle Sensors segment at closing, and Bendix assumed certain specified obligations and liabilities of the Vehicle Sensors segment. We are entitled to additional consideration in the form of certain performance and royalty-related earn-outs. As a result of the Asset Sale, we no longer operate in the Vehicle Sensors segment and we determined that the Vehicle Sensors segment, which previously constituted one of our operating segments, qualifies as a discontinued operation. Refer to Note 3 of Notes to Consolidated Financial Statements, included in Part IV, Item 15 of this report for additional discussion on this transaction. The applicable financial results of the Vehicle Sensors segment through the closing of the Asset Sale have been reported as a discontinued operation for all periods presented. +Products and Services +As a result of the sale of Vehicle Sensors in July 2011, and a reevaluation and reorganization of our operating segments in the first quarter of the fiscal year ended March 31, 2012, we currently operate in two reportable segments: Roadway Sensors and Transportation Systems. The Roadway Sensors segment includes, among other products, our Vantage, Versicam, Pico, Vantage Vector and Abacus vehicle detection systems for traffic intersection control, incident detection and certain highway traffic data collection applications. The Transportation Systems segment includes transportation engineering and consulting services, and the development of transportation management and traveler information systems for the ITS industry. See Note 13 of Notes to Consolidated Financial Statements, included in Part IV, Item 15 of this report, for further details on our reportable segments. +2 +Table of Contents +Roadway Sensors +Our Roadway Sensors segment product line uses advanced image processing technology to capture and analyze video images through sophisticated algorithms, enabling vehicle detection and transmission of both video images and data using various communication technologies. +· Our Vantage video detection systems detect vehicle presence at intersections, as well as vehicle count, speed and other traffic data used in traffic management systems. Our Vantage systems give traffic managers the ability to mitigate roadway congestion by modifying traffic signal timing or detecting incidents quickly. Our VantageView software supplements our Vantage video detection systems by providing an integrated platform to manage and “see” video detection assets remotely over a network connection. +· Our Vantage Vector product is an all-in-one vehicle detection sensor with a wide range of capabilities: stop bar detection, advanced-zone detection, and sensing that enables advanced safety and adaptive control applications. It includes all the proven benefits of Iteris video detection, including high accuracy, high availability remote viewing of video images, no trenching or pavement cutting for installation, bicycle detection capability and high precision for dilemma zone detection by integrating the video field-of-view with radar sensing. Enhanced information includes the number of vehicles, speed, and distance in user configurable zones that can be used for special applications. +· VersiCam, our integrated camera and processor video detection system, is a cost-efficient video detection system for smaller intersections that require only a few detection points. +· Pico, our compact video detection system, was developed primarily to address international video detection needs, and was designed for easy installation and configuration. +· Our Abacus products take advantage of the large number of existing installed closed-circuit television video feeds designed to monitor roadways, signalized intersections, tunnels and bridges to allow for data collection and incident detection without the set-up and calibration generally required with other systems. +We believe that future growth domestically and internationally, particularly in developing countries, will be dependent in part on the continued adoption of above-ground video detection technologies, instead of traditional in-pavement loop technology, to manage traffic. +We have historically experienced seasonality, particularly with respect to our Roadway Sensors net sales in our third and fourth fiscal quarters due to a reduction in road construction and repairs during the winter months due to inclement weather conditions. +Transportation Systems +Our Transportation Systems segment includes transportation engineering and consulting services focused on the planning, design, development and implementation of software-based systems that integrate sensors, video surveillance, computers, and advanced communications equipment to enable public agencies to monitor, control and direct traffic flow, assist in the quick dispatch of emergency crews and distribute real-time information about traffic conditions. Our services include planning, design and implementation of surface transportation infrastructure systems. We perform analysis and study goods movement, study commercial vehicle operations, provide travel demand forecasting and systems engineering, and identify mitigation measures to reduce traffic congestion. This segment also includes the activities of Meridian Environmental Technology, Inc. (“MET”), which we acquired in January 2011, and which specializes in 511 advanced traveler information systems as well as Maintenance Decision Support System (“MDSS”) management tools that allow users to create solutions to meet roadway maintenance decision needs. The operations of Berkeley Transportation Systems, Inc. (“BTS”), which we acquired in November 2011, are also included in this segment. BTS specializes in transportation performance measurement and its Performance Measurement System leverages its real-time data collection, diagnostic, fusion and warehousing platform to aggregate and compute performance measures. +Our Transportation Systems segment is largely dependent upon governmental funding and is affected by state and local budgetary issues. We believe the overall expansion of our Transportation Systems segment in the future will at least in part be dependent on the passage of a new Federal Highway Bill. Congress is currently working on such a bill. The previous Federal Highway Bill expired in October 2009 but the funding levels under the expired bill have continued through a series of short-term extensions, the most recent of which extends funding through the end of June 2012. Continued delays in the enactment of such a new Federal Highway Bill, and until such time as a bill becomes law, will prolong the uncertainty regarding the allotment of transportation funds in federal, state and local budgets. We believe that prolonged uncertainty has adversely impacted, and may continue to adversely impact, our net sales and contract revenues and our overall financial performance in future periods. +With the addition of MET in January 2011, we have experienced seasonality particularly related to certain MDSS services in our first and second fiscal quarters mainly because MDSS services are generally not required in the summer months. +3 +Table of Contents +During the fiscal year ended March 31, 2012 (“Fiscal 2012”), we began the development of IterisPeMS. IterisPeMS is an advanced, real-time data collection, diagnostic, fusion and warehousing software platform used to aggregate and compute performance measures across multiple transportation modes, including travel time, travel time variability, delay and lost throughput. This information can then be analyzed by traffic professionals to measure how a transportation network is performing and identity potential areas of improvement. IterisPeMS is also capable of providing users with easy-to-use visualization and animation features for both historical and predictive traffic conditions. Costs incurred during Fiscal 2012, which include research and development expense as well as sales and marketing expenditures were not allocated to either of the Roadway Sensors or Transportation Systems segments as this project was deemed to be a corporate level development. +Sales, Marketing and Principal Customers +We sell our Roadway Sensors products through indirect sales channels comprised of a network of independent dealers in the U.S. and certain foreign locations, who sell integrated systems and related products to the traffic management market, as well as directly to the traffic management market using a combination of our own sales personnel and an outside sales organization. Our independent dealers are trained in, and primarily responsible for, sales, installation, set-up and support of our products, and maintain an inventory of demonstration traffic products from various manufacturers and sell directly to government agencies and installation contractors. These dealers often have long-term arrangements with local government agencies in their respective territories for the supply of various products for the construction and renovation of traffic intersections, and are generally well-known suppliers of high-quality ITS products to the traffic management market. We periodically hold technical training classes for our dealers and end users and maintain a full-time staff of customer support technicians throughout the U.S. to provide technical assistance when needed. When appropriate, we have the ability to modify or make changes to our dealer network to accommodate the needs of the market and our customer base. In the states where we sell directly, we use our own staff to sell, oversee installations and set-up issues and support our products. +We market and sell our Transportation Systems services directly to government agencies pursuant to negotiated contracts that involve competitive bidding and specific qualification requirements. Most of our contracts are with federal, state and municipal customers and generally provide for cancellation or renegotiation at the option of the customer upon reasonable notice and fees paid for modification. We generally use selected members of our engineering, science and information technology teams on a regional basis to serve in sales and business development functions. Our contracts generally involve long lead times and require extensive specification development, evaluation and price negotiations. +A large portion of our revenues are derived from sales to federal, state and local government agencies. We currently have a diverse customer base, and no individual customer represented greater than 10% of our total net sales and contract revenues in Fiscal 2012 and in the fiscal years ended March 31, 2011 (“Fiscal 2011”) and March 31, 2010 (“Fiscal 2010”). Also refer to Note 13 of Notes to Consolidated Financial Statements, included in Part IV, Item 15 of this report. +Manufacturing and Materials +We use contract manufacturers to build subassemblies that are used in our roadway sensors products. Additionally, we procure certain components from qualified suppliers, both globally and locally, and generally use multi-sourcing strategies when technically and economically feasible to mitigate supply risk. These subassemblies and components are delivered to our Santa Ana, California facility where they go through final assembly and testing prior to shipment to our customers. Our key suppliers include CTS Electronics Manufacturing Solutions, Inc., Total Electronics LLC, Sony Electronics, Inc. and LG Electronics, Inc. Our manufacturing activities are conducted in approximately 9,000 square feet of space at our Santa Ana facility. Production volume at our subcontractors is based upon quarterly forecasts that we generally adjust on a monthly basis to control inventory levels. We typically do not manufacture any of the hardware used in the transportation management and traveler information systems that we design and implement. Our production facility is currently ISO 9001 certified. +Customer Support and Services +We provide warranty service and support for our products, as well as follow-up service and support for which we charge separately. Such service revenue was not a material portion of our total net sales and contract revenues for each of Fiscal 2012, Fiscal 2011 and Fiscal 2010. We believe customer support is a key competitive factor. +Backlog +Our total backlog of unfulfilled firm orders was approximately $35.0 million as of March 31, 2012, which was comprised of $3.2 million related to Roadway Sensors and $31.8 million related to Transportation Systems. Substantially the entire backlog for Roadway Sensors is expected to be recognized as revenue in the fiscal year ending March 31, 2013. We have historically recognized between 50% to 70% of our Transportation Systems backlog as of the end of a fiscal year in the subsequent fiscal year, and currently expect that trend to continue for the near future. +4 +Table of Contents +At March 31, 2011, we had backlog of approximately $28.2 million, which was comprised of $2.7 million related to Roadway Sensors and $25.5 million related to Transportation Systems. +The timing and realization of our backlog is subject to the inherent uncertainties of doing business with federal, state and local governments, particularly in view of budgetary constraints, cut-backs and other delays or reallocations of funding that these entities typically face. +Pursuant to the customary terms of our agreements with government contractors and other customers, customers can generally cancel or reschedule orders with little or no penalties. Lead times for the release of purchase orders often depend upon the scheduling and forecasting practices of our individual customers, which also can affect the timing of the conversion of our backlog into revenues. For these reasons, among others, our backlog at a particular date may not be indicative of our future revenues, in particular for our Roadway Sensors segment. +Product Development +Most of our product development activities are conducted at our principal facilities in Santa Ana, California. Our research and development costs and expenses were approximately $3.2 million for Fiscal 2012, $2.4 million for Fiscal 2011 and $2.6 million for Fiscal 2010. We expect to continue to pursue various product development programs and incur research and development expenditures in future periods. +We believe our engineering and product development capabilities are a competitive strength. We strive to continue to develop new products to meet the needs of the ever-changing ITS market as well as enhance and refine our existing product lines. Within the last four fiscal years, our Roadway Sensors segment has introduced our VersiCam and VersiCam wireless products, Pico, RZ-4 Advanced camera and our RZ-4 Advanced Wide Dynamic Range camera, which significantly improve video detection performance in certain harsh lighting conditions, and within the last fiscal year, Vantage Vector. We have also upgraded our Abacus and VantageView software products within the last fiscal year. Additionally, during Fiscal 2012, we began development of our IterisPeMS Performance Measurement System. We plan to continue this development effort in our fiscal year ending March 31, 2013. We believe that developing new offerings across our segments and enhancing, refining and marketing our existing products is a key component of strong organic growth and profitability. +Competition +We generally face significant competition in each of our target markets. Increased competition may result in price reductions, reduced gross margins and loss of market share, any of which could have a material adverse effect on our business, financial condition and results of operations. +In the market for our Roadway Sensors vehicle detection products, we compete with manufacturers and distributors of other above ground video camera detection systems and other non-intrusive detection devices, including microwave, infrared, ultrasonic and magnetic detectors, as well as manufacturers and installers of in-pavement inductive loop products, which have historically, and currently continue to be, the predominant detection system in this market. +The markets in which our Transportation Systems segment operates is highly fragmented and subject to evolving national and regional quality, operations and safety standards. Our competitors vary in number, scope and breadth of the products and services they offer. Our competitors in advanced Transportation Systems include national corporations. Our competitors in transportation engineering, planning and design include major regional firms, as well as many smaller local engineering firms. +In general, the markets for the products and services we offer are highly competitive and are characterized by rapidly changing technology and evolving standards. Many of our current and prospective competitors have longer operating histories, greater name recognition, access to larger customer bases and significantly greater financial, technical, manufacturing, distribution and marketing resources than us. As a result, they may be able to adapt more quickly to new or emerging standards or technologies or to devote greater resources to the promotion and sale of their products. It is also possible that new competitors or alliances among competitors could emerge and rapidly acquire significant market share. We believe that our ability to compete effectively in our target markets will depend on a number of factors, including the success and timing of our new product development, the compatibility of our products with a broad range of computing systems, product quality and performance, reliability, functionality, price and service and technical support. Our failure to provide services and develop and market products that compete successfully with those of other suppliers and consultants in our target markets would have a material adverse effect on our business, financial condition and results of operations. +5 +Table of Contents +Intellectual Property and Proprietary Rights +Our ability to compete effectively depends in part on our ability to develop and maintain the proprietary aspects of our technology. Our policy is to obtain appropriate proprietary rights protection for any potentially significant new technology acquired or developed by us. We currently hold five U.S. patents, three pending foreign patents and two provisional patents. One U.S. patent, which expires in May 2019, is for general technology related to CMOS sensors. Four U.S. patents, which expire between 2013 and 2029, two pending foreign patents and two provisional patents relate specifically to our Roadway Sensors technology. One of these U.S. patents and the two pending foreign patents are for an Electronic Traffic Monitor related to our Abacus product in the Roadway Sensors segment. We cannot be certain that any new patents will be granted pursuant to these or subsequent applications. As a result of the Asset Sale, certain patents were transferred to Bendix. We believe these patents were specific to that segment and the transfer of ownership does not impair our proprietary rights related to our current product and service offerings. +In addition to patent laws, we rely on copyright and trade secret laws to protect our proprietary rights. We attempt to protect our trade secrets and other proprietary information through agreements with customers and suppliers, proprietary information agreements with our employees and consultants, and other similar measures. We do not have any material licenses or trademarks other than those relating to product names. We cannot be certain that we will be successful in protecting our proprietary rights. While we believe our patents, patent applications, software and other proprietary know-how have value; changing technology makes our future success dependent principally upon our employees’ technical competence and creative skills for continuing innovation. +Litigation may be necessary in the future to enforce our proprietary rights, to determine the validity and scope of the proprietary rights of others, or to defend us against claims of infringement or invalidity by others. An adverse outcome in such litigation or similar proceedings could subject us to significant liabilities to third parties, require disputed rights to be licensed from others or require us to cease marketing or using certain products, any of which could have a material adverse effect on our business, financial condition and results of operations. In addition, the cost of addressing any intellectual property litigation claim, both in legal fees and expenses, as well as from the diversion of management’s resources, regardless of whether the claim is valid, could be significant and could have a material adverse effect on our business, financial condition and results of operations. +Employees +We refer to our employees as associates. As of March 31, 2012, we employed an aggregate of 264 full-time associates, including 57 associates in general management, administration and finance; 19 associates in sales and marketing; 160 associates in engineering and product development; 15 associates in operations, manufacturing and quality; and 13 associates in customer service. None of our associates are represented by a labor union, and we have never experienced a work stoppage. We believe our relations with our associates are good. +Government Regulation +Our manufacturing operations are subject to various federal, state and local laws and regulations, including those restricting the discharge of materials into the environment. We are not involved in any pending or, to our knowledge, threatened governmental proceedings, which would require curtailment of our operations because of such laws and regulations. We continue to expend funds in connection with our compliance with applicable environmental regulations. These expenditures have not, however, been significant in the past, and we do not expect any significant expenditure in the near future. Currently, compliance with foreign laws has not had a material impact on our business and is not expected to have a material impact in the near future. \ No newline at end of file diff --git a/raw/filings/0000350868/2011/0001104659-12-042848/item13.txt b/raw/filings/0000350868/2011/0001104659-12-042848/item13.txt new file mode 100644 index 0000000000000000000000000000000000000000..aef043b381390542a16e521bab62572290d3d144 --- /dev/null +++ b/raw/filings/0000350868/2011/0001104659-12-042848/item13.txt @@ -0,0 +1,2 @@ +ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE +The information under the captions “Corporate Governance — Director Independence” and “Certain Transactions,” appearing in our proxy statement for the 2012 Annual Meeting of Stockholders, is incorporated herein by reference. \ No newline at end of file diff --git a/raw/filings/0000350868/2011/0001104659-12-042848/item9a.txt b/raw/filings/0000350868/2011/0001104659-12-042848/item9a.txt new file mode 100644 index 0000000000000000000000000000000000000000..8b3459078d4a16e7110129fbd9a86c545e37bcd2 --- /dev/null +++ b/raw/filings/0000350868/2011/0001104659-12-042848/item9a.txt @@ -0,0 +1,11 @@ +ITEM 9A. CONTROLS AND PROCEDURES +(a) Evaluation of disclosure controls and procedures. In accordance with Rule 13a-15(b) of the Securities Exchange Act of 1934, as of the end of the period covered by this Annual Report on Form 10-K, management evaluated, with the participation of the our President and Chief Executive Officer and the Chief Financial Officer, the effectiveness of the design and operation of our disclosure controls and procedures (as defined in Rule 13a-15(e) under the Exchange Act). Based upon their evaluation of these disclosure controls and procedures, the President and Chief Executive Officer and the Chief Financial Officer have concluded that our disclosure controls and procedures were effective as of the date of such evaluation in ensuring that information required to be disclosed in our Exchange Act reports is (1) recorded, processed, summarized and reported in a timely manner, and (2) accumulated and communicated to management, including the Company’s President and Chief Executive Officer and the Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure. +(b) Changes in internal control. There was no change in our internal control over financial reporting that occurred during the fourth quarter of Fiscal 2012 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting. +Inherent Limitations on Internal Control +A control system, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. Further, the benefits of controls must be considered relative to their costs. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of management override or improper acts, if any, have been detected. These inherent limitations include the realities that judgments in decision making can be faulty, and that breakdowns can occur because of simple errors. Additionally, controls can be circumvented by the individual acts of some persons, by collusion of two or more people, or by management override of the control. The design of any system of controls is also based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions. Because of the inherent limitations in a cost-effective control system, misstatements due to management override, error or improper acts may occur and not be detected. Any resulting misstatement or loss may have an adverse and material effect on our business, financial condition and results of operations. +29 +Table of Contents +Management’s Report on Internal Control Over Financial Reporting +Our management is responsible for establishing and maintaining adequate internal control over financial reporting. Our internal control system was designed to provide reasonable assurance to management and our Board of Directors regarding the effectiveness of our internal control processes over the preparation and fair presentation of published financial statements. +We have assessed the effectiveness of our internal controls over financial reporting as of March 31, 2012. In making this assessment, we used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (“COSO”) in Internal Control—Integrated Framework. Based on our assessment, we believe that, as of March 31, 2012, our internal control over financial reporting is effective based on those criteria. +This annual report does not include an attestation report of our independent registered public accounting firm regarding internal control over financial reporting. Management’s report was not subject to attestation by our independent registered public accounting firm pursuant to the rules of the SEC applicable to smaller reporting companies. \ No newline at end of file diff --git a/raw/filings/0000350868/2012/0001104659-13-047720/filing.txt b/raw/filings/0000350868/2012/0001104659-13-047720/filing.txt new file mode 100644 index 0000000000000000000000000000000000000000..3064214a7d839cca59099642337fe140892ca43d --- /dev/null +++ b/raw/filings/0000350868/2012/0001104659-13-047720/filing.txt @@ -0,0 +1,3264 @@ +10-K +1 +a13-10816_110k.htm +10-K +Table of Contents +UNITED STATES +SECURITIES AND EXCHANGE COMMISSION +Washington, D.C. 20549 +FORM 10-K +(Mark One) +x +ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 +For the fiscal year ended March 31, 2013 +OR +o +TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 +For the transition period from to +Commission file number 001-08762 +ITERIS, INC. +(Exact Name of Registrant as Specified in Its Charter) +Delaware +95-2588496 +(State or Other Jurisdiction +of Incorporation or Organization) +(I.R.S. Employer +Identification No.) +1700 Carnegie Ave., Santa Ana, California 92705 +(Address of Principal Executive Offices) (Zip Code) +Registrant’s Telephone Number, Including Area Code: (949) 270-9400 +Securities registered pursuant to Section 12(b) of the Act: +Title of each class +Name of each exchange on which registered +Common Stock, $0.10 par value +NYSE MKT +Securities registered pursuant to Section 12(g) of the Act: None +Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes o No x +Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes o No x +Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No o +Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes x No o +Indicate by a check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. x +Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See definitions of “large accelerated filer,” “accelerated filer,” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one): +Large accelerated filer o +Accelerated filer o +Non-accelerated filer o +Smaller reporting company x +(Do not check if a smaller reporting company) +Indicate by check mark whether the registrant is a shell company (as defined in Exchange Act Rule 12b-2). Yes o No x +Based on the closing sale price of the registrant’s common stock on the last business day of the registrant’s most recently completed second fiscal quarter, the aggregate market value of the voting common stock held by nonaffiliates of the registrant was approximately $31,897,000. For the purposes of this calculation, shares owned by officers, directors and 10% stockholders known to the registrant have been deemed to be owned by affiliates. This determination of affiliate status is not necessarily a conclusive determination for other purposes. +As of May 28, 2013, there were 32,645,241 shares of our common stock outstanding. +DOCUMENTS INCORPORATED BY REFERENCE +Part III incorporates by reference certain information from the registrant’s definitive proxy statement for the 2013 Annual Meeting of Stockholders, which will be filed with the Securities and Exchange Commission not later than 120 days after the end of the fiscal year ended March 31, 2013. Except with respect to information specifically incorporated by reference in this report, the registrant’s proxy statement is not deemed to be filed as a part hereof. +Table of Contents +ITERIS, INC. +ANNUAL REPORT ON FORM 10-K +FOR THE FISCAL YEAR ENDED MARCH 31, 2013 +TABLE OF CONTENTS +PART I +ITEM 1. +BUSINESS +2 +ITEM 1A. +RISK FACTORS +8 +ITEM 1B. +UNRESOLVED STAFF COMMENTS +16 +ITEM 2. +PROPERTIES +16 +ITEM 3. +LEGAL PROCEEDINGS +16 +ITEM 4. +MINE SAFETY DISCLOSURES +16 +PART II +ITEM 5. +MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES +17 +ITEM 6. +SELECTED FINANCIAL DATA +18 +ITEM 7. +MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS +18 +ITEM 7A. +QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK +30 +ITEM 8. +FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA +30 +ITEM 9. +CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE +30 +ITEM 9A. +CONTROLS AND PROCEDURES +30 +ITEM 9B. +OTHER INFORMATION +31 +PART III +ITEM 10. +DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE +31 +ITEM 11. +EXECUTIVE COMPENSATION +31 +ITEM 12. +SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS +31 +ITEM 13. +CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE +31 +ITEM 14. +PRINCIPAL ACCOUNTING FEES AND SERVICES +31 +PART IV +ITEM 15. +EXHIBITS, FINANCIAL STATEMENT SCHEDULES +31 +Unless otherwise indicated in this report, the “Company,” “we,” “us” and “our” refer to Iteris, Inc. and its wholly-owned subsidiaries. +Iteris®, Vantage®, iPerform®, Abacus®, Vantage Vector®, Edge®, VersiCam™, Pico™, SmartCycle™, SmartScan™, iPeMS™, RZ-4™, EdgeConnect™ and VantageView™ are among the trademarks of Iteris, Inc. Any other trademarks or trade names mentioned herein are the property of their respective owners. +1 +Table of Contents +Cautionary Statement +This report, including the following discussion and analysis, contains forward-looking statements (within the meaning of the Private Securities Litigation Reform Act of 1995) that are based on our current expectations, estimates and projections about our business and our industry, and reflect management’s beliefs and certain assumptions made by us based upon information available to us as of the date of this report. When used in this report and the information incorporated herein by reference, the words “expect(s),” “feel(s),” “believe(s),” “should,” “will,” “may,” “anticipate(s),” “estimate(s),” “could,” “should,” and similar expressions or variations of these words are intended to identify forward-looking statements. These forward-looking statements include, but are not limited to, statements regarding our anticipated growth, sales, revenue, expenses, profitability, capital needs, backlog and manufacturing capabilities, competition, the impact of any current or future litigation, the impact of recent accounting pronouncements, the applications for and acceptance of our products and services, and the status of our facilities and product development. These statements are not guarantees of future performance and are subject to certain risks and uncertainties that could cause our actual results to differ materially from those projected. You should not place undue reliance on these forward-looking statements that speak only as of the date hereof. We encourage you to carefully review and consider the various disclosures made by us which describe certain factors which could affect our business, including in “ Risk Factors” set forth in Part I, Item 1A of this report, before deciding to invest in our company or to maintain or increase your investment. We undertake no obligation to revise or update publicly any forward-looking statement for any reason, including to reflect events or circumstances after the date hereof or to reflect the occurrence of unanticipated events. +PART I +ITEM 1. BUSINESS +Overview +We are a leading provider of intelligent information solutions to the traffic management market. We are focused on the development and application of advanced technologies and software-based information systems that reduce traffic congestion, provide measurement, management and predictive traffic analytics and improve the safety of surface transportation systems infrastructure. We also believe our products, services and solutions, in conjunction with sound traffic management, minimize the environmental impact of traffic congestion. We combine our unique intellectual property, products, decades of experience in traffic management and information technologies to offer a broad range of Intelligent Transportation Systems (“ITS”) solutions to customers worldwide. +We were originally incorporated in Delaware in 1987. Our principal executive offices are located at 1700 Carnegie Avenue, Santa Ana, California 92705, and our telephone number at that location is (949) 270-9400. Our Internet website address is www.iteris.com. Our annual reports on Form 10-K, quarterly reports on Form 10-Q and current reports on Form 8-K, together with amendments to these reports, are available on the “Investors” section of our website, free of charge, as soon as reasonably practicable after such material is electronically filed with, or furnished to, the Securities and Exchange Commission (“SEC”). The inclusion of our website address in this report does not include or incorporate by reference into this report any information on, or accessible through, our website. +Products and Services +We currently operate in three reportable segments: Roadway Sensors, Transportation Systems and iPerform. The Roadway Sensors segment includes, among other products, our Vantage, VersiCam, Pico, Vantage Vector, SmartCycle, SmartScan and Abacus vehicle detection systems for traffic intersection control, incident detection and certain highway traffic data collection applications. The Transportation Systems segment includes transportation engineering and consulting services, and the development of transportation management and traveler information systems for the ITS industry. This segment also includes 511 advanced traveler information systems and offers our weather related Maintenance Decision Support System management tools that allow users to create solutions to meet roadway maintenance decision needs. The iPerform segment includes our transportation performance measurement and information management solutions. The iPerform performance measurement solutions leverage its real-time data collection, diagnostic, fusion and warehousing platform to aggregate and compute performance measurements. See Note 13 of Notes to Consolidated Financial Statements, included in Part IV, Item 15 of this report, for further details on our reportable segments. +Roadway Sensors +Our Roadway Sensors segment product line uses advanced image processing technology to capture and analyze video images through sophisticated algorithms, enabling vehicle detection and transmission of both video images and data using various communication technologies. +2 +Table of Contents +· Our Vantage video detection systems detect vehicle presence at intersections, as well as vehicle count, speed and other traffic data used in traffic management systems. Vantage video detection systems typically include up to four of our RZ-4 Advanced cameras or our RZ-4 Advanced Wide Dynamic Range cameras and an EdgeConnect processor. Our Vantage systems give traffic managers the ability to mitigate roadway congestion by modifying traffic signal timing or detecting incidents quickly. Our VantageView software supplements our Vantage video detection systems by providing an integrated platform to manage and “see” video detection assets remotely over a network connection. +· Our Vantage Vector product is an all-in-one vehicle detection sensor with a wide range of capabilities including: stop bar detection, advanced-zone detection, and sensing that enables advanced safety and adaptive control applications. It includes all the proven benefits of Iteris video detection, including high accuracy, high availability remote viewing of video images, no trenching or pavement cutting for installation, bicycle detection capability and high precision for dilemma zone detection by integrating the video field-of-view with radar sensing. Enhanced information includes the number of vehicles, speed, and distance in user configurable zones that can be used for special applications. +· Our SmartSpan product uses proprietary Dynamic Zone Stabilization algorithms and provides accurate and cost effective advance detection and stop-bar detection of vehicles at intersections equipped with span wire mounted signal lights. SmartSpan can be mounted on the same span wires holding the traffic signal without sacrificing detection accuracy. +· Our Vantage systems equipped with SmartCycle can effectively differentiate between bicycles and other vehicles with a single video detection camera, enabling more efficient signalized intersections and maximized traffic throughput. Agencies using bicycle timing can now benefit from bicycle-specific virtual detection zones that can be placed anywhere within the approaching traffic lanes, eliminating the need for separate bicycle-only detection systems. +· VersiCam, our integrated camera and processor video detection system, is a cost-efficient video detection system for smaller intersections that require only a few detection points. +· Pico, our compact video detection system, was developed primarily to address international video detection needs, and was designed for easy installation and configuration. +· Our Abacus products take advantage of the large number of existing installed closed-circuit television video feeds designed to monitor roadways, signalized intersections, tunnels and bridges to allow for data collection and incident detection without the set-up and calibration generally required with other systems. +We believe that future growth domestically and internationally, particularly in developing countries, will be dependent in part on the continued adoption of above-ground video detection technologies, instead of traditional in-pavement loop technology, to manage traffic. +We have historically experienced seasonality, particularly with respect to our Roadway Sensors revenues in our third and fourth fiscal quarters due to reductions in road construction and repairs during the winter months related to inclement weather conditions. +Transportation Systems +Our Transportation Systems segment includes transportation engineering and consulting services focused on the planning, design, development and implementation of software-based systems that integrate sensors, video surveillance, computers and advanced communications equipment to enable public agencies to monitor, control and direct traffic flow, assist in the quick dispatch of emergency crews and distribute real-time information about traffic conditions. Our services include planning, design and implementation of surface transportation infrastructure systems. We perform analysis and study goods movement, study commercial vehicle operations, provide travel demand forecasting and systems engineering, and identify mitigation measures to reduce traffic congestion. This segment also includes the activities of Meridian Environmental Technology, Inc. (“MET”), acquired by us in January 2011, which specializes in 511 advanced traveler information systems as well as Maintenance Decision Support System (“MDSS”) management tools that allow users to create solutions to meet roadway maintenance decision needs. +Our Transportation Systems segment is largely dependent upon governmental funding and is affected by state and local budgetary issues. We expect the recently enacted federal highway bill, which provides for an estimated $105 billion in federal funding for highway, transit, safety, and related transportation programs through the end of September 2014, should make funds more available for transportation infrastructure, traffic management and performance measurement projects. This bill could encourages government agencies to include ITS technologies in these types of projects to a greater degree than in previous +3 +Table of Contents +legislation. In addition, various other funding mechanisms exist to support transportation infrastructure and related projects. These include bonds, dedicated sales and gas tax measures and other alternative funding sources. We believe the overall expansion of our Transportation Systems segment in the future will at least in part be dependent on the federal governments’ use of funds under the federal highway bill. Delays in the release of funding may prolong uncertainty regarding the allotment of transportation funds in federal, state and local budgets. We believe that prolonged uncertainty has adversely impacted, and may continue to adversely impact, our Transportation Systems revenues and our overall financial performance in future periods. +With the addition of MET in January 2011, we have experienced seasonality particularly related to certain MDSS services in our first and second fiscal quarters mainly because MDSS services are generally not required in the summer months when weather conditions are typically less severe. +iPerform +Our iPerform segment, formed during the first quarter of our fiscal year ended March 31, 2013 (“Fiscal 2013”), includes our performance measurement and information management solutions, including all of the operations of Berkeley Transportation Systems, Inc. (“BTS”), acquired by us in November 2011, which specializes in transportation performance measurement. The BTS performance measurement system leverages its real-time data collection, diagnostic, fusion and warehousing platform to aggregate and compute performance measurements. During the fiscal year ended March 31, 2012 (“Fiscal 2012”), we began the development of IterisPeMS, which is a state-of-the-art information management software suite that utilizes a wide range of data resources and analytical techniques to determine current and future traffic patterns, permitting the effective performance analysis and management of traffic infrastructure resources. This information can then be analyzed by traffic professionals to measure how a transportation network is performing and to identify potential areas of improvement. IterisPeMS is also capable of providing users with traffic predictive analytics and easy-to-use visualization and animation features based on historical traffic conditions. +iPerform is a market leader in performance management solutions for federal, state, local and municipal organizations. We intend to use its strong brand and deep experience in the traffic management market, as well as its market-specific intellectual property, to expand our leadership in data aggregation and analytics. By increasing investments in both technical and market development, we plan to focus on expanding the scope of its public sector solutions into the commercial marketplace. +Going forward, iPerform’s solutions are expected to include incident management applications, arterial solutions, predictive traffic, and weather-based data and analytics for both public and commercial markets, including media, automotive, and consumer applications. We plan to fund these investments through internally generated cash flow from our Roadway Sensors and Transportation Systems operating segments, as well as revenues from our iPerform segment and our available cash if necessary. +Sales, Marketing and Principal Customers +We sell our Roadway Sensors products through direct and indirect sales channels. In the territories where we sell direct, we use a combination of our own sales personnel and an outside sales organization to sell, oversee installations and set-up issues and support our products. Our indirect sales channels are comprised of a network of independent dealers in the U.S. and certain foreign locations, who sell integrated systems and related products to the traffic management market. Our independent dealers are trained in, and primarily responsible for, sales, installation, set-up and support of our products, and maintain an inventory of demonstration traffic products from various manufacturers and sell directly to government agencies and installation contractors. These dealers often have long-term arrangements with local government agencies in their respective territories for the supply of various products for the construction and renovation of traffic intersections, and are generally well-known suppliers of high-quality ITS products to the traffic management market. We periodically hold technical training classes for our dealers and end users and maintain a full-time staff of customer support technicians throughout the U.S. to provide technical assistance when needed. When appropriate, we have the ability to modify or make changes to our dealer network to accommodate the needs of the market and our customer base. +We market and sell our Transportation Systems services and solutions and iPerform solutions directly to government agencies pursuant to negotiated contracts that involve competitive bidding and specific qualification requirements. Most of our contracts are with federal, state and municipal customers and generally provide for cancellation or renegotiation at the option of the customer upon reasonable notice and fees paid for modification. We generally use selected members of our engineering, science and information technology teams on a regional basis to serve in sales and business development functions. Our contracts generally involve long lead times and require extensive specification development, evaluation and price negotiations. Additionally, we plan to focus on expanding the scope of our iPerform public sector solutions to sell into the commercial marketplace. +A large portion of our revenues are derived from sales to federal, state and local government agencies. We currently have, and historically have had, a diverse customer base. For Fiscal 2013, one individual customer represented approximately 13% of our total revenues and no other individual customer represented greater than 10% of our total revenues. For Fiscal 2012 and our fiscal year +4 +Table of Contents +ended March 31, 2011 (“Fiscal 2011”), no individual customer represented greater than 10% of our total revenues. Also refer to Note 13 of Notes to Consolidated Financial Statements, included in Part IV, Item 15 of this report. +Manufacturing and Materials +We use contract manufacturers to build subassemblies that are used in our Roadway Sensors products. Additionally, we procure certain components from qualified suppliers, both locally and globally, and generally use multi-sourcing strategies when technically and economically feasible to mitigate supply risk. These subassemblies and components are typically delivered to our Santa Ana, California facility where they go through final assembly and testing prior to shipment to our customers. Our key suppliers include CTS Electronics Manufacturing Solutions, Inc., Sony Electronics, Inc. and LG Electronics, Inc. Our manufacturing activities are conducted in approximately 9,000 square feet of space at our Santa Ana facility. Production volume at our subcontractors is based upon quarterly forecasts that we generally adjust on a monthly basis to control inventory levels. We typically do not manufacture any of the hardware used in the transportation management and traveler information systems that we design and implement. Our production facility is currently ISO 9001 certified. +Customer Support and Services +We provide warranty service and support for our products, as well as follow-up service and support for which we charge separately. Such service revenue was not a material portion of our total revenues for each of Fiscal 2013, Fiscal 2012 and Fiscal 2011. We believe customer support is a key competitive factor. +Backlog +Our total backlog of unfulfilled firm orders was approximately $38.6 million as of March 31, 2013, which was comprised of $3.1 million related to Roadway Sensors, $32.2 million related to Transportation Systems and $3.3 million related to iPerform. Substantially the entire backlog for Roadway Sensors is expected to be recognized as revenue in the fiscal year ending March 31, 2014 (“Fiscal 2014”). In the past three fiscal years, we have recognized approximately 50% to 70% of our Transportation Systems backlog as of the end of a fiscal year in the subsequent fiscal year, and currently expect that trend to continue for the near future for both Transportation Systems and iPerform. +At March 31, 2012, we had backlog of approximately $35.0 million, which was comprised of $3.2 million related to Roadway Sensors and $31.8 million related to Transportation Systems. +The timing and realization of our backlog is subject to the inherent uncertainties of doing business with federal, state and local governments, particularly in view of budgetary constraints, cut-backs and other delays or reallocations of funding that these entities typically face. +Pursuant to the customary terms of our agreements with government contractors and other customers, customers can generally cancel or reschedule orders with little or no penalties. Lead times for the release of purchase orders often depend upon the scheduling and forecasting practices of our individual customers, which also can affect the timing of the conversion of our backlog into revenues. For these reasons, among others, our backlog at a particular date may not be indicative of our future revenues, in particular for our Roadway Sensors segment. +Product Development +Most of our product development activities are conducted at our principal facilities in Santa Ana, California. Our research and development costs and expenses were approximately $3.1 million for Fiscal 2013, $3.2 million for Fiscal 2012 and $2.4 million for Fiscal 2011. We expect to continue to pursue various product development programs and incur research and development expenditures in future periods. +We believe our engineering and product development capabilities are a competitive strength. We strive to continue to develop new products to meet the needs of the ever-changing ITS market as well as enhance and refine our existing product lines. Since 2008 our Roadway Sensors segment has introduced our VersiCam and VersiCam wireless products, Pico, RZ-4 advanced camera and our RZ-4 advanced wide dynamic range camera, which significantly improve video detection performance in certain harsh lighting conditions. During Fiscal 2012, we introduced our Vantage Vector product and also upgraded our Abacus and VantageView software products. Additionally, during Fiscal 2012, we began development of our software based IterisPeMS performance measurement system, which continued through Fiscal 2013 and will continue during Fiscal 2014. We believe that developing new offerings across our segments and enhancing, refining and marketing our existing products is a key component of strong organic growth and profitability. +5 +Table of Contents +Competition +We generally face significant competition in each of our target markets. Increased competition may result in price reductions, reduced gross margins and loss of market share, any of which could have a material adverse effect on our business, financial condition and results of operations. +In the market for our Roadway Sensors vehicle detection products, we compete with manufacturers and distributors of other above ground video camera detection systems and other non-intrusive detection devices, including microwave, infrared, ultrasonic and magnetic detectors, as well as manufacturers and installers of in-pavement inductive loop products, which have historically, and currently continue to be, the predominant detection system in this market. +The markets in which our Transportation Systems segment operates is highly fragmented and subject to evolving national and regional quality, operations and safety standards. Our competitors vary in number, scope and breadth of the products and services they offer. Our competitors in advanced Transportation Systems include national corporations that generally offer expertise in traveler information, integration and transportation management. Our competitors in transportation engineering, planning and design include major regional firms, as well as many smaller local engineering firms. +The markets in which our iPeform segment operates vary from public sector customers who focus on performance measurement systems to help measure and manage the effectiveness of their transportation systems to commercial sector customers who ingest and disseminate traffic and weather related data, information and analytics through various consumer outlets. Our competitors vary in number, scope and breadth of the products and services they offer. In the public sector we compete with some of the same transportation engineering, planning and design firms that also compete with our Transportation Systems segment. In the commercial sector, we compete with a variety of entities that currently provide traffic and/or weather related data to that market. +In general, the markets for the products and services we offer are highly competitive and are characterized by rapidly changing technology and evolving standards. Many of our current and prospective competitors have longer operating histories, greater name recognition, access to larger customer bases and significantly greater financial, technical, manufacturing, distribution and marketing resources than us. As a result, they may be able to adapt more quickly to new or emerging standards or technologies or to devote greater resources to the promotion and sale of their products. It is also possible that new competitors or alliances among competitors could emerge and rapidly acquire significant market share. We believe that our ability to compete effectively in our target markets will depend on a number of factors, including the success and timing of our new product development, the compatibility of our products with a broad range of computing systems, product quality and performance, reliability, functionality, price and service and technical support. Our failure to provide services and develop and market products that compete successfully with those of other suppliers and consultants in our target markets would have a material adverse effect on our business, financial condition and results of operations. +Intellectual Property and Proprietary Rights +Our ability to compete effectively depends in part on our ability to develop and maintain the proprietary aspects of our technology. Our policy is to obtain appropriate proprietary rights protection for any potentially significant new technology acquired or developed by us. We currently hold three U.S. patents, four foreign patent applications, six patent applications in the United States (“U.S.”), and eight provisional patent filings. One U.S. patent, which expires in May 2019, is for general technology related to CMOS sensors. Two U.S. patents, which expire between 2014 and 2029, three foreign patent applications, three U.S. patent applications, and one provisional patent filing relate specifically to our Roadway Sensors technology. One pending foreign patent, three U.S. patent applications, and seven provisional patent filings relate specifically to our iPerform technology. We cannot be certain that any new patents will be granted pursuant to these or subsequent patent applications or provisional patent filings. +In addition to patent laws, we rely on copyright and trade secret laws to protect our proprietary rights. We attempt to protect our trade secrets and other proprietary information through agreements with customers and suppliers, proprietary information agreements with our employees and consultants, and other similar measures. We do not have any material licenses or trademarks other than those relating to product names. We cannot be certain that we will be successful in protecting our proprietary rights. While we believe our patents, patent applications, software and other proprietary know-how have value; changing technology makes our future success dependent principally upon our ability to successfully achieve continuing innovation. +Litigation may be necessary in the future to enforce our proprietary rights, to determine the validity and scope of the proprietary rights of others, or to defend us against claims of infringement or invalidity by others. An adverse outcome in such litigation or similar proceedings could subject us to significant liabilities to third parties, require disputed rights to be licensed from others or require us to cease marketing or using certain products, any of which could have a material adverse effect on our business, financial condition and results of operations. In addition, the cost of addressing any intellectual property litigation claim, both in legal +6 +Table of Contents +fees and expenses, as well as from the diversion of management’s resources, regardless of whether the claim is valid, could be significant and could have a material adverse effect on our business, financial condition and results of operations. +Employees +We refer to our employees as associates. As of March 31, 2013, we employed an aggregate of 258 associates, including 55 associates in general management, administration and finance; 24 associates in sales and marketing; 150 associates in engineering and product development; 14 associates in operations, manufacturing and quality assurance; and 15 associates in customer service. None of our associates are represented by a labor union, and we have never experienced a work stoppage. We believe our relations with our associates are good. +Sale of Vehicle Sensors +On July 29, 2011, we completed the sale of substantially all of the assets used in connection with our Vehicle Sensors segment to Bendix Commercial Vehicle Systems LLC (“Bendix”), a member of Knorr-Bremse Group, pursuant to an Asset Purchase Agreement signed on July 25, 2011 (the “Asset Sale”). Upon closing, Bendix paid us $14 million in cash, subject to a $2 million holdback and adjustments based upon the working capital of the Vehicle Sensors segment at closing, and Bendix assumed certain specified obligations and liabilities of the Vehicle Sensors segment. In October 2012, we received approximately $1.7 million in connection with the holdback provision. Furthermore, we are entitled to additional consideration in the form of certain performance and royalty-related earn-outs. As a result of the Asset Sale, we no longer operate in the Vehicle Sensors segment and we determined that the Vehicle Sensors segment, which previously constituted one of our operating segments, qualifies as a discontinued operation. Refer to Note 3 of Notes to Consolidated Financial Statements, included in Part IV, Item 15 of this report for additional discussion regarding the Asset Sale. The applicable financial results of the Vehicle Sensors segment through the closing of the Asset Sale have been reported as a discontinued operation for all periods presented. +Government Regulation +Our manufacturing operations are subject to various federal, state and local laws and regulations, including those restricting the discharge of materials into the environment. We are not involved in any pending or, to our knowledge, threatened governmental proceedings, which would require curtailment of our operations because of such laws and regulations. We continue to expend funds in connection with our compliance with applicable environmental regulations. These expenditures have not, however, been significant in the past, and we do not expect any significant expenditure in the near future. Currently, compliance with foreign laws has not had a material impact on our business and is not expected to have a material impact in the near future. +7 +Table of Contents +ITEM 1A. RISK FACTORS +Our business is subject to a number of risks, some of which are discussed below. Other risks are presented elsewhere in this report and in the information incorporated by reference into this report. You should consider the following risks carefully in addition to the other information contained in this report and our other filings with the SEC, including our subsequent reports on Forms 10-Q and 8-K, before deciding to buy, sell or hold our common stock. The risks and uncertainties described below are not the only ones facing our company. Additional risks and uncertainties not presently known to us or that we currently deem immaterial may also affect our business operations. If any of these risks actually occurs, our business, financial condition, or results of operations could be seriously harmed. In that event, the market price for our common stock could decline and you may lose all or part of your investment. +The economic slowdown has reduced and delayed government funding for transportation infrastructure projects and initiatives, decreased availability of financial capital for our customers and adversely impacted real estate development, all of which have adversely impacted our revenues. Decreased consumer spending, the failure of certain financial institutions and businesses, concerns about the availability and cost of credit, and reduced corporate profits and capital spending have resulted in a downturn in worldwide economic conditions, as well as budgetary shortfalls at all levels of government. These unfavorable economic conditions are having, and are expected to continue to have, a negative impact on customer orders and government funding of infrastructure projects incorporating our products and services. Such factors have resulted and may continue to result in delays, cancellations and rescheduling of backlog and customer orders. In addition, the decline in the U.S. real estate market, particularly in new home and commercial construction, has adversely impacted new road construction and has had and may continue to have adverse effects on revenues. Any of the foregoing economic conditions may adversely affect our revenues in future periods and make it extremely difficult for our customers, our suppliers and us to accurately forecast and plan future business activities. Additionally, there was uncertainty in the past few years regarding allotment of government funds due to delays in the passage of a federal highway bill, which adversely impacted our revenues and overall financial performance. Despite the recently enacted federal highway bill, delays in the allocation of funds, the priority of infrastructure projects and the availability of funds for ITS related projects could continue to adversely impact our revenues and overall financial performance. +Because we depend on government contracts and subcontracts, we face additional risks related to contracting with federal, state and local governments, including budgetary issues and fixed price contracts. A significant portion of our revenues are derived from contracts with governmental agencies, either as a general contractor, subcontractor or supplier. We anticipate that revenue from government contracts will continue to remain a significant portion of our revenues. Government business is, in general, subject to special risks and challenges, including: +· delays in funding and uncertainty regarding the allocation of funds to state and local agencies from the U.S. federal government as a result of delays in the expenditures from the federal highway bill, as well as delays or reductions in other state and local funding dedicated for transportation and ITS projects; +· other government budgetary constraints, cut-backs, delays or reallocation of government funding; +· performance bond requirements; +· long purchase cycles or approval processes; +· competitive bidding and qualification requirements; +· changes in government policies and political agendas; +· milestone requirements and liquidated damage provisions for failure to meet contract milestones; and +· international conflicts or other military operations that could cause the temporary or permanent diversion of government funding from transportation or other infrastructure projects. +Governmental budgets and plans are subject to change without warning. Certain risks of selling to governmental entities include dependence on appropriations and administrative allocation of funds, changes in governmental procurement legislation and regulations and other policies that may reflect political developments or agendas, significant changes in contract scheduling, intense competition for government business and termination of purchase decisions for the convenience of the governmental entity. Substantial delays in purchase decisions by governmental entities, and the current constraints on government budgets at the federal, state and local level, could cause our revenues and income to drop substantially or to fluctuate significantly between fiscal periods. +In addition, a number of our government contracts are fixed price contracts. As a result, we may not be able to recover any cost overruns we may incur. These fixed price contracts require us to estimate the total project cost based on preliminary projections of the project’s requirements. The financial viability of any given project depends in large part on our ability to estimate these costs +8 +Table of Contents +accurately and complete the project on a timely basis. In the event our costs on these projects exceed the fixed contractual amount, we will be required to bear the excess costs. Such additional costs would adversely affect our financial condition and results of operations. Moreover, certain of our government contracts are subject to termination or renegotiation at the convenience of the government, which could result in a large decline in our revenues in any given period. Our inability to address any of the foregoing concerns or the loss or renegotiation of any material government contract could seriously harm our business, financial condition and results of operations. +California state budgetary constraints may have a material adverse impact on us. The state of California has experienced, and is continuing to experience, a significant budget shortfall and other related budgetary issues and constraints. The state of California has historically been and is considered to be a key geographic region for our Roadway Sensors and Transportation Systems segments. Ongoing uncertainty as to the timing and accessibility of budgetary funding, changes in state funding allocations to local agencies and municipalities, or other delays in purchasing for, or commencement of, transportation projects have had and may continue to have a negative impact on our revenues and our income. +If we do not keep pace with rapid technological changes and evolving industry standards, we will not be able to remain competitive and there will be no demand for our products. Our markets are in general characterized by the following factors: +· rapid technological advances; +· downward price pressures in the marketplace as technologies mature; +· changes in customer requirements; +· additional qualification requirements related to new products or components; +· frequent new product introductions and enhancements; +· inventory issues related to transition to new or enhanced models; and +· evolving industry standards and changes in the regulatory environment. +Our future success will depend upon our ability to anticipate and adapt to changes in technology and industry standards, and to effectively develop, introduce, market and gain broad acceptance of new products and product enhancements incorporating the latest technological advancements. +If we are unable to develop and introduce new products and product enhancements successfully and in a cost-effective and timely manner, or are unable to achieve market acceptance of our new products, our operating results would be adversely affected. We believe our revenue growth and future operating results will depend on our ability to complete development of new products and enhancements, introduce these products in a timely, cost-effective manner, achieve broad market acceptance of these products and enhancements, and reduce our production costs. We cannot guarantee the success of these products, and we may not be able to introduce any new products, including the IterisPeMS software or any enhancements to our existing products on a timely basis, or at all. In addition, the introduction of any new products could adversely affect the sales of certain of our existing products. +We believe that we must continue to make substantial investments to support ongoing research and development in order to remain competitive. We need to continue to develop and introduce new products that incorporate the latest technological advancements in outdoor image processing hardware, software and camera technologies in response to evolving customer requirements. We cannot assure you that we will be able to adequately manage product transition issues. Our business and results of operations could be adversely affected if we do not anticipate or respond adequately to technological developments or changing customer requirements or if we cannot adequately manage inventory issues typically related to new product transitions and introductions. We cannot assure you that any such investments in research and development will lead to any corresponding increase in revenue. +9 +Table of Contents +We recently entered into the software development market and may be subject to additional challenges and additional costs and delays. We have only been in the business of software development for a few years and may experience development and technical challenges. Our business and results of operations could also be seriously harmed by any significant delays in our software development and updates. Certain of our new products could contain undetected design faults and software errors or “bugs” when first released by us, despite our testing. We may not discover these faults or errors until after a product has been installed and used by our customers. Any faults or errors in our existing products or in any new products may cause delays in product introduction and shipments, require design modifications or harm customer relationships, any of which could adversely affect our business and competitive position. We cannot assure you that our customer base will broadly accept any of our new products, product enhancements or software related offerings such as IterisPeMS. In addition, the software development industry can frequently experience litigation concerning intellectual property disputes, which could be costly and distract our management. +The markets in which we operate are highly competitive and have many more established competitors, which could adversely affect our revenues or the market acceptance of our products. We compete with numerous other companies in our target markets including, but not limited to, large, multinational corporations and many smaller regional engineering firms. +We compete with existing, well-established companies in our Roadway Sensors segment, both domestically and abroad. Certain technological barriers to entry make it difficult for new competitors to enter the market with competing video or other technologies; however, we are aware of new market entrants from time to time. Increased competition could result in loss of market share, price reductions and reduced gross margins, any of which could seriously harm our business, financial condition and results of operations. +The Transportation Systems market is highly fragmented and is subject to evolving national and regional quality and safety standards. Our competitors vary in size, number, scope and breadth of the products and services they offer, and include large multi-national engineering firms and smaller local regional firms. +The market for iPeform is nascent; however, we expect to compete with existing companies that are already providing consulting and traffic analytics services to public agencies, as well as certain companies performing real-time traffic collection data activities that we believe are attempting to provide related traffic analytics to public agencies. We cannot assure you that our iPeform solutions, including IterisPeMS, will be broadly accepted by the market and that competitors’ software and analytics solutions will not take and/or gain market share. As such, increased competition in this area could result in loss of market share, price reductions and reduced gross margins, any of which could seriously harm this segment and our overall business. +In all of our segments, many of our competitors have far greater name recognition and greater financial, technological, marketing, and customer service resources than we do. This may allow them to respond more quickly to new or emerging technologies and changes in customer requirements. It may also allow them to devote greater resources to the development, promotion, sale and support of their products than we can. Consolidations of end users, distributors and manufacturers in our target markets exacerbate this problem. As a result of the foregoing factors, we may not be able to compete effectively in our target markets and competitive pressures could adversely affect our business, financial condition and results of operations. +We may be unable to attract and retain key personnel, which could seriously harm our business. Due to the specialized nature of our business, we are highly dependent on the continued service of our executive officers and other key management, engineering and technical personnel. The loss of any of our officers, or any of our other executives or key members of management could adversely affect our business, financial condition, or results of operations. Our success will also depend in large part upon our ability to continue to attract, retain and motivate qualified engineering and other highly skilled technical personnel. In particular, the future success of our Transportation Systems and iPerform segments will depend on our ability to hire additional qualified engineers, planners, software developers and technical personnel. Competition for qualified employees, particularly development engineers, is intense. We may not be able to continue to attract and retain sufficient numbers of such highly skilled employees. Our inability to attract and retain additional key employees or the loss of one or more of our current key employees could adversely affect our business, financial condition and results of operations. +Our profitability could be adversely affected if we are not able to maintain adequate utilization of our Transportation Systems workforce. The cost of providing our Transportation Systems engineering and consulting services, including the extent to which we utilize our workforce, affects our profitability. The rate at which we utilize our workforce is affected by a number of factors, including: +· our ability to transition employees from completed projects to new assignments and to hire and assimilate new employees; +10 +Table of Contents +· our ability to forecast demand for our services and thereby maintain an appropriate headcount in our various regions; +· our need to devote time and resources to training, business development, professional development and other non-chargeable activities; and +· our ability to match the skill sets of our employees to the needs of the marketplace. +Our failure to successfully bid on new contracts and renew existing contracts could reduce our revenues and profits. Our business depends on our ability to successfully bid on new contracts and renew existing contracts with private and public sector customers. Contract proposals and negotiations are complex and frequently involve a lengthy bidding and selection process, which are affected by a number of factors, such as market conditions, financing arrangements and required governmental approvals. For example, a customer may require us to provide a surety bond or letter of credit to protect the client should we fail to perform under the terms of the contract. If negative market conditions continue, or if we fail to secure adequate financing arrangements or the required governmental approval or fail to meet other required conditions, we may not be able to pursue particular projects, which could reduce or eliminate our profitability. +If we experience declining or flat revenues and we fail to manage such declines effectively, we may be unable to execute our business plan and may experience future weaknesses in our operating results. Based on our business objectives, and in order to achieve future growth, we will need to continue to add additional qualified personnel, and invest in additional research and development and sales and marketing activities, which could lead to increases in our expenses and future declines in our operating results. In addition, our past expansion has placed, and future expansion is expected to place, a significant strain on our managerial, administrative, operational, financial and other resources. If we are unable to manage these activities or any revenue declines successfully, our growth, our business, our financial condition and our results of operations could continue to be adversely affected. +We may be unable to maintain profitability on a quarterly or annual basis. We cannot assure you that we will be able to sustain or improve our financial performance, or that we will be able to continue to achieve profitability on a quarterly or annual basis in the future. Our ability to maintain profitability in future periods could be impacted by budgetary constraints, government and political agendas, economic instability and other items that are not in our control. Furthermore, we rely on operating profits from the Company’s segments to fund investments in sales and marketing and research and development initiatives. We cannot assure you that at any given time these profits will sustain a sufficient level to completely support those investments. Most of our expenses are fixed in advance. As such, we generally are unable to reduce our expenses significantly in the short-term to compensate for any unexpected delay or decrease in anticipated revenues or increases in planned investments. As a result, we may experience operating losses and net losses in the future, which would make it difficult to fund our operations and achieve our business plan, and could cause the market price of our common stock to decline. +Our quarterly operating results fluctuate as a result of many factors. Therefore, we may fail to meet or exceed the expectations of securities analysts and investors, which could cause our stock price to decline. Our quarterly revenues and operating results have fluctuated and are likely to continue to vary from quarter to quarter due to a number of factors, many of which are not within our control. Factors that could affect our revenues include, among others, the following: +· delays in government contracts and funding from time to time and budgetary constraints at the federal, state and local levels; +· our ability to access stimulus funding, funding from the federal highway bill or other funding; +· declines in new home and commercial real estate construction and related road and other infrastructure construction; +· changes in our pricing policies and the pricing policies of our suppliers and competitors, pricing concessions on volume sales, as well as increased price competition in general; +· the long lead times associated with government contracts; +· the size, timing, rescheduling or cancellation of significant customer orders; +· our ability to control costs; +· our ability to raise additional capital; +11 +Table of Contents +· the mix of our products and services sold in a quarter, which has varied and is expected to continue to vary from time to time; +· seasonality due to winter weather conditions; +· seasonality with respect to revenues from our MDSS and related weather forecasting services due to the decrease in revenues generated for such services during the spring and summer time periods; +· our ability to develop, introduce, patent, market and gain market acceptance of new products, applications and product enhancements in a timely manner, or at all; +· market acceptance of the products incorporating our technologies and products; +· the introduction of new products by competitors; +· the availability and cost of components used in the manufacture of our products; +· our success in expanding and implementing our sales and marketing programs; +· the effects of technological changes in our target markets; +· the amount of our backlog at any given time; +· the nature of our government contracts; +· decrease in revenues derived from key or significant customers; +· deferrals of customer orders in anticipation of new products, applications or product enhancements; +· risks and uncertainties associated with our international business; +· general economic and political conditions; +· international conflicts and acts of terrorism; and +· other factors beyond our control, including but not limited to, natural disasters. +Due to all of the factors listed above as well as other unforeseen factors, our future operating results could be below the expectations of securities analysts or investors. If that happens, the trading price of our common stock could decline. As a result of these quarterly variations, you should not rely on quarter-to-quarter comparisons of our operating results as an indication of our future performance. +We may be subject to traffic related litigation . The traffic industry in general is subject to litigation claims due to the nature of personal injuries that result from traffic accidents. As a provider of traffic engineering services, products and solutions, we are, and could in the future continue to be, from time to time, subject to litigation for traffic related accidents, even if our products or services did not cause the particular accident. While we generally carry insurance against these types of claims, some claims may not be covered by insurance or the damages resulting from such litigation could exceed our insurance coverage limits. In the event that we are required to pay significant damages as a result of one or more lawsuits that are not covered by insurance or exceed our coverage limits, it could materially harm our business, financial condition or cash flows. Even defending against unsuccessful claims could cause us to incur significant expenses and result in a diversion of management’s attention. +We may experience production gaps that could materially and adversely impact our sales and financial results and the ultimate acceptance of our products. It is possible that we could experience unforeseen quality control issues or part shortages as we adjust production to meet current demand for our products. We have historically used single suppliers for certain significant components in our products. Should any such delay or disruption occur, or should a key supplier discontinue operations because of the current economic climate, our future sales will likely be materially and adversely affected. Additionally, we rely heavily on select contract manufacturers to produce many of our products and do not have any long-term contracts to guarantee supply of such products. Although we believe our contract manufacturers have sufficient capacity to meet our production schedules for the foreseeable future and we believe we could find alternative contract manufacturing sources for many of our products, if necessary, we could experience a production gap if for any reason our contract manufacturers were unable to meet our production requirements and our cost of goods sold could increase, adversely affecting our margins. +Our use of the percentage of completion method of accounting for our Transportation Systems revenues could result in a reduction or reversal of previously recorded revenues and profits. A significant portion of Transportation Systems revenues +12 +Table of Contents +are measured and recognized using the percentage of completion method of accounting. Our use of this accounting method results in recognition of revenues and profits ratably over the life of a contract, based generally on the proportion of costs incurred to date to total costs expected to be incurred for the entire project. The effects of revisions to revenues and estimated costs are recorded when the amounts are known or can be reasonably estimated. Such revisions could occur in any period and their effects could be material. Although we have historically made reasonably reliable estimates of the progress towards completion of long-term engineering, program management, construction management or construction contracts, the uncertainties inherent in the estimating process make it possible for actual costs to vary materially from estimates, including reductions or reversals of previously recorded revenues and profits. +We may engage in acquisitions of companies or technologies that may require us to undertake significant capital infusions and could result in disruptions of our business and diversion of resources and management attention. We have completed three acquisitions since April 2009 and, in the future, we may acquire additional complementary businesses, products, and technologies. Acquisitions may require significant capital infusions and, in general, acquisitions also involve a number of special risks, including: +· potential disruption of our ongoing business and the diversion of our resources and management’s attention; +· the failure to retain or integrate key acquired personnel; +· the challenge of assimilating diverse business cultures, and the difficulties in integrating the operations, technologies and information system of the acquired companies; +· increased costs to improve managerial, operational, financial and administrative systems and to eliminate duplicative services; +· the incurrence of unforeseen obligations or liabilities; +· potential impairment of relationships with employees or customers as a result of changes in management; and +· increased interest expense and amortization of acquired intangible assets, as well as unanticipated accounting charges. +Our competitors are also soliciting potential acquisition candidates, which could both increase the price of any acquisition targets and decrease the number of attractive companies available for acquisition. Acquisitions may also materially and adversely affect our operating results due to large write-offs, contingent liabilities, substantial depreciation, deferred compensation charges or intangible asset amortization, or other adverse tax or accounting consequences. We cannot assure you that we will be able to identify or consummate any additional acquisitions, successfully integrate any acquisitions or realize the benefits anticipated from any acquisition. +Our international business operations may be threatened by many factors that are outside of our control. While we historically have had limited international sales, revenues and operations experience, we began work on our first overseas contracts in the United Arab Emirates in the fiscal year ended March 31, 2010. We plan to expand our international efforts in the future with respect to all of our segments, and in particular, plan to expand or distribution channels in Latin American and the Middle East in general. We cannot assure you that we will be successful in our expansion efforts. International operations subject us to various inherent risks including, among others: +· political, social and economic instability, as well as international conflicts and acts of terrorism; +· inability to satisfy bonding requirements for certain international projects; +· longer accounts receivable payment cycles; +· import and export license requirements and restrictions of the U.S. and each other country in which we operate; +· currency fluctuations and restrictions, and our ability to repatriate currency from certain foreign regions; +· unexpected changes in regulatory requirements, tariffs and other trade barriers or restrictions; +13 +Table of Contents +· required compliance with existing and new foreign regulatory requirements and laws, more restrictive labor laws and obligations, including but not limited to the U.S. Foreign Corrupt Practices Act; +· difficulties in managing and staffing international operations; +· potentially adverse tax consequences; and +· reduced protection for intellectual property rights in some countries. +Substantially all of our international sales are denominated in U.S. dollars. As a result, an increase in the relative value of the dollar could make our products more expensive and potentially less price competitive in international markets. We do not currently engage in any transactions as a hedge against risks of loss due to foreign currency fluctuations. +Any of the factors mentioned above may adversely affect our future international revenues and, consequently, affect our business, financial condition and operating results. Additionally, as we pursue the expansion of our international business, certain fixed and other overhead costs could outpace our revenues, thus adversely affecting our results of operations. We may likewise face local competitors in certain international markets who are more established, have greater economies of scale and stronger customer relationships. Furthermore, as we increase our international sales, our total revenues may also be affected to a greater extent by seasonal fluctuations resulting from lower sales that typically occur during the summer months in Europe and other parts of the world. +If our internal controls over financial reporting do not comply with the requirements of the Sarbanes-Oxley Act, our business and stock price could be adversely affected. Section 404 of the Sarbanes-Oxley Act of 2002 currently requires us to evaluate the effectiveness of our internal controls over financial reporting at the end of each fiscal year and to include a management report assessing the effectiveness of our internal controls over financial reporting in all annual reports. As a smaller reporting company, for Fiscal 2013, we were exempt from the auditor attestation requirement over our internal control over financial reporting; however, to the extent we do not qualify as a non-accelerated filer or smaller reporting company in subsequent fiscal years, we will be subject to the auditor attestation requirement under Section 404(b) of the Sarbanes-Oxley Act. In such an event, we may not be able to complete the work required for such attestation on a timely basis and, even if we timely complete such requirements, our independent registered public accounting firm may still conclude that our internal controls over financial reporting are not effective. +Our management, including our CEO and CFO, does not expect that our internal controls over financial reporting will prevent all errors and all fraud. A control system, no matter how well designed and operated, can provide only reasonable, not absolute, assurance that the control system’s objectives will be met. Further, the design of a control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within Iteris have been or will be detected. These inherent limitations include the realities that judgments in decision-making can be faulty and that breakdowns can occur because of simple errors or mistakes. Controls can also be circumvented by the individual acts of some persons, by collusion of two or more people, or by management override of the controls. The design of any system of controls is based in part on certain assumptions about the likelihood of future events, and we cannot assure you that any design will succeed in achieving its stated goals under all potential future conditions. Over time, our controls may become inadequate because of changes in conditions or deterioration in the degree of compliance with policies or procedures. Because of the inherent limitations in a cost-effective control system, misstatements due to error or fraud may occur and not be detected. +We may not be able to adequately protect or enforce our intellectual property rights, which could harm our competitive position. If we are not able to adequately protect or enforce the proprietary aspects of our technology, competitors could be able to access our proprietary technology and our business, financial condition and results of operations will likely be seriously harmed. We currently attempt to protect our technology through a combination of patent, copyright, trademark and trade secret laws, employee and third party nondisclosure agreements and similar means. Despite our efforts, other parties may attempt to disclose, obtain or use our technologies or systems. Our competitors may also be able to independently develop products that are substantially equivalent or superior to our products or design around our patents. In addition, the laws of some foreign countries do not protect our proprietary rights as fully as do the laws of the U.S. As a result, we may not be able to protect our proprietary rights adequately in the U.S. or abroad. +Litigation may be necessary in the future to enforce our intellectual property rights or to determine the validity and scope of the proprietary rights of others. Litigation may also be necessary to defend against claims of infringement or invalidity by others. An adverse outcome in litigation or any similar proceedings could subject us to significant liabilities to third parties, require us to license disputed rights from others or require us to cease marketing or using certain products or technologies. We may not be able to obtain any licenses on terms acceptable to us, or at all. We also may have to indemnify certain customers or strategic partners if it is determined that we have infringed upon or misappropriated another party’s intellectual property. Our recent expansion into software development activities may subject us to increased possibility of litigation. Any of the foregoing could adversely affect our business, +14 +Table of Contents +financial condition and results of operations. In addition, the cost of addressing any intellectual property litigation claim, including legal fees and expenses, and the diversion of management’s attention and resources, regardless of whether the claim is valid, could be significant and could seriously harm our business, financial condition and results of operations. +We may need to raise additional capital in the future, which may not be available on terms acceptable to us, or at all. We have historically experienced volatility in our earnings and cash flows from operations from year to year. Although we have a $12.0 million revolving line of credit, should we have an event of default, which includes, among other things, a failure to meet certain financial covenants and a material adverse change in the business, the bank could choose to limit or take away our ability to borrow these or any funds. Should this occur, or if the credit markets further tighten or our business declines, we may need or choose to raise additional capital to repay indebtedness, pursue acquisitions or expand our operations. Such additional capital may be raised through bank borrowings, or other debt or equity financings. We cannot assure you that any additional capital will be available on a timely basis, on acceptable terms, or at all, and such additional financing may result in further dilution to our stockholders. +Our capital requirements will depend on many factors, including, but not limited to: +· market acceptance of our products and product enhancements, and the overall level of sales of our products; +· our ability to control costs; +· the supply of key components for our products; +· our ability to increase revenue and net income; +· increased research and development expenses and sales and marketing expenses; +· our need to respond to technological advancements and our competitors’ introductions of new products or technologies; +· capital improvements to new and existing facilities and enhancements to our infrastructure and systems; +· potential acquisitions of businesses and product lines; +· our relationships with customers and suppliers; +· government budgets, political agendas and other funding issues, including potential delays in government contract awards; +· our ability to successfully negotiate credit arrangements with our bank and the state of the financial markets, in general; and +· general economic conditions, including the effects of the current economic slowdown and international conflicts. +If our capital requirements are materially different from those currently planned, we may need additional capital sooner than anticipated. If additional funds are raised through the issuance of equity or convertible debt securities, the percentage ownership of our stockholders will be reduced and such securities may have rights, preferences and privileges senior to our common stock. Additional equity or debt financing may not be available on favorable terms, on a timely basis, or at all. If adequate funds are not available or are not available on acceptable terms, we may be unable to continue our operations as planned, develop or enhance our products, expand our sales and marketing programs, take advantage of future opportunities or respond to competitive pressures. +The trading price of our common stock is highly volatile. The trading price of our common stock has been subject to wide fluctuations in the past. Since April 2010, our common stock has traded at prices as low as $0.90 per share and as high as $2.25 per share. The market price of our common stock could continue to fluctuate in the future in response to various factors, including, but not limited to: +· quarterly variations in operating results; +· our ability to control costs, improve cash flow and sustain profitability; +· our ability to raise additional capital; +· shortages announced by suppliers; +· announcements of technological innovations or new products or applications by our competitors, customers or us; +15 +Table of Contents +· transitions to new products or product enhancements; +· acquisitions of businesses, products or technologies; +· the impact of any litigation; +· changes in investor perceptions; +· government funding, political agendas and other budgetary constraints; +· changes in earnings estimates or investment recommendations by securities analysts; and +· international conflicts, political unrest and acts of terrorism. +The stock market in general has from time to time experienced volatility, which has often affected the market prices of equity securities of many technology companies. This volatility has often been unrelated to the operating performance of these companies. These broad market fluctuations may adversely affect the market price of our common stock. In the past, companies that have experienced volatility in the market price of their securities have been the subject of securities class action litigation. If we were to become the subject of a class action lawsuit, it could result in substantial losses and divert management’s attention and resources from other matters. +Certain provisions of our charter documents may discourage a third party from acquiring us and may adversely affect the price of our common stock. Certain provisions of our certificate of incorporation could make it difficult for a third party to acquire us, even though an acquisition might be beneficial to our stockholders. Such provisions could limit the price that investors might be willing to pay in the future for shares of our common stock. Under the terms of our certificate of incorporation, our Board of Directors is authorized to issue, without stockholder approval, up to 2,000,000 shares of preferred stock with voting, conversion and other rights and preferences superior to those of our common stock. In August 2009, we adopted a new stockholder rights plan and declared a dividend of preferred stock purchase rights to our stockholders. Generally, the stockholder rights plan provides that if a person or group acquires 15% or more of our common stock, subject to certain exceptions and under certain circumstances, the rights may be exchanged by us for common stock or the holders of the rights, other than the acquiring person or group, could acquire additional shares of our capital stock at a discount off of the then current market price. Such exchanges or exercise of rights could cause substantial dilution to a particular acquirer and discourage the acquirer from pursuing our company. The mere existence of a stockholder rights plan often delays or makes a merger, tender offer or other acquisition more difficult. +ITEM 1B. UNRESOLVED STAFF COMMENTS +None. +ITEM 2. PROPERTIES +Our headquarters and principal operations are housed in approximately 52,000 square feet of leased office, manufacturing and warehouse space located in Santa Ana, California. This facility lease expires in 2015 and contains an option to extend the lease for an additional five years at the market rate at that time. For additional information regarding our obligations under property leases, see Note 9 of Notes to Consolidated Financial Statements, included in Part IV, Item 15 of this report. +ITEM 3. LEGAL PROCEEDINGS +The information set forth under the heading “Litigation and Other Contingencies” under Note 9 of Notes to Consolidated Financial Statements, included in Part IV, Item 15 of this report, is incorporated herein by reference. +ITEM 4. MINE SAFETY DISCLOSURES +Not applicable. +16 +Table of Contents +PART II +ITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES +Market Information and Holders +Our common stock is traded on the NYSE MKT under the symbol “ITI.” The following table sets forth, for the periods indicated, the highest and lowest sales prices for our common stock as reported by NYSE MKT: +High +Low +Fiscal 2013 +Quarter Ended June 30, 2012 +$ +1.52 +$ +1.25 +Quarter Ended September 30, 2012 +1.72 +1.34 +Quarter Ended December 31, 2012 +1.82 +1.45 +Quarter Ended March 31, 2013 +1.91 +1.55 +Fiscal 2012 +Quarter Ended June 30, 2011 +$ +1.58 +$ +1.22 +Quarter Ended September 30, 2011 +1.35 +0.90 +Quarter Ended December 31, 2011 +1.39 +1.08 +Quarter Ended March 31, 2012 +1.58 +1.31 +On May 28, 2013, the last reported sales price of our common stock on the NYSE MKT was $1.70. As of May 28, 2013, we had 402 holders of record of our common stock according to information furnished by our transfer agent. +Dividend Policy +We have never paid or declared cash dividends on our common stock, and have no current plans to pay such dividends in the foreseeable future. We currently intend to retain any earnings for working capital and general corporate purposes. The payment of any future dividends will be at the discretion of our Board of Directors and will depend upon a number of factors, including, but not limited to, future earnings, the success of our business, our capital requirements, our general financial condition and future prospects, general business conditions, the consent of our lender and such other factors as the Board of Directors may deem relevant. +Issuer Purchases of Equity Securities +In August 2011, our Board of Directors approved a stock repurchase program pursuant to which we were authorized to acquire up to $3 million of our outstanding common stock from time to time through August 2012. On August 9, 2012, our Board of Directors approved a new stock repurchase program pursuant to which we may acquire up to $3 million of our outstanding common stock for an unspecified length of time. Under the new program, we may repurchase shares from time to time in open-market and privately negotiated transactions and block trades, and may also repurchase shares pursuant to an existing or future 10b5-1 trading plan to facilitate repurchases during our closed trading windows. There is no guarantee as to the exact number of shares that will be repurchased. We may modify or terminate the repurchase program at any time without prior notice. The table below details our common stock repurchases during the fourth quarter of Fiscal 2013. All repurchased shares have been retired and resumed their status as authorized and unissued shares of our common stock. +17 +Table of Contents +Issuer Purchases of Equity Securities +Period +Total Number +of Shares +Purchased +Average +Price Paid +per Share +Total Number of +Shares +Purchased as +Part of Publicly +Announced Plans +or Programs +Maximum Number +(or Approximate +Dollar Value) of +Shares that May Yet +Be Purchased Under +the Plans or +Programs +Jan 1 to Jan 31, 2013 +109,908 +$ +1.68 +109,908 +Feb 1 to Feb 28, 2013 +286,804 +1.66 +286,804 +Mar 1 to Mar 31, 2013 +267,338 +1.75 +267,338 +Total +664,050 +$ +1.70 +664,050 +$ +1,086,000 +ITEM 6. SELECTED FINANCIAL DATA +As a smaller reporting company, we are not required to make any disclosure pursuant to this Item 6. +ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS +You should read the following discussion and analysis in conjunction with our Consolidated Financial Statements and related Notes thereto included in Part IV, Item 15 of this report and the “Risk Factors” section in Item 1A, as well as other cautionary statements and risks described elsewhere in this report, before deciding to purchase, hold or sell our common stock. +Overview +General. We are a leading provider of intelligent information solutions to the traffic management market. We are focused on the development and application of advanced technologies and software-based information systems that reduce traffic congestion, provide measurement, management and predictive traffic analytics and improve the safety of surface transportation systems infrastructure. We also believe our products, services and solutions, in conjunction with sound traffic management, minimize the environmental impact of traffic congestion. By combining our unique intellectual property, products, decades of experience in traffic management and information technologies, we offer a broad range of Intelligent Transportation Systems (“ITS”) solutions to customers worldwide. +Acquisitions. In November 2011, we acquired all of the outstanding capital stock of Berkeley Transportation Systems, Inc. (“BTS”), a privately-held company based in Berkeley, California which specializes in transportation performance measurement, for an initial cash payment of approximately $840,000. In the quarter ended December 31, 2012, the Company entered into an amendment to the BTS stock purchase agreement which modified certain earn-out provisions and as a result, the Company paid $700,000 in cash to the BTS shareholders for achievement of those modified earn-out provisions in the fourth quarter of Fiscal 2013. The amendment did not have a material impact on previous estimated amounts accrued in connection with the earn-out provisions. This payment completed the Company’s obligation under the earn-out provisions of the agreement. Additionally, we are scheduled to pay to the BTS shareholders up to a total of approximately $585,000 by November 2014 pursuant to certain holdback and deferred payment provisions. +In January 2011, we acquired all of the capital stock of Meridian Environmental Technology, Inc. (“MET”) for an initial cash payment of approximately $1.6 million. MET specializes in 511 advanced traveler information systems and offers Maintenance Decision Support System (“MDSS”) management tools that allow users to create solutions to meet roadway maintenance decision needs. We also agreed to pay up to $1 million on each of the first two anniversaries of the closing of the acquisition upon the satisfaction of certain conditions, as well as up to an additional $2 million under a 24-month earn-out provision. +In January 2012, we made a cash payment of approximately $668,000 of the first deferred payment to the shareholders of MET and held back $250,000 in accordance with certain provisions of the purchase agreement. In June 2012, we determined the contingencies related to the release of the $250,000 holdback were not met. As a result, no portion of the $250,000 holdback was released and the entire amount was reversed into operating income during the second quarter of Fiscal 2013. Additionally, no amounts were earned by the MET shareholders related to the first and second year earn-out provisions, which ended on December 31, 2011 and 2012, respectively. The second deferred payment of $1 million was due in the fourth quarter of Fiscal 2013. As a result of certain holdback provisions and other deductions, we currently expect to pay approximately $400,000 to the MET shareholders in the first quarter of the Fiscal 2014, which is recorded in our accrued liabilities in our consolidated balance sheet at March 31, 2013. +18 +Table of Contents +Refer to Note 4 of Notes to Consolidated Financial Statements, included in Part IV, Item 15 of this report, for additional discussion on these acquisitions. +Sale of Vehicle Sensors . On July 29, 2011, we completed the sale of substantially all of our assets used in connection with our Vehicle Sensors segment to Bendix pursuant to an Asset Purchase Agreement signed on July 25, 2011 (the “Asset Sale”). Upon closing, Bendix paid us $14 million in cash, subject to a $2 million holdback and adjustments based upon the working capital of the Vehicle Sensors segment at closing, and Bendix assumed certain specified obligations and liabilities of the Vehicle Sensors segment. In October 2012, we received approximately $1.7 million in connection with the holdback provision. Furthermore, we are entitled to additional consideration in the form of certain performance and royalty-related earn-outs. As of March 31, 2013, we received approximately $0.9 million in connection with royalty-related earn-outs provisions for a total of $14.6 million in cash from the Asset Sale As a result of the Asset Sale, we no longer operate in the Vehicle Sensors segment and we determined that the Vehicle Sensors segment, which previously constituted one of our operating segments, qualifies as a discontinued operation. The applicable financial results of the Vehicle Sensors segment through the closing of the Asset Sale have been reported as a discontinued operation for all periods presented. Refer to Note 3 of Notes to Consolidated Financial Statements, included in Part IV, Item 15 of this report, for additional discussion on this transaction. +Business Segments. Subsequent to the Asset Sale and our acquisition of BTS, we now operate in three reportable segments: Roadway Sensors, Transportation Systems and iPerform. +Roadway Sensors +The Roadway Sensors segment includes, among other products, our Vantage, VersiCam, Pico, Vantage Vector, SmartCycle, SmartScan and Abacus vehicle detection systems for traffic intersection control, incident detection and certain highway traffic data collection applications. +Transportation Systems +The Transportation Systems segment includes transportation engineering and consulting services, and the development of transportation management and traveler information systems for the ITS industry. This segment also includes 511 advanced traveler information systems and offers weather related Maintenance Decision Support System management tools that allow users to create solutions to meet roadway maintenance decision needs. +iPerform +The iPerform segment includes our transportation performance measurement and information management solutions. The iPerform performance measurement solutions leverage its real-time data collection, diagnostic, fusion and warehousing platform to aggregate and compute performance measurements. +Beginning in April 2013, we internally recognized certain groups within our Transportation Systems and iPerform segments to better align our resources and deliverables with the activities of those segments. As a result, all of the revenues and expenses of the predictive weather and Maintenance Decision Support System operations include in Transportation Systems will be reassigned to iPeform. +Business. Given the current ongoing uncertainties regarding global economic conditions, we continue to remain cautious about our overall business. We believe the overall ongoing unfavorable economic environment has negatively affected, and may continue to negatively affect, our financial results for the foreseeable future, and may impair our ability to accurately forecast our future financial performance and other business trends. In addition, since the end users of a majority of our products and services are governmental entities, we have been, and may continue to be, negatively affected by the budgetary issues and delays in purchasing decisions that many municipalities and other state and local agencies continue to face. Spending for new roadways, new systems to address traffic congestion and other transportation infrastructure improvements has been delayed or eliminated in some instances. However, we believe the need to rebuild and modernize aging transportation infrastructure will continue, and in addition to funds available through the federal highway bill, there exist various other funding mechanisms that support transportation infrastructure and related projects. These include bonds, dedicated sales and gas tax measures and other alternative funding sources. +Critical Accounting Policies and Estimates +“Management’s Discussion and Analysis of Financial Condition and Results of Operations” is based on our consolidated financial statements included herein, which have been prepared in accordance with accounting principles generally accepted in the +19 +Table of Contents +United States (“GAAP”). The preparation of these financial statements requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and related disclosures of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. On an ongoing basis, we evaluate these estimates and assumptions, including those related to the collectability of accounts receivable, the valuation of inventories, the recoverability of long-lived assets and goodwill, the realizability of deferred tax assets, accounting for stock-based compensation, the valuation of equity instruments, the valuation of contingent acquisition consideration, warranty reserves and other contingencies. We base these estimates on historical experience and on various other factors that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. These estimates and assumptions by their nature involve risks and uncertainties, and may prove to be inaccurate. In the event that any of our estimates or assumptions are inaccurate in any material respect, it could have a material adverse effect on our reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. +The following critical accounting policies affect our more significant judgments and estimates used in the preparation of our consolidated financial statements. +Revenue Recognition. Product revenues and related costs of sales are recognized when all of the following criteria are met: (i) persuasive evidence of an arrangement exists, (ii) delivery under the terms of the arrangement has occurred, (iii) the price to the customer is fixed or determinable, and (iv) collection of the receivable is reasonably assured. These criteria are typically met at the time of product shipment, but in certain circumstances, may not be met until receipt or acceptance by the customer. Accordingly, at the date revenue is recognized, the significant obligations or uncertainties concerning the sale have been resolved. +We recognize revenue from the sale of deliverables that are part of a multiple-element arrangement in accordance with applicable accounting guidance that establishes a relative selling price hierarchy permitting the use of an estimated selling price to determine the allocation of arrangement consideration to a deliverable in a multiple-element arrangement where neither vendor specific objective evidence (“VSOE”) nor third-party evidence (“TPE”) of fair value is available for that deliverable. In the absence of VSOE or TPE of the standalone selling price for one or more delivered or undelivered elements in a multiple-element arrangement, we are required to estimate the selling prices of those elements. Overall arrangement consideration is allocated to each element (both delivered and undelivered items) that has stand-alone value based on their relative selling prices, regardless of whether those selling prices are evidenced by VSOE or TPE or are based on our estimated selling prices. +We account for multiple-element arrangements that consist only of software and software-related services in accordance with applicable accounting guidance for software and software-related transactions. For such transactions, revenue on arrangements that include multiple elements is allocated to each element based on the relative fair value of each element, and fair value is determined by VSOE. If we cannot objectively determine the fair value of any undelivered element included in such multiple-element arrangements and the only undelivered element is post-contract customer support or maintenance, and VSOE of the fair value of such support or maintenance does not exist, revenue from the entire arrangement is recognized ratably over the support period. When the fair value of a delivered element has not been established but VSOE of fair value exists for the undelivered elements, we use the residual method to recognize revenue if the fair value of all undelivered elements is determinable. Under the residual method, the fair value of the undelivered elements is deferred and the remaining portion of the arrangement fee is allocated to the delivered elements and is recognized as revenue. +Transportation Systems revenues are derived primarily from long-term contracts with governmental agencies. When appropriate, revenues are recognized using the percentage of completion method of accounting, whereby revenue is recognized as contract performance progresses and is determined based on the relationship of costs incurred to total estimated costs. Any anticipated losses on contracts are charged to earnings when identified. Changes in job performance and estimated profitability, including those arising from contract penalty provisions and final contract settlements, may result in revisions to costs and revenues and are recognized in the period in which the revisions are determined. Profit incentives are included in revenues when their realization is reasonably assured. Certain of our revenues are recognized as services are performed and amounts are earned, which is measured by time incurred or other contractual milestones or output measures. Revenues accounted for in this manner generally relate to certain cost-plus fixed fee or time-and-materials contracts. +Accounts Receivable. The collectability of our accounts receivable is evaluated through review of outstanding invoices and ongoing credit evaluations of our customers’ financial condition. We record an allowance for doubtful accounts for specific receivables deemed to be at risk for collection as well as a general allowance based on our historical collections experience. Considerable judgment is required in assessing and estimating the ultimate realization of trade receivables, including the current credit-worthiness of each customer. If the financial condition of our customers deteriorates, resulting in an impairment of their ability to make required payments, additional allowances may be required that could adversely affect our operating results. +20 +Table of Contents +Inventories. Inventories consist of finished goods, work-in-process and raw materials and are stated at the lower of cost or market. We write down the carrying value of our inventories to net realizable value for estimated excess and obsolete inventories in an amount equal to the difference between the cost of the inventories and their estimated realizable value. These estimates are based on management’s judgments and assumptions as to future demand requirements and our evaluation of market conditions. Demand for our products may fluctuate significantly over time, and actual demand and market conditions may be more or less favorable than those projected by management. In the event that actual demand is lower than originally projected, additional inventory write-downs may be required. Estimated inventory write-downs, once established, are not reversed until the related inventory has been sold or scrapped, so if actual market conditions are more favorable in the fiscal periods subsequent to those in which we record significant write-downs, we may have higher gross margins when products are sold. +Goodwill and Other Long-Lived Assets. Goodwill is recorded as the difference, if any, between the aggregate consideration paid for an acquisition and the fair value of the acquired net tangible and intangible assets. Other long-lived assets primarily represent purchased intangible assets including developed technology, customer relationships, trade names and patents. We currently amortize our intangible assets with definitive lives over periods ranging from one to seven years using a method that reflects the pattern in which the economic benefits of the intangible asset are consumed or otherwise used or, if that pattern cannot be reliably determined, using a straight-line amortization method over the estimated useful life of the asset. +We evaluate goodwill on an annual basis in our fourth fiscal quarter or more frequently if we believe indicators of impairment exist. We have determined that our reporting units for purposes of testing for goodwill impairment are identical to our reportable segments for financial reporting purposes. In Fiscal 2012, we early adopted the provisions issued by the Financial Accounting Standard Board (“FASB”) that were intended to simplify goodwill impairment testing. This guidance permits us to first assess qualitative factors to determine whether it is more likely than not that the fair value of a reporting unit is less than its carrying amount. If we conclude that it is more likely than not that the fair value of a reporting unit is less than its carrying amount, we conduct a two-step goodwill impairment test. The first step of the impairment test involves comparing the fair values of the applicable reporting units with their carrying values. We determine the fair values of our reporting units using the income valuation approach, as well as other generally accepted valuation methodologies. If the carrying amount of a reporting unit exceeds the reporting unit’s fair value, we perform the second step of the goodwill impairment test. The second step of the goodwill impairment test involves comparing the implied fair value of the affected reporting unit’s goodwill with the carrying value of that goodwill. The amount by which the carrying value of the goodwill exceeds its implied fair value, if any, is recognized as an impairment loss. We monitor the indicators for goodwill impairment testing between annual tests. Certain adverse business conditions impacting one or more reporting units would cause us to test goodwill for impairment on an interim basis. As part of our annual assessment, management determines the most appropriate and efficient method to assess goodwill for impairment, which could include either the simplified testing approach or the two-step goodwill test described above. +We test long-lived assets and purchased intangible assets (other than goodwill) for impairment if we believe indicators of impairment exist. We determine whether the carrying value of an asset or asset group is recoverable, based on comparisons to undiscounted expected future cash flows the asset are expected to generate. If an asset is not recoverable, we record an impairment loss equal to the amount by which the carrying value of the asset exceeds its fair value. We primarily use the income valuation approach to determine the fair value of our long lived assets and purchased intangible assets. +Warranty. We generally provide a one to three year warranty from the original invoice date on our products, materials and workmanship. Products sold to various original equipment manufacturer customers sometimes carry longer warranties. Defective products will be either repaired or replaced, usually at our option, upon meeting certain criteria. We accrue a provision for the estimated costs that may be incurred for product warranties relating to a product as a component of cost of sales at the time revenue for that product is recognized. The accrued warranty reserve is included within accrued liabilities in the accompanying consolidated balance sheets. Should our actual experience of warranty returns be higher than anticipated, additional warranty reserves may be required, which would adversely affect our product gross profit and our operating results. +Income Taxes. We utilize the asset and liability method of accounting for income taxes, under which deferred taxes are determined based on the temporary differences between the financial statement and tax basis of assets and liabilities using tax rates expected to be in effect during the years in which the basis differences reverse. A valuation allowance is recorded when it is more-likely-than-not that some or all of the deferred tax assets will not be realized, which increases our income tax expense in the period such determination is made. +On an interim basis, we estimate what our anticipated annual effective tax rate will be, while also separately considering applicable discrete and other non-recurring items, and record a quarterly income tax provision in accordance with this anticipated rate. As the fiscal year progresses, we refine our estimates based upon actual events and financial results during the year. This estimation process can result in significant changes to our expected effective tax rate. When this occurs, we adjust our income tax provision during the quarter in which our estimates are refined so that the year-to-date provision reflects the expected annual effective tax rate. These changes, along with adjustments to our deferred taxes, among others, may create fluctuations in our overall effective tax rate from quarter to quarter. +21 +Table of Contents +Income tax positions must meet a more-likely-than-not recognition threshold to be recognized. Income tax positions that previously failed to meet the more-likely-than-not threshold are recognized in the first subsequent financial reporting period in which that threshold is met. Previously recognized tax positions that no longer meet the more-likely-than-not threshold are derecognized in the first subsequent financial reporting period in which that threshold is no longer met. +The application of tax laws and regulations is subject to legal and factual interpretation, judgment and uncertainty. Tax laws and regulations themselves are subject to change as a result of changes in fiscal policy, changes in legislation, the evolution of regulations and court rulings. Therefore, the actual liability for U.S. or foreign taxes may be materially different from our estimates, which could result in the need to record additional tax liabilities or potentially reverse previously recorded tax liabilities. +Stock-Based Compensation . We record stock-based compensation in the statements of operations as an expense, based on the estimated grant date fair value of our stock-based awards, whereby such fair values are amortized over the requisite service period. Our stock-based awards are currently comprised of common stock options and restricted stock units. The fair value of our stock option awards is estimated on the grant date using the Black-Scholes-Merton (“BSM”) option-pricing formula. While utilizing this model meets established requirements, the estimated fair values generated by it may not be indicative of the actual fair values of our stock option awards as it does not consider certain factors important to those awards to employees, such as continued employment and periodic vesting requirements as well as limited transferability. The fair value of our restricted stock units is based on the closing market price of our common stock on the grant date. If there are any modifications or cancellations of the underlying unvested stock-based awards, we may be required to accelerate, increase or cancel any remaining unearned stock-based compensation expense. +Recent Accounting Pronouncements +Refer to Note 1 of Notes to Consolidated Financial Statements, included in Part IV, Item 15 of this report, for a discussion of recent accounting pronouncements. +Results of Operations +The following table sets forth certain statement of operations data as a percentage of revenues for the periods indicated. +Year Ended March 31, +2013 +2012 +2011 +Total revenues +100.0 +% +100.0 +% +100.0 +% +Cost of revenues +62.3 +60.5 +56.0 +Gross profit +37.7 +% +39.5 +% +44.0 +% +Operating expenses: +Selling, general and administrative +29.3 +30.8 +32.7 +Research and development +5.0 +5.4 +4.7 +Amortization of intangible assets +1.0 +0.9 +0.3 +Change in fair value of contingent consideration +(0.3 +) +(1.1 +) +0.1 +Impairment of goodwill +— +— +15.3 +Total operating expenses +35.1 +36.0 +53.1 +Operating income (loss) +2.6 +3.5 +(9.1 +) +Non-operating income (expense): +Other income, net +0.0 +0.0 +0.0 +Interest expense, net +(0.0 +) +(0.1 +) +(0.3 +) +Income (loss) from continuing operations before income taxes +2.6 +3.4 +(9.4 +) +Provision for income taxes +(1.2 +) +(1.1 +) +(0.5 +) +Income (loss) from continuing operations +1.5 +2.3 +(9.9 +) +Gain on sale of discontinued operation, net of tax +2.4 +2.0 +— +Income (loss) from discontinued operation, net of tax +— +0.0 +(0.1 +) +Net income (loss) +3.9 +% +4.3 +% +(10.0 +)% +22 +Table of Contents +Analysis of Fiscal 2013, Fiscal 2012 and Fiscal 2011 Results of Operations +Total Revenues . Total revenues are comprised of sales from our Roadway Sensors, Transportation Systems and iPerform segments. +The following tables present details of total revenues for Fiscal 2013 compared to Fiscal 2012, and Fiscal 2012 compared to Fiscal 2011: +Year Ended March 31, +% +2013 +2012 +Increase +Change +(In thousands, except percentages) +Total revenues +$ +61,685 +$ +58,406 +$ +3,279 +5.6 +% +Year Ended March 31, +% +2012 +2011 +Increase +Change +(in thousands, except percentages) +Total revenues +$ +58,406 +$ +51,966 +$ +6,440 +12.4 +% +We currently have, and historically have had, a diverse customer base. For Fiscal 2013, one individual customer represented approximately 13% of our total revenues and no other individual customer represented greater than 10% of our total revenues. For Fiscal 2012 and Fiscal 2011, no individual customer represented greater than 10% of our total revenues. +Total revenues for Fiscal 2013 increased approximately 6% to $61.7 million, compared to $58.4 million in Fiscal 2012, due primarily to an increase of approximately 9% in Transportation Systems revenues and an increase in iPerform revenues of approximately $2.4 million, which was attributable to a full twelve months of revenues in Fiscal 2013 from the acquisition of BTS in November 2011. These increases in revenue were partially offset by an approximate 6% decrease in Roadway Sensors revenues. +Total revenues for Fiscal 2012 increased approximately 12% to $58.4 million, compared to $52.0 million in Fiscal 2011, due primarily to an increase of approximately 25% in Transportation Systems revenues, partially offset by a decrease of approximately 2% in Roadway Sensors revenues. Approximately $3.1 million of the increase in total revenues was attributable to a full year of MET revenues, while $935,000 of the increase was attributable to the acquisition of BTS in November 2011. +Roadway Sensors revenues in Fiscal 2013 decreased approximately 6% compared to Fiscal 2012, due mainly as a result of a decrease in federal stimulus funded projects and as a result of the discontinuation of redevelopment agencies in California. The federal stimulus funded projects and redevelopment agencies in California had a positive impact on Roadway Sensors revenues in the prior year periods. Roadway Sensors revenues in Fiscal 2012 were marginally lower compared to Fiscal 2011 due primarily to certain international customer orders in Fiscal 2011 which did not recur in Fiscal 2012. Going forward, we plan to focus on our core domestic intersection market and refine and deliver products that address the needs of this market, namely our Vantage processor and camera systems and our Vantage Vector video/radar hybrid sensor, as well as our SmartCycle and SmartScan products, which were introduced in Fiscal 2013. We also plan to focus on international distribution channel expansion and expect to continue to refine products that address these markets, namely our Abacus, Pico and VersiCam products. +Revenues from our Transportation Systems segment are primarily dependent upon the continued availability of funding at the local, state and federal levels from the various agencies and departments of transportation. Transportation Systems revenues for Fiscal 2013 increased approximately 9% compared to Fiscal 2012 due in part to several significant project wins in the first two quarters of Fiscal 2013. Transportation Systems revenues for Fiscal 2012 increased approximately 25% compared to Fiscal 2011, primarily due to several significant project wins in the last two quarters of Fiscal 2012, as well as a full year of MET revenues, which increased by $3.1 million from Fiscal 2011. Going forward, we plan to continue to pursue larger contracts that may contain significant sub-consulting content, which will likely contribute to variability in the timing and amount of our Transportation Systems revenues from period to period. We also intend to continue to expand our foreign operations by pursuing additional international opportunities in the Middle East and other regions. Among other factors, we believe the ability of our Transportation Systems segment to grow and successfully win and service new contracts will be highly dependent upon our continued success in recruiting and retaining qualified personnel, as well as upon government funding initiatives in the markets we serve. +Approximately $3.3 million of the total revenues in Fiscal 2013 and approximately $935,000 of the total revenues in Fiscal 2012 were attributable to the iPerform segment and was a direct result of the BTS acquisition in November 2011. Going forward, we +23 +Table of Contents +plan to continue investing in this segment, particularly in research, development, sales and marketing of the IterisPeMS performance measurement solutions with a near-term focus on delivering IterisPeMS to public agencies. We also plan for iPerform to pursue commercial opportunities in the media and automotive sectors, offering both data services and analytics. +The recently enacted federal highway bill could provide government agencies with funding for ITS technologies in transportation infrastructure, traffic management and performance measurement projects. +Gross Profit . The following tables present details of our gross profit for Fiscal 2013 compared to Fiscal 2012, and Fiscal 2012 compared to Fiscal 2011: +Year Ended March 31, +% +2013 +2012 +Increase +Change +(In thousands, except percentages) +Gross profit +$ +23,258 +$ +23,071 +$ +187 +0.8 +% +Gross profit as a % of total revenues +37.7 +% +39.5 +% +Year Ended March 31, +% +2012 +2011 +Increase +Change +(in thousands, except percentages) +Gross profit +$ +23,071 +$ +22,884 +$ +187 +0.8 +% +Gross profit as a % of total revenues +39.5 +% +44.0 +% +Our total gross profit as a percentage of total revenues for Fiscal 2013 decreased approximately 1.8% compared to Fiscal 2012 primarily as a result of our product and service mix. Revenues derived from our Roadway Sensors segment decreased to approximately 42% of our total revenues in Fiscal 2013 as compared to 47% in Fiscal 2012. Roadway Sensors revenues generally carry higher margins than Transportation Systems and iPerform revenues; therefore, a shift in the sales mix weighted less towards Roadway Sensors revenues can negatively impact our overall margin. Gross profits as a percentage of total revenues also declined, to a lesser extent, as a result of an approximate 2.7% decrease in Roadway Sensors profit margins due to the overall decrease in revenues and an increase in sustaining engineering activities. +Our total gross profit as a percentage of total revenues decreased in Fiscal 2012 compared to Fiscal 2011 primarily as a result of our product and service mix, whereby Transportation Systems revenues significantly increased as percentage of total revenues. Roadway Sensors revenues represented approximately 47% of our total revenues in Fiscal 2012 compared to 54% in Fiscal 2011. The decrease in gross profit percentage was also attributable the Roadway Sensors customer mix between dealer sales and direct sales, whereby we generally enjoy higher gross margins on direct product sales as compared to sales through our dealer channels. The decrease was also due in part to certain manufacturing overhead costs previously absorbed by the Vehicle Sensors segment that was divested in Fiscal 2011. +Roadway Sensors gross profit can fluctuate in any specific quarter or year based on, among other factors, customer and product mix, competitive pricing requirements, product warranty costs and provisions for excess and obsolete inventories, as well as shifts of engineering resources from development activities to sustaining activities, which we record as cost of goods sold. +We recognize a portion of our Transportation Systems revenues and related gross profit using percentage of completion contract accounting and the underlying mix of contract activity affects the related gross profit recognized in any given period. For the Transportation Systems segment, we expect to experience gross profit variability in future periods due to our contract mix and related sub-consulting content, as well as factors such as paid holidays and our ability to efficiently utilize our workforce, which could or may cause fluctuations in our margins from period to period. If sub-consultant content further expands as a percentage of our overall Transportation System revenues, we may experience a flat or declining gross profit percentage in this segment. +Selling, General and Administrative Expense +The following table presents selling, general and administrative expense for Fiscal 2013 and Fiscal 2012: +24 +Table of Contents +Year Ended March 31, +2013 +2012 +% of +% of +Increase +% +Amount +Revenues +Amount +Revenues +(Decrease) +Change +(In thousands, except percentages) +Salary and personnel-related +$ +12,223 +19.8 +% +$ +12,434 +21.3 +% +$ +(211 +) +(1.7 +)% +Facilities, insurance and supplies +2,255 +3.7 +1,853 +3.2 +402 +21.7 +Travel and conferences +1,281 +2.1 +1,568 +2.7 +(287 +) +(18.3 +) +Professional and outside services +1,964 +3.2 +1,778 +3.0 +186 +10.5 +Other +367 +0.6 +353 +0.6 +14 +4.0 +Selling, general and administrative +$ +18,090 +29.3 +% +$ +17,986 +30.8 +% +$ +104 +0.6 +Selling, general and administrative expenses for Fiscal 2013 were generally consistent, in total, with those in Fiscal 2012. The increase in facilities and insurance costs was due to the increase cost of rent, rent related expenses and insurance coverage for a full twelve month period for our Berkeley, California office, related to the operations of BTS that were acquired in November 2011 . This increase was partially offset by a decrease in travel expenses, as well a decrease in general salary and personnel-related expenses. +The following table presents selling, general and administrative expense for Fiscal 2012 and 2011: +Year Ended March 31, +2012 +2011 +% of +% of +Increase +% +Amount +Revenues +Amount +Revenues +(Decrease) +Change +(In thousands, except percentages) +Salary and personnel-related +$ +12,434 +21.3 +% +$ +11,952 +23.0 +% +$ +482 +4.0 +% +Facilities, insurance and supplies +1,853 +3.2 +1,379 +2.7 +474 +34.4 +Travel and conferences +1,568 +2.7 +1,205 +2.3 +363 +30.1 +Professional and outside services +1,778 +3.0 +2,150 +4.1 +(372 +) +(17.3 +) +Other +353 +0.6 +295 +0.6 +58 +19.7 +Selling, general and administrative +$ +17,986 +30.8 +% +$ +16,981 +32.7 +% +$ +1,005 +5.9 +The increase in selling, general and administrative expenses in Fiscal 2012 as compared to Fiscal 2011 was primarily due to (i) higher salary, travel and headcount-related expenses as we added certain key sales and marketing personnel, (ii) added personnel as well as facilities and other related operating costs as a result of the MET and BTS acquisitions, (iii) certain legal and professional services related to the sale of our Vehicle Sensors segment that were not offset against the gain on the Asset Sale and (iv) certain other corporate initiatives related to the development of our performance measurement software. +Research and Development Expense +The following table presents research and development expense for Fiscal 2013 and Fiscal 2012: +Year Ended March 31, +2013 +2012 +% of +% of +Increase +% +Amount +Revenues +Amount +Revenues +(Decrease) +Change +(In thousands, except percentages) +Salary and personnel-related +$ +1,454 +2.4 +% +$ +2,153 +3.7 +% +$ +(699 +) +(32.5 +)% +Facilities, development and supplies +1,378 +2.2 +792 +1.3 +586 +74.0 +Other +239 +0.4 +238 +0.4 +1 +0.4 +Research and development +$ +3,071 +5.0 +% +$ +3,183 +5.4 +% +$ +(112 +) +(3.5 +) +Research and development expense in Fiscal 2013 decreased approximately 4% when compared to Fiscal 2012, primarily due to certain expenditures related to software development in the iPeform segment that in the current year periods have been capitalized to the balance sheet as well as certain reductions to Roadway Sensors salary and personnel-related expenditures. These reductions were offset by an increase in facility rents, development and supplies expense. The increase in facility costs was +25 +Table of Contents +attributable to a full twelve month period for our Berkeley, California office, related to the operations of BTS that were acquired in November 2011. +The following table presents research and development expense for Fiscal 2012 and Fiscal 2011: +Year Ended March 31, +2012 +2011 +% of +% of +% +Amount +Revenues +Amount +Revenues +Increase +Change +(In thousands, except percentages) +Salary and personnel-related +$ +2,153 +3.7 +% +$ +1,736 +3.3 +% +$ +417 +24.0 +% +Facilities, development and supplies +792 +1.3 +557 +1.1 +235 +42.2 +Other +238 +0.4 +151 +0.3 +87 +57.6 +Research and development +$ +3,183 +5.4 +% +$ +2,444 +4.7 +% +$ +739 +30.2 +Research and development expenses for Fiscal 2012 were higher than Fiscal 2011 primarily due to (i) the allocation of additional resources to various development projects in our Roadway Sensors segment, including our Vantage Vector vehicle detection sensor, (ii) development costs related to our IterisPeMS information management solution, and (iii) additional headcount and other expenses in Fiscal 2012 related to the MET and BTS acquisitions. +Impairment of Goodwill +In Fiscal 2012, we adopted the provisions issued by the FASB that are intended to simplify goodwill impairment testing. The updated guidance permits us to first assess qualitative factors to determine whether it is more likely than not that the fair value of a reporting unit is less than its carrying amount. If we conclude that it is more likely than not that the fair value of a reporting unit is less than its carrying amount, we conduct a two-step goodwill impairment test. We performed annual impairment assessments of the carrying value of goodwill for Fiscal 2013 and Fiscal 2012 in their fourth fiscal quarters, respectively. We determined it was more appropriate and cost effective to perform a qualitative assessment in Fiscal 2012 and a quantitative first-step assessment in Fiscal 2013 to estimate the fair value of our reporting units using the income approach. Based on our assessments, we determined that no impairment was indicated as the estimated fair value of each reporting unit exceeded its respective carrying value. +During Fiscal 2011, due primarily to lower than expected operating results in our Transportation Systems reporting unit, as well as ongoing weakness specifically in the Transportation Systems markets, we determined it was necessary to perform an interim test of impairment of the carrying value of goodwill in our Transportation Systems reporting unit as of December 31, 2010. In performing the first step in this analysis, we estimated the fair value of our Transportation Systems reporting unit using the income approach. As of December 31, 2010, we determined that the carrying value of our Transportation Systems reporting unit exceeded its estimated fair value and, accordingly, we performed the second step of the impairment analysis to estimate the implied fair value of the goodwill of this reporting unit. +The implied fair value of goodwill was determined in the same manner utilized to estimate the amount of goodwill recognized in a business combination. To determine this value, we estimated the fair value of the assets and liabilities, including certain intangible assets, to be allocated to the Transportation Systems reporting unit as of December 31, 2010. The implied fair value of goodwill was measured as the difference between the estimated fair value of the reporting unit over the estimated fair value amounts of its assets and liabilities. The impairment loss for the Transportation Systems reporting unit was measured by the amount the carrying value of its goodwill exceeded the implied fair value of the goodwill. Accordingly, in order to write down Transportation Systems goodwill with a carrying value of $14.9 million to its implied fair value of $6.9 million, we recorded an impairment charge of $8.0 million in the three months ended December 31, 2010, the third quarter of Fiscal 2011. +As a result of the impairment charge taken in Fiscal 2011 and based on our goodwill impairment testing for Fiscal 2012 and Fiscal 2013, we believe the carrying value of our goodwill is not currently at risk of impairment, as the estimated fair values of our reporting units exceeded their carrying values at March 31, 2013. If our actual financial results, or the plans and estimates used in future goodwill impairment analyses, are lower than the original estimates used to assess impairment of our goodwill, we could incur future goodwill impairment charges. +Interest Expense, Net +Net interest expense was approximately $6,000, $72,000 and $152,000 in Fiscal 2013, Fiscal 2012 and Fiscal 2011, respectively. The sequential decreases were primarily due to a continuous decrease in the overall level of borrowings on our term note. +26 +Table of Contents +During the first quarter of Fiscal 2013, all principal and interest payments under the term note were paid in full. See “Liquidity and Capital Resources” below for additional details on our borrowings. +Income Taxes +The following table presents our provision for income taxes for Fiscal 2013, Fiscal 2012 and Fiscal 2011: +Year Ended March 31, +2013 +2012 +2011 +(In thousands, except percentages) +Provision for income taxes +$ +716 +$ +643 +$ +278 +Effective tax rate +43.9 +% +33.0 +% +(5.7 +)% +Our effective tax rate for Fiscal 2013 was unfavorably impacted by permanent non-deductible tax items, including share-based payments and other permanent differences amounting to approximately $82,000, and by the recording a valuation allowance against certain of our state net operating losses in the amount of $188,000, net of federal benefit. These unfavorable impacts were partially offset by the recognition of tax credits of approximately $122,000 for research and development and hiring activities, and by approximately $62,000 of tax benefit from non-taxable favorable fair value adjustments recognized for financial statement purposes. +Our effective tax rate for Fiscal 2012 was favorably impacted by the recognition of approximately $276,000 of previously unrecognized tax benefits during the year due to the expiration of statutes limitation in various jurisdictions, by the recognition of tax credits of approximately $246,000 for research and development activities, and by approximately $211,000 of tax benefit from non-taxable favorable fair value adjustments recognized for financial statement purposes. These favorable impacts were partially offset by the impact of recognizing approximately $466,000 of expense upon the expiration of a state net operating loss, net of federal benefit. Our effective tax rate for Fiscal 2011 was impacted unfavorably by a portion of the charge recorded for the impairment of goodwill, amounting to approximately $2.2 million, for which there is no corresponding tax basis. This unfavorable impact was partially offset by the impact of the recognition of approximately $327,000 of previously unrecognized tax benefits during the year due to expiration of certain federal and state statutes in various jurisdictions. +As of March 31, 2013, we recorded a valuation allowance against certain of our state net operating loss carryforwards in the amount of $188,000, net of federal tax benefit, which we estimated were more likely to not be realized within the applicable carryforward period. As of March 31, 2012, we determined that it was more likely than not that our deferred tax assets would be realized and no general valuation allowance was recorded against our deferred tax assets at that time. +As we update our estimates in future periods, adjustments to our deferred tax asset and valuation allowance may be necessary. We anticipate this will cause our future overall effective tax rate in any given period to fluctuate from prior effective tax rates and statutory tax rates. We utilize the liability method of accounting for income taxes. We record net deferred tax assets to the extent that we believe these assets will more likely than not be realized. In making such determination, we consider all available positive and negative evidence, including, but not limited to, scheduled reversals of deferred tax liabilities, projected future taxable income, tax planning strategies and recent financial performance. +At March 31, 2013, we had $22.0 million of federal net operating loss carryforwards and $9.2 million of state net operating loss carryforwards that begin to expire in 2021 and 2014, respectively. Although the impact cannot be precisely determined at this time, we believe that our net operating loss carryforwards will cause us to have future income tax payments that are substantially lower than the income tax liability calculated using statutory tax rates. Due to changes in stock ownership, our federal net operating loss carryforwards and other federal attributes are subject to a Section 382 annual limitation. As of March 31, 2013, based on the cumulative amount of tax attributes that have become available under the limitation imposed by Section 382, all of our net operating losses are currently fully available for use. +Liquidity and Capital Resources +Cash Flows +We have historically financed our operations with a combination of cash flows from operations, borrowings under credit facilities and the sale of equity securities. We currently rely on cash flows from operations, or cash position and the availability of borrowings on a line of credit facility to fund our operations, which we believe to be sufficient to fund our operations for at least the next twelve months. However, we may need or choose to raise additional capital to fund potential future acquisitions and our future growth. We may raise such funds by selling equity or debt securities to the public or to selected investors or by borrowing money from +27 +Table of Contents +financial institutions. If we raise additional funds by issuing equity or convertible debt securities, our existing stockholders may experience significant dilution and any equity securities that may be issued may have rights senior to our existing stockholders. +At March 31, 2013, we had $29.4 million in working capital, which included no borrowings on our $12.0 million line of credit and $19.1 million in cash and cash equivalents. This compares to working capital of $28.4 million at March 31, 2012, which included no borrowings on our line of credit and $18.7 million in cash and cash equivalents. +The following table summarizes our cash flows for Fiscal 2013, Fiscal 2012 and Fiscal 2011: +Year Ended March 31, +2013 +2012 +2011 +(In thousands) +Net cash provided by (used in): +Operating activities +$ +3,652 +$ +668 +$ +5,346 +Investing activities +367 +10,002 +(1,530 +) +Financing activities +(3,583 +) +(3,787 +) +(2,403 +) +Operating Activities. Cash provided by our operations in Fiscal 2013 was the result of (i) adding back to net income $901,000 of depreciation expense, $279,000 of stock-based compensation expense, $644,000 of amortization expense and $1.4 million of deferred tax assets, (ii) deducting from net income $181,000 in changes in the fair value of contingent consideration related to our prior acquisitions of MET and BTS and $1.5 million of gain on the sale of Vehicle Sensors and (iii) approximately $300,000 in negative cash flows resulting from changes in our operating assets and liabilities during Fiscal 2013, all of which was offset by our net income of $2.4 million for such fiscal year. +Our accounts receivable and net costs and estimated earnings in excess of billings increased approximately $851,000, or 5%, during Fiscal 2013 mainly as a result of an approximate 6% year-over-year increase in revenues. In the future, our accounts receivable and net costs and estimated earnings in excess of billings accounts are likely to be determined based upon, among other factors, increases or decreases in revenues, the timing of collections of existing receivables and our ability to timely invoice our billings in excess of costs. We try to offset significant increases in accounts receivables through increased and focused collection efforts; however, we cannot assure you that our efforts will be successful. +The increase in accounts payable by approximately $1.4 million at March 31, 2013 compared to March 31, 2012 was largely driven by the general timing of payments to vendors and sub-consultants. +Cash provided by our operations in Fiscal 2012 was the result of (i) adding back to net income $907,000 of depreciation expense, $331,000 of stock-based compensation expense, $504,000 of amortization expense and $286,000 of deferred tax assets, (ii) deducting from net income $619,000 in changes in the fair value of contingent consideration related to our acquisitions of MET and BTS and $1.2 million for the gain on sale of Vehicle Sensors and (iii) $2.1 million in negative cash flows resulting from changes in our operating assets and liabilities during Fiscal 2012, all of which was offset by our net income of $2.5 million for such fiscal year. +Our accounts receivable and net costs and estimated earnings in excess of billings increased approximately $3.0 million, or 22%, during Fiscal 2012 mainly as a result of a 12% year-over-year increase in net sales and contract revenues as well as the timing of collection on certain receivables. +Cash provided by our operations in Fiscal 2011 was the result of (i) $9.9 million in non-cash items within the statement of operations, primarily consisting of $8.0 million for the impairment of goodwill, depreciation expense of $1.0 million and stock-based compensation expense of $382,000; and (ii) $614,000 in positive cash flows resulting from changes in our operating assets and liabilities during Fiscal 2011, all of which was offset by our net loss of $5.2 million for such fiscal year. +Our inventories increased approximately $953,000, or 35%, during Fiscal 2011 as we built up certain inventories on hand in Fiscal 2011 to meet anticipated increases in our product net sales in our the Roadway Sensors segment. In the future, our inventory levels are likely to continue to be determined based upon, among other factors, the level of purchase orders we receive from our customers, the stage at which our products are in their respective product life cycles, and competitive situations in the marketplace. We attempt to balance such considerations against risk of obsolescence and potentially excess inventory levels. +The increase in accounts payable by approximately $920,000 from March 31, 2010 to March 31, 2011 was primarily driven by our increased inventory levels and the general timing of payments to vendors. +28 +Table of Contents +Investing Activities. Cash provided by our investing activities for Fiscal 2013 consisted of (i) $1.4 million in proceeds from the sale of the Vehicle Sensors segment, (ii) purchases of property and equipment of $815,000 and (iii) capitalized software of $190,000 related to IterisPeMS. Cash provided by our investing activities for Fiscal 2012 consisted of (i) $11.4 million in proceeds from the sale of the Vehicle Sensors segment, (ii) $1.0 million used for the acquisition of MET and BTS, which consisted of $840,000 for the initial purchase of BTS and $129,000 related to purchase price adjustments for the purchase of MET, (iii) purchases of property and equipment of $337,000 and (iv) capitalized software of $138,000 related to IterisPeMS. Cash used in our investing activities for Fiscal 2011 consisted of $1.1 million used for the acquisition of MET and purchases of property and equipment of $414,000. For further information on our acquisitions, refer to Note 4 of Notes to Consolidated Financial Statements included in Part IV, Item 15 of this report. +Financing Activities. Net cash used in our financing activities during Fiscal 2013 primarily consisted of $2.5 million used to repurchase our common stock under our stock repurchase program announced in August 2011, $634,000 in payments on our long-term debt and $700,000 paid to the BTS shareholders for achievement of earn-out provisions of the purchase agreement. Net cash used in our financing activities during Fiscal 2012 primarily consisted of $2.3 million in payments on our long-term debt, which consists of a bank term note, $676,000 related to the first year deferred payment to MET, $112,000 for the second anniversary payment for a prior acquisition and $754,000 used to repurchase our common stock under our stock repurchase program. Net cash used in our financing activities during Fiscal 2011 primarily consisted of $2.4 million in payments on our term note and $106,000 for the first anniversary payment for a prior acquisition. +Borrowings +In October 2008, we entered into a $19.5 million credit facility with California Bank & Trust (“CB&T”). This credit facility provided for a two-year revolving line of credit with borrowings of up to $12.0 million and a $7.5 million 48-month term note. In September 2010, we entered into a modification agreement with CB&T to extend the expiration date of our revolving line of credit to October 1, 2012. In September 2012, we entered into a second modification agreement with CB&T to extend the expiration date of our revolving line of credit to October 1, 2014. Interest on borrowed amounts under the revolving line of credit are payable monthly at a rate equal to the current stated prime rate (3.25% at March 31, 2013) up to the current stated prime rate plus 0.25%, depending on aggregate deposit balances maintained at the bank in relation to the total loan commitment under the credit facility. We are obligated to pay an unused line fee of 0.25% per annum applied to the average unused portion of the revolving line of credit during the preceding month. The revolving line of credit does not contain early termination fees and is secured by substantially all of our assets. As of March 31, 2013 and March 31, 2012, no amounts were borrowed under the revolving line of credit portion of the credit facility. Availability under this line of credit may be reduced or otherwise limited as a result of our obligations to comply with certain financial covenants. +As of March 31, 2012, we had outstanding borrowings of approximately $634,000 under the term note, which was set to expire on May 1, 2013. Principal payments under this term note were required to be repaid in monthly installments of $152,000. During the first quarter of Fiscal 2013, all principal and interest payments under the term note were paid in full. The term note contained no early termination fees. +In connection with our credit facility and loan agreement with the Bank, we are also required to comply with certain quarterly financial covenants. These include achieving ratios for working capital and debt service, as well as maintaining a level of profitability, all of which are further defined in the agreement. While we believe we are currently in compliance with all such financial covenants, we cannot assure you that we will not violate one or more covenants in the future. If we were to be in violation of covenants under this agreement, our lender could choose to accelerate payment on all outstanding loan balances and pursue its security interest in our assets. In this event, we cannot assure you that we would be able to quickly obtain equivalent or suitable replacement financing on acceptable terms, on a timely basis, or at all. If we were not able to secure alternative sources of financing, such acceleration would have a material adverse impact on our business and financial condition. +Off-Balance Sheet Arrangements +Other than our operating leases, which are further described at Note 9 of Notes to Consolidated Financial Statements, included in Part IV, Item 15 of this report, we do not believe we have any other material off-balance sheet arrangements at March 31, 2013. +Seasonality +We have historically experienced seasonality, particularly with respect to our Roadway Sensors net sales in our third and fourth fiscal quarters due to a reduction in intersection construction and repairs during the winter months due to inclement weather conditions. With the addition of MET in January 2011, we have also experienced seasonality related to certain MDSS services in our first and second fiscal quarters mainly because these services are generally not required spring and summer time periods. +29 +Table of Contents +ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK +Interest Rate Risk +Our exposure to interest rate risk is limited to our line of credit. Our line of credit bears interest equal to the prevailing prime rate (3.25% at March 31, 2013) plus 0% to 1.0%. We do not believe that a 10% increase in the interest rate on our line of credit would have a material impact on our financial position, operating results or cash flows. +ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA +The financial statements and supplementary data required by Regulation S-X are included in Part IV, Item 15 of this report. +ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE +None. +ITEM 9A. CONTROLS AND PROCEDURES +(a) Evaluation of disclosure controls and procedures. In accordance with Rule 13a-15(b) of the Securities Exchange Act of 1934, as amended (the “Exchange Act”), as of the end of the period covered by this Annual Report on Form 10-K, management evaluated, with the participation of the our President and Chief Executive Officer and the Chief Financial Officer, the effectiveness of the design and operation of our disclosure controls and procedures (as defined in Rule 13a-15(e) under the Exchange Act). Based upon their evaluation of these disclosure controls and procedures, the President and Chief Executive Officer and the Chief Financial Officer have concluded that our disclosure controls and procedures were effective as of the date of such evaluation in ensuring that information required to be disclosed in our Exchange Act reports is (1) recorded, processed, summarized and reported in a timely manner, and (2) accumulated and communicated to management, including the Company’s President and Chief Executive Officer and the Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure. +(b) Changes in internal control. There was no change in our internal control over financial reporting that occurred during the fourth quarter of Fiscal 2013 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting. +Inherent Limitations on Internal Control +A control system, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. Further, the benefits of controls must be considered relative to their costs. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of management override or improper acts, if any, have been detected. These inherent limitations include the realities that judgments in decision making can be faulty, and that breakdowns can occur because of simple errors. Additionally, controls can be circumvented by the individual acts of some persons, by collusion of two or more people, or by management override of the control. The design of any system of controls is also based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions. Because of the inherent limitations in a cost-effective control system, misstatements due to management override, error or improper acts may occur and not be detected. Any resulting misstatement or loss may have an adverse and material effect on our business, financial condition and results of operations. +Management’s Report on Internal Control Over Financial Reporting +Our management is responsible for establishing and maintaining adequate internal control over financial reporting. Our internal control system was designed to provide reasonable assurance to management and our Board of Directors regarding the effectiveness of our internal control processes over the preparation and fair presentation of published financial statements. +We have assessed the effectiveness of our internal controls over financial reporting as of March 31, 2013. In making this assessment, we used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (“COSO”) in Internal Control—Integrated Framework . Based on our assessment, we believe that, as of March 31, 2013, our internal control over financial reporting was effective based on those criteria. +30 +Table of Contents +This annual report does not include an attestation report of our independent registered public accounting firm regarding internal control over financial reporting. Such a report is not required pursuant to the rules of the SEC applicable to smaller reporting companies. +ITEM 9B . OTHER INFORMATION +None. +PART III +ITEM 10. DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE +(a) Identification of Directors. The information under the caption “Election of Directors,” appearing in our proxy statement for the 2013 Annual Meeting of Stockholders, is incorporated herein by reference. +(b) Identification of Executive Officers. The information under the caption “Executive Compensation and Other Information - Executive Officers,” appearing in our proxy statement for the 2013 Annual Meeting of Stockholders, is incorporated herein by reference. +(c) Compliance with Section 16(a) of the Exchange Act. The information under the caption “Section 16(a) Beneficial Ownership Reporting Compliance,” appearing in our proxy statement for the 2013 Annual Meeting of Stockholders, is incorporated herein by reference. +(d) Corporate Governance . The information under the caption “Corporate Governance,” appearing in our proxy statement for the 2013 Annual Meeting of Stockholders, is incorporated herein by reference. +(e) Audit Committee . The information under the caption “Board Meetings and Committees — Audit Committee,” appearing in our proxy statement for the 2013 Annual Meeting of Stockholders, is incorporated herein by reference. +ITEM 11. EXECUTIVE COMPENSATION +The information under the caption “Executive Compensation and Other Information,” appearing in our proxy statement for the 2013 Annual Meeting of Stockholders, is incorporated herein by reference. +ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS +The information under the captions “Equity Compensation Plans” and “Principal Stockholders and Common Stock Ownership of Certain Beneficial Owners and Management,” appearing in our proxy statement for the 2013 Annual Meeting of Stockholders, is incorporated herein by reference. +ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE +The information under the captions “Corporate Governance — Director Independence” and “Certain Transactions,” appearing in our proxy statement for the 2013 Annual Meeting of Stockholders, is incorporated herein by reference. +ITEM 14. PRINCIPAL ACCOUNTING FEES AND SERVICES +The information under the caption “Fees Paid to Independent Registered Public Accounting Firm,” appearing in our proxy statement for the 2013 Annual Meeting of Stockholders, is incorporated herein by reference. +PART IV +ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES +(a) Documents filed as part of this report: +1. Financial Statements. The following financial statements of Iteris, Inc. are included in a separate section of this Annual Report on Form 10-K commencing on the pages referenced below: +31 +Table of Contents +Report of Independent Registered Public Accounting Firm +35 +Consolidated Balance Sheets as of March 31, 2013 and 2012 +36 +Consolidated Statements of Operations for the fiscal years ended March 31, 2013, 2012 and 2011 +37 +Consolidated Statements of Stockholders’ Equity and Comprehensive Income (Loss) for the fiscal years ended March 31, 2013, 2012 and 2011 +38 +Consolidated Statements of Cash Flows for the fiscal years ended March 31, 2013, 2012 and 2011 +39 +Notes to Consolidated Financial Statements +40 +2. Exhibits . +The exhibits listed on the accompanying Exhibit Index immediately following the financial statements are filed as part of, or hereby incorporated by reference into, this report. +32 +Table of Contents +SIGNATURES +Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. +Dated: June 7, 2013 +ITERIS, INC. +(Registrant) +By +/S/ ABBAS MOHADDES +Abbas Mohaddes +Chief Executive Officer +(Principal Executive Officer) +POWER OF ATTORNEY +We, the undersigned officers and directors of Iteris, Inc., do hereby constitute and appoint James S. Miele and Abbas Mohaddes, and each of them, our true and lawful attorneys-in-fact and agents, each with full power of substitution and resubstitution, for him and in his name, place and stead, in any and all capacities, to sign any and all amendments to this report, and to file the same, with exhibits thereto, and other documents in connection therewith, with the Securities and Exchange Commission, granting unto said attorneys-in-fact and agents, and each of them, full power and authority to do and perform each and every act and thing requisite or necessary to be done in and about the premises, as fully to all intents and purposes as he might or could do in person, hereby, ratifying and confirming all that each of said attorneys-in-fact and agents, or his substitute or substitutes, may lawfully do or cause to be done by virtue hereof. +Pursuant to the requirements of the Securities Exchange Act of 1934, as amended, this report has been signed below by the following persons on behalf of the registrant in the capacities and on the dates indicated: +Signature +Title +Date +/s/ ABBAS MOHADDES +Director, President and Chief Executive Officer +June 7, 2013 +Abbas Mohaddes +(principal executive officer) +/s/ JAMES S. MIELE +Chief Financial Officer +June 7, 2013 +James S. Miele +(principal financial and accounting officer) +/s/ GREGORY A. MINER +Chairman of the Board +June 7, 2013 +Gregory A. Miner +/s/ RICHARD CHAR +Director +June 7, 2013 +Richard Char +/s/ KEVIN C. DALY +Director +June 7, 2013 +Kevin C. Daly, Ph.D. +/s/ JOEL SLUTZKY +Director +June 7, 2013 +Joel Slutzky +/s/ THOMAS L. THOMAS +Director +June 7, 2013 +Thomas L. Thomas +/s/ MIKEL WILLIAMS +Director +June 7, 2013 +Mikel Williams +33 +Table of Contents +Iteris, Inc. +Index to Consolidated Financial Statements +Report of Independent Registered Public Accounting Firm +35 +Consolidated Balance Sheets as of March 31, 2013 and 2012 +36 +Consolidated Statements of Operations for the fiscal years ended March 31, 2013, 2012 and 2011 +37 +Consolidated Statements of Stockholders’ Equity and Comprehensive Income (Loss) for the fiscal years ended March 31, 2013, 2012 and 2011 +38 +Consolidated Statements of Cash Flows for the fiscal years ended March 31, 2013, 2012 and 2011 +39 +Notes to Consolidated Financial Statements +40 +34 +Table of Contents +Report of Independent Registered Public Accounting Firm +To the Board of Directors and Stockholders +Iteris, Inc. +We have audited the accompanying consolidated balance sheets of Iteris, Inc. and subsidiaries as of March 31, 2013 and 2012, and the related consolidated statements of operations, stockholders’ equity and comprehensive income (loss), and cash flows for the years then ended. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits. +We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. Our audits included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. +In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Iteris, Inc. and subsidiaries as of March 31, 2013 and 2012, and the results of their operations and their cash flows for the years then ended, in conformity with U.S. generally accepted accounting principles. +/s/ McGladrey LLP +Irvine, California +June 7, 2013 +35 +Table of Contents +Iteris, Inc. +Consolidated Balance Sheets +(In thousands, except par value) +March 31, +2013 +2012 +Assets +Current assets: +Cash and cash equivalents +$ +19,137 +$ +18,701 +Trade accounts receivable, net of allowance for doubtful accounts of $322 and $379 at March 31, 2013 and March 31, 2012, respectively +10,946 +11,081 +Costs in excess of billings on uncompleted contracts +6,346 +5,360 +Inventories +2,465 +2,454 +Deferred income taxes +2,363 +2,904 +Prepaid expenses and other current assets +852 +425 +Total current assets +42,109 +40,925 +Property and equipment, net +1,862 +1,948 +Deferred income taxes +5,888 +6,761 +Intangible assets, net +2,124 +2,578 +Goodwill +17,318 +17,318 +Other assets +210 +210 +Total assets +$ +69,511 +$ +69,740 +Liabilities and stockholders’ equity +Current liabilities: +Trade accounts payable +$ +5,411 +$ +4,044 +Accrued payroll and related expenses +3,374 +3,398 +Accrued liabilities +1,979 +2,942 +Billings in excess of costs and estimated earnings on uncompleted contracts +1,958 +1,542 +Current portion of long-term debt +— +634 +Total current liabilities +12,722 +12,560 +Deferred rent +312 +700 +Unrecognized tax benefits +286 +351 +Other non-current liabilities +310 +657 +Total liabilities +13,630 +14,268 +Commitments and contingencies +Stockholders’ equity: +Preferred stock, $1.00 par value: +Authorized shares - 2,000 +Issued and outstanding shares - none +— +— +Common stock, $0.10 par value: +Authorized shares - 70,000 at March 31, 2013 and March 31, 2012 +Issued and outstanding shares - 33,626 at March 31, 2013 and 33,909 at March 31, 2012 +3,264 +3,391 +Additional paid-in capital +135,802 +137,645 +Accumulated deficit +(83,185 +) +(85,564 +) +Total stockholders’ equity +55,881 +55,472 +Total liabilities and stockholders’ equity +$ +69,511 +$ +69,740 +See accompanying notes. +36 +Table of Contents +Iteris, Inc. +Consolidated Statements of Operations +(In thousands, except per share amounts) +Year Ended March 31, +2013 +2012 +2011 +Total revenues +$ +61,685 +$ +58,406 +$ +51,966 +Cost of revenues +38,427 +35,335 +29,082 +Gross profit +23,258 +23,071 +22,884 +Operating expenses: +Selling, general and administrative +18,090 +17,986 +16,981 +Research and development +3,071 +3,183 +2,444 +Amortization of intangible assets +644 +504 +176 +Change in fair value of contingent consideration +(181 +) +(619 +) +55 +Impairment of goodwill +— +— +7,970 +Total operating expenses +21,624 +21,054 +27,626 +Operating income (loss) +1,634 +2,017 +(4,742 +) +Non-operating income (expense): +Other income, net +2 +4 +18 +Interest expense, net +(6 +) +(72 +) +(152 +) +Income (loss) from continuing operations before income taxes +1,630 +1,949 +(4,876 +) +Provision for income taxes +(716 +) +(643 +) +(278 +) +Income (loss) from continuing operations +914 +1,306 +(5,154 +) +Gain on sale of discontinued operation, net of tax +1,465 +1,180 +— +Income (loss) from discontinued operation, net of tax +— +28 +(55 +) +Net income (loss) +$ +2,379 +$ +2,514 +$ +(5,209 +) +Income (loss) per share from continuing operations - basic and diluted +$ +0.03 +$ +0.04 +$ +(0.15 +) +Gain per share from sale of discontinued operation - basic and diluted +$ +0.04 +$ +0.03 +$ +0.00 +Income (loss) per share from discontinued operation - basic and diluted +$ +0.00 +$ +0.00 +$ +(0.00 +) +Net income (loss) per share - basic and diluted +$ +0.07 +$ +0.07 +$ +(0.15 +) +Shares used in basic per share calculations +33,491 +34,259 +34,335 +Shares used in diluted per share calculations +33,609 +34,380 +34,335 +See accompanying notes. +37 +Table of Contents +Iteris, Inc. +Consolidated Statements of Stockholders’ Equity and Comprehensive Income (Loss) +(In thousands) +Additional +Total +Common Stock +Paid-In +Accumulated +Stockholders’ +Shares +Amount +Capital +Deficit +Equity +Balance at March 31, 2010 +34,318 +$ +3,432 +$ +137,503 +$ +(82,869 +) +$ +58,066 +Stock option exercises +46 +4 +53 +— +57 +Stock-based compensation +— +— +382 +— +382 +Net loss and comprehensive loss +— +— +— +(5,209 +) +(5,209 +) +Balance at March 31, 2011 +34,364 +3,436 +137,938 +(88,078 +) +53,296 +Stock option exercises +68 +8 +77 +— +85 +Stock-based compensation +— +— +331 +— +331 +Issuance of shares pursuant to vesting of restricted stock units +51 +5 +(5 +) +— +— +Repurchases of common stock +(574 +) +(58 +) +(696 +) +(754 +) +Net income and comprehensive income +— +— +— +2,514 +2,514 +Balance at March 31, 2012 +33,909 +3,391 +137,645 +(85,564 +) +55,472 +Stock option exercises +190 +20 +232 +— +252 +Stock-based compensation +— +— +279 +— +279 +Issuance of shares pursuant to vesting of restricted stock units +51 +5 +(29 +) +— +(24 +) +Repurchases of common stock +(1,524 +) +(152 +) +(2,325 +) +— +(2,477 +) +Net income and comprehensive income +— +— +— +2,379 +2,379 +Balance at March 31, 2013 +32,626 +$ +3,264 +$ +135,802 +$ +(83,185 +) +$ +55,881 +See accompanying notes. +38 +Table of Contents +Iteris, Inc. +Consolidated Statements of Cash Flows +(In thousands) +Year Ended March 31, +2013 +2012 +2011 +Cash flows from operating activities +Net income (loss) +$ +2,379 +$ +2,514 +$ +(5,209 +) +Adjustments to reconcile net income (loss) to net cash provided by operating activities: +Deferred income taxes +1,414 +286 +273 +Depreciation of property and equipment +901 +907 +1,030 +Stock-based compensation +279 +331 +382 +Impairment of goodwill +— +— +7,970 +Amortization of intangible assets +644 +504 +222 +Change in fair value of contingent consideration +(181 +) +(619 +) +55 +Gain on sale of discontinued operation, net of tax +(1,465 +) +(1,180 +) +— +Loss on disposal of equipment +— +1 +9 +Changes in operating assets and liabilities, net of effects of discontinued operation: +Accounts receivable +135 +(1,826 +) +1,052 +Net costs and estimated earnings in excess of billings +(570 +) +(902 +) +(501 +) +Inventories +(11 +) +79 +(953 +) +Prepaid expenses and other assets +(334 +) +284 +211 +Accounts payable and accrued expenses +461 +289 +805 +Net cash provided by operating activities +3,652 +668 +5,346 +Cash flows from investing activities +Purchases of property and equipment +(815 +) +(337 +) +(414 +) +Capitalized software +(190 +) +(138 +) +— +Cash paid for business combination +— +(969 +) +(1,116 +) +Net proceeds from sale of business segment +1,372 +11,446 +— +Net cash provided by (used in) investing activities +367 +10,002 +(1,530 +) +Cash flows from financing activities +Payments on long-term debt +(634 +) +(2,330 +) +(2,354 +) +Deferred payment for prior business combination +(700 +) +(788 +) +(106 +) +Repurchases of common stock +(2,477 +) +(754 +) +— +Proceeds from stock option exercises +252 +85 +57 +Issuance of common stock pursuant to restricted stock units +(24 +) +— +— +Net cash used in financing activities +(3,583 +) +(3,787 +) +(2,403 +) +Increase in cash and cash equivalents +436 +6,883 +1,413 +Cash and cash equivalents at beginning of period +18,701 +11,818 +10,405 +Cash and cash equivalents at end of period +$ +19,137 +$ +18,701 +$ +11,818 +Supplemental cash flow information: +Cash paid during the year for: +Interest +$ +45 +$ +111 +$ +200 +Income taxes +339 +439 +455 +Supplemental schedule of non-cash investing and financing activities: +Liabilities incurred for business combinations +$ +— +$ +971 +$ +2,610 +Issuance of common stock for vested restricted stock units +5 +5 +— +See accompanying notes. +39 +Table of Contents +Iteris, Inc. +Notes to Consolidated Financial Statements +March 31, 2013 +1. Description of Business and Summary of Significant Accounting Policies +Description of Business +Iteris, Inc. (referred to collectively with our subsidiaries in these consolidated financial statements as “Iteris,” the “Company,” “we,” “our” and “us”) is a leading provider of intelligent information solutions to the traffic management market. We are focused on the development and application of advanced technologies and software-based information systems that reduce traffic congestion, provide measurement, management and predictive traffic analytics and improve the safety of surface transportation systems infrastructure. We also believe our products, services and solutions, in conjunction with sound traffic management, minimize the environmental impact of traffic congestion. We combine our unique intellectual property, products, decades of experience in traffic management and information technologies to offer a broad range of Intelligent Transportation Systems (“ITS”) solutions to customers worldwide. Iteris was originally incorporated in Delaware in 1987. +Basis of Presentation +Our consolidated financial statements include the accounts of Iteris and our subsidiaries and have been prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”). All significant intercompany accounts and transactions have been eliminated in consolidation. +The results of continuing operations for all periods presented in the consolidated financial statements exclude the financial impact of discontinued operations. See Note 3, “Sale of Vehicle Sensors”, for further discussion related to discontinued operations presentation. +Use of Estimates +The preparation of consolidated financial statements in conformity with GAAP requires our management to make certain estimates and assumptions that affect the reported amounts of assets and liabilities and disclosures of contingent assets and liabilities at the date of the financial statements, and reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Significant estimates made in the preparation of the consolidated financial statements include the allowance for doubtful accounts, projections of taxable income used to assess realizability of deferred tax assets, inventory and warranty reserves, costs to complete long-term contracts, indirect cost rates used in cost-plus contracts, contract reserves, the valuation of purchased intangible asset and goodwill, the valuation of debt and equity instruments and estimates of future cash flows used to assess the recoverability of long-lived assets and the impairment of goodwill. +Revenue Recognition +Product revenues and related costs of sales are recognized when all of the following criteria are met: (i) persuasive evidence of an arrangement exists, (ii) delivery under the terms of the arrangement has occurred, (iii) the price to the customer is fixed or determinable, and (iv) collection of the receivable is reasonably assured. These criteria are typically met at the time of product shipment, but in certain circumstances, may not be met until receipt or acceptance by the customer. Accordingly, at the date revenue is recognized, the significant obligations or uncertainties concerning the sale have been resolved. +We recognize revenue from the sale of deliverables that are part of a multiple-element arrangement in accordance with applicable accounting guidance that establishes a relative selling price hierarchy permitting the use of an estimated selling price to determine the allocation of arrangement consideration to a deliverable in a multiple-element arrangement where neither vendor specific objective evidence (“VSOE”) nor third-party evidence (“TPE”) of fair value is available for that deliverable. In the absence of VSOE or TPE of the standalone selling price for one or more delivered or undelivered elements in a multiple-element arrangement, we are required to estimate the selling prices of those elements. Overall arrangement consideration is allocated to each element (both delivered and undelivered items) that has stand-alone value based on their relative selling prices, regardless of whether those selling prices are evidenced by VSOE or TPE or are based on our estimated selling prices. +We account for multiple-element arrangements that consist only of software and software-related services in accordance with applicable accounting guidance for software and software-related transactions. For such transactions, revenue on arrangements that include multiple elements is allocated to each element based on the relative fair value of each element, and fair value is determined by VSOE. If we cannot objectively determine the fair value of any undelivered element included in such multiple-element arrangements +40 +Table of Contents +and the only undelivered element is post-contract customer support or maintenance, and VSOE of the fair value of such support or maintenance does not exist, revenue from the entire arrangement is recognized ratably over the support period. When the fair value of a delivered element has not been established but VSOE of fair value exists for the undelivered elements, we use the residual method to recognize revenue if the fair value of all undelivered elements is determinable. Under the residual method, the fair value of the undelivered elements is deferred and the remaining portion of the arrangement fee is allocated to the delivered elements and is recognized as revenue. +Transportation Systems revenues are derived primarily from long-term contracts with governmental agencies. When appropriate, revenues are recognized using the percentage of completion method of accounting, whereby revenue is recognized as contract performance progresses and is determined based on the relationship of costs incurred to total estimated costs. Any anticipated losses on contracts are charged to earnings when identified. Changes in job performance and estimated profitability, including those arising from contract penalty provisions and final contract settlements, may result in revisions to costs and revenues and are recognized in the period in which the revisions are determined. Profit incentives are included in revenues when their realization is reasonably assured. Certain of our revenues are recognized as services are performed and amounts are earned, which is measured by time incurred or other contractual milestones or output measures. Revenues accounted for in this manner generally relate to certain cost-plus fixed fee or time-and-materials contracts. +Costs in Excess of Billings on Uncompleted Contracts +Costs in excess of billings on uncompleted contracts in the accompanying consolidated balance sheets represent unbilled amounts earned and reimbursable under services sales arrangements. At any given period-end, a large portion of the balance in this account represents the accumulation of labor, materials and other costs that have not been billed due to timing, whereby the accumulation of each month’s costs and earnings are not administratively billed until the subsequent month. Also included in this account are amounts that will become billable according to contract terms, which usually require the consideration of the passage of time, achievement of milestones or completion of the project. Such unbilled amounts are expected to be billed and collected within the next twelve months. +Costs in excess of billings on uncompleted contracts at March 31, 2013 and 2012 include approximately $937,000 and $944,000, respectively, which were not billable because certain milestone objectives specified in the contracts had not been attained. The costs and estimated earnings in excess of billings at March 31, 2013 are expected to be billed and collected during the fiscal year ending March 31, 2014. +Billings in Excess of Costs and Estimated Earnings on Uncompleted Contracts +Billings in excess of costs and estimated earnings on uncompleted contracts in the accompanying consolidated balance sheets is comprised of cash collected from customers and billings to customers on contracts in advance of work performed, advance payments negotiated as a contract condition, estimated losses on uncompleted contracts, project-related legal liabilities and other project-related reserves. The unearned amounts are expected to be earned within the next twelve months. +We record provisions for estimated losses on uncompleted contracts in the period in which such losses become known. The cumulative effects of revisions to contract revenues and estimated completion costs are recorded in the accounting period in which the amounts become evident and can be reasonably estimated. These revisions can include such items as the effects of change orders and claims, warranty claims, liquidated damages or other contractual penalties, adjustments for audit findings on contract closeout settlements. +Concentration of Credit Risk +Financial instruments that potentially subject us to a concentration of credit risk consist principally of cash and cash equivalents and trade accounts receivable. +Cash and cash equivalents consist primarily of demand deposits and money market funds maintained with several financial institutions. Deposits held with banks may exceed the amount of insurance provided on such deposits. Generally, these deposits may be redeemed upon demand and are maintained with high credit quality financial institutions and therefore are believed to have minimal credit risk. +Our accounts receivable are primarily derived from billings with customers located throughout North America, as well as in the Middle East, Europe, South America and Asia. We generally do not require collateral or other security from customers. We maintain an allowance for doubtful accounts for potential credit losses, which losses have historically been within management’s expectations. +41 +Table of Contents +Fair Values of Financial Instruments +The fair value of cash and cash equivalents, receivables, accounts payable and accrued expenses approximate carrying value because of the short period of time to maturity. The fair value of line of credit agreements and long-term debt approximate carrying value because the related effective rates of interest approximate current market rates available to us for debt with similar terms and similar remaining maturities. +Cash and Cash Equivalents +Cash and cash equivalents consist of cash and short-term investments with initial maturities of ninety days or less. Included in cash and cash equivalents of $19.1 million as of March 31, 2013, is approximately $500,000 of cash designated as collateral on performance bonds, as required under certain of our Transportation Systems contracts in the Middle East. The performance bonds require us to maintain 100% cash value of the bonds as collateral in a bank that is local to the purchasing agency. The performance bond collateral is required throughout the delivery of our services and until the contract is closed by the purchasing agency. We expect these requirements, and the related cash collateral restrictions, to remain in place through 2014. +Allowance for Doubtful Accounts +The collectability of our accounts receivable is evaluated through review of outstanding invoices and ongoing credit evaluations of our customers’ financial condition. In cases where we are aware of circumstances that may impair a specific customer’s ability to meet its financial obligations subsequent to the original sale, we will record an allowance against amounts due, and thereby reduce the net recognized receivable to the amount we reasonably believe will be collected. We also maintain an allowance based on our historical collections experience. When we determine that collection is not likely, we write off accounts receivable against the allowance for doubtful accounts. +Inventories +Inventories consist of finished goods, work-in-process and raw materials and are stated at the lower of cost or market. Cost is determined using the first-in, first-out method. +Property and Equipment +Property and equipment are recorded at cost and are depreciated using the straight-line method over the estimated useful life ranging from three to eight years. Leasehold improvements are depreciated over the term of the related lease or the estimated useful life of the improvement, whichever is shorter. +Goodwill and Long-Lived Assets +We evaluate goodwill on an annual basis in our fourth fiscal quarter or more frequently if we believe indicators of impairment exist. We have determined that our reporting units for purposes of testing for goodwill impairment are identical to our reportable segments for financial reporting purposes. In the fiscal year ended March 31, 2012 (“Fiscal 2012”) we adopted the provisions issued by the Financial Accounting Standards Board (“FASB”) that were intended to simplify goodwill impairment testing. This guidance permits us to first assess qualitative factors to determine whether it is more likely than not that the fair value of a reporting unit is less than its carrying amount. If we conclude that it is more likely than not that the fair value of a reporting unit is less than its carrying amount, we conduct a two-step goodwill impairment test. The first step of the impairment test involves comparing the fair values of the applicable reporting units with their carrying values. We determine the fair values of our reporting units using the income valuation approach, as well as other generally accepted valuation methodologies. If the carrying amount of a reporting unit exceeds the reporting unit’s fair value, we perform the second step of the goodwill impairment test. The second step of the goodwill impairment test involves comparing the implied fair value of the affected reporting unit’s goodwill with the carrying value of that goodwill. The amount by which the carrying value of the goodwill exceeds its implied fair value, if any, is recognized as an impairment loss. We performed an annual impairment assessment of the carrying value of goodwill for each of the fiscal years ended March 31, 2013, 2012 and 2011. Based on these assessments, we determined that no impairment as of each of these dates was indicated as the estimated fair value of each of our reporting units exceeded its respective carrying value. We monitor the indicators for goodwill impairment testing between annual tests. Certain adverse business conditions impacting one or more reporting units would cause us to test goodwill for impairment on an interim basis. Refer to Note 5 for additional discussion regarding our interim goodwill impairment analysis during the fiscal year ended March 31, 2011 (“Fiscal 2011”). +We test long-lived assets and purchased intangible assets (other than goodwill) for impairment if we believe indicators of impairment exist. We determine whether the carrying value of an asset or asset group is recoverable, based on comparisons to undiscounted expected future cash flows the asset are expected to generate. If an asset is not recoverable, we record an impairment loss equal to the amount by which the carrying value of the asset exceeds its fair value. We primarily use the income valuation approach to determine the fair value of our long lived assets and purchased intangible assets. +42 +Table of Contents +Income Taxes +We utilize the asset and liability method of accounting for income taxes, under which deferred taxes are determined based on the temporary differences between the financial statement and tax basis of assets and liabilities using tax rates expected to be in effect during the years in which the basis differences reverse. A valuation allowance is recorded when it is more-likely-than-not that some or all of the deferred tax assets will not be realized, which increases our income tax expense in the period such determination is made. +Income tax positions must meet a more-likely-than-not recognition threshold to be recognized. Income tax positions that previously failed to meet the more-likely-than-not threshold are recognized in the first subsequent financial reporting period in which that threshold is met. Previously recognized tax positions that no longer meet the more-likely-than-not threshold are derecognized in the first subsequent financial reporting period in which that threshold is no longer met. +Stock-Based Compensation +We record stock-based compensation in the consolidated statement of operations as an expense, based on the estimated grant date fair value of our stock-based awards, whereby such fair values are amortized over the requisite service period. Our stock-based awards are currently comprised of common stock options and restricted stock units. The fair value of our common stock option awards is estimated on the grant date using the Black-Scholes-Merton (“BSM”) option-pricing formula. While utilizing this model meets established requirements, the estimated fair values generated by it may not be indicative of the actual fair values of our common stock option awards as it does not consider certain factors important to those awards to employees, such as continued employment and periodic vesting requirements as well as limited transferability. The fair value of our restricted stock units is based on the closing market price of our common stock on the grant date. If there are any modifications or cancellations of the underlying unvested stock-based awards, we may be required to accelerate, increase or cancel any remaining unearned stock-based compensation expense. +Research and Development Expenditures +Research and development expenditures are charged to expense in the period incurred. +Shipping and Handling Costs +Shipping and handling costs are included as cost of sales in the period during which the products ship. +Sales Taxes +Sales taxes are presented on a net basis (excluded from net sales and contract revenues) in the consolidated statements of operations. +Advertising Expenses +Advertising costs are expensed in the period incurred and totaled $165,000, $187,000 and $224,000 in the fiscal years ended March 31, 2013, 2012 and 2011, respectively. +Warranty +We generally provide a one to three year warranty from the original invoice date on all products, materials and workmanship. Products sold to various original equipment manufacturer customers sometimes carry longer warranties. Defective products will be either repaired or replaced, usually at our option, upon meeting certain criteria. We accrue a provision for the estimated costs that may be incurred for product warranties relating to a product as a component of cost of sales at the time revenue for that product is recognized. The accrued warranty reserve is included within accrued liabilities in the accompanying consolidated balance sheets. +Repair and Maintenance Costs +We incur repair and maintenance costs in the normal course of business. Should the repair or maintenance result in a permanent improvement to one of our leased facilities, the cost is capitalized as a leasehold improvement and amortized over its useful life or the remainder of the lease period, whichever is shorter. Non-permanent repair and maintenance costs are charged to expense as incurred. +43 +Table of Contents +Recent Accounting Pronouncements +In May 2011, the FASB issued Accounting Standards Update (“ASU”) No. 2011-04, Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRSs (“ASU 2011-04”), which amends Accounting Standards Codification 820, Fair Value Measurements . ASU 2011-04 aims to eliminate certain differences that existed between U.S. and international fair value accounting concepts, and also clarifies existing guidance under GAAP. Additionally, among other disclosures, this ASU requires certain new quantitative and qualitative disclosures regarding unobservable fair value measurements. We adopted the amendments prescribed by ASU 2011-04 for our fiscal year ended March 31, 2013 (“Fiscal 2013”), which has not resulted in a material impact on our consolidated financial statements. +In June 2011, the FASB issued ASU No. 2011-05, Presentation of Comprehensive Income (“ASU 2011-05”). ASU 2011-05 requires the presentation of comprehensive income, the components of net income and the components of other comprehensive income either in a single continuous statement of comprehensive income or in two separate but consecutive statements. The new standard also requires presentation of adjustments for items that are reclassified from other comprehensive income to net income in the statement where the components of net income and the components of other comprehensive income are presented; however, in December 2011, the FASB issued ASU No. 2011-12, Deferral of the Effective Date for Amendments to the Presentation of Reclassifications of Items Out of Accumulated Other Comprehensive Income in Accounting Standards Update No. 2011-05 , which deferred this requirement. The amendments prescribed by ASU 2011-05 are now effective on a retrospective basis for financial statements issued for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2011. We adopted ASU 2011-05 in Fiscal 2013, which has not resulted in a material impact on our consolidated financial statements. +In September 2011, the FASB issued ASU No. 2011-08, Testing for Goodwill Impairment (“ASU 2011-08”). With respect to performing their required annual test for goodwill impairment, ASU 2011-08 gives companies the option to first perform a qualitative assessment to determine whether it is more likely than not that the fair value of a reporting unit is less than its carrying amount. If a company concludes that this is the case, it must perform the two-step test in accordance with previously existing guidance. Otherwise, a company can skip the two-step test. ASU 2011-08 is effective for fiscal years beginning after December 15, 2011. Early adoption was permitted, and we chose to adopt ASU 2011-08 in Fiscal 2012, which did not result in a material impact on our consolidated financial statements. +2. Supplementary Financial Information +Inventories +The following table presents details regarding our inventories: +March 31, +2013 +2012 +(In thousands) +Materials and supplies +$ +1,504 +$ +1,513 +Work in process +105 +98 +Finished goods +856 +843 +$ +2,465 +$ +2,454 +Property and Equipment +The following table presents details of our property and equipment: +March 31, +2013 +2012 +(In thousands) +Equipment +$ +6,126 +$ +5,545 +Leasehold improvements +1,953 +1,946 +Accumulated depreciation +(6,217 +) +(5,543 +) +$ +1,862 +$ +1,948 +44 +Table of Contents +Intangible Assets +The following table presents details regarding our intangible assets: +March 31, +2013 +2012 +Gross +Carrying +Amount +Accumulated +Amortization +Gross +Carrying +Amount +Accumulated +Amortization +(In thousands) +Technology +$ +1,856 +$ +(1,178 +) +$ +1,856 +$ +(935 +) +Customer contracts / relationships +750 +(247 +) +750 +(122 +) +Trade names and non-compete agreements +1,110 +(495 +) +1,110 +(219 +) +Capitalized software development costs +328 +— +138 +— +Total +$ +4,044 +$ +(1,920 +) +$ +3,854 +$ +(1,276 +) +Amortization expense for intangible assets subject to amortization was approximately $644,000, $504,000 and $176,000 for the fiscal years ended March 31, 2013, 2012 and 2011, respectively. +We capitalized approximately $190,000 and $138,000 for the fiscal years ended March 31, 2013 and 2012, respectively, of internal costs incurred in developing software products to be sold. These costs related to the internal development of our performance measurement software offerings. +We do not have any intangible assets with indefinite useful lives. Future estimated amortization expense is as follows: +Year Ending March 31, +(In thousands) +2014 +$ +736 +2015 +540 +2016 +469 +2017 +282 +2018 +88 +Thereafter +9 +$ +2,124 +Refer to Note 4 for additional information regarding intangible assets acquired during the last three fiscal years. If we acquire additional intangible assets in future periods, our amortization expense will increase. +Goodwill +The following table presents the activity related to the carrying value of our goodwill by reportable segment for Fiscal 2012 and Fiscal 2013: +45 +Table of Contents +Roadway +Sensors +Transportation +Systems +iPerform +Total +(In thousands) +Balance - March 31, 2011 +Goodwill +8,214 +16,278 +— +24,492 +Accumulated impairment losses +— +(7,970 +) +— +(7,970 +) +8,214 +8,308 +— +16,522 +Acquisition of Berkeley Transportation Systems, Inc. (Note 4) +— +796 +— +796 +Balance - March 31, 2012 +Goodwill +8,214 +17,074 +— +25,288 +Accumulated impairment losses +— +(7,970 +) +— +(7,970 +) +$ +8,214 +$ +9,104 +$ +— +$ +17,318 +Balance - March 31, 2013 +Goodwill +8,214 +16,278 +796 +25,288 +Accumulated impairment losses +— +(7,970 +) +— +(7,970 +) +$ +8,214 +$ +8,308 +$ +796 +$ +17,318 +Warranty Reserve Activity +The following table presents activity with respect to the warranty reserve: +Year Ended March 31, +2013 +2012 +2011 +(In thousands) +Balance at beginning of fiscal year +$ +231 +$ +279 +$ +297 +Additions charged to cost of sales +139 +86 +137 +Warranty claims +(201 +) +(134 +) +(155 +) +Balance at end of fiscal year +$ +169 +$ +231 +$ +279 +Earnings Per Share +The following table sets forth the computation of basic and diluted income (loss) from continuing operations per share: +Year Ended March 31, +2013 +2012 +2011 +(In thousands, except per share amounts) +Numerator: +Income (loss) from continuing operations +$ +914 +$ +1,306 +$ +(5,154 +) +Denominator: +Weighted average common shares used in basic computation +33,491 +34,259 +34,335 +Dilutive stock options +60 +96 +— +Dilutive restricted stock units +56 +25 +— +Dilutive warrants +2 +— +— +Weighted average common shares used in diluted computation +33,609 +34,380 +34,335 +Income (loss) from continuing operations per share: +Basic +$ +0.03 +$ +0.04 +$ +(0.15 +) +Diluted +$ +0.03 +$ +0.04 +$ +(0.15 +) +46 +Table of Contents +The following instruments were excluded for purposes of calculating weighted average common share equivalents in the computation of diluted income (loss) from continuing operations per share as their effect would have been anti-dilutive: +Year Ended March 31, +2013 +2012 +2011 +(In thousands) +Stock options +1,049 +1,840 +1,467 +Restricted stock units +— +— +54 +Warrants +4 +15 +272 +3. Sale of Vehicle Sensors +On July 29, 2011, we completed the sale of substantially all of our assets used in connection with our Vehicle Sensors segment to Bendix Commercial Vehicle Systems LLC (“Bendix”), a member of Knorr-Bremse Group, pursuant to an Asset Purchase Agreement (the “Agreement”) signed on July 25, 2011 (the “Asset Sale”). +Under the terms of the Agreement, upon the closing of the Asset Sale, Bendix paid us $14 million in cash, subject to a $2 million holdback and adjustments based upon the working capital of the Vehicle Sensors segment at closing, and Bendix assumed certain specified obligations and liabilities of the Vehicle Sensors segment. In October 2012, we received approximately $1.7 million in connection with the holdback provision. Furthermore, we are entitled to additional consideration in the form of the following performance and royalty-related earn-outs: Bendix is obligated to pay us an amount in cash equal to (i) 85% of revenue associated with royalties received under our license and distribution agreements with Audiovox Electronics Corporation and Valeo Schalter and Sensoren GmbH through December 31, 2017 and (ii) 30% of the amount, if any, by which the amount of revenue generated from the sale of our lane departure warning systems exceeds Bendix’s projection for such revenue for the two years following closing, each subject to certain reductions and limitations set forth in the Agreement. As of March 31, 2013, we received approximately $0.9 million in connection with royalty-related earn-outs provisions for a total of $14.6 million in cash from the Asset Sale. +Upon the closing of the Asset Sale and resolution of working capital adjustments (as described above), we recorded aggregate proceeds received of approximately $12.0 million. Legal and other professional fees of approximately $0.6 million that were directly related to the sale transaction were offset against the proceeds to calculate net proceeds from the Asset Sale of approximately $11.4 million. +The following table summarizes the assets and liabilities of the Vehicle Sensors segment as of the closing date of the Asset Sale (in thousands): +Cash +$ +105 +Accounts receivable +1,850 +Inventories +1,147 +Other current assets +31 +Property and equipment, net +133 +Goodwill +4,671 +Total assets +7,937 +Current liabilities +(691 +) +Net assets +$ +7,246 +In comparing the above net assets to the net proceeds received, we recorded a gain on the Asset Sale of $1.5 million and $1.2 million, after tax, in the accompanying consolidated statements of operations for Fiscal 2013 and Fiscal 2012, respectively. The effective tax rate applicable to the gain was impacted by goodwill of $4.7 million for Fiscal 2012, for which there is no corresponding tax basis. Included in the $1.5 million gain on the Asset Sale in Fiscal 2013, is an accrual for approximately $90,000, or $58,000 after tax, related to certain performance and royalty-related earn-outs (as described above) that were achieved through March 31, 2013. +In accordance with applicable accounting guidance, we determined that the Vehicle Sensors segment, which constituted one of our operating segments, qualified as a discontinued operation. The applicable financial results of the Vehicle Sensors segment have been reported as a discontinued operation in the consolidated statements of operations for all periods presented. For the fiscal years ended March 31, 2013, 2012 and 2011, Vehicle Sensors net sales classified as part of discontinued operation was $0, $3.2 million and $7.5 million, respectively. We elected not to allocate any interest expense to the discontinued operation. +47 +Table of Contents +We entered into a short-term transitional services agreement with Bendix that terminated at the end of February 2012, pursuant to which we provided them certain ongoing logistical and administrative support services. Bendix paid us a fixed monthly amount for such support services, and also paid us an hourly amount for providing certain development-related services during the transition period. +4. Acquisitions +Berkeley Transportation Systems, Inc. +In November 2011, we acquired all of the outstanding capital stock of Berkeley Transportation Systems, Inc. (“BTS”). BTS was a privately-held company based in Berkeley, California, which specializes in transportation performance measurement. BTS’ Performance Measurement System leverages its real-time data collection, diagnostic, fusion and warehousing platform to aggregate and compute performance measures. This information is used to analyze how a transportation system is performing based on pre-determined measures of effectiveness such as stops, delays and travel time. Our primary reasons for the acquisition were to add key technologies to complement our iPerform solutions and strengthen our performance measurement and management initiative as a whole. +Our consolidated financial statements for Fiscal 2013 and Fiscal 2012 include the results of operations of BTS commencing as of the acquisition date. BTS contributed approximately $3.3 million and $935,000 of revenues and approximately $294,000 and $367,000 of operating losses included in the consolidated statement of operations for Fiscal 2013 and Fiscal 2012, respectively. On or shortly after the acquisition date, we paid a total of approximately $840,000 in cash to BTS. Additionally, we are also scheduled to pay up to $250,000 at the 24-month anniversary of the closing of the acquisition, pursuant to a holdback provision, and up to $335,000 at the 36-month anniversary of the closing of the acquisition, pursuant to a deferred payment provision. In our third fiscal quarter ended December 31, 2012, the Company entered into an amendment to the BTS stock purchase agreement which modified certain earn-out provisions, and as a result, the Company paid $700,000 in cash to the BTS shareholders for achievement of those modified earn-out provisions in our fourth quarter of Fiscal 2013. The amendment did not have a material impact on previous estimated amounts accrued in connection with the earn-out provisions. This payment completed the Company’s obligation under the earn-out provisions of the agreement. +Acquisition Accounting +We accounted for the acquisition of BTS as a business combination in accordance with applicable accounting guidance. We measured the fair value of the consideration transferred (including contingent consideration) to determine the purchase price of the acquisition. We allocated the fair value of consideration transferred to tangible assets acquired, liabilities assumed and identifiable intangible assets acquired based on their estimated fair values at the acquisition date. +The BTS acquisition was recorded as follows (in thousands): +Fair value of consideration transferred: +Cash paid on or shortly after acquisition date +$ +840 +Estimated fair value of contingent consideration +971 +Total +1,811 +Allocation: +Accounts receivable +(164 +) +Other tangible assets +(375 +) +Purchased intangible assets +(1,100 +) +Liabilities +624 +Goodwill +$ +796 +The excess of the fair value of the BTS business over the aggregate fair values of identifiable assets acquired and liabilities assumed was recorded as goodwill. The primary factor that resulted in the recognition of goodwill was the acquisition of BTS’ assembled workforce, which is not a separately identifiable intangible asset. The goodwill is not expected to be deductible for income tax purposes. +Purchased Intangible Assets +The following table presents details of the intangible assets acquired from BTS: +48 +Table of Contents +Estimated +Useful Life +Amount +(In years) +(In thousands) +Backlog +3 +$ +330 +Technology +6 +290 +Customer contracts / relationships +6 +250 +Other purchased intangible assets +5 - 7 +230 +$ +1,100 +Meridian Environmental Technology, Inc. +In January 2011, we acquired all of the capital stock of Meridian Environmental Technology, Inc. (“MET”), a privately-held company based in Grand Forks, North Dakota. MET specializes in 511 advanced traveler information systems, as well as Maintenance Decision Support System management tools that allow users to create solutions to meet roadway maintenance decision needs. Our primary reasons for the acquisition were (i) to enhance our ability to provide travelers and traffic management authorities with more accurate and real-time information and network performance management tools and (ii) to provide Iteris with key capabilities in the emerging performance measurement and management market. From the date of acquisition through the end of Fiscal 2011, MET contributed approximately $1.5 million of revenues and approximately $77,000 of operating income included in the consolidated statement of operations for Fiscal 2011. +Our consolidated financial statements for the fiscal years ended March 31, 2013, 2012 and 2011 include the results of operations of MET commencing as of the acquisition date. On or shortly after the acquisition date, we paid approximately $1.6 million in cash, exclusive of $369,000 of cash acquired. We also agreed to pay up to $1 million on each of the first two anniversaries of the closing of the acquisition upon the satisfaction of certain conditions, as well as up to an additional $2 million under a 24-month earn-out provision. Acquisition-related costs were not significant and are included in selling, general and administrative expenses in the accompanying consolidated statement of operations for Fiscal 2011. +In January 2012, we made a cash payment of approximately $668,000 of the first deferred payment to the shareholders of MET and held back $250,000 in accordance with certain provisions of the purchase agreement. In June 2012, we determined the contingencies related to the release of the $250,000 holdback were not met. As a result, no portion of the $250,000 holdback was released and the entire amount was reversed into operating income during the second quarter of Fiscal 2013. Additionally, no amounts were earned by the MET shareholders related to the first and second year earn-out provisions which ended on December 31, 2011 and 2012, respectively. The second deferred payment of $1 million was due in the fourth quarter of Fiscal 2013. As a result of certain holdback provisions and other deductions, we currently expect to pay approximately $400,000 to the MET shareholders in the first quarter of the fiscal year ending March 31, 2014, which is recorded in our accrued liabilities in our consolidated balance sheet at March 31, 2013. +Acquisition Accounting +We accounted for the acquisition of MET as a business combination in accordance with applicable accounting guidance. We measured the fair value of the consideration transferred (including contingent consideration) to determine the purchase price of the acquisition. We allocated the fair value of consideration transferred to tangible assets acquired, liabilities assumed and identifiable intangible assets acquired based on their estimated fair values at the acquisition date. +The acquisition is recorded as follows (in thousands): +Fair value of consideration transferred: +Cash paid on or shortly after acquisition date +$ +1,622 +Estimated fair value of contingent consideration +2,473 +Total +4,095 +Allocation: +Cash +(369 +) +Accounts receivable +(682 +) +Other tangible current assets +(531 +) +Property and equipment +(682 +) +Purchased intangible assets +(1,620 +) +Liabilities +1,161 +Goodwill +$ +1,372 +The excess of the fair value of the business over the aggregate fair values of identifiable assets acquired and liabilities assumed was recorded as goodwill. The primary factor that resulted in the recognition of goodwill was the acquisition of MET’s +49 +Table of Contents +assembled workforce, which is not a separately identifiable intangible asset. The goodwill is not expected to be deductible for income tax purposes. +Purchased Intangible Assets +The following table presents details of the intangible assets acquired from MET: +Estimated +Useful Life +Amount +(In years) +(In thousands) +Technology +6 +$ +570 +Customer contracts / relationships +6 +500 +Other purchased intangible assets +3 - 7 +550 +$ +1,620 +5. Impairment of Goodwill +As discussed in Note 1, goodwill is tested for impairment on an annual basis in our fourth fiscal quarter or more frequently if indicators of impairment exist. +In Fiscal 2012, we early adopted the provisions issued by the FASB that are intended to simplify goodwill impairment testing. The updated guidance permits us to first assess qualitative factors to determine whether it is more likely than not that the fair value of a reporting unit is less than its carrying amount. If we conclude that it is more likely than not that the fair value of a reporting units is less than its carrying amount, we conduct a two-step goodwill impairment test. We determined it was more appropriate and cost effective to perform a qualitative assessment in Fiscal 2012 and a quantitative first-step assessment in Fiscal 2013 to estimate the fair value of our reporting units using the income approach. Based on our assessments, we determined that no impairment was indicated as the estimated fair value of each reporting unit exceeded its respective carrying value. +In Fiscal 2011, during the quarter ended December 31, 2010, due primarily to lower than expected operating results in our Transportation Systems reporting unit, as well as ongoing weakness specifically in the Transportation Systems markets, we performed an interim test of impairment of the carrying value of goodwill in our Transportation Systems reporting unit as of December 31, 2010. In performing the first step in this analysis, we estimated the fair value of our Transportation Systems reporting unit using the income approach. As of December 31, 2010, we determined that the carrying value of our Transportation Systems reporting unit exceeded its estimated fair value and, accordingly, we performed the second step of the impairment analysis to estimate the implied fair value of the goodwill of this reporting unit. +The implied fair value of goodwill was determined in the same manner utilized to estimate the amount of goodwill recognized in a business combination. To determine this value, we estimated the fair value of the assets and liabilities, including certain intangible assets, to be allocated to the Transportation Systems reporting unit as of December 31, 2010. The implied fair value of goodwill was measured as the difference between the estimated fair value of the reporting unit over the estimated fair value amounts of its assets and liabilities. The impairment loss for the Transportation Systems reporting unit was measured as the amount the carrying value of its goodwill exceeded the implied fair value of the goodwill. Accordingly, in order to write down Transportation Systems goodwill with a carrying value of $14.9 million to its implied fair value of $6.9 million, we recorded an impairment charge of $8.0 million in the three months ended December 31, 2010. +We estimated the fair value of the Transportation Systems reporting unit using the income approach, which was based on management’s business plans and financial projections at that time for the next five years, along with a perpetual growth rate thereafter of approximately 4%. The analysis also used a weighted average discount rate of approximately 14%, our estimated cost of capital, slightly adjusted for increased market risk. +6. Fair Value Measurements +We measure fair value as the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. Fair value measurements are based on a three-tier hierarchy that prioritizes the inputs used to measure fair value. These tiers include: Level 1, defined as observable inputs such as quoted prices in active markets for identical assets and liabilities; Level 2, defined as observable inputs other than Level 1 prices such as quoted prices for similar assets or liabilities or prices quoted in inactive markets; and Level 3, defined as unobservable inputs that are significant to the fair value of the asset or liability, and for which little or no market data exists, therefore requiring management to utilize its own assumptions to provide its best estimate of what market participants would use in valuing the asset or liability. +50 +Table of Contents +The liability for the estimated fair value of the contingent consideration in connection with our acquisitions of MET and BTS was determined using Level 3 inputs based on a probabilistic calculation whereby we assigned estimated probabilities to achieving the earn-out targets and then discounted the total contingent consideration to net present value. The following table reconciles this liability measured at fair value on a recurring basis for Fiscal 2013 (in thousands): +Balance at March 31, 2012 +$ +2,204 +Deferred payments made to BTS shareholders +(700 +) +Payments made or accrued to reduce MET liability +(362 +) +Change in fair value included in net income +(181 +) +Balance at March 31, 2013 +$ +961 +The change in the estimated fair value of this liability during the current fiscal year resulted primarily from payments to the shareholders of BTS related to the achievement of earn-out targets and reductions to our MET estimates regarding both the probability of achieving certain earn-out targets and the amounts of certain future deferred payments. +The current portions of the liability at March 31, 2013 and 2012 were approximately $652,000 and $1.6 million, respectively, and were included within accrued liabilities in the accompanying consolidated balance sheets. The remaining non-current portions of the liability are included within non-current liabilities in the accompanying consolidated balance sheets. +Other than the above, we did not have any material financial assets or liabilities measured at fair value on a recurring basis using Level 3 inputs as of March 31, 2013. +Our non-financial assets, such as goodwill, intangible assets and property and equipment, are measured at fair value on a non-recurring basis, generally when there is a transaction involving those assets such as a purchase transaction, a business combination or an adjustment for impairment. See Notes 4 and 5 above for further discussion regarding certain of our intangible assets and goodwill balances (including goodwill impairment) that were measured at fair value, using certain Level 3 inputs, during the fiscal years ended March 31, 2013 and 2012. +7. Credit Facility +In October 2008, we entered into a $19.5 million credit facility with California Bank & Trust (“CB&T”). This credit facility provided for a two-year revolving line of credit with borrowings of up to $12.0 million and a $7.5 million 48-month term note. In September 2010, we entered into a modification agreement with CB&T to extend the expiration date of our revolving line of credit to October 1, 2012. In September 2012, we entered into a second modification agreement with CB&T to extend the expiration date of our revolving line of credit to October 1, 2014. Interest on borrowed amounts under the revolving line of credit are payable monthly at a rate equal to the current stated prime rate (3.25% at March 31, 2013) up to the current stated prime rate plus 0.25%, depending on aggregate deposit balances maintained at the bank in relation to the total loan commitment under the credit facility. We are obligated to pay an unused line fee of 0.25% per annum applied to the average unused portion of the revolving line of credit during the preceding month. The revolving line of credit does not contain early termination fees and is secured by substantially all of our assets. As of March 31, 2013 and March 31, 2012, no amounts were borrowed under the revolving line of credit portion of the credit facility. Availability under this line of credit may be reduced or otherwise limited as a result of our obligations to comply with certain financial covenants. +As of March 31, 2012, we had outstanding borrowings of approximately $634,000 under the term note, which was set to expire on May 1, 2013. Principal payments under this term note were required to be repaid in monthly installments of $152,000. During the first quarter of Fiscal 2013, all principal and interest payments under the term note were paid in full. The term note contained no early termination fees. +8. Income Taxes +The reconciliation of our income tax provision (benefit) to taxes computed at U.S. federal statutory rates is as follows: +51 +Table of Contents +Year Ended March 31, +2013 +2012 +2011 +(In thousands) +Income tax provision (benefit) at statutory rates +$ +554 +$ +663 +$ +(1,658 +) +State income taxes net of federal benefit +18 +562 +189 +Impairment charges +— +— +2,044 +Research credits +(39 +) +(246 +) +— +Change in fair value of contingent acquisition consideration +(62 +) +(211 +) +— +Compensation charges +31 +59 +94 +Unrecognized tax benefits +— +(276 +) +(288 +) +Change in valuation allowance +188 +— +— +Other +26 +92 +(103 +) +Provision for income taxes +$ +716 +$ +643 +$ +278 +The components of deferred tax assets and liabilities are as follows: +March 31, +2013 +2012 +(In thousands) +Deferred tax assets: +Net operating losses +$ +7,031 +$ +8,246 +Credit carry forwards +960 +773 +Deferred compensation and payroll +913 +941 +Bad debt allowance and other reserves +462 +433 +Deferred rent +315 +435 +Other, net +156 +301 +Total deferred tax assets +9,837 +11,129 +Valuation allowance +(188 +) +— +Total deferred tax assets, net of valuation allowance +9,649 +11,129 +Deferred tax liabilities: +Property and equipment +(482 +) +(517 +) +Acquired intangibles +(535 +) +(754 +) +Goodwill +(381 +) +(193 +) +Total deferred tax liabilities +(1,398 +) +(1,464 +) +Net deferred tax assets +$ +8,251 +$ +9,665 +The components of current and deferred federal and state income tax provisions and (benefits) are as follows: +Year Ended March 31, +2013 +2012 +2011 +(In thousands) +Current income tax provision (benefit): +Federal +$ +(20 +) +$ +(221 +) +$ +(186 +) +State +99 +208 +264 +Deferred income tax provision (benefit): +Federal +425 +12 +251 +State +212 +644 +(51 +) +Net income tax provision +$ +716 +$ +643 +$ +278 +At March 31, 2013, we had approximately $587,000 in federal alternative minimum tax credit carryforwards that can be carried forward indefinitely. We had $22.0 million of federal net operating loss carryforwards at March 31, 2013 that begin to expire in 2021. We also had $9.2 million of state net operating loss carryforwards at March 31, 2013, of which $420,000 are scheduled to expire in 2014, $8.5 million are scheduled to expire in 2015 and $298,000 are scheduled to expire in 2031. +52 +Table of Contents +Due to changes in stock ownership, our federal net operating loss carryforwards of approximately $22.0 million as of March 31, 2013 and other federal attributes are subject to an annual limitation under Section 382 of the Internal Revenue Code. As of March 31, 2013, based on the cumulative amount of tax attributes that have become available under the limitation imposed by Section 382, all of our net operating losses are now fully available for use. Our deferred tax assets at March 31, 2013 do not include approximately $906,000 of excess tax benefits from employee stock option exercises that are a component of our net operating loss carryforwards. If and when such excess tax benefits are realized, stockholders’ equity will be increased. +As of March 31, 2013, we recorded a valuation allowance against certain of our state net operating loss carryforwards in the amount of $188,000, net of federal tax benefit, which we estimated were more likely to not be realized within the applicable carryforward period. As of March 31, 2012, we determined that it was more likely than not that our deferred tax assets would be realized and no general valuation allowance was recorded against our deferred tax assets. In making our determination as to the realizability of our deferred tax assets, we reviewed all available positive and negative evidence, including reversal of deferred tax liabilities, potential carrybacks, projected future taxable income, tax planning strategies and recent financial performance. +Unrecognized Tax Benefits +As of March 31, 2013 and 2012, our gross unrecognized tax benefits were $218,000 and $1.7 million, respectively, of which $115,000 and $1.3 million, respectively, if recognized, would affect our effective tax rate. +We recognize interest and/or penalties related to income tax matters in income tax expense. As of March 31, 2013 and 2012, we had accrued cumulatively $68,000 and $56,000, respectively, for the payment of potential interest and penalties. +A reconciliation of the beginning and ending balances of the total amounts of gross unrecognized tax benefits is as follows: +Year Ended March 31, +2013 +2012 +2011 +(In thousands) +Gross unrecognized tax benefits at beginning of year +$ +1,692 +$ +1,941 +$ +2,153 +Increases for tax positions taken in prior years +— +97 +121 +Decreases for tax positions taken in prior years +(1,431 +) +(10 +) +(15 +) +Increases for tax positions taken in the current year +17 +20 +17 +Settlement with taxing authorities +— +— +(8 +) +Lapse in statute of limitations +(60 +) +(356 +) +(327 +) +Gross unrecognized tax benefits at March 31 +$ +218 +$ +1,692 +$ +1,941 +As of March 31, 2012, our unrecognized tax benefits included $1.4 million related to estimated tax credit carryforwards which, if recognized, would have given rise to a deferred tax asset. As of March 31, 2013, we concluded that the information necessary to compute and substantiate the credits was not available or reasonably obtainable. As such, we will neither recognize a deferred tax asset for the estimated credit carryforwards, nor continue maintaining an offsetting amount of unrecognized tax benefits. We anticipate a decrease in gross unrecognized tax benefits of approximately $30,000 within the next twelve months based on federal and state statute expirations in various jurisdictions. +We are subject to taxation in the U.S. and various states. We are subject to U.S. federal tax examination for fiscal tax years ended March 31, 2010 or later, and state and local income tax examination for fiscal tax years ended March 31, 2009 or later. +9. Commitments and Contingencies +Litigation and Other Contingencies +As a provider of traffic engineering services, products and solutions, we are currently, and may in the future, from time to time, be involved in litigation relating to claims arising out of our operations in the normal course of business. While we cannot accurately predict the outcome of such litigation, we currently are not a party to any legal proceedings, the adverse outcome of which, in management’s opinion, individually or in the aggregate, would have a material adverse effect on our consolidated results of operations, financial position or cash flows. +Operating Leases +In May 2007, we entered into an agreement to lease 52,000 square feet of office space in Santa Ana, California for a term of 88 months. In September 2007, we relocated our headquarters and principal operations into this space. The monthly lease rate was $102,000 during the first year of the lease and increases each year thereafter, up to a maximum of $120,000 during the last year of the lease. The lease may be extended for a period of five years, at our option, at a lease rate to be based on the market lease rate for comparable property determined as of the commencement date of the extension period. Additionally, the lease agreement provided for $1.8 million in incentives in the form of tenant improvement allowances, which we recorded as deferred rent and capitalized leasehold improvements in our consolidated balance sheet. The deferred rent amount reduces monthly rent expense over the term of the lease, and the capitalized leasehold improvements amount are being depreciated over the initial term of the lease (the estimated useful life of the related leasehold improvements). +53 +Table of Contents +We have lease commitments for facilities in various locations throughout the U.S., as well as for certain equipment. Future minimum rental payments under these non-cancelable operating leases at March 31, 2013 were as follows: +Year Ending March 31, +(In thousands) +2014 +$ +2,251 +2015 +1,723 +2016 +526 +2017 +431 +2018 +311 +Thereafter +172 +$ +5,414 +Rent expense totaled approximately $1.9 million for each of the fiscal years ended March 31, 2013, 2012 and 2011, respectively. +Related Party Transaction +We previously subleased office space to MAXxess Systems, Inc. (“MAXxess”), one of our former subsidiaries that we sold in September 2003. MAXxess is currently owned by an investor group that includes two of our directors, one of whom is the former Chief Executive Officer of MAXxess. The sublease terminated in September 2007, at which time MAXxess owed us an aggregate of $274,000 related to this sublease and certain ancillary corporate services that we provided to MAXxess. We have previously fully reserved for amounts owed to us by MAXxess under the terms of this sublease. In August 2009, MAXxess executed a promissory note payable to Iteris in the original principal amount of $274,000. The promissory note bears interest at a rate of 6% per annum, compounded annually, with accrued interest to be paid annually on the first business day of each calendar year. Payments under the note may be made in bona fide services rendered by MAXxess to Iteris to the extent such services and amounts are pre-approved in writing by us. All amounts outstanding under the note will become due and payable on the earliest of (i) August 10, 2014, (ii) a change of control in MAXxess, or (iii) a financing by MAXxess resulting in gross proceeds of at least $10 million. As of March 31, 2013, approximately $259,000 of the original principal balance and interest for calendar year 2012 of approximately $15,000 was outstanding and payable to Iteris. Subsequent to March 31, 2013, the interest payment was received in full. All outstanding principal remains fully reserved. +Inventory Purchase Commitments +At March 31, 2013, we had firm commitments to purchase approximately $2.3 million of inventory, operating assets and other supplies, which are expected to occur primarily during the first and second quarters of our fiscal year ending March 31, 2014. +10. Stockholders’ Equity +Preferred Stock +Our certificate of incorporation provides for the issuance of up to 2,000,000 shares of preferred stock. Our Board of Directors is authorized to issue from time to time such authorized but unissued shares of preferred stock in one or more series and to fix or alter the designations, preferences, rights and any qualifications, limitations or restrictions of the shares of each such series, including the dividend, conversion, voting, redemption and liquidation rights. As of March 31, 2013 and 2012, there were no outstanding shares of preferred stock, and we do not currently have plans to issue any shares of preferred stock. +In August 2009, our Board of Directors adopted a stockholder rights plan, which calls for preferred stock purchase rights (each, a “Right”) to be distributed, as a dividend, at the rate of one Right for each share of common stock held as of September 3, 2009. Each Right will entitle holders of common stock to buy one one-thousandth of one share of Series A Junior Participating Preferred Stock of Iteris. A further description and terms of the Rights are set forth in the Rights Agreement dated August 20, 2009 by and between Iteris and Computershare Trust Company, N.A., as rights agent. In connection with the stockholder rights plan, our Board of Directors approved the adoption of a Certificate of Designations, which created the Series A Junior Participating Preferred Stock, and likewise authorized the filing of a Certification of Elimination to eliminate the two series of junior participating preferred stock, which were originally created in April 1998 in connection with our previous stockholder rights plan which expired in 2008. +54 +Table of Contents +Common Stock Warrants +As of March 31, 2013, we had outstanding fully exercisable warrants to purchase 15,000 shares of our common stock. These warrants have an exercise price per share of $1.42 and a remaining contractual life of 0.4 years. There was no activity with respect to these or any other warrants during Fiscal 2013. +In connection with our adoption of certain provisions of accounting for derivatives, which became effective for us on April 1, 2009, we determined that certain outstanding warrants to purchase shares of our common stock contained provisions that provide for a possible future adjustment to either the exercise price and/or number of shares to be issued upon exercise. As such, beginning April 1, 2009, we began recognizing these warrants as liabilities at their respective estimated fair values on each reporting date. The cumulative effect of the change in accounting for these warrants of $47,000 was recognized as an adjustment to the opening balance of accumulated deficit at April 1, 2009. The amounts recognized in the consolidated balance sheet as a result of our adoption on April 1, 2009 were determined based on the amounts that would have been recognized if this accounting treatment had been applied from the issuance date of the warrants. By March 31, 2011, all such warrants had expired unexercised, and thus there was no remaining liability recorded on our consolidated balance sheet at that date or thereafter. We estimated the fair value of these warrants using the BSM option-pricing formula. The change in the estimated fair value of the warrants for the fiscal year ended March 31, 2011 is included in “other income, net” in the accompanying consolidated statement of operations. +Common Stock Reserved for Future Issuance +The following summarizes common stock reserved for future issuance at March 31, 2013: +Number of Shares +(In thousands) +Stock options outstanding +1,744 +Restricted stock units outstanding +210 +Authorized for future issuance under stock incentive plans +921 +Warrants outstanding +15 +2,890 +11. Employee Benefit Plans +Stock Incentive Plans +In September 2007, our stockholders approved the 2007 Omnibus Incentive Plan (the “2007 Plan”), which provides that options to purchase shares of our unissued common stock may be granted to our employees, officers, consultants and directors at exercise prices which are equal to or greater than the market value of our common stock on the date of grant. Options expire no more than ten years after the date of grant and generally vest at the rate of 25% on each of the first four anniversaries of the grant date. The 2007 Plan also allows for the issuance of stock appreciation rights, restricted stock, restricted stock units (“RSUs”) and other stock-based awards based on the value of our common stock. New shares are issued to satisfy stock option exercises and share issuances under the 2007 Plan. In September 2009, our stockholders approved an amendment to increase the number of shares of our common stock authorized and reserved for issuance under the 2007 Plan by 800,000 shares to a total of 1,650,000 shares. In September 2012, our stockholders approved an amendment to increase the number of shares of our common stock authorized and reserved for issuance under the 2007 Plan by 800,000 shares to a total of 2,450,000 shares. At March 31, 2013, there were approximately 921,000 shares of common stock available for grant under this plan. As of March 31, 2013, options to purchase approximately 1,186,000 shares of common stock, as well as 210,000 RSUs, were outstanding under the 2007 Plan. +Our 1997 Stock Incentive Plan (the “1997 Plan”) terminated in September 2007; however, all stock options outstanding under the 1997 Plan remain outstanding pursuant to the terms of such stock options. As of March 31, 2013, options to purchase approximately 558,000 shares of our common stock were outstanding under the 1997 Plan. No further options or other stock-based awards may be granted under the 1997 Plan. +In connection with our merger with our Iteris, Inc. subsidiary (the “Iteris Subsidiary”) in 2004, we assumed the 1998 Stock Incentive Plan (the “1998 Plan”) of the Iteris Subsidiary and all outstanding options granted thereunder. As of March 31, 2013, there were no options remaining to purchase shares of our common stock under the 1998 Plan. No further options or other stock-based awards may be granted under the 1998 Plan. +55 +Table of Contents +Certain options granted under the 2007 Plan and the 1997 Plan (collectively, the “Plans”) and the RSUs granted under the 2007 Plan provide for accelerated vesting of unvested options in the event of a change in control under certain circumstances. +Stock Options +A summary of activity in the Plans with respect to our stock options for Fiscal 2013 is as follows: +Number +of +Options +Weighted +Average +Exercise +Price Per +Share +Weighted +Average +Remaining +Contractual +Life +Aggregate +Intrinsic +Value +(In thousands) +(Years) +(In thousands) +Options outstanding at March 31, 2012 +2,493 +$ +1.64 +Granted +220 +1.53 +Exercised +(189 +) +1.33 +Forfeited +(49 +) +1.14 +Expired +(731 +) +1.46 +Options outstanding at March 31, 2013 +1,744 +$ +1.74 +5.2 +$ +626 +Options exercisable at March 31, 2013 +1,288 +$ +1.87 +4.0 +$ +423 +Vested and expected to vest at March 31, 2013 +1,690 +$ +1.75 +5.1 +$ +601 +Options exercisable at March 31, 2013 pursuant to a change-in-control +1,744 +$ +1.74 +5.2 +$ +626 +— +— +— +— +Restricted Stock Units +In August 2010, we began granting RSUs under the 2007 Plan to certain of our employees. RSU awards are stock-based awards that entitle the holder to receive one share of our common stock for each RSU upon vesting. RSUs vest at the rate of 25% on each of the first four anniversaries of the grant date provided that the holder remains in service (as defined by the 2007 Plan) as of the vesting date. The fair value per RSU is determined based on the closing market price of our common stock on the grant date. +A summary of activity with respect to our RSUs for Fiscal 2013 is as follows: +Number +of Shares +Weighted +Average +Price Per +Share +Weighted +Average +Remaining +Life +Aggregate +Intrinsic +Value +(In thousands) +(Years) +(In thousands) +RSUs outstanding at March 31, 2012 +235 +$ +1.32 +Granted +80 +1.50 +Vested +(68 +) +1.35 +Forfeited +(37 +) +1.23 +RSUs outstanding at March 31, 2013 +210 +$ +1.39 +2.4 +$ +56 +Expected to vest at March 31, 2013 +182 +$ +1.39 +2.3 +$ +49 +Common stock issuable (for RSUs) at March 31, 2013 upon a change-in-control +210 +$ +1.39 +2.4 +$ +56 +— +— +— +— +Stock-Based Compensation +The following table presents stock-based compensation expense that is included in each functional line item in our consolidated statements of operations: +56 +Table of Contents +Year Ended March 31, +2013 +2012 +2011 +(In thousands) +Cost of revenues +$ +42 +$ +45 +$ +47 +Selling, general and administrative expense +237 +280 +305 +Income from discontinued operation, net of tax +— +6 +30 +Total stock-based compensation +$ +279 +$ +331 +$ +382 +At March 31, 2013, there was approximately $419,000 of unrecognized compensation expense related to unvested stock options and RSUs. This expense is currently expected to be recognized over a weighted average period of approximately 2.2 years. If there are any modifications or cancellations of the underlying unvested awards, we may be required to accelerate, increase or cancel any remaining unearned stock-based compensation expense. Future stock-based compensation expense and unearned stock-based compensation will increase to the extent that we grant additional stock options, RSUs or other stock-based awards. +The grant date fair value of stock options granted was estimated using the following weighted-average assumptions: +Year Ended March 31, +2013 +2012 +2011 +Expected life - years +7.0 +7.0 +7.0 +Risk-free interest rate +1.2 +% +1.6 +% +2.1 +% +Expected volatility of common stock +52 +% +52 +% +58 +% +Dividend yield +— +% +— +% +— +% +A summary of certain fair value and intrinsic value information pertaining to our stock options is as follows: +Year Ended March 31, +2013 +2012 +2011 +(In thousands, except per share amounts) +Weighted average grant date fair value per share of options granted +$ +0.81 +$ +0.61 +$ +0.86 +Intrinsic value of options exercised +$ +42 +$ +7 +$ +23 +Employee Incentive Programs +Under the terms of a Profit Sharing Plan, we may contribute to a trust fund such amounts as determined annually by the Board of Directors. No contributions were made during the fiscal years ended March 31, 2013, 2012 and 2011. +We sponsor a defined contribution 401(k) plan (“the 401(k) Plan”), adopted in 1990, under which eligible associates voluntarily contribute to the plan, up to IRS maximums, through payroll deductions. Under the provisions of the 401(k) Plan, associates have various investment choices, one of which is the purchase of Iteris common stock at market price. We match up to 90% of contributions, based on years of service, up to a stated limit. From July 1, 2009 through March 31, 2010, we temporarily suspended our matching contributions to the 401(k) Plan. Beginning in April 2010, we reinstituted certain limited matching contributions to the 401(k) Plan. Our matching contributions under the 401(k) Plan were approximately $498,000, $475,000 and $491,000 for the fiscal years ended March 31, 2013, 2012 and 2011, respectively. +12. Stock Repurchase Program +In August 2011, our Board of Directors approved a stock repurchase program pursuant to which we were authorized to acquire up to $3 million of our outstanding common stock from time to time through August 2012. On August 9, 2012, our Board of Directors approved a new stock repurchase program pursuant to which we may acquire up to $3 million of our outstanding common stock for an unspecified length of time. Under the new program, we may repurchase shares from time to time in open-market and privately negotiated transactions and block trades, and may also repurchase shares pursuant to a 10b5-1 trading plan during our closed trading windows. There is no guarantee as to the exact number of shares that will be repurchased. We may modify or terminate the repurchase program at any time without prior notice. From inception of the program in August 2011 through March 31, 2013, we repurchased approximately 2,097,000 shares of our common stock for an aggregate of approximately $3.2 million at an average price per share of $1.52. +57 +Table of Contents +For our fiscal year ended March 31, 2013 and 2012, we repurchased approximately 1,523,000 and 574,000 shares of our common stock, respectively. All repurchased shares have been retired and resumed their status as authorized and unissued shares of our common stock as of March 31, 2013. +13. Business Segments, Significant Customer and Geographic Information +Business Segments +We operate in three reportable segments: Roadway Sensors, Transportation Systems and iPerform. +The Roadway Sensors segment includes, among other products, our Vantage, VersiCam, Pico, Vantage Vector, SmartCycle, SmartScan and Abacus vehicle detection systems for traffic intersection control, incident detection and certain highway traffic data collection applications. +The Transportation Systems segment includes transportation engineering and consulting services and the development of transportation management and traveler information systems for the ITS industry. This segment includes the operations of MET, which specializes in 511 advanced traveler information systems and offers Maintenance Decision Support System management tools that allow users to create solutions to meet roadway maintenance decision needs. +The iPerform segment includes our performance measurement and information management solutions, including all the operations of BTS, which specializes in transportation performance measurement. During Fiscal 2012, we began the development of IterisPeMS. IterisPeMS is a state-of-the-art, information management software suite that utilizes a wide range of data resources and analytical techniques to determine current and future traffic patterns, permitting the effective performance analysis and management of traffic infrastructure resources. This information can then be analyzed by traffic professionals to measure how a transportation network is performing and to identify potential areas of improvement. IterisPeMS is also capable of providing users with predictive traffic analytics and easy-to-use visualization and animation features based on historical traffic conditions. +The accounting policies of our reportable segments are the same as those described in the summary of significant accounting policies (Note 1). Certain corporate expenses, including interest and amortization of intangible assets, are not allocated to the segments. The reportable segments are each managed separately because they manufacture and distribute distinct products or provide services with different processes. All reported segment revenues are derived from external customers. +Selected financial information for our reportable segments for the fiscal years ended March 31, 2013, 2012 and 2011 is as follows: +Roadway +Sensors +Transportation +Systems +iPerform +Total +(In thousands) +Year Ended March 31, 2013 +Revenues +$ +26,002 +$ +32,389 +$ +3,294 +$ +61,685 +Depreciation +221 +362 +20 +603 +Segment income (loss) +4,119 +3,622 +(294 +) +7,447 +Year Ended March 31, 2012 +Revenues +$ +27,679 +$ +29,792 +$ +935 +$ +58,406 +Depreciation +194 +393 +5 +592 +Segment income (loss) +4,813 +3,151 +(367 +) +7,597 +Year Ended March 31, 2011 +Revenues +$ +28,208 +$ +23,758 +$ +— +$ +51,966 +Depreciation +217 +250 +— +467 +Impairment of goodwill +— +7,970 +— +7,970 +Segment income (loss) +6,328 +(5,258 +) +— +1,070 +The following table reconciles total segment income to consolidated income (loss) from continuing operations before income taxes: +58 +Table of Contents +Year Ended March 31, +2013 +2012 +2011 +Segment income (loss): +Total income from reportable segments +$ +7,447 +$ +7,597 +$ +1,070 +Unallocated amounts: +Corporate and other expenses +(5,350 +) +(5,695 +) +(5,581 +) +Amortization of intangible assets +(644 +) +(504 +) +(176 +) +Change in fair value of contingent acquisition consideration +181 +619 +(55 +) +Other income, net +2 +4 +18 +Interest expense, net +(6 +) +(72 +) +(152 +) +Income (loss) from continuing operations before income taxes +$ +1,630 +$ +1,949 +$ +(4,876 +) +Significant Customer and Geographic Information +We currently have, and historically have had, a diverse customer base. For Fiscal 2013, one individual customer represented approximately 13% of our total revenues and no other individual customer represented greater than 10% of our total revenues. For Fiscal 2012 and Fiscal 2011, no individual customer represented greater than 10% of our total revenues. +No individual customer or government agency had a receivable balance at March 31, 2013 or 2012 greater than 10% of our total trade accounts receivable balances as of March 31, 2013 and 2012, respectively. +The following table sets forth the percentages of our revenues, by geographic region, derived from shipments to, or contract, service and other revenues from, external customers located outside the U.S.: +Year Ended March 31, +2013 +2012 +2011 +Middle East +3 +% +— +% +— +% +Europe +— +— +5 +Asia +— +1 +5 +Other +1 +1 +3 +4 +% +2 +% +13 +% +Substantially all of our long-lived assets are held in the U.S. +14. Quarterly Financial Data (Unaudited) +Quarter Ended: +Revenues +Gross +Profit +Net +Income +Basic Net +Income per +Share +Diluted Net +Income per +Share +(In thousands, except per share amounts) +June 30, 2012 +$ +16,304 +$ +6,264 +$ +676 +$ +0.02 +$ +0.02 +September 30, 2012 +15,504 +6,071 +550 +0.02 +0.02 +December 31, 2012 +13,994 +5,151 +1,097 +0.03 +0.03 +March 31, 2013 +15,883 +5,772 +56 +0.00 +0.00 +$ +61,685 +$ +23,258 +$ +2,379 +$ +0.07 +* +$ +0.07 +* +June 30, 2011 +$ +13,892 +$ +5,869 +$ +97 +$ +0.00 +$ +0.00 +September 30, 2011 +14,393 +6,005 +1,310 +0.04 +0.04 +December 31, 2011 +14,881 +5,464 +747 +0.02 +0.02 +March 31, 2012 +15,240 +5,733 +360 +0.01 +0.01 +$ +58,406 +$ +23,071 +$ +2,514 +$ +0.07 +* +$ +0.07 +* +59 +Table of Contents +* Annual per share amounts may not agree to the sum of the quarterly per share amounts due to differences between average shares outstanding during the periods. +60 +Table of Contents +Exhibit Index +Exhibit +Number +Description +Reference +2.1+ +Stock Purchase Agreement dated December 23, 2010 by and among Iteris, Inc., Meridian Environmental Technology, Inc., (“MET”) the shareholders of MET and Kathy J. Osborne as the Shareholders Representative +Exhibit 2.1 to the registrant’s Quarterly Report on Form 10-Q for the quarter ended December 31, 2010 as filed with the SEC on February 14, 2011 +2.2+ +Asset Purchase Agreement by and between Iteris, Inc. and Bendix Commercial Vehicle Systems LLC, dated as of July 25, 2011 +Exhibit 2.1 to the registrant’s Current Report on Form 8-K/A as filed with the SEC on November 1, 2011 +3.1 +Restated Certificate of Incorporation of the registrant +Exhibit 3.1 to the registrant’s Quarterly Report on Form 10-Q for the quarter ended September 30, 2009 as filed with the SEC on October 30, 2009 +3.2 +Certificate of Designations of Series A Junior Participating Preferred Stock +Exhibit 3.2 to the registrant’s Quarterly Report on Form 10-Q for the quarter ended September 30, 2009 as filed with the SEC on October 30, 2009 +3.3 +Bylaws of the registrant, as amended +Exhibit 4.2 to the registrant’s Registration Statement on Form S-1 (Reg. No. 033-67932) as filed with the SEC on July 6, 1993 +3.4 +Certificates of Amendment to Bylaws of the registrant dated April 24, 1998 and August 10, 2001 +Exhibit 3.4 to the registrant’s Annual Report on Form 10-K/A for the year ended March 31, 2003 as filed with the SEC on July 29, 2003 +3.5 +Certificate of Amendment to Bylaws of registrant dated September 9, 2004 +Exhibit 3.1 to the registrant’s Quarterly Report on Form 10-Q for the quarter ended September 30, 2004 as filed with the SEC on November 15, 2004 +3.6 +Certificate of Amendment to Bylaws of registrant effective September 16, 2005 +Exhibit 3.5 to the registrant’s Annual Report on Form 10-K for the year ended March 31, 2007 +3.7 +Certificate of Amendment to Bylaws of registrant effective December 7, 2007 +Exhibit 3.1 to the registrant’s Current Report on Form 8-K as filed with the SEC on December 13, 2007 +3.8 +Certificate of Amendment to Bylaws of registrant, effective August 20, 2009 +Exhibit 3.3 to the registrant’s Current Report on Form 8-K as filed with the SEC on August 21, 2009 +4.1 +Specimen of common stock certificate +Exhibit 4.1 to registrant’s Registration Statement on Form 8-A as filed with the SEC on December 8, 2004 +4.2 +Rights Agreement dated August 20, 2009 between the registrant and Computershare Trust Company, N.A., which includes the form of Certificate of Designations for the Series A Junior Participating Preferred Stock, the form of Right Certificate, and Summary of Rights to Purchase Preferred Stock as exhibits thereto +Exhibit 4.1 to the registrant’s Current Report on Form 8-K as filed with the SEC on August 21, 2009 +10.1 +Form of Indemnity Agreement entered into by the registrant and certain of its officers and directors +Exhibit 19.4 to the registrant’s Quarterly Report on Form 10-Q for the quarter ended September 30, 1988 +10.2 +Form of Indemnification Agreement entered into by the registrant and certain of its officers and directors +Exhibit 10.5 to the registrant’s Annual Report on Form 10-K for the year ended March 31, 2004 as filed with the SEC on June 29, 2004 +61 +Table of Contents +10.3* +1997 Stock Incentive Plan (the “1997 Plan”) as amended on May 3, 2003, as further amended on December 15, 2004 +Exhibit 10.32 to the registrant’s Annual Report on Form 10-K for the year ended March 31, 2005 as filed with the SEC on July 14, 2005 +10.4* +Form of Notice of Grant of Stock Option for 1997 Plan +Exhibit 99.2 to the registrant’s Registration Statement on Form S-8 (File No. 333-30396) as filed with the SEC on February 14, 2000 +10.5* +Form of Stock Option Agreement for the 1997 Plan +Exhibit 99.3 to the registrant’s Registration Statement on Form S-8 (File No. 333-30396) as filed with the SEC on February 14, 2000 +10.6* +Form of Addendum to Stock Option Agreement for 1997 Plan—Involuntary Termination Following Corporate Transaction or Change in Control +Exhibit 99.4 to the registrant’s Registration Statement on Form S-8 (File No. 333-30396) as filed with the SEC on February 14, 2000 +10.7* +Form of Addendum to Stock Option Agreement for 1997 Plan—Limited Stock Appreciation Rights +Exhibit 99.5 to the registrant’s Registration Statement on Form S-8 (File No. 333-30396) as filed with the SEC on February 14, 2000 +10.8* +Form of Stock Issuance Agreement for 1997 Plan +Exhibit 99.6 to the registrant’s Registration Statement on Form S-8 (File No. 333-30396) as filed with the SEC on February 14, 2000 +10.9* +Form of Addendum to Stock Issuance Agreement for 1997 Plan—Involuntary Termination Following Corporate Transaction/Change in Control +Exhibit 99.7 to the registrant’s Registration Statement on Form S-8 (File No. 333-30396) as filed with the SEC on February 14, 2000 +10.10* +Form of Notice of Grant of Automatic Stock Option for 1997 Plan—Initial Grant +Exhibit 99.8 to Exhibit 99.8 to registrant’s Registration Statement on Form S-8 (File No. 333-30396) as filed with the SEC on February 14, 2000 +10.11* +Form of Notice of Grant of Automatic Stock Option for 1997 Plan—Annual Grant +Exhibit 99.9 to the registrant’s Registration Statement on Form S-8 (File No. 333-30396) as filed with the SEC on February 14, 2000 +10.12* +Form of Automatic Stock Option Agreement for 1997 Plan +Exhibit 99.10 to the registrant’s Registration Statement on Form S-8 (File No. 333-30396) as filed with the SEC on February 19, 2000 +10.13* +Iteris Inc. 1998 Stock Incentive Plan (as amended on February 7, 2000) (“1998 Plan”) +Exhibit 10.24 to the registrant’s Annual Report on Form 10-K for the year ended March 31, 2005 as filed with the SEC on July 14, 2005 +10.14* +Form of Notice of Grant for 1998 Plan, including forms of Option Agreement and Stock Purchase Agreement for the following directors and executive officers: Gregory McKhann, James S. Miele and Abbas Mohaddes +Exhibit 99.2 to the registrant’s Registration Statement on Form S-8 (File No. 333-126834) as filed with the SEC on July 22, 2005 +10.15* +Form of Addendum to Stock Option Agreement for 1998 Plan +Exhibit 99.3 to the registrant’s Registration Statement on Form S-8 (File No. 333-126834) as filed with the SEC on July 22, 2005 +10.16* +Form of 1997 Stock Option Agreements +Exhibit 99.4 to the registrant’s Registration Statement on Form S-8 (File No. 333-126834) as filed with the SEC on July 22, 2005 +62 +Table of Contents +10.17 +Sublease Agreement, dated September 30, 2003, by and between Odetics, Inc. and Maij, Inc. +Exhibit 10.1 to the registrant’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2007 as filed with the SEC on August 14, 2007 +10.18 +Office Lease Agreement, dated May 24, 2007, by and between Crown Carnegie Associates, LLC and Iteris, Inc. +Exhibit 10.2 to the registrant’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2007 as filed with the SEC on August 14, 2007 +10.19* +2007 Omnibus Incentive Plan +Exhibit 10.19 to the registrant’s Annual Report on Form 10-K for the year ended March 31, 2012 as filed with the SEC on June 11, 2012 +10.20* +Forms of Stock Option Agreements under the 2007 Omnibus Incentive Plan +Exhibit 10.20 to the registrant’s Annual Report on Form 10-K for the year ended March 31, 2012 as filed with the SEC on June 11, 2012 +10.21* +Change in Control Agreement dated June 11, 2008 by and between James S. Miele and Iteris, Inc. +Exhibit 10.42 to the registrant’s Annual Report on Form 10-K for the year ended March 31, 2008 as filed with the SEC on June 12, 2008 +10.22 +Amended and Restated Loan and Security Agreement dated February 4, 2009 by and between California Bank & Trust and the registrant +Exhibit 10.1 to the registrant’s Quarterly Report on Form 10-Q for the quarter ended December 31, 2008 as filed with the SEC on February 13, 2009 +10.23 +Unsecured Promissory Note dated August 10, 2009 executed by MAXxess Systems, Inc. +Exhibit 10.1 to the registrant’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2009 as filed with the SEC on August 11, 2009 +10.24* +Letter Agreement dated July 27, 2010 by and between the registrant and Abbas Mohaddes +Exhibit 10.1 to the registrant’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2010 as filed with the SEC on July 28, 2010 +10.25* +Change in Control Agreement dated July 27, 2010 by and between the registrant and Abbas Mohaddes +Exhibit 10.2 to the registrant’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2010 as filed with the SEC on July 28, 2010 +10.26* +Form of Restricted Stock Unit Award Agreement under the 2007 Omnibus Incentive Plan +Exhibit 10.3 to the registrant’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2010 as filed with the SEC on July 28, 2010 +10.27 +Modification Agreement dated September 30, 2010 by and between Iteris, Inc. and California Bank & Trust +Exhibit 10.1 to the registrant’s Current Report on Form 8-K as filed with the SEC on October 6, 2010 +21 +Subsidiaries of the registrant +Filed herewith +23 +Consent of Independent Registered Public Accounting Firm +Filed herewith +24 +Power of Attorney +Filed herewith (included on the Signature page) +31.1 +Certification of the Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 +Filed herewith +31.2 +Certification of the Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 +Filed herewith +32.1 +Certification of the Chief Executive Officer Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 +Filed herewith +63 +Table of Contents +32.2 +Certification of the Chief Financial Officer Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 +Filed herewith +101.INS# +XBRL Instance Document +Filed herewith +101.SCH# +XBRL Taxonomy Extension Schema Document +Filed herewith +101.CAL# +XBRL Taxonomy Extension Calculation Linkbase Document +Filed herewith +101.LAB# +XBRL Taxonomy Extension Label Linkbase Document +Filed herewith +101.PRE# +XBRL Taxonomy Extension Presentation Linkbase Document +Filed herewith +101.DEF# +XBRL Taxonomy Definition Presentation Linkbase Document +Filed herewith +* Indicates a management contract or compensatory plan or arrangement ++ Confidential treatment has been requested for certain confidential portions of this exhibit pursuant to Rule 24b-2 of the Securities Exchange Act of 1934, as amended. In accordance with Rule 24b-2, these confidential portions have been omitted from the exhibit and filed separately with the SEC. +# Pursuant to Rule 406T of Regulation S-T, these interactive data files i) are not deemed filed or part of a registration statement or prospectus for purposes of Sections 11 or 12 of the Securities Act of 1933, are not deemed filed for purposes of Section 18 of the Securities Exchange Act of 1934, irrespective of any general incorporation language included in any such filings, and otherwise are not subject to liability under these sections; and ii) are deemed to have complied with Rule 405 of Regulation S-T (“Rule 405”) and are not subject to liability under the anti-fraud provisions of the Section 17(a)(1) of the Securities Act of 1933, Section 10(b) of the Securities Exchange Act of 1934 or under any other liability provision if we have made a good faith attempt to comply with Rule 405 and, after we become aware that the interactive data files fail to comply with Rule 405, we promptly amend the interactive data files. +64 \ No newline at end of file diff --git a/raw/filings/0000350868/2012/0001104659-13-047720/filing_metadata.csv b/raw/filings/0000350868/2012/0001104659-13-047720/filing_metadata.csv new file mode 100644 index 0000000000000000000000000000000000000000..44f4e48a95ee96c40e6519dd82a440c116f51a75 --- /dev/null +++ b/raw/filings/0000350868/2012/0001104659-13-047720/filing_metadata.csv @@ -0,0 +1,2 @@ +cik,ticker,company_name,form,filing_date,report_date,acceptance_datetime,accession_number,primary_document,primary_doc_description,size,is_xbrl,is_inline_xbrl,document_url,filing_index_url,year,fiscal_year,is_primary_filing +0000350868,ITI,"ITERIS, INC.",10-K,2013-06-07,2013-03-31,2013-06-07T20:02:36.000Z,0001104659-13-047720,a13-10816_110k.htm,10-K,12618631,1,0,https://www.sec.gov/Archives/edgar/data/350868/000110465913047720/a13-10816_110k.htm,https://www.sec.gov/Archives/edgar/data/350868/000110465913047720/,2012,2012,1 diff --git a/raw/filings/0000350868/2012/0001104659-13-047720/item1.txt b/raw/filings/0000350868/2012/0001104659-13-047720/item1.txt new file mode 100644 index 0000000000000000000000000000000000000000..37175b94b071839ef36abe7acbb6670731f19b32 --- /dev/null +++ b/raw/filings/0000350868/2012/0001104659-13-047720/item1.txt @@ -0,0 +1,72 @@ +ITEM 1. BUSINESS +Overview +We are a leading provider of intelligent information solutions to the traffic management market. We are focused on the development and application of advanced technologies and software-based information systems that reduce traffic congestion, provide measurement, management and predictive traffic analytics and improve the safety of surface transportation systems infrastructure. We also believe our products, services and solutions, in conjunction with sound traffic management, minimize the environmental impact of traffic congestion. We combine our unique intellectual property, products, decades of experience in traffic management and information technologies to offer a broad range of Intelligent Transportation Systems (“ITS”) solutions to customers worldwide. +We were originally incorporated in Delaware in 1987. Our principal executive offices are located at 1700 Carnegie Avenue, Santa Ana, California 92705, and our telephone number at that location is (949) 270-9400. Our Internet website address is www.iteris.com. Our annual reports on Form 10-K, quarterly reports on Form 10-Q and current reports on Form 8-K, together with amendments to these reports, are available on the “Investors” section of our website, free of charge, as soon as reasonably practicable after such material is electronically filed with, or furnished to, the Securities and Exchange Commission (“SEC”). The inclusion of our website address in this report does not include or incorporate by reference into this report any information on, or accessible through, our website. +Products and Services +We currently operate in three reportable segments: Roadway Sensors, Transportation Systems and iPerform. The Roadway Sensors segment includes, among other products, our Vantage, VersiCam, Pico, Vantage Vector, SmartCycle, SmartScan and Abacus vehicle detection systems for traffic intersection control, incident detection and certain highway traffic data collection applications. The Transportation Systems segment includes transportation engineering and consulting services, and the development of transportation management and traveler information systems for the ITS industry. This segment also includes 511 advanced traveler information systems and offers our weather related Maintenance Decision Support System management tools that allow users to create solutions to meet roadway maintenance decision needs. The iPerform segment includes our transportation performance measurement and information management solutions. The iPerform performance measurement solutions leverage its real-time data collection, diagnostic, fusion and warehousing platform to aggregate and compute performance measurements. See Note 13 of Notes to Consolidated Financial Statements, included in Part IV, Item 15 of this report, for further details on our reportable segments. +Roadway Sensors +Our Roadway Sensors segment product line uses advanced image processing technology to capture and analyze video images through sophisticated algorithms, enabling vehicle detection and transmission of both video images and data using various communication technologies. +2 +Table of Contents +· Our Vantage video detection systems detect vehicle presence at intersections, as well as vehicle count, speed and other traffic data used in traffic management systems. Vantage video detection systems typically include up to four of our RZ-4 Advanced cameras or our RZ-4 Advanced Wide Dynamic Range cameras and an EdgeConnect processor. Our Vantage systems give traffic managers the ability to mitigate roadway congestion by modifying traffic signal timing or detecting incidents quickly. Our VantageView software supplements our Vantage video detection systems by providing an integrated platform to manage and “see” video detection assets remotely over a network connection. +· Our Vantage Vector product is an all-in-one vehicle detection sensor with a wide range of capabilities including: stop bar detection, advanced-zone detection, and sensing that enables advanced safety and adaptive control applications. It includes all the proven benefits of Iteris video detection, including high accuracy, high availability remote viewing of video images, no trenching or pavement cutting for installation, bicycle detection capability and high precision for dilemma zone detection by integrating the video field-of-view with radar sensing. Enhanced information includes the number of vehicles, speed, and distance in user configurable zones that can be used for special applications. +· Our SmartSpan product uses proprietary Dynamic Zone Stabilization algorithms and provides accurate and cost effective advance detection and stop-bar detection of vehicles at intersections equipped with span wire mounted signal lights. SmartSpan can be mounted on the same span wires holding the traffic signal without sacrificing detection accuracy. +· Our Vantage systems equipped with SmartCycle can effectively differentiate between bicycles and other vehicles with a single video detection camera, enabling more efficient signalized intersections and maximized traffic throughput. Agencies using bicycle timing can now benefit from bicycle-specific virtual detection zones that can be placed anywhere within the approaching traffic lanes, eliminating the need for separate bicycle-only detection systems. +· VersiCam, our integrated camera and processor video detection system, is a cost-efficient video detection system for smaller intersections that require only a few detection points. +· Pico, our compact video detection system, was developed primarily to address international video detection needs, and was designed for easy installation and configuration. +· Our Abacus products take advantage of the large number of existing installed closed-circuit television video feeds designed to monitor roadways, signalized intersections, tunnels and bridges to allow for data collection and incident detection without the set-up and calibration generally required with other systems. +We believe that future growth domestically and internationally, particularly in developing countries, will be dependent in part on the continued adoption of above-ground video detection technologies, instead of traditional in-pavement loop technology, to manage traffic. +We have historically experienced seasonality, particularly with respect to our Roadway Sensors revenues in our third and fourth fiscal quarters due to reductions in road construction and repairs during the winter months related to inclement weather conditions. +Transportation Systems +Our Transportation Systems segment includes transportation engineering and consulting services focused on the planning, design, development and implementation of software-based systems that integrate sensors, video surveillance, computers and advanced communications equipment to enable public agencies to monitor, control and direct traffic flow, assist in the quick dispatch of emergency crews and distribute real-time information about traffic conditions. Our services include planning, design and implementation of surface transportation infrastructure systems. We perform analysis and study goods movement, study commercial vehicle operations, provide travel demand forecasting and systems engineering, and identify mitigation measures to reduce traffic congestion. This segment also includes the activities of Meridian Environmental Technology, Inc. (“MET”), acquired by us in January 2011, which specializes in 511 advanced traveler information systems as well as Maintenance Decision Support System (“MDSS”) management tools that allow users to create solutions to meet roadway maintenance decision needs. +Our Transportation Systems segment is largely dependent upon governmental funding and is affected by state and local budgetary issues. We expect the recently enacted federal highway bill, which provides for an estimated $105 billion in federal funding for highway, transit, safety, and related transportation programs through the end of September 2014, should make funds more available for transportation infrastructure, traffic management and performance measurement projects. This bill could encourages government agencies to include ITS technologies in these types of projects to a greater degree than in previous +3 +Table of Contents +legislation. In addition, various other funding mechanisms exist to support transportation infrastructure and related projects. These include bonds, dedicated sales and gas tax measures and other alternative funding sources. We believe the overall expansion of our Transportation Systems segment in the future will at least in part be dependent on the federal governments’ use of funds under the federal highway bill. Delays in the release of funding may prolong uncertainty regarding the allotment of transportation funds in federal, state and local budgets. We believe that prolonged uncertainty has adversely impacted, and may continue to adversely impact, our Transportation Systems revenues and our overall financial performance in future periods. +With the addition of MET in January 2011, we have experienced seasonality particularly related to certain MDSS services in our first and second fiscal quarters mainly because MDSS services are generally not required in the summer months when weather conditions are typically less severe. +iPerform +Our iPerform segment, formed during the first quarter of our fiscal year ended March 31, 2013 (“Fiscal 2013”), includes our performance measurement and information management solutions, including all of the operations of Berkeley Transportation Systems, Inc. (“BTS”), acquired by us in November 2011, which specializes in transportation performance measurement. The BTS performance measurement system leverages its real-time data collection, diagnostic, fusion and warehousing platform to aggregate and compute performance measurements. During the fiscal year ended March 31, 2012 (“Fiscal 2012”), we began the development of IterisPeMS, which is a state-of-the-art information management software suite that utilizes a wide range of data resources and analytical techniques to determine current and future traffic patterns, permitting the effective performance analysis and management of traffic infrastructure resources. This information can then be analyzed by traffic professionals to measure how a transportation network is performing and to identify potential areas of improvement. IterisPeMS is also capable of providing users with traffic predictive analytics and easy-to-use visualization and animation features based on historical traffic conditions. +iPerform is a market leader in performance management solutions for federal, state, local and municipal organizations. We intend to use its strong brand and deep experience in the traffic management market, as well as its market-specific intellectual property, to expand our leadership in data aggregation and analytics. By increasing investments in both technical and market development, we plan to focus on expanding the scope of its public sector solutions into the commercial marketplace. +Going forward, iPerform’s solutions are expected to include incident management applications, arterial solutions, predictive traffic, and weather-based data and analytics for both public and commercial markets, including media, automotive, and consumer applications. We plan to fund these investments through internally generated cash flow from our Roadway Sensors and Transportation Systems operating segments, as well as revenues from our iPerform segment and our available cash if necessary. +Sales, Marketing and Principal Customers +We sell our Roadway Sensors products through direct and indirect sales channels. In the territories where we sell direct, we use a combination of our own sales personnel and an outside sales organization to sell, oversee installations and set-up issues and support our products. Our indirect sales channels are comprised of a network of independent dealers in the U.S. and certain foreign locations, who sell integrated systems and related products to the traffic management market. Our independent dealers are trained in, and primarily responsible for, sales, installation, set-up and support of our products, and maintain an inventory of demonstration traffic products from various manufacturers and sell directly to government agencies and installation contractors. These dealers often have long-term arrangements with local government agencies in their respective territories for the supply of various products for the construction and renovation of traffic intersections, and are generally well-known suppliers of high-quality ITS products to the traffic management market. We periodically hold technical training classes for our dealers and end users and maintain a full-time staff of customer support technicians throughout the U.S. to provide technical assistance when needed. When appropriate, we have the ability to modify or make changes to our dealer network to accommodate the needs of the market and our customer base. +We market and sell our Transportation Systems services and solutions and iPerform solutions directly to government agencies pursuant to negotiated contracts that involve competitive bidding and specific qualification requirements. Most of our contracts are with federal, state and municipal customers and generally provide for cancellation or renegotiation at the option of the customer upon reasonable notice and fees paid for modification. We generally use selected members of our engineering, science and information technology teams on a regional basis to serve in sales and business development functions. Our contracts generally involve long lead times and require extensive specification development, evaluation and price negotiations. Additionally, we plan to focus on expanding the scope of our iPerform public sector solutions to sell into the commercial marketplace. +A large portion of our revenues are derived from sales to federal, state and local government agencies. We currently have, and historically have had, a diverse customer base. For Fiscal 2013, one individual customer represented approximately 13% of our total revenues and no other individual customer represented greater than 10% of our total revenues. For Fiscal 2012 and our fiscal year +4 +Table of Contents +ended March 31, 2011 (“Fiscal 2011”), no individual customer represented greater than 10% of our total revenues. Also refer to Note 13 of Notes to Consolidated Financial Statements, included in Part IV, Item 15 of this report. +Manufacturing and Materials +We use contract manufacturers to build subassemblies that are used in our Roadway Sensors products. Additionally, we procure certain components from qualified suppliers, both locally and globally, and generally use multi-sourcing strategies when technically and economically feasible to mitigate supply risk. These subassemblies and components are typically delivered to our Santa Ana, California facility where they go through final assembly and testing prior to shipment to our customers. Our key suppliers include CTS Electronics Manufacturing Solutions, Inc., Sony Electronics, Inc. and LG Electronics, Inc. Our manufacturing activities are conducted in approximately 9,000 square feet of space at our Santa Ana facility. Production volume at our subcontractors is based upon quarterly forecasts that we generally adjust on a monthly basis to control inventory levels. We typically do not manufacture any of the hardware used in the transportation management and traveler information systems that we design and implement. Our production facility is currently ISO 9001 certified. +Customer Support and Services +We provide warranty service and support for our products, as well as follow-up service and support for which we charge separately. Such service revenue was not a material portion of our total revenues for each of Fiscal 2013, Fiscal 2012 and Fiscal 2011. We believe customer support is a key competitive factor. +Backlog +Our total backlog of unfulfilled firm orders was approximately $38.6 million as of March 31, 2013, which was comprised of $3.1 million related to Roadway Sensors, $32.2 million related to Transportation Systems and $3.3 million related to iPerform. Substantially the entire backlog for Roadway Sensors is expected to be recognized as revenue in the fiscal year ending March 31, 2014 (“Fiscal 2014”). In the past three fiscal years, we have recognized approximately 50% to 70% of our Transportation Systems backlog as of the end of a fiscal year in the subsequent fiscal year, and currently expect that trend to continue for the near future for both Transportation Systems and iPerform. +At March 31, 2012, we had backlog of approximately $35.0 million, which was comprised of $3.2 million related to Roadway Sensors and $31.8 million related to Transportation Systems. +The timing and realization of our backlog is subject to the inherent uncertainties of doing business with federal, state and local governments, particularly in view of budgetary constraints, cut-backs and other delays or reallocations of funding that these entities typically face. +Pursuant to the customary terms of our agreements with government contractors and other customers, customers can generally cancel or reschedule orders with little or no penalties. Lead times for the release of purchase orders often depend upon the scheduling and forecasting practices of our individual customers, which also can affect the timing of the conversion of our backlog into revenues. For these reasons, among others, our backlog at a particular date may not be indicative of our future revenues, in particular for our Roadway Sensors segment. +Product Development +Most of our product development activities are conducted at our principal facilities in Santa Ana, California. Our research and development costs and expenses were approximately $3.1 million for Fiscal 2013, $3.2 million for Fiscal 2012 and $2.4 million for Fiscal 2011. We expect to continue to pursue various product development programs and incur research and development expenditures in future periods. +We believe our engineering and product development capabilities are a competitive strength. We strive to continue to develop new products to meet the needs of the ever-changing ITS market as well as enhance and refine our existing product lines. Since 2008 our Roadway Sensors segment has introduced our VersiCam and VersiCam wireless products, Pico, RZ-4 advanced camera and our RZ-4 advanced wide dynamic range camera, which significantly improve video detection performance in certain harsh lighting conditions. During Fiscal 2012, we introduced our Vantage Vector product and also upgraded our Abacus and VantageView software products. Additionally, during Fiscal 2012, we began development of our software based IterisPeMS performance measurement system, which continued through Fiscal 2013 and will continue during Fiscal 2014. We believe that developing new offerings across our segments and enhancing, refining and marketing our existing products is a key component of strong organic growth and profitability. +5 +Table of Contents +Competition +We generally face significant competition in each of our target markets. Increased competition may result in price reductions, reduced gross margins and loss of market share, any of which could have a material adverse effect on our business, financial condition and results of operations. +In the market for our Roadway Sensors vehicle detection products, we compete with manufacturers and distributors of other above ground video camera detection systems and other non-intrusive detection devices, including microwave, infrared, ultrasonic and magnetic detectors, as well as manufacturers and installers of in-pavement inductive loop products, which have historically, and currently continue to be, the predominant detection system in this market. +The markets in which our Transportation Systems segment operates is highly fragmented and subject to evolving national and regional quality, operations and safety standards. Our competitors vary in number, scope and breadth of the products and services they offer. Our competitors in advanced Transportation Systems include national corporations that generally offer expertise in traveler information, integration and transportation management. Our competitors in transportation engineering, planning and design include major regional firms, as well as many smaller local engineering firms. +The markets in which our iPeform segment operates vary from public sector customers who focus on performance measurement systems to help measure and manage the effectiveness of their transportation systems to commercial sector customers who ingest and disseminate traffic and weather related data, information and analytics through various consumer outlets. Our competitors vary in number, scope and breadth of the products and services they offer. In the public sector we compete with some of the same transportation engineering, planning and design firms that also compete with our Transportation Systems segment. In the commercial sector, we compete with a variety of entities that currently provide traffic and/or weather related data to that market. +In general, the markets for the products and services we offer are highly competitive and are characterized by rapidly changing technology and evolving standards. Many of our current and prospective competitors have longer operating histories, greater name recognition, access to larger customer bases and significantly greater financial, technical, manufacturing, distribution and marketing resources than us. As a result, they may be able to adapt more quickly to new or emerging standards or technologies or to devote greater resources to the promotion and sale of their products. It is also possible that new competitors or alliances among competitors could emerge and rapidly acquire significant market share. We believe that our ability to compete effectively in our target markets will depend on a number of factors, including the success and timing of our new product development, the compatibility of our products with a broad range of computing systems, product quality and performance, reliability, functionality, price and service and technical support. Our failure to provide services and develop and market products that compete successfully with those of other suppliers and consultants in our target markets would have a material adverse effect on our business, financial condition and results of operations. +Intellectual Property and Proprietary Rights +Our ability to compete effectively depends in part on our ability to develop and maintain the proprietary aspects of our technology. Our policy is to obtain appropriate proprietary rights protection for any potentially significant new technology acquired or developed by us. We currently hold three U.S. patents, four foreign patent applications, six patent applications in the United States (“U.S.”), and eight provisional patent filings. One U.S. patent, which expires in May 2019, is for general technology related to CMOS sensors. Two U.S. patents, which expire between 2014 and 2029, three foreign patent applications, three U.S. patent applications, and one provisional patent filing relate specifically to our Roadway Sensors technology. One pending foreign patent, three U.S. patent applications, and seven provisional patent filings relate specifically to our iPerform technology. We cannot be certain that any new patents will be granted pursuant to these or subsequent patent applications or provisional patent filings. +In addition to patent laws, we rely on copyright and trade secret laws to protect our proprietary rights. We attempt to protect our trade secrets and other proprietary information through agreements with customers and suppliers, proprietary information agreements with our employees and consultants, and other similar measures. We do not have any material licenses or trademarks other than those relating to product names. We cannot be certain that we will be successful in protecting our proprietary rights. While we believe our patents, patent applications, software and other proprietary know-how have value; changing technology makes our future success dependent principally upon our ability to successfully achieve continuing innovation. +Litigation may be necessary in the future to enforce our proprietary rights, to determine the validity and scope of the proprietary rights of others, or to defend us against claims of infringement or invalidity by others. An adverse outcome in such litigation or similar proceedings could subject us to significant liabilities to third parties, require disputed rights to be licensed from others or require us to cease marketing or using certain products, any of which could have a material adverse effect on our business, financial condition and results of operations. In addition, the cost of addressing any intellectual property litigation claim, both in legal +6 +Table of Contents +fees and expenses, as well as from the diversion of management’s resources, regardless of whether the claim is valid, could be significant and could have a material adverse effect on our business, financial condition and results of operations. +Employees +We refer to our employees as associates. As of March 31, 2013, we employed an aggregate of 258 associates, including 55 associates in general management, administration and finance; 24 associates in sales and marketing; 150 associates in engineering and product development; 14 associates in operations, manufacturing and quality assurance; and 15 associates in customer service. None of our associates are represented by a labor union, and we have never experienced a work stoppage. We believe our relations with our associates are good. +Sale of Vehicle Sensors +On July 29, 2011, we completed the sale of substantially all of the assets used in connection with our Vehicle Sensors segment to Bendix Commercial Vehicle Systems LLC (“Bendix”), a member of Knorr-Bremse Group, pursuant to an Asset Purchase Agreement signed on July 25, 2011 (the “Asset Sale”). Upon closing, Bendix paid us $14 million in cash, subject to a $2 million holdback and adjustments based upon the working capital of the Vehicle Sensors segment at closing, and Bendix assumed certain specified obligations and liabilities of the Vehicle Sensors segment. In October 2012, we received approximately $1.7 million in connection with the holdback provision. Furthermore, we are entitled to additional consideration in the form of certain performance and royalty-related earn-outs. As a result of the Asset Sale, we no longer operate in the Vehicle Sensors segment and we determined that the Vehicle Sensors segment, which previously constituted one of our operating segments, qualifies as a discontinued operation. Refer to Note 3 of Notes to Consolidated Financial Statements, included in Part IV, Item 15 of this report for additional discussion regarding the Asset Sale. The applicable financial results of the Vehicle Sensors segment through the closing of the Asset Sale have been reported as a discontinued operation for all periods presented. +Government Regulation +Our manufacturing operations are subject to various federal, state and local laws and regulations, including those restricting the discharge of materials into the environment. We are not involved in any pending or, to our knowledge, threatened governmental proceedings, which would require curtailment of our operations because of such laws and regulations. We continue to expend funds in connection with our compliance with applicable environmental regulations. These expenditures have not, however, been significant in the past, and we do not expect any significant expenditure in the near future. Currently, compliance with foreign laws has not had a material impact on our business and is not expected to have a material impact in the near future. +7 +Table of Contents \ No newline at end of file diff --git a/raw/filings/0000350868/2012/0001104659-13-047720/item13.txt b/raw/filings/0000350868/2012/0001104659-13-047720/item13.txt new file mode 100644 index 0000000000000000000000000000000000000000..9327a5bca2315d60b92f066ebbf712a378b753e5 --- /dev/null +++ b/raw/filings/0000350868/2012/0001104659-13-047720/item13.txt @@ -0,0 +1,2 @@ +ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE +The information under the captions “Corporate Governance — Director Independence” and “Certain Transactions,” appearing in our proxy statement for the 2013 Annual Meeting of Stockholders, is incorporated herein by reference. \ No newline at end of file diff --git a/raw/filings/0000350868/2012/0001104659-13-047720/item9a.txt b/raw/filings/0000350868/2012/0001104659-13-047720/item9a.txt new file mode 100644 index 0000000000000000000000000000000000000000..94ceb70d9fc3b0c774a05a32796914ac0bb35407 --- /dev/null +++ b/raw/filings/0000350868/2012/0001104659-13-047720/item9a.txt @@ -0,0 +1,11 @@ +ITEM 9A. CONTROLS AND PROCEDURES +(a) Evaluation of disclosure controls and procedures. In accordance with Rule 13a-15(b) of the Securities Exchange Act of 1934, as amended (the “Exchange Act”), as of the end of the period covered by this Annual Report on Form 10-K, management evaluated, with the participation of the our President and Chief Executive Officer and the Chief Financial Officer, the effectiveness of the design and operation of our disclosure controls and procedures (as defined in Rule 13a-15(e) under the Exchange Act). Based upon their evaluation of these disclosure controls and procedures, the President and Chief Executive Officer and the Chief Financial Officer have concluded that our disclosure controls and procedures were effective as of the date of such evaluation in ensuring that information required to be disclosed in our Exchange Act reports is (1) recorded, processed, summarized and reported in a timely manner, and (2) accumulated and communicated to management, including the Company’s President and Chief Executive Officer and the Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure. +(b) Changes in internal control. There was no change in our internal control over financial reporting that occurred during the fourth quarter of Fiscal 2013 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting. +Inherent Limitations on Internal Control +A control system, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. Further, the benefits of controls must be considered relative to their costs. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of management override or improper acts, if any, have been detected. These inherent limitations include the realities that judgments in decision making can be faulty, and that breakdowns can occur because of simple errors. Additionally, controls can be circumvented by the individual acts of some persons, by collusion of two or more people, or by management override of the control. The design of any system of controls is also based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions. Because of the inherent limitations in a cost-effective control system, misstatements due to management override, error or improper acts may occur and not be detected. Any resulting misstatement or loss may have an adverse and material effect on our business, financial condition and results of operations. +Management’s Report on Internal Control Over Financial Reporting +Our management is responsible for establishing and maintaining adequate internal control over financial reporting. Our internal control system was designed to provide reasonable assurance to management and our Board of Directors regarding the effectiveness of our internal control processes over the preparation and fair presentation of published financial statements. +We have assessed the effectiveness of our internal controls over financial reporting as of March 31, 2013. In making this assessment, we used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (“COSO”) in Internal Control—Integrated Framework . Based on our assessment, we believe that, as of March 31, 2013, our internal control over financial reporting was effective based on those criteria. +30 +Table of Contents +This annual report does not include an attestation report of our independent registered public accounting firm regarding internal control over financial reporting. Such a report is not required pursuant to the rules of the SEC applicable to smaller reporting companies. \ No newline at end of file diff --git a/raw/filings/0000350868/2012/0001104659-13-047720/rp_note.txt b/raw/filings/0000350868/2012/0001104659-13-047720/rp_note.txt new file mode 100644 index 0000000000000000000000000000000000000000..e69de29bb2d1d6434b8b29ae775ad8c2e48c5391 diff --git a/raw/filings/0000350868/2012/0001104659-13-047720/rpt_disclosure.txt b/raw/filings/0000350868/2012/0001104659-13-047720/rpt_disclosure.txt new file mode 100644 index 0000000000000000000000000000000000000000..e69de29bb2d1d6434b8b29ae775ad8c2e48c5391 diff --git a/raw/filings/0001116463/2001/0000930661-02-000960/filing.txt b/raw/filings/0001116463/2001/0000930661-02-000960/filing.txt new file mode 100644 index 0000000000000000000000000000000000000000..d5f8a0bf367a6024f4926b27a550aa5a10ab49d8 --- /dev/null +++ b/raw/filings/0001116463/2001/0000930661-02-000960/filing.txt @@ -0,0 +1,3969 @@ +10-K +1 +d10k.txt +FORM 10-K +------------------------------------------------------------------------------- +------------------------------------------------------------------------------- +SECURITIES AND EXCHANGE COMMISSION +Washington, D.C. 20549 +---------------- +FORM 10-K +(Mark one) +[X]ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE +ACT OF 1934 +for the fiscal year ended December 31, 2001. +OR +[_]TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES +EXCHANGE ACT OF 1934 +for the transition period from to . +Commission File No. 1-10492 +---------------- +ORASURE TECHNOLOGIES, INC. +(Exact Name of Registrant as Specified in Its Charter) +Delaware 36-4370966 +(State or Other Jurisdiction of (I.R.S. Employer +Incorporation or Organization) Identification No.) +150 Webster Street +Bethlehem, Pennsylvania 18015 +(Address of Principal Executive (Zip Code) +Offices) +(610) 882-1820 +(Registrant's Telephone Number, Including Area Code) +Securities registered pursuant to Section 12(b) of the Act: None +Securities registered pursuant to Section 12(g) of the Act: +Common Stock, $.000001 par value per share +(Title of Class) +Indicate by check mark whether the Registrant: (1) has filed all reports +required to be filed by Section 13 or 15(d) of the Securities Exchange Act of +1934 during the preceding 12 months (or for such shorter period that the +Registrant was required to file such reports), and (2) has been subject to +such filing requirements for the past 90 days. Yes [X] No [_] +Indicate by check mark if disclosure of delinquent filers pursuant to Item +405 of Regulation S-K is not contained herein, and will not be contained, to +the best of Registrant's knowledge, in definitive proxy or information +statements incorporated by reference in Part III of this Form 10-K or any +amendment to this Form 10-K. [_] +State the aggregate market value of the voting and non-voting common equity +held by non-affiliates of the Registrant, as of March 22, 2002: $182,120,931 +Indicate the number of shares outstanding of each of the Registrant's +classes of common stock, as of March 22, 2002: 37,442,541 shares. +Documents Incorporated by Reference: +Portions of Registrant's Definitive Proxy Statement for the 2002 Annual +Meeting of Stockholders are incorporated by reference into Part III of this +Report. +------------------------------------------------------------------------------- +------------------------------------------------------------------------------- +TABLE OF CONTENTS +Page +---- +PART I +ITEM 1. Business...................................................... 1 +ITEM 2. Properties.................................................... 26 +ITEM 3. Legal Proceedings............................................. 27 +ITEM 4. Submission of Matters to a Vote of Security Holders........... 27 +PART II +Market for Registrant's Common Equity and Related Stockholder +ITEM 5. Matters....................................................... 28 +ITEM 6. Selected Financial Data....................................... 28 +Management's Discussion and Analysis of Financial Condition +ITEM 7. and Results of Operations..................................... 30 +ITEM 7A. Quantitative and Qualitative Disclosures About Market Risk.... 40 +ITEM 8. Financial Statements and Supplementary Data................... 40 +Changes in and Disagreements with Accountants on Accounting +ITEM 9. and Financial Disclosure...................................... 40 +PART III +ITEM 10. Directors and Executive Officers of the Registrant............ 41 +ITEM 11. Executive Compensation........................................ 41 +Security Ownership of Certain Beneficial Owners and +ITEM 12. Management.................................................... 41 +ITEM 13. Certain Relationships and Related Transactions................ 41 +PART IV +Exhibits, Financial Statement Schedules, and Reports on Form +ITEM 14. 8-K........................................................... 41 +Statements contained in this Annual Report on Form 10-K regarding future +events or performance are "forward-looking statements" within the meaning of +the Private Securities Litigation Reform Act of 1995. The Company's actual +results could be quite different from those expressed or implied by the +forward-looking statements. Factors that could affect results are discussed +more fully under the Sections entitled, "Forward-Looking Statements" and "Risk +Factors," in Item 1 and elsewhere in this Report. Although forward-looking +statements help to provide complete information about the Company, readers +should keep in mind that forward-looking statements may not be reliable. +Readers are cautioned not to place undue reliance on the forward-looking +statements. +PART I +ITEM 1. Business. +On September 29, 2000, STC Technologies, Inc., a Delaware corporation +("STC"), and Epitope, Inc., an Oregon corporation ("Epitope"), were merged +(the "Merger") into OraSure Technologies, Inc. ("OraSure Technologies" or the +"Company"), a new corporation that was organized on May 5, 2000 under Delaware +law solely for the purposes of combining STC and Epitope and changing the +state of incorporation of Epitope from Oregon to Delaware. The companies were +merged pursuant to an Agreement and Plan of Merger, dated May 6, 2000, by and +among Epitope, STC and the Company. The stockholders of STC and Epitope +approved the Merger Agreement on September 29, 2000. +Epitope historically reported its financial results on the basis of a fiscal +year ending September 30, while STC previously reported its financial results +on a calendar year basis. Immediately prior to the Merger, Epitope adopted a +calendar year for financial reporting purposes. As a result, financial +information presented in this Report for 2001 and 2000 reflect results for the +calendar years ended December 31, 2001 and 2000, respectively. Since Epitope +did not adopt a calendar year reporting period until 2000, the financial +information for 1999 reflects the results of Epitope for the twelve-months +ended September 30, 1999 and the results of STC for the twelve months ended +December 31, 1999. See Note 1 to the Company's Financial Statements for a +discussion of the Merger and the change in fiscal year end. +General +OraSure Technologies develops, manufactures and markets oral fluid specimen +collection devices using proprietary oral fluid technologies and diagnostic +products including immunoassays and other in vitro diagnostic tests, and other +medical devices. These products are sold in the United States and certain +foreign countries to government agencies, clinical laboratories, physicians' +offices, hospitals, commercial and industrial entities, and various +distributors. +In vitro diagnostic testing is the process of analyzing constituents of oral +fluid, blood, urine and other bodily fluids or tissue for the presence of +specific substances or markers of infectious diseases or other conditions. In +vitro diagnostic tests are performed outside the body, in contrast to in vivo +tests which are performed directly on or within the body. The substance or +marker that a diagnostic test is intended to detect is generally referred to +as an analyte. +Immunodiagnostic testing is the leading method of in vitro testing for +antigens and antibodies. When an infectious disease caused by pathogens, such +as bacteria, viruses and fungi, or other substances are present, the body +responds by producing an antibody. Substances that stimulate production of +antibodies are generally referred to as antigens. An antibody binds +specifically with an antigen in a lock-and-key fashion that initiates a +biochemical reaction to attempt to neutralize and, ultimately, eliminate the +antigen. The ability of an antibody to bind with a specific antigen provides +the basis for immunodiagnostic testing. +Products +OraSure Technologies' business focuses on the following principal platform +technologies: (1) the OraSure(R) and Intercept(R) oral fluid collection +devices, (2) the OraQuick(R) rapid diagnostic test device, and (3) the new up- +1 +converting phosphor technology ("UPT"), including its first application, +UPlink(TM), a lateral flow testing system for various analytes. In addition, +the Company sells certain other products, including the Histofreezer(R) +portable cryosurgical system, certain immunoassay tests and reagents for +insurance risk assessment, substance abuse testing and forensic toxicology +applications, an oral fluid Western Blot confirmatory test for the Human +Immunodeficiency Virus Type 1 ("HIV-1"), and the Q.E.D.(R) saliva alcohol +test. +OraSure(R)/Intercept(R) Collection Devices +The Company's OraSure(R) oral fluid collection device is used in conjunction +with screening and confirmatory tests for HIV-1 antibodies and other analytes. +The device consists of a small, treated cotton-fiber pad on a nylon handle +that is placed in a person's mouth for two to five minutes. The device +collects oral mucosal transudate ("OMT"), a serum-derived fluid that contains +higher concentrations of antibodies and analytes than saliva. As a result, OMT +testing is a highly accurate method for detecting HIV-1 infection and other +analytes. The Company believes that oral fluid testing has several significant +advantages over blood or urine-based testing systems for both health care +professionals and individuals being tested, including eliminating the risk of +needle-stick accidents, providing a noninvasive collection technique, +requiring minimal training to administer, providing rapid and efficient +collection in almost any setting, and eliminating the cost of administration +by a trained health care professional. +The Company has received approval from the U.S. Food and Drug Administration +("FDA") to sell the OraSure(R) oral fluid collection device for use with a +laboratory-based enzyme immunoassay ("EIA") screening test for HIV-1 antibody +detection. HIV-1 antibody detection using the OraSure(R) collection device +involves three steps: (1) collection of an oral fluid specimen using the +OraSure(R) device, (2) screening of the specimen for HIV-1 antibodies at a +laboratory with an EIA screening test, and (3) laboratory confirmation of any +positive screening test results with the OraSure(R) Western Blot HIV-1 +confirmatory test (described below). A trained health care professional then +conveys test results and provides appropriate counseling to the individual who +was tested. The Company has also received FDA clearance for use of the +OraSure(R) collection device with EIAs to test for cocaine and cotinine (a +metabolite of nicotine) in oral fluid specimens. +The Company sells the OraSure(R) collection device in the insurance market +for screening life insurance applicants for HIV-1, cocaine and cotinine, and +in the public health market for HIV-1 testing. +A collection device substantially similar to the OraSure(R) device comprises +the Company's Intercept(R) oral fluid drug testing service. The Company has +received FDA clearance to use the Intercept(R) collection device with +laboratory-based EIAs to test for drugs of abuse commonly identified by the +National Institute for Drug Abuse ("NIDA") as the NIDA-5 (i.e., cannabinoids +(marijuana), cocaine, opiates, amphetamines, and phencyclidine ("PCP")), and +for barbiturates and methadone. The Company also sells, or arranges for a +third party vendor to sell, equipment required by its laboratory customers to +test oral fluid specimens collected with the Intercept(R) device. Intercept(R) +is sold in the workplace testing, public health, criminal justice and drug +rehabilitation markets. +The Company believes that the Intercept(R) service has several advantages +over certain competing products for drugs-of-abuse testing, including its +lower cost, non-invasive nature, safety, mobility and accuracy, the ease of +maintaining a chain-of-custody, the treatment of test subjects with greater +dignity, no requirement for specially-prepared collection facilities, and +difficulty of sample adulteration. The availability of an oral fluid test is +intended to allow workplace administrators to test for employee impairment on +demand, eliminate scheduling costs, and streamline the testing process. +OraQuick(R) Rapid Test +OraQuick(R) is the Company's rapid test platform designed to test an oral +fluid, whole blood or serum/plasma sample for the presence of various +antibodies or analytes. The device includes a porous flat pad used to collect +an oral fluid specimen. After collection, the pad is inserted into a vial +containing a pre-measured amount of +2 +developer solution and allowed to develop. When whole blood is to be tested, a +loop collection device is used to collect a drop of blood and mix it in the +developer solution, after which the collection pad is inserted into the +solution. The specimen and solution then flow through the testing device where +test results are observable in approximately 20 minutes. The OraQuick(R) +device is a screening test and requires a confirmation test where a positive +result is obtained. +The Company's first product utilizing this technology is the OraQuick(R) HIV +device, a rapid test for the presence of antibodies against HIV. On June 23, +2000, the Company received approval for an Investigational Device Exemption +("IDE") from the FDA authorizing the commencement of formal clinical trials +for the OraQuick(R) HIV device. Due to the critical need for an FDA-approved +rapid HIV test, the Company, after consultation with the FDA and the Centers +for Disease Control and Prevention ("CDC"), submitted an initial application +on June 29, 2001 for pre-market approval for testing of whole blood for HIV-1. +The Company expects to submit an application to the FDA for approval of an +OraQuick(R) test for HIV-1 in oral fluid in 2002. +The CDC has identified several key areas for use of the OraQuick(R) HIV +device in the United States, including certain public hospitals in U.S. +metropolitan areas with a relatively high incidence of HIV infection in +pregnant women, AIDS service organizations, community-based organizations, +outreach programs, and selected hospital emergency departments and outpatient +clinics. Under a treatment IDE, the OraQuick(R) device is being used in the +CDC's Maternal Infant Rapid Intervention at Delivery Project (MIRIAD) to test +pregnant women in five U.S. metropolitan areas. The goal of this project is to +identify those individuals who would benefit from the administration of +nevirapine, a drug used to reduce mother-to-child HIV-1 transmission. The +OraQuick(R) device was also selected for use in the CDC's LIFE Initiative, an +international effort to address the AIDS epidemic in certain African +countries, focusing on areas such as preventing mother-to-child transmission, +secondary transmitted disease prevention, HIV prevention for youth, and blood +safety systems. +At the CDC's Rapid Diagnostic's Meeting in February 2001, the CDC released +the most recent results of its ongoing multi-product, rapid HIV test study, +which was conducted independently from the Company's clinical trials used for +its FDA submission. These results indicated a 100% sensitivity and 99.5% +specificity for the OraQuick(R) device with whole blood samples. In addition, +at the 9th Conference on Retroviruses and Opportunistic Infections in February +2002, the CDC released additional clinical results which indicated a 98.6% +sensitivity and 98.9% specificity for the OraQuick(R) device with oral fluid +samples. Sensitivity is a measure of the accuracy in detecting positive +samples and specificity is a measure of the accuracy in measuring negative +samples. +In July 2000, the Company introduced the OraQuick(R) HIV device for sale +outside the United States at the International AIDS Conference in Durban, +South Africa. Clinical tests for the OraQuick(R) HIV device using oral fluid +specimens have been completed in Thailand, with the results demonstrating 100% +sensitivity and 99.9% specificity. The World Health Organization is presently +evaluating the OraQuick(R) HIV device. +The Company intends to market the OraQuick(R) HIV device, either directly or +through distributors, in the hospital, physician office and public health +markets in the United States and internationally. Agreements with distributors +will be necessary for the Company to fully exploit domestic and international +opportunities. +The Company initially intends to sell an OraQuick(R) device for the +detection of HIV-1 in the United States and certain developed countries, and +an OraQuick(R) device for the detection of both HIV-1 and the Human +Immunodeficiency Virus Type 2 ("HIV-2') in certain foreign countries. The +Company may need to obtain licenses or other rights under, or to enter into +distribution or other business arrangements in connection with, certain +patents related to HIV-2 and lateral flow technology, in order to market the +OraQuick(R) HIV device in the United States and certain other countries. See +the Section entitled "Risk Factors--Patent Issues Affecting OraQuick(R)" for a +further discussion of these issues. +3 +UPT(TM) and UPlink(TM) +Up-Converting Phosphor Technology. Up-Converting Phosphor Technology +("UPT(TM)") is a proprietary label detection platform being developed by the +Company that uses phosphor particles to detect minute quantities of various +substances. UPT(TM) utilizes the same particle shell that is coated onto a +television screen, but the internal chemistry of the particle has been +changed. These changes result in a particle that is excited by infrared light +as compared to an ultraviolet light source for television. The Company and its +research partners have developed phosphorescent particles that up-convert +infrared light to visible light, which the Company believes is a platform +technology with broad applications. +Phosphor particles have been used for decades in television screens and in +fluorescent light bulbs. When high energy ultraviolet light strikes the +phosphor-coated area in a screen or bulb, it excites the particles and low +energy visible colored light is produced. The Company's patented improvements +on this base technology employ chemical changes inside the phosphor particles +so that low energy infrared light can be used to produce a high energy visible +colored signal and is the basis for UPT(TM). This use of infrared light to +create a colored signal is called up-conversion as opposed to down-conversion, +which occurs in phosphors designed to be used with ultraviolet light. +The use of infrared light to excite the phosphor particles and produce a +colored light signal creates an important competitive advantage for the +technology in biological systems, especially human clinical diagnostics. +Existing enzyme or fluorescent-based assays employ visible or ultraviolet +light to generate the signals from the enzyme substrate or fluorescent +molecules used as reporter signals in these systems. The disadvantage of using +light in the visible or ultraviolet portion of the spectrum is that often +molecules in the cells or samples for analysis can also produce colored light +(background interference) from these excitation sources. When this occurs, a +non-specific signal is generated which dilutes or obscures the signal of +interest for the diagnostic test being administered. Because up-conversion +does not occur in nature, biological samples and specimens will not produce +light and, therefore, will not cause background interference when excited by +infrared light. +The Company believes that UPT(TM) overcomes some of the limitations of other +diagnostic detection methods and offers features not commercially available +today. The fact that UPT(TM) testing produces zero background interference +dramatically increases the potential sensitivity of any test system. In +addition, UPT(TM) offers the following other key competitive features: +. Ability to detect biological markers for several substances +simultaneously through the use of phosphor particles having various +colors (i.e. multiplexing) +. Creation of a permanent test record not subject to fading +. Applicability to a variety of instrument platforms +. Compatibility with alternative testing matrices such as oral fluid, +blood or others +. Ability to miniaturize the test platform +The Company has reached important milestones in the development of UPT(TM), +including improving the manufacturing process to produce UPT(TM) particles, +working to optimize UPT(TM) particle coating techniques, producing four +distinct colors of UPT(TM) particles to permit multiplexing, demonstrating +initial feasibility for the use of UPT(TM) particles in infectious disease, +cancer, and limited DNA detection applications, and developing a UPT(TM) +collector, test cassette, and analyzer for oral fluid testing for drugs of +abuse. +UPlink(TM). UPlink(TM) is the Company's first product application based on +UPT(TM). UPlink(TM) is designed to be a rapid, point-of-care system utilizing +a collector, lateral flow test cassette, and analyzer, which provides +instrument-read quantitative results in about 10 minutes on a variety of +samples, including oral fluid, blood, serum, urine and stool samples. +4 +In March 2000, the Company signed a research and development agreement with +Drager Safety AG & Co. KGaA (formerly Drager Sicherheitstechnik GmbH) +("Drager"), a European manufacturer and supplier of medical and safety +technology products for health care and industrial applications, to develop +and optimize an UPlink(TM) system for rapid detection of drugs of abuse in +oral fluid. The UPlink(TM) system developed with Drager is expected to be +marketed initially to law enforcement officials as a system for rapidly +assessing whether an operator or passenger in a motor vehicle is under the +influence of one or more drugs of abuse (the "roadside market") and ultimately +to certain military, criminal justice, and workplace testing markets. As part +of the research and development agreement, the Company received a non- +refundable fee and will receive additional fees upon achievement of technical +milestones. Upon successful completion of such research and development +activities, Drager has the option to become the Company's exclusive +distributor of the UPlink(TM) drugs of abuse rapid detection system in Europe +and certain other countries in the markets described above. +In June 2001, the Company submitted an application for 510(k) clearance from +the FDA for its UPlink(TM) analyzer and six oral fluid drugs-of-abuse assays-- +cocaine, opiates, amphetamines, methamphetamine, PCP and marijuana. The FDA +subsequently requested additional data for the analyzer and each of the six +drug assays. On January 31, 2002, the Company resubmitted to the FDA an +application containing the additional data for the UPlink(TM) analyzer and the +assay for opiates, and expects to resubmit one or more applications for the +remaining UPlink(TM) assays in 2002. The UPlink(TM) drug testing system is +expected initially to be marketed by the Company in the United States in the +unregulated criminal justice market. After receipt of FDA clearance for all of +the six oral fluid drugs-of-abuse assays, this product will be marketed by the +Company or its distributors in the regulated workplace market in the United +States. +In September 2000, OraSure Technologies signed a research and development +agreement with Meridian Bioscience, Inc. (formerly Meridian Diagnostics, Inc.) +("Meridian"), a medical diagnostics company. Under this agreement, the Company +and Meridian plan to develop a broad range of UPlink(TM) point-of-care tests +for the rapid detection of parasites, and gastrointestinal and upper +respiratory diseases. Pursuant to a related supply agreement, Meridian will +serve as a worldwide distributor of the analyzers and lateral flow cassettes +developed under the research and development agreement. The Company has +received and is eligible in the future to receive payments upon achievement of +certain milestones and royalties from the sale of the analyzers and testing +devices. OraSure Technologies has commenced work on the development of two +tests under the research and development agreement and expects Meridian to +submit an application for FDA 510(k) clearance of the first such test in 2002. +UPlink(TM) products developed with Meridian will be manufactured by the +Company and are expected to be marketed by Meridian in the hospital market. +Histofreezer(R) +In 1991, the Company became the exclusive United States distributor of the +Histofreezer(R) portable cryosurgical system, a low-cost alternative to liquid +nitrogen and other eradication methods for removal of warts and other benign +skin lesions. In June 1998, the Company acquired the Histofreezer(R) product +from Koninklijke, Utermohlen, N.V., The Netherlands. As part of the +acquisition, the Company established a sales office in Reeuwijk, The +Netherlands, and is selling the Histofreezer(R) product through a dealer +network in more than 20 countries worldwide. +The Histofreezer(R) product mixes two environmentally friendly cryogenic +gases in a small aerosol canister. When released, these gases are delivered to +a specially designed foam bud, cooling the bud to -50(degrees) C. The frozen +bud is then applied to the lesion for 15 to 40 seconds (depending on the type +of lesion) creating localized destruction of the target area. Histofreezer(R) +is sold in several canister sizes. Sales of this product have been targeted to +primary care physicians such as pediatricians, general and family +practitioners, and other physician segments that traditionally referred +patients to dermatologists to remove warts. The Company has established a +national network of distributors to reach the physician office market in the +United States. +5 +Immunoassay Tests and Reagents +The Company develops and sells immunoassay tests in two formats, MICRO-PLATE +and AUTO-LYTE(R), to meet the specific needs of its customers. +AUTO-LYTE(R) tests are sold in the form of bottles of liquid reagents. The +reagents are run on commercially available laboratory-based automated +analytical instruments which are manufactured by a variety of third parties. +AUTO-LYTE(R) is typically used in high volume, automated, commercial reference +laboratories to detect certain drugs or chemicals in urine. Test results are +produced quickly, allowing for high throughput. +In the MICRO-PLATE kit, the sample to be tested is placed into a small +plastic receptacle, called a microwell, along with the reagents. The result of +the test is determined by the color of the microwell upon completion of the +reaction. Controlling the reaction involves the use of a variety of reagents +by laboratory personnel. Test results are analyzed by any of a variety of +commercially available laboratory instruments which may also be provided by +the Company. OraSure Technologies has used this testing format to develop +tests that detect substances in urine, serum, sweat, and oral fluid specimens. +OraSure Technologies currently markets the MICRO-PLATE oral fluid test for +use in screening life insurance applicants to test for two of the most +important underwriting risk factors: cocaine and cotinine (a metabolite of +nicotine). The Company sells the reagents to insurance testing laboratories, +which provide the laboratory testing to insurance companies, often in +combination with the OraSure(R) oral fluid collection device. AUTO-LYTE(R) +tests are marketed for use in testing urine samples for cocaine and cotinine +and for performing a variety of urine chemistries for insurance risk +assessment purposes. +The Company also develops, manufactures, and sells toxicology and drugs-of- +abuse tests in the MICRO-PLATE format. These MICRO-PLATE tests can be +performed on commonly used instruments and can detect drugs in urine, serum, +and sweat specimens. MICRO-PLATE tests are also used as part of the +Intercept(R) product line to detect drugs-of-abuse in oral fluid specimens. +The Company's toxicology and drugs-of-abuse test products are currently sold +in the forensic toxicology, criminal justice, drug rehabilitation, and +workplace testing markets. +Whenever possible, the Company enters into multi-year sales agreements with +its customers. These agreements generally are entered into with a laboratory +which has agreed to purchase a minimum number of tests over a two-to-five-year +period. The Company also offers these customers the option of a reagent rental +agreement pursuant to which the Company sells the tests at an increased price +over a fixed period of time, which includes an additional equipment charge in +exchange for providing the customer with the required analytical laboratory +equipment. +Western Blot HIV-1 Confirmatory Test +The Company markets an oral fluid Western Blot HIV-1 confirmatory test that +received FDA approval in 1996. This test uses the original specimen collected +with the OraSure(R) oral fluid collection device to confirm positive results +of initial OraSure(R) HIV-1 screening tests. The oral fluid Western Blot HIV-1 +confirmatory test is marketed under an exclusive arrangement with bioMerieux +Inc. (formerly Organon Teknika Corporation) ("BMX"). +In February 2001, the Company announced the indefinite suspension of the +production of EPIblot(R), a serum-based Western Blot HIV-1 confirmatory test. +The serum Western Blot product accounted for approximately 5% of the Company's +2000 revenue, but had been consistently unprofitable because of low production +yields and the high cost of quality control. The discontinuation of this +product had no effect on the manufacturing or sale of the Company's oral fluid +Western Blot HIV-1 confirmatory test. +6 +Q.E.D.(R) Saliva Alcohol Test +The Q.E.D.(R) saliva alcohol test is an on-site, cost-effective test device +that is an alternative to breath or blood alcohol testing. The test is a +quantitative, saliva-based method for the detection of ethanol, and has been +cleared for sale by the FDA and the U.S. Department of Transportation ("DOT"). +In 1997, the product also received a waiver under the Clinical Laboratory +Improvement Act of 1988. Each Q.E.D.(R) test kit contains a collection stick +which is used to collect a sample of saliva and a disposable detection device +that displays results in a format similar to a thermometer. The Q.E.D.(R) +device is easy to operate and instrumentation is not required to read the +result. The product has a testing range of 0 to 0.145% blood alcohol, and +produces results in approximately two minutes. +The markets for alcohol testing are relatively small and fragmented with a +broad range of legal and procedural barriers to entry. Markets range from law +enforcement testing to workplace testing of employees in safety sensitive +occupations. The Q.E.D.(R) test has been successfully adopted by end users in +the petroleum, heavy construction, trucking, and retail industries because it +is a cost-effective, portable, easy-to-administer, quantitative testing +method. Typical usage situations include pre-employment, random, post- +accident, reasonable-cause, and return-to-duty testing. +Products Under Development +OraSure(R)/Intercept(R) Applications +Oral mucosal transudate contains many constituents found in blood and serum, +although in lower concentrations. The Company therefore believes the +OraSure(R) and Intercept(R) devices are a platform technology with a wide +variety of potential applications, where laboratory testing is available. For +example, the OraSure(R) device may be useful for the diagnosis of a variety of +infectious diseases or conditions in addition to HIV-1, such as viral +hepatitis and diabetes. OraSure Technologies has entered into an agreement +with LabOne, Inc. to develop a laboratory-based oral fluid screening test for +Hepatitis C using the OraSure(R) collection device. The Company is developing +an alcohol assay and has an application pending with the FDA for 510(k) +clearance of an assay for benzodiazepine, each of which would be used in +connection with the Intercept(R) drug testing service. Based on a reassessment +of marketability, the Company has discontinued development of an improved +formulation of the OraSure(R) device, known as OraSure(R) II, and a +laboratory-based oral fluid screening test for syphilis. +OraQuick(R) Platform +The Company believes that OraQuick(R) has significant potential as a rapid +test for physicians' offices, hospitals, and other professional use. Like the +OraSure(R) device, the Company believes that OraQuick(R) provides a platform +technology that can be modified for detection of a variety of infectious +diseases in addition to HIV, such as viral hepatitis and other diseases. +The National Institutes of Health ("NIH") previously approved a grant of +approximately $1 million to fund Phase II of the Company's project to develop +a screening and confirmation test for syphilis. Although initially intended to +fund a lab-based test using the OraSure(R) collection device, the NIH approved +the use of this grant instead for development of a screening test for syphilis +using the OraQuick(R) platform. During the first quarter of 2002, the Company +reevaluated the marketability of a syphilis test and, based on that +reevaluation, has elected to terminate this project. +UPT(TM) and UPlink(TM) Development +The Company is in the final stages of developing the UPlink(TM) drugs-of- +abuse rapid detection system under its agreement with Drager and for its own +commercial applications in the United States. The Company has commenced +development of two tests for infectious diseases and expects to commence +development of +7 +additional tests for other infectious diseases under its agreement with +Meridian. The Company has identified other potential applications of UPT(TM), +including human clinical testing for cancer, allergies, and thyroid and +cardiac conditions, therapeutic drug monitoring, biological warfare testing, +food and environmental testing, pharmaceutical research, genomics and +pharmacogenomics, veterinary testing, and surgical imaging. In addition, the +Company is studying the feasibility of using UPT(TM) labels for the detection +of infectious diseases with DNA probes. The Company has not yet chosen which +potential UPT(TM) applications to pursue or the manner in which these +opportunities will be pursued, but believes it will need to enter into +partnering arrangements with other entities to exploit the potential of +UPT(TM). +Western Blot HIV-1 Confirmatory Test +The Company believes its existing oral fluid Western Blot confirmatory test +for HIV-1 can be used for testing of serum plasma specimens and is +contemplating expanding the use of this product for these applications. +Whether the Company elects to do so will depend on a further assessment of the +market for these applications, the Company's ability to overcome the low +production yields and quality control issues which led to the discontinuation +of its Serum Western Blot HIV-1 confirmatory test in 2001, and the Company's +ability to obtain FDA approval for these new uses. +Research and Development +In 2001, research and development activities focused on the continued +development of the UPlink(TM) analyzer, test cassette and collector, the +development of certain UPlink(TM) drugs of abuse and infectious disease +assays, DNA feasibility studies, and clinical trials for the OraQuick(R) rapid +HIV-1 test. +The Company supplements its own research and development activities by +funding external research. The Company has funded research at Leiden +University, SRI International, Lehigh University and certain other entities, +and intends to continue funding external research. +Research and development expenses totaled approximately $9.4 million in +2001, $10.4 million in 2000 and $5.6 million in 1999. +Sales and Marketing +The Company's strategy is to reach its major target markets through a +combination of direct sales, strategic partnerships, and independent +distributors. The Company's marketing strategy is to raise awareness of its +products through a mix of trade shows, print advertising, and distributor +promotions to support sales in each target market. +The Company markets its products in the United States and internationally. +Revenues attributable to customers in the United States amounted to $27.3 +million, $24.8 million and $21.4 million in 2001, 2000 and 1999, respectively. +Revenues attributable to international customers amounted to $5.3 million, +$4.0 million and $2.7 million, in 2001, 2000 and 1999, respectively. +Insurance Risk Assessment +The Company currently markets the OraSure(R) oral fluid collection device +for use in screening life insurance applicants in the United States and +internationally to test for three of the most important underwriting risk +factors: HIV-1, cocaine, and cotinine. The Company sells the devices to +insurance testing laboratories, which in turn provide the devices to insurance +companies, usually in combination with testing services. The Company also +maintains a direct sales force that promotes use of the OraSure(R) device +directly to insurance companies. Insurance companies then make their own +decision regarding which laboratory to use to supply their collection devices +and testing services. The Company's OraSure(R) Western Blot confirmatory test +is distributed through BMX and is used to confirm oral fluid specimens that +test positive for HIV-1. +8 +Because insurance companies are in various stages of their adoption of the +OraSure(R) device, there exists a wide range of policy limits where the +product is being applied. Some insurance companies have chosen to extend their +testing to lower policy limits where they did not test at all before, while +others have used OraSure(R) to replace some of their blood and urine-based +testing. The Company's sales force continues to encourage additional insurance +companies to use OraSure(R) and to extend the use of the product by existing +customers. Several companies have expanded use of OraSure(R) to the $1 million +and higher dollar policy amounts. This expansion is attributable to several +factors, including increasing acceptance of the reliability of oral fluid +testing, the high quality of test results, the low cost of oral fluid testing +relative to blood tests, and the ease of use of the OraSure(R) device. +The Company also sells its AUTO-LYTE(R) and MICRO-PLATE assays and reagents +in the insurance testing market directly to laboratories, including LabOne, +Inc., Heritage Labs, Clinical Reference Laboratory, and the laboratory testing +division of Metropolitan Life Insurance Company. AUTO-LYTE(R) assays are used +principally to test urine samples for cotinine and other metabolites and to +perform urine chemistries for risk assessment purposes. MICRO-PLATE assays are +used principally to test oral fluid specimens collected with the OraSure(R) +device for cocaine and cotinine. +Infectious Disease Testing +The Company's sales personnel market products directly to customers in the +public health market primarily for HIV-1 testing. This market consists of a +broad range of clinics and laboratories and includes states, counties, and +other governmental agencies, colleges and universities, correctional +facilities and the military. There are also a number of organizations in the +public health market such as AIDS service organizations and various community- +based organizations set up primarily for the purpose of encouraging and +enabling HIV-1 testing. To better serve this market, the Company has entered +into agreements with LabOne, Inc. and Heritage Labs to provide prepackaged +OraSure(R) test kits, with prepaid laboratory testing and specimen shipping +costs included. The Company has sold the OraSure(R) and OraQuick(R) HIV +devices in the international public health markets. +Substance Abuse Testing +The Company's substance abuse products are marketed into the workplace +testing, forensic toxicology, criminal justice, and drug rehabilitation +markets, through direct sales and distributors. The forensic toxicology market +consists of 250-300 laboratories including federal, state and county crime +laboratories, medical examiner laboratories, and reference laboratories. The +criminal justice market consists of a wide variety of entities in the criminal +justice system that require drug screening, such as pre-trial services, parole +and probation officials, police forces, drug courts, prisons, drug treatment +programs and community/family service programs. The Company has entered into +agreements for the distribution of Intercept(R) collection kits and associated +reagents for drugs-of-abuse testing in the workplace testing market in the +United States and Canada through several laboratory distributors, including +LabOne, Inc., Quest Diagnostics, Clinical Reference Laboratory and NWT, Inc., +and internationally for workplace and forensic toxicology testing through Bio- +Rad Laboratories, Altrix Plc and other distributors. The Company also +distributes its Q.E.D.(R) saliva alcohol test primarily in the workplace +testing market through various distributors. +Physicians' Offices +The Company sells the Histofreezer(R) product line to distributors that +market to more than 150,000 primary care physicians and podiatrists in the +United States. Major U.S. distributors include Cardinal Healthcare, McKesson +HBOC, Physicians Sales & Service, Bergen Brunswig, and Henry Schein. +Internationally, the Company markets Histofreezer(R) in a number of countries +through a network of distributors. +International Markets +The Company sells a number of its products into international markets +primarily through distributors with knowledge of their local markets. +Principal markets include physicians' offices, insurance risk assessment, +public +9 +health, and laboratory testing. The Company assists its distributors in +registering the products and obtaining required regulatory approvals in each +country and provides training and support materials. The Company's +international marketing program includes direct assistance to distributors in +arranging for laboratory services, cooperation from screening test +manufacturers, and performance of Western Blot confirmatory tests when +necessary. +Significant Products and Customers +Several different products have contributed significantly to the Company's +financial performance, accounting for 15% or more of total revenues during the +past three years. The Company's OraSure(R) and Intercept(R) oral fluid +collection devices, Histofreezer(R), and immunoassay tests and reagents +accounted for total revenues of approximately $13.0 million, $6.7 million and +$7.4 million in 2001, $11.2 million, $6.8 million, and $6.7 million in 2000, +and $7.8 million, $5.7 million, and $6.2 million in 1999, respectively. As new +products are developed and commercialized, the Company expects to reduce its +dependence on the products referred to above. +The Company has one customer, LabOne, Inc., that has accounted for 10% or +more of total revenues. LabOne recently acquired Osborne Group, Inc., another +customer of the Company in the insurance testing market. During 2001, the +Company's sales to LabOne, Inc. and Osborne Group, Inc. together accounted for +approximately 29% of the Company's total revenues. As a result of its +acquisition of Osborne, LabOne has achieved certain operating efficiencies and +reduced its overall inventory levels which in turn lowered purchases of the +Company's insurance testing products during the fourth quarter of 2001. While +the Company believes that its relationship with LabOne is good, there can be +no assurance that sales to this customer will not decrease further or that +this customer will not choose to replace the Company's products with those of +competitors. The loss of this customer or a significant decrease of products +purchased by it would have a material adverse effect on the Company. +Supply and Manufacturing +The Company has entered into an agreement with a contractor in the United +States for the assembly and supply of OraSure(R) and Intercept(R) oral fluid +collection devices through December 31, 2002. This agreement will +automatically renew for additional annual periods unless either party provides +timely notice of termination prior to the end of an annual period. The Company +believes that other firms or the Company would be able to manufacture the +OraSure(R) and Intercept(R) devices on terms no less favorable than those set +forth in the agreement with the contractor in the event that this contractor +were to be unable or unwilling to continue manufacturing this product. A +change in manufacturer of these devices would require FDA review and approval +which could require significant time to complete and could disrupt the +Company's ability to manufacture and sell the OraSure(R) and Intercept(R) +devices. The Company expects to transfer manufacturing of its OraSure(R) and +Intercept(R) collection devices to its Bethlehem, Pennsylvania facility during +2003. +In the second quarter of 2001, the Company completed a realignment of its +manufacturing operations, which included the elimination of the manufacturing +of OraQuick(R) in the Beaverton, Oregon facility, the installation of +automated manufacturing equipment for OraQuick(R) in Bethlehem, Pennsylvania, +and the addition of contract manufacturing capacity in Thailand. In connection +with this realignment, the Company entered into a supply agreement for the +manufacture of the OraQuick(R) HIV testing device in Thailand. This agreement +has an initial term of one year, and will automatically renew for additional +annual periods unless either party provides a timely notice of termination +prior to the end of an annual period. The Company believes that other firms +would be able to manufacture the OraQuick(R) test on terms no less favorable +than those set forth in the agreement in the event that the Thailand +contractor would be unable or unwilling to continue manufacturing this +product. +The Company can purchase the HIV antigen required for the OraQuick(R) +product only from a limited number of sources. This antigen is currently +purchased from a contract supplier under a long-term agreement with an initial +term ending in January 2010 and one-year automatic renewal terms thereafter. +If for any reason the supplier should no longer be able to supply the +Company's antigen needs, the Company believes that an +10 +alternative supply could be obtained at a competitive cost. However, a change +in the antigen would require FDA approval which could require significant time +to complete and could disrupt the Company's ability to manufacture and sell +the OraQuick(R) device in the United States. +The Company expects to assemble analyzers, test cassettes and collectors +used in the Company's UPlink(TM) drugs of abuse rapid detection system and to +package this product for shipment at the Company's Bethlehem, Pennsylvania +facilities. +The Company's oral fluid Western Blot HIV-1 confirmatory test is +manufactured in the Company's Beaverton, Oregon facility. The HIV antigen +needed to manufacture the Company's Western Blot HIV-1 confirmatory test kits +is available from only a limited number of sources. The Company purchases +antigen and certain other materials for this product from BMX, which is also +the exclusive distributor of the test kits. BMX is required to supply the +Company's requirements for antigen and other materials for the term of its +distribution agreement with the Company, which originally expired on March 31, +2001. OraSure Technologies and BMX are currently negotiating certain +amendments to the agreements, including an extension of their terms. If for +any reason BMX is no longer able to supply the Company's antigen and other +material needs, the Company would be able to obtain alternate supplies at a +competitive cost, although a change in the antigen would require FDA approval +which could require significant time to complete and could disrupt the +Company's ability to manufacture and sell its Western Blot HIV-1 confirmatory +test. +Histofreezer(R) is manufactured in The Netherlands by Koninklijke, +Utermohlen, N.V. ("Utermohlen"), the company from which the Company acquired +the product in 1998. The Company purchases the product pursuant to an +exclusive production agreement between the two companies. The production +agreement provides that Utermohlen shall be the exclusive supplier of the +Histofreezer(R) product until at least December 31, 2006. The Company believes +that additional manufacturers of the Histofreezer(R) product are available on +terms no less favorable than the terms of the production agreement with +Utermohlen in the event that Utermohlen would be unable or unwilling to +continue manufacturing the Histofreezer(R) product. +The Company's AUTO-LYTE(R) and MICRO-PLATE assays are manufactured at its +Bethlehem, Pennsylvania, facility. The Company manufactures the test +components and assembles and packages the tests for distribution. The +Company's tests require the production of highly specific and sensitive +antibodies corresponding to the antigen of interest. Substantially all of the +Company's antibody requirements are provided by contract suppliers. However, +in 1999, the Company began to develop its own in-house monoclonal and +polyclonal antibody capabilities. The Company believes that it maintains +adequate reserves of antibody supplies and believes it has access to +sufficient raw materials for these products. +AUTO-LYTE(R) test kits are manufactured by adding specific antibodies to +chemical solutions which are then packaged as a defined volume of liquid in a +plastic container to be run on laboratory equipment. MICRO-PLATE test kits are +produced by placing purified antibodies into plastic microwells which are sent +to customers in multiples of 96 tests along with a set of reagents necessary +to control the reaction. +The Q.E.D.(R) saliva alcohol test is manufactured, packaged, and shipped +from the Company's Bethlehem, Pennsylvania facility. +Employees +As of December 31, 2001, the Company had 221 full-time employees, including +46 in sales, marketing, and client services; 80 in research and development; +77 in operations, manufacturing, quality control, purchasing and shipping; and +18 in administration and finance. Sixteen of the Company's employees hold +Ph.D. degrees. The Company's employees are not represented by a collective +bargaining agreement. +During 2001, the Company completed a realignment of its manufacturing +operations, pursuant to which employee headcount was reduced in its Beaverton, +Oregon facility by approximately 33%. The reduction was +11 +accomplished primarily through layoffs and attrition during the first half of +2001. During the first quarter of 2002, the Company implemented a 10% +reduction in force as a result of lower than anticipated sales levels during +2001 and the elimination of certain development projects. +Competition +The diagnostic industry is a multi-billion dollar international industry and +is intensely competitive. Many of the Company's competitors are substantially +larger and have greater financial, research, manufacturing, and marketing +resources. Important competitive factors for the Company's products include +product quality, price, ease of use, customer service, and reputation. +Industry competition is based upon scientific and technological capability, +proprietary know-how, access to adequate capital, the ability to develop and +market products and processes, the ability to attract and retain qualified +personnel, and the availability of patent protection. +A few large corporations produce a wide variety of diagnostic tests and +other medical devices and equipment, a larger number of mid-size companies +generally compete only in the diagnostic industry, and a significant number of +small companies produce only a few diagnostic products. As a result, the +diagnostic test industry is fragmented and segmented. The future market for +diagnostic tests is expected to be characterized by consolidation, greater +cost consciousness, and tighter reimbursement policies. The purchasers of +diagnostic products are expected to place increased emphasis on lowering +costs, reducing inventory levels, automation, service, and volume discounts. +The increased complexity of the market is expected to force many competitors +to enter into joint ventures or license certain products or technologies. +Competition is expected to intensify as technological advances are made and +become more widely known, and as new products reach the market. Furthermore, +new testing methodologies could be developed in the future that render the +Company's products impractical, uneconomical or obsolete. There can be no +assurance that the Company's competitors will not succeed in developing or +marketing technologies and products that are more effective than those +developed by the Company or that would render its technologies and products +obsolete or otherwise commercially unattractive. In addition, there can be no +assurance that competitors will not succeed in obtaining regulatory approval +for these products, or in introducing or commercializing them before the +Company. Such developments could have a material adverse effect on the +Company's business, financial condition, and results of operations. +Competition in the market for HIV testing is intense and is expected to +increase. The Company believes that the principal competition will come from +existing laboratory-based blood tests, point-of-care whole blood rapid tests, +urine-based assays, or other oral fluid-based tests that may be developed. The +Company's competitors include specialized biotechnology firms as well as +pharmaceutical companies with biotechnology divisions and medical diagnostic +companies. +Several companies market or have announced plans to market oral specimen +collection devices and tests outside the United States. The Company expects +the number of devices competing with its OraSure(R) device to increase as the +benefits of oral specimen-based testing become more widely accepted. +The FDA has approved an HIV-1 screening test for use with a urine sample. In +June 1998, the FDA notified Cambridge Biotech Corp. (acquired by Calypte, Inc. +in December 1998) that it had approved the use of its HIV-1 Western Blot +confirmatory test for use with urine samples. Urine testing will compete in +the same markets as the Company's products. The Company believes that urine +collection can be logistically more difficult, inconvenient, and potentially +embarrassing for the individual being tested, and that privacy and chain-of- +custody issues are further impediments to routine use of urine-based HIV +tests. The Company cannot predict the impact of the availability of urine- +based tests on the HIV testing market or on sales of the Company's products. +Significant competitors in the rapid assay HIV testing market include Abbott +Laboratories, the Ortho Diagnostics division of Johnson & Johnson, Bio-Rad +Laboratories, Trinity Biotech Plc, MedMira Laboratories, Inc. and Chembio +Diagnostic Systems, Inc. +12 +In the insurance risk assessment market, the Company's AUTO-LYTE(R) +homogeneous assays for cocaine and cotinine compete with reagents from +Microgenics, Inc. (a subsidiary of Sybron Lab Products). The Company's AUTO- +LYTE(R) homogeneous assays for beta-blockers and thiazide as well as MICRO- +PLATE heterogeneous assays specifically designed for the detection of cocaine, +cotinine, and IgG in oral fluid are the only assays available in the +marketplace. In urine chemistries, the Company's significant competitors +include The Diagnostics Systems Group of Olympus America Inc. +The Company's MICRO-PLATE drugs-of-abuse reagents are targeted to forensic +testing laboratories where sensitivity, automation, and "system solutions" are +important. In the past, these laboratories have typically had to rely on +radioimmunoassay test methods to provide an adequate level of sensitivity. +Radioimmunoassays require radioactive materials, which have a short shelf-life +and disposal problems. The Company's MICRO-PLATE tests meet the laboratories' +sensitivity needs, run on automated equipment, are not radioimmunoassays, and +are offered to the laboratory as a complete system solution of reagents, +instrumentation and software to meet the specific needs of each customer. +Options to buy or rent the instrumentation and software are offered to these +customers. +In the forensic toxicology market, the Company competes with both +homogeneous and heterogeneous tests manufactured by a host of companies. +Significant competitors in the market for these assays include Dade Behring, +Microgenics, Inc., Abbott Laboratories, Roche Diagnostics, and Immunalysis. +The Intercept(R) drug testing system competes with a wide variety of drug +testing products and services. These competitors can be divided into two +groups: 1) rapid tests, and 2) laboratory-based services. Within each product +or service group, drug testing can be further divided into testing matrices +such as urine, hair, sweat and oral fluid. Major competitors in the +laboratory-based urine drug testing market are Quest Diagnostics, LabOne, +Inc., LabCorp., Psychemedics, PharmChem, and Medtox Laboratories. The +Company's UPlink(TM) product will also compete with other on-site, rapid drug +assays. Major competitors in the rapid drug testing market include American +Biomedica, Roche Diagnostics, Biosite Diagnostics, Avitar, Inc., LifePoint, +Inc. and eScreen. +Within the sub-segment of oral fluid drugs-of-abuse testing, Intercept(R) +and UPlink(TM) will compete with Avitar, Inc., which markets a rapid drug test +to the workplace and criminal justice markets, Ansys Technologies, Inc., which +markets saliva alcohol and drug tests, and LifePoint, Inc., which has +announced plans to sell a reader-based saliva test panel that will include +alcohol testing. +Q.E.D.(R) has two direct competitors, Roche Diagnostics and Chematics. These +companies offer semi-quantitative saliva-based alcohol tests and have received +DOT approval. Indirect competitors who offer breath testing equipment include +Intoximeters, Drager, and CMI. Although there are lower priced tests on the +market that use oral fluid or breath as a test medium, these tests are +qualitative tests that are believed to be substantially lower in quality and +scope of benefits than the Company's Q.E.D.(R) test. +The Histofreezer(R) product's delivery system and warmer operating +temperature than liquid nitrogen provide the Company with the opportunity to +target sales to primary care physicians, such as family practitioners, +pediatricians, and podiatrists. The Company does not generally target sales to +dermatologists because they have the volume of patients required to support +the capital costs associated with a liquid nitrogen delivery system. There is +limited competition for convenient cryosurgical products for wart removal in +the primary care physician market. Major competitors for the Histofreezer(R) +product include CryoSurgery, Inc. and Aurium Pharma Inc. In addition, liquid +nitrogen is used by medical professionals to remove warts and other benign +skin lesions. Lastly, patients may purchase various over-the-counter products +to treat warts at home. +Patents and Proprietary Information +The Company seeks patent and other intellectual property rights to protect and +preserve its proprietary technology and its right to capitalize on the results +of its research and development activities. The Company also relies upon trade +secrets, know-how, continuing technological innovations, and licensing +opportunities to provide +13 +it with competitive advantages in its selected markets and to accelerate new +product introductions. Respecting the patent and intellectual property rights +of others, the Company regularly searches for third-party patents in its +fields of endeavor to shape its own patent and product commercialization +strategies as effectively as possible and to identify licensing opportunities. +United States patents generally have a maximum term of 20 years from the date +an application is filed. +The Company has ten United States patents and numerous foreign patents for +the OraSure(R) and Intercept(R) collection devices and related technology +relating to oral fluid collection, containers for oral fluids, methods to test +oral fluid, formulations for the manufacture of synthetic oral fluid, and +methods to control the volume of oral fluid collected and dispersed. The +Company has also applied for additional patents, in both the United States and +certain foreign countries, on such products and technology. The Company has +one patent for the OraQuick(R) rapid HIV test in the United States and intends +to apply for other patents for this product. The Company may need to obtain +licenses or other rights under, or enter into distribution or other business +arrangements in connection with, certain HIV-2 and lateral flow patents in +order to market the OraQuick(R) HIV test in the United States and certain +other countries. See the Section entitled, "Risk Factors--Patent Issues +Affecting OraQuick(R)," for a further discussion of these issues. +In April 1995, the Company received exclusive worldwide rights under patents +and know-how owned by SRI International to develop and market products that +involve the use of UPT(TM). The Company also received non-exclusive worldwide +rights under patents and know-how owned by the Sarnoff Corporation (a +subsidiary of SRI International formerly called the David Sarnoff Research +Center) to develop and market products that involve the use of UPT(TM). The +Company has the right to sublicense these rights under the agreements subject +to consent from SRI and Sarnoff. +Under the agreement with SRI, OraSure Technologies is required to make +license, maintenance and royalty payments to SRI. The Company made an initial +license payment to SRI in 1995 and paid research fees in 1995 and 1996 in +connection with development projects in which SRI participated. The Company is +obligated to make annual maintenance payments on each anniversary of the +agreement following the completion of the development period until the first +commercial sale of a product. The Company also must make royalty payments for +a period equal to the longer of ten years from the date of the first +commercial sale of the products or the term during which the manufacture, use, +or sale of a product would infringe licensed patents, but for SRI's license to +the Company. The Company believes that the royalty rates payable by the +Company are comparable to the rates generally payable by other companies under +similar arrangements. The Company's agreement with SRI terminates upon the +expiration of the Company's obligation to pay royalties to SRI. +In 1999, the Company paid $1.5 million to TPM Europe Holding B.V., its +sublicensor, for the termination of an existing license agreement between the +sublicensor and the Company with respect to the sublicense of UPT(TM) patents +owned by Leiden University, The Netherlands, and to secure a direct research, +development, and license arrangement with Leiden University. +The Company has or has licensed rights under nine United States patents and +numerous foreign patents for methods, compositions, and apparatuses relating +to phosphor technologies. Several additional UPT(TM) patent applications +remain pending in the United States and abroad. The Company expects to +continue to expand its UPT(TM) patent portfolio in 2002. Several new patent +applications were also filed by the Company in the U.S. for the design and +methods used in the UPlink(TM) rapid detection platform. +The Company has one U.S. patent relating to the Company's method for +detecting blood in urine specimens and the Company's AUTO-LYTE(R) products. +The Company has three U.S. patents and numerous foreign patents issued for +apparatuses and methods for the topical removal of skin lesions relating to +its Histofreezer(R) device. +14 +The Company has five U.S. patents and numerous foreign patents and patent +applications for the analog-to-digital threshold signaling technology used in +the Q.E.D.(R) test. These patents are related to the analog-to-digital +technology color control systems and methods, systems and devices for the +test, and detection of biochemical molecules. +It is the Company's policy to require its employees, consultants, outside +collaborators, and other advisors to execute confidentiality agreements upon +the commencement of employment or consulting relationships with the Company. +These agreements provide that all confidential information developed by or +made known to the individual during the course of the individual's +relationship with the Company, is to be kept confidential and not disclosed to +third parties except in specific circumstances. In the case of employees, the +agreements provide that all inventions conceived by the individual during his +or her tenure at the Company will be the exclusive property of the Company. +The Company owns rights to trademarks and service marks that it believes are +necessary to conduct its business as currently operated. The Company is the +owner in the United States of trademarks, including UPT(TM), UPlink(TM), +OraSure(R), Intercept(R), OraQuick(R), Histofreezer(R), Q.E.D.(R), and AUTO- +LYTE(R). The Company also is the owner of many of these marks and others in +several foreign countries. The Company is not aware of any pending claims of +infringement or other challenges to the Company's rights to use its marks in +the United States or in other countries as currently used by the Company. +Although important, the issuance of a patent or existence of trademark or +trade secret protection does not in itself ensure the Company's success. +Competitors may be able to produce products competing with a patented Company +product without infringing on the Company's patent rights. Issuance of a +patent in one country generally does not prevent manufacture or sale of the +patented product in other countries. The issuance of a patent to the Company +or to a licensor is not conclusive as to validity or as to the enforceable +scope of the patent. The validity or enforceability of a patent can be +challenged by litigation after its issuance, and, if the outcome of such +litigation is adverse to the owner of the patent, the owner's rights could be +diminished or withdrawn. Trade secret protection does not prevent independent +discovery and exploitation of the secret product or technique. +Government Regulation +General +Most of the Company's existing and proposed diagnostic products are +regulated by the FDA, certain state and local agencies, and comparable +regulatory bodies in other countries. This regulation governs almost all +aspects of development, production, and marketing, including product testing, +authorizations to market, labeling, promotion, manufacturing, and +recordkeeping. All of the Company's FDA-regulated products require some form +of action by the FDA before they can be marketed in the United States, and, +after approval or clearance, the Company must continue to comply with other +FDA requirements applicable to marketed products. Both before and after +approval or clearance, failure to comply with the FDA's requirements can lead +to significant penalties. +Domestic Regulation +Most of the Company's diagnostic products are regulated as medical devices. +The Company's Serum Western Blot HIV-1 confirmatory test, which was +discontinued in February 2001, was regulated as a biologic or blood product. +There are two review procedures by which medical devices can receive FDA +clearance or approval. Some products may qualify for clearance under Section +510(k) of the Federal Food, Drug and Cosmetic Act, in which the manufacturer +provides a pre-market notification that it intends to begin marketing the +product, and shows that the product is substantially equivalent to another +legally marketed product (i.e., that it has the same intended use and is as +safe and effective as a legally marketed device and does not raise different +questions of safety and effectiveness). In some cases, the submission must +include data from human clinical studies. Marketing may +15 +commence when the FDA issues a clearance letter finding such substantial +equivalence. An applicant must submit a 510(k) application at least 90 days +before marketing of the affected product commences. Although FDA clearance may +be granted within that 90-day period, in some cases as much as a year or more +may be required before clearance is obtained, if at all. +If the medical device does not qualify for the 510(k) procedure (either +because it is not substantially equivalent to a legally marketed device or +because it is required by statute and the FDA's implementing regulations to +have an approved application), the FDA must approve a pre-market approval +application ("PMA") before marketing can begin. PMAs must demonstrate, among +other matters, that the medical device provides a reasonable assurance of +safety and effectiveness. A PMA is typically a complex submission, including +the results of preclinical and clinical studies. Preparing a PMA is a detailed +and time-consuming process. Once a PMA has been submitted, the FDA is required +to review the submission within 180 days. However, the FDA's review may, and +often is, much longer, often requiring one year or more, and may include +requests for additional data. +Biologic products must be the subject of an approved biologics license +application ("BLA") before they can be marketed. The FDA approval process for +a biologic product is similar to the PMA approval process, involving a +demonstration of the product's safety and effectiveness based in part on both +preclinical and clinical studies. +Many of the insurance testing products are used for non-medical purposes and +many of the drugs-of-abuse products sold to state crime labs are for forensic +use. The Company intends initially to sell its UPlink(TM) rapid drug detection +system for law enforcement purposes into the criminal justice market. The FDA +does not currently regulate products used for these purposes. +Every company that manufactures biologic products or medical devices +distributed in the United States must comply with the FDA's Quality System +Regulations ("QSRs"). These regulations govern the manufacturing process, +including design, manufacture, testing, release, packaging, distribution, +documentation, and purchasing. Compliance with QSRs is required before the FDA +will approve an application, and these requirements also apply to marketed +products. Companies are also subject to other post-market and general +requirements, including compliance with restrictions imposed on marketed +products, compliance with promotional standards, recordkeeping, and reporting +of certain adverse reactions. The FDA regularly inspects companies to +determine compliance with QSRs and other post-approval requirements. Failure +to comply with statutory requirements and the FDA's regulations can lead to +substantial penalties, including monetary penalties, injunctions, product +recalls, seizure of products, and criminal prosecution. +Products that include electrical or light emitting equipment must also +comply with the FDA's safety and performance standards applicable to such +equipment. The Company's UPlink(TM) analyzer is a piece of electrical +equipment that uses a laser to read the test results and is, therefore, +subject to these requirements. In addition, there is an industry safety and +performance standard for electrical equipment established by Underwriters +Laboratories, Inc., known as UL3101. Although a voluntary standard, compliance +with UL3101 will support the Company's 510(k) submission for the UPlink(TM) +analyzer. The Company has retained Underwriters Laboratories Inc. to examine +and test the UPlink(TM) analyzer and certify that it meets the FDA +requirements and UL3101. +The Clinical Laboratory Improvement Act of 1988 ("CLIA") prohibits +laboratories from performing in vitro tests for the purpose of providing +information for the diagnosis, prevention or treatment of any disease or +impairment of, or the assessment of, the health of human beings unless there +is in effect for such laboratories a certificate issued by the U.S. Department +of Health and Human Services applicable to the category of examination or +procedure performed. Although a certificate is not required for OraSure +Technologies, the Company considers the applicability of the requirements of +CLIA in the design and development of its products. In addition, the Company +has obtained a waiver of the CLIA requirements for its Q.E.D.(R) alcohol +saliva test and may seek similar waivers for certain of its other products. A +CLIA waiver will remove certain quality control and other requirements that +must be met for certain customers to use the Company's products. +16 +In June 2000, the FDA issued observations of deficiencies following an +inspection of OraSure Technologies' manufacturing facility in Beaverton, +Oregon, stating the FDA's view that the Company's Serum Western Blot product +was not manufactured in compliance with the QSRs. The FDA had previously +issued a warning letter in September 1998, and observations of deficiencies in +January 1999 to the Company based on prior inspections of the Oregon facility. +The FDA questioned the Company's compliance with the QSRs in areas such as +process validation, purchasing controls, complaint handling, and equipment +controls at the Oregon facility. The Company has undertaken a substantial +review of its manufacturing and quality systems, and has either already made +changes or has developed plans to make changes, to satisfy the FDA's concerns +with respect to its QSR compliance. This was communicated to the FDA in a +written reply in September 2000. +On October 20, 2000, the FDA sent a letter to the Company regarding the +Serum Western Blot product voicing the agency's concern over the previously +observed deficiencies and stating its intent to revoke the Company's license +to manufacture this product if the problems were not corrected in sufficient +time. The FDA acknowledged the receipt of the Company's written responses and +found that those items which had been completed appeared to be adequate, but +required the Company to submit a comprehensive report on corrective action +plans and the schedule to address the remaining items. The Company submitted +such a report in November 2000, and believes that it either has already +implemented changes or has appropriate plans in place to implement changes +that will adequately address the FDA's concerns. +Production of the Serum Western Blot product line was voluntarily +discontinued by the Company and, in response to this voluntary action by the +Company, the associated biologics license was revoked on October 12, 2001. +However, OraSure Technologies has recognized that the basic changes to the +overall quality system needed to remedy the FDA's observations would also +assist in the quality for all of the Company's product lines, and therefore +has devoted a considerable amount of time and resources to improving quality +procedures throughout the Company. Even with the substantial efforts and the +progress made to date, there is a risk that the FDA will not be satisfied with +the Company's efforts. If the FDA is not satisfied, it could take action +intended to force OraSure Technologies to stop manufacturing its products at +the Oregon facility (which consists solely of the manufacture of Company's +oral fluid Western Blot HIV-1 confirmatory test) until the FDA believes the +Company is in compliance with QSR requirements. Also, although the FDA has +granted the Company permission to obtain certificates needed for export of +products, the FDA could refuse export permission in the future if the agency +determines that the Company's progress toward QSR compliance is not +sufficient. +International +The Company is also subject to regulations in foreign countries governing +products, human clinical trials and marketing, and may need to obtain approval +from international public health agencies, such as the World Health +Organization, in order to sell products in certain countries. Approval +processes vary from country to country, and the length of time required for +approval or to obtain other clearances may in some cases be longer than that +required for U.S. governmental approvals. The extent of potentially adverse +governmental regulation affecting the Company that might arise from future +legislative or administrative action cannot be predicted. The Company will +pursue approval only in those countries that have a significant market +opportunity. +The International Organization for Standardization ("ISO") is a worldwide +federation of national standards bodies from some 130 countries, established +in 1947. The mission of ISO is to promote the development of standardization +and related activities in the world with a view to facilitating the +international exchange of goods and services. ISO certification is evidenced +by the CE mark and indicates that the Company's quality system complies with +standards applicable to activities ranging from initial product design and +development through production and distribution. ISO certification is a +prerequisite to obtaining a CE mark, which is required for distribution of +medical devices in the European common markets. +In the first quarter of 1999, the Company received approval to use the CE +mark for the OraSure(R) and Intercept(R) collection devices. In December 2000, +the Company's Bethlehem facility received final certification for the European +Medical Device Directive (93/42/EEC), ISO 9001, ISO 13485, and EN46001. The +Company has also received authorization to use the CE mark for its +Histofreezer(R) product line. +17 +In order to obtain the CE mark for a product containing electrical +equipment, that product would need to meet several international safety and +performance standards (IEC 60825-1; IEC/EN 61010-1, CSA C 22.2, IEC 1010-1, EN +61000). The Company's UPlink(TM) analyzer will need to meet these standards in +order to obtain its CE mark. The Company has retained Underwriter +Laboratories, Inc. and Laird Technologies to examine and test the UPlink(TM) +analyzer and certify that it meets these international standards. +The Company must also submit evidence of marketing approval or clearance by +the FDA to Health Canada's Therapeutic Products Programme prior to commencing +sales in Canada. The Company has completed this process for several of its +current products which require FDA review. +Environmental Regulation +Because of the nature of its current and proposed research, development, and +manufacturing processes, the Company is subject to stringent federal, state, +and local laws, rules, regulations, and policies governing the use, +generation, manufacture, storage, air emission, effluent discharge, and +handling and disposal of materials and wastes. The Company believes that it +has complied with these laws and regulations in all material respects and has +not been required to take any action to correct any noncompliance. +Forward-Looking Statements +This Report contains certain "forward-looking statements," within the +meaning of the Federal securities laws. These may include statements about +expected revenues, earnings, expenses or other financial performance, future +product performance or development, expected regulatory filings and approvals, +planned business transactions, views of future industry or market conditions, +other factors that could affect future operations or financial position, and +statements that include the words "believes," "expects," "anticipates," +"intends," "plans," "estimates," "may," "will," "should," "could," or similar +expressions. Forward-looking statements are not guarantees of future +performance or results. Known and unknown factors could cause actual +performance or results to be materially different from those expressed or +implied in these statements. Some of these factors are: ability to market +products; impact of competitors, competing products and technology changes; +ability to develop, commercialize and market new products; market acceptance +of oral fluid testing products and up-converting phosphor technology products; +ability to fund research and development and other projects and operations; +ability to obtain and timing of obtaining necessary regulatory approvals; +ability to develop product distribution channels; uncertainty relating to +patent protection and potential patent infringement claims; ability to enter +into international manufacturing agreements; obstacles to international +marketing and manufacturing of products; ability to sell products +internationally; loss or impairment of sources of capital; exposure to product +liability and other types of litigation; changes in international, federal or +state laws and regulations; changes in relationships with strategic partners +and reliance on strategic partners for the performance of critical activities +under collaborative arrangements; changes in accounting practices or +interpretation of accounting requirements; customer consolidations and +inventory practices; equipment failures and ability to obtain needed raw +materials and components; the impact of terrorist attacks and civil unrest; +and general political, business and economic conditions. These and other +factors that could cause the forward-looking statements to be materially +different are described in greater detail in the Section entitled, "Risk +Factors," and elsewhere in this Report. Although forward-looking statements +help to provide complete information about future prospects, they may not be +reliable. The forward-looking statements are made as of the date of this +Report and Orasure Technologies undertakes no duty to update these statements. +Risk Factors +The following is a discussion of certain significant risk factors that could +potentially affect the Company's financial condition, performance and +prospects. +Competing Products +The diagnostic industry is focused on the testing of biological specimens in +a laboratory or at the point-of-care and is highly competitive and rapidly +changing. The Company's principal competitors have considerably +18 +greater financial, technical, and marketing resources. As new products enter +the market, the Company's products may become obsolete or a competitor's +products may be more effective or more effectively marketed and sold than the +Company's. If OraSure Technologies fails to maintain and enhance its +competitive position, its customers may decide to use products developed by +competitors which could result in a loss of revenues. +Ability to Develop New Products +In order to remain competitive, the Company must commit substantial +resources each year to research and development. The research and development +process generally takes a significant amount of time from inception to +commercial product launch. This process is conducted in various stages, and +during each stage there is a substantial risk that the Company will not +achieve its goals and will have to abandon a product in which it has invested +substantial amounts. +During 2001, 2000 and 1999, the Company incurred $9.4 million, $10.4 million +and $5.6 million, respectively, in research and development expenses. The +Company expects to continue to incur significant costs in its research and +development activities. Moreover, there can be no assurance that OraSure +Technologies will succeed in its research and development efforts. If the +Company fails to develop commercially successful products, or if competitors +develop more effective products or a greater number of successful new +products, customers may decide to use products developed by the Company's +competitors, which would result in a loss of revenues. +Market Acceptance of Oral Fluid Testing Products +The Company has made significant progress in gaining acceptance of oral +fluid testing for HIV in the insurance and public health markets. The Company +has also made significant progress in gaining acceptance of oral fluid testing +for drugs of abuse in the workplace and criminal justice testing markets. +Other markets, particularly the physician office market, may resist the +adoption of oral fluid testing as a replacement for other testing methods in +use today. In addition, certain state laws prohibit or restrict the use of +oral fluid testing for drugs of abuse in certain markets. There can be no +assurance that the Company will be able to expand the use of its oral fluid +testing products in these or other markets. +Loss or Impairment of Sources of Capital +Although the Company has made significant progress in the past toward +controlling expenses and increasing product revenue, historically the Company +has depended, to a substantial degree, on capital raised through the sale of +equity securities and bank borrowings to fund its operations. The Company's +future liquidity and capital requirements will depend on numerous factors, +including, but not limited to, the costs and timing of the expansion of +manufacturing capacity, the success of product development efforts, the costs +and timing of expansion of sales and marketing activities, the timing of +commercial launch of new products, the extent to which existing and new +products gain market acceptance, competing technological and market +developments, and the scope and timing of strategic acquisitions. If +additional financing is needed, the Company may seek to raise funds through +the sale of equity or other securities or through bank borrowings. There can +be no assurance that financing through the sale of securities, bank borrowings +or otherwise, will be available to the Company on satisfactory terms, if at +all. +Ability of the Company to Develop Product Distribution Channels +The Company has marketed many of its products by collaborating with +laboratories, diagnostic companies and distributors. For example, the +Company's OraSure(R) oral fluid collection device is distributed to the +insurance industry through major insurance testing laboratories. One of these +laboratories, LabOne, Inc., acquired another insurance laboratory customer, +Osborne Group, Inc., in 2001 and these customers together accounted for +approximately 29%, 30%, and 28% of the Company's revenues for the years 2001, +2000, and 1999, respectively. The Company's sales depend to a substantial +degree on its ability to sell products to these customers and develop +19 +new product distribution channels, and on the marketing abilities of the +companies with which it collaborates. In addition, some of the Company's +distributors have recently consolidated, and such consolidation has had, and +may continue to have, an adverse impact on the level of orders for the +Company's products. There can be no assurance that such companies will +continue to be able to purchase or distribute the Company's products or +maintain historic order volumes, or that new distribution channels will be +available on satisfactory terms. +Obtaining and Maintaining Regulatory Approvals and Clearances +As described more fully above under "Government Regulation," many of the +Company's proposed and existing products are subject to regulation by the FDA +and other governmental or public health agencies. In particular, the Company +is subject to strict governmental controls on the development, manufacture, +labeling, distribution and marketing of its products. The process of obtaining +required approvals or clearances from governmental or public health agencies +varies according to the nature of, and uses for, the specific product and can +involve lengthy and detailed laboratory testing, human clinical trials, +sampling activities, and other costly, time-consuming procedures. The +submission of an application to a regulatory authority does not guarantee that +it will grant an approval or clearance to market the product. Each authority +may impose its own requirements and delay or refuse to grant approval or +clearance, even though a product has been approved in another country. +The approval or clearance process for a new product can be complex and +lengthy. The time taken to obtain approval or clearance varies depending on +the nature of the application and may result in the passage of a significant +period of time from the date of submission of the application. This time span +increases the costs to develop new products and increases the risk that the +Company will not succeed in introducing or selling them. +Changes in government regulations could also require the Company to undergo +additional trials or procedures, or could make it impractical or impossible +for the Company to market its products for certain uses, in certain markets, +or at all. Other changes in government regulations, such as the adoption of +the FDA's Quality System Regulation, may adversely affect the Company's +financial condition and results of operations by requiring that the Company +incur the expense of changing or implementing new manufacturing and control +procedures. +In addition, the European Union has established a requirement that +diagnostic medical devices used to test biological specimens must receive +regulatory approval known as a CE mark by December 31, 2003. After that date, +export to the European community of products without the CE mark will be +stopped or delayed until the mark is received. This requirement will affect +many of OraSure Technologies' products. OraSure Technologies will not be +permitted to make European sales of its products for which a CE mark is not +obtained by December 31, 2003, which could lead to the termination of +strategic alliances for sales of those products in Europe. While the Company +intends to apply for CE marks for certain of its existing and future products, +and is not aware of any material reason why such approvals will not be +granted, there can be no assurance that any CE marks will be received prior to +the deadline. +At the present time, the Company has received FDA clearance or approval for +the OraSure(R) and Intercept(R) oral fluid collection devices, the +Histofreezer(R) portable cryosurgical system, the Q.E.D.(R) saliva alcohol +test, the OraSure(R) oral fluid Western Blot confirmatory test for HIV-1, and +various other tests. The Company has also received CE mark approval for the +OraSure(R), Intercept(R) and Histofreezer(R) products. The Company has +submitted to the FDA an application for pre-market approval of its OraQuick(R) +rapid HIV-1 test using whole blood and expects to file an application for oral +fluid applications in 2002. The Company has also submitted an application to +the FDA for 510(k) clearance of the UPlink(TM) drugs of abuse rapid detection +system, has resubmitted additional data requested by the FDA for the +UPlink(TM) analyzer and opiates assay, and is in the process of gathering +additional data requested by the FDA for the full NIDA-5 drug panel for that +product. See the Sections entitled "Products" and "Government Regulation" for +a further discussion of regulatory approvals and clearances obtained for the +Company's products. +20 +Regulatory Compliance +The Company can manufacture and sell many of its products, both in the +United States and in some cases abroad, only if it complies with regulations +of government agencies such as the FDA. The Company has implemented a quality +system that is intended to comply with applicable regulations. The FDA has +issued warning letters with respect to the Serum Western Blot product, stating +that the Company is not in compliance with the FDA's regulations. The Company +has responded to each of these letters and voluntarily discontinued this +product. Although the Company believes that it has satisfactorily addressed +the points raised by the FDA, the FDA could force the Company to stop +manufacturing products at its Oregon facility if the FDA concludes that the +Company remains out of compliance with applicable regulations. In addition, +until the FDA agrees that the Company has resolved all points raised in the +letters, the Company may not be able to obtain regulatory clearance +certificates needed in certain foreign countries. The FDA could also require +the Company to recall products if it fails to comply with applicable +regulations, which could force the Company to stop manufacturing such +products. See the Section entitled "Government Regulation" for a further +discussion of regulatory compliance matters. +History of Losses and Projected Profitability +The Company has not achieved full-year profitability. The Company incurred +net losses of approximately $3.7 million, $12.7 million and $4.2 million in +2001, 2000 and 1999, respectively, and as of December 31, 2001, the Company +had an accumulated deficit of approximately $126.1 million. +The Company's limited combined operating history makes it difficult to +forecast future operating results. In order to achieve sustainable +profitability, the Company's revenues will have to continue to grow at a +significant rate. The Company's ability to achieve revenue growth will be +dependent upon a number of factors including, without limitation, creating +market acceptance for and selling increasing volumes of the OraSure(R) +collection device, the Intercept(R) and UPlink(TM) drugs-of-abuse products, +and the OraQuick(R) rapid HIV-1 test, achieving growth in international +markets with the Company's OraQuick(R) rapid HIV-1 test and other products, +obtaining timely FDA approval or clearance for the OraQuick(R) rapid HIV-1 +test and UPlink(TM) drugs-of-abuse rapid detection system, and commercially +developing, and obtaining regulatory approval and creating market acceptance +for, UPT(TM) and other products in a time frame consistent with the Company's +objectives. The Company has not yet fully achieved these objectives. In the +event that the Company cannot create a significant commercial market for its +OraQuick(R) test, the Intercept(R) and UPlink(TM) products, or its other +products, or to the extent other events described in this Section occur, the +Company's revenue, and consequently profitability, could be lower than +estimated. Even if the Company achieves profitability, there is no assurance +that such profitability can be sustained in the future. +Stock Price Volatility +Because the Company's stock price may be volatile, the stock price could +experience substantial declines. The market price of the Company's common +stock has historically experienced and might continue to experience volatility +in the future in response to a number of factors, including quarter-to-quarter +variations in operating results, analysts' reports, the relative low trading +value for the Company's stock, market conditions in the industry, regulatory +developments affecting the Company's products, changes in governmental +regulations, and changes in general conditions in the economy or in the +financial or stock markets. +The market has also recently experienced significant decreases in value. +This recent market decline has affected the market prices of securities issued +by many companies, often for reasons unrelated to their operating performance, +and may adversely affect the price of the Company's common stock. +Ability to Market New Products +OraSure Technologies' future success will depend, in part, on the market +acceptance, and the timing of such acceptance, of new products such as the +Intercept(R) drug testing service, the OraQuick(R) rapid HIV-1 test, products +21 +currently under final development such as the UPlink(TM) drugs of abuse rapid +detection system and other products using up-converting phosphor technology, +and other new products or technologies that may be developed or acquired and +introduced in the future. To achieve market acceptance, OraSure Technologies +must make substantial marketing efforts and spend significant funds to inform +potential customers and the public of the perceived benefits of these +products. The Company currently has limited evidence on which to evaluate the +market reaction to products that may be developed, and there can be no +assurance that any products will meet with market acceptance and fill the +market need that is perceived to exist. +Reliance on Patents and Other Proprietary Rights +The diagnostics industry places considerable importance on obtaining patent, +trademark, and trade secret protection, as well as other intellectual property +rights, for new technologies, products and processes. The Company's success +depends, in part, on its ability to develop and maintain a strong intellectual +property portfolio or obtain licensing to patents and other technology for +products and technologies both in the United States and in other countries. +As appropriate, the Company intends to file patent applications and obtain +patent protection for its proprietary technology. These patent applications +and patents will cover, as applicable, compositions of matter for the +Company's products, methods of making those products, methods of using those +products, and apparatus relating to the use or manufacture of those products. +The Company will also rely on trade secrets, know-how, and continuing +technological advancements to protect its proprietary technology. The Company +has entered, and will continue to enter, into confidentiality agreements with +its employees, consultants, advisors and collaborators. However, these parties +may not honor these agreements and the Company may not be able to successfully +protect its rights to unpatented trade secrets and know-how. Others may +independently develop substantially equivalent proprietary information and +techniques or otherwise gain access to the Company's trade secrets and know- +how. +Many of the Company's employees, including scientific and management +personnel, were previously employed by competing companies. Although the +Company encourages and expects all of its employees to abide by any +confidentiality agreement with a prior employer, competing companies may +allege trade secret violations and similar claims against OraSure +Technologies. +The Company may incur substantial costs and be required to expend +substantial resources in asserting or protecting its intellectual property +rights, or in defending suits against it related to intellectual property +rights. Disputes regarding intellectual property rights could substantially +delay product development or commercialization activities. Disputes regarding +intellectual property rights might include state, federal or foreign court +litigation as well as patent interference, patent reexamination, patent +reissue, or trademark opposition proceedings in the United States Patent and +Trademark Office. Opposition or revocation proceedings could be instituted in +a foreign patent office. An adverse decision in any proceeding regarding +intellectual property rights could result in the loss of the Company's rights +to a patent, an invention, or trademark. +To facilitate development and commercialization of a proprietary technology +base, the Company may need to obtain licenses to patents or other proprietary +rights from other parties. Obtaining and maintaining such licenses may require +the payment by the Company of substantial costs. In addition, if the Company +is unable to obtain these types of licenses, the Company's product development +and commercialization efforts may be delayed or precluded. +Patent Issues Affecting OraQuick(R) +There are several factors that will affect the specific countries in which +the Company will be able to sell its OraQuick(R) rapid HIV test and therefore +the overall sales potential of the test. One factor is whether the Company can +arrange a sublicense or distribution agreement related to patents for +detection of the HIV-2 virus. HIV-2 is a type of the HIV virus estimated to +represent a small fraction of the known HIV cases worldwide. Nevertheless, +HIV-2 is considered to be an important component in the testing regimen for +HIV in many markets. HIV-2 +22 +patents are in force in most of the countries of North America and Western +Europe, as well as in Japan, Korea, South Africa, and Australia. Access to a +license for one or more HIV-2 patents may be necessary to sell HIV-2 tests in +countries where such patents are in force, or to manufacture in countries +where such patents are in force and then sell into non-patent markets. Since +HIV-2 patents are in force in the United States, the Company may be restricted +from manufacturing an OraQuick(R) rapid HIV-2 test in the United States and +selling into other countries, even if there were no HIV-2 patents in those +other countries. +The importance of HIV-2 differs by country, and can be affected by both +regulatory requirements and by competitive pressures. In most countries, any +product used to screen the blood supply will be required to detect HIV-2, +although the OraQuick(R) rapid HIV test has not been intended for that market +purpose. In other markets, including the United States, a test that can detect +only the more prevalent HIV-1 type is considered sufficient by the FDA, except +in testing related to blood supply. Because the competitive situation in each +country will be affected by the availability of other testing products as well +as the country's regulatory environment, the Company may be at a competitive +disadvantage in some markets without an HIV-2 product even if HIV-2 detection +is not required by regulations. In particular, the Company may be limited in +its ability to sell a product that does not include an HIV-2 test, or a +competitor's product that includes an HIV-2 test may be preferred and have a +competitive advantage over an HIV-1 only test sold by the Company. +The Company has obtained licenses to HIV-1 patents held by the manufacturer +of the HIV-1 antigen used in the OraQuick(R) device and by the National +Institutes of Health. The Company is not aware of any other HIV-1 patents +which would need to be licensed in order to manufacture and sell the +OraQuick(R) rapid HIV-1 test. +Another factor that may affect the specific countries in which the Company +will be able to sell an OraQuick(R) rapid HIV-1 or HIV-2 test, and therefore +the overall sales potential, concerns whether the Company can arrange a +sublicense or distribution agreement related to any patents which claim +lateral flow assay methods and devices covering the OraQuick(R) rapid HIV +tests or their use. OraQuick(R) is a lateral flow assay device that tests for +specific antibodies or other substances. The term "lateral flow" generally +refers to a test strip through which a sample flows and which provides a test +result on a portion of the strip downstream from where the sample is applied. +There are numerous patents in the United States and other countries which +claim lateral flow assay methods and devices. Some of these patents may +broadly cover the technology used in the OraQuick(R) assay and are in force in +the United States and other countries. The Company may not be able to make the +OraQuick(R) test in the United States and sell it in countries where there is +no patent on the device. The Company has obtained or intends to obtain +licenses under several lateral flow patents, which it believes should be +sufficient to permit the manufacturing and sale of the OraQuick(R) device as +currently contemplated. +In the event that it is determined that a license is required and it is not +possible to negotiate a license agreement under a necessary patent, the +Company may be able to modify the OraQuick(R) rapid HIV test such that a +license would not be necessary. However, this alternative could delay +introduction of the OraQuick(R) rapid HIV test into the United States and +other markets. +Loss of Key Personnel +The Company's success will depend to a large extent upon the contributions +of its executive officers, management, and sales, marketing, and scientific +staff. The Company may not be able to attract or retain qualified employees in +the future due to the intense competition for qualified personnel among +medical products businesses. If the Company is not able to attract and retain +the necessary personnel to accomplish its business objectives, the Company may +experience constraints that will adversely affect its ability to effectively +sell and market its products, to meet the demands of its strategic partners in +a timely fashion, or to support internal research and development programs. In +particular, product development programs depend on the ability to attract and +retain highly skilled scientists, including molecular biologists, biochemists +and engineers, and sales and marketing efforts depend on the ability to +attract and retain skilled and experienced sales and marketing +representatives. Recruiting qualified personnel can be an intensely +competitive and time-consuming process. Although OraSure Technologies believes +it will be successful in attracting and retaining qualified personnel, +competition for experienced scientists and other personnel from numerous +companies and academic and other research institutions may limit its ability +to do so on acceptable terms. +23 +All of the Company's employees, other than a few senior officers who have +employment agreements, are at-will employees, which means that either the +employee or OraSure Technologies may terminate their employment at any time. +If the Company experiences difficulty in recruiting and retaining qualified +personnel, it may need to provide higher compensation to such personnel than +currently anticipated or the Company may incur additional expenses for the +recruitment of qualified personnel. +The Company's business strategies will require additional expertise in +specific industries and areas applicable to the development efforts related to +up-converting phosphor technologies. These activities will require the +addition of new personnel, including management, and the development of +additional expertise by existing management personnel. The inability to +acquire these services or to develop this expertise could impair the +development, if any, of products related to these technologies. +International Marketing and Manufacturing +The Company intends to increase international sales of its products. The +Company's international revenues accounted for approximately $5.3 million or +16% of total revenues for 2001, approximately $4 million or 14% of total +revenues for 2000, and approximately $2.7 million or 11% of total revenues for +1999. +A number of factors can slow or prevent international sales, or +substantially increase the cost of international sales, including those set +forth below: +. Regulatory requirements (including compliance with applicable customs +regulations) may slow, limit, or prevent the offering of products in +foreign jurisdictions; +. Cultural and political differences may make it difficult to effectively +market, sell and gain acceptance of products in foreign jurisdictions; +. Inexperience in international markets may slow or limit the Company's +ability to sell products in foreign countries; +. Exchange rates, currency fluctuations, tariffs and other barriers, +extended payment terms and dependence on and difficulties in managing +international distributors or representatives may affect the Company's +revenues even when product sales occur; +. The creditworthiness of foreign entities may be less certain and foreign +accounts receivable collection may be more difficult; +. Economic conditions and the absence of available funding sources may +slow or limit the Company's ability to sell its products in foreign +countries; +. International markets often have long sales cycles, especially sales to +foreign governments, quasi-governmental agencies and international +public health agencies, thereby delaying or limiting the Company's +ability to sell its products; and +. The Company may be at a disadvantage if competitors in foreign countries +sell competing products at prices at or below such competitors' or the +Company's cost. +The Company has entered into a contract for the manufacture and supply of +the OraQuick(R) HIV device in Thailand. However, the Company does not have +significant direct experience with the use of international manufacturers. +Factors such as economic and political conditions and foreign regulatory +requirements may slow or prevent the manufacture of the Company's products in +countries other than the United States. Interruption of the supply of the +Company's products could reduce revenues or cause the Company to incur +significant additional expenses in finding an alternative source of supply. +Product Liability Exposure +The Company may be held liable if any of its products, or any product which +is made with the use or incorporation of any of the technologies belonging to +the Company, causes injury of any type or is found otherwise unsuitable during +product testing, manufacturing, marketing, sale or usage. Although the Company +has +24 +obtained product liability insurance, this insurance may not fully cover +potential liabilities. As the Company brings new products to market, the +Company may need to increase its product liability coverage. Inability to +obtain sufficient insurance coverage at an acceptable cost or otherwise to +protect against potential product liability claims could affect the Company's +decision to commercialize products developed by the Company or its strategic +partners. +Ability to Fully Commercialize UPT(TM) +The Company's up-converting phosphor technology is new and, except for the +UPlink(TM) rapid detection system, is in the early stage of development. +Commercial development of UPT(TM) for certain other applications may not be +successful. Successful products require significant development and +investment, including testing, to demonstrate their cost-effectiveness or +other benefits prior to commercialization. In addition, regulatory approval +must be obtained before most products based upon UPT(TM) may be sold. +Additional development efforts on these products will be required before any +regulatory authority will review them. Regulatory authorities may not approve +these products for commercial sale. Accordingly, because of these +uncertainties, products based upon UPT(TM) may not be commercialized. The +failure to develop UPT(TM) products with commercial potential would negatively +affect OraSure Technologies' future revenues. +Dependence on Strategic Partners +Although the Company intends to pursue some product opportunities +independently, opportunities that require a significant level of investment +for development and commercialization or a distribution network beyond the +Company's existing sales force may necessitate involving one or more strategic +partners. In particular, the Company's strategy for development and +commercialization of UPT(TM) and certain other products, such as the +OraQuick(R) rapid HIV test, may entail entering into additional arrangements +with distributors or other corporate partners, universities, research +laboratory licensees, and others. OraSure Technologies may be required to +transfer material rights to such strategic partners, licensees, and others. +While the Company expects that its current and future partners, licensees, and +others have and will have an economic motivation to succeed in performing +their contractual responsibilities, the amount and timing of resources to be +devoted to these activities will be controlled by others. Consequently, there +can be no assurance that any revenues or profits will be derived from such +arrangements. +Dependence on Third Party Licenses and Rights +The Company has licensed the worldwide rights to up-converting phosphor +compositions, methods, and apparatuses for use in diagnostic applications, +which are the subject of numerous United States and patents and several +pending United States applications. Corresponding patents and patent +applications have been granted, issued or filed in numerous foreign countries, +including, for example, European countries, Japan, and Canada. OraSure +Technologies cooperates with the licensor to prosecute such patent +applications and protect such patent rights. If the licensors do not meet +their obligations under the license agreements or do not reasonably consent to +sublicenses by the Company, or if the license agreement is terminated, the +Company could lose the opportunity to develop UPT(TM). +Recent Economic Downturn and Terrorist Attacks +Since the September 11, 2001 terrorist attacks, the United States economy +has experienced a decline. Changes in economic conditions could adversely +affect the Company's business. For example, in a difficult economic +environment, customers may be unwilling or unable to invest in new diagnostic +products, may elect to reduce the amount of their purchases or may perform +less drug testing because of declining employment levels. A weakening business +climate could also cause longer sales cycles and slower growth, and could +expose the Company to increased business or credit risk in dealing with +customers adversely affected by economic conditions. +25 +The terrorist attacks and subsequent governmental responses to these attacks +could cause further economic instability or lead to further acts of terrorism +in the United States and elsewhere. These actions could adversely affect +economic conditions outside the United States and reduce demand for our +products internationally. Terrorist attacks could also cause regulatory +agencies, such as the FDA or agencies that perform similar functions outside +the United States, to focus their resources on vaccines or other products +intended to address the threat of biological or chemical warfare. This +diversion of resources could delay the Company's ability to obtain regulatory +approvals required to manufacture, market or sell its products in the United +States and other countries. +Restructuring of Operations +The Company may from time to time restructure and consolidate various +aspects of its operations in order to achieve cost savings and other +efficiencies. For example, during 2001 the Company completed a restructuring +of its manufacturing operations which included the transfer of OraQuick(R) +manufacturing from the Beaverton, Oregon facility to Bethlehem, Pennsylvania. +In addition, the Company plans to close the Oregon facility during 2003 and +transfer all remaining manufacturing operations, which are solely related to +the Western Blot HIV-1 confirmatory test, and research and development +activities to Pennsylvania. The transfer of operations may result in the loss +of scientific or other personnel and thereby delay the transfer or disrupt the +continuation of operations thereafter. The Company will also be required to +obtain FDA approval to transfer certain operations to another location, which +could delay the transfer or disrupt continued operations. Any delay or +disruption of operations, and in particular manufacturing operations, could +result in increased costs or could prevent the Company from selling certain +products and thereby result in a loss of revenue. +The previous discussion of the Company's business should be read in +conjunction with the Financial Statements and accompanying notes included in +Item 14 of this Annual Report on Form 10-K. +ITEM 2. Properties. +On April 30, 1999, the Company signed a five-year lease to rent 25,845 +square feet of space at the John M. Cook Technology Center in Bethlehem, +Pennsylvania, which the Company uses as its main corporate, sales and +marketing, and research and development offices. Annual rent for the first +five years of this lease is approximately $270,000. The lease also includes a +five-year renewal option and a ten-year purchase option. +The Company owns a 33,500 square foot building in Bethlehem, Pennsylvania +which is used for manufacturing, engineering, information systems and +accounting activities. The Company rents additional warehouse space on an as- +needed basis. The Company leases space for a sales office in Reeuwijk, The +Netherlands. +The Company leases approximately 30,500 square feet of office, +manufacturing, and laboratory space in Beaverton, Oregon, under a lease that +expires on January 31, 2005. The Company has base lease obligations under the +lease, which escalate during the term of the lease and average approximately +$375,000 per year. The Company also leases 2,265 square feet of warehouse +space in Oregon to store inventory and equipment under a lease expiring +September 30, 2002. The Company expects to consolidate the research and +development and manufacturing operations currently performed in Oregon with +the Company's Bethlehem operation during 2003. +The Company has executed a lease for an approximate 48,000 square foot +manufacturing, research and development and office facility to be constructed +on property adjacent to its existing corporate headquarters in Bethlehem, +Pennsylvania. Construction of the facility is expected to be completed during +the summer of 2002. The lease has an initial term of 10 years and base rental +rate starting at $480,000 and increasing to $528,000 per year over the initial +term. The lease also has a five-year renewal option and a ten-year purchase +option. +The Company believes that its existing and proposed facilities are adequate +for its requirements. +26 +ITEM 3. Legal Proceedings. +The Company is from time to time involved in legal proceedings arising in +the ordinary course of business. In the Company's opinion, based on the advice +of counsel, these proceedings are not expected to have a material adverse +effect on the Company's financial position or results of operations. +ITEM 4. Submission of Matters to a Vote of Security Holders. +No matters were submitted to a vote of security holders during the fourth +quarter of the year ended December 31, 2001. +27 +PART II +ITEM 5. Market for Registrant's Common Equity and Related Stockholder Matters. +The Company's Common Stock is listed for trading on the National Market tier +of The Nasdaq Stock Market ("NASDAQ") under the symbol OSUR. High and low +sales prices reported by NASDAQ during the periods indicated are shown below. +Prices for quarters ending prior to the September 29, 2000 Merger with Epitope +and STC, represent the high and low sales prices reported by NASDAQ for the +common stock of the Company's predecessor, Epitope, which traded under the +symbol EPTO. +Year ended December 31 +----------------------------- +2001 2000 +-------------- -------------- +High Low High Low +------- ------ ------- ------ +First Quarter.................................. $10.000 $5.875 $18.188 $5.563 +Second Quarter................................. 12.640 6.688 14.375 7.000 +Third Quarter.................................. 15.000 7.260 15.938 9.938 +Fourth Quarter................................. 12.880 8.890 13.500 5.563 +On March 22, 2002, there were 787 holders of record and, based on mailings +for the 2001 Annual Meeting of Stockholders, approximately 9,500 holders in +street name of the Common Stock, and the closing price of the Common Stock was +$6.48 per share. The Company has never paid any cash dividends, and the Board +of Directors does not anticipate paying cash dividends in the foreseeable +future. The Company intends to retain any future earnings to provide funds for +the operation and expansion of its business. +ITEM 6. Selected Financial Data. +The following table sets forth selected financial data of the Company. See +Note 1 to the Company's Financial Statements for a discussion of the Merger +with Epitope and STC and change in the fiscal year end of Epitope. The data +below for the year ended September 30, 1997 includes discontinued operations +of two of Epitope's former subsidiaries, Agritope, Inc. and Andrew and +Williamson Sales, Co. The charge for discontinued operations during this +period includes the operating losses of these subsidiaries through their +disposition dates and final losses on disposal incurred by Epitope. This +information should be read in conjunction with the Financial Statements and +notes thereto included in Item 14 and the information set forth in Item 7, +"Management's Discussion and Analysis of Financial Condition and Results of +Operations." +28 +Selected Financial Data +(In thousands, except per share data) +Year ended Three months ended Year ended +December 31, December 31, September 30, +-------------------- -------------------- ------------------------------ +2001 2000 1999 1998 1999 1998 1997 +--------- --------- --------- --------- --------- --------- -------- +Operating Results: +Revenues................ $ 32,573 $ 28,788 $ 6,822 $ 5,138 $ 24,046 $ 20,444 $ 17,282 +Costs and expenses...... 36,906 42,917 7,105 5,857 28,138 22,721 23,295 +Other income (expense), +net.................... 634 1,407 (138) (159) (91) (98) 782 +Loss from continuing +operations before +income taxes........... (3,699) (12,722) (421) (878) (4,183) (2,374) (5,231) +Loss from continuing +operations............. (3,728) (12,747) (471) (878) (4,233) (2,374) (5,231) +Discontinued +operations............. -- -- -- -- -- -- (18,359) +Net loss................ (3,728) (12,747) (471) (878) (4,233) (2,374) (23,590) +Per Share of Common +Stock: +Loss from continuing +operations............. $ (0.10) $ (0.36) $ (0.02) $ (0.03) $ (0.14) $ (0.09) $ (0.20) +Loss from discontinued +operations............. -- -- -- -- -- -- (0.70) +Basic and diluted net +loss................... (0.10) (0.36) (0.02) (0.03) (0.14) (0.09) (0.90) +Shares used in per share +calculations:.......... 36,868 35,002 30,887 26,246 30,597 26,180 26,055 +Financial position: +Working capital......... $ 19,764 $ 21,440 $ 16,314 $ 8,255 $ 16,773 $ 8,725 $ 12,470 +Total assets............ 37,285 37,736 29,626 20,075 30,251 20,783 25,978 +Long-term debt.......... 3,586 4,644 5,820 6,001 5,820 6,001 4,026 +Accumulated deficit..... (126,092) (122,365) (109,618) (105,603) (109,104) (104,903) (96,837) +Stockholders' equity.... 26,541 26,172 18,238 10,264 18,592 10,701 17,873 +29 +ITEM 7. Management's Discussion and Analysis of Financial Condition and +Results of Operations. +Statements below regarding future events or performance are "forward-looking +statements" within the meaning of the Private Securities Litigation Reform Act +of 1995. The Company's actual results could be quite different from those +expressed or implied by the forward-looking statements. Factors that could +affect results are discussed more fully under the Sections entitled "Forward- +Looking Statements" and "Risk Factors" in Item 1 and elsewhere in this Annual +Report on Form 10-K. Although forward-looking statements help to provide +complete information about the Company, readers should keep in mind that +forward-looking statements may not be reliable. Readers are cautioned not to +place undue reliance on the forward-looking statements. +On September 29, 2000, STC Technologies, Inc. ("STC"), a privately held +company, and Epitope, Inc. ("Epitope"), a public company whose stock was +traded on the Nasdaq Stock Market, were merged into the Company (the +"Merger"). The Merger was structured as an all stock transaction and was +accounted for as a "pooling of interests." +Epitope previously reported its financial results on the basis of a fiscal +year ending September 30, while STC previously reported its financial results +on a calendar year basis. Immediately prior to the Merger, Epitope adopted a +calendar year for financial reporting purposes. As a result, the Financial +Data for 2001 and 2000 reflect results for the calendar years ended December +31, 2001 and 2000, respectively. Since Epitope did not adopt a calendar year +reporting period until 2000, the Financial Data for 1999 reflects the results +of Epitope for the twelve-months ended September 30, 1999 and the results of +STC for the twelve months ended December 31, 1999. See Note 1 to the Company's +Financial Statements for a discussion of the Merger and the change in fiscal +year end. +In selecting the presentation of results for 1999, the Company determined +that it was not necessary to restate the Epitope 1999 results on a calendar +year basis. To do so would have required the addition of Epitope's results for +the three months ended December 31, 1999 and the elimination of Epitope's +results for the three months ended December 31, 1998. A comparison of the +results for these three-month periods demonstrated that there were no events, +transactions or economic changes that caused the Epitope results for these +periods to be materially different. Accordingly, a restatement of the Epitope +results would not have materially affected the comparison of STC results for +the twelve months ended December 31, 1999 and Epitope results for the twelve +months ended September 30, 1999. +Certain reclassifications have been made to prior period market segment +revenues to conform to the current year presentation. The following discussion +should be read in conjunction with the financial statements contained herein +and the notes thereto, along with the Section entitled, "Critical Accounting +Policies and Estimates" set forth below. +Results of Operations--2001 Compared to 2000 +Total revenues increased 13% to approximately $32.6 million in 2001 from +approximately $28.8 million in 2000. Excluding revenues of approximately $1.6 +million in 2000 from the Serum Western Blot confirmatory test, which was +discontinued in January 2001, total revenues would have increased +approximately 20%. +30 +The table below shows the amount of the Company's total revenues (in +thousands, except %) generated in each of its principal markets and by +licensing and product development activities. +Percentage of +Percentage Total +Dollars Change Revenues (%) +----------------- Inc. --------------- +2001 2000 (Dec.) 2001 2000 +-------- -------- ---------- ------ ------ +Market revenues +Insurance risk assessment...... $ 11,713 $ 14,693 (20)% 36% 51% +Infectious disease testing..... 5,754 3,453 67 18 12 +Substance abuse testing........ 6,955 3,172 119 21 11 +Physicians' office therapies... 6,674 6,777 (2) 20 24 +-------- -------- ------ ------ +31,096 28,095 11 95 98 +Licensing and product +development.................... 1,477 693 113 5 2 +-------- -------- ------ ------ +Total revenues.................. $ 32,573 $ 28,788 13% 100% 100% +======== ======== ====== ====== +Sales to the insurance risk assessment market declined by 20% to +approximately $11.7 million in 2001 from approximately $14.7 million in 2000, +as a result of the discontinuation of the Company's Serum Western Blot +confirmatory test, improved efficiencies by end users in the use of OraSure(R) +collection devices and by insurance testing laboratories in the use of +immunoassay tests, inventory consolidations which resulted from the merger of +the Company's two largest insurance laboratory customers, LabOne, Inc. and +Osborne Group, Inc., and lower sales of urine assays. Partially offsetting +this decline was an increase in sales of oral fluid assays resulting from +increased penetration of the insurance risk assessment market. +Sales to the infectious disease testing market increased 67% to +approximately $5.8 million in 2001 from approximately $3.5 million in 2000, as +a result of continued penetration of the Company's OraSure(R) laboratory-based +HIV-1 test and shipments of the OraQuick(R) rapid HIV test into sub-Saharan +Africa. +Sales to the substance abuse testing market increased 119% to approximately +$7.0 million in 2001 from approximately $3.2 million in 2000, as a result of +the substantial market penetration of the Intercept(R) drug testing service +into the workplace and criminal justice markets and increased forensic +toxicology sales. Of the $7.0 million in substance abuse testing revenues, +approximately $1.7 million resulted from the sale of equipment manufactured by +third party vendors. +Sales to the physicians' office therapies market, which consisted solely of +the Histofreezer(R) portable cryosurgical system, declined 2% to approximately +$6.7 million in 2001 from approximately $6.8 million in 2000, as a result of +inventory consolidation by distributors in the United States and lower +international sales. Despite this small decline in revenues, Histofreezer(R) +sales in the United States improved steadily throughout 2001 on a quarter-to- +quarter basis. +As a percentage of total revenues, international revenues increased to +approximately 16% in 2001 from approximately 14% in 2000, with Histofreezer(R) +accounting for approximately 39% of 2001 international revenues. LabOne, Inc., +the Company's largest customer, and Osborne Group, Inc., which was acquired by +LabOne, Inc. in 2001, together accounted for approximately 29% and 30% of +total revenues in 2001 and 2000, respectively. +Licensing and product development revenues increased 113% to approximately +$1.5 million in 2001 from approximately $0.7 million in 2000, reflecting a +different mix of development work performed in 2001. During 2001, licensing +and product development revenues were primarily from the continued development +of the UPlink(TM) drugs-of-abuse rapid detection system under an agreement +with Drager, development of infectious disease applications for UPlink(TM) +under an agreement with Meridian Bioscience, and the second phase of a grant +from the National Institutes of Health ("NIH") for the development of an oral +fluid syphilis test. During +31 +2000, licensing and product development revenues consisted primarily of income +from a collaboration with LabOne, Inc. related to the Intercept(R) drug +testing service, development work with Drager on the UPlink(TM) drugs-of-abuse +rapid detection system, and the first phase of the NIH grant. Under its +agreements with Drager and Meridian Bioscience, the Company expects to receive +additional development revenues if it meets certain milestones in 2002. +The first phase of the NIH grant was for development of a laboratory-based +oral fluid syphilis test using the OraSure(R) collection device. During 2001, +the Company requested and the NIH approved a change for the second phase of +that grant to apply to the development of a rapid test for syphilis using the +OraQuick(R) platform. During the first quarter of 2002, the Company reassessed +this project and the potential marketability of the resulting product, and +elected to terminate development of the syphilis test. As a result, the +Company does not expect to receive further funding under the NIH grant. +The Company's gross margin increased to approximately 62% in 2001 from 61% +in 2000. This increase was primarily the result of lower material costs and +productivity gains, negotiated contract savings, cost savings as a result of +restructuring the Company's manufacturing operations, and higher licensing and +product development revenues, partially offset by incremental costs and +manufacturing inefficiencies associated with the initial production of +UPlink(TM) analyzers and commencement of OraQuick(R) manufacturing. +Additionally, during the fourth quarter of 2001, the gross margin was +negatively affected by the recording of an inventory reserve of approximately +$0.6 million related to OraQuick(R) HIV tests manufactured for sale to the +Company's African distributor. Because of the failure by the Company's African +distributor to meet its contractually-required minimum purchase commitments, +the Company reevaluated its international distribution strategy for +OraQuick(R) and terminated its agreement with this distributor in February +2002. The reserve was required because of concerns about the remaining shelf +life of the inventory in relation to the Company's ability to rapidly +establish a new distribution channel to sell OraQuick(R) in Africa. During +2000, the Company wrote off approximately $0.5 million for expired OraSure(R) +collection device inventory and $0.6 million for Serum Western Blot +confirmatory test inventory that was obsolete, expired, or rendered unsaleable +as a result of the discontinuation of that product. +Research and development expenses declined 10% to approximately $9.4 million +in 2001 from approximately $10.4 million in 2000. Research and development +efforts in 2001 were focused upon the continued development of the UPlink(TM) +analyzer, test cassette and collector, the development of certain UPlink(TM) +drugs of abuse and infectious disease assays, DNA feasibility studies, and +clinical trials for the OraQuick(R) rapid HIV-1 test. The investments into +these projects were offset by reduced expenditures related to development of +the OraQuick(R) device and lower personnel and consulting expenses at the +Company's Beaverton, Oregon facility. +Sales and marketing expenses increased 14% to approximately $7.9 million in +2001 from approximately $6.9 million in 2000. This increase was primarily the +result of additional costs associated with increased staffing levels and +related expenses, and the expansion of the Company's customer service +functions. +General and administrative expenses remained flat at approximately $6.9 +million in both 2001 and 2000. Higher professional fees associated with +certain partnering activities in 2001 were offset by cost savings from the +elimination of duplicative overhead structures as a result of the Merger. +During the first quarter of 2002, the Company will record a charge of +approximately $0.6 million relating to severance payments, including +approximately $480,000 for Robert D. Thompson, the Company's former Chief +Executive Officer, who resigned on January 31, 2002, and approximately +$100,000 in severance payments in connection with a 10% workforce reduction +implemented during that period. +Merger-related expenses were approximately $7.6 million in 2000. These costs +included fees for investment bankers, attorneys and accountants, filing fees, +proxy solicitation expenses, employee severance, and integration costs. There +were no such costs in 2001. +32 +Restructuring-related expenses were $450,000 as a result of the +manufacturing restructuring in the first quarter of 2001. These costs included +expenses for employee severance and travel and transport resulting from +relocating and consolidating manufacturing operations, and were paid by June +30, 2001. There were no such costs in 2000. +Interest expense decreased by 18% to $403,000 in 2001 from $490,000 in 2000 +as a result of loan principal repayments. +Interest income decreased by 29% to approximately $0.9 million in 2001 from +approximately $1.3 million in 2000 as a result of lower cash and cash +equivalents available for investment and lower interest rates. +Gain on the sale of securities was $100,000 in 2001 as a result of the sale +of LabOne, Inc. common stock the Company received as part of a distribution +arrangement with LabOne, entered into in 1999 for the Company's Intercept(R) +drug testing service. In 2000, the Company recorded a gain on the sale of +securities of $600,000, as a result of the sale of Andrew & Williamson Sales +Company ("A&W") preferred stock the Company had received as part of a +settlement with A&W in 1997. +During 2001 and 2000, provisions for foreign income taxes were recorded. +Results of Operations--2000 Compared to 1999 +Total revenue increased 20% to approximately $28.8 million in 2000 from +approximately $24.0 million in 1999. The table below shows the amount (in +thousands) and percentage of the Company's total revenue contributed by each +of its principal markets and by licensing and product development activities. +Percentage of +Percentage Total +Dollars Change Revenues (%) +--------------- Inc. --------------- +2000 1999 (Dec.) 2000 1999 +------- ------- ---------- ------ ------ +Market sales +Insurance risk assessment........ $14,693 $12,364 19% 51% 51% +Infectious disease testing....... 3,453 2,549 35 12 11 +Substance abuse testing.......... 3,172 2,491 27 11 10 +Physicians' office therapies..... 6,777 5,744 18 24 24 +------- ------- ------ ------ +28,095 23,148 21 98 96 +Licensing and product +development...................... 693 898 (23) 2 4 +------- ------- ------ ------ +Total revenues.................... $28,788 $24,046 20% 100% 100% +======= ======= ====== ====== +Sales to the insurance risk assessment market increased by 19% to +approximately $14.7 million in 2000 from approximately $12.4 million in 1999, +as a result of increased market acceptance of the OraSure(R) oral fluid +collection device and higher sales of the associated immunoassay tests. +Sales to the infectious disease testing market increased 35% to +approximately $3.5 million in 2000 from approximately $2.5 million in 1999, as +a result of increased penetration of the Company's higher priced public health +HIV-1 kit. +Sales to the substance abuse testing market increased 27% to approximately +$3.2 million in 2000 from approximately $2.5 million in 1999, as a result of +the market introduction of the Intercept(R) drug testing service and increased +Q.E.D.(R) and forensic toxicology sales. +Sales to the physicians' office therapies market, which consisted solely of +the Histofreezer(R) portable cryosurgical system, increased 18% to +approximately $6.8 million in 2000 from approximately $5.7 million in 1999, as +a result of price and volume increases both domestically and internationally. +33 +As a percentage of total revenues, international revenues increased to +approximately 14% in 2000 from 12% in 1999, as a result of increased +international sales of the Histofreezer(R) product and the OraSure(R) +collection devices. LabOne, Inc. and Osborne Group Inc., which was acquired by +LabOne, Inc. in 2001, together accounted for approximately 30% and 28% of the +total revenues in 2000 and 1999, respectively. +Licensing and product development revenue decreased 23% to $0.7 million in +2000 from $0.9 million in 1999, reflecting a different mix of development work +performed in 2000. During 2000, licensing and product development revenue +primarily consisted of income from a collaboration with LabOne, Inc. related +to the Intercept(R) drug testing service, development work with Drager on the +UPlink(TM) drugs-of-abuse rapid detection system, and receipt of the first +phase of the NIH grant for the development of an oral fluid syphilis test. +During 1999, the Company received licensing and product development revenue in +connection with a research agreement to collaborate on the development of +analytes for point-of-care testing, a business and technology assessment of +UPT(TM) for food pathogen applications, and the Company's collaboration with +LabOne for the Intercept(R) drug testing service. +The Company's gross margin declined slightly to 61% in 2000 from 62% in +1999. The decline was the result of the Company's write off of approximately +$0.5 million of expired OraSure(R) collection device inventory and $0.6 +million of obsolete, expired, or unsaleable Serum Western Blot inventory, and +manufacturing inefficiencies related to the start up of the OraQuick(R) +product line. Partially offsetting these factors in 2000 were favorable +changes in product mix and greater revenues compared to the Company's fixed +costs. +Research and development expenses increased 86% to approximately $10.4 +million in 2000 from approximately $5.6 million in 1999. Research and +development efforts in 2000 were focused on development of the OraQuick(R) +rapid HIV test, development of the UPlink(TM) analyzer, test cassette and +collector for drugs-of-abuse applications, DNA feasibility studies, and +regulatory compliance. In addition, the Company also performed research and +development activities with respect to additional Intercept(R) products, new +antibody development, and improvements to existing products. +Sales and marketing expenses increased approximately 22% to approximately +$6.9 million from approximately $5.7 million in 1999. This increase was +primarily the result of costs associated with cultivating foreign markets for +the OraQuick(R) rapid HIV test, which was launched in July 2000, launching the +Intercept(R) drug testing service in the United States in February 2000, and +expanded sales activities for the Company's other product lines. +General and administrative expenses increased 10% to approximately $6.9 +million in 2000 from approximately $6.2 million in 1999. This increase was the +result of increased staffing levels and operating expenses associated with a +facility expansion in Bethlehem, Pennsylvania. +In 1999, the Company recorded a $1.5 million charge for acquired in-process +technology from TPM Europe Holding B.V., its sublicensor, relating to the +termination of an existing license agreement between the sublicensor and the +Company with respect to the sublicense of UPT(TM) patents owned by Leiden +University, The Netherlands, and securing a direct research, development, and +license arrangement with Leiden University. The Company accounted for the +purchase price of the technology as acquired in-process technology expense, +because at the date of the transaction, the technology rights acquired by the +Company had not progressed to a stage where the technology, or any alternative +future use of the technology, had met technological feasibility. Furthermore, +there existed a significant amount of uncertainty as to the Company's ability +to complete the development of this technology and achieve market acceptance +of any related commercial products within a reasonable timeframe. There were +no such expenses in 2000. +Merger-related expenses were approximately $7.6 million in 2000. These costs +included fees for investment bankers, attorneys and accountants, filing fees, +proxy solicitation expenses, employee severance, and integration costs. There +were no such expenses in 1999. +34 +Interest expense decreased to $490,000 in 2000 from $545,000 in 1999, as a +result of loan principal repayments and the refinancing of certain debt. +Interest income increased to approximately $1.3 million in 2000 from +approximately $0.6 million in 1999, as a result of higher cash and cash +equivalents available for investment generated by the exercise of stock +options and warrants. +Gain on the sale of securities was $600,000 in 2000 as a result of a gain on +the sale of A&W preferred stock the Company had received as a part of a +settlement with A&W in 1997. There was no similar item in 1999. +During 2000 and 1999, provisions for foreign income taxes were recorded. +Results of Operations--Three Months Ended December 31, 1999 Compared to 1998 +Total revenues increased 33% to approximately $6.8 million for the three +months ended December 31, 1999 from approximately $5.1 million for the +comparable period in 1998. This increase resulted from increased sales across +all market segments, including a $400,000 increase in sales to the infectious +disease market, a $300,000 increase in sales to the substance abuse testing +market, and increased licensing and product development revenue. +The Company's gross margin increased to approximately 63% for the three +months ended December 31, 1999 from approximately 59% in 1998. This increase +was primarily the result of a more favorable product mix and higher product +sales and licensing and product development revenue. +Operating expenses increased 23% to approximately $4.6 million for the three +months ended December 31, 1999 from approximately $3.8 million in 1998, +primarily as a result of a general increase in overall sales and marketing +expenses, including additional costs associated with preparation for the +Company's national launch of the Intercept(R) drug testing service in February +2000. +Other expenses decreased to approximately $138,000 for the three months +ended December 31, 1999 from approximately $159,000 in 1998, primarily as a +result of lower interest expense and increased interest income, partially +offset by higher foreign currency losses. +During the three months ended December 31, 1999, a provision for foreign +income taxes of $50,000 was recorded. +Liquidity and Capital Resources +General. The Company's cash, cash equivalents, and short-term investments +position was approximately $15.2 million at December 31, 2001, a decrease of +approximately $4.9 million from the Company's position at December 31, 2000. +This decrease was principally attributable to the Company's net loss of $3.7 +million, increased accounts receivable and inventory levels, capital +investment into new manufacturing facilities and equipment, and loan principal +repayments, partially offset by proceeds from the exercise of stock options. +At December 31, 2001, the Company's working capital was approximately $19.8 +million. +The Company recorded lower than anticipated product sales in 2001 and +expects its revenues for the first two quarters of 2002 to be roughly +comparable to revenue levels recorded for the same periods in 2001. In +addition, the Company hired personnel during 2001 to support a sales level +higher than that now anticipated through mid-2002. Consequently, in the first +quarter of 2002, the Company terminated certain development projects and +implemented an approximate 10% reduction in its workforce. +Net cash used in operating activities was approximately $5.3 million in +2001, a decrease of approximately $4.8 million from 2000. The $5.3 million of +cash used in operating activities resulted primarily from the Company's net +loss of $3.7 million, the build up of higher inventory levels of OraQuick(R) +raw materials and +35 +electronic components for UPlink(TM) readers in anticipation of sales growth, +and an increase in accounts receivable levels. +Net cash used in investing activities during 2001 was $66,000. The Company +purchased approximately $2.8 million of property and equipment and funded this +through net proceeds of approximately $2.1 million of short-term investments +and $637,500 the Company received upon the sale of LabOne, Inc. common stock. +Capital expenditures are anticipated to increase during 2002 as a result of +additional commitments the Company has made for the purchase and installation +of manufacturing equipment for UPlink(TM), and additional tenant fit out costs +expected in connection with its existing facilities and a new facility the +Company has leased in Bethlehem, Pennsylvania. +Net cash provided by financing activities was approximately $2.7 million, +reflecting the proceeds received from the exercise of stock options of +approximately $3.9 million, offset by approximately $1.1 million of loan +principal repayments. +At December 31, 2001, the Company had a $1.0 million working capital line of +credit in place that accrues interest at LIBOR plus 235 basis points and a +$3.0 million equipment line of credit that accrues interest at a rate fixed at +prime at the time of draw down. There were no borrowings under these lines of +credit outstanding at December 31, 2001. The credit facilities require, among +other items, the maintenance of minimum financial ratios and a first lien +position on the Company's accounts receivable and the financed equipment. The +Company's lines of credit expire on April 30, 2002 and are expected to be +extended and/or replaced with other credit or bank facilities, although there +can be no assurance of renewal or extension. +The Company believes that it has sufficient cash, cash equivalents, and +short-term investments for the foreseeable future. The Company's future +liquidity and capital requirements will depend on numerous factors, including, +but not limited to, the costs and timing of the expansion of manufacturing +capacity, the success of product development efforts, the timing of receipt of +regulatory approvals, the costs and timing of expansion of sales and marketing +activities, the timing of commercial launch of new products, the extent to +which existing and new products gain market acceptance, competing +technological and market developments, and the scope and timing of strategic +acquisitions. If additional financing is needed, the Company may seek to raise +funds through the sale of equity or other securities, bank borrowings or +otherwise. There can be no assurance that financing through the sale of +securities, bank borrowings or otherwise will be available to the Company on +satisfactory terms, if at all. +36 +Contractual Obligations and Commercial Commitments. The following sets forth +the Company's approximate aggregate obligations at December 31, 2001 for +future payments under contracts and other contingent commitments, for the +years 2002 and beyond: +Payments due by December 31, +------------------------------------------------------- +Contractual Obligations Total 2002 2003 2004 2005 Thereafter +----------------------- ----------- ---------- ---------- ---------- -------- ---------- +Long-term debt(1)....... $ 4,644,030 $1,057,572 $2,236,923(2) $ 247,842 $ 92,421 $1,009,272 +Operating leases(3)..... 7,012,252 934,225 1,131,534 1,142,514 579,979 3,224,000 +Employment +contracts(4)........... 3,287,469 2,090,305 1,197,164 -- -- -- +Capital +expenditures(5)........ 644,995 644,995 -- -- -- -- +Minimum commitments +under contracts(6)..... 2,100,000 300,000 225,000 225,000 225,000 1,125,000 +----------- ---------- ---------- ---------- -------- ---------- +Total contractual +obligations............ $17,688,746 $5,027,097 $4,790,621 $1,615,356 $897,400 $5,358,272 +=========== ========== ========== ========== ======== ========== +-------- +(1) Represents principal repayments required under notes payable to the +Company's lenders. See Note 8 to the financial statements included +herein. +(2) $1,903,211 of the $2,236,923 represents a note payable which is subject +to a call option in December 2003. If the note is not called in December +2003, payments of $577,542, $643,829 and $681,840 would be due in 2003, +2004, and 2005, respectively. +(3) Represents payments required under the Company's operating leases. See +Notes 11 and 12 to the financial statements included herein. +(4) Represents salary, retention bonus or severance payments payable under +the terms of employment agreements executed by the Company. See Note 11 +to the financial statements included herein. +(5) Represents payments required by non-cancelable purchase orders related to +capital expenditures. See Note 11 to the financial statements included +herein. +(6) Represents payments required pursuant to certain research, licensing and +royalty agreements executed by the Company. See Note 11 to the financial +statements included herein. +Critical Accounting Policies and Estimates +Management's Discussion and Analysis of Financial Condition and Results of +Operations discusses the Company's financial statements, which have been +prepared in accordance with accounting principles generally accepted in the +United States. The preparation of these financial statements requires +management to make estimates and assumptions that affect the reported amounts +of assets and liabilities, the disclosure of contingent assets and liabilities +at the date of the financial statements, and the reported amounts of revenues +and expenses during the reporting period. On an on-going basis, management +evaluates its judgments and estimates, including those related to bad debts, +inventories, investments, intangible assets, income taxes, revenue +recognition, restructuring costs, contingencies, and litigation. Management +bases its judgments and estimates on historical experience and on various +other factors that are believed to be reasonable under the circumstances, the +results of which form the basis for making judgments about the carrying value +of assets and liabilities that are not readily apparent from other sources. +Actual results may differ from these estimates under different assumptions or +conditions. +The Company's significant accounting policies are described in Note 2 to the +financial statements included in Item 14 of this Report. Management considers +the following policies to be most critical in understanding the more complex +judgments that are involved in preparing the Company's financial statements +and the uncertainties that could impact its results of operations, financial +condition, and cash flows. +Revenue Recognition. The Company follows U.S. Securities and Exchange +Commission Staff Accounting Bulletin No. 101, "Revenue Recognition in +Financial Statements" ("SAB 101"). This bulletin draws on existing accounting +rules and provides specific guidance on revenue recognition of up-front non- +refundable licensing and development fees. The Company licenses certain +products or technology to outside third parties, in return for which the +Company receives up-front licensing fees, some of which can be significant. In +accordance with SAB 101, the Company is required to defer immediate +recognition of these fees as revenue, and instead ratably recognize this +revenue over the related license period. +37 +The Company also enters into research and development contracts with +corporate, government or private entities. These contracts generally provide +for payments to the Company upon achievement of certain research or +development milestones. Product development revenues from these contracts are +recognized only if the specified milestone is achieved and accepted by the +customer and payment from the customer is probable. Any amounts received prior +to the performance of product development efforts are recorded as deferred +revenues. Recognition of revenue under these contracts can be sporadic, as it +is the result of achieving specific research and development milestones. +Furthermore, revenue from future milestone payments will not be recognized if +the underlying research and development milestone is not achieved. +The Company recognizes product revenues when products are shipped. The +Company does not grant price protection or product return rights to its +customers, except for warranty returns. Where a product fails to comply with +its limited warranty, the Company can either replace the product or provide +the customer with a refund of the purchase price or credit against future +purchases. Historically, returns arising from warranty issues have been +infrequent and immaterial. Accordingly, the Company expenses warranty returns +as incurred. While such returns have been immaterial in the past, management +cannot guarantee that the Company will continue to experience the same rate of +warranty claims as it has in the past. Any significant increase in product +warranty claims could have a material adverse impact on the Company's +operating results for the period in which such claims occur. +Allowance for Uncollectible Accounts Receivable. Accounts receivable are +reduced by an estimated allowance for amounts that may become uncollectible in +the future. On an ongoing basis, management performs credit evaluations of the +Company's customers and adjusts credit limits based upon the customer's +payment history and creditworthiness, as determined by a review of their +current credit information. The Company continuously monitors collections and +payments from its customers. Based upon the Company's historical experience +and any specific customer collection issues that are identified, management +uses its judgment to establish and evaluate the adequacy of the Company's +allowance for estimated credit losses. While such credit losses have been +within the Company's expectations and the allowance provided, the Company +cannot guarantee that it will continue to experience the same credit loss +rates as it has in the past. Furthermore, some of the Company's accounts +receivable have resulted from sales to distributors located in foreign +countries in South Africa and South America. Also, at December 31, 2001, +approximately $1.3 million or 21.4% of the Company's accounts receivable were +due from one major customer. Any significant changes in the liquidity or +financial position of this customer, or the economies of these foreign +nations, could have a material adverse impact on the collectibility of the +Company's accounts receivable and its future operating results. +Inventories. The Company's inventories are valued at the lower of cost or +market, determined on a first-in, first-out basis, and include the cost of raw +materials, labor and overhead. The majority of the Company's inventories are +subject to expiration dating. The Company continually evaluates the carrying +value of its inventories and when, in the opinion of management, factors +indicate that impairment has occurred, either a reserve is established against +the inventories' carrying value or the inventories are completely written off. +Management bases these decisions on the level of inventories on hand in +relation to the Company's estimated forecast of product demand, production +requirements over the next twelve months and the expiration dates of raw +materials and finished goods. Although the Company makes every effort to +ensure the accuracy of its forecasts of future product demand, any significant +unanticipated changes in demand could have a significant impact on the +carrying value of the Company's inventories and its reported operating +results. +Income Taxes. The Company has a history of losses, which has generated a +sizeable federal tax net operating loss ("NOL") carryforward of approximately +$69.1 million as of December 31, 2001. Generally accepted accounting +principles require the Company to record a valuation allowance against the +deferred tax asset associated with this NOL carryforward if it is more likely +than not that the Company will not be able to utilize the NOL carryforward to +offset future taxes. Due to the size of the NOL carryforward in relation to +the Company's history of unprofitable operations, the Company has not +recognized any of this net deferred tax asset. +It is possible that the Company could be profitable in the future at levels +which would cause management to conclude that it is more likely than not that +the Company will realize all or a portion of the NOL carryforward. +38 +Upon reaching such a conclusion, the Company would immediately record the +estimated net realizable value of the deferred tax asset at that time and +would then begin to provide for income taxes at a rate equal to the Company's +combined federal and state effective rates, which management believes would +approximate 40%. Subsequent revisions to the estimated net realizable value of +the deferred tax asset could cause the Company's provision for income taxes to +vary significantly from period to period. +Certain Relationships and Related Transactions +The Company has entered into a Commercial Lease (the "Lease") with Tech III +Partners, LLC ("Tech Partners"), which provides for the construction of a +48,000 square foot facility on land adjacent to the Company's Bethlehem, +Pennsylvania headquarters, and the lease of that facility to the Company. Tech +Partners is owned and controlled by Michael J. Gausling, the Company's +President and Chief Executive Officer, and Dr. R. Sam Niedbala, the Company's +Executive Vice President and Chief Science Officer. The facility is expected +to house manufacturing, research and development, and administrative +operations required to support the expected growth of the Company's business. +Construction of the facility is expected to be completed during the summer of +2002. +The Lease has an initial 10-year term commencing after completion of +construction and a base rent starting at $480,000 and increasing to $528,000 +per year over that term. The base rental rate may be increased after the fifth +year of the initial term in order to reflect changes in the interest rate on +debt incurred by Tech Partners to finance construction of the leased +facilities. The Company has not guaranteed any debt incurred by Tech Partners. +The Lease also provides the Company with options to renew the Lease for an +additional five years at a rental rate of $600,000 per year, and to purchase +the facility at any time during the initial ten-year term at a fair value. +Prior to deciding to enter into the Lease, the Company's Board of Directors +retained Imperial Realty Appraisal LLC, an independent commercial real estate +appraisal firm, to evaluate the proposed base rental rate under the Lease. +Imperial Realty issued an opinion indicating that the annual base rent set +forth in the Lease is below the market rental rate the Company could otherwise +expect to pay to lease a comparable commercial property in the same general +geographic market. The terms of the Lease are otherwise substantially similar +to the commercial lease entered into by the Company with a third party for its +existing Bethlehem, Pennsylvania headquarters. +On January 31, 2002, the employment agreement with Robert D. Thompson, the +Company's former Chief Executive Officer, was terminated, and Mr. Thompson +resigned from the Company. The Company and Mr. Thompson have entered into a +severance agreement pursuant to which Mr. Thompson will receive approximately +$480,000. The severance agreement provides that a $75,000 interest-free loan +previously made to Mr. Thompson in connection with his relocation from +Portland, Oregon, will be repaid by application of an amount equal to his net +bi-weekly salary commencing on or after April 17, 2002. +Recent Accounting Pronouncements +In June 2001, the Financial Accounting Standards Board ("FASB") issued +Statement of Financial Accounting Standards ("SFAS") No. 141, "Business +Combinations" ("SFAS No. 141"), which requires that all business combinations +initiated after June 30, 2001 be accounted for under the purchase method and +addresses the initial recognition and measurement of goodwill and other +intangible assets acquired in a business combination. Business combinations +accounted for under the pooling of interests method prior to June 30, 2001 +will not be affected. The adoption of SFAS No. 141 will not have any impact on +the Company's financial position or results of operations. +In June 2001, the FASB issued SAFS No. 142, "Goodwill and Other Intangible +Assets" ("SFAS No. 142"). SFAS No. 142 addresses the initial recognition and +measurement of intangible assets acquired in a business combination and the +accounting for goodwill and other intangible assets subsequent to their +acquisition. SFAS No. 142 provides that intangible assets with finite useful +lives be amortized and that goodwill and intangible assets with indefinite +lives not be amortized, but rather be tested at least annually for impairment. +The adoption of SFAS No. 142 will not have any impact on the Company's +financial position or results of operations. +39 +In August 2001, the FASB issued SFAS No. 144, "Accounting for the Impairment +or Disposal of Long-Lived Assets" ("SFAS No. 144"). SFAS No. 144 addresses the +financial accounting and reporting for the impairment or disposal of long- +lived assets and replaces SFAS No. 121, "Accounting for the Impairment of +Long-Lived Assets and for Long-Lived Assets to be Disposed of." SFAS No. 144 +provides updated guidance concerning the recognition and measurement of an +impairment loss for certain types of long-lived assets and modifies the +accounting and reporting of discontinued operations. The adoption of SFAS No. +144 will not have any impact on the Company's financial position or results of +operations. +ITEM 7A. Quantitative and Qualitative Disclosures About Market Risk. +The Company does not hold any amounts of derivative financial instruments or +derivative commodity instruments, and accordingly has no material market risk +to report under this Item. +The Company's holdings of financial instruments are comprised of U.S. +corporate debt, certificates of deposit, government securities, and commercial +paper. All such instruments are classified as securities available for sale. +The Company's debt security portfolio represents funds held temporarily +pending use in its business and operations. The Company seeks reasonable +assuredness of the safety of principal and market liquidity by investing in +rated fixed income securities while at the same time seeking to achieve a +favorable rate of return. Market risk exposure consists principally of +exposure to changes in interest rates. If changes in interest rates would +affect the investments adversely, the Company could decide to hold the +security to maturity or sell the security. The Company's holdings are also +exposed to the risks of changes in the credit quality of issuers. The Company +typically invests in the shorter end of the maturity spectrum. +The Company does not currently have any foreign currency exchange contracts +or purchase currency options to hedge local currency cash flows. The Company +has operations in The Netherlands which are subject to foreign currency +fluctuations. As currency rates change, translation of income statements of +these operations from Euros to U.S. dollars affects year-to-year comparability +of operating results. The Company's operations in The Netherlands represented +approximately $2.0 million or 1% of the Company's revenues for the year ended +December 31, 2001. Management does not expect the risk of foreign currency +fluctuations to be material. +ITEM 8. Financial Statements and Supplementary Data. +Information with respect to this Item is contained in the Company's +Financial Statements included in Item 14 of this Annual Report on Form 10-K. +ITEM 9. Changes in and Disagreements with Accountants on Accounting and +Financial Disclosure. +None. +40 +PART III +The Company has omitted from Part III the information that will appear in +the Company's Definitive Proxy Statement for its 2002 Annual Meeting of +Stockholders (the "Proxy Statement"), which will be filed within 120 days +after the end of the Company's fiscal year pursuant to Regulation 14A. +ITEM 10. Directors and Executive Officers of the Registrant. +The information required by this item is incorporated by reference to the +information under the captions "Election of Directors," "Executive Officers," +and "Section 16(a) Beneficial Ownership Reporting Compliance" in the Proxy +Statement. +ITEM 11. Executive Compensation. +The information required by this item is incorporated by reference to the +information under the caption "Executive Compensation" in the Proxy Statement. +ITEM 12. Security Ownership of Certain Beneficial Owners and Management. +The information required by this item with respect to the securities +ownership of certain beneficial owners and management is incorporated by +reference to the information under the caption "Principal Stockholders" in the +Proxy Statement. +ITEM 13. Certain Relationships and Related Transactions. +The information required by this item is incorporated by reference to the +information under the captions "Certain Relationships and Related +Transactions" and "Employment Agreements" in the Proxy Statement. +PART IV +ITEM 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K. +(a)(1) and (a)(2). For a list of the Financial Statements filed herewith, +see the Index to Financial Statements following the signature page to this +Report. No schedules are included with the Financial Statements because the +required information is inapplicable or is presented in the Financial +Statements or related notes thereto. +(a)(3) Exhibits. See Index to Exhibits following the Financial Statements in +this Report. +(b) Reports on Form 8-K. +1. Current Report on Form 8-K dated October 24, 2001, attaching a press +release that announced third quarter 2001 financial results and disclosed +certain "Frequently Asked Questions" and answers to those questions. +41 +SIGNATURES +Pursuant to the requirements of Section 13 or 15(d) of the Securities +Exchange Act of 1934, the Registrant has duly caused this Report to be signed +on its behalf by the undersigned, thereunto duly authorized, on March 28, +2002. +Orasure Technologies, Inc. +/s/ Michael J. Gausling +By: _________________________________ +Michael J. Gausling +President and Chief Executive +Officer +Pursuant to the requirements of the Securities Exchange Act of 1934, this +report has been signed on March 28, 2002, by the following persons on behalf +of the Registrant and in the capacities indicated. +Signature Title +--------- ----- +/s/ Michael J. Gausling President, Chief Executive Officer and +___________________________________________ Director (Principal Executive Officer) +Michael J. Gausling +/s/ Ronald H. Spair Executive Vice President and Chief +___________________________________________ Financial Officer (Principal Financial +Ronald H. Spair Officer) +/s/ Mark L. Kuna Controller +___________________________________________ (Principal Accounting Officer) +Mark L. Kuna +/s/ *Michael G. Bolton Director +___________________________________________ +Michael G. Bolton +/s/ *William W. Crouse Director +___________________________________________ +William W. Crouse +/s/ *Carter H. Eckert Director +___________________________________________ +Carter H. Eckert +/s/ *Frank G. Hausmann Director +___________________________________________ +Frank G. Hausmann +/s/ *Gregory B. Lawless Director +___________________________________________ +Gregory B. Lawless +/s/ *Roger L. Pringle Director +___________________________________________ +Roger L. Pringle +/s/ *Ronald H. Spair +*By: ______________________________________ +Ronald H. Spair +(Attorney-in-Fact) +42 +INDEX TO FINANCIAL STATEMENTS +Page +---- +Report of Arthur Andersen LLP--Independent Public Accountants.............. F-2 +Report of PricewaterhouseCoopers LLP--Independent Accountants.............. F-3 +Balance Sheets............................................................. F-4 +Statements of Operations................................................... F-5 +Statements of Stockholders' Equity......................................... F-6 +Statements of Cash Flows................................................... F-7 +Notes to Financial Statements.............................................. F-8 +F-1 +REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS +To OraSure Technologies, Inc.: +We have audited the accompanying balance sheets of OraSure Technologies, +Inc. (a Delaware corporation) as of December 31, 2001 and 2000, and the +related statements of operations, stockholders' equity and cash flows for the +years ended December 31, 2001 and 2000, the three months ended December 31, +1999, and the year ended September 30, 1999. These financial statements are +the responsibility of the Company's management. Our responsibility is to +express an opinion on these financial statements based on our audits. We did +not audit the financial statements of Epitope, Inc., a company acquired during +2000 in a transaction accounted for as a pooling of interests, as discussed in +Note 1. Such statements are included in the financial statements of OraSure +Technologies, Inc. and reflect total revenues of 39 percent and 42 percent for +the three months ended December 31, 1999 and year ended September 30, 1999, +respectively, of the related totals. Those statements were audited by other +auditors whose report has been furnished to us, and our opinion, insofar as it +relates to amounts included for Epitope, Inc., is based solely upon the report +of the other auditors. +We conducted our audits in accordance with auditing standards generally +accepted in the United States. Those standards require that we plan and +perform the audit to obtain reasonable assurance about whether the financial +statements are free of material misstatement. An audit includes examining, on +a test basis, evidence supporting the amounts and disclosures in the financial +statements. An audit also includes assessing the accounting principles used +and significant estimates made by management, as well as evaluating the +overall financial statement presentation. We believe that our audits and the +report of other auditors provide a reasonable basis for our opinion. +In our opinion, based on our audits and the report of other auditors, the +financial statements referred to above present fairly, in all material +respects, the financial position of OraSure Technologies, Inc. as of +December 31, 2001 and 2000, and the results of its operations and its cash +flows for the years ended December 31, 2001 and 2000, the three months ended +December 31, 1999, and the year ended September 30, 1999, in conformity with +accounting principles generally accepted in the United States. +ARTHUR ANDERSEN LLP +Philadelphia, Pennsylvania, +January 31, 2002 (except for +the facility lease discussed +in Note 12, as to which the +date is March 21, 2002) +F-2 +REPORT OF INDEPENDENT ACCOUNTANTS +To the Board of Directors and Shareholders of +OraSure Technologies, Inc. +In our opinion, the consolidated statements of operations, of changes in +shareholders' equity and of cash flows of Epitope, Inc. (the Company) (not +presented herein) present fairly, in all material respects, the Company's +results of operations and cash flows for the three months ended December 31, +1999 and for the year ended September 30, 1999, in conformity with accounting +principles generally accepted in the United States of America. These financial +statements are the responsibility of the Company's management; our +responsibility is to express an opinion on these financial statements based on +our audits. We conducted our audits of these statements in accordance with +auditing standards generally accepted in the United States of America, which +require that we plan and perform the audit to obtain reasonable assurance +about whether the financial statements are free of material misstatement. An +audit includes examining, on a test basis, evidence supporting the amounts and +disclosures in the financial statements, assessing the accounting principles +used and significant estimates made by management and evaluating the overall +financial statement presentation. We believe that our audits provide a +reasonable basis for our opinion. We have not audited the consolidated +financial statements of the Company for any period subsequent to December 31, +1999. +PricewaterhouseCoopers LLP +Portland, Oregon +January 15, 2001 +F-3 +ORASURE TECHNOLOGIES, INC. +BALANCE SHEETS +December 31, +---------------------------- +2001 2000 +------------- ------------- +ASSETS +CURRENT ASSETS: +Cash and cash equivalents....................... $ 2,426,346 $ 5,095,639 +Short-term investments.......................... 12,764,903 14,956,779 +Accounts receivable, net of allowance for +doubtful accounts of $209,492 and $114,685..... 6,057,927 5,276,772 +Notes receivable from officer................... 75,000 175,649 +Inventories..................................... 4,444,772 1,495,604 +Prepaid expenses and other...................... 1,038,511 1,113,691 +------------- ------------- +Total current assets........................... 26,807,459 28,114,134 +PROPERTY AND EQUIPMENT, net...................... 7,800,137 6,738,034 +PATENTS AND PRODUCT RIGHTS, net.................. 2,042,533 2,402,386 +OTHER ASSETS..................................... 634,546 481,618 +------------- ------------- +$ 37,284,675 $ 37,736,172 +============= ============= +LIABILITIES AND STOCKHOLDERS' EQUITY +CURRENT LIABILITIES: +Current portion of long-term debt............... $ 1,057,572 $ 1,125,138 +Accounts payable................................ 2,874,061 2,120,534 +Accrued expenses................................ 3,111,886 3,428,862 +------------- ------------- +Total current liabilities...................... 7,043,519 6,674,534 +------------- ------------- +LONG-TERM DEBT................................... 3,586,458 4,644,098 +------------- ------------- +OTHER LIABILITIES................................ 114,025 245,464 +------------- ------------- +COMMITMENTS AND CONTINGENCIES (Note 11) +STOCKHOLDERS' EQUITY: +Preferred stock, par value $.000001; 25,000,000 +shares authorized, none issued................. -- -- +Common stock, par value $.000001; 120,000,000 +shares authorized, 37,403,269 and 36,434,004 +shares issued and outstanding.................. 37 36 +Additional paid-in capital...................... 152,758,591 148,767,789 +Accumulated other comprehensive loss............ (125,664) (231,247) +Accumulated deficit............................. (126,092,291) (122,364,502) +------------- ------------- +Total stockholders' equity..................... 26,540,673 26,172,076 +------------- ------------- +$ 37,284,675 $ 37,736,172 +============= ============= +The accompanying notes are an integral part of these statements. +F-4 +ORASURE TECHNOLOGIES, INC. +STATEMENTS OF OPERATIONS +For the For the year +For the year ended three ended +December 31, months ended September +--------------------------- December 31, 30, +2001 2000 1999 1999 +------------ ------------- ------------ ------------ --- --- +REVENUES: +Product................ $ 31,095,850 $ 28,095,408 $ 6,460,501 $ 23,147,808 +Licensing and product +development........... 1,477,494 692,808 361,153 898,213 +------------ ------------- ----------- ------------ +32,573,344 28,788,216 6,821,654 24,046,021 +COST OF PRODUCTS SOLD... 12,333,695 11,102,096 2,491,760 9,125,995 +------------ ------------- ----------- ------------ +Gross profit.......... 20,239,649 17,686,120 4,329,894 14,920,026 +------------ ------------- ----------- ------------ +OPERATING EXPENSES: +Research and +development........... 9,389,313 10,399,120 1,412,288 5,590,807 +Sales and marketing.... 7,880,496 6,932,068 1,682,030 5,696,673 +General and +administrative........ 6,852,326 6,876,516 1,518,488 6,224,408 +Acquired in-process +technology............ -- -- -- 1,500,000 +Merger--related........ -- 7,607,158 -- -- +Restructuring-- +related............... 450,000 -- -- -- +------------ ------------- ----------- ------------ +24,572,135 31,814,862 4,612,806 19,011,888 +------------ ------------- ----------- ------------ +Operating loss........ (4,332,486) (14,128,742) (282,912) (4,091,862) +INTEREST EXPENSE........ (402,686) (490,415) (135,357) (544,643) +INTEREST INCOME......... 933,050 1,315,666 183,855 594,928 +FOREIGN CURRENCY GAIN +(LOSS)................. 3,122 (18,696) (186,873) (141,687) +GAIN ON SALE OF +SECURITIES............. 100,000 600,000 -- -- +------------ ------------- ----------- ------------ +Loss before income +taxes................ (3,699,000) (12,722,187) (421,287) (4,183,264) +INCOME TAXES............ 28,789 24,363 50,000 50,000 +------------ ------------- ----------- ------------ +NET LOSS................ $ (3,727,789) $ (12,746,550) $ (471,287) $ (4,233,264) +============ ============= =========== ============ +BASIC AND DILUTED NET +LOSS PER SHARE......... $ (0.10) $ (0.36) $ (0.02) $ (0.14) +============ ============= =========== ============ +WEIGHTED AVERAGE NUMBER +OF SHARES OUTSTANDING.. 36,868,101 35,002,283 30,887,007 30,596,882 +============ ============= =========== ============ +The accompanying notes are an integral part of these statements. +F-5 +ORASURE TECHNOLOGIES, INC. +STATEMENTS OF STOCKHOLDERS' EQUITY +Accumulated +Common Stock Additional Other +----------------- Paid-in Comprehensive Accumulated +Shares Amount Capital Income (Loss) Deficit Total +---------- ------ ------------ ------------- ------------- ------------ +Balance at September 30, +1998................... 26,228,340 $ 26 $115,589,348 $ 15,042 $(104,902,963) $ 10,701,453 +Sale of common stock, +net of expenses........ 5,720,003 6 8,851,345 -- -- 8,851,351 +Common stock issued upon +exercise of options.... 632,580 1 3,028,575 -- -- 3,028,576 +Common stock issued as +compensation........... 6,233 -- 29,996 -- -- 29,996 +Common stock issued +under Employee Stock +Purchase Plan and +Savings Plan........... 28,965 -- 135,172 -- -- 135,172 +Compensation expense for +stock option grants.... -- -- 321,006 -- -- 321,006 +------------ +Comprehensive loss: +Net loss............... -- -- -- -- (4,233,264) (4,233,264) +Currency translation +adjustment............ -- -- -- (74,260) -- (74,260) +Net unrealized loss on +marketable +securities............ -- -- -- (200,000) -- (200,000) +------------ +Total comprehensive +loss.................. (4,507,524) +---------- ---- ------------ --------- ------------- ------------ +Balance at September 30, +1999................... 32,616,121 33 127,955,442 (259,218) (109,136,227) 18,560,030 +Common stock issued upon +exercise of options.... 12,846 -- 58,250 -- -- 58,250 +Common stock issued +under Employee Stock +Purchase Plan and +Savings Plan........... 3,944 -- 21,689 -- -- 21,689 +Compensation expense for +stock option grants.... -- -- 87,200 -- -- 87,200 +------------ +Comprehensive loss: +Net loss............... -- -- -- -- (471,287) (471,287) +Currency translation +adjustment............ -- -- -- (38,298) -- (38,298) +Net unrealized loss on +marketable +securities............ -- -- -- (131,250) -- (131,250) +Adjustment for change +in year-end........... -- -- (7,092) 169,548 (10,438) 152,018 +------------ +Total comprehensive +loss.................. (488,817) +---------- ---- ------------ --------- ------------- ------------ +Balance at December 31, +1999................... 32,632,911 33 128,115,489 (259,218) (109,617,952) 18,238,352 +Common stock issued upon +exercise of options.... 1,319,624 1 5,720,997 -- -- 5,720,998 +Common stock issued upon +exercise of warrants... 2,405,907 2 13,865,364 -- -- 13,865,366 +Common stock issued +under Employee Stock +Purchase Plan and +Savings Plan........... 75,562 -- 273,254 -- -- 273,254 +Compensation expense for +stock option grants.... -- -- 792,685 -- -- 792,685 +------------ +Comprehensive loss: +Net loss............... -- -- -- -- (12,746,550) (12,746,550) +Currency translation +adjustment............ -- -- -- (61,140) -- (61,140) +Net unrealized gain on +marketable +securities............ -- -- -- 89,111 -- 89,111 +------------ +Total comprehensive +loss.................. (12,718,579) +---------- ---- ------------ --------- ------------- ------------ +Balance at December 31, +2000................... 36,434,004 36 148,767,789 (231,247) (122,364,502) 26,172,076 +Common stock issued upon +exercise of options.... 968,729 1 3,851,805 -- -- 3,851,806 +Common stock issued +under Employee Stock +Purchase Plan and +Savings Plan........... 536 -- 2,123 -- -- 2,123 +Compensation expense for +stock option grants.... -- -- 136,874 -- -- 136,874 +------------ +Comprehensive loss: +Net loss............... -- -- -- -- (3,727,789) (3,727,789) +Currency translation +adjustment............ -- -- -- (75,670) -- (75,670) +Net unrealized gain on +marketable +securities............ -- -- -- 181,253 -- 181,253 +------------ +Total comprehensive +loss.................. (3,622,206) +---------- ---- ------------ --------- ------------- ------------ +Balance at December 31, +2001................... 37,403,269 $ 37 $152,758,591 $(125,664) $(126,092,291) $ 26,540,673 +========== ==== ============ ========= ============= ============ +The accompanying notes are an integral part of these statements. +F-6 +ORASURE TECHNOLOGIES, INC. +STATEMENTS OF CASH FLOWS +For the year ended For the three For the +December 31, months ended year ended +-------------------------- December 31, September +2001 2000 1999 30, 1999 +------------ ------------ ------------- ------------ +OPERATING ACTIVITIES: +Net loss............... $ (3,727,789) $(12,746,550) $ (471,287) $ (4,233,264) +Adjustments to +reconcile net loss to +net cash provided by +(used in) operating +activities: +Stock based +compensation +expense.............. 136,874 792,685 87,200 321,006 +Common stock issued as +compensation for +services............. -- 62,409 -- 105,471 +Amortization of +deferred revenue..... (179,167) (143,334) (40,313) (107,500) +Acquired in-process +technology........... -- -- -- 1,500,000 +Depreciation and +amortization......... 2,175,055 2,243,001 448,654 1,855,479 +Gain on sale of +securities and +disposition of +investment in +affiliated company... (116,853) (600,000) -- -- +(Gain) loss on +disposition of +property and +equipment............ 173,975 10,844 42,245 (36,952) +Provision for reserve +for excess and +obsolete +inventories.......... 600,000 1,141,351 -- -- +Deferred income +taxes................ -- -- 91,497 -- +Changes in assets and +liabilities-- +Accounts receivable.. (1,118,408) (1,853,514) (261,924) (985,070) +Inventories.......... (3,549,168) (231,516) 237,956 (300,882) +Prepaid expenses and +other............... 175,829 (153,631) (76,981) 31,817 +Accounts payable..... 443,050 308,789 (199,275) 47,904 +Accrued expenses and +other............... (269,248) 1,125,020 482,312 843,381 +------------ ------------ ----------- ------------ +Net cash provided by +(used in) operating +activities......... (5,255,850) (10,044,446) 340,084 (958,610) +------------ ------------ ----------- ------------ +INVESTING ACTIVITIES: +Purchases of property +and equipment......... (2,763,639) (3,071,565) (626,036) (1,701,520) +Proceeds from the sale +of property and +equipment............. 33,231 -- 78,250 98,250 +Purchase of patents and +product rights........ -- (619,589) (18,024) (1,627,377) +Purchase of short-term +investments........... (21,297,303) (24,869,468) (1,250,261) (37,624,613) +Proceeds from sale of +short-term +investments........... 23,420,432 22,339,595 2,016,757 29,383,614 +Proceeds from sale of +securities............ 637,500 600,000 -- -- +Proceeds from +disposition of +investment in +affiliated company.... 106,102 -- -- -- +Investment in +affiliated companies.. -- (20,404) (32,181) (17,435) +(Increase) decrease in +other assets.......... (202,819) 50,000 -- 195,273 +------------ ------------ ----------- ------------ +Net cash provided by +(used in) investing +activities......... (66,496) (5,591,431) 168,505 (11,293,808) +------------ ------------ ----------- ------------ +FINANCING ACTIVITIES: +Proceeds from term +debt.................. -- -- -- 2,219,433 +Repayment of term +debt.................. (1,125,206) (1,054,194) (250,374) (1,872,475) +Net proceeds from +issuance of common +stock................. 3,853,929 19,797,206 79,939 11,939,624 +------------ ------------ ----------- ------------ +Net cash provided by +(used in) financing +activities......... 2,728,723 18,743,012 (170,435) 12,286,582 +------------ ------------ ----------- ------------ +EFFECT OF FOREIGN +EXCHANGE RATE CHANGES +ON CASH................ (75,670) (61,140) (38,298) (74,260) +------------ ------------ ----------- ------------ +NET INCREASE (DECREASE) +IN CASH AND CASH +EQUIVALENTS............ (2,669,293) 3,045,995 299,856 (40,096) +CASH AND CASH +EQUIVALENTS, BEGINNING +OF PERIOD.............. 5,095,639 2,049,644 1,749,788 2,370,469 +------------ ------------ ----------- ------------ +CASH AND CASH +EQUIVALENTS, END OF +PERIOD................. $ 2,426,346 $ 5,095,639 $ 2,049,644 $ 2,330,373 +============ ============ =========== ============ +The accompanying notes are an integral part of these statements. +F-7 +ORASURE TECHNOLOGIES, INC. +NOTES TO THE FINANCIAL STATEMENTS +1. BACKGROUND: +The Company +OraSure Technologies, Inc. (the "Company") develops, manufactures and +markets oral specimen collection devices using its proprietary oral fluid +technologies, proprietary diagnostic products including in vitro diagnostic +tests, and other medical devices. These products are sold in the United States +and certain foreign countries to government agencies, clinical laboratories, +physician offices, hospitals, commercial and industrial entities and various +distributors. +Merger +On September 29, 2000, STC Technologies, Inc. ("STC") and Epitope, Inc. +("Epitope") were merged (the "Merger") into the Company, a newly formed +subsidiary of Epitope incorporated under Delaware law solely for the purposes +of combining the two companies and changing the state of incorporation of +Epitope from Oregon to Delaware. The companies were merged pursuant to an +Agreement and Plan of Merger, dated May 6, 2000, by and among Epitope, the +Company and STC, which was subsequently approved by both companies' +stockholders on September 29, 2000. The Merger was accounted for as a pooling +of interests and, accordingly, all prior period financial statements of +Epitope have been restated to include the results of operations, financial +position and cash flows of STC. Information concerning common stock, employee +stock plans and per share data has been restated on an equivalent share basis. +The financial statements as of September 30, 1999 and for the year then ended +include Epitope's previous September 30 fiscal year amounts and STC's December +31, 1999 calendar year amounts. +Change in year-end +On September 29, 2000, the Board of Directors of Epitope approved a change +in the fiscal year-end of Epitope from September 30 to December 31, effective +with the calendar year beginning January 1, 2000. A three-month transition +period from October 1, 1999 through December 31, 1999 (the "Transition +Period") preceded the start of the 2000 fiscal year. References to "1999" mean +the year ended September 30, 1999 and include Epitope's previous September 30 +fiscal year amounts and STC's December 31, 1999 calendar year amounts. +References to "2001" and "2000" mean the combined results of the two companies +for the years ended December 31, 2001 and 2000, respectively. As a result of +the Merger, financial statements for the Transition Period include amounts for +Epitope and STC for the three months ended December 31, 1999. Accordingly, +STC's results of operations for the three months ended December 31, 1999 are +included in both the financial statements for 1999 and for the Transition +Period. Included in the statement of stockholders' equity is a $152,018 +adjustment for the change in fiscal year-end, which represents STC's results +of operations for the three months ended December 31, 1999 that is included in +both 1999 and the Transition Period. +F-8 +A reconciliation of revenues, operating income (loss) and net income (loss) +of Epitope and STC for the periods prior to the combination is as follows: +Three months +ended Year ended +December 31, September +1999 30, 1999 +------------ ----------- +Revenues: +Epitope......................................... $2,669,026 $10,031,020 +STC............................................. 4,152,628 14,015,001 +---------- ----------- +Combined....................................... $6,821,654 $24,046,021 +========== =========== +Operating income (loss): +Epitope......................................... $ (549,488) $(3,515,544) +STC............................................. 266,576 (576,318) +---------- ----------- +Combined....................................... $ (282,912) $(4,091,862) +========== =========== +Net income (loss): +Epitope......................................... $ (481,725) $(3,237,644) +STC............................................. 10,438 (995,620) +---------- ----------- +Combined....................................... $ (471,287) $(4,233,264) +========== =========== +There were no material adjustments required to conform the accounting +policies of the two companies. Certain amounts of Epitope have been +reclassified to conform to the current presentation. The amounts depicted +above for both companies have been adjusted to reflect the elimination of +intercompany transactions between Epitope and STC. +In connection with the Merger, during the year ended December 31, 2000, the +Company recorded Merger-related expenses of $7.6 million, which were comprised +of the following: +Cash costs: +Transaction costs............................................. $5,273,748 +Employee costs................................................ 1,079,607 +Other integration costs....................................... 608,393 +---------- +Subtotal..................................................... 6,961,748 +Stock-based compensation....................................... 645,410 +---------- +Total Merger-related expenses.................................. $7,607,158 +========== +Transaction costs include investment banking, legal, accounting, printing +and other direct costs of the Merger. Employee costs represent severance +benefits paid to terminated employees whose responsibilities were deemed +redundant as a result of the Merger, as well as certain relocation expenses. +Other integration costs include financial system conversion costs and +integration-related travel expenses. Stock-based compensation represents the +amount of unamortized deferred compensation on certain nonqualified options +granted by Epitope in prior years, which were immediately accelerated upon the +closing of the Merger under terms of the grants. Of the $7.6 million Merger- +related expenses incurred, $690,750 was accrued at December 31, 2000 and paid +in 2001. +2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES: +Use of Estimates +The preparation of financial statements in conformity with accounting +principles generally accepted in the United States requires management to make +estimates and assumptions that affect the reported amounts of +F-9 +assets and liabilities and disclosure of contingent assets and liabilities at +the date of the financial statements and the reported amounts of revenues and +expenses during the reporting period. Actual results could differ from those +estimates. +Cash and Cash Equivalents +The Company considers all highly liquid investments purchased with an +original maturity of ninety days or less to be cash equivalents. As of +December 31, 2001 and 2000, cash equivalents consisted of certificates of +deposit, commercial paper and U.S. government and agency obligations. +Short-term Investments +The Company considers all short-term investments as available-for-sale +securities, in accordance with Statement of Financial Accounting Standards +("SFAS") No. 115, "Accounting for Certain Investments in Debt and Equity +Securities." These securities are comprised of certificates of deposits, U.S. +government and agency obligations and corporate bonds with original maturities +greater than ninety days and less than one year. Available-for-sale securities +are carried at fair value, based upon quoted market prices with unrealized +gains and losses reported in stockholders' equity as a component of +accumulated other comprehensive income (loss). +The following is a summary of available-for-sale securities at December 31, +2001 and 2000: +Gross Gross +Amortized Unrealized Unrealized +Cost Gains Losses Fair Value +----------- ---------- ---------- ----------- +December 31, 2001 +Certificates of deposit........ $ 2,398,963 $ 709 $ -- $ 2,399,672 +Government and agency bonds.... 5,027,637 70,200 -- 5,097,837 +Corporate bonds................ 5,267,939 37,109 (37,654) 5,267,394 +----------- -------- -------- ----------- +Total current available-for-sale +securities..................... $12,694,539 $108,018 $(37,654) $12,764,903 +=========== ======== ======== =========== +December 31, 2000 +Certificates of deposit........ $ 2,864,038 $ -- $ -- $ 2,864,038 +Government and agency bonds.... 6,587,463 49,785 -- 6,637,248 +Corporate bonds................ 5,366,167 89,326 -- 5,455,493 +----------- -------- -------- ----------- +Total current available-for-sale +securities..................... $14,817,668 $139,111 $ -- $14,956,779 +=========== ======== ======== =========== +In addition, at December 31, 2000, certain available-for-sale marketable +securities with a carrying value of $287,500, including an unrealized loss of +$250,000, were classified as other assets due to the Company's intent to hold +these securities for greater than one year. In 2001, the Company recorded a +gain of $100,000 upon the sale of these securities. +Supplemental Cash Flow Information +For 2001, 2000, the Transition Period and 1999, the Company paid interest of +$402,686, $490,410, $135,357 and $565,025, respectively. +For 2001, 2000, the Transition Period and 1999, the Company recorded +provisions for bad debts of $100,000, $0, $0 and $8,851, respectively. The +Company had deductions of $5,193, $4,269, $0 and $0 against the allowance for +doubtful accounts in 2001, 2000, the Transition Period and 1999, respectively. +During 2001, the Company exchanged $337,253 of accounts receivable for an +investment in a nonaffiliated entity. +F-10 +Inventories +Inventories are stated at the lower of cost or market determined on a first- +in, first-out basis, and include the cost of raw materials, labor and +overhead. The majority of the Company's inventories are subject to expiration +dating. The Company continually evaluates quantities on hand and the carrying +value of its inventories to determine the need for reserves for excess and +obsolete inventories, based primarily on the estimated forecast of product +sales. When factors indicate that impairment has occurred, either a reserve is +established against the inventories' carrying value or the inventories are +completely written off, as in the case of lapsing expiration dates. The +Company currently buys its entire Histofreezer(R) product line from a foreign +vendor, with such purchases payable in Euros. Changes in the exchange rate of +the Euro could impact the Company's product cost. +Property and Equipment +Property and equipment are stated at cost. Additions or improvements are +capitalized, while repairs and maintenance are charged to expense. +Depreciation and amortization are provided using the straight-line method over +the estimated useful lives of the related assets or the lease term, whichever +is shorter. Buildings are depreciated over 20 years, while computer equipment, +machinery and equipment, and furniture and fixtures are depreciated over three +to ten years. Leasehold improvements are generally amortized over the shorter +of the estimated useful lives or the terms of the related leases. When assets +are sold or otherwise disposed of, the related property amounts are relieved +from the accounts, and any gain or loss is recorded in the statement of +operations. +Patents and Product Rights +Patents and product rights consist of costs associated with the acquisition +of patents and product distribution rights and direct costs associated with +patent submissions. Patents and product rights are amortized using the +straight-line method over estimated useful lives of five to ten years. +Amortization expense for 2001, 2000, the Transition Period and 1999 was +$359,853, $816,111, $123,366 and $482,106, respectively. +Revenue Recognition +The Company recognizes product revenues when products are shipped. The +Company does not grant price protection or product return rights to its +customers, except for warranty returns. Historically, returns arising from +warranty issues have been infrequent and immaterial. Accordingly, the Company +expenses warranty returns as incurred. +The Company follows U.S. Securities and Exchange Commission Staff Accounting +Bulletin No. 101 "Revenue Recognition in Financial Statements" ("SAB 101"). +The bulletin draws on existing accounting rules and provides specific guidance +on revenue recognition of up-front non-refundable licensing and development +fees. In accordance with SAB 101, up-front licensing fees are deferred and +recognized ratably over the related license period. Product development +revenues are recognized over the period in which the related product +development efforts are performed. Amounts received prior to the performance +of product development efforts are recorded as deferred revenues. Grant +revenue is recognized as the related work is performed and costs are incurred. +In accordance with Emerging Issues Task Force ("EITF") Issue No. 00-10, +"Accounting for Shipping and Handling Fees and Costs," the Company records +shipping and handling charges billed to customers as revenue. +Significant Customer Concentration +In 2001, 2000 and 1999, one customer accounted for approximately 29 percent, +30 percent and 28 percent of total revenues, respectively. The same customer +accounted for approximately 21 percent and 24 percent of accounts receivable +as of December 31, 2001 and 2000, respectively. +F-11 +Research and Development +Research and development costs are charged to expense as incurred. +Income Taxes +The Company follows SFAS No. 109, "Accounting for Income Taxes" ("SFAS No. +109"), pursuant to which the liability method is used in accounting for income +taxes. Under this method, deferred tax assets and liabilities are determined +based on differences between the financial reporting and tax bases of assets +and liabilities and are measured using enacted tax rates that are expected to +be in effect when the differences reverse. +Foreign Currency Translation +Pursuant to SFAS No. 52, "Foreign Currency Translation," the assets and +liabilities of the Company's foreign operations are translated from Euros into +U.S. dollars at current exchange rates as of the balance sheet date, and +revenues and expenses are translated at average exchange rates for the period. +Resulting translation adjustments are reflected as a separate component of +stockholders' equity. +Stock-Based Compensation +The Company accounts for stock-based compensation to employees and directors +using the intrinsic value method in accordance with APB Opinion No. 25, +"Accounting for Stock Issued to Employees" and related interpretations. The +Company accounts for stock-based compensation to nonemployees using the fair +value method in accordance with SFAS No. 123, "Accounting for Stock-Based +Compensation" ("SFAS No. 123") and EITF Issue No. 96-18, "Accounting for +Equity Instruments That Are Issued to Other Than Employees for Acquiring or in +Conjunction with Selling, Goods or Services" ("EITF No. 96-18"). +Net Loss Per Common Share +The Company has presented basic and diluted net loss per share pursuant to +SFAS No. 128, "Earnings per Share" ("SFAS 128"). In accordance with SFAS 128, +basic and diluted net loss per share has been computed using the weighted- +average number of shares of common stock outstanding during the period. +Diluted loss per share is generally computed assuming the conversion or +exercise of all dilutive securities such as common stock options and warrants; +however, outstanding common stock options and warrants to purchase 3,915,233, +4,677,357, 6,907,212 and 7,002,673 shares were excluded from the computation +of diluted net loss per common share for 2001, 2000, the Transition Period and +1999, respectively, because they were anti-dilutive due to the Company's +losses. +Impairment of Long-Lived Assets +In accordance with SFAS No. 144, "Accounting for the Impairment or Disposal +of Long-Lived Assets" ("SFAS No. 144"), if indicators of impairment exist, the +Company assesses the recoverability of the affected long-lived assets, which +include property and equipment and patents and product rights, by determining +whether the carrying value of such assets can be recovered through the sum of +the undiscounted future operating cash flows and eventual disposition of the +asset. If impairment is indicated, the Company measures the amount of such +impairment by comparing the carrying value of the assets to the fair value of +these assets, generally determined based on the present value of the expected +future cash flows associated with the use of the asset. Management believes +the future cash flows to be received from the long-lived assets will exceed +the assets' carrying value, and accordingly the Company has not recognized any +impairment losses through December 31, 2001. +F-12 +Other Comprehensive Income (Loss) +The Company follows SFAS No. 130, "Reporting Comprehensive Income." This +statement requires the classification of items of other comprehensive income +(loss) by their nature and disclosure of the accumulated balance of other +comprehensive income (loss), separately from retained earnings and additional +paid-in capital, in the equity section of the balance sheet. +Restructuring-related Expenses +In February, 2001, the Company announced plans to restructure certain of its +manufacturing operations. As a result of this restructuring, the Company +incurred an infrequent charge of $450,000 for restructuring costs, primarily +comprised of expenses for employee severance, travel and transport resulting +from relocating and consolidating manufacturing operations. All restructuring- +related expenses were paid by June 30, 2001. +Recent Accounting Pronouncements +In June 2001, the Financial Accounting Standards Board ("FASB") issued SFAS +No. 141, "Business Combinations" ("SFAS No. 141"), which requires that all +business combinations initiated after June 30, 2001 be accounted for under the +purchase method and addresses the initial recognition and measurement of +goodwill and other intangible assets acquired in a business combination. +Business combinations accounted for under the pooling of interests method +prior to June 30, 2001 will not be changed. The adoption of SFAS No. 141 by +the Company will not have any impact on the Company's financial position or +results of operations. +In June 2001, the FASB issued SAFS No. 142, "Goodwill and Other Intangible +Assets" ("SFAS No. 142"). SFAS No. 142 addresses the initial recognition and +measurement of intangible assets acquired in a business combination and the +accounting for goodwill and other intangible assets subsequent to their +acquisition. SFAS No. 142 provides that intangible assets with finite useful +lives be amortized, and that goodwill and intangible assets with indefinite +lives not be amortized, but rather be tested at least annually for impairment. +The adoption of SFAS No. 142 will not have any impact on the Company's +financial position or results of operations. +In June 2001, the FASB issued SFAS No. 143, "Accounting for Asset Retirement +Obligations" ("SFAS No. 143"). SFAS No. 143 addresses financial accounting and +reporting for obligations associated with the retirement of long-lived assets +and the associated asset retirement costs. SFAS No. 143 requires the fair +value of a liability associated with an asset retirement be recognized in the +period in which it is incurred, with the associated retirement costs +capitalized as part of the carrying amount of the long-lived asset and +subsequently depreciated over its useful life. The adoption of SFAS No. 143 +will not have any impact on the Company's financial position or results of +operations. +Gain on Sale of Securities +In December 2001, the Company recognized a gain of $100,000 on the sale of +50,000 shares of LabOne, Inc. common stock received in connection with a +distribution agreement entered into by the Company and LabOne, Inc. in April +1999. The Company's original investment associated with these shares was +$537,500. The Company no longer holds any common shares or warrants of LabOne, +Inc. +In December 1996, a subsidiary of the Company completed a merger with Andrew +and Williamson Sales, Co. ("A&W"), which was rescinded on May 27, 1997. The +Company received A&W preferred stock in the recission, which had been carried +at zero value due to the circumstances surrounding A&W's financial condition +at the time the stock was received in 1997. In 2000, the Company sold the A&W +preferred stock for $600,000. +F-13 +Reclassifications +Certain amounts from prior periods have been reclassified to conform to the +current year presentations. +3. INVENTORIES: +December 31, +------------------------- +2001 2000 +------------ ----------- +Raw materials................................. $ 2,918,825 $ 473,575 +Work in process............................... 644,397 348,819 +Finished goods................................ 881,550 673,210 +------------ ----------- +$ 4,444,772 $ 1,495,604 +============ =========== +4. PROPERTY AND EQUIPMENT: +December 31, +------------------------- +2001 2000 +------------ ----------- +Building and leasehold improvements........... $ 5,464,353 $ 4,599,859 +Machinery and equipment....................... 9,935,897 7,848,905 +Computer equipment............................ 2,131,606 2,134,411 +Furniture and fixtures........................ 1,205,750 1,096,176 +Construction in progress...................... 698,675 942,937 +------------ ----------- +19,436,281 16,622,288 +Less--Accumulated depreciation and +amortization................................. (11,636,144) (9,884,254) +------------ ----------- +$ 7,800,137 $ 6,738,034 +============ =========== +Depreciation expense was $1,815,202, $1,426,890, $325,288 and $1,373,373 for +2001, 2000, the Transition Period and 1999, respectively. +5. PATENTS AND PRODUCT RIGHTS: +In June 1998, the Company acquired the patents and exclusive worldwide +distribution rights to its Histofreezer(R) product. The purchase price of +$2,548,690, including transaction costs, has been recorded as patents and +product rights and is being amortized using the straight-line method over an +estimated useful life of ten years. In connection with this acquisition, the +Company also entered into a product purchase agreement with the manufacturer +of the Histofreezer(R) product, with an initial term extending through +December 31, 2006. +6. ACCRUED EXPENSES: +December 31, +------------------------- +2001 2000 +------------ ----------- +Payroll and related benefits.................. $ 1,728,651 $ 1,331,545 +Professional fees............................. 271,112 372,211 +Deferred revenue.............................. 401,060 741,295 +Other......................................... 711,063 983,811 +------------ ----------- +$ 3,111,886 $ 3,428,862 +============ =========== +7. CREDIT FACILITIES: +The Company has a $1,000,000 revolving line of credit with a bank which +bears interest at LIBOR plus 235 basis points. Borrowings under this line are +collateralized by the Company's accounts receivable. The line expires on April +30, 2002. There were no borrowings against the line at December 31, 2001 or +2000. +F-14 +The Company also has a $3,000,000 equipment facility with a bank, with +interest fixed at the bank's prime rate on the date of commencement. +Borrowings under this line are collateralized by the equipment financed. There +were no outstanding borrowings under this facility as of December 31, 2001 or +2000. The unused portion of the equipment facility expires on April 30, 2002. +These credit facilities require, among other items, the maintenance of +certain financial covenants. +8. LONG-TERM DEBT: +December 31, +------------------------ +2001 2000 +----------- ----------- +Note payable to bank, interest at 8%, monthly +installments of principal and interest of $59,219 +through December 2003, at which point the remaining +principal is subject to a call option by the lender +or payable in monthly installments of principal and +interest based on the prime rate plus 1% through +December 2005, secured by certain property and +equipment, inventory and intangible assets......... $ 2,435,902 $ 2,927,226 +Note payable to bank, interest at 8%, monthly +installments of principal and interest of $8,181 +through December 2003, with remaining monthly +installments of principal and interest based on the +prime rate plus 1% through December 2018, subject +to call options by the lender every five years +commencing March 31, 2010, secured by the Company's +building........................................... 904,238 928,021 +Note payable to Pennsylvania Industrial Development +Authority, interest at 2%, monthly installments of +principal and interest of $4,895 through March +2010, secured by a second lien on the Company's +building........................................... 442,285 491,518 +Note payable to bank, interest at 7.8%, monthly +installments of principal and interest of $23,146 +through July 2004, secured by certain property and +equipment, inventory and intangible assets......... 647,779 864,937 +Note payable to bank, interest at 7.75%, monthly +installments of principal and interest of $31,271 +through July 2002, secured by certain property and +equipment, inventory and intangible assets......... 213,826 557,534 +----------- ----------- +4,644,030 5,769,236 +Less--Current portion............................... (1,057,572) (1,125,138) +----------- ----------- +$ 3,586,458 $ 4,644,098 +=========== =========== +Long-term debt maturities as of December 31, 2001 are as follows: +2002............................................................ $1,057,572 +2003............................................................ 2,236,923 +2004............................................................ 247,842 +2005............................................................ 92,421 +2006............................................................ 95,800 +Thereafter...................................................... 913,472 +---------- +$4,644,030 +========== +These notes payable require, among other items, the maintenance of certain +financial covenants. +F-15 +9. INCOME TAXES: +At December 31, 2001, the Company had net operating loss carryforwards for +federal income tax purposes of approximately $69.1 million that have begun to +expire and will continue to expire through 2021. The Tax Reform Act of 1986 +contains provisions that may limit the annual amount of net operating loss +carryforwards available to be used in any given year in the event of +significant changes in ownership. In connection with the Merger, a change in +ownership occurred. Management believes the annual limitation will not have a +material effect on the Company's ability to utilize its loss carryforwards. +Given the Company's losses in recent years, management believes a valuation +allowance is needed as of December 31, 2001. +The tax effect of temporary differences as established in accordance with +SFAS No. 109 that give rise to deferred income taxes are as follows: +December 31 +-------------------------- +2001 2000 +------------ ------------ +Deferred tax asset: +Net operating loss carryforwards............. $ 26,949,000 $ 24,901,000 +Stock based compensation..................... 2,643,000 2,253,000 +Accruals and reserves currently not +deductible.................................. 1,696,000 1,384,000 +Patent costs................................. 445,000 491,000 +Research and development credit +carryforwards............................... 1,850,000 1,677,000 +Valuation allowance on deferred tax assets... (33,583,000) (30,706,000) +------------ ------------ +$ -- $ -- +============ ============ +10. STOCKHOLDERS' EQUITY: +Stock Options +As a result of the Merger, the Epitope, Inc. 2000 Stock Award Plan was +adopted by the Company and renamed the OraSure Technologies, Inc. 2000 Stock +Award Plan (the "2000 Plan"). The 2000 Plan permits stock-based awards to +employees, outside directors and consultants or other third-party advisors. +Awards which may be granted under the 2000 Plan include qualified incentive +stock options, nonqualified stock options, stock appreciation rights, +restricted awards, performance awards and other stock-based awards. +Under the terms of the 2000 Plan, qualified incentive stock options for +shares of common stock may be granted to eligible employees, including +officers of the Company. To date, options have generally been granted with +ten-year exercise periods and an exercise price not less than the fair market +value on date of grant. Options generally vest over four years, with one +quarter of the options vesting one year after grant with the remainder vesting +on a monthly basis over the next three years. +The 2000 Plan also provides that nonqualified options may be granted at a +price not less than 75 percent of the fair market value of a share of common +stock on the date of grant. The option term and vesting schedule of such +awards may either be unlimited or have a specified period in which to vest and +be exercised. For the discounted nonqualified options issued, the Company +amortizes, on a straight-line basis over the vesting period of the options, +the difference between the exercise price and the fair market value of a share +of stock on the date of grant. +The Company applies APB Opinion No. 25 and the related interpretations in +accounting for stock options granted to employees. Accordingly, compensation +expense is recognized for the intrinsic value (the difference between the +exercise price and the fair value of the Company's common stock) on the date +of grant. Compensation, if any, is deferred and charged to expense over the +respective vesting period. In 2000, the Company issued an executive an option +to purchase 375,000 shares of common stock for $4.59 per share. The fair +market value of the Company's common stock at the date of issuance was $6.13. +The Company recorded +F-16 +deferred compensation of $577,500 on the date of grant to be amortized over +the vesting period of three years. However, the options immediately vested +upon the closing of the Merger in accordance with change in control rights +contained in the stock option grant. As a result, the Company recorded +$577,500 of compensation expense in 2000 related to the options. The Company +recorded an additional $215,185 of compensation expense in 2000 due to the +amortization of deferred compensation related to other stock options due to +the change in control rights provided under the applicable stock option +grants. +Under SFAS No. 123, compensation expense related to stock options granted to +employees and directors is computed based on the fair value of the stock +option at the date of grant using an option valuation methodology, typically +the Black-Scholes pricing model. Pursuant to the disclosure requirements of +SFAS No. 123, had compensation expense for the Company's common stock option +plan been determined based upon the fair value of the options at the date of +grant, the Company's net loss for 2001, 2000 and 1999 would have increased as +follows: +Year ended +December 31, Year ended +--------------------------- September +2001 2000 30, 1999 +------------ ------------- ------------ +Net loss: +As reported....................... $ (3,727,789) $ (12,746,550) $ (4,233,264) +============ ============= ============ +Pro forma......................... $ (6,640,938) $ (17,611,122) $ (6,553,202) +============ ============= ============ +Basic and diluted net loss per +share: +As reported....................... $ (0.10) $ (0.36) $ (0.14) +============ ============= ============ +Pro forma......................... $ (0.18) $ (0.50) $ (0.21) +============ ============= ============ +The weighted average fair value of the options granted during 2001, 2000 +and, 1999, is estimated at $7.10, $4.96 and $2.44 per share, respectively, +using the Black-Scholes option pricing model with the following assumptions: +dividend yield of zero; volatility of 65 percent, 64 percent and 55 percent, +respectively; weighted average risk-free interest rate of 4.86 percent, 6.13 +percent and 5.31 percent, respectively; and an expected life of 7.0, 7.0 and +4.3 years, respectively. +The Company accounts for stock-based compensation to non-employees using the +fair value method, in accordance with SFAS No. 123 and EITF No. 96-18. In +2001, the Company recorded compensation expense related to options to purchase +19,000 shares of the Company's common stock granted to members of a non- +employee advisory board and an outside consultant. Compensation expense of +$136,874 was computed based on the estimated fair value of the stock options +at the date of grant, using the Black-Scholes option pricing model. +F-17 +Information with respect to the options granted under the 2000 Plan and +predecessor plans is as follows: +Price per +Shares Share +---------- ----------- +Balance, September 30, 1998......................... 3,958,199 $1.29-18.17 +Granted............................................ 1,331,869 0.80- 6.84 +Exercised.......................................... (632,580) 3.54- 6.31 +Canceled........................................... (242,122) 0.80-18.17 +---------- ----------- +Balance, September 30, 1999......................... 4,415,366 0.80- 3.97 +Granted............................................ 584,143 0.80- 3.97 +Exercised.......................................... (17,846) 3.22- 5.04 +Canceled........................................... (184,228) 0.80-18.17 +Adjustment for change in year end.................. (427,530) 0.80- 2.83 +---------- ----------- +Balance, December 31, 1999.......................... 4,369,905 0.80-18.17 +Granted............................................ 1,596,142 4.59-15.03 +Exercised.......................................... (1,319,624) 0.80- 6.00 +Canceled........................................... (139,066) 0.80-18.17 +---------- ----------- +Balance, December 31, 2000.......................... 4,507,357 0.80-15.03 +Granted............................................ 357,000 7.88-12.95 +Exercised.......................................... (968,729) 0.80- 9.47 +Canceled........................................... (150,395) 0.80-14.81 +---------- ----------- +Balance, December 31, 2001.......................... 3,745,233 $0.80-15.03 +========== =========== +At December 31, 2001, 1,272,909 shares were available for future grants +under the 2000 Plan. The following table summarizes information about stock +options outstanding at December 31, 2001: +Options outstanding Options exercisable +----------------------------------------------------------------------------- +Weighted +average Weighted Weighted +remaining average average +Number life, in exercise Number exercise +Range of exercise prices outstanding years price exercisable price +------------------------ ----------- --------- -------- ----------- -------- +$ 0.80.................. 490,703 7.39 $ 0.80 226,658 $ 0.80 +$ 2.83-$4.17............ 539,176 12.34 3.70 539,176 3.70 +$ 4.22-$4.59............ 397,800 11.23 4.56 397,800 4.56 +$ 4.72-$4.97............ 153,194 6.98 4.79 153,194 4.79 +$ 5.04.................. 541,123 12.67 5.04 541,123 5.04 +$ 5.50-$6.84............ 177,851 7.06 6.49 177,851 6.49 +$ 7.09.................. 927,176 8.95 7.09 275,151 7.09 +$ 7.30-$10.71........... 398,460 9.36 9.89 84,818 9.47 +$10.92-$14.84........... 117,750 9.01 12.69 27,750 12.87 +$15.03.................. 2,000 8.52 15.03 2,000 15.03 +--------- --------- +3,745,233 9.89 $ 5.57 2,425,521 $ 4.84 +========= ========= +Employee Stock Purchase Plan +In 1993, Epitope's stockholders approved the adoption of the 1993 Employee +Stock Purchase Plan ("1993 ESPP"). The 1993 ESPP, as subsequently amended by +Epitope's stockholders, covered a maximum of 500,000 shares of common stock +for subscription over established offering periods. As a result of the Merger, +the 1993 ESPP was adopted and renamed by the Company. The Compensation +Committee of the Board of directors +F-18 +determines the number of offering periods, the number of shares offered, and +the length of each period, provided that no more than three offering periods +may be set during each fiscal year of the Company. The purchase price for +stock purchased under the 1993 ESPP for each subscription period is the lesser +of 85 percent of the fair market value of a share of common stock at the +commencement of the subscription period and the fair market value at the close +of the subscription period. An employee may also elect to withdraw at any time +during the subscription period and receive the amounts paid plus interest at +the rate of 6 percent. +As of December 31, 2001 and 2000, 8,804 and 9,832 shares of common stock, +respectively, were subscribed for through one offering. These shares may be +purchased over 24 months at an initial subscription price of $3.96. During the +years ended December 31, 2001 and 2000, 536 and 70,253 shares, respectively, +were issued at prices ranging from $2.74 to $4.78 per share under the 1993 +ESPP. +Common Stock Warrants +As of December 31, 2001, the following warrants to purchase shares of common +stock were outstanding: +Exercise +Date of Issuance Shares Price Expiration Date +---------------- ------- -------- --------------- +July 15, 1992.......................... 50,000 $16.44 July 15, 2002 +September 30, 1998..................... 120,000 $ 6.13 September 30, 2008 +------- +170,000 +======= +11. COMMITMENTS AND CONTINGENCIES: +Phosphor Agreements +In April 1995, the Company entered into several research, licensing and +royalty agreements (collectively the "Phosphor Agreements"), related to +development and commercialization of the Company's up-converting phosphor +technology ("UPT(TM)"). Under the terms of the Phosphor Agreements, as +amended, the Company is obligated to make an annual license payment of $50,000 +and an annual minimum royalty payment of $100,000 for usage of patented +technology licensed to the Company. Upon the first commercial sale of a +UPT(TM)-based product or service, the Company is then obligated to pay +royalties based upon a percentage of the net sales of UPT(TM)-based products, +research and development fees and sublicensing revenues, for a period equal to +the longer of ten years from the date of the first commercial sale of a +UPT(TM)-based product or service (which occurred in 2001) or the remaining +life of the patents underlying the licensed technology, which expire through +2017. Royalties from the commercial sale of products or services can be +credited against the Company's minimum royalty obligation of $100,000 per +year. +In July 1999, the Company paid approximately $1,500,000 to acquire certain +rights (the "Rights") related to UPT(TM). The Company accounted for the +purchase price of the Rights as acquired in-process technology expense, +because at the date of the transaction, the Rights acquired by the Company had +not progressed to a stage where the technology, or any alternative future use +of the technology, had met technological feasibility. Furthermore, there +existed a significant amount of uncertainty as to the Company's ability to +complete the development of this technology and achieve market acceptance of +any related commercial products within a reasonable timeframe. In connection +with this acquisition of this in-process technology, the Company is required +to pay sponsored research funds of $125,000 in 2002 and $50,000 per year +thereafter, as well as royalties of $25,000 per year, until the Rights expire +in 2008. During 2001, the Company finalized development of its first +commercial product utilizing this technology. +F-19 +Leases +The Company leases office, manufacturing, warehouse and laboratory +facilities under operating lease agreements. Future payments required under +these leases are as follows: +2002............................................................ $ 654,225 +2003............................................................ 651,534 +2004............................................................ 662,514 +2005............................................................ 99,979 +2006 and thereafter............................................. -- +---------- +$2,068,252 +========== +Rent expense for 2001, 2000 and 1999 was $805,878, $716,748 and $461,105, +respectively. +Capital Expenditures +As of December 31, 2001, the Company had outstanding non-cancelable purchase +commitments of $644,995 related to capital expenditures. +Employment Agreements +Under terms of employment agreements with certain executive officers and +other employees, extending through 2003, the Company is required to pay each +individual a base salary and for some individuals, a retention bonus, for +continuing employment with the Company. The agreements require payments of +$2,090,305 and $1,197,164, in 2002 and 2003, respectively, which include the +severance payments discussed below. +On January 31, 2002, the Company terminated an employment agreement with an +executive officer. During the first quarter of 2002, the Company will record +$480,063 in severance expenses, of which, $269,010 and $211,053 is payable in +2002 and 2003, respectively. These expenses include continued salary and +benefit premium payments to this officer, related employment taxes, and the +value of certain computer equipment transferred to this individual. As of +January 31, 2002, the Company held a $75,000 note receivable from this +officer, which he has agreed to repay in bi-weekly principal installments of +approximately $7,000, commencing in April 2002 (See Note 12). +Litigation +From time-to-time, the Company is involved in certain legal actions arising +in the ordinary course of business. In management's opinion, based upon the +advice of counsel, the outcome of such actions are not expected to have a +material adverse effect on the Company's future financial position or results +of operations. +12. RELATED-PARTY TRANSACTIONS: +Officer Notes +In March and October 2000, the Company issued notes receivable to an officer +of the Company ("Officer Notes") for $75,000 and $100,649, respectively, for +relocation purposes. The Officer Notes do not bear interest if they are repaid +on or before the earlier of the tenth day following the close of sale on the +officer's previous residences or the due date of the Officer Notes, as +extended. In May 2001, this officer repaid the Officer Note having an +outstanding balance of $100,649. In January 2002, this same officer resigned +from the Company and as part of his severance agreement, agreed to repay the +remaining $75,000 balance in bi-weekly principal installments of approximately +$7,000, commencing in April 2002. (See Note 11). +Facility Lease +Effective March 1, 2002, the Company signed a 10-year operating lease with +Tech III Partners, LLC, an entity owned and controlled by two of the Company's +executive officers. Under the terms of this lease, the +F-20 +Company will lease a 48,000 square foot facility currently being constructed +on land adjacent to the Company's headquarters, at a base rent of $480,000 per +year, increasing to $528,000 per year, during the initial 10-year term. The +lease also provides for certain renewal and purchase options. +13. RETIREMENT PLANS: +As a result of the Merger, during 2000 and a portion of 2001, the Company +maintained two distinct retirement plans covering substantially all of its +employees. Both plans permitted voluntary employee contributions to be +excluded from the employees' current taxable income under the provisions of +Internal Revenue Code Section 401(k) and the regulations thereunder. During +the prior periods reported, generally all employees of Epitope were eligible +to participate in a profit sharing and deferred savings plan. The plan +provided for a Company matching contribution (either in cash, Company stock, +or a combination of both) equal to 50 percent of an employee's contribution, +not to exceed 2.5 percent of an employee's compensation. The Company +contributed 5,309, 2,691 and 12,693 shares valued at $62,409, $17,492 and +$75,475 during 2000, the Transition Period, and 1999, respectively, to this +plan. During the prior periods reported, generally all employees of STC were +eligible to participate in a profit sharing plan. The plan provided for the +Company, subject to the Board of Directors' discretion, to match employee +contributions up to $3,000 or 8% of a participant's salary, whichever is less. +Company contributions to the plan were $75,789, $122,903, $19,247, and +$113,708 for 2001, 2000, the Transition Period, and 1999, respectively. +On May 1, 2001, the Company merged the two aforementioned plans into the +OraSure Technologies, Inc. 401(k) Plan (the "New Plan"). The New Plan permits +voluntary employee contributions to be excluded from an employer's current +taxable income under provisions of Internal Revenue Code Section 401(k) and +the regulations thereunder. The New Plan also provides for the Company to +match employee contributions up to the lesser of $4,000 or 10% of the +employee's salary. Contributions to the New Plan were $239,402 in 2001. +14. GEOGRAPHIC INFORMATION: +Under the disclosure requirements of SFAS No. 131, "Segment Disclosures and +Related Information," the Company operates within one segment, medical devices +and products. The Company's products are sold principally in the United States +and Europe. Operating income and identifiable assets are not applicable since +all of the Company's revenues outside the United States are export sales. +The following table represents total revenues by geographic area (amount in +thousands): +For the year +ended For the three For the year +December 31, months ended ended +--------------- December 31, September 30, +2001 2000 1999 1999 +------- ------- ------------- ------------- +United States.................... $27,321 $24,763 $5,912 $21,382 +Europe........................... 3,510 2,507 659 1,816 +Other regions.................... 1,742 1,518 251 848 +------- ------- ------ ------- +$32,573 $28,788 $6,822 $24,046 +======= ======= ====== ======= +15. QUARTERLY DATA (Unaudited): +The following tables summarize the quarterly results of operations for each +of the quarters in 2001 and 2000, as well as the Transition Period and the +comparable three-month period ended December 31, 1998. These quarterly results +are unaudited, but in the opinion of management, have been prepared on the +same basis as the Company's audited financial information and include all +adjustments (consisting only of normal recurring adjustments) necessary for a +fair presentation of the information set forth herein (all amounts in +thousands, except per share amounts). +F-21 +2001 Results +----------------------------------------------------------- +Three months ended +---------------------------------------------- Year ended +March 31, June 30, September 30, December 31, December 31, +2001 2001 2001 2001 2001 +--------- -------- ------------- ------------ ------------ --- +Revenues................ $ 7,404 $ 8,508 $ 8,598 $ 8,063 $ 32,573 +Costs and expenses...... 8,636 9,105 8,609 10,556 36,906 +------- ------- ------- ------- -------- +Operating loss......... (1,232) (597) (11) (2,493) (4,333) +Other income, net....... 251 159 26 198 634 +------- ------- ------- ------- -------- +Income (loss) before +income taxes.......... (981) (438) 15 (2,295) (3,699) +Income taxes............ 16 6 (1) 8 29 +------- ------- ------- ------- -------- +Net income (loss)....... $ (997) $ (444) $ 16 $(2,303) $ (3,728) +======= ======= ======= ======= ======== +Basic and diluted net +loss per share......... $ (0.03) $ (0.01) $ 0.00 $ (0.06) $ (0.10) +======= ======= ======= ======= ======== +Weighted average number +of shares outstanding.. 36,457 36,702 39,009 37,246 36,868 +======= ======= ======= ======= ======== +2000 Results +----------------------------------------------------------- +Three months ended +---------------------------------------------- Year ended +March 31, June 30, September 30, December 31, December 31, +2000 2000 2000 2000 2000 +--------- -------- ------------- ------------ ------------ +Revenues................ $ 6,619 $ 7,161 $ 7,222 $ 7,786 $ 28,788 +Costs and expenses...... 7,512 8,313 15,435 11,657 42,917 +------- ------- ------- ------- -------- +Operating loss......... (893) (1,152) (8,213) (3,871) (14,129) +Other income, net....... 115 771 302 219 1,407 +------- ------- ------- ------- -------- +Loss before income +taxes................. (778) (381) (7,911) (3,652) (12,722) +Income taxes............ 56 (44) 13 -- 25 +------- ------- ------- ------- -------- +Net loss................ $ (834) $ (337) $(7,924) $(3,652) $(12,747) +======= ======= ======= ======= ======== +Basic and diluted net +loss per share......... $ (0.03) $ (0.01) $ (0.22) $ (0.10) $ (0.36) +======= ======= ======= ======= ======== +Weighted average number +of shares outstanding.. 33,442 34,818 35,370 36,361 35,002 +======= ======= ======= ======= ======== +Three months ended +December 31, +------------------ +1999 1998 +--------- -------- +Revenues................ $ 6,822 $ 5,138 +Costs and expenses...... 7,105 5,857 +------- ------- +Operating loss......... (283) (719) +Other expense........... (138) (159) +------- ------- +Loss before income +taxes................. (421) (878) +Income taxes............ 50 -- +------- ------- +Net loss................ $ (471) $ (878) +======= ======= +Basic and diluted net +loss per share......... $ (0.02) $ (0.03) +======= ======= +Weighted average number +of shares outstanding.. 30,887 26,246 +======= ======= +F-22 +INDEX TO EXHIBITS +Exhibit +Number Exhibit +------- ------- +2.1 Agreement and Plan of Merger, dated as of May 6, 2000, by and among +Epitope, Inc., the Company and STC Technologies, Inc., including the +Epitope Stockholders Agreement and the STC Stockholders Agreement +attached as Exhibits A and B thereto and the other exhibits attached +thereto, is incorporated by reference to Exhibit 2 to the Current +Report on Form 8-K of Epitope, Inc. dated May 9, 2000. +3.1 Certificate of Incorporation of OraSure Technologies is incorporated +by reference to Exhibit 3.1 to the Company's Registration Statement on +Form S-4 (No. 333-39210). +3.1.1 Certificate of Amendment to Certificate of Incorporation dated May 23, +2000 is incorporated by reference to Exhibit 3.1.1 to the Company's +Registration Statement on Form S-4 (No. 333-39210). +3.1.2 Certificate of Designation of Series A Preferred Stock of OraSure +Technologies (filed as Exhibit A to the Rights Agreement referred to +in Exhibit 4.2). +3.2 Amended and Restated Bylaws of OraSure Technologies, effective as of +September 27, 2001, are incorporated by reference to Exhibit 3 to the +Company's Quarterly Report on Form 10-Q for the quarter ended +September 30, 2001. +4.1 Specimen certificate representing shares of OraSure Technologies +$.000001 par value Common Stock is incorporated by reference to +Exhibit 4.1 to the Company's Registration Statement on Form S-4 +(No. 333-39210). +4.2 Rights Agreement, dated as of May 6, 2000, between OraSure +Technologies and ChaseMellon Shareholder Service, L.L.C. (now called +Mellon Investor Services LLC), as Rights Agent, is incorporated by +reference to Exhibit 4.2 to the Company's Registration Statement on +Form S-4 (No. 333-39210). +4.3 Stockholders' Agreement among STC Technologies, Inc., HealthCare +Ventures V, L.P., RHO Management Trust II, Hudson Trust and +Pennsylvania Early Stage Partners, L.P., dated March 30, 1999, is +incorporated by reference to Exhibit 4.3 to the Company's Registration +Statement on Form S-4 (No. 333-39210). +4.4 Amendment to Stockholders' Agreement filed is Exhibit 4.3 is +incorporated by reference to Exhibit 4.4 to the Company's Registration +Statement on Form S-4 (No. 333-39210). +4.5 Second Amendment to Stockholders' Agreement filed as Exhibit 4.3 is +incorporated by reference to Exhibit 4 to the Company's Quarterly +Report on Form 10-Q for the quarter ended June 30, 2001. +10.1 Form of Indemnification Agreement (and list of parties to such +agreement) is incorporated by reference to Exhibit 10.1 to the +Company's Registration Statement on Form S-4 (No. 333-39210).* +10.2 Separation Agreement and Release dated as of February 14, 2002 between +OraSure Technologies and Robert D. Thompson.* +10.3 Employment Agreement dated as of September 29, 2000 between OraSure +Technologies and Robert D. Thompson is incorporated by reference to +Exhibit 10.3 to the Company's Annual Report on Form 10-K for the year +ended December 31, 2000.* +10.4 Employment Agreement dated as of September 29, 2000 between OraSure +Technologies and Michael J. Gausling is incorporated by reference to +Exhibit 10.4 to the Company's Annual Report on Form 10-K for the year +ended December 31, 2000.* +10.5 Employment Agreement dated as of November 1, 2001 between OraSure +Technologies and Ronald H. Spair is incorporated be reference to +Exhibit 10 to the Company's Quarterly Report on Form 10-Q for the +quarter ended September 30, 2001.* +Exhibit +Number Exhibit +------- ------- +10.6 Employment Agreement dated as of September 29, 2000 between OraSure +Technologies and William Hinchey is incorporated by reference to +Exhibit 10.5 to the Company's Annual Report on Form 10-K for the year +ended December 31, 2000.* +10.7 Employment Agreement dated as of September 29, 2000 between OraSure +Technologies and Dr. R. Sam Niedbala is incorporated by reference to +Exhibit 10.6 to the Company's Annual Report on Form 10-K for the year +ended December 31, 2000.* +10.8 Employment Agreement dated as of September 29, 2000 between OraSure +Technologies and William D. Block is incorporated by reference to +Exhibit 10.7 to the Company's Annual Report on Form 10-K for the year +ended December 31, 2000.* +10.9 Employment Agreement dated as of September 29, 2000 between OraSure +Technologies and J. Richard George is incorporated by reference to +Exhibit 10.8 to the Company's Annual Report on Form 10-K for the year +ended December 31, 2000.* +10.10 Employment Agreement dated as of September 29, 2000 between OraSure +Technologies and P. Michael Formica.* +10.11 Description of Non-Employee Director Compensation Policy is +incorporated by reference to Exhibit 10 to the Company's Quarterly +Report on Form 10-Q for the quarter ended March 31, 2001.* +10.12 Incentive Stock Option Plan of Epitope, Inc. as amended, is +incorporated by reference to Exhibit 10.2 to the Epitope, Inc. Annual +Report on Form 10-K for 1994.* +10.13 Amended and Restated Epitope, Inc. 1991 Stock Award Plan is +incorporated by reference to Exhibit 10.2 to the Epitope, Inc. Annual +Report on Form 10-K for 1997.* +10.14 OraSure Technologies, Inc. Employee Incentive and Non-Qualified Stock +Option Plan, as amended and restated effective September 29, 2000, is +incorporated by reference to Exhibit 10.12 to the Company's Annual +Report on Form 10-K for the year ended December 31, 2000.* +10.15 OraSure Technologies, Inc. 2000 Stock Award Plan, as amended effective +as of September 29, 2000, is incorporated by reference to Exhibit +10.13 to the Company's Annual Report on Form 10-K for the year ended +December 31, 2000.* +10.16 Nonqualified Stock Option Agreement For Discounted Non-Plan Option +between Epitope, Inc. and Robert D. Thompson is incorporated by +reference to Exhibit 10.14 to the Company's Annual Report on Form 10-K +for the year ended December 31, 2000.* +10.17 Production Agreement with Koninklinjke Utermohlen, N.V. dated June 9, +1998 is incorporated by reference to Exhibit 10.8 to the Company's +Registration Statement on Form S-4 (No. 333-39210). +10.18 Amendment No. 1 to Production Agreement, dated as of December 11, +2001, between the Company and Koninklijke Utermohlen N.V. +10.19 Research and License Agreement with SRI International and David +Sarnoff Research Center dated April 26, 1995 is incorporated by +reference to Exhibit 10.9 to the Company's Registration Statement on +Form S-4 (No. 333-39210). +10.20 First Amendment to Research and License Agreement among SRI +International and David Sarnoff Research Center and the Company dated +September 1, 1995 is incorporated by reference to Exhibit 10.10 of the +Company's Registration Statement on Form S-4 (No. 333-39210). +10.21 Third Amendment to Research and License Agreement dated August 30, +2000 among SRI International, Sarnoff Corporation (formerly David +Sarnoff Research Center) and the Company is incorporated by reference +to Exhibit 10.19 to the Company's Annual Report on Form 10-K for the +year ended December 31, 2000. +Exhibit +Number Exhibit +------- ------- +10.22 Commercial Lease between Northampton County New Jobs Corp., as +Landlord, and STC Technologies, Inc., as Tenant, dated April 30, 1999, +is incorporated by reference to Exhibit 10.11 to the Company's +Registration Statement on Form S-4 (No 333-39210). +10.23 Lease dated October 25, 1999 between PS Business Parks, L.P., a +California Limited Partnership, and Epitope, Inc., is incorporated by +reference to Exhibit 10.6 to the Epitope, Inc. Annual Report on +Form 10-K for 1999. +10.24 Commercial Lease between Tech III Partners, LLC and OraSure +Technologies, dated March 1, 2002. +23.1 Consent of Arthur Andersen LLP. +23.2 Consent of PricewaterhouseCoopers LLP. +24 Powers of Attorney. +99 Letter dated March 28, 2002 from OraSure Technologies to the +Securities and Exchange Commission concerning certain representations +from Arthur Andersen LLP. +-------- +* Management contract or compensatory plan or arrangement. \ No newline at end of file diff --git a/raw/filings/0001116463/2001/0000930661-02-000960/filing_metadata.csv b/raw/filings/0001116463/2001/0000930661-02-000960/filing_metadata.csv new file mode 100644 index 0000000000000000000000000000000000000000..c4fe28f7e4e01c709347477bed8ee73d94379f21 --- /dev/null +++ b/raw/filings/0001116463/2001/0000930661-02-000960/filing_metadata.csv @@ -0,0 +1,2 @@ +cik,ticker,company_name,form,filing_date,report_date,acceptance_datetime,accession_number,primary_document,primary_doc_description,size,is_xbrl,is_inline_xbrl,document_url,filing_index_url,year,fiscal_year,is_primary_filing +0001116463,OSUR,ORASURE TECHNOLOGIES INC,10-K,2002-03-29,2001-12-31,2002-03-29T05:00:00.000Z,0000930661-02-000960,d10k.txt,FORM 10-K,493934,0,0,https://www.sec.gov/Archives/edgar/data/1116463/000093066102000960/d10k.txt,https://www.sec.gov/Archives/edgar/data/1116463/000093066102000960/,2001,2001,1 diff --git a/raw/filings/0001116463/2001/0000930661-02-000960/item1.txt b/raw/filings/0001116463/2001/0000930661-02-000960/item1.txt new file mode 100644 index 0000000000000000000000000000000000000000..666c8b3e77bfcf9e367055d8beaa9bd9d32a1224 --- /dev/null +++ b/raw/filings/0001116463/2001/0000930661-02-000960/item1.txt @@ -0,0 +1,1608 @@ +ITEM 1. Business. +On September 29, 2000, STC Technologies, Inc., a Delaware corporation +("STC"), and Epitope, Inc., an Oregon corporation ("Epitope"), were merged +(the "Merger") into OraSure Technologies, Inc. ("OraSure Technologies" or the +"Company"), a new corporation that was organized on May 5, 2000 under Delaware +law solely for the purposes of combining STC and Epitope and changing the +state of incorporation of Epitope from Oregon to Delaware. The companies were +merged pursuant to an Agreement and Plan of Merger, dated May 6, 2000, by and +among Epitope, STC and the Company. The stockholders of STC and Epitope +approved the Merger Agreement on September 29, 2000. +Epitope historically reported its financial results on the basis of a fiscal +year ending September 30, while STC previously reported its financial results +on a calendar year basis. Immediately prior to the Merger, Epitope adopted a +calendar year for financial reporting purposes. As a result, financial +information presented in this Report for 2001 and 2000 reflect results for the +calendar years ended December 31, 2001 and 2000, respectively. Since Epitope +did not adopt a calendar year reporting period until 2000, the financial +information for 1999 reflects the results of Epitope for the twelve-months +ended September 30, 1999 and the results of STC for the twelve months ended +December 31, 1999. See Note 1 to the Company's Financial Statements for a +discussion of the Merger and the change in fiscal year end. +General +OraSure Technologies develops, manufactures and markets oral fluid specimen +collection devices using proprietary oral fluid technologies and diagnostic +products including immunoassays and other in vitro diagnostic tests, and other +medical devices. These products are sold in the United States and certain +foreign countries to government agencies, clinical laboratories, physicians' +offices, hospitals, commercial and industrial entities, and various +distributors. +In vitro diagnostic testing is the process of analyzing constituents of oral +fluid, blood, urine and other bodily fluids or tissue for the presence of +specific substances or markers of infectious diseases or other conditions. In +vitro diagnostic tests are performed outside the body, in contrast to in vivo +tests which are performed directly on or within the body. The substance or +marker that a diagnostic test is intended to detect is generally referred to +as an analyte. +Immunodiagnostic testing is the leading method of in vitro testing for +antigens and antibodies. When an infectious disease caused by pathogens, such +as bacteria, viruses and fungi, or other substances are present, the body +responds by producing an antibody. Substances that stimulate production of +antibodies are generally referred to as antigens. An antibody binds +specifically with an antigen in a lock-and-key fashion that initiates a +biochemical reaction to attempt to neutralize and, ultimately, eliminate the +antigen. The ability of an antibody to bind with a specific antigen provides +the basis for immunodiagnostic testing. +Products +OraSure Technologies' business focuses on the following principal platform +technologies: (1) the OraSure(R) and Intercept(R) oral fluid collection +devices, (2) the OraQuick(R) rapid diagnostic test device, and (3) the new up- +1 +converting phosphor technology ("UPT"), including its first application, +UPlink(TM), a lateral flow testing system for various analytes. In addition, +the Company sells certain other products, including the Histofreezer(R) +portable cryosurgical system, certain immunoassay tests and reagents for +insurance risk assessment, substance abuse testing and forensic toxicology +applications, an oral fluid Western Blot confirmatory test for the Human +Immunodeficiency Virus Type 1 ("HIV-1"), and the Q.E.D.(R) saliva alcohol +test. +OraSure(R)/Intercept(R) Collection Devices +The Company's OraSure(R) oral fluid collection device is used in conjunction +with screening and confirmatory tests for HIV-1 antibodies and other analytes. +The device consists of a small, treated cotton-fiber pad on a nylon handle +that is placed in a person's mouth for two to five minutes. The device +collects oral mucosal transudate ("OMT"), a serum-derived fluid that contains +higher concentrations of antibodies and analytes than saliva. As a result, OMT +testing is a highly accurate method for detecting HIV-1 infection and other +analytes. The Company believes that oral fluid testing has several significant +advantages over blood or urine-based testing systems for both health care +professionals and individuals being tested, including eliminating the risk of +needle-stick accidents, providing a noninvasive collection technique, +requiring minimal training to administer, providing rapid and efficient +collection in almost any setting, and eliminating the cost of administration +by a trained health care professional. +The Company has received approval from the U.S. Food and Drug Administration +("FDA") to sell the OraSure(R) oral fluid collection device for use with a +laboratory-based enzyme immunoassay ("EIA") screening test for HIV-1 antibody +detection. HIV-1 antibody detection using the OraSure(R) collection device +involves three steps: (1) collection of an oral fluid specimen using the +OraSure(R) device, (2) screening of the specimen for HIV-1 antibodies at a +laboratory with an EIA screening test, and (3) laboratory confirmation of any +positive screening test results with the OraSure(R) Western Blot HIV-1 +confirmatory test (described below). A trained health care professional then +conveys test results and provides appropriate counseling to the individual who +was tested. The Company has also received FDA clearance for use of the +OraSure(R) collection device with EIAs to test for cocaine and cotinine (a +metabolite of nicotine) in oral fluid specimens. +The Company sells the OraSure(R) collection device in the insurance market +for screening life insurance applicants for HIV-1, cocaine and cotinine, and +in the public health market for HIV-1 testing. +A collection device substantially similar to the OraSure(R) device comprises +the Company's Intercept(R) oral fluid drug testing service. The Company has +received FDA clearance to use the Intercept(R) collection device with +laboratory-based EIAs to test for drugs of abuse commonly identified by the +National Institute for Drug Abuse ("NIDA") as the NIDA-5 (i.e., cannabinoids +(marijuana), cocaine, opiates, amphetamines, and phencyclidine ("PCP")), and +for barbiturates and methadone. The Company also sells, or arranges for a +third party vendor to sell, equipment required by its laboratory customers to +test oral fluid specimens collected with the Intercept(R) device. Intercept(R) +is sold in the workplace testing, public health, criminal justice and drug +rehabilitation markets. +The Company believes that the Intercept(R) service has several advantages +over certain competing products for drugs-of-abuse testing, including its +lower cost, non-invasive nature, safety, mobility and accuracy, the ease of +maintaining a chain-of-custody, the treatment of test subjects with greater +dignity, no requirement for specially-prepared collection facilities, and +difficulty of sample adulteration. The availability of an oral fluid test is +intended to allow workplace administrators to test for employee impairment on +demand, eliminate scheduling costs, and streamline the testing process. +OraQuick(R) Rapid Test +OraQuick(R) is the Company's rapid test platform designed to test an oral +fluid, whole blood or serum/plasma sample for the presence of various +antibodies or analytes. The device includes a porous flat pad used to collect +an oral fluid specimen. After collection, the pad is inserted into a vial +containing a pre-measured amount of +2 +developer solution and allowed to develop. When whole blood is to be tested, a +loop collection device is used to collect a drop of blood and mix it in the +developer solution, after which the collection pad is inserted into the +solution. The specimen and solution then flow through the testing device where +test results are observable in approximately 20 minutes. The OraQuick(R) +device is a screening test and requires a confirmation test where a positive +result is obtained. +The Company's first product utilizing this technology is the OraQuick(R) HIV +device, a rapid test for the presence of antibodies against HIV. On June 23, +2000, the Company received approval for an Investigational Device Exemption +("IDE") from the FDA authorizing the commencement of formal clinical trials +for the OraQuick(R) HIV device. Due to the critical need for an FDA-approved +rapid HIV test, the Company, after consultation with the FDA and the Centers +for Disease Control and Prevention ("CDC"), submitted an initial application +on June 29, 2001 for pre-market approval for testing of whole blood for HIV-1. +The Company expects to submit an application to the FDA for approval of an +OraQuick(R) test for HIV-1 in oral fluid in 2002. +The CDC has identified several key areas for use of the OraQuick(R) HIV +device in the United States, including certain public hospitals in U.S. +metropolitan areas with a relatively high incidence of HIV infection in +pregnant women, AIDS service organizations, community-based organizations, +outreach programs, and selected hospital emergency departments and outpatient +clinics. Under a treatment IDE, the OraQuick(R) device is being used in the +CDC's Maternal Infant Rapid Intervention at Delivery Project (MIRIAD) to test +pregnant women in five U.S. metropolitan areas. The goal of this project is to +identify those individuals who would benefit from the administration of +nevirapine, a drug used to reduce mother-to-child HIV-1 transmission. The +OraQuick(R) device was also selected for use in the CDC's LIFE Initiative, an +international effort to address the AIDS epidemic in certain African +countries, focusing on areas such as preventing mother-to-child transmission, +secondary transmitted disease prevention, HIV prevention for youth, and blood +safety systems. +At the CDC's Rapid Diagnostic's Meeting in February 2001, the CDC released +the most recent results of its ongoing multi-product, rapid HIV test study, +which was conducted independently from the Company's clinical trials used for +its FDA submission. These results indicated a 100% sensitivity and 99.5% +specificity for the OraQuick(R) device with whole blood samples. In addition, +at the 9th Conference on Retroviruses and Opportunistic Infections in February +2002, the CDC released additional clinical results which indicated a 98.6% +sensitivity and 98.9% specificity for the OraQuick(R) device with oral fluid +samples. Sensitivity is a measure of the accuracy in detecting positive +samples and specificity is a measure of the accuracy in measuring negative +samples. +In July 2000, the Company introduced the OraQuick(R) HIV device for sale +outside the United States at the International AIDS Conference in Durban, +South Africa. Clinical tests for the OraQuick(R) HIV device using oral fluid +specimens have been completed in Thailand, with the results demonstrating 100% +sensitivity and 99.9% specificity. The World Health Organization is presently +evaluating the OraQuick(R) HIV device. +The Company intends to market the OraQuick(R) HIV device, either directly or +through distributors, in the hospital, physician office and public health +markets in the United States and internationally. Agreements with distributors +will be necessary for the Company to fully exploit domestic and international +opportunities. +The Company initially intends to sell an OraQuick(R) device for the +detection of HIV-1 in the United States and certain developed countries, and +an OraQuick(R) device for the detection of both HIV-1 and the Human +Immunodeficiency Virus Type 2 ("HIV-2') in certain foreign countries. The +Company may need to obtain licenses or other rights under, or to enter into +distribution or other business arrangements in connection with, certain +patents related to HIV-2 and lateral flow technology, in order to market the +OraQuick(R) HIV device in the United States and certain other countries. See +the Section entitled "Risk Factors--Patent Issues Affecting OraQuick(R)" for a +further discussion of these issues. +3 +UPT(TM) and UPlink(TM) +Up-Converting Phosphor Technology. Up-Converting Phosphor Technology +("UPT(TM)") is a proprietary label detection platform being developed by the +Company that uses phosphor particles to detect minute quantities of various +substances. UPT(TM) utilizes the same particle shell that is coated onto a +television screen, but the internal chemistry of the particle has been +changed. These changes result in a particle that is excited by infrared light +as compared to an ultraviolet light source for television. The Company and its +research partners have developed phosphorescent particles that up-convert +infrared light to visible light, which the Company believes is a platform +technology with broad applications. +Phosphor particles have been used for decades in television screens and in +fluorescent light bulbs. When high energy ultraviolet light strikes the +phosphor-coated area in a screen or bulb, it excites the particles and low +energy visible colored light is produced. The Company's patented improvements +on this base technology employ chemical changes inside the phosphor particles +so that low energy infrared light can be used to produce a high energy visible +colored signal and is the basis for UPT(TM). This use of infrared light to +create a colored signal is called up-conversion as opposed to down-conversion, +which occurs in phosphors designed to be used with ultraviolet light. +The use of infrared light to excite the phosphor particles and produce a +colored light signal creates an important competitive advantage for the +technology in biological systems, especially human clinical diagnostics. +Existing enzyme or fluorescent-based assays employ visible or ultraviolet +light to generate the signals from the enzyme substrate or fluorescent +molecules used as reporter signals in these systems. The disadvantage of using +light in the visible or ultraviolet portion of the spectrum is that often +molecules in the cells or samples for analysis can also produce colored light +(background interference) from these excitation sources. When this occurs, a +non-specific signal is generated which dilutes or obscures the signal of +interest for the diagnostic test being administered. Because up-conversion +does not occur in nature, biological samples and specimens will not produce +light and, therefore, will not cause background interference when excited by +infrared light. +The Company believes that UPT(TM) overcomes some of the limitations of other +diagnostic detection methods and offers features not commercially available +today. The fact that UPT(TM) testing produces zero background interference +dramatically increases the potential sensitivity of any test system. In +addition, UPT(TM) offers the following other key competitive features: +. Ability to detect biological markers for several substances +simultaneously through the use of phosphor particles having various +colors (i.e. multiplexing) +. Creation of a permanent test record not subject to fading +. Applicability to a variety of instrument platforms +. Compatibility with alternative testing matrices such as oral fluid, +blood or others +. Ability to miniaturize the test platform +The Company has reached important milestones in the development of UPT(TM), +including improving the manufacturing process to produce UPT(TM) particles, +working to optimize UPT(TM) particle coating techniques, producing four +distinct colors of UPT(TM) particles to permit multiplexing, demonstrating +initial feasibility for the use of UPT(TM) particles in infectious disease, +cancer, and limited DNA detection applications, and developing a UPT(TM) +collector, test cassette, and analyzer for oral fluid testing for drugs of +abuse. +UPlink(TM). UPlink(TM) is the Company's first product application based on +UPT(TM). UPlink(TM) is designed to be a rapid, point-of-care system utilizing +a collector, lateral flow test cassette, and analyzer, which provides +instrument-read quantitative results in about 10 minutes on a variety of +samples, including oral fluid, blood, serum, urine and stool samples. +4 +In March 2000, the Company signed a research and development agreement with +Drager Safety AG & Co. KGaA (formerly Drager Sicherheitstechnik GmbH) +("Drager"), a European manufacturer and supplier of medical and safety +technology products for health care and industrial applications, to develop +and optimize an UPlink(TM) system for rapid detection of drugs of abuse in +oral fluid. The UPlink(TM) system developed with Drager is expected to be +marketed initially to law enforcement officials as a system for rapidly +assessing whether an operator or passenger in a motor vehicle is under the +influence of one or more drugs of abuse (the "roadside market") and ultimately +to certain military, criminal justice, and workplace testing markets. As part +of the research and development agreement, the Company received a non- +refundable fee and will receive additional fees upon achievement of technical +milestones. Upon successful completion of such research and development +activities, Drager has the option to become the Company's exclusive +distributor of the UPlink(TM) drugs of abuse rapid detection system in Europe +and certain other countries in the markets described above. +In June 2001, the Company submitted an application for 510(k) clearance from +the FDA for its UPlink(TM) analyzer and six oral fluid drugs-of-abuse assays-- +cocaine, opiates, amphetamines, methamphetamine, PCP and marijuana. The FDA +subsequently requested additional data for the analyzer and each of the six +drug assays. On January 31, 2002, the Company resubmitted to the FDA an +application containing the additional data for the UPlink(TM) analyzer and the +assay for opiates, and expects to resubmit one or more applications for the +remaining UPlink(TM) assays in 2002. The UPlink(TM) drug testing system is +expected initially to be marketed by the Company in the United States in the +unregulated criminal justice market. After receipt of FDA clearance for all of +the six oral fluid drugs-of-abuse assays, this product will be marketed by the +Company or its distributors in the regulated workplace market in the United +States. +In September 2000, OraSure Technologies signed a research and development +agreement with Meridian Bioscience, Inc. (formerly Meridian Diagnostics, Inc.) +("Meridian"), a medical diagnostics company. Under this agreement, the Company +and Meridian plan to develop a broad range of UPlink(TM) point-of-care tests +for the rapid detection of parasites, and gastrointestinal and upper +respiratory diseases. Pursuant to a related supply agreement, Meridian will +serve as a worldwide distributor of the analyzers and lateral flow cassettes +developed under the research and development agreement. The Company has +received and is eligible in the future to receive payments upon achievement of +certain milestones and royalties from the sale of the analyzers and testing +devices. OraSure Technologies has commenced work on the development of two +tests under the research and development agreement and expects Meridian to +submit an application for FDA 510(k) clearance of the first such test in 2002. +UPlink(TM) products developed with Meridian will be manufactured by the +Company and are expected to be marketed by Meridian in the hospital market. +Histofreezer(R) +In 1991, the Company became the exclusive United States distributor of the +Histofreezer(R) portable cryosurgical system, a low-cost alternative to liquid +nitrogen and other eradication methods for removal of warts and other benign +skin lesions. In June 1998, the Company acquired the Histofreezer(R) product +from Koninklijke, Utermohlen, N.V., The Netherlands. As part of the +acquisition, the Company established a sales office in Reeuwijk, The +Netherlands, and is selling the Histofreezer(R) product through a dealer +network in more than 20 countries worldwide. +The Histofreezer(R) product mixes two environmentally friendly cryogenic +gases in a small aerosol canister. When released, these gases are delivered to +a specially designed foam bud, cooling the bud to -50(degrees) C. The frozen +bud is then applied to the lesion for 15 to 40 seconds (depending on the type +of lesion) creating localized destruction of the target area. Histofreezer(R) +is sold in several canister sizes. Sales of this product have been targeted to +primary care physicians such as pediatricians, general and family +practitioners, and other physician segments that traditionally referred +patients to dermatologists to remove warts. The Company has established a +national network of distributors to reach the physician office market in the +United States. +5 +Immunoassay Tests and Reagents +The Company develops and sells immunoassay tests in two formats, MICRO-PLATE +and AUTO-LYTE(R), to meet the specific needs of its customers. +AUTO-LYTE(R) tests are sold in the form of bottles of liquid reagents. The +reagents are run on commercially available laboratory-based automated +analytical instruments which are manufactured by a variety of third parties. +AUTO-LYTE(R) is typically used in high volume, automated, commercial reference +laboratories to detect certain drugs or chemicals in urine. Test results are +produced quickly, allowing for high throughput. +In the MICRO-PLATE kit, the sample to be tested is placed into a small +plastic receptacle, called a microwell, along with the reagents. The result of +the test is determined by the color of the microwell upon completion of the +reaction. Controlling the reaction involves the use of a variety of reagents +by laboratory personnel. Test results are analyzed by any of a variety of +commercially available laboratory instruments which may also be provided by +the Company. OraSure Technologies has used this testing format to develop +tests that detect substances in urine, serum, sweat, and oral fluid specimens. +OraSure Technologies currently markets the MICRO-PLATE oral fluid test for +use in screening life insurance applicants to test for two of the most +important underwriting risk factors: cocaine and cotinine (a metabolite of +nicotine). The Company sells the reagents to insurance testing laboratories, +which provide the laboratory testing to insurance companies, often in +combination with the OraSure(R) oral fluid collection device. AUTO-LYTE(R) +tests are marketed for use in testing urine samples for cocaine and cotinine +and for performing a variety of urine chemistries for insurance risk +assessment purposes. +The Company also develops, manufactures, and sells toxicology and drugs-of- +abuse tests in the MICRO-PLATE format. These MICRO-PLATE tests can be +performed on commonly used instruments and can detect drugs in urine, serum, +and sweat specimens. MICRO-PLATE tests are also used as part of the +Intercept(R) product line to detect drugs-of-abuse in oral fluid specimens. +The Company's toxicology and drugs-of-abuse test products are currently sold +in the forensic toxicology, criminal justice, drug rehabilitation, and +workplace testing markets. +Whenever possible, the Company enters into multi-year sales agreements with +its customers. These agreements generally are entered into with a laboratory +which has agreed to purchase a minimum number of tests over a two-to-five-year +period. The Company also offers these customers the option of a reagent rental +agreement pursuant to which the Company sells the tests at an increased price +over a fixed period of time, which includes an additional equipment charge in +exchange for providing the customer with the required analytical laboratory +equipment. +Western Blot HIV-1 Confirmatory Test +The Company markets an oral fluid Western Blot HIV-1 confirmatory test that +received FDA approval in 1996. This test uses the original specimen collected +with the OraSure(R) oral fluid collection device to confirm positive results +of initial OraSure(R) HIV-1 screening tests. The oral fluid Western Blot HIV-1 +confirmatory test is marketed under an exclusive arrangement with bioMerieux +Inc. (formerly Organon Teknika Corporation) ("BMX"). +In February 2001, the Company announced the indefinite suspension of the +production of EPIblot(R), a serum-based Western Blot HIV-1 confirmatory test. +The serum Western Blot product accounted for approximately 5% of the Company's +2000 revenue, but had been consistently unprofitable because of low production +yields and the high cost of quality control. The discontinuation of this +product had no effect on the manufacturing or sale of the Company's oral fluid +Western Blot HIV-1 confirmatory test. +6 +Q.E.D.(R) Saliva Alcohol Test +The Q.E.D.(R) saliva alcohol test is an on-site, cost-effective test device +that is an alternative to breath or blood alcohol testing. The test is a +quantitative, saliva-based method for the detection of ethanol, and has been +cleared for sale by the FDA and the U.S. Department of Transportation ("DOT"). +In 1997, the product also received a waiver under the Clinical Laboratory +Improvement Act of 1988. Each Q.E.D.(R) test kit contains a collection stick +which is used to collect a sample of saliva and a disposable detection device +that displays results in a format similar to a thermometer. The Q.E.D.(R) +device is easy to operate and instrumentation is not required to read the +result. The product has a testing range of 0 to 0.145% blood alcohol, and +produces results in approximately two minutes. +The markets for alcohol testing are relatively small and fragmented with a +broad range of legal and procedural barriers to entry. Markets range from law +enforcement testing to workplace testing of employees in safety sensitive +occupations. The Q.E.D.(R) test has been successfully adopted by end users in +the petroleum, heavy construction, trucking, and retail industries because it +is a cost-effective, portable, easy-to-administer, quantitative testing +method. Typical usage situations include pre-employment, random, post- +accident, reasonable-cause, and return-to-duty testing. +Products Under Development +OraSure(R)/Intercept(R) Applications +Oral mucosal transudate contains many constituents found in blood and serum, +although in lower concentrations. The Company therefore believes the +OraSure(R) and Intercept(R) devices are a platform technology with a wide +variety of potential applications, where laboratory testing is available. For +example, the OraSure(R) device may be useful for the diagnosis of a variety of +infectious diseases or conditions in addition to HIV-1, such as viral +hepatitis and diabetes. OraSure Technologies has entered into an agreement +with LabOne, Inc. to develop a laboratory-based oral fluid screening test for +Hepatitis C using the OraSure(R) collection device. The Company is developing +an alcohol assay and has an application pending with the FDA for 510(k) +clearance of an assay for benzodiazepine, each of which would be used in +connection with the Intercept(R) drug testing service. Based on a reassessment +of marketability, the Company has discontinued development of an improved +formulation of the OraSure(R) device, known as OraSure(R) II, and a +laboratory-based oral fluid screening test for syphilis. +OraQuick(R) Platform +The Company believes that OraQuick(R) has significant potential as a rapid +test for physicians' offices, hospitals, and other professional use. Like the +OraSure(R) device, the Company believes that OraQuick(R) provides a platform +technology that can be modified for detection of a variety of infectious +diseases in addition to HIV, such as viral hepatitis and other diseases. +The National Institutes of Health ("NIH") previously approved a grant of +approximately $1 million to fund Phase II of the Company's project to develop +a screening and confirmation test for syphilis. Although initially intended to +fund a lab-based test using the OraSure(R) collection device, the NIH approved +the use of this grant instead for development of a screening test for syphilis +using the OraQuick(R) platform. During the first quarter of 2002, the Company +reevaluated the marketability of a syphilis test and, based on that +reevaluation, has elected to terminate this project. +UPT(TM) and UPlink(TM) Development +The Company is in the final stages of developing the UPlink(TM) drugs-of- +abuse rapid detection system under its agreement with Drager and for its own +commercial applications in the United States. The Company has commenced +development of two tests for infectious diseases and expects to commence +development of +7 +additional tests for other infectious diseases under its agreement with +Meridian. The Company has identified other potential applications of UPT(TM), +including human clinical testing for cancer, allergies, and thyroid and +cardiac conditions, therapeutic drug monitoring, biological warfare testing, +food and environmental testing, pharmaceutical research, genomics and +pharmacogenomics, veterinary testing, and surgical imaging. In addition, the +Company is studying the feasibility of using UPT(TM) labels for the detection +of infectious diseases with DNA probes. The Company has not yet chosen which +potential UPT(TM) applications to pursue or the manner in which these +opportunities will be pursued, but believes it will need to enter into +partnering arrangements with other entities to exploit the potential of +UPT(TM). +Western Blot HIV-1 Confirmatory Test +The Company believes its existing oral fluid Western Blot confirmatory test +for HIV-1 can be used for testing of serum plasma specimens and is +contemplating expanding the use of this product for these applications. +Whether the Company elects to do so will depend on a further assessment of the +market for these applications, the Company's ability to overcome the low +production yields and quality control issues which led to the discontinuation +of its Serum Western Blot HIV-1 confirmatory test in 2001, and the Company's +ability to obtain FDA approval for these new uses. +Research and Development +In 2001, research and development activities focused on the continued +development of the UPlink(TM) analyzer, test cassette and collector, the +development of certain UPlink(TM) drugs of abuse and infectious disease +assays, DNA feasibility studies, and clinical trials for the OraQuick(R) rapid +HIV-1 test. +The Company supplements its own research and development activities by +funding external research. The Company has funded research at Leiden +University, SRI International, Lehigh University and certain other entities, +and intends to continue funding external research. +Research and development expenses totaled approximately $9.4 million in +2001, $10.4 million in 2000 and $5.6 million in 1999. +Sales and Marketing +The Company's strategy is to reach its major target markets through a +combination of direct sales, strategic partnerships, and independent +distributors. The Company's marketing strategy is to raise awareness of its +products through a mix of trade shows, print advertising, and distributor +promotions to support sales in each target market. +The Company markets its products in the United States and internationally. +Revenues attributable to customers in the United States amounted to $27.3 +million, $24.8 million and $21.4 million in 2001, 2000 and 1999, respectively. +Revenues attributable to international customers amounted to $5.3 million, +$4.0 million and $2.7 million, in 2001, 2000 and 1999, respectively. +Insurance Risk Assessment +The Company currently markets the OraSure(R) oral fluid collection device +for use in screening life insurance applicants in the United States and +internationally to test for three of the most important underwriting risk +factors: HIV-1, cocaine, and cotinine. The Company sells the devices to +insurance testing laboratories, which in turn provide the devices to insurance +companies, usually in combination with testing services. The Company also +maintains a direct sales force that promotes use of the OraSure(R) device +directly to insurance companies. Insurance companies then make their own +decision regarding which laboratory to use to supply their collection devices +and testing services. The Company's OraSure(R) Western Blot confirmatory test +is distributed through BMX and is used to confirm oral fluid specimens that +test positive for HIV-1. +8 +Because insurance companies are in various stages of their adoption of the +OraSure(R) device, there exists a wide range of policy limits where the +product is being applied. Some insurance companies have chosen to extend their +testing to lower policy limits where they did not test at all before, while +others have used OraSure(R) to replace some of their blood and urine-based +testing. The Company's sales force continues to encourage additional insurance +companies to use OraSure(R) and to extend the use of the product by existing +customers. Several companies have expanded use of OraSure(R) to the $1 million +and higher dollar policy amounts. This expansion is attributable to several +factors, including increasing acceptance of the reliability of oral fluid +testing, the high quality of test results, the low cost of oral fluid testing +relative to blood tests, and the ease of use of the OraSure(R) device. +The Company also sells its AUTO-LYTE(R) and MICRO-PLATE assays and reagents +in the insurance testing market directly to laboratories, including LabOne, +Inc., Heritage Labs, Clinical Reference Laboratory, and the laboratory testing +division of Metropolitan Life Insurance Company. AUTO-LYTE(R) assays are used +principally to test urine samples for cotinine and other metabolites and to +perform urine chemistries for risk assessment purposes. MICRO-PLATE assays are +used principally to test oral fluid specimens collected with the OraSure(R) +device for cocaine and cotinine. +Infectious Disease Testing +The Company's sales personnel market products directly to customers in the +public health market primarily for HIV-1 testing. This market consists of a +broad range of clinics and laboratories and includes states, counties, and +other governmental agencies, colleges and universities, correctional +facilities and the military. There are also a number of organizations in the +public health market such as AIDS service organizations and various community- +based organizations set up primarily for the purpose of encouraging and +enabling HIV-1 testing. To better serve this market, the Company has entered +into agreements with LabOne, Inc. and Heritage Labs to provide prepackaged +OraSure(R) test kits, with prepaid laboratory testing and specimen shipping +costs included. The Company has sold the OraSure(R) and OraQuick(R) HIV +devices in the international public health markets. +Substance Abuse Testing +The Company's substance abuse products are marketed into the workplace +testing, forensic toxicology, criminal justice, and drug rehabilitation +markets, through direct sales and distributors. The forensic toxicology market +consists of 250-300 laboratories including federal, state and county crime +laboratories, medical examiner laboratories, and reference laboratories. The +criminal justice market consists of a wide variety of entities in the criminal +justice system that require drug screening, such as pre-trial services, parole +and probation officials, police forces, drug courts, prisons, drug treatment +programs and community/family service programs. The Company has entered into +agreements for the distribution of Intercept(R) collection kits and associated +reagents for drugs-of-abuse testing in the workplace testing market in the +United States and Canada through several laboratory distributors, including +LabOne, Inc., Quest Diagnostics, Clinical Reference Laboratory and NWT, Inc., +and internationally for workplace and forensic toxicology testing through Bio- +Rad Laboratories, Altrix Plc and other distributors. The Company also +distributes its Q.E.D.(R) saliva alcohol test primarily in the workplace +testing market through various distributors. +Physicians' Offices +The Company sells the Histofreezer(R) product line to distributors that +market to more than 150,000 primary care physicians and podiatrists in the +United States. Major U.S. distributors include Cardinal Healthcare, McKesson +HBOC, Physicians Sales & Service, Bergen Brunswig, and Henry Schein. +Internationally, the Company markets Histofreezer(R) in a number of countries +through a network of distributors. +International Markets +The Company sells a number of its products into international markets +primarily through distributors with knowledge of their local markets. +Principal markets include physicians' offices, insurance risk assessment, +public +9 +health, and laboratory testing. The Company assists its distributors in +registering the products and obtaining required regulatory approvals in each +country and provides training and support materials. The Company's +international marketing program includes direct assistance to distributors in +arranging for laboratory services, cooperation from screening test +manufacturers, and performance of Western Blot confirmatory tests when +necessary. +Significant Products and Customers +Several different products have contributed significantly to the Company's +financial performance, accounting for 15% or more of total revenues during the +past three years. The Company's OraSure(R) and Intercept(R) oral fluid +collection devices, Histofreezer(R), and immunoassay tests and reagents +accounted for total revenues of approximately $13.0 million, $6.7 million and +$7.4 million in 2001, $11.2 million, $6.8 million, and $6.7 million in 2000, +and $7.8 million, $5.7 million, and $6.2 million in 1999, respectively. As new +products are developed and commercialized, the Company expects to reduce its +dependence on the products referred to above. +The Company has one customer, LabOne, Inc., that has accounted for 10% or +more of total revenues. LabOne recently acquired Osborne Group, Inc., another +customer of the Company in the insurance testing market. During 2001, the +Company's sales to LabOne, Inc. and Osborne Group, Inc. together accounted for +approximately 29% of the Company's total revenues. As a result of its +acquisition of Osborne, LabOne has achieved certain operating efficiencies and +reduced its overall inventory levels which in turn lowered purchases of the +Company's insurance testing products during the fourth quarter of 2001. While +the Company believes that its relationship with LabOne is good, there can be +no assurance that sales to this customer will not decrease further or that +this customer will not choose to replace the Company's products with those of +competitors. The loss of this customer or a significant decrease of products +purchased by it would have a material adverse effect on the Company. +Supply and Manufacturing +The Company has entered into an agreement with a contractor in the United +States for the assembly and supply of OraSure(R) and Intercept(R) oral fluid +collection devices through December 31, 2002. This agreement will +automatically renew for additional annual periods unless either party provides +timely notice of termination prior to the end of an annual period. The Company +believes that other firms or the Company would be able to manufacture the +OraSure(R) and Intercept(R) devices on terms no less favorable than those set +forth in the agreement with the contractor in the event that this contractor +were to be unable or unwilling to continue manufacturing this product. A +change in manufacturer of these devices would require FDA review and approval +which could require significant time to complete and could disrupt the +Company's ability to manufacture and sell the OraSure(R) and Intercept(R) +devices. The Company expects to transfer manufacturing of its OraSure(R) and +Intercept(R) collection devices to its Bethlehem, Pennsylvania facility during +2003. +In the second quarter of 2001, the Company completed a realignment of its +manufacturing operations, which included the elimination of the manufacturing +of OraQuick(R) in the Beaverton, Oregon facility, the installation of +automated manufacturing equipment for OraQuick(R) in Bethlehem, Pennsylvania, +and the addition of contract manufacturing capacity in Thailand. In connection +with this realignment, the Company entered into a supply agreement for the +manufacture of the OraQuick(R) HIV testing device in Thailand. This agreement +has an initial term of one year, and will automatically renew for additional +annual periods unless either party provides a timely notice of termination +prior to the end of an annual period. The Company believes that other firms +would be able to manufacture the OraQuick(R) test on terms no less favorable +than those set forth in the agreement in the event that the Thailand +contractor would be unable or unwilling to continue manufacturing this +product. +The Company can purchase the HIV antigen required for the OraQuick(R) +product only from a limited number of sources. This antigen is currently +purchased from a contract supplier under a long-term agreement with an initial +term ending in January 2010 and one-year automatic renewal terms thereafter. +If for any reason the supplier should no longer be able to supply the +Company's antigen needs, the Company believes that an +10 +alternative supply could be obtained at a competitive cost. However, a change +in the antigen would require FDA approval which could require significant time +to complete and could disrupt the Company's ability to manufacture and sell +the OraQuick(R) device in the United States. +The Company expects to assemble analyzers, test cassettes and collectors +used in the Company's UPlink(TM) drugs of abuse rapid detection system and to +package this product for shipment at the Company's Bethlehem, Pennsylvania +facilities. +The Company's oral fluid Western Blot HIV-1 confirmatory test is +manufactured in the Company's Beaverton, Oregon facility. The HIV antigen +needed to manufacture the Company's Western Blot HIV-1 confirmatory test kits +is available from only a limited number of sources. The Company purchases +antigen and certain other materials for this product from BMX, which is also +the exclusive distributor of the test kits. BMX is required to supply the +Company's requirements for antigen and other materials for the term of its +distribution agreement with the Company, which originally expired on March 31, +2001. OraSure Technologies and BMX are currently negotiating certain +amendments to the agreements, including an extension of their terms. If for +any reason BMX is no longer able to supply the Company's antigen and other +material needs, the Company would be able to obtain alternate supplies at a +competitive cost, although a change in the antigen would require FDA approval +which could require significant time to complete and could disrupt the +Company's ability to manufacture and sell its Western Blot HIV-1 confirmatory +test. +Histofreezer(R) is manufactured in The Netherlands by Koninklijke, +Utermohlen, N.V. ("Utermohlen"), the company from which the Company acquired +the product in 1998. The Company purchases the product pursuant to an +exclusive production agreement between the two companies. The production +agreement provides that Utermohlen shall be the exclusive supplier of the +Histofreezer(R) product until at least December 31, 2006. The Company believes +that additional manufacturers of the Histofreezer(R) product are available on +terms no less favorable than the terms of the production agreement with +Utermohlen in the event that Utermohlen would be unable or unwilling to +continue manufacturing the Histofreezer(R) product. +The Company's AUTO-LYTE(R) and MICRO-PLATE assays are manufactured at its +Bethlehem, Pennsylvania, facility. The Company manufactures the test +components and assembles and packages the tests for distribution. The +Company's tests require the production of highly specific and sensitive +antibodies corresponding to the antigen of interest. Substantially all of the +Company's antibody requirements are provided by contract suppliers. However, +in 1999, the Company began to develop its own in-house monoclonal and +polyclonal antibody capabilities. The Company believes that it maintains +adequate reserves of antibody supplies and believes it has access to +sufficient raw materials for these products. +AUTO-LYTE(R) test kits are manufactured by adding specific antibodies to +chemical solutions which are then packaged as a defined volume of liquid in a +plastic container to be run on laboratory equipment. MICRO-PLATE test kits are +produced by placing purified antibodies into plastic microwells which are sent +to customers in multiples of 96 tests along with a set of reagents necessary +to control the reaction. +The Q.E.D.(R) saliva alcohol test is manufactured, packaged, and shipped +from the Company's Bethlehem, Pennsylvania facility. +Employees +As of December 31, 2001, the Company had 221 full-time employees, including +46 in sales, marketing, and client services; 80 in research and development; +77 in operations, manufacturing, quality control, purchasing and shipping; and +18 in administration and finance. Sixteen of the Company's employees hold +Ph.D. degrees. The Company's employees are not represented by a collective +bargaining agreement. +During 2001, the Company completed a realignment of its manufacturing +operations, pursuant to which employee headcount was reduced in its Beaverton, +Oregon facility by approximately 33%. The reduction was +11 +accomplished primarily through layoffs and attrition during the first half of +2001. During the first quarter of 2002, the Company implemented a 10% +reduction in force as a result of lower than anticipated sales levels during +2001 and the elimination of certain development projects. +Competition +The diagnostic industry is a multi-billion dollar international industry and +is intensely competitive. Many of the Company's competitors are substantially +larger and have greater financial, research, manufacturing, and marketing +resources. Important competitive factors for the Company's products include +product quality, price, ease of use, customer service, and reputation. +Industry competition is based upon scientific and technological capability, +proprietary know-how, access to adequate capital, the ability to develop and +market products and processes, the ability to attract and retain qualified +personnel, and the availability of patent protection. +A few large corporations produce a wide variety of diagnostic tests and +other medical devices and equipment, a larger number of mid-size companies +generally compete only in the diagnostic industry, and a significant number of +small companies produce only a few diagnostic products. As a result, the +diagnostic test industry is fragmented and segmented. The future market for +diagnostic tests is expected to be characterized by consolidation, greater +cost consciousness, and tighter reimbursement policies. The purchasers of +diagnostic products are expected to place increased emphasis on lowering +costs, reducing inventory levels, automation, service, and volume discounts. +The increased complexity of the market is expected to force many competitors +to enter into joint ventures or license certain products or technologies. +Competition is expected to intensify as technological advances are made and +become more widely known, and as new products reach the market. Furthermore, +new testing methodologies could be developed in the future that render the +Company's products impractical, uneconomical or obsolete. There can be no +assurance that the Company's competitors will not succeed in developing or +marketing technologies and products that are more effective than those +developed by the Company or that would render its technologies and products +obsolete or otherwise commercially unattractive. In addition, there can be no +assurance that competitors will not succeed in obtaining regulatory approval +for these products, or in introducing or commercializing them before the +Company. Such developments could have a material adverse effect on the +Company's business, financial condition, and results of operations. +Competition in the market for HIV testing is intense and is expected to +increase. The Company believes that the principal competition will come from +existing laboratory-based blood tests, point-of-care whole blood rapid tests, +urine-based assays, or other oral fluid-based tests that may be developed. The +Company's competitors include specialized biotechnology firms as well as +pharmaceutical companies with biotechnology divisions and medical diagnostic +companies. +Several companies market or have announced plans to market oral specimen +collection devices and tests outside the United States. The Company expects +the number of devices competing with its OraSure(R) device to increase as the +benefits of oral specimen-based testing become more widely accepted. +The FDA has approved an HIV-1 screening test for use with a urine sample. In +June 1998, the FDA notified Cambridge Biotech Corp. (acquired by Calypte, Inc. +in December 1998) that it had approved the use of its HIV-1 Western Blot +confirmatory test for use with urine samples. Urine testing will compete in +the same markets as the Company's products. The Company believes that urine +collection can be logistically more difficult, inconvenient, and potentially +embarrassing for the individual being tested, and that privacy and chain-of- +custody issues are further impediments to routine use of urine-based HIV +tests. The Company cannot predict the impact of the availability of urine- +based tests on the HIV testing market or on sales of the Company's products. +Significant competitors in the rapid assay HIV testing market include Abbott +Laboratories, the Ortho Diagnostics division of Johnson & Johnson, Bio-Rad +Laboratories, Trinity Biotech Plc, MedMira Laboratories, Inc. and Chembio +Diagnostic Systems, Inc. +12 +In the insurance risk assessment market, the Company's AUTO-LYTE(R) +homogeneous assays for cocaine and cotinine compete with reagents from +Microgenics, Inc. (a subsidiary of Sybron Lab Products). The Company's AUTO- +LYTE(R) homogeneous assays for beta-blockers and thiazide as well as MICRO- +PLATE heterogeneous assays specifically designed for the detection of cocaine, +cotinine, and IgG in oral fluid are the only assays available in the +marketplace. In urine chemistries, the Company's significant competitors +include The Diagnostics Systems Group of Olympus America Inc. +The Company's MICRO-PLATE drugs-of-abuse reagents are targeted to forensic +testing laboratories where sensitivity, automation, and "system solutions" are +important. In the past, these laboratories have typically had to rely on +radioimmunoassay test methods to provide an adequate level of sensitivity. +Radioimmunoassays require radioactive materials, which have a short shelf-life +and disposal problems. The Company's MICRO-PLATE tests meet the laboratories' +sensitivity needs, run on automated equipment, are not radioimmunoassays, and +are offered to the laboratory as a complete system solution of reagents, +instrumentation and software to meet the specific needs of each customer. +Options to buy or rent the instrumentation and software are offered to these +customers. +In the forensic toxicology market, the Company competes with both +homogeneous and heterogeneous tests manufactured by a host of companies. +Significant competitors in the market for these assays include Dade Behring, +Microgenics, Inc., Abbott Laboratories, Roche Diagnostics, and Immunalysis. +The Intercept(R) drug testing system competes with a wide variety of drug +testing products and services. These competitors can be divided into two +groups: 1) rapid tests, and 2) laboratory-based services. Within each product +or service group, drug testing can be further divided into testing matrices +such as urine, hair, sweat and oral fluid. Major competitors in the +laboratory-based urine drug testing market are Quest Diagnostics, LabOne, +Inc., LabCorp., Psychemedics, PharmChem, and Medtox Laboratories. The +Company's UPlink(TM) product will also compete with other on-site, rapid drug +assays. Major competitors in the rapid drug testing market include American +Biomedica, Roche Diagnostics, Biosite Diagnostics, Avitar, Inc., LifePoint, +Inc. and eScreen. +Within the sub-segment of oral fluid drugs-of-abuse testing, Intercept(R) +and UPlink(TM) will compete with Avitar, Inc., which markets a rapid drug test +to the workplace and criminal justice markets, Ansys Technologies, Inc., which +markets saliva alcohol and drug tests, and LifePoint, Inc., which has +announced plans to sell a reader-based saliva test panel that will include +alcohol testing. +Q.E.D.(R) has two direct competitors, Roche Diagnostics and Chematics. These +companies offer semi-quantitative saliva-based alcohol tests and have received +DOT approval. Indirect competitors who offer breath testing equipment include +Intoximeters, Drager, and CMI. Although there are lower priced tests on the +market that use oral fluid or breath as a test medium, these tests are +qualitative tests that are believed to be substantially lower in quality and +scope of benefits than the Company's Q.E.D.(R) test. +The Histofreezer(R) product's delivery system and warmer operating +temperature than liquid nitrogen provide the Company with the opportunity to +target sales to primary care physicians, such as family practitioners, +pediatricians, and podiatrists. The Company does not generally target sales to +dermatologists because they have the volume of patients required to support +the capital costs associated with a liquid nitrogen delivery system. There is +limited competition for convenient cryosurgical products for wart removal in +the primary care physician market. Major competitors for the Histofreezer(R) +product include CryoSurgery, Inc. and Aurium Pharma Inc. In addition, liquid +nitrogen is used by medical professionals to remove warts and other benign +skin lesions. Lastly, patients may purchase various over-the-counter products +to treat warts at home. +Patents and Proprietary Information +The Company seeks patent and other intellectual property rights to protect and +preserve its proprietary technology and its right to capitalize on the results +of its research and development activities. The Company also relies upon trade +secrets, know-how, continuing technological innovations, and licensing +opportunities to provide +13 +it with competitive advantages in its selected markets and to accelerate new +product introductions. Respecting the patent and intellectual property rights +of others, the Company regularly searches for third-party patents in its +fields of endeavor to shape its own patent and product commercialization +strategies as effectively as possible and to identify licensing opportunities. +United States patents generally have a maximum term of 20 years from the date +an application is filed. +The Company has ten United States patents and numerous foreign patents for +the OraSure(R) and Intercept(R) collection devices and related technology +relating to oral fluid collection, containers for oral fluids, methods to test +oral fluid, formulations for the manufacture of synthetic oral fluid, and +methods to control the volume of oral fluid collected and dispersed. The +Company has also applied for additional patents, in both the United States and +certain foreign countries, on such products and technology. The Company has +one patent for the OraQuick(R) rapid HIV test in the United States and intends +to apply for other patents for this product. The Company may need to obtain +licenses or other rights under, or enter into distribution or other business +arrangements in connection with, certain HIV-2 and lateral flow patents in +order to market the OraQuick(R) HIV test in the United States and certain +other countries. See the Section entitled, "Risk Factors--Patent Issues +Affecting OraQuick(R)," for a further discussion of these issues. +In April 1995, the Company received exclusive worldwide rights under patents +and know-how owned by SRI International to develop and market products that +involve the use of UPT(TM). The Company also received non-exclusive worldwide +rights under patents and know-how owned by the Sarnoff Corporation (a +subsidiary of SRI International formerly called the David Sarnoff Research +Center) to develop and market products that involve the use of UPT(TM). The +Company has the right to sublicense these rights under the agreements subject +to consent from SRI and Sarnoff. +Under the agreement with SRI, OraSure Technologies is required to make +license, maintenance and royalty payments to SRI. The Company made an initial +license payment to SRI in 1995 and paid research fees in 1995 and 1996 in +connection with development projects in which SRI participated. The Company is +obligated to make annual maintenance payments on each anniversary of the +agreement following the completion of the development period until the first +commercial sale of a product. The Company also must make royalty payments for +a period equal to the longer of ten years from the date of the first +commercial sale of the products or the term during which the manufacture, use, +or sale of a product would infringe licensed patents, but for SRI's license to +the Company. The Company believes that the royalty rates payable by the +Company are comparable to the rates generally payable by other companies under +similar arrangements. The Company's agreement with SRI terminates upon the +expiration of the Company's obligation to pay royalties to SRI. +In 1999, the Company paid $1.5 million to TPM Europe Holding B.V., its +sublicensor, for the termination of an existing license agreement between the +sublicensor and the Company with respect to the sublicense of UPT(TM) patents +owned by Leiden University, The Netherlands, and to secure a direct research, +development, and license arrangement with Leiden University. +The Company has or has licensed rights under nine United States patents and +numerous foreign patents for methods, compositions, and apparatuses relating +to phosphor technologies. Several additional UPT(TM) patent applications +remain pending in the United States and abroad. The Company expects to +continue to expand its UPT(TM) patent portfolio in 2002. Several new patent +applications were also filed by the Company in the U.S. for the design and +methods used in the UPlink(TM) rapid detection platform. +The Company has one U.S. patent relating to the Company's method for +detecting blood in urine specimens and the Company's AUTO-LYTE(R) products. +The Company has three U.S. patents and numerous foreign patents issued for +apparatuses and methods for the topical removal of skin lesions relating to +its Histofreezer(R) device. +14 +The Company has five U.S. patents and numerous foreign patents and patent +applications for the analog-to-digital threshold signaling technology used in +the Q.E.D.(R) test. These patents are related to the analog-to-digital +technology color control systems and methods, systems and devices for the +test, and detection of biochemical molecules. +It is the Company's policy to require its employees, consultants, outside +collaborators, and other advisors to execute confidentiality agreements upon +the commencement of employment or consulting relationships with the Company. +These agreements provide that all confidential information developed by or +made known to the individual during the course of the individual's +relationship with the Company, is to be kept confidential and not disclosed to +third parties except in specific circumstances. In the case of employees, the +agreements provide that all inventions conceived by the individual during his +or her tenure at the Company will be the exclusive property of the Company. +The Company owns rights to trademarks and service marks that it believes are +necessary to conduct its business as currently operated. The Company is the +owner in the United States of trademarks, including UPT(TM), UPlink(TM), +OraSure(R), Intercept(R), OraQuick(R), Histofreezer(R), Q.E.D.(R), and AUTO- +LYTE(R). The Company also is the owner of many of these marks and others in +several foreign countries. The Company is not aware of any pending claims of +infringement or other challenges to the Company's rights to use its marks in +the United States or in other countries as currently used by the Company. +Although important, the issuance of a patent or existence of trademark or +trade secret protection does not in itself ensure the Company's success. +Competitors may be able to produce products competing with a patented Company +product without infringing on the Company's patent rights. Issuance of a +patent in one country generally does not prevent manufacture or sale of the +patented product in other countries. The issuance of a patent to the Company +or to a licensor is not conclusive as to validity or as to the enforceable +scope of the patent. The validity or enforceability of a patent can be +challenged by litigation after its issuance, and, if the outcome of such +litigation is adverse to the owner of the patent, the owner's rights could be +diminished or withdrawn. Trade secret protection does not prevent independent +discovery and exploitation of the secret product or technique. +Government Regulation +General +Most of the Company's existing and proposed diagnostic products are +regulated by the FDA, certain state and local agencies, and comparable +regulatory bodies in other countries. This regulation governs almost all +aspects of development, production, and marketing, including product testing, +authorizations to market, labeling, promotion, manufacturing, and +recordkeeping. All of the Company's FDA-regulated products require some form +of action by the FDA before they can be marketed in the United States, and, +after approval or clearance, the Company must continue to comply with other +FDA requirements applicable to marketed products. Both before and after +approval or clearance, failure to comply with the FDA's requirements can lead +to significant penalties. +Domestic Regulation +Most of the Company's diagnostic products are regulated as medical devices. +The Company's Serum Western Blot HIV-1 confirmatory test, which was +discontinued in February 2001, was regulated as a biologic or blood product. +There are two review procedures by which medical devices can receive FDA +clearance or approval. Some products may qualify for clearance under Section +510(k) of the Federal Food, Drug and Cosmetic Act, in which the manufacturer +provides a pre-market notification that it intends to begin marketing the +product, and shows that the product is substantially equivalent to another +legally marketed product (i.e., that it has the same intended use and is as +safe and effective as a legally marketed device and does not raise different +questions of safety and effectiveness). In some cases, the submission must +include data from human clinical studies. Marketing may +15 +commence when the FDA issues a clearance letter finding such substantial +equivalence. An applicant must submit a 510(k) application at least 90 days +before marketing of the affected product commences. Although FDA clearance may +be granted within that 90-day period, in some cases as much as a year or more +may be required before clearance is obtained, if at all. +If the medical device does not qualify for the 510(k) procedure (either +because it is not substantially equivalent to a legally marketed device or +because it is required by statute and the FDA's implementing regulations to +have an approved application), the FDA must approve a pre-market approval +application ("PMA") before marketing can begin. PMAs must demonstrate, among +other matters, that the medical device provides a reasonable assurance of +safety and effectiveness. A PMA is typically a complex submission, including +the results of preclinical and clinical studies. Preparing a PMA is a detailed +and time-consuming process. Once a PMA has been submitted, the FDA is required +to review the submission within 180 days. However, the FDA's review may, and +often is, much longer, often requiring one year or more, and may include +requests for additional data. +Biologic products must be the subject of an approved biologics license +application ("BLA") before they can be marketed. The FDA approval process for +a biologic product is similar to the PMA approval process, involving a +demonstration of the product's safety and effectiveness based in part on both +preclinical and clinical studies. +Many of the insurance testing products are used for non-medical purposes and +many of the drugs-of-abuse products sold to state crime labs are for forensic +use. The Company intends initially to sell its UPlink(TM) rapid drug detection +system for law enforcement purposes into the criminal justice market. The FDA +does not currently regulate products used for these purposes. +Every company that manufactures biologic products or medical devices +distributed in the United States must comply with the FDA's Quality System +Regulations ("QSRs"). These regulations govern the manufacturing process, +including design, manufacture, testing, release, packaging, distribution, +documentation, and purchasing. Compliance with QSRs is required before the FDA +will approve an application, and these requirements also apply to marketed +products. Companies are also subject to other post-market and general +requirements, including compliance with restrictions imposed on marketed +products, compliance with promotional standards, recordkeeping, and reporting +of certain adverse reactions. The FDA regularly inspects companies to +determine compliance with QSRs and other post-approval requirements. Failure +to comply with statutory requirements and the FDA's regulations can lead to +substantial penalties, including monetary penalties, injunctions, product +recalls, seizure of products, and criminal prosecution. +Products that include electrical or light emitting equipment must also +comply with the FDA's safety and performance standards applicable to such +equipment. The Company's UPlink(TM) analyzer is a piece of electrical +equipment that uses a laser to read the test results and is, therefore, +subject to these requirements. In addition, there is an industry safety and +performance standard for electrical equipment established by Underwriters +Laboratories, Inc., known as UL3101. Although a voluntary standard, compliance +with UL3101 will support the Company's 510(k) submission for the UPlink(TM) +analyzer. The Company has retained Underwriters Laboratories Inc. to examine +and test the UPlink(TM) analyzer and certify that it meets the FDA +requirements and UL3101. +The Clinical Laboratory Improvement Act of 1988 ("CLIA") prohibits +laboratories from performing in vitro tests for the purpose of providing +information for the diagnosis, prevention or treatment of any disease or +impairment of, or the assessment of, the health of human beings unless there +is in effect for such laboratories a certificate issued by the U.S. Department +of Health and Human Services applicable to the category of examination or +procedure performed. Although a certificate is not required for OraSure +Technologies, the Company considers the applicability of the requirements of +CLIA in the design and development of its products. In addition, the Company +has obtained a waiver of the CLIA requirements for its Q.E.D.(R) alcohol +saliva test and may seek similar waivers for certain of its other products. A +CLIA waiver will remove certain quality control and other requirements that +must be met for certain customers to use the Company's products. +16 +In June 2000, the FDA issued observations of deficiencies following an +inspection of OraSure Technologies' manufacturing facility in Beaverton, +Oregon, stating the FDA's view that the Company's Serum Western Blot product +was not manufactured in compliance with the QSRs. The FDA had previously +issued a warning letter in September 1998, and observations of deficiencies in +January 1999 to the Company based on prior inspections of the Oregon facility. +The FDA questioned the Company's compliance with the QSRs in areas such as +process validation, purchasing controls, complaint handling, and equipment +controls at the Oregon facility. The Company has undertaken a substantial +review of its manufacturing and quality systems, and has either already made +changes or has developed plans to make changes, to satisfy the FDA's concerns +with respect to its QSR compliance. This was communicated to the FDA in a +written reply in September 2000. +On October 20, 2000, the FDA sent a letter to the Company regarding the +Serum Western Blot product voicing the agency's concern over the previously +observed deficiencies and stating its intent to revoke the Company's license +to manufacture this product if the problems were not corrected in sufficient +time. The FDA acknowledged the receipt of the Company's written responses and +found that those items which had been completed appeared to be adequate, but +required the Company to submit a comprehensive report on corrective action +plans and the schedule to address the remaining items. The Company submitted +such a report in November 2000, and believes that it either has already +implemented changes or has appropriate plans in place to implement changes +that will adequately address the FDA's concerns. +Production of the Serum Western Blot product line was voluntarily +discontinued by the Company and, in response to this voluntary action by the +Company, the associated biologics license was revoked on October 12, 2001. +However, OraSure Technologies has recognized that the basic changes to the +overall quality system needed to remedy the FDA's observations would also +assist in the quality for all of the Company's product lines, and therefore +has devoted a considerable amount of time and resources to improving quality +procedures throughout the Company. Even with the substantial efforts and the +progress made to date, there is a risk that the FDA will not be satisfied with +the Company's efforts. If the FDA is not satisfied, it could take action +intended to force OraSure Technologies to stop manufacturing its products at +the Oregon facility (which consists solely of the manufacture of Company's +oral fluid Western Blot HIV-1 confirmatory test) until the FDA believes the +Company is in compliance with QSR requirements. Also, although the FDA has +granted the Company permission to obtain certificates needed for export of +products, the FDA could refuse export permission in the future if the agency +determines that the Company's progress toward QSR compliance is not +sufficient. +International +The Company is also subject to regulations in foreign countries governing +products, human clinical trials and marketing, and may need to obtain approval +from international public health agencies, such as the World Health +Organization, in order to sell products in certain countries. Approval +processes vary from country to country, and the length of time required for +approval or to obtain other clearances may in some cases be longer than that +required for U.S. governmental approvals. The extent of potentially adverse +governmental regulation affecting the Company that might arise from future +legislative or administrative action cannot be predicted. The Company will +pursue approval only in those countries that have a significant market +opportunity. +The International Organization for Standardization ("ISO") is a worldwide +federation of national standards bodies from some 130 countries, established +in 1947. The mission of ISO is to promote the development of standardization +and related activities in the world with a view to facilitating the +international exchange of goods and services. ISO certification is evidenced +by the CE mark and indicates that the Company's quality system complies with +standards applicable to activities ranging from initial product design and +development through production and distribution. ISO certification is a +prerequisite to obtaining a CE mark, which is required for distribution of +medical devices in the European common markets. +In the first quarter of 1999, the Company received approval to use the CE +mark for the OraSure(R) and Intercept(R) collection devices. In December 2000, +the Company's Bethlehem facility received final certification for the European +Medical Device Directive (93/42/EEC), ISO 9001, ISO 13485, and EN46001. The +Company has also received authorization to use the CE mark for its +Histofreezer(R) product line. +17 +In order to obtain the CE mark for a product containing electrical +equipment, that product would need to meet several international safety and +performance standards (IEC 60825-1; IEC/EN 61010-1, CSA C 22.2, IEC 1010-1, EN +61000). The Company's UPlink(TM) analyzer will need to meet these standards in +order to obtain its CE mark. The Company has retained Underwriter +Laboratories, Inc. and Laird Technologies to examine and test the UPlink(TM) +analyzer and certify that it meets these international standards. +The Company must also submit evidence of marketing approval or clearance by +the FDA to Health Canada's Therapeutic Products Programme prior to commencing +sales in Canada. The Company has completed this process for several of its +current products which require FDA review. +Environmental Regulation +Because of the nature of its current and proposed research, development, and +manufacturing processes, the Company is subject to stringent federal, state, +and local laws, rules, regulations, and policies governing the use, +generation, manufacture, storage, air emission, effluent discharge, and +handling and disposal of materials and wastes. The Company believes that it +has complied with these laws and regulations in all material respects and has +not been required to take any action to correct any noncompliance. +Forward-Looking Statements +This Report contains certain "forward-looking statements," within the +meaning of the Federal securities laws. These may include statements about +expected revenues, earnings, expenses or other financial performance, future +product performance or development, expected regulatory filings and approvals, +planned business transactions, views of future industry or market conditions, +other factors that could affect future operations or financial position, and +statements that include the words "believes," "expects," "anticipates," +"intends," "plans," "estimates," "may," "will," "should," "could," or similar +expressions. Forward-looking statements are not guarantees of future +performance or results. Known and unknown factors could cause actual +performance or results to be materially different from those expressed or +implied in these statements. Some of these factors are: ability to market +products; impact of competitors, competing products and technology changes; +ability to develop, commercialize and market new products; market acceptance +of oral fluid testing products and up-converting phosphor technology products; +ability to fund research and development and other projects and operations; +ability to obtain and timing of obtaining necessary regulatory approvals; +ability to develop product distribution channels; uncertainty relating to +patent protection and potential patent infringement claims; ability to enter +into international manufacturing agreements; obstacles to international +marketing and manufacturing of products; ability to sell products +internationally; loss or impairment of sources of capital; exposure to product +liability and other types of litigation; changes in international, federal or +state laws and regulations; changes in relationships with strategic partners +and reliance on strategic partners for the performance of critical activities +under collaborative arrangements; changes in accounting practices or +interpretation of accounting requirements; customer consolidations and +inventory practices; equipment failures and ability to obtain needed raw +materials and components; the impact of terrorist attacks and civil unrest; +and general political, business and economic conditions. These and other +factors that could cause the forward-looking statements to be materially +different are described in greater detail in the Section entitled, "Risk +Factors," and elsewhere in this Report. Although forward-looking statements +help to provide complete information about future prospects, they may not be +reliable. The forward-looking statements are made as of the date of this +Report and Orasure Technologies undertakes no duty to update these statements. +Risk Factors +The following is a discussion of certain significant risk factors that could +potentially affect the Company's financial condition, performance and +prospects. +Competing Products +The diagnostic industry is focused on the testing of biological specimens in +a laboratory or at the point-of-care and is highly competitive and rapidly +changing. The Company's principal competitors have considerably +18 +greater financial, technical, and marketing resources. As new products enter +the market, the Company's products may become obsolete or a competitor's +products may be more effective or more effectively marketed and sold than the +Company's. If OraSure Technologies fails to maintain and enhance its +competitive position, its customers may decide to use products developed by +competitors which could result in a loss of revenues. +Ability to Develop New Products +In order to remain competitive, the Company must commit substantial +resources each year to research and development. The research and development +process generally takes a significant amount of time from inception to +commercial product launch. This process is conducted in various stages, and +during each stage there is a substantial risk that the Company will not +achieve its goals and will have to abandon a product in which it has invested +substantial amounts. +During 2001, 2000 and 1999, the Company incurred $9.4 million, $10.4 million +and $5.6 million, respectively, in research and development expenses. The +Company expects to continue to incur significant costs in its research and +development activities. Moreover, there can be no assurance that OraSure +Technologies will succeed in its research and development efforts. If the +Company fails to develop commercially successful products, or if competitors +develop more effective products or a greater number of successful new +products, customers may decide to use products developed by the Company's +competitors, which would result in a loss of revenues. +Market Acceptance of Oral Fluid Testing Products +The Company has made significant progress in gaining acceptance of oral +fluid testing for HIV in the insurance and public health markets. The Company +has also made significant progress in gaining acceptance of oral fluid testing +for drugs of abuse in the workplace and criminal justice testing markets. +Other markets, particularly the physician office market, may resist the +adoption of oral fluid testing as a replacement for other testing methods in +use today. In addition, certain state laws prohibit or restrict the use of +oral fluid testing for drugs of abuse in certain markets. There can be no +assurance that the Company will be able to expand the use of its oral fluid +testing products in these or other markets. +Loss or Impairment of Sources of Capital +Although the Company has made significant progress in the past toward +controlling expenses and increasing product revenue, historically the Company +has depended, to a substantial degree, on capital raised through the sale of +equity securities and bank borrowings to fund its operations. The Company's +future liquidity and capital requirements will depend on numerous factors, +including, but not limited to, the costs and timing of the expansion of +manufacturing capacity, the success of product development efforts, the costs +and timing of expansion of sales and marketing activities, the timing of +commercial launch of new products, the extent to which existing and new +products gain market acceptance, competing technological and market +developments, and the scope and timing of strategic acquisitions. If +additional financing is needed, the Company may seek to raise funds through +the sale of equity or other securities or through bank borrowings. There can +be no assurance that financing through the sale of securities, bank borrowings +or otherwise, will be available to the Company on satisfactory terms, if at +all. +Ability of the Company to Develop Product Distribution Channels +The Company has marketed many of its products by collaborating with +laboratories, diagnostic companies and distributors. For example, the +Company's OraSure(R) oral fluid collection device is distributed to the +insurance industry through major insurance testing laboratories. One of these +laboratories, LabOne, Inc., acquired another insurance laboratory customer, +Osborne Group, Inc., in 2001 and these customers together accounted for +approximately 29%, 30%, and 28% of the Company's revenues for the years 2001, +2000, and 1999, respectively. The Company's sales depend to a substantial +degree on its ability to sell products to these customers and develop +19 +new product distribution channels, and on the marketing abilities of the +companies with which it collaborates. In addition, some of the Company's +distributors have recently consolidated, and such consolidation has had, and +may continue to have, an adverse impact on the level of orders for the +Company's products. There can be no assurance that such companies will +continue to be able to purchase or distribute the Company's products or +maintain historic order volumes, or that new distribution channels will be +available on satisfactory terms. +Obtaining and Maintaining Regulatory Approvals and Clearances +As described more fully above under "Government Regulation," many of the +Company's proposed and existing products are subject to regulation by the FDA +and other governmental or public health agencies. In particular, the Company +is subject to strict governmental controls on the development, manufacture, +labeling, distribution and marketing of its products. The process of obtaining +required approvals or clearances from governmental or public health agencies +varies according to the nature of, and uses for, the specific product and can +involve lengthy and detailed laboratory testing, human clinical trials, +sampling activities, and other costly, time-consuming procedures. The +submission of an application to a regulatory authority does not guarantee that +it will grant an approval or clearance to market the product. Each authority +may impose its own requirements and delay or refuse to grant approval or +clearance, even though a product has been approved in another country. +The approval or clearance process for a new product can be complex and +lengthy. The time taken to obtain approval or clearance varies depending on +the nature of the application and may result in the passage of a significant +period of time from the date of submission of the application. This time span +increases the costs to develop new products and increases the risk that the +Company will not succeed in introducing or selling them. +Changes in government regulations could also require the Company to undergo +additional trials or procedures, or could make it impractical or impossible +for the Company to market its products for certain uses, in certain markets, +or at all. Other changes in government regulations, such as the adoption of +the FDA's Quality System Regulation, may adversely affect the Company's +financial condition and results of operations by requiring that the Company +incur the expense of changing or implementing new manufacturing and control +procedures. +In addition, the European Union has established a requirement that +diagnostic medical devices used to test biological specimens must receive +regulatory approval known as a CE mark by December 31, 2003. After that date, +export to the European community of products without the CE mark will be +stopped or delayed until the mark is received. This requirement will affect +many of OraSure Technologies' products. OraSure Technologies will not be +permitted to make European sales of its products for which a CE mark is not +obtained by December 31, 2003, which could lead to the termination of +strategic alliances for sales of those products in Europe. While the Company +intends to apply for CE marks for certain of its existing and future products, +and is not aware of any material reason why such approvals will not be +granted, there can be no assurance that any CE marks will be received prior to +the deadline. +At the present time, the Company has received FDA clearance or approval for +the OraSure(R) and Intercept(R) oral fluid collection devices, the +Histofreezer(R) portable cryosurgical system, the Q.E.D.(R) saliva alcohol +test, the OraSure(R) oral fluid Western Blot confirmatory test for HIV-1, and +various other tests. The Company has also received CE mark approval for the +OraSure(R), Intercept(R) and Histofreezer(R) products. The Company has +submitted to the FDA an application for pre-market approval of its OraQuick(R) +rapid HIV-1 test using whole blood and expects to file an application for oral +fluid applications in 2002. The Company has also submitted an application to +the FDA for 510(k) clearance of the UPlink(TM) drugs of abuse rapid detection +system, has resubmitted additional data requested by the FDA for the +UPlink(TM) analyzer and opiates assay, and is in the process of gathering +additional data requested by the FDA for the full NIDA-5 drug panel for that +product. See the Sections entitled "Products" and "Government Regulation" for +a further discussion of regulatory approvals and clearances obtained for the +Company's products. +20 +Regulatory Compliance +The Company can manufacture and sell many of its products, both in the +United States and in some cases abroad, only if it complies with regulations +of government agencies such as the FDA. The Company has implemented a quality +system that is intended to comply with applicable regulations. The FDA has +issued warning letters with respect to the Serum Western Blot product, stating +that the Company is not in compliance with the FDA's regulations. The Company +has responded to each of these letters and voluntarily discontinued this +product. Although the Company believes that it has satisfactorily addressed +the points raised by the FDA, the FDA could force the Company to stop +manufacturing products at its Oregon facility if the FDA concludes that the +Company remains out of compliance with applicable regulations. In addition, +until the FDA agrees that the Company has resolved all points raised in the +letters, the Company may not be able to obtain regulatory clearance +certificates needed in certain foreign countries. The FDA could also require +the Company to recall products if it fails to comply with applicable +regulations, which could force the Company to stop manufacturing such +products. See the Section entitled "Government Regulation" for a further +discussion of regulatory compliance matters. +History of Losses and Projected Profitability +The Company has not achieved full-year profitability. The Company incurred +net losses of approximately $3.7 million, $12.7 million and $4.2 million in +2001, 2000 and 1999, respectively, and as of December 31, 2001, the Company +had an accumulated deficit of approximately $126.1 million. +The Company's limited combined operating history makes it difficult to +forecast future operating results. In order to achieve sustainable +profitability, the Company's revenues will have to continue to grow at a +significant rate. The Company's ability to achieve revenue growth will be +dependent upon a number of factors including, without limitation, creating +market acceptance for and selling increasing volumes of the OraSure(R) +collection device, the Intercept(R) and UPlink(TM) drugs-of-abuse products, +and the OraQuick(R) rapid HIV-1 test, achieving growth in international +markets with the Company's OraQuick(R) rapid HIV-1 test and other products, +obtaining timely FDA approval or clearance for the OraQuick(R) rapid HIV-1 +test and UPlink(TM) drugs-of-abuse rapid detection system, and commercially +developing, and obtaining regulatory approval and creating market acceptance +for, UPT(TM) and other products in a time frame consistent with the Company's +objectives. The Company has not yet fully achieved these objectives. In the +event that the Company cannot create a significant commercial market for its +OraQuick(R) test, the Intercept(R) and UPlink(TM) products, or its other +products, or to the extent other events described in this Section occur, the +Company's revenue, and consequently profitability, could be lower than +estimated. Even if the Company achieves profitability, there is no assurance +that such profitability can be sustained in the future. +Stock Price Volatility +Because the Company's stock price may be volatile, the stock price could +experience substantial declines. The market price of the Company's common +stock has historically experienced and might continue to experience volatility +in the future in response to a number of factors, including quarter-to-quarter +variations in operating results, analysts' reports, the relative low trading +value for the Company's stock, market conditions in the industry, regulatory +developments affecting the Company's products, changes in governmental +regulations, and changes in general conditions in the economy or in the +financial or stock markets. +The market has also recently experienced significant decreases in value. +This recent market decline has affected the market prices of securities issued +by many companies, often for reasons unrelated to their operating performance, +and may adversely affect the price of the Company's common stock. +Ability to Market New Products +OraSure Technologies' future success will depend, in part, on the market +acceptance, and the timing of such acceptance, of new products such as the +Intercept(R) drug testing service, the OraQuick(R) rapid HIV-1 test, products +21 +currently under final development such as the UPlink(TM) drugs of abuse rapid +detection system and other products using up-converting phosphor technology, +and other new products or technologies that may be developed or acquired and +introduced in the future. To achieve market acceptance, OraSure Technologies +must make substantial marketing efforts and spend significant funds to inform +potential customers and the public of the perceived benefits of these +products. The Company currently has limited evidence on which to evaluate the +market reaction to products that may be developed, and there can be no +assurance that any products will meet with market acceptance and fill the +market need that is perceived to exist. +Reliance on Patents and Other Proprietary Rights +The diagnostics industry places considerable importance on obtaining patent, +trademark, and trade secret protection, as well as other intellectual property +rights, for new technologies, products and processes. The Company's success +depends, in part, on its ability to develop and maintain a strong intellectual +property portfolio or obtain licensing to patents and other technology for +products and technologies both in the United States and in other countries. +As appropriate, the Company intends to file patent applications and obtain +patent protection for its proprietary technology. These patent applications +and patents will cover, as applicable, compositions of matter for the +Company's products, methods of making those products, methods of using those +products, and apparatus relating to the use or manufacture of those products. +The Company will also rely on trade secrets, know-how, and continuing +technological advancements to protect its proprietary technology. The Company +has entered, and will continue to enter, into confidentiality agreements with +its employees, consultants, advisors and collaborators. However, these parties +may not honor these agreements and the Company may not be able to successfully +protect its rights to unpatented trade secrets and know-how. Others may +independently develop substantially equivalent proprietary information and +techniques or otherwise gain access to the Company's trade secrets and know- +how. +Many of the Company's employees, including scientific and management +personnel, were previously employed by competing companies. Although the +Company encourages and expects all of its employees to abide by any +confidentiality agreement with a prior employer, competing companies may +allege trade secret violations and similar claims against OraSure +Technologies. +The Company may incur substantial costs and be required to expend +substantial resources in asserting or protecting its intellectual property +rights, or in defending suits against it related to intellectual property +rights. Disputes regarding intellectual property rights could substantially +delay product development or commercialization activities. Disputes regarding +intellectual property rights might include state, federal or foreign court +litigation as well as patent interference, patent reexamination, patent +reissue, or trademark opposition proceedings in the United States Patent and +Trademark Office. Opposition or revocation proceedings could be instituted in +a foreign patent office. An adverse decision in any proceeding regarding +intellectual property rights could result in the loss of the Company's rights +to a patent, an invention, or trademark. +To facilitate development and commercialization of a proprietary technology +base, the Company may need to obtain licenses to patents or other proprietary +rights from other parties. Obtaining and maintaining such licenses may require +the payment by the Company of substantial costs. In addition, if the Company +is unable to obtain these types of licenses, the Company's product development +and commercialization efforts may be delayed or precluded. +Patent Issues Affecting OraQuick(R) +There are several factors that will affect the specific countries in which +the Company will be able to sell its OraQuick(R) rapid HIV test and therefore +the overall sales potential of the test. One factor is whether the Company can +arrange a sublicense or distribution agreement related to patents for +detection of the HIV-2 virus. HIV-2 is a type of the HIV virus estimated to +represent a small fraction of the known HIV cases worldwide. Nevertheless, +HIV-2 is considered to be an important component in the testing regimen for +HIV in many markets. HIV-2 +22 +patents are in force in most of the countries of North America and Western +Europe, as well as in Japan, Korea, South Africa, and Australia. Access to a +license for one or more HIV-2 patents may be necessary to sell HIV-2 tests in +countries where such patents are in force, or to manufacture in countries +where such patents are in force and then sell into non-patent markets. Since +HIV-2 patents are in force in the United States, the Company may be restricted +from manufacturing an OraQuick(R) rapid HIV-2 test in the United States and +selling into other countries, even if there were no HIV-2 patents in those +other countries. +The importance of HIV-2 differs by country, and can be affected by both +regulatory requirements and by competitive pressures. In most countries, any +product used to screen the blood supply will be required to detect HIV-2, +although the OraQuick(R) rapid HIV test has not been intended for that market +purpose. In other markets, including the United States, a test that can detect +only the more prevalent HIV-1 type is considered sufficient by the FDA, except +in testing related to blood supply. Because the competitive situation in each +country will be affected by the availability of other testing products as well +as the country's regulatory environment, the Company may be at a competitive +disadvantage in some markets without an HIV-2 product even if HIV-2 detection +is not required by regulations. In particular, the Company may be limited in +its ability to sell a product that does not include an HIV-2 test, or a +competitor's product that includes an HIV-2 test may be preferred and have a +competitive advantage over an HIV-1 only test sold by the Company. +The Company has obtained licenses to HIV-1 patents held by the manufacturer +of the HIV-1 antigen used in the OraQuick(R) device and by the National +Institutes of Health. The Company is not aware of any other HIV-1 patents +which would need to be licensed in order to manufacture and sell the +OraQuick(R) rapid HIV-1 test. +Another factor that may affect the specific countries in which the Company +will be able to sell an OraQuick(R) rapid HIV-1 or HIV-2 test, and therefore +the overall sales potential, concerns whether the Company can arrange a +sublicense or distribution agreement related to any patents which claim +lateral flow assay methods and devices covering the OraQuick(R) rapid HIV +tests or their use. OraQuick(R) is a lateral flow assay device that tests for +specific antibodies or other substances. The term "lateral flow" generally +refers to a test strip through which a sample flows and which provides a test +result on a portion of the strip downstream from where the sample is applied. +There are numerous patents in the United States and other countries which +claim lateral flow assay methods and devices. Some of these patents may +broadly cover the technology used in the OraQuick(R) assay and are in force in +the United States and other countries. The Company may not be able to make the +OraQuick(R) test in the United States and sell it in countries where there is +no patent on the device. The Company has obtained or intends to obtain +licenses under several lateral flow patents, which it believes should be +sufficient to permit the manufacturing and sale of the OraQuick(R) device as +currently contemplated. +In the event that it is determined that a license is required and it is not +possible to negotiate a license agreement under a necessary patent, the +Company may be able to modify the OraQuick(R) rapid HIV test such that a +license would not be necessary. However, this alternative could delay +introduction of the OraQuick(R) rapid HIV test into the United States and +other markets. +Loss of Key Personnel +The Company's success will depend to a large extent upon the contributions +of its executive officers, management, and sales, marketing, and scientific +staff. The Company may not be able to attract or retain qualified employees in +the future due to the intense competition for qualified personnel among +medical products businesses. If the Company is not able to attract and retain +the necessary personnel to accomplish its business objectives, the Company may +experience constraints that will adversely affect its ability to effectively +sell and market its products, to meet the demands of its strategic partners in +a timely fashion, or to support internal research and development programs. In +particular, product development programs depend on the ability to attract and +retain highly skilled scientists, including molecular biologists, biochemists +and engineers, and sales and marketing efforts depend on the ability to +attract and retain skilled and experienced sales and marketing +representatives. Recruiting qualified personnel can be an intensely +competitive and time-consuming process. Although OraSure Technologies believes +it will be successful in attracting and retaining qualified personnel, +competition for experienced scientists and other personnel from numerous +companies and academic and other research institutions may limit its ability +to do so on acceptable terms. +23 +All of the Company's employees, other than a few senior officers who have +employment agreements, are at-will employees, which means that either the +employee or OraSure Technologies may terminate their employment at any time. +If the Company experiences difficulty in recruiting and retaining qualified +personnel, it may need to provide higher compensation to such personnel than +currently anticipated or the Company may incur additional expenses for the +recruitment of qualified personnel. +The Company's business strategies will require additional expertise in +specific industries and areas applicable to the development efforts related to +up-converting phosphor technologies. These activities will require the +addition of new personnel, including management, and the development of +additional expertise by existing management personnel. The inability to +acquire these services or to develop this expertise could impair the +development, if any, of products related to these technologies. +International Marketing and Manufacturing +The Company intends to increase international sales of its products. The +Company's international revenues accounted for approximately $5.3 million or +16% of total revenues for 2001, approximately $4 million or 14% of total +revenues for 2000, and approximately $2.7 million or 11% of total revenues for +1999. +A number of factors can slow or prevent international sales, or +substantially increase the cost of international sales, including those set +forth below: +. Regulatory requirements (including compliance with applicable customs +regulations) may slow, limit, or prevent the offering of products in +foreign jurisdictions; +. Cultural and political differences may make it difficult to effectively +market, sell and gain acceptance of products in foreign jurisdictions; +. Inexperience in international markets may slow or limit the Company's +ability to sell products in foreign countries; +. Exchange rates, currency fluctuations, tariffs and other barriers, +extended payment terms and dependence on and difficulties in managing +international distributors or representatives may affect the Company's +revenues even when product sales occur; +. The creditworthiness of foreign entities may be less certain and foreign +accounts receivable collection may be more difficult; +. Economic conditions and the absence of available funding sources may +slow or limit the Company's ability to sell its products in foreign +countries; +. International markets often have long sales cycles, especially sales to +foreign governments, quasi-governmental agencies and international +public health agencies, thereby delaying or limiting the Company's +ability to sell its products; and +. The Company may be at a disadvantage if competitors in foreign countries +sell competing products at prices at or below such competitors' or the +Company's cost. +The Company has entered into a contract for the manufacture and supply of +the OraQuick(R) HIV device in Thailand. However, the Company does not have +significant direct experience with the use of international manufacturers. +Factors such as economic and political conditions and foreign regulatory +requirements may slow or prevent the manufacture of the Company's products in +countries other than the United States. Interruption of the supply of the +Company's products could reduce revenues or cause the Company to incur +significant additional expenses in finding an alternative source of supply. +Product Liability Exposure +The Company may be held liable if any of its products, or any product which +is made with the use or incorporation of any of the technologies belonging to +the Company, causes injury of any type or is found otherwise unsuitable during +product testing, manufacturing, marketing, sale or usage. Although the Company +has +24 +obtained product liability insurance, this insurance may not fully cover +potential liabilities. As the Company brings new products to market, the +Company may need to increase its product liability coverage. Inability to +obtain sufficient insurance coverage at an acceptable cost or otherwise to +protect against potential product liability claims could affect the Company's +decision to commercialize products developed by the Company or its strategic +partners. +Ability to Fully Commercialize UPT(TM) +The Company's up-converting phosphor technology is new and, except for the +UPlink(TM) rapid detection system, is in the early stage of development. +Commercial development of UPT(TM) for certain other applications may not be +successful. Successful products require significant development and +investment, including testing, to demonstrate their cost-effectiveness or +other benefits prior to commercialization. In addition, regulatory approval +must be obtained before most products based upon UPT(TM) may be sold. +Additional development efforts on these products will be required before any +regulatory authority will review them. Regulatory authorities may not approve +these products for commercial sale. Accordingly, because of these +uncertainties, products based upon UPT(TM) may not be commercialized. The +failure to develop UPT(TM) products with commercial potential would negatively +affect OraSure Technologies' future revenues. +Dependence on Strategic Partners +Although the Company intends to pursue some product opportunities +independently, opportunities that require a significant level of investment +for development and commercialization or a distribution network beyond the +Company's existing sales force may necessitate involving one or more strategic +partners. In particular, the Company's strategy for development and +commercialization of UPT(TM) and certain other products, such as the +OraQuick(R) rapid HIV test, may entail entering into additional arrangements +with distributors or other corporate partners, universities, research +laboratory licensees, and others. OraSure Technologies may be required to +transfer material rights to such strategic partners, licensees, and others. +While the Company expects that its current and future partners, licensees, and +others have and will have an economic motivation to succeed in performing +their contractual responsibilities, the amount and timing of resources to be +devoted to these activities will be controlled by others. Consequently, there +can be no assurance that any revenues or profits will be derived from such +arrangements. +Dependence on Third Party Licenses and Rights +The Company has licensed the worldwide rights to up-converting phosphor +compositions, methods, and apparatuses for use in diagnostic applications, +which are the subject of numerous United States and patents and several +pending United States applications. Corresponding patents and patent +applications have been granted, issued or filed in numerous foreign countries, +including, for example, European countries, Japan, and Canada. OraSure +Technologies cooperates with the licensor to prosecute such patent +applications and protect such patent rights. If the licensors do not meet +their obligations under the license agreements or do not reasonably consent to +sublicenses by the Company, or if the license agreement is terminated, the +Company could lose the opportunity to develop UPT(TM). +Recent Economic Downturn and Terrorist Attacks +Since the September 11, 2001 terrorist attacks, the United States economy +has experienced a decline. Changes in economic conditions could adversely +affect the Company's business. For example, in a difficult economic +environment, customers may be unwilling or unable to invest in new diagnostic +products, may elect to reduce the amount of their purchases or may perform +less drug testing because of declining employment levels. A weakening business +climate could also cause longer sales cycles and slower growth, and could +expose the Company to increased business or credit risk in dealing with +customers adversely affected by economic conditions. +25 +The terrorist attacks and subsequent governmental responses to these attacks +could cause further economic instability or lead to further acts of terrorism +in the United States and elsewhere. These actions could adversely affect +economic conditions outside the United States and reduce demand for our +products internationally. Terrorist attacks could also cause regulatory +agencies, such as the FDA or agencies that perform similar functions outside +the United States, to focus their resources on vaccines or other products +intended to address the threat of biological or chemical warfare. This +diversion of resources could delay the Company's ability to obtain regulatory +approvals required to manufacture, market or sell its products in the United +States and other countries. +Restructuring of Operations +The Company may from time to time restructure and consolidate various +aspects of its operations in order to achieve cost savings and other +efficiencies. For example, during 2001 the Company completed a restructuring +of its manufacturing operations which included the transfer of OraQuick(R) +manufacturing from the Beaverton, Oregon facility to Bethlehem, Pennsylvania. +In addition, the Company plans to close the Oregon facility during 2003 and +transfer all remaining manufacturing operations, which are solely related to +the Western Blot HIV-1 confirmatory test, and research and development +activities to Pennsylvania. The transfer of operations may result in the loss +of scientific or other personnel and thereby delay the transfer or disrupt the +continuation of operations thereafter. The Company will also be required to +obtain FDA approval to transfer certain operations to another location, which +could delay the transfer or disrupt continued operations. Any delay or +disruption of operations, and in particular manufacturing operations, could +result in increased costs or could prevent the Company from selling certain +products and thereby result in a loss of revenue. +The previous discussion of the Company's business should be read in +conjunction with the Financial Statements and accompanying notes included in +Item 14 of this Annual Report on Form 10-K. \ No newline at end of file diff --git a/raw/filings/0001116463/2001/0000930661-02-000960/item13.txt b/raw/filings/0001116463/2001/0000930661-02-000960/item13.txt new file mode 100644 index 0000000000000000000000000000000000000000..f2e83c65078face220aa4b042e16bae66b139a9c --- /dev/null +++ b/raw/filings/0001116463/2001/0000930661-02-000960/item13.txt @@ -0,0 +1,4 @@ +ITEM 13. Certain Relationships and Related Transactions. +The information required by this item is incorporated by reference to the +information under the captions "Certain Relationships and Related +Transactions" and "Employment Agreements" in the Proxy Statement. \ No newline at end of file diff --git a/raw/filings/0001116463/2001/0000930661-02-000960/item9a.txt b/raw/filings/0001116463/2001/0000930661-02-000960/item9a.txt new file mode 100644 index 0000000000000000000000000000000000000000..e69de29bb2d1d6434b8b29ae775ad8c2e48c5391 diff --git a/raw/filings/0001116463/2001/0000930661-02-000960/rp_note.txt b/raw/filings/0001116463/2001/0000930661-02-000960/rp_note.txt new file mode 100644 index 0000000000000000000000000000000000000000..54e99b5183f8291f3dd5470b9118591169e4a445 --- /dev/null +++ b/raw/filings/0001116463/2001/0000930661-02-000960/rp_note.txt @@ -0,0 +1,21 @@ +12. RELATED-PARTY TRANSACTIONS: +Officer Notes +In March and October 2000, the Company issued notes receivable to an officer +of the Company ("Officer Notes") for $75,000 and $100,649, respectively, for +relocation purposes. The Officer Notes do not bear interest if they are repaid +on or before the earlier of the tenth day following the close of sale on the +officer's previous residences or the due date of the Officer Notes, as +extended. In May 2001, this officer repaid the Officer Note having an +outstanding balance of $100,649. In January 2002, this same officer resigned +from the Company and as part of his severance agreement, agreed to repay the +remaining $75,000 balance in bi-weekly principal installments of approximately +$7,000, commencing in April 2002. (See Note 11). +Facility Lease +Effective March 1, 2002, the Company signed a 10-year operating lease with +Tech III Partners, LLC, an entity owned and controlled by two of the Company's +executive officers. Under the terms of this lease, the +F-20 +Company will lease a 48,000 square foot facility currently being constructed +on land adjacent to the Company's headquarters, at a base rent of $480,000 per +year, increasing to $528,000 per year, during the initial 10-year term. The +lease also provides for certain renewal and purchase options. \ No newline at end of file diff --git a/raw/filings/0001116463/2001/0000930661-02-000960/rpt_disclosure.txt b/raw/filings/0001116463/2001/0000930661-02-000960/rpt_disclosure.txt new file mode 100644 index 0000000000000000000000000000000000000000..b7abae064e2b5454397724f455e82e18f3a264d4 --- /dev/null +++ b/raw/filings/0001116463/2001/0000930661-02-000960/rpt_disclosure.txt @@ -0,0 +1,16 @@ +Certain Relationships and Related Transactions +We have entered into a commercial lease (the +“Lease”) with Tech III Partners, LLC (“Tech Partners”), which provided for the construction of a 48,000 square foot facility on land adjacent to our Bethlehem, Pennsylvania headquarters, and the lease of that facility to us. Tech +Partners is owned and controlled by Michael J. Gausling, the Company’s President and Chief Executive Officer, and Dr. R. Sam Niedbala, the Company’s Executive Vice President and Chief Science Officer. The facility is our new corporate +headquarters and will house manufacturing, research and development, and administrative operations required to support the expected growth of our business. Construction of the facility was completed in October 2002. +The Lease has an initial ten-year term ending in October 2012 +and a base rent starting at $780,000 and increasing to $858,240 per year over that term. The base rental rate may be increased after the fifth year of the initial term in order to reflect changes in the interest rate on debt incurred by Tech +Partners to finance construction of the leased facilities. We have not guaranteed any debt incurred by Tech Partners. We also have an option to renew the Lease for an additional five years at a rental rate of $975,360 per year, and to purchase the +facility at any time during the initial ten-year term based on a formula set forth in the Lease. +10 +Prior to +deciding to enter into the Lease and an amendment increasing the base rent to reflect certain tenant fit-out costs, our Board of Directors retained Imperial Realty Appraisal LLC, an independent commercial real estate appraisal firm, to evaluate the +proposed base rental rate. Imperial Realty issued opinions indicating that the annual base rent set forth in the Lease, as amended, is below the market rental rate we could otherwise expect to pay to lease a comparable commercial property in the +same general geographic market. The terms of the Lease are otherwise substantially similar to a commercial lease we entered into with a third party for our existing Bethlehem, Pennsylvania facilities. +Information regarding employment and severance agreements +between the named executive officers and the Company is set forth in the Section entitled, “Employment Agreements,” in this Proxy Statement. \ No newline at end of file diff --git a/raw/filings/0001116463/2002/0000950109-03-001919/filing.txt b/raw/filings/0001116463/2002/0000950109-03-001919/filing.txt new file mode 100644 index 0000000000000000000000000000000000000000..65e4a46b100d7a8b1e77c9687d20379eb9eba11d --- /dev/null +++ b/raw/filings/0001116463/2002/0000950109-03-001919/filing.txt @@ -0,0 +1,3820 @@ +10-K +1 +d10k.htm +ORASURE TECHNOLOGIES, INC. FORM 10-K +Orasure Technologies, Inc. Form 10-K +Table of Contents +SECURITIES AND EXCHANGE COMMISSION +Washington, D.C. 20549 +FORM 10-K +(Mark one) +x +ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934 +for the fiscal year ended December 31, 2002. +OR +¨ +TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934 +for the transition period from +to . +Commission File No. 001-16537 +ORASURE TECHNOLOGIES, INC. +(Exact Name of Registrant as Specified in Its Charter) +Delaware +36-4370966 +(State or Other Jurisdiction of +(I.R.S. Employer Identification No.) +Incorporation or Organization) +220 East First Street +Bethlehem, Pennsylvania +18015 +(Address of Principal Executive Offices) +(Zip Code) +(610) +882-1820 +(Registrant’s Telephone Number, Including Area Code) +Securities registered pursuant to Section 12(b) of the Act: +None +Securities registered pursuant to +Section 12(g) of the Act: +Common Stock, +$.000001 par value per share +(Title of Class) +Indicate by check mark whether the Registrant: (1) has filed all reports required to be filed by Section 13 +or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No ¨ +Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not +contained herein, and will not be contained, to the best of Registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. x +Indicate by check +mark whether the Registrant is an accelerated filer (as defined in Exchange Act Rule 12b-2). Yes x No ¨ +State the aggregate market value of the voting and non-voting common equity held by non-affiliates of the Registrant, computed by reference to the price at which the common equity was last sold, or the average bid and asked price of +such common equity, as of the last business day of the Registrant’s most recently completed second fiscal quarter (June 28, 2002) : $200,531,507 +Indicate the number of shares outstanding of each of the Registrant’s classes of common stock, as of +March 26, 2003: 38,363,618 shares. +Documents +Incorporated by Reference: +Portions of the +Registrant’s Definitive Proxy Statement for the 2003 Annual Meeting of Stockholders are incorporated by reference into Part III of this Report. +Table of Contents +TABLE OF CONTENTS +Page +PART +I +ITEM 1. +Business +1 +ITEM 2. +Properties +28 +ITEM 3. +Legal Proceedings +29 +ITEM 4. +Submission of Matters to a Vote of Security Holders +29 +PART +II +ITEM 5. +Market for Registrant’s Common Equity and Related Stockholder Matters +30 +ITEM 6. +Selected Financial Data +30 +ITEM 7. +Management’s Discussion and Analysis of Financial Condition and Results of Operations +32 +ITEM 7A. +Quantitative and Qualitative Disclosures About Market Risk +44 +ITEM 8. +Financial Statements and Supplementary Data +44 +ITEM 9. +Changes in and Disagreements with Accountants on Accounting and Financial Disclosure +44 +PART +III +ITEM 10. +Directors and Executive Officers of the Registrant +45 +ITEM 11. +Executive Compensation +45 +ITEM 12. +Security Ownership of Certain Beneficial Owners and Management +45 +ITEM 13. +Certain Relationships and Related Transactions +45 +ITEM 14. +Controls and Procedures +45 +PART +IV +ITEM 15. +Exhibits, Financial Statement Schedules, and Reports on Form 8-K +46 +Signatures +47 +Certifications +48 +Table of Contents +Statements +contained in this Report regarding future events or performance are “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995. Our actual results could be quite different from those expressed +or implied by the forward-looking statements. Factors that could affect our results are discussed more fully under the Sections entitled, “Forward-Looking Statements” and “Risk Factors,” in Item 1 and elsewhere in this Report. +Although forward-looking statements help to provide complete information about us, readers should keep in mind that forward-looking statements may not be reliable. Readers are cautioned not to place undue reliance on the forward-looking statements. +PART I +ITEM 1. Business. +Our Company was formed in May 2000 under Delaware law solely for the purposes of combining two companies, STC Technologies, Inc. (“STC” or “STC Technologies”) and Epitope, Inc. (“Epitope”), and +changing the state of incorporation of Epitope from Oregon to Delaware. STC Technologies and Epitope were merged into our Company on September 29, 2000 (the “Merger”). Our principal offices are located at 220 East First Street, Bethlehem, +Pennsylvania 18015, and our telephone number is (610) 882-1820. +General +We develop, +manufacture and market oral fluid specimen collection devices using proprietary oral fluid technologies, diagnostic products including immunoassays and other in vitro diagnostic tests, and other medical devices. These products are sold in the +United States and certain foreign countries to various distributors, government agencies, clinical laboratories, physicians’ offices, hospitals, and commercial and industrial entities. +In vitro diagnostic testing is the process of analyzing +oral fluid, blood, urine and other bodily fluids or tissue for the presence of specific substances or markers for drugs of abuse, infectious diseases or other conditions. In vitro diagnostic tests are performed outside the body, in contrast +to in vivo tests, which are performed directly on or within the body. The substance or marker that a diagnostic test is intended to detect is generally referred to as an analyte. +Immunodiagnostic testing is the leading method of in vitro testing for antigens and antibodies. When +an infectious disease caused by pathogens, such as bacteria, viruses and fungi, or other substances are present, the body responds by producing an antibody. Substances that stimulate production of antibodies are generally referred to as antigens. An +antibody binds specifically with an antigen in a lock-and-key fashion that initiates a biochemical reaction to attempt to neutralize and, ultimately, eliminate the antigen. The ability of an antibody to bind with a specific antigen provides the +basis for immunodiagnostic testing. +Additional +information about the Company can be found on our website. Our website address is www.orasure.com. We make available free of charge through a link provided at such website our Annual Reports on Form 10-K, our Quarterly Reports on Form 10-Q and our +Current Reports on Form 8-K, as well as any amendments to those Reports. Such reports are made available as soon as reasonably practicable after they are filed or furnished to the Securities and Exchange Commission. Our Internet website and the +information contained in or connected to that website are not intended to be incorporated by reference into this Report. +Products +Our principal products currently include the following: +• +The OraSure ® and Intercept ® oral fluid collection devices; +• +The OraQuick ® rapid HIV-1 antibody test; +• +The Histofreezer ® wart removal system; +1 +Table of Contents +• +Certain immunoassay tests and reagents for insurance risk assessment, substance abuse and forensic toxicology applications; +• +An oral fluid Western Blot confirmatory test for the Human Immunodeficiency Virus Type 1 (“HIV-1”); and +• +The Q.E.D. ® saliva alcohol test. +OraSure ® /Intercept ® Collection Devices +Our OraSure ® oral fluid collection device is used in +conjunction with screening and confirmatory tests for HIV-1 antibodies and other analytes. This device consists of a small, treated cotton-fiber pad on a nylon handle that is placed in a person’s mouth for two to five minutes. The device +collects oral mucosal transudate (“OMT”), a serum-derived fluid that contains higher concentrations of certain antibodies and analytes than saliva. As a result, OMT testing is a highly accurate method for detecting HIV-1 infection and +other analytes. +We believe that oral fluid +testing has several significant advantages over blood or urine-based testing systems, for both health care professionals and the individuals being tested. These advantages include eliminating the risk of needle-stick accidents, providing a +noninvasive collection technique, requiring minimal training to administer, providing rapid and efficient collection in almost any setting, and reducing the cost of administration by a trained health care professional. +We have received premarket approval from the U.S. Food and +Drug Administration (the “FDA”) to sell the OraSure ® collection +device for use with a laboratory-based enzyme immunoassay (“EIA”) screening test for HIV-1 antibody detection. This EIA screening test has been approved by the FDA for use with our OraSure ® device and is manufactured and sold by another party. +HIV-1 antibody detection using the OraSure ® collection device involves three steps: +• +Collection of an oral fluid specimen using the OraSure ® device; +• +Screening of the specimen for HIV-1 antibodies at a laboratory with an EIA screening test approved by the FDA for use with the OraSure ® device; and +• +Laboratory confirmation of any positive screening test results with our oral fluid Western Blot HIV-1 confirmatory test (described below). +A trained health care professional +then conveys test results and provides appropriate counseling to the individual who was tested. We have also received FDA 510(k) clearance for use of the OraSure ® collection device with EIAs to test for cocaine and cotinine (a metabolite of nicotine) in oral fluid specimens. +A collection device that is substantially +similar to the OraSure ® device is sold under the name, Intercept ® , and is used to collect OMT for oral fluid drug testing. We have received FDA 510(k) +clearance to use the Intercept ® collection device with laboratory-based EIAs to +test for drugs of abuse commonly identified by the National Institute for Drug Abuse (“NIDA”) as the NIDA-5 (i.e., cannabinoids (marijuana), cocaine, opiates, amphetamines/methamphetamines, and phencyclidine (“PCP”)), and for +barbiturates, methadone and benzodiazepines. +We +believe that the Intercept ® device has several advantages over certain +competing drug testing products, including its lower total cost, its non-invasive nature, safety, mobility and accuracy, the ease of maintaining a chain-of-custody, the treatment of test subjects with greater dignity, no requirement for +specially-prepared collection facilities, and difficulty of sample adulteration. The availability of an oral fluid test is intended to allow our customers to test for drug impairment on demand, eliminate scheduling costs and inconvenience, and +streamline the testing process. +2 +Table of Contents +OraQuick ® Rapid Test +OraQuick ® is our rapid test platform designed to test an oral fluid, whole blood or serum/plasma sample for the presence of various +antibodies or analytes. The device uses a porous flat pad to collect an oral fluid specimen. After collection, the pad is inserted into a vial containing a pre-measured amount of developer solution and allowed to develop. When whole blood is to be +tested, a loop collection device is used to collect less than a drop of blood and mix it in the developer solution, after which the collection pad is inserted into the solution. The specimen and solution then flow through the testing device where +test results are observable in approximately 20 minutes. The OraQuick ® device +is a screening test and requires a confirmation test where an initial positive result is obtained. +Our first product utilizing this technology is the OraQuick ® rapid HIV-1 antibody test, a rapid test for the presence of antibodies against HIV-1. On November 7, 2002, we received +premarket approval of this test from the FDA for detecting HIV-1 in finger-stick whole blood samples. This FDA approval is based on data indicating that the OraQuick ® test has sensitivity of 99.6% and specificity of 100%, based on clinical studies we performed using finger-stick whole +blood specimens. Sensitivity is a measure of the accuracy for detecting positive specimens, and specificity is a measure of the accuracy for identifying negative specimens. +As a result of this FDA approval, the OraQuick ® test is available for use by the nearly 40,000 locations in the United States certified under the Clinical Laboratory +Improvements Amendments of 1988 (“CLIA”), to perform moderately complex diagnostic tests. Additionally, in January 2003, we received a waiver under CLIA for the OraQuick ® rapid HIV-1 antibody test. This waiver will also permit the use of the OraQuick ® test by approximately 140,000 additional sites in the United States not certified under CLIA to perform +moderately complex tests, such as outreach clinics, community-based organizations and physicians’ offices. +During 2003, we expect to submit an application to the FDA for approval of an OraQuick ® test for use in detecting antibodies for HIV in oral fluid samples. We are also likely to pursue FDA approval of the use +of the OraQuick ® test for detecting HIV in venous whole blood and serum/plasma +samples. +The Centers for Disease Control and +Prevention (“CDC”) has identified several key areas for use of our OraQuick ® device in the United States, including certain public hospitals in U.S. metropolitan areas with a relatively high incidence of HIV infection in pregnant women, AIDS service organizations, community-based organizations, outreach +programs, and selected hospital emergency departments and outpatient clinics. Under a treatment Investigational Device Exemption granted by the FDA, the OraQuick ® device is being used in the CDC’s Mother-Infant Rapid Intervention at Delivery Project (MIRIAD) to test pregnant +women in five U.S. metropolitan areas. The goal of this project is to identify those individuals who would benefit from the administration of nevirapine, a drug used to reduce mother-to-child HIV-1 transmission. The OraQuick ® device was also selected for use in the CDC’s LIFE Initiative, an international +effort to address the AIDS epidemic in certain African countries, focusing on areas such as preventing mother-to-child transmission, secondary transmitted disease prevention, HIV prevention for youth, and blood safety systems. +Histofreezer ® +In 1991, we became the exclusive United States distributor of the Histofreezer ® wart removal system, a low-cost alternative to liquid nitrogen and other methods for removal of warts and other benign +skin lesions by physicians. In June 1998, we acquired the Histofreezer ® product +from Koninklijke, Utermöhlen, N.V., The Netherlands. As part of the acquisition, we established a sales office in Reeuwijk, The Netherlands, and we are selling the Histofreezer ® product through a dealer network in more than 20 countries worldwide. Most of our Histofreezer ® sales occur in the United States to family doctors, pediatricians and podiatrists. +The Histofreezer ® product mixes two environmentally friendly cryogenic gases in a small aerosol canister. +When released, these gases are delivered to a specially designed foam bud, cooling the bud to –50°C. The frozen bud is then applied to the wart or lesion for 15 to 40 seconds (depending on the type of lesion) creating localized destruction +of the target area. +3 +Table of Contents +Immunoassay +Tests and Reagents +We develop and sell +immunoassay tests in two formats, known as MICRO-PLATE and AUTO-LYTE ® , to meet +the specific needs of our customers. +AUTO-LYTE ® tests are sold in the form of bottles of liquid +reagents. These reagents are run on commercially available laboratory-based automated analytical instruments, which are manufactured by a variety of third parties. AUTO-LYTE ® is typically used in high volume, automated, commercial reference insurance laboratories to detect certain drugs or +chemicals in urine. Test results are produced quickly, allowing for high throughput. +In the MICRO-PLATE kit, the sample to be tested is placed into a small plastic receptacle, called a microwell, along with the reagents. The result of the test is determined by the color of the +microwell upon completion of the reaction. Controlling the reaction involves the use of a variety of reagents by laboratory personnel. Test results are analyzed by any of a variety of commercially available laboratory instruments, which we may also +provide to our laboratory customers. MICRO-PLATE tests can be performed on commonly used instruments and can detect drugs in urine, serum, and sweat specimens. MICRO-PLATE tests are also used as part of the Intercept ® product line to detect drugs of abuse in oral fluid specimens. +Whenever possible, we enter into multi-year sales agreements +with our customers. These agreements generally are entered into with a laboratory that has agreed to purchase a minimum number of tests over a two-to-five-year period. We also offer these customers the option of a reagent rental agreement under +which we sell the tests at an increased price over a fixed period of time, which includes an additional equipment charge in exchange for providing the customer with the required analytical laboratory equipment. We obtain this equipment from third +party vendors. +Western Blot HIV-1 +Confirmatory Test +We market an oral fluid +Western Blot HIV-1 confirmatory test that received premarket approval from the FDA in 1996. This test uses the original specimen collected with the OraSure ® oral fluid collection device to confirm positive results of initial oral fluid HIV-1 EIA screening tests. The oral fluid +Western Blot HIV-1 confirmatory test is marketed under an exclusive arrangement with bioMerieux Inc. (formerly Organon Teknika Corporation) (“BMX”). +In January 2001, we suspended the production of EPIblot ® , a serum-based Western Blot HIV-1 confirmatory test. The serum Western Blot product accounted for approximately 5% of the +Company’s 2000 revenues, but had been consistently unprofitable because of low production yields and the high cost of quality control. The discontinuation of this product had no effect on the manufacturing or sale of our oral fluid Western Blot +HIV-1 confirmatory test. +Q.E.D. ® Saliva Alcohol Test +Our Q.E.D. ® saliva alcohol test is an on-site, cost-effective test device that is an alternative to breath or blood alcohol testing. +The test is a quantitative, saliva-based method for the detection of ethanol, and has been cleared for sale by the FDA and the U.S. Department of Transportation (“DOT”). In 1997, the product also received a CLIA waiver. +Each Q.E.D. ® test kit contains a collection stick that is used to collect a sample of saliva and a disposable detection device that +displays results in a format similar to a thermometer. The Q.E.D. ® device is +easy to operate and instrumentation is not required to read the result. The product has a testing range of 0 to 0.145% blood alcohol, and produces results in approximately two minutes. +4 +Table of Contents +Products Under Development +UPT ™ and UP link ™ Development +During 2002 and prior years, much of our research and development efforts were focused on our Up-Converting Phosphor Technology +(“UPT ™ ”) and the first UPT ™ application expected to be commercialized, our UP link ™ rapid, point-of-care system for detecting drugs of abuse in oral fluid. +Up-Converting Phosphor Technology . UPT ™ is a proprietary label detection platform that uses phosphor particles to detect minute +quantities of various substances. UPT ™ utilizes the same particle shell that +is coated onto a television screen, but the internal chemistry of the particle has been changed. These changes result in a particle that is excited by infrared light as compared to an ultraviolet light source for television screens. With assistance +from our research partners, we have developed phosphorescent particles that up-convert infrared light to visible light, which we believe is a platform technology with broad applications. +Phosphor particles have been used for decades in television screens and in fluorescent light bulbs. When high +energy ultraviolet light strikes the phosphor-coated area in a screen or bulb, it excites the particles and low energy visible colored light is produced. Our patented improvements on this base technology employ chemical changes inside the phosphor +particles so that low energy infrared light can be used to produce a high energy visible colored signal and is the basis for UPT ™ . This use of infrared light to create a colored signal is called up-conversion as opposed to down-conversion, which +occurs in phosphors designed to be used with ultraviolet light. +The use of infrared light to excite the phosphor particles and produce a visible light signal creates what we believe is an important competitive advantage for the technology in biological systems, especially human clinical +diagnostics. Existing enzyme or fluorescent-based assays employ visible or ultraviolet light to generate the signals from the enzyme substrate or fluorescent molecules used as reporter signals in these systems. The disadvantage of using light in the +visible or ultraviolet portion of the spectrum is that often molecules in the cells or samples for analysis can also produce background interference from these excitation sources. When this occurs, a non-specific signal is generated which dilutes or +obscures the signal of interest for the diagnostic test being administered. Because up-conversion does not occur in nature, biological samples and specimens will not produce light and, therefore, will not cause background interference when excited +by infrared light. +We believe that +UPT ™ overcomes some of the limitations of other diagnostic detection methods +and offers features not commercially available today. The fact that UPT ™ +testing produces zero background interference dramatically increases the potential sensitivity of any test system. In addition, UPT ™ offers the following other key competitive features: +• +Ability to multiplex or detect biological markers for several substances simultaneously through the use of phosphor particles having various colors; +• +Creation of a permanent test record not subject to fading; +• +Applicability to a variety of instrument platforms; +• +Compatibility with alternative testing matrices such as oral fluid, blood or others; and +• +Ability to miniaturize the test platform. +We have reached certain important milestones in the development of UPT ™ , including improving the manufacturing process to produce UPT ™ particles, working to optimize UPT ™ particle coating techniques, producing four distinct colors of UPT ™ particles to permit multiplexing, demonstrating initial feasibility for the use of UPT ™ particles in infectious disease, cancer, and limited DNA detection applications, and developing a +UPT ™ collector, test cassette, and analyzer for use in testing oral fluid for +drugs of abuse. +We believe UPT ™ may have several potential applications for in vitro diagnostics, including human clinical testing for +cancer, allergies, and thyroid and cardiac conditions, and for therapeutic drug monitoring, biological +5 +Table of Contents +warfare testing, food and environmental testing, pharmaceutical research, genomics and pharmacogenomics, veterinary testing, and surgical +imaging. We also believe that UPT ™ labels may be used for the detection of infectious diseases with DNA probes. +However, we have not yet fully explored these potential UPT ™ applications and have not determined which +applications to pursue or the manner in which these opportunities will be pursued, if at all. We believe we will need to enter into partnering arrangements with other entities to exploit fully the potential of UPT ™ . +UP link ™ . UP link ™ is our first product UPT ™ -based application under development. UP link ™ is designed to be a rapid, +point-of-care system utilizing a collector, lateral flow test cassette, and analyzer (including software), that can quickly provide instrument-read results on a variety of samples, including oral fluid, blood, serum, urine and stool samples. +In April 2002, we received 510(k) +clearance from the FDA for the UP link ™ system to detect opiates in oral +fluid. This is the only point-of-care oral fluid drug test system to receive FDA clearance. The UP link ™ +analyzer has also been certified as meeting certain standards required for the sale of electrical and light-emitting equipment internationally. Although our opiates-only UP link ™ detection system has no commercial potential, we are developing an UP link ™ detection system for the full NIDA-5 panel of tests – cocaine, methamphetamines/amphetamines, PCP, opiates and marijuana – which we +believe can be commercialized. We intend to apply for FDA 510(k) clearance of an UP link ™ system for the +full NIDA-5 panel of tests in mid-summer of 2003. Subject to receipt of this FDA clearance, we plan to market this system directly in the workplace and criminal justice markets in the United States. +Although we have made significant progress with respect to the +development of the UP link ™ rapid point-of-care drugs of abuse detection system, there can be no +assurance that we will be successful in completing this development or in commercializing this potential new product. Assuming FDA 510(k) clearance is obtained, we do not expect to receive significant amounts of revenues from this product until at +least 2004 or later. +In March 2000, we signed a +research and development agreement with Dräger Safety AG & Co. KGaA (formerly Dräger Sicherheitstechnik GmbH) (“Dräger Safety”), a European manufacturer and supplier of medical and safety technology products for health +care and industrial applications. This agreement provided for the development of the UP link ™ system for rapid detection of drugs of abuse in oral fluid. After research and development activities are completed, Dräger Safety has the option to become our exclusive distributor of this product in Europe and +certain other countries to law enforcement officials for rapidly assessing whether an operator or passenger in a motor vehicle is under the influence of one or more drugs of abuse (the “roadside market”) and ultimately to certain military, +criminal justice, and workplace testing markets. We received a non-refundable fee from Dräger Safety under the agreement and will receive additional fees upon achievement of certain technical milestones. +In September 2000, we signed a research and development +agreement with Meridian Bioscience, Inc. (formerly Meridian Diagnostics, Inc.) (“Meridian”), a medical diagnostics company. Under this agreement, we intended to develop a range of UP link ™ point-of-care tests for the rapid detection of parasites, and gastrointestinal and upper respiratory diseases. +Development of one test, for the respiratory syncytial virus (“RSV”), has been substantially completed and this product is currently undergoing field trials. However, due to development delays and certain other events, we have agreed in +principle with Meridian to terminate this agreement. Despite the expected termination of our agreement, we intend to complete development and pursue FDA 510(k) clearance and commercialization of the RSV test. In addition, we intend to seek other +potential parties to help fund the development of other infectious disease applications for UP link ™ that +we had previously intended to develop with Meridian. +We are participating in a $4.2 million, four-year grant for research and development of saliva/oral fluid-based diagnostic technologies, awarded by the National Institutes of Health (the “NIH”) to the University of +Pennsylvania. The grant will cover basic research in the following three main areas: +• +New technologies for collecting bacterial/viral protein and nucleic acid samples from the human mouth; +6 +Table of Contents +• +The combination of the University of Pennsylvania’s microfluidic processing technology with our UPT ™ technology for sample preparation; and +• +The detection of viral or bacterial markers. +The research plan under the grant contemplates achieving these goals through the use of our UP link ™ rapid detection system. +Our portion of funding under the grant is expected to be made available over a four-year period, with approximately $400,000 available in +the first year and each year thereafter. Payments under the grant in the second, third and fourth years, will be subject to availability of funds from the NIH and satisfactory progress of the research and development project. +OraSure ® /Intercept ® Applications +Oral mucosal transudate contains many constituents found in blood and serum, although in lower concentrations. We believe the +OraSure ® and Intercept ® devices are a platform technology with a wide variety of potential applications, where laboratory testing is available. +For example, the OraSure ® device may be useful for the diagnosis of a variety +of infectious diseases or conditions in addition to HIV-1, such as viral hepatitis. +OraQuick ® Platform +We believe that OraQuick ® has significant potential as a point-of-care test platform for physicians’ offices, +hospitals, and other markets. Like the OraSure ® device, we believe that +OraQuick ® provides a platform technology that can be modified for detection of +a variety of infectious diseases in addition to HIV, such as viral hepatitis and other diseases. +We have received FDA premarket approval for the OraQuick ® test for detecting HIV-1 in finger-stick whole blood samples. We are developing additional applications and will likely seek FDA approval for OraQuick ® for use in testing oral fluid, venous whole blood and serum/plasma samples. +Research and Development +In 2002, our research and development activities focused on +the continued development of the UP link ™ analyzer, test cassette and collector, the development of the +UP link ™ drugs of abuse and RSV assays, DNA feasibility studies, clinical trials for the +OraQuick ® rapid HIV-1 antibody test, and improvements to certain of our +existing products. +We supplement our own +research and development activities by funding external research. We have funded research at Leiden University and certain other entities, and intend to continue funding external research. +Research and development expenses totaled approximately $8.3 million in 2002, $9.4 million in 2001, and $10.4 +million in 2000. +Sales and Marketing +Our strategy is to reach our major target markets through a +combination of direct sales, strategic partnerships, and independent distributors. Our marketing strategy is to raise awareness of our products through a mix of trade shows, print advertising, and distributor promotions to support sales in each +target market. +We market our products in the +United States and internationally. Revenues attributable to customers in the United States amounted to $28.1 million, $27.3 million and $24.8 million in 2002, 2001 and 2000, respectively. Revenues attributable to international customers amounted to +$3.9 million, $5.3 million and $4.0 million, or 12%, 16% and 14% of our total revenues, in 2002, 2001 and 2000, respectively. +7 +Table of Contents +Insurance +Risk Assessment +We currently market the +OraSure ® oral fluid collection device for use in screening life insurance +applicants in the United States and internationally to test for three of the most important underwriting risk factors: HIV-1, cocaine, and cotinine (a metabolite of nicotine). Devices are sold to insurance testing laboratories, including +Lab One , Heritage Labs and Clinical Reference Laboratories. These laboratories in turn provide the devices to insurance companies, usually in combination with testing services. +We also maintain a direct sales force that promotes use of the OraSure ® device directly to insurance companies. Insurance companies then make their own decision regarding which +laboratory to use to supply their collection devices and testing services. Our OraSure ® Western Blot confirmatory test is distributed through BMX to laboratories and is used to confirm oral fluid specimens that initially test positive for HIV-1. +Because insurance companies are in various stages of their adoption of the OraSure ® device, there exists a wide range of policy limits where the product is being applied. +Some insurance companies have chosen to extend their testing to lower policy limits where they did not test at all before, while others have used OraSure ® to replace some of their blood and urine-based testing. In general, most of our insurance company customers use the +OraSure ® device in connection with life insurance policies having face amounts +of up to $250,000, with some customers using the device for policies of up to $500,000 in amount. +Our sales force continues to encourage additional insurance companies to use OraSure ® and to extend the use of the product by existing customers. A small number of companies have expanded use of +OraSure ® to the $1 million and higher dollar policy amounts. This expansion is +attributable to several factors, including increasing acceptance of the reliability of oral fluid testing, the high quality of test results, the low cost of oral fluid testing relative to blood tests, and the ease of use of the OraSure ® device. +We also sell our AUTO-LYTE ® and MICRO-PLATE assays and reagents in the insurance testing market directly to laboratories, including Lab One , +Heritage Labs, Clinical Reference Laboratory, and the laboratory testing division of the Metropolitan Life Insurance Company. AUTO-LYTE ® assays are used principally to test urine samples for cotinine and other metabolites and to perform urine chemistries for +risk assessment purposes. MICRO-PLATE assays are used principally to test oral fluid specimens collected with the OraSure ® device for cocaine and cotinine. +Infectious Disease Testing +Our sales personnel market the OraSure ® oral fluid collection device, separately and as a kit in combination with laboratory testing services (as described below), and the OraQuick ® rapid HIV-1 antibody test directly to customers in the public health market for HIV-1 testing. This market consists of a +broad range of clinics and laboratories and includes states, counties, and other governmental agencies, colleges and universities, correctional facilities and the military. There are also a number of organizations in the public health market such as +AIDS service organizations and various community-based organizations set up primarily for the purpose of encouraging and enabling HIV-1 testing. +To better serve our public health customers, we have entered into agreements with Lab One and Heritage Labs to provide prepackaged +OraSure ® test kits, with prepaid laboratory testing and specimen shipping costs +included. We also sell the OraSure ® and OraQuick ® devices in the international public health markets. +In June 2002, we entered into an agreement under which Abbott +Laboratories was appointed as the co-exclusive distributor of the OraQuick ® +rapid HIV-1 antibody test in the United States. We expect Abbott ultimately to focus primarily on the hospital and physician office market, while we intend to primarily target our direct sales to the public health and criminal justice markets, the +military, the CDC and other agencies. +8 +Table of Contents +Substance +Abuse Testing +Our substance abuse products +are marketed into the workplace testing, forensic toxicology, criminal justice, and drug rehabilitation markets, through direct sales and distributors. The forensic toxicology market consists of 250 – 300 laboratories including federal, state +and county crime laboratories, medical examiner laboratories, and reference laboratories. The criminal justice market consists of a wide variety of entities in the criminal justice system that require drug screening, such as pre-trial services, +parole and probation officials, police forces, drug courts, prisons, drug treatment programs and community/family service programs. +We have entered into agreements for the distribution of Intercept ® collection kits and associated reagents for drugs-of-abuse testing in the workplace testing market in the United States +and Canada through several laboratory distributors, including Lab One , Quest Diagnostics, Clinical Reference Laboratory and NWT, Inc., and internationally for workplace and forensic toxicology testing through Bio-Rad Laboratories, Altrix +HealthCare, plc, and other distributors. We assist our laboratory customers in customizing their testing services by selling them equipment required to test oral fluid specimens collected with the Intercept ® device. +We also distribute our Q.E.D. ® saliva alcohol test primarily through various distributors. The markets for alcohol testing are relatively small and +fragmented with a broad range of legal and procedural barriers to entry. Markets range from law enforcement testing to workplace testing of employees in safety sensitive occupations. The Q.E.D. ® test has been successfully adopted by end users in the petroleum, heavy construction, trucking, and retail industries +because it is a cost-effective, portable, easy-to-administer, quantitative testing method. Typical usage situations include pre-employment, random, post-accident, reasonable-cause, and return-to-duty testing. +Physicians’ Offices +We sell the Histofreezer ® product line to distributors that market to more than 150,000 primary care physicians and podiatrists in the +United States. Major U.S. distributors include Cardinal Healthcare, McKesson HBOC, Physicians Sales & Service, AmerisourceBergen Corporation, and Henry Schein. Internationally, we market Histofreezer ® in a number of countries through a network of distributors. We are presently exploring ways to further penetrate the +physicians’ office market and we are considering expanding into potential new markets for Histofreezer ® . +International Markets +We +sell a number of our products into international markets primarily through distributors with knowledge of their local markets. Principal markets include physicians’ offices, insurance risk assessment, public health, and laboratory testing. +We assist our international distributors in +registering the products and obtaining required regulatory approvals in each country, and we provide training and support materials. Our international marketing program includes direct assistance to distributors in arranging for laboratory services, +cooperation from screening test manufacturers, and performance of Western Blot confirmatory tests when necessary. +Significant Products and Customers +Several different products have contributed significantly to our financial performance, accounting for 15% or more of total revenues +during the past three years. The OraSure ® and Intercept ® oral fluid collection devices, Histofreezer ® product, and immunoassay tests and reagents accounted for total revenues of approximately $14.3 million, $7.2 million and +$7.6 million in 2002, $13.0 million, $6.7 million and $7.4 million in 2001, and $11.2 million, $6.8 million and $6.7 million in 2000, respectively. As new products are developed and commercialized, we expect to reduce our dependence on these +products. +We currently have one customer, +Lab One , that accounted for 26% of our total revenues during 2002. +9 +Table of Contents +In August +2001, Lab One acquired Osborne Group, Inc., our second largest laboratory customer in the insurance risk assessment market. As a result of this acquisition and other operating improvements, Lab One has achieved certain efficiencies and +reduced its overall inventory levels, which in turn lowered their purchases of our insurance testing assays during 2002. We believe this is an indication that the market for our insurance testing assays will continue to come under pressure as +Lab One and our other laboratory customers are expected to try to reduce their costs by improving their efficiencies or possibly using competing products. There can be no assurance that sales to Lab One will not decrease further or that +this customer will not choose to replace our assays or other products with internally-developed products or products manufactured by our competitors. The loss of Lab One or a significant decrease in the volume of products purchased by it would +have a material adverse effect on our results of operations. +Supply and Manufacturing +We have entered into an agreement with a contractor in the United States for the assembly and supply of our OraSure ® and Intercept ® oral fluid collection devices. This agreement has a current term through December 31, 2003 and automatically renews for +additional annual periods, unless either party provides timely notice of termination prior to the end of an annual period. A change in the manufacturer of the OraSure ® device would require FDA review and approval, which could require significant time to complete and disrupt our ability to +manufacture this product. Subject to receipt of the applicable FDA approval, we intend to terminate the agreement with this contractor and transfer manufacturing of both the OraSure ® and Intercept ® collection devices to our Bethlehem, Pennsylvania facility beginning later in 2003. +We manufacture the OraQuick ® test in our Bethlehem, Pennsylvania facilities. In addition, we have entered into a supply agreement for the +assembly of the OraQuick ® device in Thailand, in order to supply certain +international markets. This agreement has an initial term of one year, and will automatically renew for additional annual periods unless either party provides a timely notice of termination prior to the end of an annual period. We believe that other +firms would be able to manufacture the OraQuick ® test on terms no less +favorable than those set forth in the agreement if the Thailand contractor would be unable or unwilling to continue manufacturing this product. +We can purchase the HIV antigen and the nitrocellulose strips required for the OraQuick ® test only from a limited number of sources. The antigen is currently purchased from a single contract supplier under a +long-term agreement with an initial term ending in January 2010 and one-year automatic renewal terms thereafter. The nitrocellulose used in the test is also provided by a single contract supplier, and we are presently negotiating a long-term supply +agreement with this party. If for any reason these suppliers are no longer able to supply our antigen or nitrocellulose needs, we believe that alternative supplies could be obtained at a competitive cost. However, a change in the antigen or +nitrocellulose would require FDA approval and some additional development work, which would require significant time to complete and could disrupt our ability to manufacture and sell the OraQuick ® device. +The oral fluid Western Blot HIV-1 confirmatory test is manufactured in our Beaverton, Oregon facility. Subject to receipt of FDA approval, +we expect to transfer the manufacturing of this product to our Bethlehem, Pennsylvania facility. The HIV antigen needed to manufacture the Western Blot test is available from only a limited number of sources. For many years, we have purchased the +antigen for this product from BMX on an exclusive basis. BMX is also the exclusive distributor of the Western Blot test kits. +In October 2002, we entered into new agreements with BMX, which replaced existing agreements between the companies. These new agreements +provide for the continued supply by BMX of the HIV-1 antigen and distribution of the oral fluid Western Blot product by BMX on an exclusive worldwide basis. If for any reason BMX is no longer able to supply our antigen needs, we would be able to +obtain alternate supplies at a competitive cost. However, a change in the antigen would require FDA approval and some additional development work, which would require significant time to complete and could disrupt our ability to manufacture and sell +the Western Blot HIV-1 confirmatory test. +10 +Table of Contents +We expect to +assemble analyzers, test cassettes and collectors used in our UP link ™ drugs of abuse rapid detection system and to package this product for shipment at our Bethlehem, Pennsylvania facilities. +Histofreezer ® is manufactured in The Netherlands by Koninklijke, Utermöhlen, N.V. (“Utermöhlen”), the company from which we acquired the product in 1998. We purchase the product pursuant to an +exclusive production agreement. This agreement provides that Utermöhlen will be the exclusive supplier of the Histofreezer ® product until at least December 31, 2006. We believe that additional manufacturers of the Histofreezer ® product are available on terms no less favorable than the terms of the production agreement with Utermöhlen, in the +event that Utermöhlen would be unable or unwilling to continue manufacturing the Histofreezer ® product. +Our +AUTO-LYTE ® and MICRO-PLATE assays are manufactured in our Bethlehem, +Pennsylvania facility. These tests require the production of highly specific and sensitive antibodies corresponding to the antigen of interest. Substantially all our antibody requirements are provided by contract suppliers. We believe that we have +adequate reserves of antibody supplies and that we have access to sufficient raw materials for these products. +The Q.E.D. ® saliva alcohol test is manufactured and packaged for shipment in our Bethlehem, Pennsylvania facility. +Employees +As of December 31, 2002, we had 187 full-time employees, including 38 in sales, marketing, and client services; 44 in research and +development; 87 in operations, manufacturing, quality control, purchasing and shipping; and 18 in administration and finance. Seventeen of our employees hold Ph.D. degrees. This compares to 225 employees as of December 31, 2001. Our employees are +not currently represented by a collective bargaining agreement. +During 2002, we implemented a 17% headcount reduction primarily as a result of lower than anticipated sales levels during 2001 and the elimination of certain development projects. We intend to close our Oregon facilities and move +these operations to Bethlehem, Pennsylvania beginning later in 2003. +Competition +The +diagnostic industry is a multi-billion dollar international industry and is intensely competitive. Many of our competitors are substantially larger and have greater financial, research, manufacturing, and marketing resources. +Important competitive factors for our products include product +quality, price, ease of use, customer service, and reputation. Industry competition is based on the following: +• +Scientific and technological capability; +• +Proprietary know-how; +• +Access to adequate capital; +• +The ability to develop and market products and processes; +• +The ability to attract and retain qualified personnel; and +• +The availability of patent protection. +A few large corporations produce a wide variety of diagnostic tests and other medical devices and equipment. A larger number of mid-size +companies generally compete only in the diagnostic industry, and a significant number of small companies produce only a few diagnostic products. As a result, the diagnostic test industry is highly fragmented and segmented. +11 +Table of Contents +The future +market for diagnostic tests is expected to be characterized by consolidation, greater cost consciousness, and tighter reimbursement policies. The purchasers of diagnostic products are expected to place increased emphasis on lowering costs, reducing +inventory levels, automation, service, and volume discounts. The increased complexity of the market is expected to force many competitors to enter into joint ventures or license certain products or technologies. +We expect competition to intensify as technological advances +are made and become more widely known, and as new products reach the market. Furthermore, new testing methodologies could be developed in the future that render our products impractical, uneconomical or obsolete. There can be no assurance that our +competitors will not succeed in developing or marketing technologies and products that are more effective than those we develop or that would render our technologies and products obsolete or otherwise commercially unattractive. In addition, there +can be no assurance that our competitors will not succeed in obtaining regulatory approval for these products, or introduce or commercialize them before we can do so. These developments could have a material adverse effect on our business, financial +condition and results of operations. +Several +companies market or have announced plans to market oral specimen collection devices and tests outside the United States. We expect the number of devices competing with our Intercept ® and OraSure ® devices to increase as the benefits of oral specimen-based testing become more widely accepted. +Competition in the market for HIV testing is intense and is +expected to increase. We believe that the principal competition will come from existing laboratory-based blood tests, point-of-care whole blood rapid tests, laboratory-based urine assays, or other oral fluid-based tests that may be developed. Our +competitors include specialized biotechnology firms as well as pharmaceutical companies with biotechnology divisions and medical diagnostic companies. +Significant competitors for our OraQuick ® rapid HIV-1 antibody test, such as the Ortho Diagnostics division of Johnson & Johnson and Bio-Rad Laboratories, sell +laboratory-based HIV-1 EIAs, and Calypte, Inc. sells an HIV-1 screening test for urine, in the United States. In addition, Abbott Laboratories currently sells a competing rapid HIV test in the United States. We believe several other companies may +seek FDA approval to sell competing rapid HIV tests in the United States. +In the insurance risk assessment market, our AUTO-LYTE ® homogeneous assays for cocaine and cotinine compete with reagents from Microgenics, Inc. (a subsidiary of Apogent Technologies). Our AUTO-LYTE ® homogeneous assays for beta-blockers and thiazide as well as MICRO-PLATE heterogeneous assays specifically designed for +the detection of cocaine, cotinine, and IgG in oral fluid are the only assays available in the marketplace. However, we expect to face increasing competition from assays developed internally by our laboratory customers, which could be produced at a +cost lower than the price typically paid for our products. In urine chemistries, our significant competitors include The Diagnostics Systems Group of Olympus America Inc. and DRI. +Our MICRO-PLATE drugs-of-abuse reagents are targeted to forensic testing laboratories where sensitivity, +automation, and “system solutions” are important. In the past, these laboratories have typically had to rely on radioimmunoassay test methods to provide an adequate level of sensitivity. Radioimmunoassays require radioactive materials, +which have a short shelf-life and disposal problems. Our MICRO-PLATE tests meet the laboratories’ sensitivity needs, run on automated equipment, are not radioimmunoassays, and are offered to the laboratory as a complete system solution of +reagents, instrumentation and software to meet the specific needs of each customer. Options to buy or rent the instrumentation and software, which we purchase from third party vendors, are offered to these customers. +In the forensic toxicology market, we compete with both +homogeneous and heterogeneous tests manufactured by many companies. Significant competitors in the market for these assays include Microgenics, Inc., Roche Diagnostics, and Immunalysis. +12 +Table of Contents +The +Intercept ® drug testing system competes with laboratory-based drug testing +products and services using testing matrices such as urine, hair, sweat and oral fluid. Major competitors include Ansys Technologies, Inc., Dade Behring, Psychemedics, and Immunalysis. +Our UP link ™ product also is expected to compete with other on-site, rapid drug assays and instrument-read tests. Major competitors in this area +include American Biomedica, Roche Diagnostics, Biosite Diagnostics, Avitar, Inc., Ansys Technologies, Inc., and eScreen. Another potential competitor, LifePoint, Inc., has announced plans to sell a reader-based saliva test panel that will include +alcohol testing. +Q.E.D. ® has two direct competitors, Roche Diagnostics and Chematics. These companies offer +semi-quantitative saliva-based alcohol tests and have received DOT approval. Indirect competitors who offer breath testing equipment include Intoximeters, Dräger Safety, and CMI. Although there are lower priced tests on the market that use oral +fluid or breath as a test medium, these tests are qualitative tests that are believed to be substantially lower in quality and scope of benefits than our Q.E.D. ® test. +The Histofreezer ® product’s delivery system and warmer operating temperature than liquid nitrogen provide us with the opportunity to target sales to primary care physicians, such as family practitioners, +pediatricians, and podiatrists. We do not generally target sales to dermatologists because they have the volume of patients required to support the capital costs associated with a liquid nitrogen delivery system, which is also used to remove warts +and other benign skin lesions. There is limited competition for convenient cryosurgical products for wart removal in the primary care physician market. Major competitors for the Histofreezer ® product include CryoSurgery, Inc. in the United States and Wartner in Europe. +Patents and Proprietary Information +We seek patent and other intellectual property rights to +protect and preserve our proprietary technology and our right to capitalize on the results of our research and development activities. We also rely on trade secrets, know-how, continuing technological innovations, and licensing opportunities to +provide competitive advantages for our products in our markets and to accelerate new product introductions. We regularly search for third-party patents in fields related to our business to shape our own patent and product commercialization +strategies as effectively as possible and to identify licensing opportunities. United States patents generally have a maximum term of 20 years from the date an application is filed. +We have sixteen United States patents and numerous foreign patents for the OraSure ® and Intercept ® collection devices and related technology relating to oral fluid collection, containers for oral fluids, methods to test +oral fluid, formulations for the manufacture of synthetic oral fluid, and methods to control the volume of oral fluid collected and dispersed. We have also applied for additional patents, in both the United States and certain foreign countries, on +such products and technology. +We have one patent +and certain pending patent applications for the OraQuick ® rapid HIV antibody +test in the United States. We also intend to apply for additional patents for this product. We have obtained licenses to certain lateral flow patents and to certain HIV-1 patents held by other parties in order to market the OraQuick ® test. We obtained these licenses through the payment of certain upfront fees and ongoing +royalties. We believe these royalties are comparable to rates generally paid by other companies under similar arrangements. +We may also need to obtain licenses or other rights under, or enter into distribution or other business arrangements in connection with, +certain patents for the Human Immunodeficiency Virus Type 2 (“HIV-2”) and certain other lateral flow patents, in order to manufacture and sell the OraQuick ® HIV test. See the Section entitled, “Risk Factors,” for a further discussion of these issues. +In April 1995, we received exclusive worldwide rights under +patents and know-how owned by SRI International to develop and market products that involve the use of UPT ™ . We +also received non-exclusive worldwide rights under patents and know-how owned by the Sarnoff Corporation (a subsidiary of SRI +13 +Table of Contents +International formerly called the David Sarnoff Research Center) to develop and market products that involve the use of UPT ™ . We have the right to sublicense these rights, subject to consent from SRI and Sarnoff. +Under the agreement with SRI, we are required to make license, +maintenance and royalty payments to SRI. We must also make royalty payments for a period equal to the longer of ten years from the date of the first commercial sale of the products or the term during which the manufacture, use, or sale of a product +would infringe licensed patents, but for our license with SRI. We believe that the royalty rates payable to SRI are comparable to the rates generally payable by other companies under similar arrangements. Our agreement with SRI terminates upon the +expiration of our obligation to pay royalties. +In 1999, we paid $1.5 million to TPM Europe Holding B.V., our sublicensor, for the termination of an existing license agreement between the sublicensor and the Company with respect to the sublicense of UPT ™ patents owned by Leiden University, The Netherlands, and to secure a direct research, development, and license arrangement with Leiden +University. +We have or have licensed rights +under nine U.S. patents and numerous foreign patents for methods, compositions, and apparatuses relating to phosphor technologies. Several additional UPT ™ patent applications remain pending in the United States and abroad. We expect to continue to expand our UPT ™ patent portfolio in 2003. Several new patents were granted during 2002 in the U.S. for the design of the UP link ™ rapid detection platform. +We have one U.S. patent relating to the method for detecting blood in urine specimens using our AUTO-LYTE ® products. +We have five U.S. patents and numerous foreign patents issued for apparatuses and methods for the topical +removal of skin lesions relating to our Histofreezer ® product. We have also +licensed another patent relating to apparatuses and methods for the topical removal of skin lesions relating to our Histofreezer ® product. +We have four U.S. patents and numerous foreign patents and patent applications for the technology used in the Q.E.D. ® test. These patents are related to the analog-to-digital technology color control systems +and methods, systems and devices for the test, and detection of biochemical molecules. +We require our employees, consultants, outside collaborators, and other advisors to execute confidentiality agreements upon the commencement of employment or consulting relationships with us. These +agreements provide that all confidential information developed by or made known to the individual during the course of the individual’s relationship with us, is to be kept confidential and not disclosed to third parties except in specific +circumstances. In the case of employees, the agreements provide that all inventions conceived by the individual during his or her tenure with us will be our exclusive property. +We own rights to trademarks and service marks that we believe are necessary to conduct our business as +currently operated. In the United States, we own the UPT ™ , +UP link ™ , OraSure ® , Intercept ® , OraQuick ® , Histofreezer ® , Q.E.D. ® , and AUTO-LYTE ® trademarks. We also own many of these marks and others in several foreign countries. +Although important, the issuance of a patent or existence of +trademark or trade secret protection does not in itself ensure the success of our business. Competitors may be able to produce products competing with our patented products without infringing our patent rights. Issuance of a patent in one country +generally does not prevent manufacture or sale of the patented product in other countries. The issuance of a patent is not conclusive as to validity or as to the enforceable scope of the patent. The validity or enforceability of a patent can be +challenged by litigation after its issuance. If the outcome of such litigation is adverse to the owner of the patent, the owner’s rights could be diminished or withdrawn. Trade secret protection does not prevent independent discovery and +exploitation of the secret product or technique. +14 +Table of Contents +We are not +aware of any pending claims of infringement or other challenges to our patents or our rights to use our trademarks or trade secrets in the United States or in other countries. +Government Regulation +General +Most of our products are regulated by the FDA, certain state and local agencies, and comparable regulatory bodies in other countries. This +regulation governs almost all aspects of development, production, and marketing, including product testing, authorizations to market, labeling, promotion, manufacturing, and recordkeeping. +All of our FDA-regulated products require some form of action by the FDA before they can be marketed in the +United States. After approval or clearance by the FDA, we must continue to comply with other FDA requirements applicable to marketed products. Both before and after approval or clearance, failure to comply with the FDA’s requirements can lead +to significant penalties and product recalls or could disrupt our ability to sell these products. In addition, the FDA could refuse permission to obtain certificates needed to export our products if the agency determines that we are not in +compliance. +Domestic Regulation +Most of our diagnostic products are +regulated as medical devices. Our Serum Western Blot HIV-1 confirmatory test, which was discontinued in February 2001, was regulated as a biologic or blood product. +There are two review procedures by which medical devices can receive FDA clearance or approval. Some products +may qualify for clearance under Section 510(k) of the Federal Food, Drug and Cosmetic Act. To obtain this clearance, the manufacturer must provide a premarket notification that it intends to begin marketing the product, and show that the product is +substantially equivalent to another legally marketed product (i.e., that it has the same intended use and is as safe and effective as a legally marketed device and does not raise different questions of safety and effectiveness). In some cases, the +submission must include data from human clinical studies. Marketing may commence when the FDA issues a clearance letter finding substantial equivalence. An applicant must submit a 510(k) application at least 90 days before marketing of the affected +product commences. Although FDA clearance may be granted within that 90-day period, in some cases as much as a year or more may be required before clearance is obtained, if at all. +If the medical device does not qualify for the 510(k) procedure (either because it is not substantially +equivalent to a legally marketed device or because it is required by statute and the FDA’s regulations to have an approved application), the FDA must approve a premarket approval application (“PMA”) before marketing can begin. PMAs +must demonstrate, among other matters, that the medical device provides a reasonable assurance of safety and effectiveness. A PMA is typically a complex submission, including the results of preclinical and clinical studies. Preparing a PMA is a +detailed and time-consuming process. Once a PMA has been submitted, the FDA is required to review the submission within 180 days. However, the FDA’s review may, and often is, much longer, often requiring one year or more, and may include +requests for additional data. The OraQuick ® rapid HIV-1 antibody test received +PMA approval in November 2002. +In 2002, Congress +enacted the Medical Device User Fee and Modernization Act, which authorizes the FDA to assess and collect user fees for premarket notifications and premarket approval applications filed on or after October 1, 2002. Fees for fiscal year 2003 range +from $2,187 for premarket notifications to $154,000 for premarket approval applications, although fee reductions are available for companies qualifying as small businesses. We do not currently qualify as a small business. +Biologic products must be the subject of an approved biologics +license application before they can be marketed. The FDA approval process for a biologic product is similar to the PMA approval process, involving a demonstration of the product’s safety and effectiveness based in part on both preclinical and +clinical studies. We currently do not manufacture or sell any biologic products. +15 +Table of Contents +Many of our +insurance testing products are used for non-medical purposes and many of our drugs-of-abuse products sold to state crime labs are for forensic use. The FDA does not currently regulate products used for these purposes. +Every company that manufactures medical devices distributed in +the United States must comply with the FDA’s Quality System Regulations (“QSRs”). These regulations govern the manufacturing process, including design, manufacture, testing, release, packaging, distribution, documentation and +purchasing. In complying with QSRs, manufacturers must continue to expend time, money, and effort in the area of production and quality control to ensure full technical compliance. Companies are also subject to other post-market and general +requirements, including restrictions imposed on marketed products, promotional standards, and requirements for recordkeeping and reporting of certain adverse reactions. If there are any modifications made to our marketed devices, a premarket +notification or premarket approval application may be required to be submitted to, and cleared or approved by, the FDA, before the modified device may be marketed. The FDA regularly inspects companies to determine compliance with QSRs and other +post-market requirements. Failure to comply with statutory requirements and the FDA’s regulations can result in warning letters, monetary penalties, suspension or withdrawal of regulatory approvals, operating restrictions, total or partial +suspension of production, injunctions, product recalls, seizure of products, and criminal prosecution. +Products that include electrical or light emitting equipment must also comply with the FDA’s safety and performance standards +applicable to such equipment. Our UP link ™ analyzer is a piece of electrical equipment that uses a laser +to read the test results and is, therefore, subject to these requirements. In addition, there is an industry safety and performance standard for electrical equipment established by Underwriters Laboratories, Inc., known as UL3101-1. Although a +voluntary standard, compliance with UL3101-1 supported our 510(k) submission for the UP link ™ analyzer. +Underwriters Laboratories Inc. was retained to examine and test the UP link ™ analyzer and has certified +that this product meets the FDA requirements and UL3101-1. +The Clinical Laboratory Improvements Amendments of 1988, or CLIA, prohibit laboratories from performing in vitro tests for the purpose of providing information for the diagnosis, prevention or treatment of any disease or +impairment of, or the assessment of, the health of human beings unless there is in effect for such laboratories a certificate issued by the U.S. Department of Health and Human Services applicable to the category of examination or procedure +performed. We consider the applicability of the requirements of CLIA in the design and development of our products. We have obtained a waiver of the CLIA requirements for our OraQuick ® rapid HIV-1 antibody test and Q.E.D. ® alcohol saliva test and may seek similar waivers for certain other products. A CLIA waiver allows certain customers to use +the waived products that may not have been able to use them without complying with certain quality control and other requirements. +Certain of our products may also be affected by state regulations in the United States. For example, there are several states that +restrict or do not currently permit oral fluid drug testing in the workplace or other markets. In addition, several states prohibit or limit the use of rapid, point-of-care HIV testing. We are presently working with legislators or regulators in +certain of these states in an effort to modify or remove any restrictions affecting our ability to sell products. +International +We are also subject to regulations in foreign countries governing products, human clinical trials and marketing, and may need to obtain +approval from international public health agencies, such as the World Health Organization, in order to sell products in certain countries. Approval processes vary from country to country, and the length of time required for approval or to obtain +other clearances may in some cases be longer than that required for U.S. governmental approvals. We generally pursue approval only in those countries that we believe have a significant market opportunity. +The International Organization for Standardization +(“ISO”) is a worldwide federation of national standards bodies from some 130 countries, established in 1947. The mission of ISO is to promote the development of standardization and related activities in the world with a view to +facilitating the international exchange of goods +16 +Table of Contents +and services. ISO certification is evidenced by the CE mark and indicates that our quality system complies with standards applicable to +activities ranging from initial product design and development through production and distribution. In addition, we must comply with the essential requirements of the In Vitro Diagnostic Directive in order to receive authorization to affix a CE mark +to our products. A CE mark will be required for distribution of medical devices in the European common markets beginning in December 2003. +In the first quarter of 1999, we received authorization to use the CE mark for the OraSure ® and Intercept ® collection devices based on meeting ISO standards at our Beaverton facility. In December 2000, our Bethlehem facility +received final certification for the European Medical Device Directive (93/42/EEC), ISO 9001, ISO 13485, and EN 46001. We have also received authorization to use the CE mark for our Histofreezer ® product line. +Prior to international sale of a product containing electrical and light-emitting equipment, the safety and performance of such a product +must be demonstrated. We retained Underwriters Laboratories, Inc. and Laird Technologies to examine and test the UP link ™ analyzer, and they certified that this product meets the following international standards and directives: IEC 60825-1, IEC/EN 61010-1, CAN/CSA 22.2 No. 1010.1-92, IEC 1010-1, EN 61000 (in part), and EN 55022, EMC Directive +89/336/EEC. +We must also submit evidence of +marketing approval or clearance by the FDA to Health Canada’s Therapeutic Products Programme, and we must comply with certain registration requirements, prior to commencing sales in Canada. We have completed this process for several of our +current products that require FDA review and may do so with respect to other products in the future. +Environmental Regulation +Because of the nature of our current and proposed research, development, and manufacturing processes, we are subject to stringent federal, +state and local laws, rules, regulations and policies governing the use, generation, manufacture, storage, air emission, effluent discharge and handling and disposal of materials and wastes. We believe that we have complied with these laws and +regulations in all material respects. We have not been required to take any action to correct any environmental noncompliance. +Forward-Looking Statements +This Report contains certain “forward-looking statements,” within the meaning of the Federal securities laws. These may include +statements about our expected revenues, earnings, expenses or other financial performance, future product performance or development, expected regulatory filings and approvals, planned business transactions, views of future industry, competitive or +market conditions, and other factors that could affect our future operations, results of operations or financial position. These statements often include the words “believes,” “expects,” “anticipates,” +“intends,” “plans,” “estimates,” “may,” “will,” “should,” “could,” or similar expressions. +Forward-looking statements are not guarantees of future performance or results. Known and unknown factors +could cause actual performance or results to be materially different from those expressed or implied in these statements. Some of these factors are: ability to market products; impact of competitors, competing products and technology changes; +ability to develop, commercialize and market new products; market acceptance of oral fluid testing products and up-converting phosphor technology products; ability to fund research and development and other projects and operations; ability to +maintain new or existing product distribution channels; reliance on sole supply sources for critical product components; availability of related products produced by third parties; ability to obtain and timing of obtaining necessary regulatory +approvals; ability to comply with applicable regulatory requirements; history of losses and ability to achieve sustained profitability; volatility of our stock price; uncertainty relating to patent protection and potential patent infringement +claims; availability of licenses to patents or other technology; ability to enter into international manufacturing agreements; obstacles to +17 +Table of Contents +international marketing and manufacturing of products; ability to sell products internationally; loss or impairment of sources of capital; +ability to meet financial covenants in agreements with financial institutions; ability to retain qualified personnel; exposure to product liability and other types of litigation; changes in international, federal or state laws and regulations; +changes in relationships with strategic partners and reliance on strategic partners for the performance of critical activities under collaborative arrangements; changes in accounting practices or interpretation of accounting requirements; customer +consolidations and inventory practices; equipment failures and ability to obtain needed raw materials and components; the impact of terrorist attacks and civil unrest; ability to complete consolidation or restructuring activities; ability to +identify, complete and realize the full benefits of potential acquisitions; and general political, business and economic conditions. These and other factors that could cause the forward-looking statements to be materially different are described in +greater detail in the Section entitled, “Risk Factors,” and elsewhere in this Report. +Although forward-looking statements help to provide complete information about future prospects, they may not be reliable. The forward-looking statements are made as of the date of this Report and we +undertake no duty to update these statements. +Risk Factors +The following is a discussion of certain +significant risk factors that could potentially negatively impact our financial condition, performance and prospects. +We Face Intense Competition From New and Existing Diagnostic Products. +The diagnostic industry is focused on the testing of +biological specimens in a laboratory or at the point-of-care and is highly competitive and rapidly changing. Our principal competitors often have considerably greater financial, technical and marketing resources. As new products enter the market, +our products may become obsolete or a competitor’s products may be more effective or more effectively marketed and sold than ours. If we fail to maintain and enhance our competitive position, our customers may decide to use products developed +by competitors which could result in a loss of revenues. +Our Research and Development Efforts May Not Succeed or Our Competitors May Develop More Effective or Successful Diagnostic Products. +In order to remain competitive, we must commit substantial resources each year to research and development. The research and development +process generally takes a significant amount of time from inception to commercial product launch. This process is conducted in various stages. During each stage there is a substantial risk that we will not achieve our goals on a timely basis, if at +all, and we may have to abandon a product in which we have invested substantial amounts. +During 2002, 2001 and 2000, we incurred $8.3 million, $9.4 million and $10.4 million, respectively, in research and development expenses. We expect to continue to incur significant costs from our +research and development activities. A primary focus of our efforts has been, and is expected to continue to be, the development of our UPT ™ technology and the related UP link ™ rapid detection +system. However, there can be no assurance that we will succeed in our research and development efforts with respect to UPT ™ , UP link ™ or other technologies or products. If we fail to develop commercially +successful products, or if competitors develop more effective products or a greater number of successful new products, customers may decide to use products developed by our competitors. This would result in a loss of revenues and adversely affect +our results of operations, cash flows and business. +If Acceptance and Adoption of Our Oral Fluid Testing in the Market Does Not Continue, Our Future Results May Suffer. +We have made significant progress in gaining acceptance of oral fluid testing for HIV in the insurance and public health markets. We have +also made significant progress in gaining acceptance of oral fluid testing for +18 +Table of Contents +drugs of abuse in the workplace and criminal justice testing markets. Other markets, particularly the physicians’ office market, may +resist the adoption of oral fluid testing as a replacement for other testing methods in use today. In addition, certain state laws prohibit or restrict the use of oral fluid testing for drugs of abuse in certain markets. There can be no assurance +that we will be able to expand the use of our oral fluid testing products in these or other markets. +Our Failure to Maintain Existing Distribution Channels, or Develop New Distribution Channels, May Result in Lower Revenues. +We have marketed many of our products by +collaborating with laboratories, diagnostic companies and distributors. For example, our OraSure ® oral fluid collection device is distributed to the insurance industry through major insurance testing laboratories. Our sales depend to a substantial degree on our ability to sell products to these customers and develop new +product distribution channels, and on the marketing abilities of the companies with which we collaborate. +Some of our distributors have recently consolidated, and such consolidation has had, and may continue to have, an adverse impact on the +level of orders for our products. One of these laboratories, Lab One , acquired another large insurance laboratory customer, Osborne Group, in 2001. These customers together accounted for approximately 26%, 29% and 30% of our revenues for the +years 2002, 2001, and 2000, respectively. As a result of efficiencies gained following this acquisition, Lab One purchased approximately $1 million less of our insurance assays in 2002 than both companies purchased in 2001. +In addition, some distributors have experienced, and may +continue to experience, pressure from their customers to reduce the price of their products and testing services. For example, Lab One and our other insurance testing laboratories are facing this pressure and may consider using lower cost +insurance testing assays that they develop internally or purchase from our competitors. This has reduced our sales of insurance assays and is expected to lower sales of these products in 2003 and beyond. +Although we will try to maintain and expand our business with +our distributors, there can be no assurance that such companies will continue to purchase or distribute our products or maintain historic order volumes, or that new distribution channels will be available on satisfactory terms. +The Use of Sole Supply Sources For Critical Components of +Our Products Could Adversely Affect Our Business. +We currently purchase certain critical components of our products from sole supply sources. For example, all of the HIV-1 antigen used to make our oral fluid Western Blot HIV-1 confirmatory test is purchased from BMX, and all of the +HIV-1 antigen and nitrocellulose required to make our OraQuick ® rapid HIV-1 +antibody test are purchased from sole source suppliers. If these suppliers are unable or unwilling to supply the required component, we would need to find another source, and perform additional development work and obtain FDA approval for the use of +the alternative component for our products. Completing that development and obtaining such FDA approval could require significant time to complete and may not occur at all. These events could either disrupt our ability to manufacture and sell +certain of our products or completely prevent us from doing so. Either event would have a material adverse effect on our results of operations, cash flows and business. +The Unavailability of Certain Products Distributed by a Third Party Could Adversely Affect Sales of Our +OraSure ® Oral Fluid Collection Device. +In testing an oral fluid sample collected with an +OraSure ® device for HIV-1, our customers must use an HIV-1 screening test +approved by the FDA for use with our OraSure ® device. Where an oral fluid +sample screens positive for HIV-1, our customers must then use our oral fluid Western Blot confirmatory test, which has also been approved by the FDA for use with our OraSure ® device, to confirm that positive indication. +19 +Table of Contents +BMX +(bioMerieux, Inc.) manufactures and sells the only oral fluid HIV-1 screening test that has received FDA approval for use in detecting HIV-1 in an oral fluid specimen collected with our OraSure ® collection device. BMX has developed a new HIV-1 screening test, and has indicated that this new test will eventually +replace its existing FDA-approved HIV-1 screening test. We are working with BMX to obtain FDA approval for use of the new screening test with our OraSure ® device. BMX also supplies the HIV-1 antigen used to manufacture our oral fluid Western Blot HIV-1 confirmatory test and is +the exclusive world-wide distributor of that product. +If BMX ceases to manufacture or sell an HIV-1 screening test approved by the FDA for use with our OraSure ® collection device, or if our oral fluid Western Blot HIV-1 confirmatory test is not made available to our customers (because BMX either fails to supply the HIV-1 antigen required to make this product +or fails to distribute this product), we would need to find alternate suppliers for these products, which would require additional development work and FDA approval. These activities would likely require significant time to complete. If our +customers cannot obtain an HIV-1 screening test or Western Blot HIV-1 confirmatory test that have been approved by the FDA for use in connection with our OraSure ® collection device, these customers would likely stop purchasing our OraSure ® device. Sales of the OraSure ® device were approximately $12.7 million and $11.5 million, or 40% and 35% of our total revenues in 2002 and 2001, +respectively. +The Time Needed to Obtain +Regulatory Approvals and Respond to Changes in Regulatory Requirements Could Adversely Affect Our Business. +As described more fully above under the Section entitled, “Government Regulation,” many of our proposed and existing products +are subject to regulation by the FDA and other governmental or public health agencies. In particular, we are subject to strict governmental controls on the development, manufacture, labeling, distribution and marketing of our products. +The process of obtaining required approvals or clearances from +governmental or public health agencies varies according to the nature of, and uses for, the specific product and can involve lengthy and detailed laboratory testing, human clinical trials, sampling activities and other costly, time-consuming +procedures. For example, we will likely seek FDA approval for the use of the OraQuick ® rapid HIV antibody test on oral fluid, venous whole blood and serum/plasma samples. Approval of these claims will include the submission of clinical data and could require significant time to obtain. The submission of an application +to the FDA or other regulatory authority for these or other claims does not guarantee that an approval or clearance to market the product will be received. Each authority may impose its own requirements and delay or refuse to grant approval or +clearance, even though a product has been approved in another country. +Moreover, the approval or clearance process for a new product can be complex and lengthy. The time taken to obtain approval or clearance varies depending on the nature of the application and may result in the passage of a +significant period of time from the date of submission of the application. This time span increases our costs to develop new products and increases the risk that we will not succeed in introducing or selling them. +Newly promulgated or changed regulations could also require us +to undergo additional trials or procedures, or could make it impractical or impossible for us to market our products for certain uses, in certain markets, or at all. For example, the Substance Abuse and Mental Health Services Administration +(“SAMHSA”), which is part of the U.S. Department of Health and Human Services, is in the process of drafting regulations for the use of oral fluid drug testing for federal workers. Although we believe the SAMHSA regulations, when issued in +final form, will permit us to market and sell our oral fluid drug tests for use with federal workers, there is no guarantee that those regulations will do so, and our ability to sell those products in that market could be limited. Other changes in +government regulations, such as the adoption of the FDA’s Quality System Regulation, may also adversely affect our results of operations by requiring that we incur the expense of changing or implementing new manufacturing and control +procedures. +20 +Table of Contents +The +regulations in some states may restrict our ability to sell products in those states. For example, certain states restrict or do not allow the testing of oral fluid for drugs of abuse or the rapid, point-of-care testing for HIV. While we intend to +work with state legislators and regulators to remove or modify any applicable restrictions, there is no guarantee we will be successful in these efforts. +In addition, all in vitro diagnostic products that are to be sold in the European Union (“EU”) must bear the CE mark +indicating conformance with the essential requirements of the In Vitro Diagnostic Directive (“IVDD”). The deadline for meeting this requirement is December 7, 2003. We will not be permitted to sell our products in the EU without a CE mark +after this date, which could lead to the termination of strategic alliances and agreements for sales of those products in the EU. While we intend to CE mark certain existing and future products, and are not aware of any material reason why we will +be unable to do so, there can be no assurance that compliance with all provisions of the IVDD will be demonstrated and the CE mark obtained prior to the deadline. +At the present time, we have received FDA clearance or approval for the OraSure ® and Intercept ® oral fluid collection devices, the OraQuick ® rapid HIV-1 antibody test (for use with finger-stick whole blood samples), the UP link ™ drug testing system and opiates assay, the Histofreezer ® wart removal system, the Q.E.D. ® saliva alcohol test, the OraSure ® oral fluid Western Blot HIV-1 confirmatory test, and various other tests. The OraSure ® and Intercept ® collection devices (collection pad only) and Histofreezer ® product currently bear the CE mark. See the Sections entitled, “Products” and “Government Regulation,” +for a further discussion of regulatory approvals and clearances obtained for our products. +Failure to Comply With FDA or Other Requirements May Require Us to Suspend Production of Our Products Which Could Result in a Loss of Revenues. +We can manufacture and sell many of our products, both in the +United States and in some cases abroad, only if we comply with regulations of government agencies such as the FDA. We have implemented quality assurance and other systems that are intended to comply with applicable regulations. +During 2000, the FDA issued warning letters with respect to +our Serum Western Blot product, stating that we were not in compliance with the FDA’s regulations. We have responded to each of these letters and voluntarily discontinued this product. Although we believe that we have satisfactorily addressed +the points raised by the FDA, the FDA could force us to stop manufacturing products at our Oregon facility if the FDA concludes that we remain out of compliance with applicable regulations. The FDA could also require us to recall products if we fail +to comply with applicable regulations, which could force us to stop manufacturing such products. See the Section entitled, “Government Regulation,” for a further discussion of regulatory requirements. +We Have a History of Losses. +We have not achieved full-year profitability. We incurred net +losses of approximately $3.3 million, $3.7 million and $12.7 million in 2002, 2001 and 2000 respectively. As of December 31, 2002, the Company had an accumulated deficit of approximately $129.4 million. +Our limited combined operating history makes it difficult to +forecast our future operating results. In order to achieve sustainable profitability, our revenues will have to continue to grow at a significant rate. However, our revenues have remained essentially flat during the past three years. +Our ability to achieve revenue growth, and therefore +profitability, will be dependent upon a number of factors including, without limitation, the following: +• +Creating market acceptance for and selling increasing volumes of the OraSure ® collection device, the Intercept ® and UP link ™ drug testing products, and the OraQuick ® rapid HIV-1 antibody test; +21 +Table of Contents +• +The degree to which certain of our new products (i.e., the OraQuick ® rapid HIV-1 antibody test) may replace sales of our existing products (i.e., the OraSure ® device for HIV-1 testing) and the financial impact of that change; +• +Achieving growth in international markets with our OraQuick ® rapid HIV-1 antibody test and other products; and +• +Commercially developing, and obtaining regulatory approval and creating market acceptance for, UPT ™ , the UP link ™ drugs-of-abuse rapid detection system, and other new products in a time frame consistent with our objectives. +We have not yet fully achieved these objectives and there can be no assurance that we will be able to do so. Moreover, even if we achieve +our objectives and become profitable, there can be no assurance that we will be able to sustain such profitability in the future. +Our Reported Financial Results May be Adversely Affected by Changes in Accounting Principles Generally Accepted in the United States. +We prepare our financial statements in +conformity with accounting principles generally accepted in the United States. These accounting principles are subject to interpretation by the Financial Accounting Standards Board, the American Institute of Certified Public Accountants, the +Securities and Exchange Commission and various bodies formed to interpret and create appropriate accounting policies. A change in these policies or interpretations could have a significant effect on our reported financial results, and could affect +the reporting of transactions completed before the announcement of a change. +For example, while current accounting rules allow us to exclude the expense of stock options from our financial statements, influential legislators and business policy groups have suggested that the +rules be changed to require those options to be expensed. We rely on stock options as an important component of our employee compensation packages. If we are required to expense options, we may be less likely to achieve profitability, or we may have +to decrease or eliminate option grants. Decreasing or eliminating option grants may adversely impact our ability to attract and retain qualified employees. +Volatility and Other Factors May Affect Our Stock Price. +Our stock price may be volatile, and could experience substantial declines. The market price of our common +stock has historically experienced and might continue to experience volatility in the future in response to a number of factors, including quarter-to-quarter variations in operating results, analysts’ reports, the relatively low trading volume +for our stock, market conditions in the industry, regulatory and other developments affecting our products, changes in governmental regulations, changes in general conditions in the economy or in the financial or stock markets, and terrorist +attacks, civil unrest and war. +The market has +also recently experienced significant decreases in value. This market decline has affected the market prices of securities issued by many companies, often for reasons unrelated to their operating performance, and may adversely affect the price of +our common stock. +A Market for Our Products +May Not Develop. +Our future success will +depend, in part, on the market acceptance, and the timing of such acceptance, of new products such as the Intercept ® drug testing service, the OraQuick ® rapid HIV-1 antibody test, products currently under development such as the UP link ™ +drugs of abuse rapid detection system and other products using the UPT ™ technology, and other new products or +technologies that may be developed or acquired and introduced in the future. To achieve market acceptance, we must make substantial marketing efforts and spend significant funds to inform potential customers and the public of the perceived benefits +of these products. We currently have limited evidence on which to evaluate the market reaction to products that may be developed, and there can be no assurance that any products will meet with market acceptance and fill the market need that is +perceived to exist. +22 +Table of Contents +Our Success +Depends on Our Ability to Protect Our Proprietary Technology. +The diagnostics industry places considerable importance on obtaining patent, trademark, and trade secret protection, as well as other intellectual property rights, for new technologies, products and processes. Our success +depends, in part, on our ability to develop and maintain a strong intellectual property portfolio or obtain licenses to patents and other technology for products and technologies both in the United States and in other countries. +As appropriate, we intend to file patent applications and +obtain patent protection for our proprietary technology. These patent applications and patents will cover, as applicable, compositions of matter for our products, methods of making those products, methods of using those products, and apparatus +relating to the use or manufacture of those products. We will also rely on trade secrets, know-how, and continuing technological advancements to protect our proprietary technology. +We have entered, and will continue to enter, into confidentiality agreements with our employees, consultants, +advisors and collaborators. However, these parties may not honor these agreements and we may not be able to successfully protect our rights to unpatented trade secrets and know-how. Others may independently develop substantially equivalent +proprietary information and techniques or otherwise gain access to our trade secrets and know-how. +Many of our employees, including scientific and management personnel, were previously employed by competing companies. Although we +encourage and expect all of our employees to abide by any confidentiality agreement with a prior employer, competing companies may allege trade secret violations and similar claims against us. +We may collaborate with universities and governmental research +organizations which, as a result, may acquire part of the rights to any inventions or technical information derived from collaboration with them. +To facilitate development and commercialization of a proprietary technology base, we may need to obtain licenses to patents or other +proprietary rights from other parties. Obtaining and maintaining such licenses may require the payment of substantial costs. In addition, if we are unable to obtain these types of licenses, our product development and commercialization efforts may +be delayed or precluded. +We may incur +substantial costs and be required to expend substantial resources in asserting or protecting our intellectual property rights, or in defending suits against us related to intellectual property rights. Disputes regarding intellectual property rights +could substantially delay product development or commercialization activities. Disputes regarding intellectual property rights might include state, federal or foreign court litigation as well as patent interference, patent reexamination, patent +reissue, or trademark opposition proceedings in the United States Patent and Trademark Office. Opposition or revocation proceedings could be instituted in a foreign patent office. An adverse decision in any proceeding regarding intellectual property +rights could result in the loss or limitation of our rights to a patent, an invention or trademark. +The Sales Potential for OraQuick ® Will be Affected by Our Ability to Obtain Certain Licenses. +There are several factors that will affect the specific +countries in which we will be able to sell our OraQuick ® rapid HIV antibody +test and therefore the overall sales potential of the test. One factor is whether we can arrange a sublicense or distribution agreement related to patents for detection of the HIV-2 virus. HIV-2 is a type of the HIV virus estimated to represent a +small fraction of the known HIV cases worldwide. Nevertheless, HIV-2 is considered to be an important component in the testing regimen for HIV in many markets. HIV-2 patents are in force in most of the countries of North America and Western Europe, +as well as in Japan, Korea, South Africa, and Australia. Access to a license for one or more HIV-2 patents may be necessary to sell HIV-2 tests in countries where such patents are in force, or to manufacture in countries where such patents are in +force and then sell into non-patent markets. Since HIV-2 patents are in force in the United States, we may be restricted from manufacturing an OraQuick ® rapid HIV-2 antibody test in the United States and selling into other countries, even if there were no HIV-2 patents in +those other countries. +23 +Table of Contents +The importance +of HIV-2 differs by country, and can be affected by both regulatory requirements and by competitive pressures. In most countries, any product used to screen the blood supply will be required to detect HIV-2, although the OraQuick ® rapid HIV antibody test has not been intended for that market purpose. In other markets, +including the United States, a test that can detect only the more prevalent HIV-1 type is considered sufficient by the FDA, except in testing related to blood supply. Because the competitive situation in each country will be affected by the +availability of other testing products as well as the country’s regulatory environment, we may be at a competitive disadvantage in some markets without an HIV-2 product even if HIV-2 detection is not required by regulations. In particular, our +ability to sell a product that does not include an HIV-2 test may be limited, or a competitor’s product that includes an HIV-2 test may be preferred and have a competitive advantage over an HIV-1 only test that we sell. +We have obtained licenses to HIV-1 patents held by the +manufacturer of the HIV-1 antigen used in the OraQuick ® device and by the +National Institutes of Health. We are not aware of any other HIV-1 patents which would need to be licensed in order to manufacture and sell the OraQuick ® rapid HIV-1 antibody test. +Another factor that may affect the specific countries in which we will be able to sell an OraQuick ® rapid HIV-1 or HIV-2 test, and therefore the overall sales potential, concerns whether we can arrange a +sublicense or distribution agreement related to any patents which claim lateral flow assay methods and devices covering the OraQuick ® rapid HIV antibody tests or their use. OraQuick ® is a lateral flow assay device that tests for specific antibodies or other substances. The term “lateral flow” +generally refers to a test strip through which a sample flows and which provides a test result on a portion of the strip downstream from where the sample is applied. There are numerous patents in the United States and other countries which claim +lateral flow assay methods and devices. Some of these patents may broadly cover the technology used in the OraQuick ® test and are in force in the United States and other countries. We may not be able to make the OraQuick ® test in the United States and sell it in countries where there is no patent on the device. We have obtained licenses under +several lateral flow patents, which we believe should be sufficient to permit the manufacturing and sale of the OraQuick ® device as currently contemplated. However, licenses under additional patents may be required. +In the event that it is determined that a license is required and it is not possible to negotiate a license agreement under a necessary +patent, we may be able to modify the OraQuick ® rapid HIV antibody test such +that a license would not be necessary. However, this alternative could delay or limit our ability to sell the OraQuick ® rapid HIV antibody test in the United States and other markets, which would adversely affect our results of operations, cash flows and business. +If We Lose Our Key Personnel or Are Unable to Attract and +Retain Qualified Personnel as Necessary, Our Business Could be Harmed. +Our success will depend to a large extent upon the contributions of our executive officers, management, and sales, marketing, and scientific staff. We may not be able to attract or retain qualified +employees in the future due to the intense competition for qualified personnel among medical products businesses. +If we are not able to attract and retain the necessary personnel to accomplish our business objectives, we may experience constraints that +will adversely affect our ability to effectively sell and market our products, to meet the demands of our strategic partners in a timely fashion, or to support internal research and development programs. In particular, product development programs +depend on the ability to attract and retain highly skilled scientists, including molecular biologists, biochemists and engineers, and sales and marketing efforts depend on the ability to attract and retain skilled and experienced sales and marketing +representatives. Recruiting qualified personnel can be an intensely competitive and time-consuming process. Although we believe we will be successful in attracting and retaining qualified personnel, competition for experienced scientists and other +personnel from numerous companies and academic and other research institutions may limit our ability to do so on acceptable terms. +24 +Table of Contents +All of our employees, other than a few senior officers who have employment agreements, are +at-will employees, which means that either the employee or the Company may terminate their employment at any time. If we experience difficulty in recruiting and retaining qualified personnel, we may need to provide higher compensation to such +personnel than currently anticipated or we may incur additional expenses for the recruitment of qualified personnel. +Our business strategies will require additional expertise in specific industries and areas applicable to the development efforts related +to up-converting phosphor or other technologies. These activities will require the addition of new personnel, including management, and the development of additional expertise by existing management personnel. The inability to acquire these services +or to develop this expertise could impair the development, if any, of products related to these technologies. +Our Increasing International Presence May be Affected by Regulatory, Cultural or Other Restraints. +We intend to increase international sales of our products. +Our international sales accounted for approximately $3.9 million or 12% of total revenues for 2002, approximately $5.3 million or 16% of total revenues for 2001, and approximately $4 million or 14% of total revenues for 2000. +A number of factors can slow or prevent international sales, +or substantially increase the cost of international sales, including those set forth below: +• +Regulatory requirements (including compliance with applicable customs regulations) may slow, limit, or prevent the offering of products in foreign jurisdictions; +• +The unavailability of licenses to certain patents in force in a foreign country which cover our products may restrict our ability to sell into that country; +• +Our inability to obtain the CE mark on our products in a timely manner may preclude or delay our ability to sell products to the European Union; +• +Cultural and political differences may make it difficult to effectively market, sell and gain acceptance of products in foreign jurisdictions; +• +Inexperience in international markets may slow or limit our ability to sell products in foreign countries; +• +Exchange rates, currency fluctuations, tariffs and other barriers, extended payment terms and dependence on and difficulties in managing international distributors +or representatives may affect our revenues even when product sales occur; +• +The creditworthiness of foreign entities may be less certain and foreign accounts receivable collection may be more difficult; +• +Economic conditions, the absence of available funding sources, terrorism, civil unrest and war may slow or limit our ability to sell our products in foreign +countries; +• +International markets often have long sales cycles, especially sales to foreign governments, quasi-governmental agencies and international public health agencies, +thereby delaying or limiting our ability to sell our products; and +• +We may be at a disadvantage if competitors in foreign countries sell competing products at prices at or below such competitors’ or our cost. +In February 2000, we entered into +an agreement for the distribution of our OraQuick ® rapid HIV antibody test in a +number of African countries. Because of the inability of our African distributor to obtain required regulatory approvals, the lack of funding sources in those countries for the purchase of our product and other factors, our distributor failed to +meet its minimum purchase commitments under our agreement. As a result, we were forced to record a reserve for approximately $0.6 million of OraQuick ® inventory manufactured in contemplation of sales to this distributor. +25 +Table of Contents +In addition, +we have entered into a contract for the manufacture and supply of the OraQuick ® +rapid HIV antibody test in Thailand. However, we do not have significant direct experience with the use of international manufacturers. Factors such as economic and political conditions and foreign regulatory requirements may slow or prevent the +manufacture of our products in countries other than the United States. Interruption of the supply of our products could reduce revenues or cause us to incur significant additional expenses in finding an alternative source of supply. +We May be Sued for Product Liabilities for Injuries +Resulting From the Use of Our Diagnostic Products. +We may be held liable if any of our products, or any product which is made with the use or incorporation of any of our technologies, causes injury of any type or is found otherwise unsuitable during product testing, manufacturing, +marketing, sale or usage. Although we have obtained product liability insurance, this insurance may not fully cover potential liabilities. As we bring new products to market, we may need to increase our product liability coverage. If we decide to +obtain the required regulatory approvals and sell any of our products in the consumer or over-the-counter market, the risk of potential product liability exposure and the required level of insurance coverage could increase. Inability to obtain +sufficient insurance coverage at an acceptable cost or otherwise to protect against potential product liability claims could affect our decision to commercialize new products. +We May Not be Able to Commercialize Our UPT ™ , UP link ™ or Other New Products Which Could Negatively Affect Our Future Revenues. +Our UPT ™ technology and the UP link ™ rapid detection system are +still under development. Commercial development of the UP link ™ system or the UPT ™ technology for certain other applications and other new products may not be successful. Successful products require +significant development and investment, including testing, to demonstrate their cost-effectiveness or other benefits prior to commercialization. In addition, regulatory approval must be obtained before most products may be sold. Additional +development efforts on these products will be required before any regulatory authority will review them. Regulatory authorities may not approve these products for commercial sale. In addition, even if a product is developed and all applicable +regulatory approvals are obtained, there may be little or no market for the product. Accordingly, because of these uncertainties, the UP link ™ rapid detection system, other applications of UPT ™ or other +new products may not be successfully commercialized, which could negatively affect our results of operations, cash flows and business. +We Are Dependent Upon Strategic Partners to Assist in Developing and Commercializing Some of Our Diagnostic Products. +Although we intend to pursue some product opportunities +independently, opportunities that require a significant level of investment for development and commercialization or a distribution network beyond our existing sales force may necessitate involving one or more strategic partners. In particular, our +strategy for development and commercialization of UPT ™ , including the UP link ™ rapid detection system, and certain other products may entail entering into additional arrangements with distributors or other corporate +partners, universities, research laboratories, licensees and others. We may be required to transfer material rights to such strategic partners, licensees and others. While we expect that our current and future partners, licensees and others have and +will have an economic motivation to succeed in performing their contractual responsibilities, the amount and timing of resources to be devoted to these activities will be controlled by others. Consequently, there can be no assurance that any +revenues or profits will be derived from such arrangements. +We are Dependent Upon Patents, Licenses and Other Proprietary Rights From Third Parties, Including Rights to Up-Converting Phosphor Compositions, Methods and Apparatuses. +We have licensed the worldwide rights to up-converting +phosphor compositions, methods and apparatuses for use in diagnostic applications, which are the subject of numerous United States patents and several pending United States applications. Corresponding patents and patent applications have been +granted, issued or filed in +26 +Table of Contents +numerous foreign countries, including, for example, European countries, Japan and Canada. We cooperate with the licensor to prosecute such +patent applications and protect such patent rights. If the licensors do not meet their obligations under the license agreements or do not reasonably consent to sublicenses by us, or if the license agreement is terminated, we could lose the +opportunity to develop UPT ™ . +We May Require Future Additional Funding to Stay in Business. +Although we have made significant progress in the past toward +controlling expenses and increasing product revenue, we have historically depended, to a substantial degree, on capital raised through the sale of equity securities and bank borrowings to fund our operations. +Our future liquidity and capital requirements will depend on +numerous factors, including, but not limited to, the following: +• +The costs and timing of the expansion of our manufacturing capacity; +• +The success of our research and product development efforts; +• +The scope and results of clinical testing; +• +The magnitude of capital expenditures; +• +Changes in existing and potential relationships with business partners; +• +The time and cost of obtaining regulatory approvals; +• +The costs involved in obtaining and enforcing patents, proprietary rights and necessary licenses; +• +The costs and timing of expansion of sales and marketing activities; +• +The timing of the commercial launch of new products; +• +The extent to which existing and new products gain market acceptance; +• +Competing technological and market developments; and +• +The scope and timing of strategic acquisitions. +If additional financing is needed, we may seek to raise funds through the sale of equity or other securities or through bank borrowings. +There can be no assurance that financing through the sale of securities, bank borrowings or otherwise, will be available to us on satisfactory terms, if at all. +The Recent Economic Downturn and Terrorist Attacks May Adversely Affect Our Business. +Since the September 11, 2001 terrorist attacks, the United +States economy has experienced a decline. Changes in economic conditions could adversely affect our business. For example, in a difficult economic environment, customers may be unwilling or unable to invest in new diagnostic products, may elect to +reduce the amount of their purchases or may perform less drug testing because of declining employment levels. A weakening business climate could also cause longer sales cycles and slower growth, and could expose us to increased business or credit +risk in dealing with customers adversely affected by economic conditions. +The terrorist attacks and subsequent governmental responses to these attacks could cause further economic instability or lead to further acts of terrorism in the United States and elsewhere. These actions could adversely +affect economic conditions outside the United States and reduce demand for our products internationally. Terrorist attacks could also cause regulatory agencies, such as the FDA or agencies that perform similar functions outside the United States, to +focus their resources on vaccines or other products intended to address the threat of biological or chemical warfare. This diversion of resources could delay our ability to obtain regulatory approvals required to manufacture, market or sell our +products in the United States and other countries. +27 +Table of Contents +Efforts to +Consolidate or Restructure Could Adversely Affect Our Business. +We may from time to time restructure and consolidate various aspects of our operations in order to achieve cost savings and other efficiencies. For example, during 2001 we began a restructuring of our manufacturing +operations which included the transfer of OraQuick ® manufacturing from the +Beaverton, Oregon facility to Bethlehem, Pennsylvania. In addition, we plan to close the Oregon facility and transfer all remaining manufacturing operations and research and development activities in that facility related to the Western Blot HIV-1 +confirmatory test and our contract manufacturing operations for OraSure ® and +Intercept ® , to our facilities in Pennsylvania. The transfer of operations may +result in the loss of scientific or other personnel and thereby delay the transfer or disrupt the continuation of operations thereafter. We will also be required to obtain FDA approval to transfer certain operations to another location, which could +delay the transfer or disrupt continued operations. Any delay or disruption of operations, and in particular manufacturing operations, could result in increased costs or could delay or prevent us from selling certain products and thereby result in a +loss of revenue. +Future Acquisitions or +Investments Could Disrupt Our Ongoing Business, Distract Our Management, Increase Our Expenses and Adversely Affect Our Business. +We may consider strategic acquisitions or investments as a way to expand our business in the future. These activities, and their impact on +our business, are subject to the following risk factors: +• +Suitable acquisitions or investments may not be found or consummated on terms that are satisfactory to us; +• +We may be unable to successfully integrate an acquired company’s personnel, assets, management systems and technology into our business; +• +Acquisitions may require substantial expense and management time and could disrupt our business; +• +An acquisition and subsequent integration activities may require greater capital resources than originally anticipated at the time of acquisition; +• +An acquisition may result in the incurrence of unexpected expenses, the dilution of our earnings or our existing stockholders’ percentage ownership, or +potential losses from undiscovered liabilities not covered by an indemnification from the seller(s) of the acquired business; +• +An acquisition may result in the loss of existing key personnel or customers or the loss of the acquired company’s key personnel or customers; +• +The benefits to be derived from an acquisition could be affected by other factors, such as regulatory developments, general economic conditions and increased +competition; and +• +An acquisition of a foreign business may involve additional risks, including not being able to successfully assimilate differences in foreign business practices or +overcome language barriers. +The +incurrence of one or more of the above or other factors may prevent us from achieving all or a significant part of the benefits expected from an acquisition or investment. This may adversely affect our financial condition, results of operations and +ability to grow our business. +The previous +discussion of our business should be read in conjunction with the Financial Statements and accompanying notes included in Item 15 of this Annual Report on Form 10-K. +ITEM 2. Properties. +In October 2002, we leased an approximate 48,000 square foot facility, which is our new primary corporate office and manufacturing facility, on property in Bethlehem, Pennsylvania. The lease has a ten-year initial term +ending in October 2012 and base rental rate starting at $780,000 and increasing to $858,000 per year over that initial term. The lease also has a five-year renewal option at an annual base rental rate of $975,000 and a ten-year purchase option. +28 +Table of Contents +In April 1999, +we signed a five-year lease to rent 25,845 square feet of space at the John M. Cook Technology Center in Bethlehem, Pennsylvania, which we use for our sales and marketing and research and development offices. Annual base rent for the initial +five-year term of this lease ending in March 2005 is approximately $244,000. The lease also includes a five-year renewal option at an annual base rental rate of $271,000 and a ten-year purchase option. +We own a 33,500 square foot building in Bethlehem, +Pennsylvania, which is used for manufacturing, engineering and information systems activities. +We lease approximately 30,500 square feet of office, manufacturing, and laboratory space in Beaverton, Oregon, under a lease that expires in January, 2005. We have annual base lease obligations under +the lease starting at $351,000 and increasing to $395,000 during the term of the lease. We expect to consolidate the research and development and manufacturing operations currently performed in Oregon with our Bethlehem operations beginning later in +2003. +We rent additional warehouse space on an +as-needed basis. We also lease space for small sales offices in Chicago, Illinois and Reeuwijk, The Netherlands. +We believe that the facilities described above are adequate for our current requirements. +ITEM 3. Legal Proceedings. +From time to time we are involved in legal proceedings arising in the ordinary course of business. In our opinion, based on the advice of counsel, these proceedings are not expected to have a material +adverse effect on our financial position or results of operations. +ITEM +4. Submission of Matters to a Vote of Security Holders. +No matters were submitted to a vote of security holders during the fourth quarter of the year ended December +31, 2002. +29 +Table of Contents +PART II +ITEM 5. Market for Registrant’s Common Equity and Related Stockholder Matters. +Our Common Stock is listed for trading on the National Market tier of The Nasdaq Stock Market (“NASDAQ”) under the symbol OSUR. +High and low sales prices reported by NASDAQ during the periods indicated are shown below. +Year ended December 31, +2002 +2001 +High +Low +High +Low +First Quarter +$ +12.280 +$ +4.750 +$ +10.000 +$ +5.875 +Second Quarter +8.350 +5.500 +12.640 +6.688 +Third Quarter +6.820 +3.330 +15.000 +7.260 +Fourth Quarter +8.150 +3.700 +12.880 +8.890 +On March +21, 2003, there were 522 holders of record and approximately 12,500 holders in street name of the Common Stock, and the closing price of the Common Stock was $7.17 per share. We have never paid any cash dividends, and the Board of Directors does not +anticipate paying cash dividends in the foreseeable future. We are generally not permitted to pay dividends or make other distributions to our stockholders under the terms of our credit facilities with Comerica Bank, without first obtaining +Comerica’s consent. We intend to retain any future earnings to provide funds for the operation and expansion of our business. +ITEM 6. Selected Financial Data. +The following table sets forth selected financial data of the Company. On September 29, 2000, STC and Epitope were merged into the Company (the “Merger”). The Merger was accounted for as a +pooling of interests and, accordingly, all prior period financial statements of Epitope have been restated to include the results of operations, financial position and cash flows of STC. The selected financial data as of September 30, 1999 and 1998 +and for each of the years then ended, include Epitope’s previous September 30 fiscal year amounts and STC’s December 31 calendar year amounts. On September 20, 2000, the Company changed its fiscal year-end from September 30 to December 31, +effective with the calendar year beginning January 1, 2000. A three-month transition period from October 1, 1999 through December 31, 1999 (the “Transition Period”) precedes the start of the 2000 fiscal year. As a result of the Merger, +financial statements for the Transition Period include amounts for Epitope and STC for the three months ended December 31, 1999. Accordingly, STC’s results of operations for the three months ended December 31, 1999 are included in both the +financial statements for the year ended September 30, 1999 and for the Transition Period. +This information should be read in conjunction with the Financial Statements and notes thereto included in Item 15 and the information set forth in Item 7, “Management’s Discussion and +Analysis of Financial Condition and Results of Operations.” +30 +Table of Contents +Selected Financial Data +(In thousands, except per share data) +Year ended December 31, +Three months ended December 31, +Year ended +September 30, +2002 +2001 +2000 +1999 +1998 +1999 +1998 +Operating Results: +(Unaudited) +Revenues +$ +32,010 +$ +32,573 +$ +28,788 +$ +6,822 +$ +5,138 +$ +24,046 +$ +20,444 +Costs and expenses +35,550 +36,906 +42,917 +7,105 +5,857 +28,138 +22,721 +Other income (expense), net +198 +634 +1,407 +(138 +) +(159 +) +(91 +) +(98 +) +Net loss +(3,342 +) +(3,728 +) +(12,747 +) +(471 +) +(878 +) +(4,233 +) +(2,374 +) +Basic and diluted net loss per share +$ +(0.09 +) +$ +(0.10 +) +$ +(0.36 +) +$ +(0.02 +) +$ +(0.03 +) +$ +(0.14 +) +$ +(0.09 +) +Weighted average number of shares outstanding +37,583 +36,868 +35,002 +30,887 +26,246 +30,597 +26,180 +December 31, +September 30, +2002 +2001 +2000 +1999 +1998 +1999 +1998 +Financial position: +Working capital +$ +18,931 +$ +19,764 +$ +21,440 +$ +16,314 +$ +8,255 +$ +16,773 +$ +8,725 +Total assets +35,737 +37,285 +37,736 +29,626 +20,075 +30,251 +20,783 +Long-term debt, excluding current portion +3,409 +3,586 +4,644 +5,820 +6,001 +5,820 +6,001 +Accumulated deficit +(129,435 +) +(126,092 +) +(122,365 +) +(109,618 +) +(105,603 +) +(109,104 +) +(104,903 +) +Stockholders’ equity +26,019 +26,541 +26,172 +18,238 +10,264 +18,592 +10,701 +31 +Table of Contents +ITEM 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations. +Statements below regarding future events or performance are “forward-looking statements” within the meaning of the Private +Securities Litigation Reform Act of 1995. Our actual results could be quite different from those expressed or implied by the forward-looking statements. Factors that could affect results are discussed more fully under the Sections entitled, +“Forward-Looking Statements” and “Risk Factors,” in Item 1 and elsewhere in this Report. Although forward-looking statements help to provide complete information about us, readers should keep in mind that forward-looking +statements may not be reliable. Readers are cautioned not to place undue reliance on the forward-looking statements. +The following discussion should be read in conjunction with the financial statements contained herein and the notes thereto, along with +the Section entitled, “Critical Accounting Policies and Estimates” set forth below. +Results of Operations—2002 Compared to 2001 +Total revenues decreased 2% to approximately $32.0 million in 2002 from approximately $32.6 million in 2001. The decline in 2002 revenues +was primarily the result of a $1.2 million decrease in licensing and product development revenues, partially offset by higher product revenues. Product revenues were approximately $31.7 million in 2002, representing an increase of 2% over 2001 +levels. +The table below shows the amount of our +total revenues (in thousands, except %) generated in each of our principal markets and by licensing and product development activities. +Dollars +Percentage Change Inc. (Dec.) +Percentage of Total Revenues (%) +2002 +2001 +2002 +2001 +Market revenues +Insurance risk assessment +$ +12,030 +$ +11,713 +3 +% +38 +% +36 +% +Infectious disease testing +6,063 +5,754 +5 +19 +18 +Substance abuse testing +6,434 +6,955 +(7 +) +20 +21 +Physicians’ office therapies +7,165 +6,674 +7 +22 +20 +31,692 +31,096 +2 +99 +95 +Licensing and product development +318 +1,477 +(78 +) +1 +5 +Total revenues +$ +32,010 +$ +32,573 +(2 +)% +100 +% +100 +% +Sales to +the insurance risk assessment market increased by 3% to approximately $12.0 million in 2002 from approximately $11.7 million in 2001, as a result of increased sales of our OraSure ® laboratory-based HIV-1 test, partially offset by lower sales of assays and reagents. We expect that sales of our insurance +assays and reagents will come under increased competitive pressure in the future. The laboratories that purchase these products are facing pressure from their insurance customers to reduce the cost of testing services. As a result, these +laboratories are expected to reduce their purchases of our products and instead use lower cost internally developed assays or reagents or testing products purchased from our competitors. Although we will make every effort to retain this business, +our revenues could be negatively impacted by as much as $1.5 million in 2003 and $2.0 million in 2004, when compared to 2002 revenues in the insurance risk assessment market. +Sales to the infectious disease testing market increased 5% to approximately $6.1 million in 2002 from +approximately $5.8 million in 2001, as a result of a $0.6 million increase in sales of our OraSure ® laboratory-based HIV-1 test into the public health market, offset by a $300,000 decrease in international sales of the OraQuick ® rapid HIV antibody test. In June 2002, we entered into an agreement with Abbott Laboratories for the co-exclusive +distribution of the OraQuick ® test in the United States. We received FDA +approval of the OraQuick ® test for detecting HIV-1 in finger-stick whole blood +samples in November 2002 and received a CLIA waiver for this product in January 2003. +32 +Table of Contents +We shipped an +initial order for approximately $200,000 of OraQuick ® devices to Abbott in the +fourth quarter of 2002, representing our first domestic sale of this product following FDA approval. We expect that sales of OraQuick ® will increase substantially in 2003, the first full year that this product is commercially available in the United States. +We expect that Abbott will purchase at least $4.0 million of OraQuick ® devices +during the first 15 months of our agreement, which is the minimum purchase commitment required to retain co-exclusive distribution rights. Additionally, we expect that sales of the OraQuick ® device in the public health and military markets will increase throughout the year as acceptance of this product grows. +Sales of our OraSure ® laboratory-based HIV-1 test are expected to be negatively +affected by the successful penetration of the OraQuick ® device in the public +health market, as some customers will likely substitute OraQuick ® for +OraSure ® . However, the degree of this substitution and resulting financial +impact cannot be determined at this time. International sales of OraQuick ® are +also expected to contribute to our revenues in the infectious disease testing market in 2003. +Sales to the substance abuse testing market decreased 7% to approximately $6.4 million in 2002 from approximately $7.0 million in 2001, primarily as a result of the absence of $1.0 million in sales of +laboratory equipment manufactured by third party vendors and $0.5 million in sales of UP link ™ analyzers, +which occurred in 2001. Offsetting this aggregate decrease were an approximate $400,000 increase in international sales of our Intercept ® collection device and related assays and an approximate $200,000 increase in sales of domestic substance abuse products. +We intend to aggressively support our Intercept ® product line in 2003 through +the deployment of additional sales representatives and increased marketing expenditures. +Sales to the physicians’ office therapies market, which consisted solely of our Histofreezer ® wart removal system, increased 7% to approximately $7.2 million in 2002 from approximately $6.7 million in 2001, as a +result of increased product sales in the United States partially offset by lower international sales. The increase in domestic sales of Histofreezer ® was partially attributable to distributors increasing their inventory levels in the fourth quarter of 2002 as a result of +an announced price increase in the U.S. market, which became effective in December 2002. This increase in inventory levels in advance of the price increase is expected to reduce Histofreezer ® product sales during the first quarter of 2003. However, we believe that Histofreezer ® sales levels in the U.S. will return to a more normal pattern beginning in the second and third quarters of 2003. +We are evaluating distribution channel expansion for our Histofreezer ® product +line in order to expand our penetration of the physicians’ offices therapies market, and are considering selling Histofreezer ® in certain other markets not covered by our current distribution partners. +As a percentage of total revenues, international revenues +decreased to approximately 12% in 2002 from approximately 16% in 2001, with Histofreezer ® accounting for approximately 48% of 2002 international revenues. This decrease is primarily attributable to lower international sales of OraQuick ® and the absence of UP link ™ analyzer sales to Dräger Safety, which occurred in 2001. +Lab One , our largest customer, and Osborne Group, which was acquired by Lab One in 2001, together accounted for approximately +26% and 29% of total revenues in 2002 and 2001, respectively. We expect this percentage to decrease further in 2003, reflecting lower anticipated sales of insurance assays and reagents to Lab One and increased sales of the OraQuick ® rapid HIV-1 antibody test , as described above. +Licensing and product development revenues decreased 78% to +approximately $300,000 in 2002 from approximately $1.5 million in 2001, reflecting a significant drop in funded research and development. During 2001, licensing and product development revenues were primarily derived from the continued development +of the UP link ™ drugs-of-abuse rapid detection system under our agreement with Dräger Safety, +development of infectious disease applications for UP link ™ under our agreement with Meridian Bioscience, +and the second phase of a grant from the National Institutes of Health (“NIH”) for the development of an oral fluid syphilis test. The decrease in 2002 resulted from the absence of research and development funding from both Dräger +Safety and Meridian, as our projects with these companies advanced to a stage where we became responsible for funding, and the termination of work under the NIH grant for the development of the syphilis test. +33 +Table of Contents +We do not +expect significant research and development funding from Dräger Safety in 2003 and we agreed in principle to terminate our agreement with Meridian in early 2003. However, we expect licensing and product development revenues to increase modestly +in 2003 as a result of approximately $400,000 in annual research and development funding expected under our collaborative UP link ™ and oral fluid research project with The University of Pennsylvania, which will be received under a grant awarded by the NIH. +Our gross margin decreased to approximately 60% in 2002 from 62% in 2001. This decrease was primarily the result of lower licensing and +product development revenues, offset by a more favorable product mix and our ongoing cost savings efforts. Additionally, as we prepared for FDA approval and the commercial launch of OraQuick ® in the United States during 2002, we incurred substantial expenses related to staffing, materials and overhead. These +expenses were included in our cost of goods throughout 2002, however, we did not begin to generate revenues from OraQuick ® until the initial sales of this product in the United States in December 2002. We anticipate that the benefits of these expenditures will be realized during 2003 and that the incremental revenues +associated with the production and sale of OraQuick ® will positively impact our +gross margin in the future. We also recognized approximately $1.4 million of inventory scrap in 2002 and are implementing programs designed to reduce scrap levels in 2003. We expect that these programs will also help improve our gross margin in 2003 +and beyond. +Research and development expenses +declined 12% to approximately $8.3 million in 2002 from approximately $9.4 million in 2001. Decreased expenditures for staffing, consulting and travel were partially offset by increased clinical trials costs related to our efforts to obtain FDA +approval of the OraQuick ® rapid HIV-1 antibody test. We expect that our +expenditures in support of regulatory filings for our products will increase in 2003, primarily related to clinical trials for the CLIA waiver and the oral fluid and certain other claims for OraQuick ® and the transfer of manufacturing from our Beaverton, Oregon facilities to Bethlehem, Pennsylvania. +Sales and marketing expenses increased 1% to approximately +$8.1 million in 2002 from approximately $8.0 million in 2001. This increase was primarily the result of additional consulting fees for the development of our strategic marketing plans and increased staffing costs, offset by lower travel expenses, +sales commissions and freight costs. We expect sales and marketing expenses to increase substantially in 2003 as we support the launch of OraQuick ® and invest in the promotion of our Intercept ® products. We plan to increase our staffing levels in support of these, and other key products, and to incur higher related +expenses for travel, sales commissions, advertising and public relations. +General and administrative expenses declined 6% to approximately $6.3 million in 2002 from approximately $6.8 million in 2001. This decrease was primarily the result of lower legal, recruiting, and staffing costs offset by +an approximate $0.5 million severance charge related to the departure of our former Chief Executive Officer in the first quarter of 2002. Additionally, we had an approximate $200,000 loss on disposal of equipment in 2001, which we did not have in +2002. We expect general and administrative costs to increase during 2003, reflecting additional facility-related costs from the occupancy of our new corporate headquarters in Bethlehem, Pennsylvania, higher premium costs for directors and +officers’ liability insurance, and higher professional advisor fees as a result of compliance with the Sarbanes-Oxley Act of 2002. +Restructuring-related expenses were approximately $0.5 million in 2001. These costs included expenses for employee severance and travel +and transport resulting from relocating and consolidating manufacturing operations. There were no such costs in 2002. +Interest expense decreased by 29% to $285,000 in 2002 from $403,000 in 2001, as a result of lower average outstanding borrowings and lower +effective interest rates. +Interest income +decreased by 48% to $483,000 in 2002 from $933,000 in 2001, as a result of lower cash and cash equivalents available for investment and lower interest rates. +34 +Table of Contents +Gain on the +sale of securities was $100,000 in 2001 as a result of the sale of Lab One common stock we received as part of an Intercept ® distribution agreement with Lab One, entered into in 1999. There were no such sales in 2002. +Results of Operations—2001 Compared to 2000 +Total revenues increased 13% to approximately $32.6 million +in 2001 from approximately $28.8 million in 2000. Excluding revenues of approximately $1.6 million in 2000 from the Serum Western Blot confirmatory test, which was discontinued in January 2001, total revenues would have increased approximately 20%. +The table below shows the amount of our total +revenues (in thousands, except %) generated in each of our principal markets and by licensing and product development activities. +Dollars +Percentage +Change +Inc. (Dec.) +Percentage of +Total Revenues (%) +2001 +2000 +2001 +2000 +Market revenues +Insurance risk assessment +$ +11,713 +$ +14,693 +(20 +)% +36 +% +51 +% +Infectious disease testing +5,754 +3,453 +67 +18 +12 +Substance abuse testing +6,955 +3,172 +119 +21 +11 +Physicians’ office therapies +6,674 +6,777 +(2 +) +20 +24 +31,096 +28,095 +11 +95 +98 +Licensing and product development +1,477 +693 +113 +5 +2 +Total revenues +$ +32,573 +$ +28,788 +13 +% +100 +% +100 +% +Sales to +the insurance risk assessment market declined by 20% to approximately $11.7 million in 2001 from approximately $14.7 million in 2000, as a result of the discontinuation of our Serum Western Blot confirmatory test, improved efficiencies by end users +in the use of OraSure ® collection devices and by insurance testing laboratories +in the use of immunoassay tests, inventory consolidations which resulted from the merger of our two largest insurance laboratory customers, Lab One and Osborne Group, and lower sales of urine assays. Partially offsetting this decline was an +increase in sales of oral fluid assays resulting from increased penetration of the insurance risk assessment market. +Sales to the infectious disease testing market increased 67% to approximately $5.8 million in 2001 from approximately $3.5 million in +2000, as a result of continued penetration of the OraSure ® laboratory-based +HIV-1 test and shipments of the OraQuick ® rapid HIV antibody test into +sub-Saharan Africa. +Sales to the substance abuse +testing market increased 119% to approximately $7.0 million in 2001 from approximately $3.2 million in 2000, as a result of the substantial market penetration of the Intercept ® drug testing service into the workplace and criminal justice markets and increased forensic toxicology sales. Of the $7.0 +million in substance abuse testing revenues, approximately $1.7 million resulted from the sale of equipment manufactured by third party vendors. +Sales to the physicians’ office therapies market, which consisted solely of the Histofreezer ® wart removal system, declined 2% to approximately $6.7 million in 2001 from approximately $6.8 million in 2000, +as a result of inventory consolidation by distributors in the United States and lower international sales. Despite this small decline in revenues, Histofreezer ® sales in the United States improved steadily throughout 2001 on a quarter-to-quarter basis. +As a percentage of total revenues, international revenues +increased to approximately 16% in 2001 from approximately 14% in 2000, with Histofreezer ® accounting for approximately 39% of 2001 international revenues. Lab One , our largest customer, and Osborne Group, which was acquired by Lab One in 2001, together accounted for approximately 29% and 30% of total revenues +in 2001 and 2000, respectively. +35 +Table of Contents +Licensing and +product development revenues increased 113% to approximately $1.5 million in 2001 from approximately $0.7 million in 2000, reflecting a different mix of development work performed in 2001. During 2001, licensing and product development revenues were +primarily from the continued development of the UP link ™ drugs-of-abuse rapid detection system under an +agreement with Dräger Safety, development of infectious disease applications for UP link ™ under an +agreement with Meridian, and the second phase of a grant from the NIH for the development of an oral fluid syphilis test. +During 2000, licensing and product development revenues consisted primarily of income from a collaboration with Lab One related to +the Intercept ® drug testing service, development work with Dräger Safety +on the UP link ™ drugs-of-abuse rapid detection system, and the first phase of the NIH grant. +The first phase of the NIH grant was for +development of a laboratory-based oral fluid syphilis test using the OraSure ® +collection device. During 2001, we requested and the NIH approved a change for the second phase of that grant to apply to the development of a rapid test for syphilis using the OraQuick ® platform. During the first quarter of 2002, we reassessed this project and the potential marketability of the resulting +product, and elected to terminate development of the syphilis test. As a result, we will not receive further funding under this NIH grant. +Our gross margin increased to approximately 62% in 2001 from 61% in 2000. This increase was primarily the result of lower material costs +and productivity gains, negotiated contract savings, cost savings as a result of restructuring our manufacturing operations, and higher licensing and product development revenues, partially offset by incremental costs and manufacturing +inefficiencies associated with the initial production of UP link ™ analyzers and commencement of +OraQuick ® manufacturing. Additionally, during the fourth quarter of 2001, the +gross margin was negatively affected by the recording of an inventory reserve of approximately $0.6 million related to OraQuick ® rapid HIV antibody tests manufactured for sale to our African distributor. Because of the failure by our African distributor to meet its contractually-required minimum purchase commitments, we +reevaluated our international distribution strategy for OraQuick ® and +terminated our agreement with this distributor in February 2002. The reserve was required because of concerns about the remaining shelf life of the inventory in relation to our ability to rapidly establish a new distribution channel to sell +OraQuick ® in Africa. During 2000, we wrote off approximately $0.5 million for +expired OraSure ® collection device inventory and $0.6 million for Serum Western +Blot confirmatory test inventory that was obsolete, expired, or rendered unsaleable as a result of the discontinuation of that product. +Research and development expenses declined 10% to approximately $9.4 million in 2001 from approximately $10.4 million in 2000. Research +and development efforts in 2001 were focused upon the continued development of the UP link ™ analyzer, test cassette and collector, the development of certain UP link ™ drugs of abuse and infectious disease assays, DNA feasibility studies, and clinical trials for the OraQuick ® rapid HIV-1 antibody test. The investments in these projects were offset by reduced expenditures related to development of +the OraQuick ® device and lower personnel and consulting expenses at our Oregon +facility. +Sales and marketing +expenses increased 15% to approximately $8.0 million in 2001 from approximately $6.9 million in 2000. This increase was primarily the result of additional costs associated with increased staffing levels and related expenses, and the expansion of our +customer service functions. +General and +administrative expenses remained flat at approximately $6.8 million in 2001 and $6.9 million in 2000. Higher professional fees associated with certain partnering activities in 2001 were offset by cost savings from the elimination of duplicative +overhead structures as a result of the Merger of STC and Epitope into the Company. +Merger-related expenses were approximately $7.6 million in 2000. These costs included fees for investment bankers, attorneys and accountants, filing fees, proxy solicitation expenses, employee +severance, and integration costs. There were no such costs in 2001. +36 +Table of Contents +Restructuring-related expenses were $450,000 as a result of the manufacturing restructuring in the first quarter of 2001. These costs included expenses for employee severance and travel and transport resulting from relocating and +consolidating manufacturing operations, and were paid by June 30, 2001. There were no such costs in 2000. +Interest expense decreased by 18% to $403,000 in 2001 from $490,000 in 2000 as a result of loan principal repayments. +Interest income decreased by 29% to approximately $0.9 million +in 2001 from approximately $1.3 million in 2000 as a result of lower cash and cash equivalents available for investment and lower interest rates. +Gain on the sale of securities was $100,000 in 2001 as a result of the sale of Lab One common stock that we received as part of an +Intercept ® distribution arrangement with Lab One, entered into in 1999. +In 2000, we recorded a gain on the sale of securities of $600,000, as a result of the sale of Andrew & Williamson Sales Company (“A&W”) preferred stock we had received as part of a settlement with A&W in 1997. +During 2001 and 2000, provisions for foreign income taxes were +recorded. +Liquidity and Capital Resources +December 31, +December 31, +2002 +2001 +(In thousands) +Cash and cash equivalents +$ +4,364 +$ +2,426 +Short-term investments +10,544 +12,765 +Working capital +18,931 +19,764 +The +Company’s cash, cash equivalents and short-term investments decreased approximately $283,000 during 2002 to approximately $14.9 million at December 31, 2002, primarily as a result of the Company’s net loss for 2002, an increase in +inventories, a decrease in accounts payable, and capital expenditures. Offsetting these uses of cash were an increase in accounts receivable collections and proceeds from stock option exercises. At December 31, 2002, the Company’s working +capital was approximately $18.9 million. +Net +cash used in operating activities was approximately $0.5 million in 2002, a decrease of approximately $4.7 million from the $5.3 million used in operations in 2001. The $0.5 million of cash used in operating activities resulted primarily from the +Company’s net loss for the year of $3.3 million and a reduction in accounts payable, offset by $2.3 million in depreciation and amortization and by a significant improvement in our collection of accounts receivable. +Net cash used in investing activities during 2002 was +$231,000. We purchased approximately $1.6 million of property and equipment and expended $0.7 million on licenses, product supply and distribution agreements. These expenditures were funded through net proceeds of approximately $2.2 million +generated from the sale of short-term investments. +Capital expenditures are anticipated to increase during 2003 to approximately $3.0 million as a result of additional commitments we have made for the purchase and installation of manufacturing and research and development equipment +for UP link ™ and OraQuick ® . We also expect to purchase additional information systems equipment to support our new corporate and manufacturing +facility in Bethlehem, Pennsylvania and to upgrade certain older equipment. +Net cash provided by financing activities was approximately $2.7 million, reflecting the proceeds received from the exercise of stock options of approximately $2.8 million, offset by $169,000 of net +loan principal repayments. +37 +Table of Contents +In September +2002, we entered into a new $10.9 million credit facility (“New Credit Facility”) with Comerica Bank, pursuant to which we refinanced substantially all of our previously outstanding mortgage and term debt and increased our equipment and +working capital lines of credit. The New Credit Facility is comprised of an $887,000 mortgage loan, a $3.0 million term loan, a $3.0 million non-revolving equipment line of credit, and a $4.0 million revolving working capital line of credit. +The $887,000 mortgage loan matures in September +2012, bears interest at an annual floating rate equal to Comerica’s prime rate, and is repayable in fixed monthly principal and interest installments of $7,426 through September 2007, at which time the interest rate and fixed monthly repayment +amount will be reset for the remaining 60 monthly installments. The outstanding balance of the loan at December 31, 2002 was $874,186. +The $3.0 million term loan matures in March 2006, bears interest at a fixed rate of 4.99% and is repayable in forty-two consecutive equal +monthly principal payments of $71,429, plus interest. The outstanding balance of the loan at December 31, 2002 was $2,785,714. +Under the non-revolving equipment line of credit, we can borrow up to $3.0 million to finance eligible equipment purchases through +September 9, 2003. Interest on outstanding borrowings accrues at a rate, selected at our option, equal to Comerica’s prime rate, 180-day or 360-day LIBOR plus 2.625%, or the 4-year Treasury Note Rate plus 2.30%, determined at the time of each +borrowing. Borrowings are repayable in 48 consecutive, equal monthly principal installments, plus interest. As of December 31, 2002, we had an outstanding balance of approximately $423,658 under this facility consisting of two individual loans of +(i) $179,786 with a fixed annual interest rate of 5.07% and (ii) $243,872 with a floating annual interest rate equal to Comerica’s prime rate of 4.25% at December 31, 2002. We also had $2,564,356 available for future borrowings under this +facility as of December 31, 2002. +Under the +revolving working capital line of credit, we can borrow up to $4.0 million to finance working capital and other needs. Interest on outstanding borrowings shall accrue at a rate, selected at our option, equal to Comerica’s prime rate less 0.25%, +or 30-day LIBOR plus 2.55%, determined at the time of the initial borrowing. Borrowings are repayable by September 9, 2003, with interest payable monthly. We had no outstanding borrowings under this facility at December 31, 2002. +All borrowings under the New Credit Facility are +collateralized by a first priority security interest in all of our assets, including present and future accounts receivable, chattel paper, contracts and contract rights, equipment and accessories, general intangibles, investments, instruments, +inventories, and a mortgage on our manufacturing facility in Bethlehem, Pennsylvania. Borrowings under the equipment and working capital lines of credit are limited to commercially standard percentages of equipment purchases and accounts receivable, +respectively. The New Credit Facility contains certain covenants that set forth minimum requirements for our quick ratio, liquidity, and tangible net worth and that require that we achieve positive net income for the year ending December 31, 2003 +and for each year thereafter. The New Credit Facility also restricts our ability to pay dividends, to make certain investments, to incur additional indebtedness, to sell or otherwise dispose of a substantial portion of assets, and to merge or +consolidate operations with an unaffiliated entity, without the consent of Comerica. +In October 2002, we entered into new agreements with bioMérieux, Inc. (“BMX”), which replaced existing agreements between the parties, for the supply by BMX of HIV-1 antigen required +to manufacture our oral fluid Western Blot HIV-1 confirmatory test, and for the distribution by BMX of the oral fluid Western Blot product on an exclusive worldwide basis. These agreements have an initial term ending December 31, 2005, which may be +extended until December 31, 2007 under certain circumstances. As consideration for BMX entering into the new agreements, we have agreed to pay BMX $750,000 in installments through March 31, 2003. +We have entered into a ten-year facility lease with Tech III +Partners, LLC (“Tech Partners”), an entity owned and controlled by two of our executive officers (See “Certain Relationships and Related Transactions,” included herein). Under the terms of this operating lease, we began leasing a +48,000 square-foot facility in +38 +Table of Contents +October 2002 at a base rent of $780,000 per year, increasing to $852,240 per year, during the initial 10-year term. The base rental may be +increased after the fifth year of the initial term in order to reflect changes in the interest rate on debt incurred by Tech Partners to finance construction of the leased facilities. We have not guaranteed any debt incurred by Tech Partners. The +lease also provides us with options to renew the lease for an additional five years at a rental rate of $975,360 per year, and to purchase the facility at any time during the initial ten-year term based on a formula set forth in the lease. +The combination of our current cash position and +available borrowings under our New Credit Facility is expected to be sufficient to fund our foreseeable operating and capital needs. However, our cash requirements may vary materially from those now planned due to many factors, including, but not +limited to, the cost and timing of the expansion of our manufacturing capacity, the progress of our research and development programs, the scope and results of clinical testing, the magnitude of capital expenditures, changes in existing and +potential relationships with business partners, the time and cost of obtaining regulatory approvals, the costs involved in obtaining and enforcing patents, proprietary rights and any necessary licenses, the cost and timing of expansion of sales and +marketing activities, the timing of commercial launch of new products, market acceptance of new products, competing technological and market developments, the scope and timing of strategic acquisitions, and other factors. +Contractual Obligations and Commercial Commitments . The +following sets forth our approximate aggregate obligations at December 31, 2002 for future payments under contracts and other contingent commitments, for the years 2003 and beyond: +Payments due by December 31, +Contractual Obligations +Total +2003 +2004 +2005 +2006 +2007 +Thereafter +Long-term debt(1) +$ +4,475,328 +$ +1,065,966 +$ +1,073,633 +$ +1,077,085 +$ +425,817 +$ +118,313 +$ +714,514 +Operating leases(2) +9,357,185 +1,467,879 +1,460,066 +887,585 +780,000 +783,108 +3,978,547 +Employment contracts(3) +1,503,780 +1,503,780 +— +— +— +— +— +Purchase obligations(4) +2,097,460 +2,097,460 +— +— +— +— +— +Minimum commitments under contracts(5) +1,950,000 +300,000 +300,000 +225,000 +225,000 +225,000 +675,000 +Total contractual obligations +$ +19,383,753 +$ +6,435,085 +$ +2,833,699 +$ +2,189,670 +$ +1,430,817 +$ +1,126,421 +$ +5,368,061 +(1) +Represents principal repayments required under notes payable to our lenders. See Note 8 to the financial statements included herein. +(2) +Represents payments required under our operating leases. See Notes 11 and 12 to the financial statements included herein. +(3) +Represents salary, retention bonus or severance payments payable under the terms of employment agreements executed by us with certain officers and employees. See +Note 11 to the financial statements included herein. +(4) +Represents payments required by non-cancelable purchase orders related to inventory, services and capital expenditures. See Note 11 to the financial statements +included herein. +(5) +Represents payments required pursuant to certain research, licensing and royalty agreements executed by the Company. See Note 11 to the financial statements included +herein. +Off-Balance Sheet +Arrangements . We do not have any off-balance sheet arrangements, as defined in Item 304(a)(4)(ii) of Regulation S-K under the Securities Exchange Act of 1934, as amended. +Critical Accounting Policies and Estimates +Management’s Discussion and Analysis of Financial +Condition and Results of Operations discusses our financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires that +we make estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenues and expenses during the +39 +Table of Contents +reporting period. On an on-going basis, we evaluate our judgments and estimates, including those related to bad debts, inventories, +investments, intangible assets, income taxes, revenue recognition, restructuring costs, contingencies, and litigation. We base our judgments and estimates on historical experience and on various other factors that are believed to be reasonable under +the circumstances, the results of which form the basis for making judgments about the carrying value of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different +assumptions or conditions. +Our significant +accounting policies are described in Note 2 to the financial statements included in Item 15 of this Report. We consider the following accounting estimates, which have been discussed with our Audit Committee, to be most critical in understanding the +more complex judgments that are involved in preparing our financial statements and the uncertainties that could impact our results of operations, financial condition, and cash flows. +Revenue Recognition . We follow U.S. Securities and Exchange Commission Staff +Accounting Bulletin No. 101, “Revenue Recognition in Financial Statements” (“SAB 101”). This bulletin draws on existing accounting rules and provides specific guidance on revenue recognition of up-front non-refundable licensing +and development fees. We license certain products or technology to outside third parties, in return for which we receive up-front licensing fees. Some of these fees can be significant. In accordance with SAB 101, we recognize this revenue ratably +over the related license period. +We also enter +into research and development contracts with corporate, government and/or private entities. These contracts generally provide for payments to us upon achievement of certain research or development milestones. Product development revenues from these +contracts are recognized only if the specified milestone is achieved and accepted by the customer and payment from the customer is probable. Any amounts received prior to the performance of product development efforts are recorded as deferred +revenues. Recognition of revenue under these contracts can be sporadic, as it is the result of achieving specific research and development milestones. Furthermore, revenue from future milestone payments will not be recognized if the underlying +research and development milestone is not achieved. +We recognize product revenues when products are shipped. We do not grant price protection or product return rights to our customers, except for warranty returns. Where a product fails to comply with its limited warranty, we can +either replace the product or provide the customer with a refund of the purchase price or credit against future purchases. Historically, returns arising from warranty issues have been infrequent and immaterial. Accordingly, we expense warranty +returns as incurred. While such returns have been immaterial in the past, we cannot guarantee that we will continue to experience the same rate of warranty claims as we have in the past. Any significant increase in product warranty claims could have +a material adverse impact on our operating results for the period in which the claims occur. +Allowance for Uncollectible Accounts Receivable . Accounts receivable are reduced by an estimated allowance for amounts that may become uncollectible in the future. On an +ongoing basis, we perform credit evaluations of our customers and adjust credit limits based upon the customer’s payment history and creditworthiness, as determined by a review of their current credit information. We also continuously monitor +collections and payments from our customers. +Based upon historical experience and any specific customer collection issues that are identified, we use our judgment to establish and evaluate the adequacy of our allowance for estimated credit losses, which was $292,146 at December +31, 2002. While credit losses have been within our expectations and the allowance provided, these losses can vary from period to period ($213,188, $5,193 and $4,269 in 2002, 2001 and 2000, respectively). Furthermore, there is no assurance that we +will experience credit losses at the same rates as we have in the past. Also, at December 31, 2002, approximately $1.0 million or 19% of our accounts receivable were due from one major customer. Any significant changes in the liquidity or financial +position of this customer, or others, could have a material adverse impact on the collectibility of our accounts receivable and future operating results. +40 +Table of Contents +Inventories . Our inventories are valued at the lower of cost or market, determined on a first-in, first-out basis, and include the cost of raw materials, labor and overhead. The majority of our +inventories are subject to expiration dating. We continually evaluate the carrying value of our inventories and when, in the opinion of management, factors indicate that impairment has occurred, either a reserve is established against the +inventories’ carrying value or the inventories are completely written off. We base these decisions on the level of inventories on hand in relation to our estimated forecast of product demand, production requirements over the next twelve months +and the expiration dates of raw materials and finished goods. During 2002, 2001 and 2000, we wrote-off inventory which had a cost of approximately $1.4 million, $0.6 million and $1.1 million, respectively, as a result of increased scrap levels and +product expiration issues. Forecasting product demand can be a complex process, especially for a new product such as our OraQuick ® rapid HIV-1 antibody test, which was launched in the United States in November 2002. Although we make every effort to +ensure the accuracy of our forecasts of future product demand, any significant unanticipated changes in demand could have a significant impact on the carrying value of our inventories and reported operating results. +Long-lived and Intangible +Assets . Our long-lived assets are comprised of property and equipment and an investment in a nonaffiliated entity, and our intangible assets primarily consist of patents and product rights. Together, these assets have a +net book value of approximately $10.6 million or 30% of our total assets at December 31, 2002. Our investment in a privately-held nonaffiliated company is recorded under the cost method of accounting, because we do not have a controlling interest in +this company nor do we have the ability to exert significant influence over the operating and financial policies of this investee company. Property and equipment, patents and product rights are amortized on a straight-line basis over their useful +lives, which we determine based upon our estimate of the period of time over which each asset will generate revenues. An impairment of long-lived or intangible assets could occur whenever events or changes in circumstances indicate that the net book +value of these assets may not be recoverable. Events which could trigger an asset impairment include significant underperformance relative to expected historical or projected future operating results, significant changes in the manner of our use of +an asset or in our strategy for our overall business, significant negative industry or economic trends, shortening of product life-cycles or changes in technology, and negative financial performance of our nonaffiliated investee company. If we +believe impairment of an asset has occurred, we measure the amount of such impairment by comparing the net book value of the affected assets to the fair value of these assets, which is generally determined based upon the present value of the +expected cash flows associated with the use of these assets. If the net book value exceeds the fair value of the impaired assets, we would incur an impairment expense equal to this difference. We currently believe the future cash flows to be +received from our long-lived and intangible assets will exceed their book value and, as such, we have not recognized any impairment losses through December 31, 2002. Any unanticipated significant impairment in the future, however, could have a +material adverse impact to our balance sheet and future operating results. +Deferred Tax Assets . We have a history of losses, which has generated a sizeable federal tax net operating loss (“NOL”) carryforward of approximately $79.6 +million as of December 31, 2002. The deferred tax asset associated with these NOLs and other temporary differences is approximately $31.8 million at December 31, 2002. Under generally accepted accounting principles, we are required to record a +valuation allowance against our deferred tax asset if it is more likely than not that some portion or all of the deferred tax asset will not be realized. The ultimate realization of deferred tax assets is dependent upon the generation of taxable +income in the future. Due to the size of the NOL carryforward in relation to our history of unprofitable operations, we have not recognized any of our net deferred tax asset. It is possible that we could be profitable in the future at levels which +would cause us to conclude that it is more likely than not that we will realize all or a portion of the deferred tax asset. Upon reaching such a conclusion, we would immediately record the estimated net realizable value of the deferred tax asset at +that time and would then begin to provide for income taxes at a rate equal to our combined federal and state effective rates, which we believe would approximate 40%. Subsequent revisions to the estimated net realizable value of the deferred tax +asset could cause our provision for income taxes to vary significantly from period to period. +Contingencies . In the ordinary course of business, we have entered into various contractual relationships with strategic corporate partners, customers, distributors, +research laboratories and universities, licensors, +41 +Table of Contents +licensees, suppliers, vendors and other parties. As such, we could be subject to litigation, claims or assessments arising from any or all of +these relationships. We account for contingencies such as these in accordance with Statement of Financial Accounting Standards No. 5, “Accounting for Contingencies” (“SFAS 5”). SFAS 5 requires us to record an estimated loss +contingency when information available prior to issuance of our financial statements indicates that it is probable that an asset has been impaired or a liability has been incurred at the date of the financial statements and the amount of the loss +can be reasonably estimated. Accounting for contingencies arising from contractual or legal proceedings requires that we use our best judgment when estimating an accrual related to such contingencies. As additional information becomes known, our +accrual for a loss contingency could fluctuate, thereby creating variability in our results of operations from period to period. Likewise, an actual loss arising from a loss contingency which significantly exceeds the amount accrued for in our +financial statements could have a material adverse impact on our operating results for the period in which such actual loss becomes known. +Certain Relationships and Related Transactions +We have entered into a commercial lease (the “Lease”) with Tech III Partners, LLC (“Tech Partners”), which provided +for the construction of a 48,000 square foot facility on land adjacent to our Bethlehem, Pennsylvania headquarters, and the lease of that facility to us. Tech Partners is owned and controlled by Michael J. Gausling, the Company’s President and +Chief Executive Officer, and Dr. R. Sam Niedbala, the Company’s Executive Vice President and Chief Science Officer. The facility will house manufacturing, research and development, and administrative operations required to support the expected +growth of our business. Construction of the facility was completed in October 2002. +The Lease, as amended, has an initial ten-year term ending in October 2012 and a base rent starting at $780,000 and increasing to $858,240 per year over that term. The base rental rate may be increased +after the fifth year of the initial term in order to reflect changes in the interest rate on debt incurred by Tech Partners to finance construction of the leased facilities. We have not guaranteed any debt incurred by Tech Partners. The Lease also +provides us with options to renew the Lease for an additional five years at a rental rate of $975,360 per year, and to purchase the facility at any time during the initial ten-year term based on a formula set forth in the Lease. +Prior to deciding to enter into the Lease and an amendment +increasing the base rental to reflect the cost of certain tenant fit-out improvements, our Board of Directors retained Imperial Realty Appraisal LLC, an independent commercial real estate appraisal firm, to evaluate the proposed base rental rate. +Imperial Realty issued opinions indicating that the annual base rent set forth in the Lease, as amended, is below the market rental rate we could otherwise expect to pay to lease a comparable commercial property in the same general geographic +market. The terms of the Lease are otherwise substantially similar to a commercial lease we entered into with a third party for our existing Bethlehem, Pennsylvania headquarters. +In January 2002, we terminated the employment agreement with Robert D. Thompson, our former Chief Executive +Officer, and Mr. Thompson entered into a severance agreement pursuant to which Mr. Thompson will receive approximately $480,000. We also held a $75,000 note receivable previously made to Mr. Thompson in connection with his relocation from Portland, +Oregon, which was repaid during 2002. +Recent Accounting +Pronouncements +SFAS No. 143, +“Accounting for Asset Retirement Obligations” (“SFAS 143”), which was released in August 2001, addresses financial accounting and reporting for obligations associated with the retirement of tangible long-lived assets and their +associated asset retirement costs. SFAS 143 requires an enterprise to record the fair value of an asset retirement obligation as a liability in the period in which it incurs a legal obligation associated with the retirement of intangible long-lived +assets that result from the acquisition, construction, development, or normal use of the asset. The enterprise is also required to record a corresponding increase to the carrying amount of the related long-lived asset (i.e. the associated asset +retirement cost) and to depreciate that +42 +Table of Contents +cost over the life of the asset. The liability is changed at the end of each period to reflect the passage of time (i.e. accretion expense) +and changes in the estimated future cash flows underlying the initial fair value measurement. Because of the extensive use of estimates, most enterprises will record a gain or loss when they settle the obligation. We are required to adopt SFAS 143 +for our fiscal year beginning January 1, 2003. We do not expect the adoption of SFAS 143 to have a material impact on our financial position or results of operations. +In April 2002, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 145, +“Rescission of FASB Statements No. 4, 44 and 64, Amendment of FASB Statement No. 13, and Technical Corrections” (“SFAS 145”). SFAS 145 amends existing guidance on reporting gains and losses on the extinguishment of debt to +prohibit the classification of the gain or loss as extraordinary, as the use of such extinguishments have become part of the risk management strategy of many companies. SFAS 145 also amends SFAS 13 to require sale-leaseback accounting for certain +lease modifications that have economic effects similar to sale-leaseback transactions. The provisions of SFAS 145 related to the rescission of SFAS 4 are applied in fiscal years beginning after May 15, 2002. Earlier application of these provisions +is encouraged. The provisions of SFAS 145 related to SFAS 13 were effective for transactions occurring after May 15, 2002. The adoption of SFAS 145 is not expected to have a material effect on our financial statements. +In June 2002, the FASB issued SFAS No. 146, “Accounting +for Costs Associated with Exit or Disposal Activities” (“SFAS 146”). SFAS 146 addresses significant issues regarding the recognition, measurement, and reporting of costs associated with exit and disposal activities, including +restructuring activities. SFAS 146 also addresses recognition of certain costs related to terminating a contract that is not a capital lease, costs to consolidate facilities or relocate employees, and termination benefits provided to employees that +are involuntarily terminated under the terms of a one-time benefit arrangement that is not an ongoing benefit arrangement or an individual deferred-compensation contract. SFAS 146 is effective for exit or disposal activities that are initiated after +December 31, 2002. The adoption of SFAS 146 is not expected to have any impact on our financial position or results of operations. +In November 2002, the FASB issued Interpretation No. 45, “Guarantor’s Accounting and Disclosure Requirements for Guarantees, +Including Indirect Guarantees of Indebtedness to Others, an interpretation of FASB Statements No. 5, 57 and 107 and a rescission of FASB Interpretation No. 34.” This Interpretation elaborates on the disclosures to be made by a guarantor in its +interim and annual financial statements about its obligations under guarantees issued. The Interpretation also clarifies that a guarantor is required to recognize, at inception of a guarantee, a liability for the fair value of the obligation +undertaken. The initial recognition and measurement provisions of the Interpretation are applicable to guarantees issued or modified after December 31, 2002, and are not expected to have a material effect on our financial statements. +In December 2002, the FASB issued SFAS No. 148, +“Accounting for Stock-Based Compensation – Transition and Disclosure (“SFAS 148”), an amendment of FASB Statement No. 123.” SFAS 148 amends SFAS 123, “Accounting for Stock-Based Compensation,” to provide +alternative methods of transition for a voluntary change to the fair value method of accounting for stock-based employee compensation. In addition, SFAS 148 amends the disclosure requirements of Statement 123 to require prominent disclosures in both +annual and interim financial statements. The disclosure modifications are required for fiscal years ending after December 15, 2002, and are included in the notes to our financial statements. +In January 2003, the FASB issued Interpretation No. 46, +“Consolidation of Variable Interest Entities, an interpretation of ARB No. 51.” This Interpretation addresses the consolidation by business enterprises of variable interest entities as defined in the Interpretation. The Interpretation +applies immediately to variable interests in variable interest entities created after January 31, 2003, and to variable interests in variable interest entities obtained after January 31, 2003. Because we have no involvement with any variable +interest entities, the application of this Interpretation is not expected to have a material effect on our financial statements. +43 +Table of Contents +ITEM 7A. Quantitative and Qualitative Disclosures About Market Risk. +We do not hold any amounts of derivative financial instruments or derivative commodity instruments. Therefore, we have no material market +risk related to derivatives to report under this Item. +Our holdings of financial instruments are comprised of U.S. corporate debt, certificates of deposit, government securities, and commercial paper. All such instruments are classified as securities available for sale. Our debt security +portfolio represents funds held temporarily pending use in our business and operations. We seek reasonable assuredness of the safety of principal and market liquidity by investing in rated fixed income securities while at the same time seeking to +achieve a favorable rate of return. Market risk exposure consists principally of exposure to changes in interest rates. If changes in interest rates would affect the investments adversely, we could decide to hold the security to maturity or sell the +security. Our holdings are also exposed to the risks of changes in the credit quality of issuers. We typically invest in the shorter end of the maturity spectrum. +We do not currently have any foreign currency exchange contracts or purchase currency options to hedge local +currency cash flows. We have operations in The Netherlands which are subject to foreign currency fluctuations. As currency rates change, translation of income statements of these operations from Euros to U.S. dollars affects year-to-year +comparability of operating results. Our operations in The Netherlands represented approximately $1.7 million or 5% of our revenues for the year ended December 31, 2002. We do not expect the risk of foreign currency fluctuations to be +material. +ITEM 8. Financial Statements and Supplementary Data. +Information with respect to this Item is contained in our Financial Statements included in Item 15 of this Annual Report on Form 10-K. +Arthur Andersen LLP (“Andersen”) +audited the Company’s financial statements as of December 31, 2001 and for each of the years in the two-year period ended December 31, 2001 included in this Report. Because our former engagement team leaders have since left Andersen, Andersen +did not reissue its report on those financial statements, and a copy of a previously issued report is included herein. Andersen has not consented to the use of such report or to any reference made to their firm in this Report. Andersen was convicted +on June 15, 2002 of federal obstruction of justice arising from the government’s investigation of Enron Corp. You may have no effective remedy against Andersen in connection with a material misstatement or omission in the financial statements +audited by Andersen, particularly in the event that Andersen ceases to exist or becomes insolvent as a result of the conviction or other proceedings against Andersen. +Additionally, as a result of the departure of our former engagement team leaders, Andersen is no longer in a +position to consent to the inclusion or incorporation by reference in any prospectus of their report on the above-referenced financial statements, and investors in any offerings for which the Company uses their audit report will not be entitled to +recovery against them under Section 11 of the Securities Act of 1933, as amended, for any material misstatements or omissions in those financial statements. +ITEM 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure. +On May 21, 2002, we dismissed Arthur Andersen LLP and retained KPMG LLP as our independent accountants. Disclosure of this action is set +forth in our Current Report on Form 8-K dated May 21, 2002. +44 +Table of Contents +PART III +We have omitted from Part III the +information that will appear in our Definitive Proxy Statement for our 2003 Annual Meeting of Stockholders (the “Proxy Statement”), which will be filed within 120 days after the end of our fiscal year pursuant to Regulation 14A. +ITEM 10. Directors and Executive Officers of the Registrant. +The information required by this item is incorporated by reference to the information under the captions, “Election of +Directors,” “Executive Officers,” and “Section 16(a) Beneficial Ownership Reporting Compliance,” in the Proxy Statement. +ITEM 11. Executive Compensation. +The information required by this item is incorporated by reference to the information under the caption, “Executive Compensation,” in the Proxy Statement. +ITEM 12. Security Ownership of Certain Beneficial Owners and Management. +The information required by this item with respect to the securities ownership of certain beneficial owners and management, and equity +compensation plan information, is incorporated by reference to the information under the captions, “Principal Stockholders” and “Equity Compensation Plan Information,” respectively, in the Proxy Statement. +ITEM 13. Certain Relationships and Related Transactions. +The information required by this item is incorporated by reference to the information under the captions, “Certain Relationships and +Related Transactions” and “Employment Agreements,” in the Proxy Statement. +ITEM 14. Controls and Procedures. +(a) Evaluation of Disclosure Controls and Procedures . Within the 90 days preceding the filing of this Report, an evaluation was performed under the supervision and with +the participation of the Company’s management, including the Company’s Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of the Company’s disclosure controls and procedures. Based on +that evaluation, the Company’s management, including such officers, concluded that the Company’s disclosure controls and procedures were effective in timely alerting them to material information relating to the Company, which is required +to be included in its periodic filings with the Securities and Exchange Commission. +(b) Changes in Internal Controls . There have been no significant changes in the Company’s internal controls or in other factors that could significantly affect +internal controls (including any corrective actions with regard to significant deficiencies or material weaknesses) subsequent to the date of the evaluation referred to in paragraph (a) of this Item. +45 +Table of Contents +PART IV +ITEM 15. Exhibits, Financial Statement Schedules, and Reports on Form 8-K. +(a)(1) and (a)(2). For a list of the Financial Statements filed herewith, see the Index to Financial Statements following the signature +page to this Report. No schedules are included with the Financial Statements because the required information is inapplicable or is presented in the Financial Statements or related notes thereto. +(a)(3) Exhibits . See Index to +Exhibits following the Financial Statements in this Report. +(b) Reports on Form 8-K. +1. Current Report on Form 8-K dated November 7, 2002, attaching a press release that announced the receipt of U.S. Food and Drug Administration approval of our OraQuick ® Rapid HIV-1 Antibody Test for the detection of HIV-1 in finger-stick whole blood samples. +46 +Table of Contents +SIGNATURES +Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this Report to be signed on its behalf by the undersigned, thereunto duly authorized, on March 31, 2003. +ORASURE TECHNOLOGIES, INC. +By: +/s/ M ICHAEL J. +G AUSLING +Michael J. Gausling +President and Chief Executive Officer +Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed on March 31, 2003, by the following persons on behalf of the Registrant and in the capacities indicated. +Signature +Title +/s/ M ICHAEL J. +G AUSLING +President, Chief Executive Officer and Director +Michael J. Gausling +(Principal Executive Officer) +/s/ R ONALD H. +S PAIR +Executive Vice President and Chief Financial Officer +Ronald H. Spair +(Principal Financial Officer) +/s/ M ARK L. +K UNA +Vice President and Controller +Mark L. Kuna +(Principal Accounting Officer) +/s/ *C ARTER H. +E CKERT +Director +Carter H. Eckert +/s/ *F RANK G. +H AUSMANN +Director +Frank G. Hausmann +/s/ *R ICHARD J. +L ANE +Director +Richard J. Lane +/s/ *G REGORY B. +L AWLESS +Director +Gregory B. Lawless +/s/ *R OGER L. +P RINGLE +Director +Roger L. Pringle +/s/ *D OUGLAS G. +W ATSON +Director +Douglas G. Watson +*By: +/s/ R ONALD H. +S PAIR +Ronald H. Spair +(Attorney-in-Fact) +47 +Table of Contents +Certification +I, Michael J. Gausling, +certify that: +1. +I have reviewed this annual report on Form 10-K of OraSure Technologies, Inc; +2. +Based on my knowledge, this annual report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements +made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this annual report; +3. +Based on my knowledge, the financial statements, and other financial information included in this annual report, fairly present in all material respects the +financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this annual report; +4. +The registrant’s other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act +Rules 13a-14 and 15d-14) for the registrant and we have: +a) +Designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made +known to us by others within those entities, particularly during the period in which this annual report is being prepared; +b) +Evaluated the effectiveness of the registrant’s disclosure controls and procedures as of a date within 90 days prior to the filing date of this annual report +(the “Evaluation Date”); and +c) +Presented in this annual report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date; +5. +The registrant’s other certifying officer and I have disclosed, based on our most recent evaluation, to the registrant’s auditors and the audit committee +of registrant’s board of directors (or persons performing the equivalent functions): +a) +All significant deficiencies in the design or operation of internal controls which could adversely affect the registrant’s ability to record, process, summarize +and report financial data and have identified for the registrant’s auditors any material weaknesses in internal controls; and +b) +Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal controls; and +6. +The registrant’s other certifying officer and I have indicated in this annual report whether there were significant changes in internal controls or in other +factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses. +Date: March 31, 2003 +/s/ M ICHAEL J. +G AUSLING +Michael J. Gausling +President and Chief Executive +Officer +(Principal Executive Officer) +48 +Table of Contents +Certification +I, Ronald H. Spair, certify +that: +1. +I have reviewed this annual report on Form 10-K of OraSure Technologies, Inc; +2. +Based on my knowledge, this annual report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements +made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this annual report; +3. +Based on my knowledge, the financial statements, and other financial information included in this annual report, fairly present in all material respects the +financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this annual report; +4. +The registrant’s other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act +Rules 13a-14 and 15d-14) for the registrant and we have: +a) +Designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made +known to us by others within those entities, particularly during the period in which this annual report is being prepared; +b) +Evaluated the effectiveness of the registrant’s disclosure controls and procedures as of a date within 90 days prior to the filing date of this annual report +(the “Evaluation Date”); and +c) +Presented in this annual report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date; +5. +The registrant’s other certifying officer and I have disclosed, based on our most recent evaluation, to the registrant’s auditors and the audit committee +of registrant’s board of directors (or persons performing the equivalent functions): +a) +All significant deficiencies in the design or operation of internal controls which could adversely affect the registrant’s ability to record, process, summarize +and report financial data and have identified for the registrant’s auditors any material weaknesses in internal controls; and +b) +Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal controls; and +6. +The registrant’s other certifying officer and I have indicated in this annual report whether there were significant changes in internal controls or in other +factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses +Date: March 31, 2003 +/s/ R ONALD H. +S PAIR +Ronald H. Spair +Executive Vice President and +Chief Financial Officer +(Principal Financial Officer) +49 +Table of Contents +INDEX TO +FINANCIAL STATEMENTS +Page +Independent Auditors’ Report +F-2 +Report of Independent Public Accountants +F-3 +Balance Sheets +F-4 +Statements of Operations +F-5 +Statements of Stockholders’ Equity and Comprehensive Loss +F-6 +Statements of Cash Flows +F-7 +Notes to Financial Statements +F-8 +F-1 +Table of Contents +INDEPENDENT +AUDITOR’S REPORT +The +Board of Directors and Stockholders +OraSure Technologies, Inc.: +We have audited the accompanying balance sheet of OraSure Technologies, Inc. +as of December 31, 2002 and the related statements of operations, stockholders’ equity and comprehensive loss, and cash flows for the year then ended. These financial statements are the responsibility of the Company’s management. Our +responsibility is to express an opinion on these financial statements based on our audit. The financial statements of OraSure Technologies, Inc. as of December 31, 2001 and for each of the years in the two-year period ended December 31, 2001 were +audited by other auditors who have ceased operations. Those auditors expressed an unqualified opinion on those financial statements in their report dated January 31, 2002, except for the facility lease discussed in Note 12 as to which the date was +March 21, 2002. +We conducted our audit in accordance with +auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit +includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the +overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion. +In our opinion, the 2002 financial statements referred to above present fairly, in all material respects, the financial position of OraSure Technologies, Inc. as of December 31, 2002, and the results +of its operations and its cash flows for the year then ended in conformity with accounting principles generally accepted in the United States of America. +/s/ KPMG LLP +Philadelphia, Pennsylvania +January 27, 2003 +F-2 +Table of Contents +The following is a copy of +a report issued by Arthur Andersen LLP and included in the Company’s 2001 Annual Report on Form 10-K. This report has not been reissued by Arthur Andersen LLP, and Arthur Andersen LLP has not issued a consent to its use in this filing. +REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS +To OraSure Technologies, +Inc.: +We have audited the accompanying balance +sheets of OraSure Technologies, Inc. (a Delaware corporation) as of December 31, 2001 and 2000, and the related statements of operations, stockholders’ equity and cash flows for the years ended December 31, 2001 and 2000, the three months ended +December 31, 1999, and the year ended September 30, 1999. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits. We did not +audit the financial statements of Epitope, Inc., a company acquired during 2000 in a transaction accounted for as a pooling of interests, as discussed in Note 1. Such statements are included in the financial statements of OraSure Technologies, Inc. +and reflect total revenues of 39 percent and 42 percent for the three months ended December 31, 1999 and year ended September 30, 1999, respectively, of the related totals. Those statements were audited by other auditors whose report has been +furnished to us, and our opinion, insofar as it relates to amounts included for Epitope, Inc., is based solely upon the report of the other auditors. +We conducted our audits in accordance with auditing standards generally accepted in the United States. Those standards require that we +plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial +statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits and the report of other auditors +provide a reasonable basis for our opinion. +In +our opinion, based on our audits and the report of other auditors, the financial statements referred to above present fairly, in all material respects, the financial position of OraSure Technologies, Inc. as of December 31, 2001 and 2000, and the +results of its operations and its cash flows for the years ended December 31, 2001 and 2000, the three months ended December 31, 1999, and the year ended September 30, 1999, in conformity with accounting principles generally accepted in the United +States. +ARTHUR ANDERSEN LLP +Philadelphia, Pennsylvania, +January 31, 2002 (except for the +facility lease discussed in Note 12, +as to which the date is March 21, 2002) +F-3 +Table of Contents +ORASURE +TECHNOLOGIES, INC. +BALANCE SHEETS +December 31, +2002 +2001 +ASSETS +CURRENT ASSETS: +Cash and cash equivalents +$ +4,364,308 +$ +2,426,346 +Short-term investments +10,543,876 +12,764,903 +Accounts receivable, net of allowance for doubtful accounts of $292,146 and +$209,492 +5,197,787 +6,057,927 +Note receivable from officer +— +75,000 +Inventories +4,088,474 +4,444,772 +Prepaid expenses and other +925,707 +1,038,511 +Total current assets +25,120,152 +26,807,459 +PROPERTY AND EQUIPMENT, net +7,427,950 +7,800,137 +PATENTS AND PRODUCT RIGHTS, net +2,543,519 +2,042,533 +OTHER ASSETS +645,626 +634,546 +$ +35,737,247 +$ +37,284,675 +LIABILITIES AND STOCKHOLDERS’ EQUITY +CURRENT LIABILITIES: +Current portion of long-term debt +$ +1,065,966 +$ +1,057,572 +Accounts payable +1,801,952 +2,874,061 +Accrued expenses +3,321,509 +3,111,886 +Total current liabilities +6,189,427 +7,043,519 +LONG-TERM DEBT +3,409,362 +3,586,458 +OTHER LIABILITIES +119,546 +114,025 +COMMITMENTS AND CONTINGENCIES (Note 11) +STOCKHOLDERS’ EQUITY: +Preferred stock, par value $.000001; 25,000,000 shares authorized, none +issued +— +— +Common stock, par value $.000001; 120,000,000 shares authorized, 38,100,557 and +37,403,269 shares issued and outstanding +38 +37 +Additional paid-in capital +155,638,314 +152,758,591 +Accumulated other comprehensive loss +(184,676 +) +(125,664 +) +Accumulated deficit +(129,434,764 +) +(126,092,291 +) +Total stockholders’ equity +26,018,912 +26,540,673 +$ +35,737,247 +$ +37,284,675 +The +accompanying notes are an integral part of these statements. +F-4 +Table of Contents +ORASURE +TECHNOLOGIES, INC. +STATEMENTS OF +OPERATIONS +For the year ended December 31, +2002 +2001 +2000 +REVENUES: +Product +$ +31,691,495 +$ +31,095,850 +$ +28,095,408 +Licensing and product development +318,272 +1,477,494 +692,808 +32,009,767 +32,573,344 +28,788,216 +COST OF PRODUCTS SOLD +12,888,556 +12,333,695 +11,102,096 +Gross profit +19,121,211 +20,239,649 +17,686,120 +OPERATING EXPENSES: +Research and development +8,274,351 +9,389,313 +10,399,120 +Sales and marketing +8,068,879 +7,980,496 +6,932,068 +General and administrative +6,318,513 +6,752,326 +6,876,516 +Merger-related +— +— +7,607,158 +Restructuring-related +— +450,000 +— +22,661,743 +24,572,135 +31,814,862 +Operating loss +(3,540,532 +) +(4,332,486 +) +(14,128,742 +) +INTEREST EXPENSE +(284,678 +) +(402,686 +) +(490,415 +) +INTEREST INCOME +483,431 +933,050 +1,315,666 +FOREIGN CURRENCY GAIN (LOSS) +(694 +) +3,122 +(18,696 +) +GAIN ON SALE OF SECURITIES +— +100,000 +600,000 +Loss before income taxes +(3,342,473 +) +(3,699,000 +) +(12,722,187 +) +INCOME TAXES +— +28,789 +24,363 +NET LOSS +$ +(3,342,473 +) +$ +(3,727,789 +) +$ +(12,746,550 +) +BASIC AND DILUTED NET LOSS PER SHARE +$ +(0.09 +) +$ +(0.10 +) +$ +(0.36 +) +WEIGHTED AVERAGE NUMBER OF SHARES OUTSTANDING +37,582,780 +36,868,101 +35,002,283 +The +accompanying notes are an integral part of these statements. +F-5 +Table of Contents +ORASURE +TECHNOLOGIES, INC. +STATEMENTS OF +STOCKHOLDERS’ EQUITY AND COMPREHENSIVE LOSS +Common Stock +Additional Paid-in Capital +Accumulated Other Comprehensive Loss +Accumulated Deficit +Total +Shares +Amount +Balance at December 31, 1999 +32,632,911 +$ +33 +$ +128,115,489 +$ +(259,218 +) +$ +(109,617,952 +) +$ +18,238,352 +Common stock issued upon exercise of options +1,319,624 +1 +5,720,997 +— +— +5,720,998 +Common stock issued upon exercise of warrants +2,405,907 +2 +13,865,364 +— +— +13,865,366 +Common stock issued under Employee Stock Purchase Plan and Savings Plan +75,562 +— +273,254 +— +— +273,254 +Compensation expense for stock option grants +— +— +792,685 +— +— +792,685 +Comprehensive loss: +Net loss +— +— +— +— +(12,746,550 +) +(12,746,550 +) +Currency translation adjustment +— +— +— +(61,140 +) +— +(61,140 +) +Net unrealized gain on marketable securities +— +— +— +89,111 +— +89,111 +Total comprehensive loss +(12,718,579 +) +Balance at December 31, 2000 +36,434,004 +36 +148,767,789 +(231,247 +) +(122,364,502 +) +26,172,076 +Common stock issued upon exercise of options +968,729 +1 +3,851,805 +— +— +3,851,806 +Common stock issued under Employee Stock Purchase Plan +536 +— +2,123 +— +— +2,123 +Compensation expense for stock option grants +— +— +136,874 +— +— +136,874 +Comprehensive loss: +Net loss +— +— +— +— +(3,727,789 +) +(3,727,789 +) +Currency translation adjustment +— +— +— +(75,670 +) +— +(75,670 +) +Net unrealized gain on marketable securities +— +— +— +181,253 +— +181,253 +Total comprehensive loss +(3,622,206 +) +Balance at December 31, 2001 +37,403,269 +37 +152,758,591 +(125,664 +) +(126,092,291 +) +26,540,673 +Common stock issued upon exercise of options +688,454 +1 +2,793,742 +— +— +2,793,743 +Common stock issued under Employee Stock Purchase Plan +8,834 +— +35,042 +— +— +35,042 +Compensation expense for stock option grants +— +— +50,939 +— +— +50,939 +Comprehensive loss: +Net loss +— +— +— +— +(3,342,473 +) +(3,342,473 +) +Currency translation adjustment +— +— +— +(6,481 +) +— +(6,481 +) +Net unrealized loss on marketable securities +— +— +— +(52,531 +) +— +(52,531 +) +Total comprehensive loss +(3,401,485 +) +Balance at December 31, 2002 +38,100,557 +$ +38 +$ +155,638,314 +$ +(184,676 +) +$ +(129,434,764 +) +$ +26,018,912 +The accompanying notes are an integral part of these statements +F-6 +Table of Contents +ORASURE +TECHNOLOGIES, INC. +STATEMENTS OF CASH +FLOWS +For the year ended December 31, +2002 +2001 +2000 +OPERATING ACTIVITIES: +Net loss +$ +(3,342,473 +) +$ +(3,727,789 +) +$ +(12,746,550 +) +Adjustments to reconcile net loss to net cash used in operating +activities: +Stock based compensation expense +50,939 +136,874 +792,685 +Common stock issued as compensation for services +— +— +62,409 +Amortization of deferred revenue +(107,500 +) +(179,167 +) +(143,334 +) +Depreciation and amortization +2,286,682 +2,175,055 +2,243,001 +Gain on sale of securities and disposition of investment in affiliated +company +— +(116,853 +) +(600,000 +) +Loss on disposition of property and equipment +2,553 +173,975 +10,844 +Provision for excess and obsolete inventories +1,373,614 +600,000 +1,141,351 +Changes in assets and liabilities- +Accounts receivable +860,140 +(1,118,408 +) +(1,853,514 +) +Notes receivable +75,000 +100,649 +Inventories +(1,017,316 +) +(3,549,168 +) +(231,516 +) +Prepaid expenses and other +112,804 +75,180 +(153,631 +) +Accounts payable +(884,594 +) +443,050 +308,789 +Accrued expenses and other +72,644 +(269,248 +) +1,125,020 +Net cash used in operating activities +(517,507 +) +(5,255,850 +) +(10,044,446 +) +INVESTING ACTIVITIES: +Purchases of property and equipment +(1,649,129 +) +(2,763,639 +) +(3,071,565 +) +Proceeds from the sale of property and equipment +2,393 +33,231 +— +Purchase of patents, licenses and product rights +(700,000 +) +— +(619,589 +) +Purchase of short-term investments +(9,306,439 +) +(21,297,303 +) +(24,869,468 +) +Proceeds from sale of short-term investments +11,474,935 +23,420,432 +22,339,595 +Proceeds from sale of securities +— +637,500 +600,000 +Proceeds from disposition of investment in affiliated company +— +106,102 +— +Investment in affiliated companies +— +— +(20,404 +) +(Increase) decrease in other assets +(52,660 +) +(202,819 +) +50,000 +Net cash used in investing activities +(230,900 +) +(66,496 +) +(5,591,431 +) +FINANCING ACTIVITIES: +Borrowings of term debt +4,322,854 +— +— +Repayment of term debt +(4,491,556 +) +(1,125,206 +) +(1,054,194 +) +Net proceeds from issuance of common stock +2,828,785 +3,853,929 +19,797,206 +Net cash provided by financing activities +2,660,083 +2,728,723 +18,743,012 +EFFECT OF FOREIGN EXCHANGE RATE CHANGES ON CASH +26,286 +(75,670 +) +(61,140 +) +NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS +1,937,962 +(2,669,293 +) +3,045,995 +CASH AND CASH EQUIVALENTS, BEGINNING OF YEAR +2,426,346 +5,095,639 +2,049,644 +CASH AND CASH EQUIVALENTS, END OF YEAR +$ +4,364,308 +$ +2,426,346 +$ +5,095,639 +The accompanying notes are an integral part of these statements. +F-7 +Table of Contents +ORASURE TECHNOLOGIES, INC. +NOTES TO THE FINANCIAL STATEMENTS +1. BACKGROUND: +The Company +We develop, manufacture and market oral specimen collection +devices using our proprietary oral fluid technologies, diagnostic products including in vitro diagnostic tests, and other medical devices. These products are sold in the United States and certain foreign countries to various distributors, +government agencies, clinical laboratories, physicians’ offices, hospitals, and commercial and industrial entities. +Merger +On September 29, 2000, STC Technologies, Inc. (“STC”) and Epitope, Inc. (“Epitope”) were merged (the +“Merger”) into OraSure Technologies, Inc., a newly formed company, incorporated under Delaware law solely for the purposes of combining the two companies and changing the state of incorporation of Epitope from Oregon to Delaware. The +Merger was accounted for as a pooling of interests. There were no material adjustments required to conform the accounting policies of the two companies. In connection with the Merger, during the year ended December 31, 2000, we recorded +merger-related expenses of $7.6 million, which were comprised of the following: +Cash costs: +Transaction costs +$5,273,748 +Employee costs +1,079,607 +Other integration costs +608,393 +Subtotal +6,961,748 +Stock-based compensation +645,410 +Total Merger-related expenses +$7,607,158 +Transaction costs include investment banking, legal, accounting, printing and other direct costs of the Merger. Employee costs represent severance benefits paid to terminated employees whose responsibilities were deemed redundant as +a result of the Merger, as well as certain relocation expenses. Other integration costs include financial system conversion costs and integration-related travel expenses. Stock-based compensation represents the amount of unamortized deferred +compensation on certain nonqualified options granted by Epitope in prior years, which were immediately accelerated upon the closing of the Merger under the terms of the grants. +2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES: +Use of Estimates +The preparation of financial statements in conformity with +accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date +of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. +Cash and Cash Equivalents +We consider all highly liquid investments purchased with a purchased maturity of ninety days or less to be cash equivalents. As of +December 31, 2002 and 2001, cash equivalents consisted of certificates of deposit, commercial paper and U.S. government and agency obligations. +F-8 +Table of Contents +Short-term +Investments +We consider all short-term +investments as available-for-sale securities, in accordance with Statement of Financial Accounting Standards (“SFAS”) No. 115, “Accounting for Certain Investments in Debt and Equity Securities.” These securities are comprised of +certificates of deposits, commercial paper, U.S. government and agency obligations and corporate bonds with original maturities greater than ninety days and less than one year. Available-for-sale securities are carried at fair value, based upon +quoted market prices, with unrealized gains and losses reported in stockholders’ equity as a component of accumulated other comprehensive loss. +The following is a summary of our available-for-sale securities at December 31, 2002 and 2001: +Amortized Cost +Gross Unrealized Gains +Gross Unrealized Losses +Fair Value +December 31, 2002 +Certificates of deposit +$ +3,581,734 +$ +— +$ +— +$ +3,581,734 +Commercial paper +399,017 +88 +— +399,105 +Government and agency bonds +1,974,734 +— +(3,321 +) +1,971,413 +Corporate bonds +4,570,558 +22,041 +(975 +) +4,591,624 +Total available-for-sale securities +$ +10,526,043 +$ +22,129 +$ +(4,296 +) +$ +10,543,876 +December 31, 2001 +Certificates of deposit +$ +2,398,963 +$ +709 +$ +— +$ +2,399,672 +Government and agency bonds +5,027,637 +70,200 +— +5,097,837 +Corporate bonds +5,267,939 +37,109 +(37,654 +) +5,267,394 +Total available-for-sale securities +$ +12,694,539 +$ +108,018 +$ +(37,654 +) +$ +12,764,903 +Supplemental Cash Flow Information +For 2002, 2001 and 2000, we paid interest of $268,340, $402,686 and $490,410, respectively. +For 2002, 2001 and 2000, we recorded provisions for bad debts of $295,842, $100,000, and $0, respectively. We had deductions of $213,188, +$5,193 and $4,269 against the allowance for doubtful accounts in 2002, 2001 and 2000, respectively. +During 2001, the Company exchanged $337,253 of accounts receivable for an investment in a nonaffiliated entity. +Inventories +Inventories are stated at the lower of cost or market +determined on a first-in, first-out basis, and include the cost of raw materials, labor and overhead. The majority of our inventories are subject to expiration dating. We continually evaluate quantities on hand and the carrying value of our +inventories to determine the need for reserves for excess and obsolete inventories, based primarily on the estimated forecast of product sales. When factors indicate that impairment has occurred, either a reserve is established against the +inventories’ carrying value or the inventories are completely written off, as in the case of lapsing expiration dates. We currently buy our entire Histofreezer ® product line from a foreign vendor, with such purchases payable in Euros. Changes in the exchange rate of the Euro could impact our product cost. +Property and Equipment +Property and equipment are stated at cost. Additions or +improvements are capitalized, while repairs and maintenance are charged to expense. Depreciation and amortization are provided using the straight-line method +F-9 +Table of Contents +over the estimated useful lives of the related assets or the lease term, whichever is shorter. Buildings are depreciated over 20 years, while +computer equipment, machinery and equipment, and furniture and fixtures are depreciated over three to ten years. Leasehold improvements are generally amortized over the shorter of the estimated useful lives or the terms of the related leases. When +assets are sold or otherwise disposed of, the related property amounts are relieved from the accounts, and any gain or loss is recorded in the statement of operations. +Patents and Product Rights +Patents and product rights consist of costs associated with the acquisition of patents and product +distribution rights and direct costs associated with patent submissions. Patents and product rights are amortized using the straight-line method over estimated useful lives of five to ten years. Amortization expense for 2002, 2001 and 2000 was +$416,247, $359,853 and $816,111, respectively. +Other Assets +Included in +other assets is a $337,253 investment, representing a 9.4% ownership interest in a privately-held nonaffiliated company. We do not have a controlling interest in this company, nor do we have an ownership or voting interest which allows us to exert +significant influence over the operating and financial policies of this investee company. Accordingly, we have accounted for this investment using the cost method of accounting. +Impairment of Long-Lived Assets +In accordance with SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets”, +if indicators of impairment exist, we assess the recoverability of the affected long-lived assets, which include property and equipment, patents and product rights, by determining whether the carrying value of such assets can be recovered through +the sum of the undiscounted future operating cash flows and eventual disposition of the asset. If impairment is indicated, we measure the amount of such impairment by comparing the carrying value of the assets to the fair value of these assets, +generally determined based on the present value of the expected future cash flows associated with the use of the asset. We believe the future cash flows to be received from our long-lived assets will exceed the assets’ carrying value, and +accordingly we have not recognized any impairment losses through December 31, 2002. +Revenue Recognition +We recognize product revenues when products are shipped. We do not grant price protection or product return rights to our customers, except for warranty returns. Historically, returns arising from +warranty issues have been infrequent and immaterial. Accordingly, we expense warranty returns as incurred. +We follow U.S. Securities and Exchange Commission Staff Accounting Bulletin No. 101 “Revenue Recognition in Financial +Statements” (“SAB 101”). The bulletin draws on existing accounting rules and provides specific guidance on revenue recognition of up-front non-refundable licensing and development fees. In accordance with SAB 101, up-front licensing +fees are deferred and recognized ratably over the related license period. Product development revenues are recognized over the period in which the related product development efforts are performed. Amounts received prior to the performance of +product development efforts are recorded as deferred revenues. Grant revenue is recognized as the related work is performed and costs are incurred. +In accordance with Emerging Issues Task Force (“EITF”) Issue No. 00-10, “Accounting for Shipping and Handling Fees and +Costs,” we record shipping and handling charges billed to our customers as product revenue and the related expense as cost of products sold. +F-10 +Table of Contents +Significant +Customer Concentration +In 2002, 2001 and +2000, one customer accounted for approximately 26 percent, 29 percent and 30 percent, respectively, of our total revenues. The same customer accounted for approximately 19 percent and 21 percent of accounts receivable as of December 31, 2002 and +2001, respectively. +Research and Development +Research and development costs are charged +to expense as incurred. +Restructuring-related +Expenses +In February 2001, we announced +plans to restructure certain of our manufacturing operations. As a result of this restructuring, we incurred an infrequent charge of $450,000 for restructuring costs, primarily comprised of expenses for employee severance, travel and transport +resulting from relocating and consolidating manufacturing operations. All restructuring-related expenses were paid by June 30, 2001. +Stock-Based Compensation +We account for stock-based compensation to employees and directors using the intrinsic value method in accordance with APB Opinion No. 25, +“Accounting for Stock Issued to Employees” and related interpretations. We account for stock-based compensation to nonemployees using the fair value method in accordance with SFAS No. 123, “Accounting for Stock-Based +Compensation” (“SFAS 123”) and EITF Issue No. 96-18, “Accounting for Equity Instruments That Are Issued to Other Than Employees for Acquiring or in Conjunction with Selling, Goods or Services.” +We have elected to adopt the disclosure provisions of SFAS +123, as amended by SFAS 148 “Accounting for Stock-Based Compensation — Transition and Disclosure” (“SFAS 148”). Under SFAS 123, compensation expense related to stock options granted to employees and directors is computed +based on the fair value of the stock option at the date of grant using an option valuation methodology, typically the Black-Scholes option pricing model. Pursuant to the disclosure requirements of SFAS 123, had compensation expense for our common +stock option plan been determined based upon the fair value of the options at the date of grant, our net loss for 2002, 2001 and 2000 would have increased as follows: +Year ended December 31, +2002 +2001 +2000 +Net loss: +As reported +$ +(3,342,473 +) +$ +(3,727,789 +) +$ +(12,746,550 +) +Add: stock-based employee compensation expense included in net loss +— +— +792,685 +Deduct: total stock-based employee compensation expense determined under the fair +value-based method for all awards +(3,359,281 +) +(2,913,149 +) +(5,657,257 +) +Pro forma +$ +(6,701,754 +) +$ +(6,640,938 +) +$ +(17,611,122 +) +Basic and diluted net loss per share: +As reported +$ +(0.09 +) +$ +(0.10 +) +$ +(0.36 +) +Pro forma +$ +(0.18 +) +$ +(0.18 +) +$ +(0.50 +) +Income Taxes +We follow +SFAS No. 109, “Accounting for Income Taxes”, pursuant to which the liability method is used in accounting for income taxes. Under this method, deferred tax assets and liabilities are recognized for the future +F-11 +Table of Contents +tax consequences of operating loss and credit carryforwards and differences between the financial reporting and tax basis of assets and +liabilities and are measured using enacted tax rates that are expected to be in effect when the items reverse. +Foreign Currency Translation +Pursuant to SFAS No. 52, “Foreign Currency Translation,” the assets and liabilities of our foreign operations are translated +from Euros into U.S. dollars at current exchange rates as of the balance sheet date, and revenues and expenses are translated at average exchange rates for the period. Resulting translation adjustments are reflected as a separate component of +stockholders’ equity. +Gain on Sale of +Securities +In December 2001, we recognized +a gain of $100,000 on the sale of 50,000 shares of Lab One , Inc. common stock received in connection with a distribution agreement we entered into with Lab One , Inc. in April 1999. Our original investment associated with these shares was +$537,500. We no longer hold any common shares or warrants of Lab One , Inc. +In December 1996, a former subsidiary of ours completed a merger with Andrew and Williamson Sales, Co. (“A&W”), which was rescinded in May 1997. We received A&W preferred stock in the +recission, which had been carried at zero value due to the circumstances surrounding A&W’s financial condition at the time the stock was received in 1997. In 2000, we sold the A&W preferred stock for $600,000. +Net Loss Per Common Share +We have presented basic and diluted net loss per share +pursuant to SFAS No. 128, “Earnings per Share” (“SFAS 128”). In accordance with SFAS 128, basic and diluted net loss per share has been computed using the weighted-average number of shares of common stock outstanding during the +period. Diluted loss per share is generally computed assuming the conversion or exercise of all dilutive securities such as common stock options and warrants; however, outstanding common stock options and warrants to purchase 3,999,608, 3,915,233 +and 4,677,357 shares were excluded from the computation of diluted net loss per common share for 2002, 2001 and 2000, respectively, because they were anti-dilutive due to our losses. +Other Comprehensive Income (Loss) +We follow SFAS No. 130, “Reporting Comprehensive Income.” This statement requires the +classification of items of other comprehensive income (loss) by their nature and disclosure of the accumulated balance of other comprehensive income (loss), separately from accumulated deficit and additional paid-in capital, in the equity section of +our balance sheet. +Fair Value of Financial +Instruments +As of December 31, 2002, the +carrying values of cash and cash equivalents, short-term investments, accounts receivable, accounts payable, and accrued expenses approximate their respective fair values based on their short-term nature. In addition, we believe the carrying value +of our debt instruments, which do not have readily ascertainable market value, approximates their fair values, given that the interest rates on outstanding borrowings approximate market rates. +Recent Accounting Pronouncements +SFAS No. 143, “Accounting for Asset Retirement +Obligations” (“SFAS 143”), which was released in August 2001, addresses financial accounting and reporting for obligations associated with the retirement of tangible long-lived assets and their associated asset retirement costs. SFAS +143 requires an enterprise to record +F-12 +Table of Contents +the fair value of an asset retirement obligation as a liability in the period in which it incurs a legal obligation associated with the +retirement of intangible long-lived assets that result from the acquisition, construction, development, or normal use of the asset. The enterprise is also required to record a corresponding increase to the carrying amount of the related long-lived +asset (i.e. the associated asset retirement cost) and to depreciate that cost over the life of the asset. The liability is changed at the end of each period to reflect the passage of time (i.e. accretion expense) and changes in the estimated future +cash flows underlying the initial fair value measurement. Because of the extensive use of estimates, most enterprises will record a gain or loss when they settle the obligation. We are required to adopt SFAS 143 for our fiscal year beginning January +1, 2003. We do not expect the adoption of SFAS 143 to have a material impact on our financial position or results of operations. +In April 2002, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 145, “Rescission of FASB Statements No. 4, +44 and 64, Amendment of FASB Statement No. 13, and Technical Corrections” (“SFAS 145”). SFAS 145 amends existing guidance on reporting gains and losses on the extinguishment of debt to prohibit the classification of the gain or loss +as extraordinary, as the use of such extinguishments have become part of the risk management strategy of many companies. SFAS 145 also amends SFAS 13 to require sale-leaseback accounting for certain lease modifications that have economic effects +similar to sale-leaseback transactions. The provisions of SFAS 145 related to the rescission of SFAS 4 are applied in fiscal years beginning after May 15, 2002. Earlier application of these provisions is encouraged. The provisions of SFAS 145 +related to SFAS 13 were effective for transactions occurring after May 15, 2002. The adoption of SFAS 145 is not expected to have a material effect on our financial statements. +In June 2002, the FASB issued SFAS No. 146, “Accounting for Costs Associated with Exit or Disposal +Activities” (“SFAS 146”). SFAS 146 addresses significant issues regarding the recognition, measurement, and reporting of costs associated with exit and disposal activities, including restructuring activities. SFAS 146 also addresses +recognition of certain costs related to terminating a contract that is not a capital lease, costs to consolidate facilities or relocate employees, and termination benefits provided to employees that are involuntarily terminated under the terms of a +one-time benefit arrangement that is not an ongoing benefit arrangement or an individual deferred-compensation contract. SFAS 146 is effective for exit or disposal activities that are initiated after December 31, 2002. The adoption of SFAS 146 is +not expected to have any impact on our financial position or results of operations. +In November 2002, the FASB issued Interpretation No. 45, “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness to Others, an +interpretation of FASB Statements No. 5, 57 and 107 and a rescission of FASB Interpretation No. 34.” This Interpretation elaborates on the disclosures to be made by a guarantor in its interim and annual financial statements about its +obligations under guarantees issued. The Interpretation also clarifies that a guarantor is required to recognize, at inception of a guarantee, a liability for the fair value of the obligation undertaken. The initial recognition and measurement +provisions of the Interpretation are applicable to guarantees issued or modified after December 31, 2002, and are not expected to have a material effect on our financial statements. +In December 2002, the FASB issued SFAS No. 148, “Accounting for Stock-Based Compensation – +Transition and Disclosure, an amendment of FASB Statement No. 123” (“SFAS 148”). SFAS 148 amends SFAS No. 123, “Accounting for Stock-Based Compensation,” to provide alternative methods of transition for a voluntary change to +the fair value method of accounting for stock-based employee compensation. In addition, SFAS 148 amends the disclosure requirements of SFAS No. 123 to require prominent disclosures in both annual and interim financial statements. The disclosure +modifications are required for fiscal years ending after December 15, 2002, and are included in the notes to our financial statements. +In January 2003, the FASB issued Interpretation No. 46, “Consolidation of Variable Interest Entities, an interpretation of ARB No. +51.” This Interpretation addresses the consolidation by business enterprises of variable interest entities as defined in the Interpretation. The Interpretation applies immediately to variable interests in +F-13 +Table of Contents +variable interest entities created after January 31, 2003, and to variable interests in variable interest entities obtained after January 31, +2003. Because we have no involvement with any variable interest entities, the application of this Interpretation is not expected to have a material effect on our financial statements. +Reclassifications +Certain amounts from prior periods have been reclassified to conform to the current year presentations. +3. INVENTORIES: +December 31, +2002 +2001 +Raw materials +$ +2,787,967 +$ +2,918,825 +Work in process +430,977 +644,397 +Finished goods +869,530 +881,550 +$ +4,088,474 +$ +4,444,772 +4. PROPERTY AND EQUIPMENT: +December 31, +2002 +2001 +Building and leasehold improvements +$ +5,893,702 +$ +5,464,353 +Machinery and equipment +10,104,511 +9,935,897 +Computer equipment +2,314,015 +2,131,606 +Furniture and fixtures +1,442,644 +1,205,750 +Construction in progress +656,061 +698,675 +20,410,933 +19,436,281 +Less—Accumulated depreciation and amortization +(12,982,983 +) +(11,636,144 +) +$ +7,427,950 +$ +7,800,137 +Depreciation expense was $1,828,855, $1,815,202 and $1,426,890 for 2002, 2001 and 2000, respectively. +5. PATENTS AND PRODUCT RIGHTS: +In June 1998, we acquired the patents and exclusive worldwide distribution rights to our Histofreezer ® product. The purchase price of $2,548,690, including transaction costs, has been recorded as patents and product rights and is being amortized using +the straight-line method over an estimated useful life of ten years. In connection with this acquisition, we also entered into a product purchase agreement with the manufacturer of the Histofreezer ® product, with an initial term extending through December 31, 2006. +In October 2002, we entered into new supply and distribution agreements with bioMérieux, Inc. +(“BMX”), which replaced existing agreements between the parties, for the supply by BMX of HIV-1 antigen required to manufacture our oral fluid Western Blot HIV-1 confirmatory test and for the distribution by BMX of the oral fluid Western +Blot product on an exclusive worldwide basis. These agreements have an initial term ending December 31, 2005, which may be extended until December 31, 2007 under certain circumstances. As consideration for BMX entering into the new agreements, we +agreed to pay BMX $750,000, of which $250,000 is included in our accompanying balance sheet at December 31, 2002 in accrued expenses and will be paid in March 2003. We recorded the $750,000 as additional Patent and Product Rights on our balance +sheet and are amortizing this amount through December 2005, the initial term of the agreements. +F-14 +Table of Contents +6. ACCRUED EXPENSES: +December 31, +2002 +2001 +Payroll and related benefits +$ +1,387,834 +$ +1,728,651 +Laboratory testing fees +531,921 +278,305 +Professional fees +296,162 +271,112 +Deferred revenue +316,139 +401,060 +Other +789,453 +432,758 +$ +3,321,509 +$ +3,111,886 +7. CREDIT FACILITIES: +In September 2002, we entered into a new $10.9 million credit facility (“New Credit Facility”) with a new bank, pursuant to which we refinanced substantially all of our previously outstanding mortgage and term debt +and increased our equipment and working capital lines of credit. The New Credit Facility is comprised of an $887,000 mortgage loan, a $3.0 million term loan, a $3.0 million non-revolving equipment line of credit and a $4.0 million revolving working +capital line of credit (see Note 8). +Under the +non-revolving equipment line of credit, we can borrow up to $3.0 million to finance eligible equipment purchases through September 9, 2003. Interest on outstanding borrowings accrues at a rate, selected at our option, equal to the bank’s prime +rate, 180-day or 360-day LIBOR plus 2.625%, or the 4-year Treasury Note rate plus 2.30%, determined at the time of each borrowing. Borrowings are repayable in 48 consecutive, equal monthly principal installments, plus interest. As of December 31, +2002, we had $2,564,356 available for future borrowings under the non-revolving equipment line of credit. +Under the revolving working capital line of credit, we can borrow up to $4.0 million to finance working capital and other needs. Interest +on outstanding borrowings shall accrue at a rate, selected at our option, equal to the bank’s prime rate less 0.25%, or 30-day LIBOR plus 2.55%, determined at the time of the initial borrowing. Borrowings are repayable by September 9, 2003, +with interest payable monthly. We had no outstanding borrowings under this facility at December 31, 2002. +All borrowings under the New Credit Facility are collateralized by a first priority security interest in all of our assets, including +present and future accounts receivable, chattel paper, contracts and contract rights, equipment and accessories, general intangibles, investments, instruments, inventories, and a mortgage on our manufacturing facility in Bethlehem, Pennsylvania. +Borrowings under the equipment and working capital lines of credit are limited to commercially standard percentages of equipment purchases and accounts receivable, respectively. The New Credit Facility contains certain covenants that set forth +minimum requirements for our quick ratio, liquidity, and tangible net worth and that require us to achieve positive net income for the year ending December 31, 2003 and for each year thereafter. The New Credit Facility also restricts our ability to +pay dividends, to make certain investments, to incur additional indebtedness, to sell or otherwise dispose of a substantial portion of assets, and to merge or consolidate operations with an unaffiliated entity, without the consent of the bank. +F-15 +Table of Contents +8. LONG-TERM DEBT: +December 31, +2002 +2001 +Term loan payable to bank, interest at 4.99%, monthly principal installments of $71,429, +plus interest, through March 2006, secured by a first priority security interest in all of our assets. +$ +2,785,714 +$ +— +Mortgage loan payable to bank, interest at an annual floating rate equal to the +bank’s prime rate (4.25% at December 31, 2002), fixed monthly installments of principal and interest of $7,426 through September 2007, at which time the interest rate and fixed monthly repayment amount is reset for the remaining sixty monthly +installments, secured by our building. +874,186 +— +Note payable to bank, interest at an annual floating rate equal to the bank’s prime +rate (4.25% at December 31, 2002), monthly principal installments of $5,081, plus interest, through December 2006, secured by certain equipment. +243,872 +— +Note payable to bank, interest at 5.07%, monthly principal installments of $3,995, plus +interest, through September 2006, secured by certain equipment. +179,786 +— +Note payable to Pennsylvania Industrial Development Authority, interest at 2%, monthly +installments of principal and interest of $4,895 through March 2010, secured by a second lien on our building. +391,770 +442,285 +Notes payable to bank, interest at 8%, refinanced in September 2002. +— +3,987,919 +Note payable to bank, interest at 7.75%, monthly installments of principal and interest +of $31,271 through July 2002, secured by certain property and equipment, inventory and intangible assets. +— +213,826 +4,475,328 +4,644,030 +Less—Current portion +(1,065,966 +) +(1,057,572 +) +$ +3,409,362 +$ +3,586,458 +Long-term debt maturities as of December 31, 2002 are as follows: +2003 +$1,065,966 +2004 +1,073,633 +2005 +1,077,085 +2006 +425,817 +2007 +118,313 +Thereafter +714,514 +$4,475,328 +These +notes payable require, among other items, the maintenance of certain financial covenants (see Note 7). +9. INCOME TAXES: +At December 31, 2002, we had net operating loss carryforwards for federal income tax purposes of approximately $79.6 million that have begun to expire and will continue to expire through 2022. The Tax +Reform Act of 1986 contains provisions that may limit the annual amount of net operating loss carryforwards available to be used in any given year in the event of significant changes in ownership. In connection with the Merger, a change in ownership +occurred. We believe the annual limitation will not have a material effect on our ability to utilize our loss carryforwards. Given our losses in recent years, we believe a full valuation allowance is needed as of December 31, 2002. +F-16 +Table of Contents +The tax effect of temporary differences as established in accordance with SFAS No. 109 +that give rise to deferred income taxes are as follows: +December 31 +2002 +2001 +Deferred tax asset: +Net operating loss carryforwards +$ +27,358,000 +$ +26,949,000 +Stock based compensation +— +2,643,000 +Accruals and reserves currently not deductible +1,614,000 +1,696,000 +Patent costs +558,000 +445,000 +Research and development credit carryforwards +2,252,000 +1,850,000 +Valuation allowance on deferred tax assets +(31,782,000 +) +(33,583,000 +) +$ +— +$ +— +10. STOCKHOLDERS’ EQUITY: +Stock Options +We grant stock-based awards under the OraSure Technologies, Inc. 2000 Stock Award Plan (the “2000 Plan”). The 2000 Plan permits stock-based awards to employees, outside directors and consultants or other +third-party advisors. Awards which may be granted under the 2000 Plan include qualified incentive stock options, nonqualified stock options, stock appreciation rights, restricted awards, performance awards and other stock-based awards. +Under the terms of the 2000 Plan, qualified incentive stock +options for shares of our common stock may be granted to eligible employees, including our officers. To date, options generally have been granted with ten-year exercise periods and an exercise price not less than the fair market value on the date of +grant. Options generally vest over four years, with one quarter of the options vesting one year after grant and the remainder vesting on a monthly basis over the next three years. The 2000 Plan also provides that nonqualified options may be granted +at a price not less than 75 percent of the fair market value of a share of common stock on the date of grant. The option term and vesting schedule of such awards may either be unlimited or have a specified period in which to vest and be exercised. +We apply APB Opinion No. 25 and the related +interpretations in accounting for stock options granted to employees and directors. Accordingly, compensation expense, if any, is recognized for the intrinsic value (the difference between the exercise price and the fair value of our common stock) +on the date of grant. Compensation, if any, is deferred and charged to expense over the respective vesting period. In 2000, we issued an executive an option to purchase 375,000 shares of common stock for $4.59 per share. The fair market value of our +common stock at the date of issuance was $6.13. We recorded deferred compensation of $577,500 on the date of grant to be amortized over the vesting period of three years. However, the options immediately vested upon the closing of the Merger in +accordance with change in control rights contained in the stock option grant. As a result, we recorded $577,500 of compensation expense in 2000 related to these options. We also recorded an additional $215,185 of compensation expense in 2000 due to +the amortization of deferred compensation related to other stock options, resulting from the change in control rights provided under the applicable stock option grants. +The weighted average fair value of the options granted during 2002, 2001 and 2000 is estimated at $3.45, +$7.10 and $4.96 per share, respectively, using the Black-Scholes option pricing model, with the following assumptions: dividend yield of zero; volatility of 71 percent, 65 percent and 64 percent, respectively; weighted average risk-free interest +rate of 2.89 percent, 4.86 percent and 6.13 percent, respectively; and an expected life of 5.0, 7.0 and 4.3 years, respectively. +We account for stock-based compensation to non-employees using the fair value method, in accordance with SFAS No. 123 and EITF No. 96-18. +In 2002 and 2001, we recorded compensation expense of $50,939 and +F-17 +Table of Contents +$136,874 related to options to purchase 20,000 shares and 19,000 shares, respectively, of our common stock granted to outside consultants or +members of a non-employee advisory board. No such awards were made in 2000. Compensation expense was computed based on the estimated fair value of the stock options at the date of grant, using the Black-Scholes option pricing model. +Information with respect to the options granted under the 2000 +Plan and predecessor plans is as follows: +Shares +Price per Share +Weighted Average +Exercise Price +per Share +Balance, December 31, 1999 +4,369,905 +$0.80–$18.17 +$ 3.93 +Granted +1,596,142 +4.59 – 15.03 +6.82 +Exercised +(1,319,624 +) +0.80 – 6.00 +4.32 +Canceled +(139,066 +) +0.80 – 18.17 +3.57 +Balance, December 31, 2000 +4,507,357 +0.80 – 15.03 +4.85 +Granted +357,000 +7.88 – 12.95 +10.51 +Exercised +(968,729 +) +0.80 – 9.47 +3.98 +Canceled +(150,395 +) +0.80 – 14.81 +6.14 +Balance, December 31, 2001 +3,745,233 +0.80 – 15.03 +5.57 +Granted +1,267,275 +3.83 – 7.42 +5.74 +Exercised +(688,454 +) +0.80 – 7.09 +4.06 +Canceled +(444,446 +) +0.80 – 14.84 +6.14 +Balance, December 31, 2002 +3,879,608 +$0.80–$15.03 +$ 5.83 +At +December 31, 2002, 2,218,019 shares were available for future grants under the 2000 Plan. The following table summarizes information about stock options outstanding at December 31, 2002: +Options outstanding +Options exercisable +Range of exercise prices +Number outstanding +Weighted average remaining life, in years +Weighted average exercise price +Number exercisable +Weighted average exercise price +$ 0.80–$2.83 +485,605 +5.99 +$ +1.29 +368,991 +$ +1.45 +$ 3.22–$4.17 +422,592 +14.85 +4.05 +294,592 +4.05 +$ 4.18–$4.97 +144,994 +15.03 +4.52 +133,994 +4.52 +$ 5.04 +471,573 +13.05 +5.04 +471,573 +5.04 +$ 5.50–$5.81 +35,313 +5.15 +5.77 +35,313 +5.77 +$ 5.87 +880,951 +9.08 +5.87 +110,832 +5.87 +$ 6.00–$6.87 +221,019 +7.48 +6.73 +159,351 +6.69 +$ 7.09 +688,581 +7.95 +7.09 +399,050 +7.09 +$ 7.42–$10.71 +415,980 +8.42 +9.77 +202,097 +9.59 +$10.92–$15.03 +113,000 +8.00 +12.68 +56,123 +12.72 +3,879,608 +9.60 +$ +5.83 +2,231,916 +$ +5.43 +Employee Stock Purchase Plan +In 1993, Epitope’s stockholders approved the adoption of the 1993 Employee Stock Purchase Plan (“1993 ESPP”). The 1993 ESPP, as subsequently amended by Epitope’s stockholders, covered a maximum of 500,000 shares +of common stock for subscription over established offering periods. As a result of the Merger, the 1993 ESPP was adopted and renamed by us. The Compensation Committee of the Board of Directors determines the number of offering periods, the number of +shares offered, and the length of each period, provided that no more than three offering periods may be set during any given fiscal year. The purchase price for stock purchased under the 1993 ESPP for each subscription period is the lesser of 85 +percent of the fair market value of a share of +F-18 +Table of Contents +common stock at the commencement of the subscription period and the fair market value at the close of the subscription period. An employee +may also elect to withdraw at any time during the subscription period and receive the amounts paid plus interest at the rate of 6 percent. +As of December 31, 2002 and 2001, 0 and 8,834 shares of common stock, respectively, were subscribed for through one offering. These shares +may be purchased over 24 months at an initial subscription price of $3.96. During the years ended December 31, 2002, 2001 and 2000, 8,834, 536 and 70,253 shares, respectively, were issued at prices ranging from $2.74 to $4.78 per share under the +1993 ESPP. +Common Stock Warrants +As of December 31, 2002, warrants to +purchase 120,000 shares of common stock at $6.13 per share were outstanding. These warrants were issued on September 30, 1998 and expire on September 30, 2008. +11. COMMITMENTS AND CONTINGENCIES: +Phosphor Agreements +In April 1995, we entered into several research, licensing and royalty agreements (collectively the +“Phosphor Agreements”), related to development and commercialization of our up-converting phosphor technology (“UPT ™ ”). Under the terms of the Phosphor Agreements, as amended, we are obligated to make an annual license payment of $50,000 and an annual minimum royalty payment of $100,000 for usage of patented technology licensed to +us. Upon the first commercial sale of a UPT ™ -based product or service, we are obligated to pay royalties based +upon a percentage of the net sales of UPT ™ -based products, research and development fees and sublicensing +revenues, for a period equal to the longer of ten years from the date of the first commercial sale of a UPT ™ -based product or service (which occurred in 2001) or the remaining life of the patents underlying the licensed technology, which expire through 2017. Royalties from the commercial sale of products or services can be credited against +our minimum royalty obligation of $100,000 per year. In connection with the acquisition of certain technology related to UPT ™ , we are also required to pay sponsored research funds of $125,000 per year in 2003 and 2004, decreasing to $50,000 per year through 2008, as well as royalties of $25,000 per year, until 2008. +Leases +We lease office, manufacturing, warehouse and laboratory +facilities under operating lease agreements. Future payments required under these leases are as follows: +2003 +$1,467,879 +2004 +1,460,066 +2005 +887,585 +2006 +780,000 +2007 +783,108 +Thereafter +3,978,547 +$9,357,185 +Rent +expense for 2002, 2001 and 2000 was $1,070,510, $805,878 and $716,748, respectively. +Purchase Commitments +As of December 31, 2002, we had outstanding non-cancelable purchase commitments in the amount of $2,097,460, of which $688,626, $351,416 and $1,057,418 are related to inventory, services and capital +expenditures, respectively. +F-19 +Table of Contents +Employment +Agreements +Under terms of employment +agreements with certain executive officers and other employees, extending through 2003, we are required to pay each individual a base salary and for some individuals, a retention bonus, for continuing employment with our Company. The agreements +require payments of $1,503,780 in 2003, which includes the severance payments discussed below. +In January 2002, we terminated an employment agreement with our former chief executive officer. During the first quarter of 2002, we recorded $480,063 in severance expenses, of which, $215,113 is +payable in 2003. These expenses include continued salary and benefit premium payments to this officer, related employment taxes, and the value of certain computer equipment transferred to this individual. We also held a $75,000 note receivable from +this officer, which was repaid during 2002. +Litigation +From +time-to-time, we are involved in certain legal actions arising in the ordinary course of business. In management’s opinion, based upon the advice of counsel, the outcome of such actions are not expected to have a material adverse effect on our +future financial position or results of operations. +12. RELATED-PARTY FACILITY LEASE: +We have entered into a ten-year facility lease with Tech III Partners, LLC (“Tech Partners”), an entity owned and controlled by two of our executive officers. Under the terms of this +operating lease, we began leasing a 48,000 square foot facility in October 2002, at a base rent of $780,000 per year, increasing to $858,240 per year, during the initial ten-year term. The base rental rate may be increased after the fifth year of +the initial term, in order to reflect changes in the debt incurred by Tech Partners to finance construction of the leased facilities. We have not guaranteed any debt incurred by Tech Partners. This lease also provides us with options to renew our +lease for an additional five years at a rental rate of $975,360 per year and to purchase the facility at any time during the initial ten year-term, based upon a formula set forth in the lease agreement. +13. RETIREMENT PLANS: +As a result of the Merger, during 2000 and a portion of 2001, +we maintained two distinct retirement plans covering substantially all of our employees. Both plans permitted voluntary employee contributions to be excluded from the employees’ current taxable income under the provisions of Internal Revenue +Code Section 401(k) and the regulations thereunder. Generally, all employees of Epitope were eligible to participate in a profit sharing and deferred savings plan. The plan provided for us to make a matching contribution (either in cash, our common +stock, or a combination of both) equal to 50 percent of an employee’s contribution, not to exceed 2.5 percent of an employee’s compensation. We contributed 5,309 shares valued at $62,409 during 2000 to this plan. Generally, all employees +of STC were eligible to participate in a profit sharing plan. The plan provided for us, subject to the Board of Directors’ discretion, to match employee contributions up to $3,000 or 8% of a participant’s salary, whichever is less. Our +contributions to the plan were $75,789 and $122,903 for 2001 and 2000, respectively. +On May 1, 2001, we merged the two aforementioned plans into the OraSure Technologies, Inc. 401(k) Plan (the “New Plan”). The New Plan permits voluntary employee contributions to be excluded +from an employee’s current taxable income under provisions of Internal Revenue Code Section 401(k) and the regulations thereunder. The New Plan also provides for us to match employee contributions up to the lesser of $4,000 or 10% of the +employee’s salary. Contributions to the New Plan were $443,280 and $239,402 in 2002 and 2001, respectively. +F-20 +Table of Contents +14. GEOGRAPHIC INFORMATION: +Under the disclosure requirements of SFAS No.131, “Segment Disclosures and Related Information,” we operate within one segment, medical devices and products. Our products are sold principally +in the United States and Europe. Segmentation of operating income and identifiable assets is not applicable since all of our revenues outside the United States are export sales. +The following table represents total revenues by geographic area (amount in thousands): +For the year ended December 31, +2002 +2001 +2000 +United States +$ +28,124 +$ +27,321 +$ +24,763 +Europe +2,726 +3,510 +2,507 +Other regions +1,160 +1,742 +1,518 +$ +32,010 +$ +32,573 +$ +28,788 +15. QUARTERLY DATA (Unaudited): +The following tables summarize the quarterly results of operations for each of the quarters in 2002 and 2001. These quarterly results are unaudited, but in the opinion of management, have been prepared +on the same basis as our audited financial information and include all adjustments (consisting only of normal recurring adjustments) necessary for a fair presentation of the information set forth herein (all amounts in thousands, except per share +amounts). +2002 Results +Three months ended +Year ended +December 31, +2002 +March 31, 2002 +June 30, 2002 +September 30, 2002 +December 31, 2002 +Revenues +$ +7,725 +$ +7,930 +$ +8,107 +$ +8,248 +$ +32,010 +Costs and expenses +9,387 +9,285 +8,508 +8,371 +35,551 +Operating loss +(1,662 +) +(1,355 +) +(401 +) +(123 +) +(3,541 +) +Other income, net +69 +74 +14 +41 +198 +Net loss +$ +(1,593 +) +$ +(1,281 +) +$ +(387 +) +$ +(82 +) +$ +(3,343 +) +Basic and diluted net loss per share +$ +(0.04 +) +$ +(0.03 +) +$ +(0.01 +) +$ +(0.00 +) +$ +(0.09 +) +Weighted average number of shares outstanding +37,434 +37,494 +37,536 +37,863 +37,583 +2001 Results +Three months ended +Year ended +December 31, +2001 +March 31, 2001 +June 30, 2001 +September 30, 2001 +December 31, 2001 +Revenues +$ +7,404 +$ +8,508 +$ +8,598 +$ +8,063 +$ +32,573 +Costs and expenses +8,636 +9,105 +8,609 +10,556 +36,906 +Operating loss +(1,232 +) +(597 +) +(11 +) +(2,493 +) +(4,333 +) +Other income, net +251 +159 +26 +198 +634 +Income (loss) before income taxes +(981 +) +(438 +) +15 +(2,295 +) +(3,699 +) +Income taxes (benefit) +16 +6 +(1 +) +8 +29 +Net income (loss) +$ +(997 +) +$ +(444 +) +$ +16 +$ +(2,303 +) +$ +(3,728 +) +Basic and diluted net loss per share +$ +(0.03 +) +$ +(0.01 +) +$ +0.00 +$ +(0.06 +) +$ +(0.10 +) +Weighted average number of shares outstanding +36,457 +36,702 +39,009 +37,246 +36,868 +F-21 +Table of Contents +INDEX TO EXHIBITS +Exhibit Number +Exhibit +2.1 +Agreement and Plan of Merger, dated as of May 6, 2000, by and among Epitope, Inc., the Company and STC Technologies, +Inc., including the Epitope Stockholders Agreement and the STC Stockholders Agreement attached as Exhibits A and B thereto and the other exhibits attached thereto, is incorporated by reference to Exhibit 2 to the Current Report on Form 8-K of +Epitope, Inc. dated May 9, 2000. +3.1 +Certificate of Incorporation of OraSure Technologies is incorporated by reference to Exhibit 3.1 to the Company’s +Registration Statement on Form S-4 (No. 333-39210), filed June 14, 2000. +3.1.1 +Certificate of Amendment to Certificate of Incorporation dated May 23, 2000 is incorporated by reference to Exhibit +3.1.1 to the Company’s Registration Statement on Form S-4 (No. 333-39210), filed June 14, 2000. +3.1.2 +Certificate of Designation of Series A Preferred Stock of OraSure Technologies (filed as Exhibit A to the Rights +Agreement referred to in Exhibit 4.2). +3.2 +Amended and Restated Bylaws of OraSure Technologies, effective as of February 4, 2003. +4.1 +Specimen certificate representing shares of OraSure Technologies $.000001 par value Common Stock is incorporated by +reference to Exhibit 4.1 to Amendment No. 1 to the Company’s Registration Statement on Form S-4 (No. 333-39210), filed August 8, 2000. +4.2 +Rights Agreement, dated as of May 6, 2000, between OraSure Technologies and ChaseMellon Shareholder Service, L.L.C. +(now called Mellon Investor Services LLC), as Rights Agent, is incorporated by reference to Exhibit 4.2 to Amendment No. 1 to the Company’s Registration Statement on Form S-4 (No. 333-39210), filed August 8, 2000. +4.3 +Stockholders’ Agreement among STC Technologies, Inc., HealthCare Ventures V, L.P., RHO Management Trust II, +Hudson Trust and Pennsylvania Early Stage Partners, L.P., dated March 30, 1999, is incorporated by reference to Exhibit 4.3 to Amendment No. 3 to the Company’s Registration Statement on Form S-4 (No. 333-39210), filed August 30, +2000. +4.4 +Amendment to Stockholders’ Agreement filed is Exhibit 4.3 is incorporated by reference to Exhibit 4.4 to +Amendment No. 3 to the Company’s Registration Statement on Form S-4 (No. 333-39210), filed August 30, 2000. +4.5 +Second Amendment to Stockholders’ Agreement filed as Exhibit 4.3 is incorporated by reference to Exhibit 4 to the +Company’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2001. +10.1 +Form of Indemnification Agreement (and list of parties to such agreement) is incorporated by reference to Exhibit 10.1 +to Amendment No. 3 to the Company’s Registration Statement on Form S-4 (No. 333-39210), filed August 30, 2000.* +10.2 +Separation Agreement and Release dated as of February 14, 2002 between OraSure Technologies and Robert D. Thompson is +incorporated by reference to Exhibit 10.2 to the Company’s Annual Report on Form 10-K for the year ended December 31, 2001.* +10.3 +Employment Agreement dated as of September 29, 2000 between OraSure Technologies and Robert D. Thompson is +incorporated by reference to Exhibit 10.3 to the Company’s Annual Report on Form 10-K for the year ended December 31, 2000.* +10.4 +Employment Agreement dated as of September 29, 2000 between OraSure Technologies and Michael J. Gausling is +incorporated by reference to Exhibit 10.4 to the Company’s Annual Report on Form 10-K for the year ended December 31, 2000.* +Table of Contents +Exhibit Number +Exhibit +10.5 +Employment Agreement dated as of November 1, 2001 between OraSure Technologies and Ronald H. Spair is incorporated be +reference to Exhibit 10 to the Company’s Quarterly Report on Form 10-Q for the quarter ended September 30, 2001.* +10.6 +Employment Agreement dated as of September 29, 2000 between OraSure Technologies and Dr. R. Sam Niedbala is +incorporated by reference to Exhibit 10.6 to the Company’s Annual Report on Form 10-K for the year ended December 31, 2000.* +10.7 +Employment Agreement dated as of September 29, 2000 between OraSure Technologies and P. Michael Formica is +incorporated by reference to Exhibit 10.10 to the Company’s Annual Report on Form 10-K for the year ended December 31, 2001.* +10.8 +Description of Non-Employee Director Compensation Policy, as amended effective as of February 4, +2003.* +10.9 +Amended and Restated Epitope, Inc. 1991 Stock Award Plan.* +10.10 +OraSure Technologies, Inc. Employee Incentive and Non-Qualified Stock Option Plan, as amended and restated effective +September 29, 2000, is incorporated by reference to Exhibit 10.12 to the Company’s Annual Report on Form 10-K for the year ended December 31, 2000.* +10.11 +OraSure Technologies, Inc. 2000 Stock Award Plan, as amended effective as of May 20, 2002, is incorporated by +reference to Exhibit 10.1 to Amendment No. 1 to the Company’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2002.* +10.12 +Nonqualified Stock Option Agreement For Discounted Non-Plan Option between Epitope, Inc. and Robert D. Thompson is +incorporated by reference to Exhibit 10.14 to the Company’s Annual Report on Form 10-K for the year ended December 31, 2000.* +10.13 +Description of OraSure Technologies, Inc. 2002 Employee Cash Bonus Plan is incorporated by reference to Exhibit 10.2 +to Amendment No. 1 to the Company’s Quarterly Report on Form 10-Q for the Quarter ended June 30, 2002.* +10.14 +Description of OraSure Technologies, Inc. 2003 Self-Funding Annual Incentive Plan.* +10.15 +Description of OraSure Technologies, Inc. Management Stock Option Award Guidelines.* +10.16 +Production Agreement with Koninklinjke Utermöhlen, N.V. dated June 9, 1998 is incorporated by reference to +Exhibit 10.8 to Amendment No. 3 to the Company’s Registration Statement on Form S-4 (No. 333-39210), filed August 30, 2000. +10.17 +Amendment No. 1 to Production Agreement, dated as of December 11, 2001, between the Company and Koninklijke +Utermöhlen N.V., is incorporated by reference to Exhibit 10.18 to the Company’s Annual Report on Form 10-K for the year ended December 31, 2001. +10.18 +Research and License Agreement with SRI International and David Sarnoff Research Center dated April 26, 1995 is +incorporated by reference to Exhibit 10.9 to Amendment No. 4 to the Company’s Registration Statement on Form S-4 (No. 333-39210), filed August 31, 2000. +10.19 +First Amendment to Research and License Agreement among SRI International and David Sarnoff Research Center and the +Company dated September 1, 1995 is incorporated by reference to Exhibit 10.10 to Amendment No. 3 to the Company’s Registration Statement on Form S-4 (No. 333-39210), filed August 30, 2000. +Table of Contents +Exhibit Number +Exhibit +10.20 +Third Amendment to Research and License Agreement dated August 30, 2000 among SRI International, Sarnoff Corporation +(formerly David Sarnoff Research Center) and the Company is incorporated by reference to Exhibit 10.19 to the Company’s Annual Report on Form 10-K for the year ended December 31, 2000. +10.21 +Commercial Lease between Northampton County New Jobs Corp., as Landlord, and STC Technologies, Inc., as Tenant, dated +April 30, 1999, is incorporated by reference to Exhibit 10.11 to Amendment No. 1 to the Company’s Registration Statement on Form S-4 (No 333-39210), filed August 8, 2000. +10.22 +Lease dated October 25, 1999 between PS Business Parks, L.P., a California Limited Partnership, and Epitope, Inc., is +incorporated by reference to Exhibit 10.6 to the Epitope, Inc. Annual Report on Form 10-K for 1999. +10.23 +Commercial Lease between Tech III Partners, LLC and OraSure Technologies, dated March 1, 2002, is incorporated by +reference to Exhibit 10.24 to the Company’s Annual Report on Form 10-K for the year ended December 31, 2001. +10.24 +Amendment No. 1 to Commercial Lease, dated as of October 21, 2002, between Tech III Partners, LLC and OraSure +Technologies, Inc., is incorporated by reference to Exhibit 10.2 to the Company’s Quarterly Report on Form 10-Q for the quarter ended September 30, 2002. +10.25 +Loan and Security Agreement, dated as of September 10, 2002, between Comerica Bank – California and OraSure +Technologies, Inc., is incorporated by reference to Exhibit 10.1 to the Company’s Quarterly Report on Form 10-Q for the quarter ended September 30, 2002. +10.26 +Distribution Agreement, dated as of October 11. 2002, between OraSure Technologies, Inc. and bioMérieux, Inc., +is incorporated by reference to Exhibit 10.3 to the Company’s Quarterly Report on Form 10-Q for the quarter ended September 30, 2002. +10.27 +Supply Agreement, dated as of October 11, 2002, between OraSure Technologies, Inc. and bioMérieux, Inc., is +incorporated by reference to Exhibit 10.4 to the Company’s Quarterly Report on Form 10-Q for the quarter ended September 30, 2002. +23 +Consent of KPMG LLP. +24 +Powers of Attorney. +99.1 +Certification pursuant to 18 U.S.C. §1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of +2002. +99.2 +Certification pursuant to 18 U.S.C. §1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of +2002. +* +Management contract or compensatory plan or arrangement. \ No newline at end of file diff --git a/raw/filings/0001116463/2002/0000950109-03-001919/filing_metadata.csv b/raw/filings/0001116463/2002/0000950109-03-001919/filing_metadata.csv new file mode 100644 index 0000000000000000000000000000000000000000..7aa214baa68958d07bca28994a8b53103583d1f3 --- /dev/null +++ b/raw/filings/0001116463/2002/0000950109-03-001919/filing_metadata.csv @@ -0,0 +1,2 @@ +cik,ticker,company_name,form,filing_date,report_date,acceptance_datetime,accession_number,primary_document,primary_doc_description,size,is_xbrl,is_inline_xbrl,document_url,filing_index_url,year,fiscal_year,is_primary_filing +0001116463,OSUR,ORASURE TECHNOLOGIES INC,10-K,2003-03-31,2002-12-31,2003-03-31T19:04:26.000Z,0000950109-03-001919,d10k.htm,"ORASURE TECHNOLOGIES, INC. FORM 10-K",1294539,0,0,https://www.sec.gov/Archives/edgar/data/1116463/000095010903001919/d10k.htm,https://www.sec.gov/Archives/edgar/data/1116463/000095010903001919/,2002,2002,1 diff --git a/raw/filings/0001116463/2002/0000950109-03-001919/item1.txt b/raw/filings/0001116463/2002/0000950109-03-001919/item1.txt new file mode 100644 index 0000000000000000000000000000000000000000..35ee7900220e9897c20735bf4d6b651f5ba8a375 --- /dev/null +++ b/raw/filings/0001116463/2002/0000950109-03-001919/item1.txt @@ -0,0 +1,899 @@ +ITEM 1. Business. +Our Company was formed in May 2000 under Delaware law solely for the purposes of combining two companies, STC Technologies, Inc. (“STC” or “STC Technologies”) and Epitope, Inc. (“Epitope”), and +changing the state of incorporation of Epitope from Oregon to Delaware. STC Technologies and Epitope were merged into our Company on September 29, 2000 (the “Merger”). Our principal offices are located at 220 East First Street, Bethlehem, +Pennsylvania 18015, and our telephone number is (610) 882-1820. +General +We develop, +manufacture and market oral fluid specimen collection devices using proprietary oral fluid technologies, diagnostic products including immunoassays and other in vitro diagnostic tests, and other medical devices. These products are sold in the +United States and certain foreign countries to various distributors, government agencies, clinical laboratories, physicians’ offices, hospitals, and commercial and industrial entities. +In vitro diagnostic testing is the process of analyzing +oral fluid, blood, urine and other bodily fluids or tissue for the presence of specific substances or markers for drugs of abuse, infectious diseases or other conditions. In vitro diagnostic tests are performed outside the body, in contrast +to in vivo tests, which are performed directly on or within the body. The substance or marker that a diagnostic test is intended to detect is generally referred to as an analyte. +Immunodiagnostic testing is the leading method of in vitro testing for antigens and antibodies. When +an infectious disease caused by pathogens, such as bacteria, viruses and fungi, or other substances are present, the body responds by producing an antibody. Substances that stimulate production of antibodies are generally referred to as antigens. An +antibody binds specifically with an antigen in a lock-and-key fashion that initiates a biochemical reaction to attempt to neutralize and, ultimately, eliminate the antigen. The ability of an antibody to bind with a specific antigen provides the +basis for immunodiagnostic testing. +Additional +information about the Company can be found on our website. Our website address is www.orasure.com. We make available free of charge through a link provided at such website our Annual Reports on Form 10-K, our Quarterly Reports on Form 10-Q and our +Current Reports on Form 8-K, as well as any amendments to those Reports. Such reports are made available as soon as reasonably practicable after they are filed or furnished to the Securities and Exchange Commission. Our Internet website and the +information contained in or connected to that website are not intended to be incorporated by reference into this Report. +Products +Our principal products currently include the following: +• +The OraSure ® and Intercept ® oral fluid collection devices; +• +The OraQuick ® rapid HIV-1 antibody test; +• +The Histofreezer ® wart removal system; +1 +Table of Contents +• +Certain immunoassay tests and reagents for insurance risk assessment, substance abuse and forensic toxicology applications; +• +An oral fluid Western Blot confirmatory test for the Human Immunodeficiency Virus Type 1 (“HIV-1”); and +• +The Q.E.D. ® saliva alcohol test. +OraSure ® /Intercept ® Collection Devices +Our OraSure ® oral fluid collection device is used in +conjunction with screening and confirmatory tests for HIV-1 antibodies and other analytes. This device consists of a small, treated cotton-fiber pad on a nylon handle that is placed in a person’s mouth for two to five minutes. The device +collects oral mucosal transudate (“OMT”), a serum-derived fluid that contains higher concentrations of certain antibodies and analytes than saliva. As a result, OMT testing is a highly accurate method for detecting HIV-1 infection and +other analytes. +We believe that oral fluid +testing has several significant advantages over blood or urine-based testing systems, for both health care professionals and the individuals being tested. These advantages include eliminating the risk of needle-stick accidents, providing a +noninvasive collection technique, requiring minimal training to administer, providing rapid and efficient collection in almost any setting, and reducing the cost of administration by a trained health care professional. +We have received premarket approval from the U.S. Food and +Drug Administration (the “FDA”) to sell the OraSure ® collection +device for use with a laboratory-based enzyme immunoassay (“EIA”) screening test for HIV-1 antibody detection. This EIA screening test has been approved by the FDA for use with our OraSure ® device and is manufactured and sold by another party. +HIV-1 antibody detection using the OraSure ® collection device involves three steps: +• +Collection of an oral fluid specimen using the OraSure ® device; +• +Screening of the specimen for HIV-1 antibodies at a laboratory with an EIA screening test approved by the FDA for use with the OraSure ® device; and +• +Laboratory confirmation of any positive screening test results with our oral fluid Western Blot HIV-1 confirmatory test (described below). +A trained health care professional +then conveys test results and provides appropriate counseling to the individual who was tested. We have also received FDA 510(k) clearance for use of the OraSure ® collection device with EIAs to test for cocaine and cotinine (a metabolite of nicotine) in oral fluid specimens. +A collection device that is substantially +similar to the OraSure ® device is sold under the name, Intercept ® , and is used to collect OMT for oral fluid drug testing. We have received FDA 510(k) +clearance to use the Intercept ® collection device with laboratory-based EIAs to +test for drugs of abuse commonly identified by the National Institute for Drug Abuse (“NIDA”) as the NIDA-5 (i.e., cannabinoids (marijuana), cocaine, opiates, amphetamines/methamphetamines, and phencyclidine (“PCP”)), and for +barbiturates, methadone and benzodiazepines. +We +believe that the Intercept ® device has several advantages over certain +competing drug testing products, including its lower total cost, its non-invasive nature, safety, mobility and accuracy, the ease of maintaining a chain-of-custody, the treatment of test subjects with greater dignity, no requirement for +specially-prepared collection facilities, and difficulty of sample adulteration. The availability of an oral fluid test is intended to allow our customers to test for drug impairment on demand, eliminate scheduling costs and inconvenience, and +streamline the testing process. +2 +Table of Contents +OraQuick ® Rapid Test +OraQuick ® is our rapid test platform designed to test an oral fluid, whole blood or serum/plasma sample for the presence of various +antibodies or analytes. The device uses a porous flat pad to collect an oral fluid specimen. After collection, the pad is inserted into a vial containing a pre-measured amount of developer solution and allowed to develop. When whole blood is to be +tested, a loop collection device is used to collect less than a drop of blood and mix it in the developer solution, after which the collection pad is inserted into the solution. The specimen and solution then flow through the testing device where +test results are observable in approximately 20 minutes. The OraQuick ® device +is a screening test and requires a confirmation test where an initial positive result is obtained. +Our first product utilizing this technology is the OraQuick ® rapid HIV-1 antibody test, a rapid test for the presence of antibodies against HIV-1. On November 7, 2002, we received +premarket approval of this test from the FDA for detecting HIV-1 in finger-stick whole blood samples. This FDA approval is based on data indicating that the OraQuick ® test has sensitivity of 99.6% and specificity of 100%, based on clinical studies we performed using finger-stick whole +blood specimens. Sensitivity is a measure of the accuracy for detecting positive specimens, and specificity is a measure of the accuracy for identifying negative specimens. +As a result of this FDA approval, the OraQuick ® test is available for use by the nearly 40,000 locations in the United States certified under the Clinical Laboratory +Improvements Amendments of 1988 (“CLIA”), to perform moderately complex diagnostic tests. Additionally, in January 2003, we received a waiver under CLIA for the OraQuick ® rapid HIV-1 antibody test. This waiver will also permit the use of the OraQuick ® test by approximately 140,000 additional sites in the United States not certified under CLIA to perform +moderately complex tests, such as outreach clinics, community-based organizations and physicians’ offices. +During 2003, we expect to submit an application to the FDA for approval of an OraQuick ® test for use in detecting antibodies for HIV in oral fluid samples. We are also likely to pursue FDA approval of the use +of the OraQuick ® test for detecting HIV in venous whole blood and serum/plasma +samples. +The Centers for Disease Control and +Prevention (“CDC”) has identified several key areas for use of our OraQuick ® device in the United States, including certain public hospitals in U.S. metropolitan areas with a relatively high incidence of HIV infection in pregnant women, AIDS service organizations, community-based organizations, outreach +programs, and selected hospital emergency departments and outpatient clinics. Under a treatment Investigational Device Exemption granted by the FDA, the OraQuick ® device is being used in the CDC’s Mother-Infant Rapid Intervention at Delivery Project (MIRIAD) to test pregnant +women in five U.S. metropolitan areas. The goal of this project is to identify those individuals who would benefit from the administration of nevirapine, a drug used to reduce mother-to-child HIV-1 transmission. The OraQuick ® device was also selected for use in the CDC’s LIFE Initiative, an international +effort to address the AIDS epidemic in certain African countries, focusing on areas such as preventing mother-to-child transmission, secondary transmitted disease prevention, HIV prevention for youth, and blood safety systems. +Histofreezer ® +In 1991, we became the exclusive United States distributor of the Histofreezer ® wart removal system, a low-cost alternative to liquid nitrogen and other methods for removal of warts and other benign +skin lesions by physicians. In June 1998, we acquired the Histofreezer ® product +from Koninklijke, Utermöhlen, N.V., The Netherlands. As part of the acquisition, we established a sales office in Reeuwijk, The Netherlands, and we are selling the Histofreezer ® product through a dealer network in more than 20 countries worldwide. Most of our Histofreezer ® sales occur in the United States to family doctors, pediatricians and podiatrists. +The Histofreezer ® product mixes two environmentally friendly cryogenic gases in a small aerosol canister. +When released, these gases are delivered to a specially designed foam bud, cooling the bud to –50°C. The frozen bud is then applied to the wart or lesion for 15 to 40 seconds (depending on the type of lesion) creating localized destruction +of the target area. +3 +Table of Contents +Immunoassay +Tests and Reagents +We develop and sell +immunoassay tests in two formats, known as MICRO-PLATE and AUTO-LYTE ® , to meet +the specific needs of our customers. +AUTO-LYTE ® tests are sold in the form of bottles of liquid +reagents. These reagents are run on commercially available laboratory-based automated analytical instruments, which are manufactured by a variety of third parties. AUTO-LYTE ® is typically used in high volume, automated, commercial reference insurance laboratories to detect certain drugs or +chemicals in urine. Test results are produced quickly, allowing for high throughput. +In the MICRO-PLATE kit, the sample to be tested is placed into a small plastic receptacle, called a microwell, along with the reagents. The result of the test is determined by the color of the +microwell upon completion of the reaction. Controlling the reaction involves the use of a variety of reagents by laboratory personnel. Test results are analyzed by any of a variety of commercially available laboratory instruments, which we may also +provide to our laboratory customers. MICRO-PLATE tests can be performed on commonly used instruments and can detect drugs in urine, serum, and sweat specimens. MICRO-PLATE tests are also used as part of the Intercept ® product line to detect drugs of abuse in oral fluid specimens. +Whenever possible, we enter into multi-year sales agreements +with our customers. These agreements generally are entered into with a laboratory that has agreed to purchase a minimum number of tests over a two-to-five-year period. We also offer these customers the option of a reagent rental agreement under +which we sell the tests at an increased price over a fixed period of time, which includes an additional equipment charge in exchange for providing the customer with the required analytical laboratory equipment. We obtain this equipment from third +party vendors. +Western Blot HIV-1 +Confirmatory Test +We market an oral fluid +Western Blot HIV-1 confirmatory test that received premarket approval from the FDA in 1996. This test uses the original specimen collected with the OraSure ® oral fluid collection device to confirm positive results of initial oral fluid HIV-1 EIA screening tests. The oral fluid +Western Blot HIV-1 confirmatory test is marketed under an exclusive arrangement with bioMerieux Inc. (formerly Organon Teknika Corporation) (“BMX”). +In January 2001, we suspended the production of EPIblot ® , a serum-based Western Blot HIV-1 confirmatory test. The serum Western Blot product accounted for approximately 5% of the +Company’s 2000 revenues, but had been consistently unprofitable because of low production yields and the high cost of quality control. The discontinuation of this product had no effect on the manufacturing or sale of our oral fluid Western Blot +HIV-1 confirmatory test. +Q.E.D. ® Saliva Alcohol Test +Our Q.E.D. ® saliva alcohol test is an on-site, cost-effective test device that is an alternative to breath or blood alcohol testing. +The test is a quantitative, saliva-based method for the detection of ethanol, and has been cleared for sale by the FDA and the U.S. Department of Transportation (“DOT”). In 1997, the product also received a CLIA waiver. +Each Q.E.D. ® test kit contains a collection stick that is used to collect a sample of saliva and a disposable detection device that +displays results in a format similar to a thermometer. The Q.E.D. ® device is +easy to operate and instrumentation is not required to read the result. The product has a testing range of 0 to 0.145% blood alcohol, and produces results in approximately two minutes. +4 +Table of Contents +Products Under Development +UPT ™ and UP link ™ Development +During 2002 and prior years, much of our research and development efforts were focused on our Up-Converting Phosphor Technology +(“UPT ™ ”) and the first UPT ™ application expected to be commercialized, our UP link ™ rapid, point-of-care system for detecting drugs of abuse in oral fluid. +Up-Converting Phosphor Technology . UPT ™ is a proprietary label detection platform that uses phosphor particles to detect minute +quantities of various substances. UPT ™ utilizes the same particle shell that +is coated onto a television screen, but the internal chemistry of the particle has been changed. These changes result in a particle that is excited by infrared light as compared to an ultraviolet light source for television screens. With assistance +from our research partners, we have developed phosphorescent particles that up-convert infrared light to visible light, which we believe is a platform technology with broad applications. +Phosphor particles have been used for decades in television screens and in fluorescent light bulbs. When high +energy ultraviolet light strikes the phosphor-coated area in a screen or bulb, it excites the particles and low energy visible colored light is produced. Our patented improvements on this base technology employ chemical changes inside the phosphor +particles so that low energy infrared light can be used to produce a high energy visible colored signal and is the basis for UPT ™ . This use of infrared light to create a colored signal is called up-conversion as opposed to down-conversion, which +occurs in phosphors designed to be used with ultraviolet light. +The use of infrared light to excite the phosphor particles and produce a visible light signal creates what we believe is an important competitive advantage for the technology in biological systems, especially human clinical +diagnostics. Existing enzyme or fluorescent-based assays employ visible or ultraviolet light to generate the signals from the enzyme substrate or fluorescent molecules used as reporter signals in these systems. The disadvantage of using light in the +visible or ultraviolet portion of the spectrum is that often molecules in the cells or samples for analysis can also produce background interference from these excitation sources. When this occurs, a non-specific signal is generated which dilutes or +obscures the signal of interest for the diagnostic test being administered. Because up-conversion does not occur in nature, biological samples and specimens will not produce light and, therefore, will not cause background interference when excited +by infrared light. +We believe that +UPT ™ overcomes some of the limitations of other diagnostic detection methods +and offers features not commercially available today. The fact that UPT ™ +testing produces zero background interference dramatically increases the potential sensitivity of any test system. In addition, UPT ™ offers the following other key competitive features: +• +Ability to multiplex or detect biological markers for several substances simultaneously through the use of phosphor particles having various colors; +• +Creation of a permanent test record not subject to fading; +• +Applicability to a variety of instrument platforms; +• +Compatibility with alternative testing matrices such as oral fluid, blood or others; and +• +Ability to miniaturize the test platform. +We have reached certain important milestones in the development of UPT ™ , including improving the manufacturing process to produce UPT ™ particles, working to optimize UPT ™ particle coating techniques, producing four distinct colors of UPT ™ particles to permit multiplexing, demonstrating initial feasibility for the use of UPT ™ particles in infectious disease, cancer, and limited DNA detection applications, and developing a +UPT ™ collector, test cassette, and analyzer for use in testing oral fluid for +drugs of abuse. +We believe UPT ™ may have several potential applications for in vitro diagnostics, including human clinical testing for +cancer, allergies, and thyroid and cardiac conditions, and for therapeutic drug monitoring, biological +5 +Table of Contents +warfare testing, food and environmental testing, pharmaceutical research, genomics and pharmacogenomics, veterinary testing, and surgical +imaging. We also believe that UPT ™ labels may be used for the detection of infectious diseases with DNA probes. +However, we have not yet fully explored these potential UPT ™ applications and have not determined which +applications to pursue or the manner in which these opportunities will be pursued, if at all. We believe we will need to enter into partnering arrangements with other entities to exploit fully the potential of UPT ™ . +UP link ™ . UP link ™ is our first product UPT ™ -based application under development. UP link ™ is designed to be a rapid, +point-of-care system utilizing a collector, lateral flow test cassette, and analyzer (including software), that can quickly provide instrument-read results on a variety of samples, including oral fluid, blood, serum, urine and stool samples. +In April 2002, we received 510(k) +clearance from the FDA for the UP link ™ system to detect opiates in oral +fluid. This is the only point-of-care oral fluid drug test system to receive FDA clearance. The UP link ™ +analyzer has also been certified as meeting certain standards required for the sale of electrical and light-emitting equipment internationally. Although our opiates-only UP link ™ detection system has no commercial potential, we are developing an UP link ™ detection system for the full NIDA-5 panel of tests – cocaine, methamphetamines/amphetamines, PCP, opiates and marijuana – which we +believe can be commercialized. We intend to apply for FDA 510(k) clearance of an UP link ™ system for the +full NIDA-5 panel of tests in mid-summer of 2003. Subject to receipt of this FDA clearance, we plan to market this system directly in the workplace and criminal justice markets in the United States. +Although we have made significant progress with respect to the +development of the UP link ™ rapid point-of-care drugs of abuse detection system, there can be no +assurance that we will be successful in completing this development or in commercializing this potential new product. Assuming FDA 510(k) clearance is obtained, we do not expect to receive significant amounts of revenues from this product until at +least 2004 or later. +In March 2000, we signed a +research and development agreement with Dräger Safety AG & Co. KGaA (formerly Dräger Sicherheitstechnik GmbH) (“Dräger Safety”), a European manufacturer and supplier of medical and safety technology products for health +care and industrial applications. This agreement provided for the development of the UP link ™ system for rapid detection of drugs of abuse in oral fluid. After research and development activities are completed, Dräger Safety has the option to become our exclusive distributor of this product in Europe and +certain other countries to law enforcement officials for rapidly assessing whether an operator or passenger in a motor vehicle is under the influence of one or more drugs of abuse (the “roadside market”) and ultimately to certain military, +criminal justice, and workplace testing markets. We received a non-refundable fee from Dräger Safety under the agreement and will receive additional fees upon achievement of certain technical milestones. +In September 2000, we signed a research and development +agreement with Meridian Bioscience, Inc. (formerly Meridian Diagnostics, Inc.) (“Meridian”), a medical diagnostics company. Under this agreement, we intended to develop a range of UP link ™ point-of-care tests for the rapid detection of parasites, and gastrointestinal and upper respiratory diseases. +Development of one test, for the respiratory syncytial virus (“RSV”), has been substantially completed and this product is currently undergoing field trials. However, due to development delays and certain other events, we have agreed in +principle with Meridian to terminate this agreement. Despite the expected termination of our agreement, we intend to complete development and pursue FDA 510(k) clearance and commercialization of the RSV test. In addition, we intend to seek other +potential parties to help fund the development of other infectious disease applications for UP link ™ that +we had previously intended to develop with Meridian. +We are participating in a $4.2 million, four-year grant for research and development of saliva/oral fluid-based diagnostic technologies, awarded by the National Institutes of Health (the “NIH”) to the University of +Pennsylvania. The grant will cover basic research in the following three main areas: +• +New technologies for collecting bacterial/viral protein and nucleic acid samples from the human mouth; +6 +Table of Contents +• +The combination of the University of Pennsylvania’s microfluidic processing technology with our UPT ™ technology for sample preparation; and +• +The detection of viral or bacterial markers. +The research plan under the grant contemplates achieving these goals through the use of our UP link ™ rapid detection system. +Our portion of funding under the grant is expected to be made available over a four-year period, with approximately $400,000 available in +the first year and each year thereafter. Payments under the grant in the second, third and fourth years, will be subject to availability of funds from the NIH and satisfactory progress of the research and development project. +OraSure ® /Intercept ® Applications +Oral mucosal transudate contains many constituents found in blood and serum, although in lower concentrations. We believe the +OraSure ® and Intercept ® devices are a platform technology with a wide variety of potential applications, where laboratory testing is available. +For example, the OraSure ® device may be useful for the diagnosis of a variety +of infectious diseases or conditions in addition to HIV-1, such as viral hepatitis. +OraQuick ® Platform +We believe that OraQuick ® has significant potential as a point-of-care test platform for physicians’ offices, +hospitals, and other markets. Like the OraSure ® device, we believe that +OraQuick ® provides a platform technology that can be modified for detection of +a variety of infectious diseases in addition to HIV, such as viral hepatitis and other diseases. +We have received FDA premarket approval for the OraQuick ® test for detecting HIV-1 in finger-stick whole blood samples. We are developing additional applications and will likely seek FDA approval for OraQuick ® for use in testing oral fluid, venous whole blood and serum/plasma samples. +Research and Development +In 2002, our research and development activities focused on +the continued development of the UP link ™ analyzer, test cassette and collector, the development of the +UP link ™ drugs of abuse and RSV assays, DNA feasibility studies, clinical trials for the +OraQuick ® rapid HIV-1 antibody test, and improvements to certain of our +existing products. +We supplement our own +research and development activities by funding external research. We have funded research at Leiden University and certain other entities, and intend to continue funding external research. +Research and development expenses totaled approximately $8.3 million in 2002, $9.4 million in 2001, and $10.4 +million in 2000. +Sales and Marketing +Our strategy is to reach our major target markets through a +combination of direct sales, strategic partnerships, and independent distributors. Our marketing strategy is to raise awareness of our products through a mix of trade shows, print advertising, and distributor promotions to support sales in each +target market. +We market our products in the +United States and internationally. Revenues attributable to customers in the United States amounted to $28.1 million, $27.3 million and $24.8 million in 2002, 2001 and 2000, respectively. Revenues attributable to international customers amounted to +$3.9 million, $5.3 million and $4.0 million, or 12%, 16% and 14% of our total revenues, in 2002, 2001 and 2000, respectively. +7 +Table of Contents +Insurance +Risk Assessment +We currently market the +OraSure ® oral fluid collection device for use in screening life insurance +applicants in the United States and internationally to test for three of the most important underwriting risk factors: HIV-1, cocaine, and cotinine (a metabolite of nicotine). Devices are sold to insurance testing laboratories, including +Lab One , Heritage Labs and Clinical Reference Laboratories. These laboratories in turn provide the devices to insurance companies, usually in combination with testing services. +We also maintain a direct sales force that promotes use of the OraSure ® device directly to insurance companies. Insurance companies then make their own decision regarding which +laboratory to use to supply their collection devices and testing services. Our OraSure ® Western Blot confirmatory test is distributed through BMX to laboratories and is used to confirm oral fluid specimens that initially test positive for HIV-1. +Because insurance companies are in various stages of their adoption of the OraSure ® device, there exists a wide range of policy limits where the product is being applied. +Some insurance companies have chosen to extend their testing to lower policy limits where they did not test at all before, while others have used OraSure ® to replace some of their blood and urine-based testing. In general, most of our insurance company customers use the +OraSure ® device in connection with life insurance policies having face amounts +of up to $250,000, with some customers using the device for policies of up to $500,000 in amount. +Our sales force continues to encourage additional insurance companies to use OraSure ® and to extend the use of the product by existing customers. A small number of companies have expanded use of +OraSure ® to the $1 million and higher dollar policy amounts. This expansion is +attributable to several factors, including increasing acceptance of the reliability of oral fluid testing, the high quality of test results, the low cost of oral fluid testing relative to blood tests, and the ease of use of the OraSure ® device. +We also sell our AUTO-LYTE ® and MICRO-PLATE assays and reagents in the insurance testing market directly to laboratories, including Lab One , +Heritage Labs, Clinical Reference Laboratory, and the laboratory testing division of the Metropolitan Life Insurance Company. AUTO-LYTE ® assays are used principally to test urine samples for cotinine and other metabolites and to perform urine chemistries for +risk assessment purposes. MICRO-PLATE assays are used principally to test oral fluid specimens collected with the OraSure ® device for cocaine and cotinine. +Infectious Disease Testing +Our sales personnel market the OraSure ® oral fluid collection device, separately and as a kit in combination with laboratory testing services (as described below), and the OraQuick ® rapid HIV-1 antibody test directly to customers in the public health market for HIV-1 testing. This market consists of a +broad range of clinics and laboratories and includes states, counties, and other governmental agencies, colleges and universities, correctional facilities and the military. There are also a number of organizations in the public health market such as +AIDS service organizations and various community-based organizations set up primarily for the purpose of encouraging and enabling HIV-1 testing. +To better serve our public health customers, we have entered into agreements with Lab One and Heritage Labs to provide prepackaged +OraSure ® test kits, with prepaid laboratory testing and specimen shipping costs +included. We also sell the OraSure ® and OraQuick ® devices in the international public health markets. +In June 2002, we entered into an agreement under which Abbott +Laboratories was appointed as the co-exclusive distributor of the OraQuick ® +rapid HIV-1 antibody test in the United States. We expect Abbott ultimately to focus primarily on the hospital and physician office market, while we intend to primarily target our direct sales to the public health and criminal justice markets, the +military, the CDC and other agencies. +8 +Table of Contents +Substance +Abuse Testing +Our substance abuse products +are marketed into the workplace testing, forensic toxicology, criminal justice, and drug rehabilitation markets, through direct sales and distributors. The forensic toxicology market consists of 250 – 300 laboratories including federal, state +and county crime laboratories, medical examiner laboratories, and reference laboratories. The criminal justice market consists of a wide variety of entities in the criminal justice system that require drug screening, such as pre-trial services, +parole and probation officials, police forces, drug courts, prisons, drug treatment programs and community/family service programs. +We have entered into agreements for the distribution of Intercept ® collection kits and associated reagents for drugs-of-abuse testing in the workplace testing market in the United States +and Canada through several laboratory distributors, including Lab One , Quest Diagnostics, Clinical Reference Laboratory and NWT, Inc., and internationally for workplace and forensic toxicology testing through Bio-Rad Laboratories, Altrix +HealthCare, plc, and other distributors. We assist our laboratory customers in customizing their testing services by selling them equipment required to test oral fluid specimens collected with the Intercept ® device. +We also distribute our Q.E.D. ® saliva alcohol test primarily through various distributors. The markets for alcohol testing are relatively small and +fragmented with a broad range of legal and procedural barriers to entry. Markets range from law enforcement testing to workplace testing of employees in safety sensitive occupations. The Q.E.D. ® test has been successfully adopted by end users in the petroleum, heavy construction, trucking, and retail industries +because it is a cost-effective, portable, easy-to-administer, quantitative testing method. Typical usage situations include pre-employment, random, post-accident, reasonable-cause, and return-to-duty testing. +Physicians’ Offices +We sell the Histofreezer ® product line to distributors that market to more than 150,000 primary care physicians and podiatrists in the +United States. Major U.S. distributors include Cardinal Healthcare, McKesson HBOC, Physicians Sales & Service, AmerisourceBergen Corporation, and Henry Schein. Internationally, we market Histofreezer ® in a number of countries through a network of distributors. We are presently exploring ways to further penetrate the +physicians’ office market and we are considering expanding into potential new markets for Histofreezer ® . +International Markets +We +sell a number of our products into international markets primarily through distributors with knowledge of their local markets. Principal markets include physicians’ offices, insurance risk assessment, public health, and laboratory testing. +We assist our international distributors in +registering the products and obtaining required regulatory approvals in each country, and we provide training and support materials. Our international marketing program includes direct assistance to distributors in arranging for laboratory services, +cooperation from screening test manufacturers, and performance of Western Blot confirmatory tests when necessary. +Significant Products and Customers +Several different products have contributed significantly to our financial performance, accounting for 15% or more of total revenues +during the past three years. The OraSure ® and Intercept ® oral fluid collection devices, Histofreezer ® product, and immunoassay tests and reagents accounted for total revenues of approximately $14.3 million, $7.2 million and +$7.6 million in 2002, $13.0 million, $6.7 million and $7.4 million in 2001, and $11.2 million, $6.8 million and $6.7 million in 2000, respectively. As new products are developed and commercialized, we expect to reduce our dependence on these +products. +We currently have one customer, +Lab One , that accounted for 26% of our total revenues during 2002. +9 +Table of Contents +In August +2001, Lab One acquired Osborne Group, Inc., our second largest laboratory customer in the insurance risk assessment market. As a result of this acquisition and other operating improvements, Lab One has achieved certain efficiencies and +reduced its overall inventory levels, which in turn lowered their purchases of our insurance testing assays during 2002. We believe this is an indication that the market for our insurance testing assays will continue to come under pressure as +Lab One and our other laboratory customers are expected to try to reduce their costs by improving their efficiencies or possibly using competing products. There can be no assurance that sales to Lab One will not decrease further or that +this customer will not choose to replace our assays or other products with internally-developed products or products manufactured by our competitors. The loss of Lab One or a significant decrease in the volume of products purchased by it would +have a material adverse effect on our results of operations. +Supply and Manufacturing +We have entered into an agreement with a contractor in the United States for the assembly and supply of our OraSure ® and Intercept ® oral fluid collection devices. This agreement has a current term through December 31, 2003 and automatically renews for +additional annual periods, unless either party provides timely notice of termination prior to the end of an annual period. A change in the manufacturer of the OraSure ® device would require FDA review and approval, which could require significant time to complete and disrupt our ability to +manufacture this product. Subject to receipt of the applicable FDA approval, we intend to terminate the agreement with this contractor and transfer manufacturing of both the OraSure ® and Intercept ® collection devices to our Bethlehem, Pennsylvania facility beginning later in 2003. +We manufacture the OraQuick ® test in our Bethlehem, Pennsylvania facilities. In addition, we have entered into a supply agreement for the +assembly of the OraQuick ® device in Thailand, in order to supply certain +international markets. This agreement has an initial term of one year, and will automatically renew for additional annual periods unless either party provides a timely notice of termination prior to the end of an annual period. We believe that other +firms would be able to manufacture the OraQuick ® test on terms no less +favorable than those set forth in the agreement if the Thailand contractor would be unable or unwilling to continue manufacturing this product. +We can purchase the HIV antigen and the nitrocellulose strips required for the OraQuick ® test only from a limited number of sources. The antigen is currently purchased from a single contract supplier under a +long-term agreement with an initial term ending in January 2010 and one-year automatic renewal terms thereafter. The nitrocellulose used in the test is also provided by a single contract supplier, and we are presently negotiating a long-term supply +agreement with this party. If for any reason these suppliers are no longer able to supply our antigen or nitrocellulose needs, we believe that alternative supplies could be obtained at a competitive cost. However, a change in the antigen or +nitrocellulose would require FDA approval and some additional development work, which would require significant time to complete and could disrupt our ability to manufacture and sell the OraQuick ® device. +The oral fluid Western Blot HIV-1 confirmatory test is manufactured in our Beaverton, Oregon facility. Subject to receipt of FDA approval, +we expect to transfer the manufacturing of this product to our Bethlehem, Pennsylvania facility. The HIV antigen needed to manufacture the Western Blot test is available from only a limited number of sources. For many years, we have purchased the +antigen for this product from BMX on an exclusive basis. BMX is also the exclusive distributor of the Western Blot test kits. +In October 2002, we entered into new agreements with BMX, which replaced existing agreements between the companies. These new agreements +provide for the continued supply by BMX of the HIV-1 antigen and distribution of the oral fluid Western Blot product by BMX on an exclusive worldwide basis. If for any reason BMX is no longer able to supply our antigen needs, we would be able to +obtain alternate supplies at a competitive cost. However, a change in the antigen would require FDA approval and some additional development work, which would require significant time to complete and could disrupt our ability to manufacture and sell +the Western Blot HIV-1 confirmatory test. +10 +Table of Contents +We expect to +assemble analyzers, test cassettes and collectors used in our UP link ™ drugs of abuse rapid detection system and to package this product for shipment at our Bethlehem, Pennsylvania facilities. +Histofreezer ® is manufactured in The Netherlands by Koninklijke, Utermöhlen, N.V. (“Utermöhlen”), the company from which we acquired the product in 1998. We purchase the product pursuant to an +exclusive production agreement. This agreement provides that Utermöhlen will be the exclusive supplier of the Histofreezer ® product until at least December 31, 2006. We believe that additional manufacturers of the Histofreezer ® product are available on terms no less favorable than the terms of the production agreement with Utermöhlen, in the +event that Utermöhlen would be unable or unwilling to continue manufacturing the Histofreezer ® product. +Our +AUTO-LYTE ® and MICRO-PLATE assays are manufactured in our Bethlehem, +Pennsylvania facility. These tests require the production of highly specific and sensitive antibodies corresponding to the antigen of interest. Substantially all our antibody requirements are provided by contract suppliers. We believe that we have +adequate reserves of antibody supplies and that we have access to sufficient raw materials for these products. +The Q.E.D. ® saliva alcohol test is manufactured and packaged for shipment in our Bethlehem, Pennsylvania facility. +Employees +As of December 31, 2002, we had 187 full-time employees, including 38 in sales, marketing, and client services; 44 in research and +development; 87 in operations, manufacturing, quality control, purchasing and shipping; and 18 in administration and finance. Seventeen of our employees hold Ph.D. degrees. This compares to 225 employees as of December 31, 2001. Our employees are +not currently represented by a collective bargaining agreement. +During 2002, we implemented a 17% headcount reduction primarily as a result of lower than anticipated sales levels during 2001 and the elimination of certain development projects. We intend to close our Oregon facilities and move +these operations to Bethlehem, Pennsylvania beginning later in 2003. +Competition +The +diagnostic industry is a multi-billion dollar international industry and is intensely competitive. Many of our competitors are substantially larger and have greater financial, research, manufacturing, and marketing resources. +Important competitive factors for our products include product +quality, price, ease of use, customer service, and reputation. Industry competition is based on the following: +• +Scientific and technological capability; +• +Proprietary know-how; +• +Access to adequate capital; +• +The ability to develop and market products and processes; +• +The ability to attract and retain qualified personnel; and +• +The availability of patent protection. +A few large corporations produce a wide variety of diagnostic tests and other medical devices and equipment. A larger number of mid-size +companies generally compete only in the diagnostic industry, and a significant number of small companies produce only a few diagnostic products. As a result, the diagnostic test industry is highly fragmented and segmented. +11 +Table of Contents +The future +market for diagnostic tests is expected to be characterized by consolidation, greater cost consciousness, and tighter reimbursement policies. The purchasers of diagnostic products are expected to place increased emphasis on lowering costs, reducing +inventory levels, automation, service, and volume discounts. The increased complexity of the market is expected to force many competitors to enter into joint ventures or license certain products or technologies. +We expect competition to intensify as technological advances +are made and become more widely known, and as new products reach the market. Furthermore, new testing methodologies could be developed in the future that render our products impractical, uneconomical or obsolete. There can be no assurance that our +competitors will not succeed in developing or marketing technologies and products that are more effective than those we develop or that would render our technologies and products obsolete or otherwise commercially unattractive. In addition, there +can be no assurance that our competitors will not succeed in obtaining regulatory approval for these products, or introduce or commercialize them before we can do so. These developments could have a material adverse effect on our business, financial +condition and results of operations. +Several +companies market or have announced plans to market oral specimen collection devices and tests outside the United States. We expect the number of devices competing with our Intercept ® and OraSure ® devices to increase as the benefits of oral specimen-based testing become more widely accepted. +Competition in the market for HIV testing is intense and is +expected to increase. We believe that the principal competition will come from existing laboratory-based blood tests, point-of-care whole blood rapid tests, laboratory-based urine assays, or other oral fluid-based tests that may be developed. Our +competitors include specialized biotechnology firms as well as pharmaceutical companies with biotechnology divisions and medical diagnostic companies. +Significant competitors for our OraQuick ® rapid HIV-1 antibody test, such as the Ortho Diagnostics division of Johnson & Johnson and Bio-Rad Laboratories, sell +laboratory-based HIV-1 EIAs, and Calypte, Inc. sells an HIV-1 screening test for urine, in the United States. In addition, Abbott Laboratories currently sells a competing rapid HIV test in the United States. We believe several other companies may +seek FDA approval to sell competing rapid HIV tests in the United States. +In the insurance risk assessment market, our AUTO-LYTE ® homogeneous assays for cocaine and cotinine compete with reagents from Microgenics, Inc. (a subsidiary of Apogent Technologies). Our AUTO-LYTE ® homogeneous assays for beta-blockers and thiazide as well as MICRO-PLATE heterogeneous assays specifically designed for +the detection of cocaine, cotinine, and IgG in oral fluid are the only assays available in the marketplace. However, we expect to face increasing competition from assays developed internally by our laboratory customers, which could be produced at a +cost lower than the price typically paid for our products. In urine chemistries, our significant competitors include The Diagnostics Systems Group of Olympus America Inc. and DRI. +Our MICRO-PLATE drugs-of-abuse reagents are targeted to forensic testing laboratories where sensitivity, +automation, and “system solutions” are important. In the past, these laboratories have typically had to rely on radioimmunoassay test methods to provide an adequate level of sensitivity. Radioimmunoassays require radioactive materials, +which have a short shelf-life and disposal problems. Our MICRO-PLATE tests meet the laboratories’ sensitivity needs, run on automated equipment, are not radioimmunoassays, and are offered to the laboratory as a complete system solution of +reagents, instrumentation and software to meet the specific needs of each customer. Options to buy or rent the instrumentation and software, which we purchase from third party vendors, are offered to these customers. +In the forensic toxicology market, we compete with both +homogeneous and heterogeneous tests manufactured by many companies. Significant competitors in the market for these assays include Microgenics, Inc., Roche Diagnostics, and Immunalysis. +12 +Table of Contents +The +Intercept ® drug testing system competes with laboratory-based drug testing +products and services using testing matrices such as urine, hair, sweat and oral fluid. Major competitors include Ansys Technologies, Inc., Dade Behring, Psychemedics, and Immunalysis. +Our UP link ™ product also is expected to compete with other on-site, rapid drug assays and instrument-read tests. Major competitors in this area +include American Biomedica, Roche Diagnostics, Biosite Diagnostics, Avitar, Inc., Ansys Technologies, Inc., and eScreen. Another potential competitor, LifePoint, Inc., has announced plans to sell a reader-based saliva test panel that will include +alcohol testing. +Q.E.D. ® has two direct competitors, Roche Diagnostics and Chematics. These companies offer +semi-quantitative saliva-based alcohol tests and have received DOT approval. Indirect competitors who offer breath testing equipment include Intoximeters, Dräger Safety, and CMI. Although there are lower priced tests on the market that use oral +fluid or breath as a test medium, these tests are qualitative tests that are believed to be substantially lower in quality and scope of benefits than our Q.E.D. ® test. +The Histofreezer ® product’s delivery system and warmer operating temperature than liquid nitrogen provide us with the opportunity to target sales to primary care physicians, such as family practitioners, +pediatricians, and podiatrists. We do not generally target sales to dermatologists because they have the volume of patients required to support the capital costs associated with a liquid nitrogen delivery system, which is also used to remove warts +and other benign skin lesions. There is limited competition for convenient cryosurgical products for wart removal in the primary care physician market. Major competitors for the Histofreezer ® product include CryoSurgery, Inc. in the United States and Wartner in Europe. +Patents and Proprietary Information +We seek patent and other intellectual property rights to +protect and preserve our proprietary technology and our right to capitalize on the results of our research and development activities. We also rely on trade secrets, know-how, continuing technological innovations, and licensing opportunities to +provide competitive advantages for our products in our markets and to accelerate new product introductions. We regularly search for third-party patents in fields related to our business to shape our own patent and product commercialization +strategies as effectively as possible and to identify licensing opportunities. United States patents generally have a maximum term of 20 years from the date an application is filed. +We have sixteen United States patents and numerous foreign patents for the OraSure ® and Intercept ® collection devices and related technology relating to oral fluid collection, containers for oral fluids, methods to test +oral fluid, formulations for the manufacture of synthetic oral fluid, and methods to control the volume of oral fluid collected and dispersed. We have also applied for additional patents, in both the United States and certain foreign countries, on +such products and technology. +We have one patent +and certain pending patent applications for the OraQuick ® rapid HIV antibody +test in the United States. We also intend to apply for additional patents for this product. We have obtained licenses to certain lateral flow patents and to certain HIV-1 patents held by other parties in order to market the OraQuick ® test. We obtained these licenses through the payment of certain upfront fees and ongoing +royalties. We believe these royalties are comparable to rates generally paid by other companies under similar arrangements. +We may also need to obtain licenses or other rights under, or enter into distribution or other business arrangements in connection with, +certain patents for the Human Immunodeficiency Virus Type 2 (“HIV-2”) and certain other lateral flow patents, in order to manufacture and sell the OraQuick ® HIV test. See the Section entitled, “Risk Factors,” for a further discussion of these issues. +In April 1995, we received exclusive worldwide rights under +patents and know-how owned by SRI International to develop and market products that involve the use of UPT ™ . We +also received non-exclusive worldwide rights under patents and know-how owned by the Sarnoff Corporation (a subsidiary of SRI +13 +Table of Contents +International formerly called the David Sarnoff Research Center) to develop and market products that involve the use of UPT ™ . We have the right to sublicense these rights, subject to consent from SRI and Sarnoff. +Under the agreement with SRI, we are required to make license, +maintenance and royalty payments to SRI. We must also make royalty payments for a period equal to the longer of ten years from the date of the first commercial sale of the products or the term during which the manufacture, use, or sale of a product +would infringe licensed patents, but for our license with SRI. We believe that the royalty rates payable to SRI are comparable to the rates generally payable by other companies under similar arrangements. Our agreement with SRI terminates upon the +expiration of our obligation to pay royalties. +In 1999, we paid $1.5 million to TPM Europe Holding B.V., our sublicensor, for the termination of an existing license agreement between the sublicensor and the Company with respect to the sublicense of UPT ™ patents owned by Leiden University, The Netherlands, and to secure a direct research, development, and license arrangement with Leiden +University. +We have or have licensed rights +under nine U.S. patents and numerous foreign patents for methods, compositions, and apparatuses relating to phosphor technologies. Several additional UPT ™ patent applications remain pending in the United States and abroad. We expect to continue to expand our UPT ™ patent portfolio in 2003. Several new patents were granted during 2002 in the U.S. for the design of the UP link ™ rapid detection platform. +We have one U.S. patent relating to the method for detecting blood in urine specimens using our AUTO-LYTE ® products. +We have five U.S. patents and numerous foreign patents issued for apparatuses and methods for the topical +removal of skin lesions relating to our Histofreezer ® product. We have also +licensed another patent relating to apparatuses and methods for the topical removal of skin lesions relating to our Histofreezer ® product. +We have four U.S. patents and numerous foreign patents and patent applications for the technology used in the Q.E.D. ® test. These patents are related to the analog-to-digital technology color control systems +and methods, systems and devices for the test, and detection of biochemical molecules. +We require our employees, consultants, outside collaborators, and other advisors to execute confidentiality agreements upon the commencement of employment or consulting relationships with us. These +agreements provide that all confidential information developed by or made known to the individual during the course of the individual’s relationship with us, is to be kept confidential and not disclosed to third parties except in specific +circumstances. In the case of employees, the agreements provide that all inventions conceived by the individual during his or her tenure with us will be our exclusive property. +We own rights to trademarks and service marks that we believe are necessary to conduct our business as +currently operated. In the United States, we own the UPT ™ , +UP link ™ , OraSure ® , Intercept ® , OraQuick ® , Histofreezer ® , Q.E.D. ® , and AUTO-LYTE ® trademarks. We also own many of these marks and others in several foreign countries. +Although important, the issuance of a patent or existence of +trademark or trade secret protection does not in itself ensure the success of our business. Competitors may be able to produce products competing with our patented products without infringing our patent rights. Issuance of a patent in one country +generally does not prevent manufacture or sale of the patented product in other countries. The issuance of a patent is not conclusive as to validity or as to the enforceable scope of the patent. The validity or enforceability of a patent can be +challenged by litigation after its issuance. If the outcome of such litigation is adverse to the owner of the patent, the owner’s rights could be diminished or withdrawn. Trade secret protection does not prevent independent discovery and +exploitation of the secret product or technique. +14 +Table of Contents +We are not +aware of any pending claims of infringement or other challenges to our patents or our rights to use our trademarks or trade secrets in the United States or in other countries. +Government Regulation +General +Most of our products are regulated by the FDA, certain state and local agencies, and comparable regulatory bodies in other countries. This +regulation governs almost all aspects of development, production, and marketing, including product testing, authorizations to market, labeling, promotion, manufacturing, and recordkeeping. +All of our FDA-regulated products require some form of action by the FDA before they can be marketed in the +United States. After approval or clearance by the FDA, we must continue to comply with other FDA requirements applicable to marketed products. Both before and after approval or clearance, failure to comply with the FDA’s requirements can lead +to significant penalties and product recalls or could disrupt our ability to sell these products. In addition, the FDA could refuse permission to obtain certificates needed to export our products if the agency determines that we are not in +compliance. +Domestic Regulation +Most of our diagnostic products are +regulated as medical devices. Our Serum Western Blot HIV-1 confirmatory test, which was discontinued in February 2001, was regulated as a biologic or blood product. +There are two review procedures by which medical devices can receive FDA clearance or approval. Some products +may qualify for clearance under Section 510(k) of the Federal Food, Drug and Cosmetic Act. To obtain this clearance, the manufacturer must provide a premarket notification that it intends to begin marketing the product, and show that the product is +substantially equivalent to another legally marketed product (i.e., that it has the same intended use and is as safe and effective as a legally marketed device and does not raise different questions of safety and effectiveness). In some cases, the +submission must include data from human clinical studies. Marketing may commence when the FDA issues a clearance letter finding substantial equivalence. An applicant must submit a 510(k) application at least 90 days before marketing of the affected +product commences. Although FDA clearance may be granted within that 90-day period, in some cases as much as a year or more may be required before clearance is obtained, if at all. +If the medical device does not qualify for the 510(k) procedure (either because it is not substantially +equivalent to a legally marketed device or because it is required by statute and the FDA’s regulations to have an approved application), the FDA must approve a premarket approval application (“PMA”) before marketing can begin. PMAs +must demonstrate, among other matters, that the medical device provides a reasonable assurance of safety and effectiveness. A PMA is typically a complex submission, including the results of preclinical and clinical studies. Preparing a PMA is a +detailed and time-consuming process. Once a PMA has been submitted, the FDA is required to review the submission within 180 days. However, the FDA’s review may, and often is, much longer, often requiring one year or more, and may include +requests for additional data. The OraQuick ® rapid HIV-1 antibody test received +PMA approval in November 2002. +In 2002, Congress +enacted the Medical Device User Fee and Modernization Act, which authorizes the FDA to assess and collect user fees for premarket notifications and premarket approval applications filed on or after October 1, 2002. Fees for fiscal year 2003 range +from $2,187 for premarket notifications to $154,000 for premarket approval applications, although fee reductions are available for companies qualifying as small businesses. We do not currently qualify as a small business. +Biologic products must be the subject of an approved biologics +license application before they can be marketed. The FDA approval process for a biologic product is similar to the PMA approval process, involving a demonstration of the product’s safety and effectiveness based in part on both preclinical and +clinical studies. We currently do not manufacture or sell any biologic products. +15 +Table of Contents +Many of our +insurance testing products are used for non-medical purposes and many of our drugs-of-abuse products sold to state crime labs are for forensic use. The FDA does not currently regulate products used for these purposes. +Every company that manufactures medical devices distributed in +the United States must comply with the FDA’s Quality System Regulations (“QSRs”). These regulations govern the manufacturing process, including design, manufacture, testing, release, packaging, distribution, documentation and +purchasing. In complying with QSRs, manufacturers must continue to expend time, money, and effort in the area of production and quality control to ensure full technical compliance. Companies are also subject to other post-market and general +requirements, including restrictions imposed on marketed products, promotional standards, and requirements for recordkeeping and reporting of certain adverse reactions. If there are any modifications made to our marketed devices, a premarket +notification or premarket approval application may be required to be submitted to, and cleared or approved by, the FDA, before the modified device may be marketed. The FDA regularly inspects companies to determine compliance with QSRs and other +post-market requirements. Failure to comply with statutory requirements and the FDA’s regulations can result in warning letters, monetary penalties, suspension or withdrawal of regulatory approvals, operating restrictions, total or partial +suspension of production, injunctions, product recalls, seizure of products, and criminal prosecution. +Products that include electrical or light emitting equipment must also comply with the FDA’s safety and performance standards +applicable to such equipment. Our UP link ™ analyzer is a piece of electrical equipment that uses a laser +to read the test results and is, therefore, subject to these requirements. In addition, there is an industry safety and performance standard for electrical equipment established by Underwriters Laboratories, Inc., known as UL3101-1. Although a +voluntary standard, compliance with UL3101-1 supported our 510(k) submission for the UP link ™ analyzer. +Underwriters Laboratories Inc. was retained to examine and test the UP link ™ analyzer and has certified +that this product meets the FDA requirements and UL3101-1. +The Clinical Laboratory Improvements Amendments of 1988, or CLIA, prohibit laboratories from performing in vitro tests for the purpose of providing information for the diagnosis, prevention or treatment of any disease or +impairment of, or the assessment of, the health of human beings unless there is in effect for such laboratories a certificate issued by the U.S. Department of Health and Human Services applicable to the category of examination or procedure +performed. We consider the applicability of the requirements of CLIA in the design and development of our products. We have obtained a waiver of the CLIA requirements for our OraQuick ® rapid HIV-1 antibody test and Q.E.D. ® alcohol saliva test and may seek similar waivers for certain other products. A CLIA waiver allows certain customers to use +the waived products that may not have been able to use them without complying with certain quality control and other requirements. +Certain of our products may also be affected by state regulations in the United States. For example, there are several states that +restrict or do not currently permit oral fluid drug testing in the workplace or other markets. In addition, several states prohibit or limit the use of rapid, point-of-care HIV testing. We are presently working with legislators or regulators in +certain of these states in an effort to modify or remove any restrictions affecting our ability to sell products. +International +We are also subject to regulations in foreign countries governing products, human clinical trials and marketing, and may need to obtain +approval from international public health agencies, such as the World Health Organization, in order to sell products in certain countries. Approval processes vary from country to country, and the length of time required for approval or to obtain +other clearances may in some cases be longer than that required for U.S. governmental approvals. We generally pursue approval only in those countries that we believe have a significant market opportunity. +The International Organization for Standardization +(“ISO”) is a worldwide federation of national standards bodies from some 130 countries, established in 1947. The mission of ISO is to promote the development of standardization and related activities in the world with a view to +facilitating the international exchange of goods +16 +Table of Contents +and services. ISO certification is evidenced by the CE mark and indicates that our quality system complies with standards applicable to +activities ranging from initial product design and development through production and distribution. In addition, we must comply with the essential requirements of the In Vitro Diagnostic Directive in order to receive authorization to affix a CE mark +to our products. A CE mark will be required for distribution of medical devices in the European common markets beginning in December 2003. +In the first quarter of 1999, we received authorization to use the CE mark for the OraSure ® and Intercept ® collection devices based on meeting ISO standards at our Beaverton facility. In December 2000, our Bethlehem facility +received final certification for the European Medical Device Directive (93/42/EEC), ISO 9001, ISO 13485, and EN 46001. We have also received authorization to use the CE mark for our Histofreezer ® product line. +Prior to international sale of a product containing electrical and light-emitting equipment, the safety and performance of such a product +must be demonstrated. We retained Underwriters Laboratories, Inc. and Laird Technologies to examine and test the UP link ™ analyzer, and they certified that this product meets the following international standards and directives: IEC 60825-1, IEC/EN 61010-1, CAN/CSA 22.2 No. 1010.1-92, IEC 1010-1, EN 61000 (in part), and EN 55022, EMC Directive +89/336/EEC. +We must also submit evidence of +marketing approval or clearance by the FDA to Health Canada’s Therapeutic Products Programme, and we must comply with certain registration requirements, prior to commencing sales in Canada. We have completed this process for several of our +current products that require FDA review and may do so with respect to other products in the future. +Environmental Regulation +Because of the nature of our current and proposed research, development, and manufacturing processes, we are subject to stringent federal, +state and local laws, rules, regulations and policies governing the use, generation, manufacture, storage, air emission, effluent discharge and handling and disposal of materials and wastes. We believe that we have complied with these laws and +regulations in all material respects. We have not been required to take any action to correct any environmental noncompliance. +Forward-Looking Statements +This Report contains certain “forward-looking statements,” within the meaning of the Federal securities laws. These may include +statements about our expected revenues, earnings, expenses or other financial performance, future product performance or development, expected regulatory filings and approvals, planned business transactions, views of future industry, competitive or +market conditions, and other factors that could affect our future operations, results of operations or financial position. These statements often include the words “believes,” “expects,” “anticipates,” +“intends,” “plans,” “estimates,” “may,” “will,” “should,” “could,” or similar expressions. +Forward-looking statements are not guarantees of future performance or results. Known and unknown factors +could cause actual performance or results to be materially different from those expressed or implied in these statements. Some of these factors are: ability to market products; impact of competitors, competing products and technology changes; +ability to develop, commercialize and market new products; market acceptance of oral fluid testing products and up-converting phosphor technology products; ability to fund research and development and other projects and operations; ability to +maintain new or existing product distribution channels; reliance on sole supply sources for critical product components; availability of related products produced by third parties; ability to obtain and timing of obtaining necessary regulatory +approvals; ability to comply with applicable regulatory requirements; history of losses and ability to achieve sustained profitability; volatility of our stock price; uncertainty relating to patent protection and potential patent infringement +claims; availability of licenses to patents or other technology; ability to enter into international manufacturing agreements; obstacles to +17 +Table of Contents +international marketing and manufacturing of products; ability to sell products internationally; loss or impairment of sources of capital; +ability to meet financial covenants in agreements with financial institutions; ability to retain qualified personnel; exposure to product liability and other types of litigation; changes in international, federal or state laws and regulations; +changes in relationships with strategic partners and reliance on strategic partners for the performance of critical activities under collaborative arrangements; changes in accounting practices or interpretation of accounting requirements; customer +consolidations and inventory practices; equipment failures and ability to obtain needed raw materials and components; the impact of terrorist attacks and civil unrest; ability to complete consolidation or restructuring activities; ability to +identify, complete and realize the full benefits of potential acquisitions; and general political, business and economic conditions. These and other factors that could cause the forward-looking statements to be materially different are described in +greater detail in the Section entitled, “Risk Factors,” and elsewhere in this Report. +Although forward-looking statements help to provide complete information about future prospects, they may not be reliable. The forward-looking statements are made as of the date of this Report and we +undertake no duty to update these statements. +Risk Factors +The following is a discussion of certain +significant risk factors that could potentially negatively impact our financial condition, performance and prospects. +We Face Intense Competition From New and Existing Diagnostic Products. +The diagnostic industry is focused on the testing of +biological specimens in a laboratory or at the point-of-care and is highly competitive and rapidly changing. Our principal competitors often have considerably greater financial, technical and marketing resources. As new products enter the market, +our products may become obsolete or a competitor’s products may be more effective or more effectively marketed and sold than ours. If we fail to maintain and enhance our competitive position, our customers may decide to use products developed +by competitors which could result in a loss of revenues. +Our Research and Development Efforts May Not Succeed or Our Competitors May Develop More Effective or Successful Diagnostic Products. +In order to remain competitive, we must commit substantial resources each year to research and development. The research and development +process generally takes a significant amount of time from inception to commercial product launch. This process is conducted in various stages. During each stage there is a substantial risk that we will not achieve our goals on a timely basis, if at +all, and we may have to abandon a product in which we have invested substantial amounts. +During 2002, 2001 and 2000, we incurred $8.3 million, $9.4 million and $10.4 million, respectively, in research and development expenses. We expect to continue to incur significant costs from our +research and development activities. A primary focus of our efforts has been, and is expected to continue to be, the development of our UPT ™ technology and the related UP link ™ rapid detection +system. However, there can be no assurance that we will succeed in our research and development efforts with respect to UPT ™ , UP link ™ or other technologies or products. If we fail to develop commercially +successful products, or if competitors develop more effective products or a greater number of successful new products, customers may decide to use products developed by our competitors. This would result in a loss of revenues and adversely affect +our results of operations, cash flows and business. +If Acceptance and Adoption of Our Oral Fluid Testing in the Market Does Not Continue, Our Future Results May Suffer. +We have made significant progress in gaining acceptance of oral fluid testing for HIV in the insurance and public health markets. We have +also made significant progress in gaining acceptance of oral fluid testing for +18 +Table of Contents +drugs of abuse in the workplace and criminal justice testing markets. Other markets, particularly the physicians’ office market, may +resist the adoption of oral fluid testing as a replacement for other testing methods in use today. In addition, certain state laws prohibit or restrict the use of oral fluid testing for drugs of abuse in certain markets. There can be no assurance +that we will be able to expand the use of our oral fluid testing products in these or other markets. +Our Failure to Maintain Existing Distribution Channels, or Develop New Distribution Channels, May Result in Lower Revenues. +We have marketed many of our products by +collaborating with laboratories, diagnostic companies and distributors. For example, our OraSure ® oral fluid collection device is distributed to the insurance industry through major insurance testing laboratories. Our sales depend to a substantial degree on our ability to sell products to these customers and develop new +product distribution channels, and on the marketing abilities of the companies with which we collaborate. +Some of our distributors have recently consolidated, and such consolidation has had, and may continue to have, an adverse impact on the +level of orders for our products. One of these laboratories, Lab One , acquired another large insurance laboratory customer, Osborne Group, in 2001. These customers together accounted for approximately 26%, 29% and 30% of our revenues for the +years 2002, 2001, and 2000, respectively. As a result of efficiencies gained following this acquisition, Lab One purchased approximately $1 million less of our insurance assays in 2002 than both companies purchased in 2001. +In addition, some distributors have experienced, and may +continue to experience, pressure from their customers to reduce the price of their products and testing services. For example, Lab One and our other insurance testing laboratories are facing this pressure and may consider using lower cost +insurance testing assays that they develop internally or purchase from our competitors. This has reduced our sales of insurance assays and is expected to lower sales of these products in 2003 and beyond. +Although we will try to maintain and expand our business with +our distributors, there can be no assurance that such companies will continue to purchase or distribute our products or maintain historic order volumes, or that new distribution channels will be available on satisfactory terms. +The Use of Sole Supply Sources For Critical Components of +Our Products Could Adversely Affect Our Business. +We currently purchase certain critical components of our products from sole supply sources. For example, all of the HIV-1 antigen used to make our oral fluid Western Blot HIV-1 confirmatory test is purchased from BMX, and all of the +HIV-1 antigen and nitrocellulose required to make our OraQuick ® rapid HIV-1 +antibody test are purchased from sole source suppliers. If these suppliers are unable or unwilling to supply the required component, we would need to find another source, and perform additional development work and obtain FDA approval for the use of +the alternative component for our products. Completing that development and obtaining such FDA approval could require significant time to complete and may not occur at all. These events could either disrupt our ability to manufacture and sell +certain of our products or completely prevent us from doing so. Either event would have a material adverse effect on our results of operations, cash flows and business. +The Unavailability of Certain Products Distributed by a Third Party Could Adversely Affect Sales of Our +OraSure ® Oral Fluid Collection Device. +In testing an oral fluid sample collected with an +OraSure ® device for HIV-1, our customers must use an HIV-1 screening test +approved by the FDA for use with our OraSure ® device. Where an oral fluid +sample screens positive for HIV-1, our customers must then use our oral fluid Western Blot confirmatory test, which has also been approved by the FDA for use with our OraSure ® device, to confirm that positive indication. +19 +Table of Contents +BMX +(bioMerieux, Inc.) manufactures and sells the only oral fluid HIV-1 screening test that has received FDA approval for use in detecting HIV-1 in an oral fluid specimen collected with our OraSure ® collection device. BMX has developed a new HIV-1 screening test, and has indicated that this new test will eventually +replace its existing FDA-approved HIV-1 screening test. We are working with BMX to obtain FDA approval for use of the new screening test with our OraSure ® device. BMX also supplies the HIV-1 antigen used to manufacture our oral fluid Western Blot HIV-1 confirmatory test and is +the exclusive world-wide distributor of that product. +If BMX ceases to manufacture or sell an HIV-1 screening test approved by the FDA for use with our OraSure ® collection device, or if our oral fluid Western Blot HIV-1 confirmatory test is not made available to our customers (because BMX either fails to supply the HIV-1 antigen required to make this product +or fails to distribute this product), we would need to find alternate suppliers for these products, which would require additional development work and FDA approval. These activities would likely require significant time to complete. If our +customers cannot obtain an HIV-1 screening test or Western Blot HIV-1 confirmatory test that have been approved by the FDA for use in connection with our OraSure ® collection device, these customers would likely stop purchasing our OraSure ® device. Sales of the OraSure ® device were approximately $12.7 million and $11.5 million, or 40% and 35% of our total revenues in 2002 and 2001, +respectively. +The Time Needed to Obtain +Regulatory Approvals and Respond to Changes in Regulatory Requirements Could Adversely Affect Our Business. +As described more fully above under the Section entitled, “Government Regulation,” many of our proposed and existing products +are subject to regulation by the FDA and other governmental or public health agencies. In particular, we are subject to strict governmental controls on the development, manufacture, labeling, distribution and marketing of our products. +The process of obtaining required approvals or clearances from +governmental or public health agencies varies according to the nature of, and uses for, the specific product and can involve lengthy and detailed laboratory testing, human clinical trials, sampling activities and other costly, time-consuming +procedures. For example, we will likely seek FDA approval for the use of the OraQuick ® rapid HIV antibody test on oral fluid, venous whole blood and serum/plasma samples. Approval of these claims will include the submission of clinical data and could require significant time to obtain. The submission of an application +to the FDA or other regulatory authority for these or other claims does not guarantee that an approval or clearance to market the product will be received. Each authority may impose its own requirements and delay or refuse to grant approval or +clearance, even though a product has been approved in another country. +Moreover, the approval or clearance process for a new product can be complex and lengthy. The time taken to obtain approval or clearance varies depending on the nature of the application and may result in the passage of a +significant period of time from the date of submission of the application. This time span increases our costs to develop new products and increases the risk that we will not succeed in introducing or selling them. +Newly promulgated or changed regulations could also require us +to undergo additional trials or procedures, or could make it impractical or impossible for us to market our products for certain uses, in certain markets, or at all. For example, the Substance Abuse and Mental Health Services Administration +(“SAMHSA”), which is part of the U.S. Department of Health and Human Services, is in the process of drafting regulations for the use of oral fluid drug testing for federal workers. Although we believe the SAMHSA regulations, when issued in +final form, will permit us to market and sell our oral fluid drug tests for use with federal workers, there is no guarantee that those regulations will do so, and our ability to sell those products in that market could be limited. Other changes in +government regulations, such as the adoption of the FDA’s Quality System Regulation, may also adversely affect our results of operations by requiring that we incur the expense of changing or implementing new manufacturing and control +procedures. +20 +Table of Contents +The +regulations in some states may restrict our ability to sell products in those states. For example, certain states restrict or do not allow the testing of oral fluid for drugs of abuse or the rapid, point-of-care testing for HIV. While we intend to +work with state legislators and regulators to remove or modify any applicable restrictions, there is no guarantee we will be successful in these efforts. +In addition, all in vitro diagnostic products that are to be sold in the European Union (“EU”) must bear the CE mark +indicating conformance with the essential requirements of the In Vitro Diagnostic Directive (“IVDD”). The deadline for meeting this requirement is December 7, 2003. We will not be permitted to sell our products in the EU without a CE mark +after this date, which could lead to the termination of strategic alliances and agreements for sales of those products in the EU. While we intend to CE mark certain existing and future products, and are not aware of any material reason why we will +be unable to do so, there can be no assurance that compliance with all provisions of the IVDD will be demonstrated and the CE mark obtained prior to the deadline. +At the present time, we have received FDA clearance or approval for the OraSure ® and Intercept ® oral fluid collection devices, the OraQuick ® rapid HIV-1 antibody test (for use with finger-stick whole blood samples), the UP link ™ drug testing system and opiates assay, the Histofreezer ® wart removal system, the Q.E.D. ® saliva alcohol test, the OraSure ® oral fluid Western Blot HIV-1 confirmatory test, and various other tests. The OraSure ® and Intercept ® collection devices (collection pad only) and Histofreezer ® product currently bear the CE mark. See the Sections entitled, “Products” and “Government Regulation,” +for a further discussion of regulatory approvals and clearances obtained for our products. +Failure to Comply With FDA or Other Requirements May Require Us to Suspend Production of Our Products Which Could Result in a Loss of Revenues. +We can manufacture and sell many of our products, both in the +United States and in some cases abroad, only if we comply with regulations of government agencies such as the FDA. We have implemented quality assurance and other systems that are intended to comply with applicable regulations. +During 2000, the FDA issued warning letters with respect to +our Serum Western Blot product, stating that we were not in compliance with the FDA’s regulations. We have responded to each of these letters and voluntarily discontinued this product. Although we believe that we have satisfactorily addressed +the points raised by the FDA, the FDA could force us to stop manufacturing products at our Oregon facility if the FDA concludes that we remain out of compliance with applicable regulations. The FDA could also require us to recall products if we fail +to comply with applicable regulations, which could force us to stop manufacturing such products. See the Section entitled, “Government Regulation,” for a further discussion of regulatory requirements. +We Have a History of Losses. +We have not achieved full-year profitability. We incurred net +losses of approximately $3.3 million, $3.7 million and $12.7 million in 2002, 2001 and 2000 respectively. As of December 31, 2002, the Company had an accumulated deficit of approximately $129.4 million. +Our limited combined operating history makes it difficult to +forecast our future operating results. In order to achieve sustainable profitability, our revenues will have to continue to grow at a significant rate. However, our revenues have remained essentially flat during the past three years. +Our ability to achieve revenue growth, and therefore +profitability, will be dependent upon a number of factors including, without limitation, the following: +• +Creating market acceptance for and selling increasing volumes of the OraSure ® collection device, the Intercept ® and UP link ™ drug testing products, and the OraQuick ® rapid HIV-1 antibody test; +21 +Table of Contents +• +The degree to which certain of our new products (i.e., the OraQuick ® rapid HIV-1 antibody test) may replace sales of our existing products (i.e., the OraSure ® device for HIV-1 testing) and the financial impact of that change; +• +Achieving growth in international markets with our OraQuick ® rapid HIV-1 antibody test and other products; and +• +Commercially developing, and obtaining regulatory approval and creating market acceptance for, UPT ™ , the UP link ™ drugs-of-abuse rapid detection system, and other new products in a time frame consistent with our objectives. +We have not yet fully achieved these objectives and there can be no assurance that we will be able to do so. Moreover, even if we achieve +our objectives and become profitable, there can be no assurance that we will be able to sustain such profitability in the future. +Our Reported Financial Results May be Adversely Affected by Changes in Accounting Principles Generally Accepted in the United States. +We prepare our financial statements in +conformity with accounting principles generally accepted in the United States. These accounting principles are subject to interpretation by the Financial Accounting Standards Board, the American Institute of Certified Public Accountants, the +Securities and Exchange Commission and various bodies formed to interpret and create appropriate accounting policies. A change in these policies or interpretations could have a significant effect on our reported financial results, and could affect +the reporting of transactions completed before the announcement of a change. +For example, while current accounting rules allow us to exclude the expense of stock options from our financial statements, influential legislators and business policy groups have suggested that the +rules be changed to require those options to be expensed. We rely on stock options as an important component of our employee compensation packages. If we are required to expense options, we may be less likely to achieve profitability, or we may have +to decrease or eliminate option grants. Decreasing or eliminating option grants may adversely impact our ability to attract and retain qualified employees. +Volatility and Other Factors May Affect Our Stock Price. +Our stock price may be volatile, and could experience substantial declines. The market price of our common +stock has historically experienced and might continue to experience volatility in the future in response to a number of factors, including quarter-to-quarter variations in operating results, analysts’ reports, the relatively low trading volume +for our stock, market conditions in the industry, regulatory and other developments affecting our products, changes in governmental regulations, changes in general conditions in the economy or in the financial or stock markets, and terrorist +attacks, civil unrest and war. +The market has +also recently experienced significant decreases in value. This market decline has affected the market prices of securities issued by many companies, often for reasons unrelated to their operating performance, and may adversely affect the price of +our common stock. +A Market for Our Products +May Not Develop. +Our future success will +depend, in part, on the market acceptance, and the timing of such acceptance, of new products such as the Intercept ® drug testing service, the OraQuick ® rapid HIV-1 antibody test, products currently under development such as the UP link ™ +drugs of abuse rapid detection system and other products using the UPT ™ technology, and other new products or +technologies that may be developed or acquired and introduced in the future. To achieve market acceptance, we must make substantial marketing efforts and spend significant funds to inform potential customers and the public of the perceived benefits +of these products. We currently have limited evidence on which to evaluate the market reaction to products that may be developed, and there can be no assurance that any products will meet with market acceptance and fill the market need that is +perceived to exist. +22 +Table of Contents +Our Success +Depends on Our Ability to Protect Our Proprietary Technology. +The diagnostics industry places considerable importance on obtaining patent, trademark, and trade secret protection, as well as other intellectual property rights, for new technologies, products and processes. Our success +depends, in part, on our ability to develop and maintain a strong intellectual property portfolio or obtain licenses to patents and other technology for products and technologies both in the United States and in other countries. +As appropriate, we intend to file patent applications and +obtain patent protection for our proprietary technology. These patent applications and patents will cover, as applicable, compositions of matter for our products, methods of making those products, methods of using those products, and apparatus +relating to the use or manufacture of those products. We will also rely on trade secrets, know-how, and continuing technological advancements to protect our proprietary technology. +We have entered, and will continue to enter, into confidentiality agreements with our employees, consultants, +advisors and collaborators. However, these parties may not honor these agreements and we may not be able to successfully protect our rights to unpatented trade secrets and know-how. Others may independently develop substantially equivalent +proprietary information and techniques or otherwise gain access to our trade secrets and know-how. +Many of our employees, including scientific and management personnel, were previously employed by competing companies. Although we +encourage and expect all of our employees to abide by any confidentiality agreement with a prior employer, competing companies may allege trade secret violations and similar claims against us. +We may collaborate with universities and governmental research +organizations which, as a result, may acquire part of the rights to any inventions or technical information derived from collaboration with them. +To facilitate development and commercialization of a proprietary technology base, we may need to obtain licenses to patents or other +proprietary rights from other parties. Obtaining and maintaining such licenses may require the payment of substantial costs. In addition, if we are unable to obtain these types of licenses, our product development and commercialization efforts may +be delayed or precluded. +We may incur +substantial costs and be required to expend substantial resources in asserting or protecting our intellectual property rights, or in defending suits against us related to intellectual property rights. Disputes regarding intellectual property rights +could substantially delay product development or commercialization activities. Disputes regarding intellectual property rights might include state, federal or foreign court litigation as well as patent interference, patent reexamination, patent +reissue, or trademark opposition proceedings in the United States Patent and Trademark Office. Opposition or revocation proceedings could be instituted in a foreign patent office. An adverse decision in any proceeding regarding intellectual property +rights could result in the loss or limitation of our rights to a patent, an invention or trademark. +The Sales Potential for OraQuick ® Will be Affected by Our Ability to Obtain Certain Licenses. +There are several factors that will affect the specific +countries in which we will be able to sell our OraQuick ® rapid HIV antibody +test and therefore the overall sales potential of the test. One factor is whether we can arrange a sublicense or distribution agreement related to patents for detection of the HIV-2 virus. HIV-2 is a type of the HIV virus estimated to represent a +small fraction of the known HIV cases worldwide. Nevertheless, HIV-2 is considered to be an important component in the testing regimen for HIV in many markets. HIV-2 patents are in force in most of the countries of North America and Western Europe, +as well as in Japan, Korea, South Africa, and Australia. Access to a license for one or more HIV-2 patents may be necessary to sell HIV-2 tests in countries where such patents are in force, or to manufacture in countries where such patents are in +force and then sell into non-patent markets. Since HIV-2 patents are in force in the United States, we may be restricted from manufacturing an OraQuick ® rapid HIV-2 antibody test in the United States and selling into other countries, even if there were no HIV-2 patents in +those other countries. +23 +Table of Contents +The importance +of HIV-2 differs by country, and can be affected by both regulatory requirements and by competitive pressures. In most countries, any product used to screen the blood supply will be required to detect HIV-2, although the OraQuick ® rapid HIV antibody test has not been intended for that market purpose. In other markets, +including the United States, a test that can detect only the more prevalent HIV-1 type is considered sufficient by the FDA, except in testing related to blood supply. Because the competitive situation in each country will be affected by the +availability of other testing products as well as the country’s regulatory environment, we may be at a competitive disadvantage in some markets without an HIV-2 product even if HIV-2 detection is not required by regulations. In particular, our +ability to sell a product that does not include an HIV-2 test may be limited, or a competitor’s product that includes an HIV-2 test may be preferred and have a competitive advantage over an HIV-1 only test that we sell. +We have obtained licenses to HIV-1 patents held by the +manufacturer of the HIV-1 antigen used in the OraQuick ® device and by the +National Institutes of Health. We are not aware of any other HIV-1 patents which would need to be licensed in order to manufacture and sell the OraQuick ® rapid HIV-1 antibody test. +Another factor that may affect the specific countries in which we will be able to sell an OraQuick ® rapid HIV-1 or HIV-2 test, and therefore the overall sales potential, concerns whether we can arrange a +sublicense or distribution agreement related to any patents which claim lateral flow assay methods and devices covering the OraQuick ® rapid HIV antibody tests or their use. OraQuick ® is a lateral flow assay device that tests for specific antibodies or other substances. The term “lateral flow” +generally refers to a test strip through which a sample flows and which provides a test result on a portion of the strip downstream from where the sample is applied. There are numerous patents in the United States and other countries which claim +lateral flow assay methods and devices. Some of these patents may broadly cover the technology used in the OraQuick ® test and are in force in the United States and other countries. We may not be able to make the OraQuick ® test in the United States and sell it in countries where there is no patent on the device. We have obtained licenses under +several lateral flow patents, which we believe should be sufficient to permit the manufacturing and sale of the OraQuick ® device as currently contemplated. However, licenses under additional patents may be required. +In the event that it is determined that a license is required and it is not possible to negotiate a license agreement under a necessary +patent, we may be able to modify the OraQuick ® rapid HIV antibody test such +that a license would not be necessary. However, this alternative could delay or limit our ability to sell the OraQuick ® rapid HIV antibody test in the United States and other markets, which would adversely affect our results of operations, cash flows and business. +If We Lose Our Key Personnel or Are Unable to Attract and +Retain Qualified Personnel as Necessary, Our Business Could be Harmed. +Our success will depend to a large extent upon the contributions of our executive officers, management, and sales, marketing, and scientific staff. We may not be able to attract or retain qualified +employees in the future due to the intense competition for qualified personnel among medical products businesses. +If we are not able to attract and retain the necessary personnel to accomplish our business objectives, we may experience constraints that +will adversely affect our ability to effectively sell and market our products, to meet the demands of our strategic partners in a timely fashion, or to support internal research and development programs. In particular, product development programs +depend on the ability to attract and retain highly skilled scientists, including molecular biologists, biochemists and engineers, and sales and marketing efforts depend on the ability to attract and retain skilled and experienced sales and marketing +representatives. Recruiting qualified personnel can be an intensely competitive and time-consuming process. Although we believe we will be successful in attracting and retaining qualified personnel, competition for experienced scientists and other +personnel from numerous companies and academic and other research institutions may limit our ability to do so on acceptable terms. +24 +Table of Contents +All of our employees, other than a few senior officers who have employment agreements, are +at-will employees, which means that either the employee or the Company may terminate their employment at any time. If we experience difficulty in recruiting and retaining qualified personnel, we may need to provide higher compensation to such +personnel than currently anticipated or we may incur additional expenses for the recruitment of qualified personnel. +Our business strategies will require additional expertise in specific industries and areas applicable to the development efforts related +to up-converting phosphor or other technologies. These activities will require the addition of new personnel, including management, and the development of additional expertise by existing management personnel. The inability to acquire these services +or to develop this expertise could impair the development, if any, of products related to these technologies. +Our Increasing International Presence May be Affected by Regulatory, Cultural or Other Restraints. +We intend to increase international sales of our products. +Our international sales accounted for approximately $3.9 million or 12% of total revenues for 2002, approximately $5.3 million or 16% of total revenues for 2001, and approximately $4 million or 14% of total revenues for 2000. +A number of factors can slow or prevent international sales, +or substantially increase the cost of international sales, including those set forth below: +• +Regulatory requirements (including compliance with applicable customs regulations) may slow, limit, or prevent the offering of products in foreign jurisdictions; +• +The unavailability of licenses to certain patents in force in a foreign country which cover our products may restrict our ability to sell into that country; +• +Our inability to obtain the CE mark on our products in a timely manner may preclude or delay our ability to sell products to the European Union; +• +Cultural and political differences may make it difficult to effectively market, sell and gain acceptance of products in foreign jurisdictions; +• +Inexperience in international markets may slow or limit our ability to sell products in foreign countries; +• +Exchange rates, currency fluctuations, tariffs and other barriers, extended payment terms and dependence on and difficulties in managing international distributors +or representatives may affect our revenues even when product sales occur; +• +The creditworthiness of foreign entities may be less certain and foreign accounts receivable collection may be more difficult; +• +Economic conditions, the absence of available funding sources, terrorism, civil unrest and war may slow or limit our ability to sell our products in foreign +countries; +• +International markets often have long sales cycles, especially sales to foreign governments, quasi-governmental agencies and international public health agencies, +thereby delaying or limiting our ability to sell our products; and +• +We may be at a disadvantage if competitors in foreign countries sell competing products at prices at or below such competitors’ or our cost. +In February 2000, we entered into +an agreement for the distribution of our OraQuick ® rapid HIV antibody test in a +number of African countries. Because of the inability of our African distributor to obtain required regulatory approvals, the lack of funding sources in those countries for the purchase of our product and other factors, our distributor failed to +meet its minimum purchase commitments under our agreement. As a result, we were forced to record a reserve for approximately $0.6 million of OraQuick ® inventory manufactured in contemplation of sales to this distributor. +25 +Table of Contents +In addition, +we have entered into a contract for the manufacture and supply of the OraQuick ® +rapid HIV antibody test in Thailand. However, we do not have significant direct experience with the use of international manufacturers. Factors such as economic and political conditions and foreign regulatory requirements may slow or prevent the +manufacture of our products in countries other than the United States. Interruption of the supply of our products could reduce revenues or cause us to incur significant additional expenses in finding an alternative source of supply. +We May be Sued for Product Liabilities for Injuries +Resulting From the Use of Our Diagnostic Products. +We may be held liable if any of our products, or any product which is made with the use or incorporation of any of our technologies, causes injury of any type or is found otherwise unsuitable during product testing, manufacturing, +marketing, sale or usage. Although we have obtained product liability insurance, this insurance may not fully cover potential liabilities. As we bring new products to market, we may need to increase our product liability coverage. If we decide to +obtain the required regulatory approvals and sell any of our products in the consumer or over-the-counter market, the risk of potential product liability exposure and the required level of insurance coverage could increase. Inability to obtain +sufficient insurance coverage at an acceptable cost or otherwise to protect against potential product liability claims could affect our decision to commercialize new products. +We May Not be Able to Commercialize Our UPT ™ , UP link ™ or Other New Products Which Could Negatively Affect Our Future Revenues. +Our UPT ™ technology and the UP link ™ rapid detection system are +still under development. Commercial development of the UP link ™ system or the UPT ™ technology for certain other applications and other new products may not be successful. Successful products require +significant development and investment, including testing, to demonstrate their cost-effectiveness or other benefits prior to commercialization. In addition, regulatory approval must be obtained before most products may be sold. Additional +development efforts on these products will be required before any regulatory authority will review them. Regulatory authorities may not approve these products for commercial sale. In addition, even if a product is developed and all applicable +regulatory approvals are obtained, there may be little or no market for the product. Accordingly, because of these uncertainties, the UP link ™ rapid detection system, other applications of UPT ™ or other +new products may not be successfully commercialized, which could negatively affect our results of operations, cash flows and business. +We Are Dependent Upon Strategic Partners to Assist in Developing and Commercializing Some of Our Diagnostic Products. +Although we intend to pursue some product opportunities +independently, opportunities that require a significant level of investment for development and commercialization or a distribution network beyond our existing sales force may necessitate involving one or more strategic partners. In particular, our +strategy for development and commercialization of UPT ™ , including the UP link ™ rapid detection system, and certain other products may entail entering into additional arrangements with distributors or other corporate +partners, universities, research laboratories, licensees and others. We may be required to transfer material rights to such strategic partners, licensees and others. While we expect that our current and future partners, licensees and others have and +will have an economic motivation to succeed in performing their contractual responsibilities, the amount and timing of resources to be devoted to these activities will be controlled by others. Consequently, there can be no assurance that any +revenues or profits will be derived from such arrangements. +We are Dependent Upon Patents, Licenses and Other Proprietary Rights From Third Parties, Including Rights to Up-Converting Phosphor Compositions, Methods and Apparatuses. +We have licensed the worldwide rights to up-converting +phosphor compositions, methods and apparatuses for use in diagnostic applications, which are the subject of numerous United States patents and several pending United States applications. Corresponding patents and patent applications have been +granted, issued or filed in +26 +Table of Contents +numerous foreign countries, including, for example, European countries, Japan and Canada. We cooperate with the licensor to prosecute such +patent applications and protect such patent rights. If the licensors do not meet their obligations under the license agreements or do not reasonably consent to sublicenses by us, or if the license agreement is terminated, we could lose the +opportunity to develop UPT ™ . +We May Require Future Additional Funding to Stay in Business. +Although we have made significant progress in the past toward +controlling expenses and increasing product revenue, we have historically depended, to a substantial degree, on capital raised through the sale of equity securities and bank borrowings to fund our operations. +Our future liquidity and capital requirements will depend on +numerous factors, including, but not limited to, the following: +• +The costs and timing of the expansion of our manufacturing capacity; +• +The success of our research and product development efforts; +• +The scope and results of clinical testing; +• +The magnitude of capital expenditures; +• +Changes in existing and potential relationships with business partners; +• +The time and cost of obtaining regulatory approvals; +• +The costs involved in obtaining and enforcing patents, proprietary rights and necessary licenses; +• +The costs and timing of expansion of sales and marketing activities; +• +The timing of the commercial launch of new products; +• +The extent to which existing and new products gain market acceptance; +• +Competing technological and market developments; and +• +The scope and timing of strategic acquisitions. +If additional financing is needed, we may seek to raise funds through the sale of equity or other securities or through bank borrowings. +There can be no assurance that financing through the sale of securities, bank borrowings or otherwise, will be available to us on satisfactory terms, if at all. +The Recent Economic Downturn and Terrorist Attacks May Adversely Affect Our Business. +Since the September 11, 2001 terrorist attacks, the United +States economy has experienced a decline. Changes in economic conditions could adversely affect our business. For example, in a difficult economic environment, customers may be unwilling or unable to invest in new diagnostic products, may elect to +reduce the amount of their purchases or may perform less drug testing because of declining employment levels. A weakening business climate could also cause longer sales cycles and slower growth, and could expose us to increased business or credit +risk in dealing with customers adversely affected by economic conditions. +The terrorist attacks and subsequent governmental responses to these attacks could cause further economic instability or lead to further acts of terrorism in the United States and elsewhere. These actions could adversely +affect economic conditions outside the United States and reduce demand for our products internationally. Terrorist attacks could also cause regulatory agencies, such as the FDA or agencies that perform similar functions outside the United States, to +focus their resources on vaccines or other products intended to address the threat of biological or chemical warfare. This diversion of resources could delay our ability to obtain regulatory approvals required to manufacture, market or sell our +products in the United States and other countries. +27 +Table of Contents +Efforts to +Consolidate or Restructure Could Adversely Affect Our Business. +We may from time to time restructure and consolidate various aspects of our operations in order to achieve cost savings and other efficiencies. For example, during 2001 we began a restructuring of our manufacturing +operations which included the transfer of OraQuick ® manufacturing from the +Beaverton, Oregon facility to Bethlehem, Pennsylvania. In addition, we plan to close the Oregon facility and transfer all remaining manufacturing operations and research and development activities in that facility related to the Western Blot HIV-1 +confirmatory test and our contract manufacturing operations for OraSure ® and +Intercept ® , to our facilities in Pennsylvania. The transfer of operations may +result in the loss of scientific or other personnel and thereby delay the transfer or disrupt the continuation of operations thereafter. We will also be required to obtain FDA approval to transfer certain operations to another location, which could +delay the transfer or disrupt continued operations. Any delay or disruption of operations, and in particular manufacturing operations, could result in increased costs or could delay or prevent us from selling certain products and thereby result in a +loss of revenue. +Future Acquisitions or +Investments Could Disrupt Our Ongoing Business, Distract Our Management, Increase Our Expenses and Adversely Affect Our Business. +We may consider strategic acquisitions or investments as a way to expand our business in the future. These activities, and their impact on +our business, are subject to the following risk factors: +• +Suitable acquisitions or investments may not be found or consummated on terms that are satisfactory to us; +• +We may be unable to successfully integrate an acquired company’s personnel, assets, management systems and technology into our business; +• +Acquisitions may require substantial expense and management time and could disrupt our business; +• +An acquisition and subsequent integration activities may require greater capital resources than originally anticipated at the time of acquisition; +• +An acquisition may result in the incurrence of unexpected expenses, the dilution of our earnings or our existing stockholders’ percentage ownership, or +potential losses from undiscovered liabilities not covered by an indemnification from the seller(s) of the acquired business; +• +An acquisition may result in the loss of existing key personnel or customers or the loss of the acquired company’s key personnel or customers; +• +The benefits to be derived from an acquisition could be affected by other factors, such as regulatory developments, general economic conditions and increased +competition; and +• +An acquisition of a foreign business may involve additional risks, including not being able to successfully assimilate differences in foreign business practices or +overcome language barriers. +The +incurrence of one or more of the above or other factors may prevent us from achieving all or a significant part of the benefits expected from an acquisition or investment. This may adversely affect our financial condition, results of operations and +ability to grow our business. +The previous +discussion of our business should be read in conjunction with the Financial Statements and accompanying notes included in Item 15 of this Annual Report on Form 10-K. \ No newline at end of file diff --git a/raw/filings/0001116463/2002/0000950109-03-001919/item13.txt b/raw/filings/0001116463/2002/0000950109-03-001919/item13.txt new file mode 100644 index 0000000000000000000000000000000000000000..9d360a400c4e394edc2051136e0a40b728574418 --- /dev/null +++ b/raw/filings/0001116463/2002/0000950109-03-001919/item13.txt @@ -0,0 +1,3 @@ +ITEM 13. Certain Relationships and Related Transactions. +The information required by this item is incorporated by reference to the information under the captions, “Certain Relationships and +Related Transactions” and “Employment Agreements,” in the Proxy Statement. \ No newline at end of file diff --git a/raw/filings/0001116463/2002/0000950109-03-001919/item9a.txt b/raw/filings/0001116463/2002/0000950109-03-001919/item9a.txt new file mode 100644 index 0000000000000000000000000000000000000000..e69de29bb2d1d6434b8b29ae775ad8c2e48c5391 diff --git a/raw/filings/0001116463/2002/0000950109-03-001919/rp_note.txt b/raw/filings/0001116463/2002/0000950109-03-001919/rp_note.txt new file mode 100644 index 0000000000000000000000000000000000000000..fedf06bac6d4e8fa6615ccdec6776e2ec63ff3d1 --- /dev/null +++ b/raw/filings/0001116463/2002/0000950109-03-001919/rp_note.txt @@ -0,0 +1,5 @@ +12. RELATED-PARTY FACILITY LEASE: +We have entered into a ten-year facility lease with Tech III Partners, LLC (“Tech Partners”), an entity owned and controlled by two of our executive officers. Under the terms of this +operating lease, we began leasing a 48,000 square foot facility in October 2002, at a base rent of $780,000 per year, increasing to $858,240 per year, during the initial ten-year term. The base rental rate may be increased after the fifth year of +the initial term, in order to reflect changes in the debt incurred by Tech Partners to finance construction of the leased facilities. We have not guaranteed any debt incurred by Tech Partners. This lease also provides us with options to renew our +lease for an additional five years at a rental rate of $975,360 per year and to purchase the facility at any time during the initial ten year-term, based upon a formula set forth in the lease agreement. \ No newline at end of file diff --git a/raw/filings/0001116463/2002/0000950109-03-001919/rpt_disclosure.txt b/raw/filings/0001116463/2002/0000950109-03-001919/rpt_disclosure.txt new file mode 100644 index 0000000000000000000000000000000000000000..b7abae064e2b5454397724f455e82e18f3a264d4 --- /dev/null +++ b/raw/filings/0001116463/2002/0000950109-03-001919/rpt_disclosure.txt @@ -0,0 +1,16 @@ +Certain Relationships and Related Transactions +We have entered into a commercial lease (the +“Lease”) with Tech III Partners, LLC (“Tech Partners”), which provided for the construction of a 48,000 square foot facility on land adjacent to our Bethlehem, Pennsylvania headquarters, and the lease of that facility to us. Tech +Partners is owned and controlled by Michael J. Gausling, the Company’s President and Chief Executive Officer, and Dr. R. Sam Niedbala, the Company’s Executive Vice President and Chief Science Officer. The facility is our new corporate +headquarters and will house manufacturing, research and development, and administrative operations required to support the expected growth of our business. Construction of the facility was completed in October 2002. +The Lease has an initial ten-year term ending in October 2012 +and a base rent starting at $780,000 and increasing to $858,240 per year over that term. The base rental rate may be increased after the fifth year of the initial term in order to reflect changes in the interest rate on debt incurred by Tech +Partners to finance construction of the leased facilities. We have not guaranteed any debt incurred by Tech Partners. We also have an option to renew the Lease for an additional five years at a rental rate of $975,360 per year, and to purchase the +facility at any time during the initial ten-year term based on a formula set forth in the Lease. +10 +Prior to +deciding to enter into the Lease and an amendment increasing the base rent to reflect certain tenant fit-out costs, our Board of Directors retained Imperial Realty Appraisal LLC, an independent commercial real estate appraisal firm, to evaluate the +proposed base rental rate. Imperial Realty issued opinions indicating that the annual base rent set forth in the Lease, as amended, is below the market rental rate we could otherwise expect to pay to lease a comparable commercial property in the +same general geographic market. The terms of the Lease are otherwise substantially similar to a commercial lease we entered into with a third party for our existing Bethlehem, Pennsylvania facilities. +Information regarding employment and severance agreements +between the named executive officers and the Company is set forth in the Section entitled, “Employment Agreements,” in this Proxy Statement. \ No newline at end of file diff --git a/raw/filings/0001116463/2006/0001193125-07-057268/filing.txt b/raw/filings/0001116463/2006/0001193125-07-057268/filing.txt new file mode 100644 index 0000000000000000000000000000000000000000..872a977d00ae1343ae50b1802f47cb6fdd7ee38f --- /dev/null +++ b/raw/filings/0001116463/2006/0001193125-07-057268/filing.txt @@ -0,0 +1,4850 @@ +10-K +1 +d10k.htm +FORM 10-K +Form 10-K +Table of Contents +UNITED STATES +SECURITIES AND EXCHANGE COMMISSION +Washington, D.C. 20549 +FORM 10-K +ANNUAL REPORT PURSUANT +TO SECTIONS +13 OR 15(d) OF THE +SECURITIES EXCHANGE ACT OF 1934 +(Mark One) +x +ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 +For the fiscal year ended December 31, 2006 +OR +¨ +TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 +For the transition period from to +Commission File No. 001-16537 +ORASURE TECHNOLOGIES, INC. +(Exact Name of Registrant as Specified in Its Charter) +Delaware +36-4370966 +(State or Other Jurisdiction of +Incorporation or Organization) +(I.R.S. Employer Identification No.) +220 East First Street +Bethlehem, Pennsylvania +18015 +(Address of Principal Executive Offices) +(Zip Code) +(610) 882-1820 +(Registrant’s Telephone Number, Including Area Code) +Securities registered pursuant to +Section 12(b) of the Act: +Title of Each Class +Name of Each Exchange on Which Registered +Common Stock $0.000001 par value per share +The NASDAQ Stock Market LLC +Securities registered pursuant to Section 12(g) of the Act: None +Indicate by check mark if the Registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes ¨ No x +Indicate by check mark if the Registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Exchange Act. Yes ¨ No x +Indicate +by check mark whether the Registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required +to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No ¨ +Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is +not contained herein, and will not be contained, to the best of Registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. x +Indicate by check mark whether the Registrant is a large accelerated filer, an accelerated filer, or a +non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. +Large accelerated filer ¨ +Accelerated filer x +Non-accelerated filer ¨ +Indicate by check mark whether the Registrant is a shell company (as defined in Rule 12b-2 of the +Exchange Act). Yes ¨ No x +State the aggregate market value of the voting and non-voting common equity held by nonaffiliates, computed by reference to the price at which the common +equity was last sold, or the average bid and asked price of such common equity, as of the last business day of the Registrant’s most recently completed second fiscal quarter (June 30, 2006): $434,917,582 +Indicate the number of shares outstanding of each of the Registrant’s classes of common stock, as of March 12, 2007: 46,127,212 shares. +Documents Incorporated by Reference: +Portions of the Registrant’s Definitive Proxy Statement for the 2007 Annual Meeting of Stockholders are incorporated by reference into Part III of this Report. +Table of Contents +Table of Contents +Page +PART I +ITEM 1. +Business +1 +ITEM 1A. +Risk Factors +19 +ITEM 1B. +Unresolved Staff Comments +33 +ITEM 2. +Properties +33 +ITEM 3. +Legal Proceedings +33 +ITEM 4. +Submission of Matters to a Vote of Security Holders +34 +PART II +ITEM 5. +Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities +35 +ITEM 6. +Selected Financial Data +37 +ITEM 7. +Management’s Discussion and Analysis of Financial Condition and Results of Operations +38 +ITEM 7A. +Quantitative and Qualitative Disclosures About Market Risk +55 +ITEM 8. +Financial Statements and Supplementary Data +55 +ITEM 9. +Changes in and Disagreements with Accountants on Accounting and Financial Disclosure +56 +ITEM 9A. +Controls and Procedures +56 +ITEM 9B. +Other Information +57 +PART III +ITEM 10. +Directors, Executive Officers and Corporate Governance +58 +ITEM 11. +Executive Compensation +58 +ITEM 12. +Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters +58 +ITEM 13. +Certain Relationships and Related Transactions, and Director Independence +58 +ITEM 14. +Principal Accountant Fees and Services +58 +PART IV +ITEM 15. +Exhibits and Financial Statement Schedules +59 +Table of Contents +This Report contains certain “forward-looking statements,” within the meaning of the Federal +securities laws. These may include statements about our expected revenues, earnings, expenses or other financial performance, future product performance or development, expected regulatory filings and approvals, planned business transactions, views +of future industry, competitive or market conditions, and other factors that could affect our future operations, results of operations or financial position. These statements often include words, such as “believes,” “expects,” +“anticipates,” “intends,” “plans,” “estimates,” “may,” “will,” “should,” “could,” or similar expressions. +Forward-looking statements are not guarantees of future performance or +results. Known and unknown factors could cause actual performance or results to be materially different from those expressed or implied in these statements. Factors that could affect our results are discussed more fully under Item 1A., entitled +“Risk Factors,” and elsewhere in this Annual Report. Although forward-looking statements help to provide complete information about us, readers should keep in mind that forward-looking statements may not be reliable. Readers are cautioned +not to place undue reliance on the forward-looking statements. The forward-looking statements are made as of the date of this Report and we undertake no duty to update these statements. +PART I +ITEM 1. Business. +Our business principally involves the development, manufacture, marketing and sale of oral fluid specimen collection devices using our proprietary oral fluid technologies, as well as other diagnostic products +including immunoassays and other in vitro diagnostic tests that are used on other specimen types, and other medical devices. Our diagnostic products include tests which are processed in a laboratory and tests which are performed on a rapid +basis at the point of care. These products are sold in the United States and internationally to various clinical laboratories, hospitals, clinics, community-based organizations and other public health organizations, distributors, government +agencies, physicians’ offices, and commercial and industrial entities. One of our products is also sold in the over-the-counter (“OTC”) or consumer retail market in the United States, Canada, Europe, Australia and certain other +foreign countries. +In vitro diagnostic testing is the +process of analyzing oral fluid, blood, urine and other bodily fluids or tissue for the presence of specific substances or markers for infectious diseases, drugs of abuse or other conditions. In vitro diagnostic tests are performed outside +the body, in contrast to in vivo tests, which are performed directly on or within the body. The substance or marker that a diagnostic test is intended to detect is generally referred to as an analyte. +Immunodiagnostic testing is the leading method of in vitro testing for +antigens and antibodies. When an infectious disease is caused by pathogens, such as bacteria, viruses and fungi, or other substances are present, the body responds by producing an antibody. Substances that stimulate production of antibodies are +generally referred to as antigens. An antibody binds specifically with an antigen in a lock-and-key fashion that initiates a biochemical reaction to attempt to neutralize and, ultimately, eliminate the antigen. The ability of an antibody to bind +with a specific antigen provides the basis for immunodiagnostic testing. +Our Company was formed in May 2000 under Delaware law solely for the purposes of combining two companies, STC Technologies, Inc. (“STC” or “STC Technologies”) and Epitope, Inc. +(“Epitope”), and changing the state of incorporation of Epitope from Oregon to Delaware. STC Technologies and Epitope were merged into our Company on September 29, 2000. Our principal offices are located at 220 East First Street, +Bethlehem, Pennsylvania 18015, and our telephone number is (610) 882-1820. +Additional information about us can be found on our website. Our website address is www.orasure.com. We make available free of charge through a link provided at such website our Annual Reports on Form 10-K, our +1 +Table of Contents +Quarterly Reports on Form 10-Q and our Current Reports on Form 8-K, as well as any amendments to those Reports. These Reports are made available as soon as +reasonably practicable after they are filed or furnished to the Securities and Exchange Commission. Our Internet website and the information contained in or connected to that website are not intended to be incorporated by reference into this Annual +Report. +Products +The following is a summary of our principal products and their regulatory +and commercial status: +Product +Description +Regulatory Status +Commercial +Status +OraQuick +ADVANCE ® HIV-1/2 +A rapid, point-of-care test for antibodies to the Human Immunodeficiency Virus Type 1 (“HIV-1”) and Type 2 (“HIV-2” and together with HIV-1, “HIV-1/2”) that can be +visually read at the point of care in approximately 20 minutes. +Premarket approval (“PMA”) approved by the U.S. Food and Drug Administration (“FDA”) (March 2004—June 2004) for use with oral fluid, finger-stick and venous whole blood, +and plasma. CLIA (Clinical Laboratory Improvement Amendments of 1988) waived for use with oral fluid, finger-stick and venous whole blood (June 2004). +Marketed +CE mark application filed. +Pending +Registered in Mexico. +Marketed +OraQuick ADVANCE ® OTC +In development. +OraQuick ® HCV +A rapid, point-of-care test for antibodies to the hepatitis C virus (“HCV”) +In development. +OraSure ® +Oral fluid collection device for the detection of antibodies to HIV-1 in an oral fluid sample in a laboratory setting. +PMA approved by FDA in December 1994. +Marketed +Also FDA 510(k) cleared for use in detecting cocaine and cotinine (an indicator of nicotine) in oral fluid. +Marketed +CE marked and registered in the United Kingdom. Also registered in Mexico, Canada, Columbia, South Africa, Afghanistan, Argentina, Brazil and Trinidad. +Marketed +Intercept ® +Oral fluid collection device, along with nine related immunoassays, for oral fluid drugs of abuse (“DOA”) testing in a laboratory setting. +Collection device—FDA 510(k) cleared in 2000. +Marketed +MICRO-PLATE DOA Assays +Used to detect the following drugs in an oral fluid sample: marijuana, cocaine, opiates, amphetamines, methamphetamines, PCP, benzodiazepines, barbiturates and methadone. +Nine drug assays—FDA 510(k) cleared during 2000-2001. +Marketed +Intercept ® device CE marked and registered in the United Kingdom. Various assays are CE marked and registered in the United Kingdom, Austria, Belgium, Denmark, Finland, France, +Germany, Ireland, Italy, Luxembourg, Mexico, Netherlands, Portugal, Spain, Sweden, Korea, Canada, Afghanistan and Brazil. +Marketed +2 +Table of Contents +Product +Description +Regulatory Status +Commercial +Status +Homogeneous DOA Assays +Homogeneous fully-automated oral fluid DOA assays. +In development. +Cryosurgical Systems—Professional +Cryosurgical system for the removal of warts and other benign skin lesions, marketed under the Histofreezer ® tradename primarily to the physicians’ office +market. +Nine indications—FDA 510(k) cleared during 1991—1999. +Marketed +CE marked and registered in Europe, Venezuela, Thailand, New Zealand, Hong Kong, Brazil, Mexico, Canada and Afghanistan. +Marketed +Cryosurgical Systems—OTC +Cryosurgical (freezing) system for the removal of common and plantar warts, sold in the OTC markets in the United States and Canada under the Compound W Freeze Off ® +tradename by Prestige Brands Holdings, Inc., in Europe, Australia and New Zealand under the Scholl and Dr. Scholl Freeze Spray tradenames by SSL International plc. and in Mexico under the POINTTS tradename by Genomma Labs. +FDA 510(k) cleared for two Freeze Off ® indications in February 2003. +Freeze Off ® registered in Canada. +Scholl Freeze Spray CE marked and registered in several European countries. +POINTTS registered in Mexico. +Marketed +Marketed +Marketed +Marketed +Cryosurgical Systems—OTC Product Line Extensions +Cryosurgical system for an indication other than common warts or plantar warts. +In development. +Cryosurgical system combined with salicylic acid. +In development. +In addition to the +above products, we also sell certain immunoassay tests and reagents for insurance risk assessment, substance abuse testing and forensic toxicology applications; an oral fluid Western blot HIV-1 confirmatory test approved by the FDA for confirming +positive HIV-1 test results obtained from the use of our OraSure ® collection device; and the FDA 510(k) cleared Q.E.D. ® point-of-care saliva alcohol test. +OraQuick ® Rapid +Test Platform +OraQuick ® is our rapid test platform designed to test oral fluid, whole blood (i.e., +both finger-stick and venous) and plasma samples for the presence of various antibodies or analytes. The device uses a porous flat pad to collect an oral fluid specimen. After collection, the pad is inserted into a vial containing a pre-measured +amount of developer solution and allowed to develop. When whole blood or plasma is to be tested, a loop collection device is used to collect a drop of blood or plasma and mix it in the developer solution, after which the collection pad is inserted +into the solution and allowed to develop. In all cases, the specimen and developer solution then flow through the testing device where test results are observable in approximately 20 minutes. The OraQuick ® device is a screening test and requires a confirmation test where an initial positive +result is obtained. +We have commercialized this technology in +the form of our OraQuick ADVANCE ® rapid +HIV-1/2 antibody test. This is a rapid, point-of-care test which has received FDA approval for the detection of antibodies to both HIV-1 and HIV-2 in oral fluid, finger-stick and venous whole blood and plasma. This test is available for use by the +nearly 40,000 locations in the United States certified under the Clinical Laboratory Improvements Amendment of 1988 (“CLIA”) to perform moderately complex tests. We have also received a CLIA waiver for use of the OraQuick +ADVANCE ® test with oral fluid and +finger-stick and venous whole blood. As a result, the test can be used by approximately 140,000 additional sites in the United States not certified under CLIA to perform moderately complex tests, such as outreach clinics, community-based +organizations and physicians’ offices. +3 +Table of Contents +On the international front, we are in the process of obtaining a CE mark for our OraQuick +ADVANCE ® test so that we will be able to +sell this product in Europe. We have a distributor in place for the United Kingdom and are pursuing distribution arrangements in several additional European countries. We are selling OraQuick ® in Mexico and Africa and are completing registrations of our OraQuick ® test in several countries in Latin America, Asia, the +Middle East and Russia. We are aggressively seeking to expand our distribution network for this product throughout the world. +We believe that the OraQuick ADVANCE ® device, because it is approved for detecting antibodies to both HIV-1 and HIV-2 in finger-stick and venous whole blood, oral fluid and plasma samples, +provides a significant competitive advantage in the market for rapid HIV testing in the United States and elsewhere around the world. Demand for OraQuick ADVANCE ® has quickly grown since the launch of that product in late 2004. +OraSure ® /Intercept ® Collection Devices +Our OraSure ® oral fluid collection device is used in conjunction with screening and confirmatory tests for HIV-1 antibodies and other analytes. This device consists of a small, treated cotton-fiber +pad on a handle that is placed in a person’s mouth for two to five minutes. The device collects oral mucosal transudate (“OMT”), a serum-derived fluid that contains higher concentrations of certain antibodies and analytes than saliva. +As a result, OMT testing is a highly accurate method for detecting HIV-1 infection and other analytes. +We believe that oral fluid testing has several significant advantages over blood or urine-based systems for infectious disease testing, for both health +care professionals and the individuals being tested. These advantages include eliminating the risk of needle-stick accidents, providing a non-invasive collection technique, requiring minimal training to administer, providing rapid and efficient +collection in almost any setting, and reducing the cost of administration by a trained health care professional. +We have received premarket approval from the FDA to sell the OraSure ® collection device for use with a laboratory-based enzyme immunoassay (“EIA”) screening test for HIV-1 +antibody detection. This EIA screening test has been approved by the FDA for use with our OraSure ® device and is manufactured and sold by bioMerieux, Inc. (“BMX”). +HIV-1 antibody detection using the OraSure ® collection device involves three steps: +• +Collection of an oral fluid specimen using the OraSure ® device; +• +Screening of the specimen for HIV-1 antibodies at a laboratory with an EIA screening test approved by the FDA for use with the OraSure ® device; and +• +Laboratory confirmation of any positive screening test results with our oral fluid Western blot HIV-1 confirmatory test (described below). +A trained health care professional then +conveys test results and provides appropriate counseling to the individual who was tested. We have also received FDA 510(k) clearance for use of the OraSure ® collection device with EIAs to test for cocaine and cotinine (a metabolite of nicotine) in oral fluid specimens primarily for insurance risk +assessment purposes. +In late 2006, BMX announced that it will +discontinue manufacturing the HIV-1 EIA screening test during 2007 and that, due to quality problems, it may have difficulty supplying this screening test prior to the time it ceases manufacturing. As a result, we are working with BMX, the FDA and +Centers for Disease Control and Prevention (“CDC”), our major laboratory customers and other potential suppliers to find or develop an alternative HIV-1 EIA screening test that can be used with oral fluid samples collected with our +OraSure ® device. +A collection device that is substantially similar to the OraSure ® device is sold under the name Intercept ® , and is used to collect OMT for oral fluid drug +testing. We have received FDA 510(k) clearance to use the +4 +Table of Contents +Intercept ® collection device with laboratory-based EIAs to test for drugs of abuse commonly identified by the National Institute for Drug Abuse (“NIDA”) as the NIDA-5 (i.e., cannabinoids +(marijuana), cocaine, opiates, amphetamines/methamphetamines and phencyclidine (“PCP”)), and for barbiturates, methadone and benzodiazepines. Each of these EIAs is also FDA 510(k) cleared for use with the Intercept ® device. +We have received a CE mark for the Intercept ® and OraSure ® devices and both are distributed in Canada, the United Kingdom and Mexico. The +OraSure ® device and our oral fluid drugs of abuse +assays are also sold in several other foreign countries. +We +believe that the Intercept ® device has several +advantages over competing urine and other drugs-of-abuse testing products, including its lower total testing cost, its non-invasive nature, mobility and accuracy, the ease of maintaining a chain-of-custody, the treatment of test subjects with +greater dignity, no requirement for specially-prepared collection facilities and difficulty of sample adulteration. The availability of an oral fluid test is intended to allow our customers to test for drug impairment, eliminate scheduling costs and +inconvenience, and thereby streamline the testing process. +Cryosurgical Systems (Skin Lesion Removal Products) +The Histofreezer ® cryosurgical removal +system is a low-cost alternative to liquid nitrogen and other methods for removal of warts and other benign skin lesions by physicians. The Histofreezer ® product mixes two environmentally friendly cryogenic gases in a small aerosol canister. When released, these gases are delivered to a +specially designed foam bud, cooling the bud to a maximum of –50°C to –55°C. The frozen bud is then applied to the wart or lesion for 15 to 40 seconds (depending on the type of lesion) creating localized destruction of the target +area by freezing. We have received 510(k) clearance for use of the Histofreezer ® product to remove common warts and eight other types of benign skin lesions, and this product has been CE marked and registered for distribution throughout Europe. +We have also received FDA 510(k) clearance to market and sell a cryosurgical +product similar to the Histofreezer ® product in the +OTC or retail market for the removal of common and plantar warts only. This product is being distributed in the United States and Canadian OTC markets under the name Freeze Off ® by Prestige Brands Holdings, Inc. (“Prestige”), the owner of the Compound W ® line of wart removal products. Prestige is the owner of both the Freeze +Off ® and Compound W ® tradenames. In September 2006, Prestige announced that it had acquired the +Wartner ® cryosurgical wart removal product line, +which competes with the Freeze Off ® product in the +U.S. and Canadian OTC markets. Because we believe that the Wartner acquisition constitutes a breach of our agreement with Prestige, we have initiated an arbitration proceeding against Prestige. As a result, it is uncertain whether Prestige will +continue to distribute the Freeze Off ® product +after 2007. For a more detailed description of our dispute with Prestige, see Item 3, “Legal Proceedings,” in this Annual Report. +Internationally, we distribute a similar CE marked cryosurgical wart removal product into the OTC footcare market in Europe, Australia and New Zealand +through our distributor, SSL International plc (“SSL”), under the Scholl and Dr. Scholl trademarks. SSL is the owner of the Scholl and Dr. Scholl trademarks in countries outside North and South America. We have also launched an +OTC cryosurgical product in Mexico through our distributor Genomma Labs, under the POINTTS tradename. +Immunoassay Tests and Reagents +We develop and sell immunoassay tests in two formats, known as MICRO-PLATE and AUTO-LYTE ® , to meet the specific needs of our customers. +In a MICRO-PLATE kit, the sample to be tested is placed into a small plastic +receptacle, called a microwell, along with the reagents. The result of the test is determined by the color of the microwell upon completion of the reaction. Controlling the reaction involves the use of a variety of reagents by laboratory personnel. +Test results +5 +Table of Contents +are analyzed by any of a variety of commercially available laboratory instruments, which we may also provide to our laboratory customers. MICRO-PLATE tests +can be performed on commonly used instruments and can detect drugs in urine, serum and sweat specimens. MICRO-PLATE tests are also used as part of the Intercept ® product line to detect drugs of abuse in oral fluid specimens. +AUTO-LYTE ® tests are sold in the form of bottles of liquid reagents. These reagents are run on +commercially available laboratory-based automated analytical instruments, which are manufactured by a variety of third parties. AUTO-LYTE ® is typically used in high volume, automated, commercial reference insurance laboratories to detect certain drugs or chemicals in urine. Test results +are produced quickly, allowing for high throughput. In recent years, sales of our AUTO-LYTE ® tests have been substantially reduced largely because of competition from cheaper “home-brew” tests used by our laboratory customers. As a result, we eventually expect to stop +selling our AUTO-LYTE ® tests. +Western blot HIV-1 Confirmatory Test +We sell an oral fluid Western blot HIV-1 confirmatory test that received +premarket approval from the FDA in 1996. This test uses the original specimen collected with the OraSure ® oral fluid collection device to confirm positive results of initial oral fluid HIV-1 EIA screening tests. The oral fluid Western blot HIV-1 confirmatory test is currently marketed under +an exclusive arrangement with BMX. +In March 2007, BMX notified +us that it will not renew the agreement under which it supplies the HIV-1 antigen used to manufacture our oral fluid Western blot HIV-1 confirmatory test or the agreement under which it distributes that product on an exclusive, world-wide basis. As +a result, these agreements will terminate on December 31, 2007. Pursuant to the terms of the antigen supply agreement, we have the right to purchase an additional two-year supply of the antigen following termination so that we can continue to +manufacture and sell our oral fluid Western blot test. When this additional two-year supply is combined with our existing inventory of the HIV-1 antigen, we believe we will have a sufficient supply of HIV-1 antigen to meet the demand for our Western +blot test for three to four years after the agreement terminates. We also intend to pursue a long-term supply agreement directly with the vendor (a former affiliate of BMX) used by BMX to manufacture the HIV-1 antigen. During 2006, sales of our oral +fluid Western blot HIV-1 confirmatory test totaled approximately $330,000. +Q.E.D. ® Saliva +Alcohol Test +Our Q.E.D. ® saliva alcohol test is a point-of-care test device that is a cost-effective +alternative to breath or blood alcohol testing. The test is a quantitative, saliva-based method for the detection of ethanol, has been cleared for sale by the FDA and has received a CLIA waiver. The U.S. Department of Transportation +(“DOT”) has also approved the test for purchase. +Each Q.E.D. ® test kit contains a +collection stick that is used to collect a sample of saliva and a disposable detection device that displays results in a format similar to a thermometer. The Q.E.D. ® device is easy to operate and instrumentation is not required to read the result. The product has a testing range of 0 +to 0.145% blood alcohol and produces results in approximately two minutes. +Products Under Development +OraQuick ® Platform +We believe that OraQuick ® has significant potential as a point-of-care testing platform for clinics and other +public health entities, hospitals, physicians’ offices and other markets. Because the OraQuick ® platform is simple to use and can operate in a non-invasive manner with oral fluid, we believe it will be suitable for use by consumers without the assistance of a doctor or other +medical professional. We also believe that OraQuick ® provides a platform technology that can be modified for detection of a variety of infectious diseases in addition to HIV, such as viral hepatitis and certain sexually transmitted diseases. +6 +Table of Contents +We are currently devoting significant resources to obtaining FDA approval to sell our OraQuick +ADVANCE ® HIV-1/2 test in the United States +OTC market. We have completed several laboratory-based operational studies and have initiated and will continue to perform additional clinical studies, including label comprehension studies, in support of our application for FDA approval. We are +also developing a counseling and referral system and product packaging and labeling suitable for the OTC market, all of which will be key components of our clinical studies. We expect this clinical work to continue during 2007 and early 2008, after +which we intend to submit an application for FDA approval. +During 2005, we obtained a license from Ortho-Clinical Diagnostics and Chiron Corporation to patents relating to the Hepatitis C virus, or HCV, and we have made substantial progress in developing a rapid HCV test using the OraQuick ® platform. In addition, in late 2006 we entered into an +agreement with Schering-Plough Corporation (“Schering-Plough”) to collaborate on the development and promotion of our OraQuick ® HCV test for use with oral fluid. Under the terms of our agreement, we will be reimbursed by Schering-Plough for a portion of our costs to develop the +test, and Schering-Plough will provide detailing and other promotional support for the test in the U.S. physicians’ office market, once the test is approved by the FDA. We are also in negotiations to obtain rights to a rapid HCV test +manufactured by a third party that we intend to distribute into international markets. +OraSure ® /Intercept ® +Applications +Oral mucosal transudate, or OMT, contains +many constituents found in blood and serum, although in lower concentrations. We believe the OraSure ® and Intercept ® devices are a platform technology with a wide variety of potential applications, where laboratory testing is available. For example, the OraSure ® device may be useful for the collection of a variety of antibodies or markers for infectious diseases or conditions in +addition to HIV-1, such as antibodies to viral hepatitis. +In +2004, the Substance Abuse and Mental Health Services Administration (“SAMHSA”) issued proposed regulations for oral fluid drug testing for federal workers. When issued in final form, these regulations may require certain modifications to +our Intercept ® product in order to permit its use +by federal workers. As a result, we are developing modifications to the Intercept ® collection device that we anticipate will be required by these regulations or are otherwise likely to be desired by our customers. +We are also currently developing additional drugs of abuse assays for use with our Intercept ® collection device. In October 2006, we signed a letter of intent with Roche +Diagnostics to negotiate a joint development and commercialization agreement for homogeneous fully-automated oral fluid drugs of abuse assays that can be run on random access chemistry analyzers. The oral fluid assays will be developed for use with +our Intercept ® collection device and Roche’s +KIMS (kinetic information of microparticles in solution) technology. The assays will be designed to run on various automated analyzers and to allow oral fluid samples to be processed with the same efficiency currently achieved with urine-based drug +tests. The parties are in the process of negotiating a definitive joint development and commercialization agreement. +In light of BMX’s announced decision to cease production of the HIV-1 EIA screening assay used with our OraSure ® device, we are working with BMX, the FDA and CDC, our major laboratory customers and +other potential suppliers to find or develop an alternative HIV-1 EIA screening test that can be used with our OraSure ® device. +OTC Cryosurgical Systems Products +We currently sell our Histofreezer ® cryosurgical systems product in the physicians’ office or professional market. This product has been approved by the FDA for the treatment of a +total of nine different types of benign skin lesions. Our OTC cryosurgical product has been approved by the FDA for two types of skin lesions—common warts and plantar warts. +7 +Table of Contents +We believe that one or more of the seven remaining Histofreezer ® indications may be attractive to the OTC market. We are developing an OTC cryosurgical +product for one of these indications, and we intend to seek FDA 510(k) clearance of that product during 2007. In addition, we are developing an extension of our existing OTC cryosurgical wart removal product in order to sell that product in +combination with salicylic acid for the treatment of common and plantar warts. We also intend to seek FDA clearance of this product extension in 2007. +Business Strategy +We have adopted a multi-part growth strategy, pursuant to which we intend to leverage our extensive diagnostic experience in order to maximize the +available opportunities from our existing products and technologies, and supplement our existing product pipeline by accessing other technologies and products. We intend to follow a disciplined approach to maximize the value of our business for the +benefit of our stockholders. +Our overall vision is to become a +recognized global leader focused on providing innovative diagnostic solutions that add substantial value to existing and emerging healthcare needs. In order to achieve this vision, our business strategy includes the following key elements: +• +Extension of Base Businesses . We intend to maximize the sales potential of our existing product lines and technologies in the markets +where they are currently sold, with a focus on expanding, where possible, the number of our oral fluid product offerings. Under this part of the strategy, we intend to fully capitalize on the potential market reach of our OraQuick ® , OraSure ® , Intercept ® , Histofreezer ® and Freeze Off ® products by investing in our sales and marketing efforts where appropriate, making product improvements and enhancements, and optimizing our distribution channels. We also intend to +expand the reach of our existing products and technology platforms into new markets and will focus specifically on expanding into international markets. +• +Infectious Disease Testing . We will pursue new products and technology platforms in the infectious disease, point-of-care testing +business to supplement our existing product pipeline. This may include either the development of new infectious disease products or the acquisition of new technologies or products. One new product we are pursuing is the development of a rapid HCV +test on our OraQuick ® platform. +• +OTC Opportunities . We intend to identify or develop products that can be sold in the OTC or retail marketplace. A significant +opportunity that we are pursuing under this part of our strategy is to seek FDA approval to sell our OraQuick ADVANCE ® rapid HIV-1/2 antibody test in the United States OTC market. We are also working to expand the distribution of our OTC cryosurgical product +internationally beyond Europe, Australia, New Zealand and Mexico where the product is currently distributed. +• +Operational Improvements . We intend to remain focused on the continuous improvement of our operations. These improvements will +include, but not be limited to, expanding the use of automated manufacturing for our product lines as demand increases, expanding the global sourcing of components and assemblies to achieve efficiencies and cost improvements, making infrastructure +and information technology investments as needed to improve effectiveness and productivity, and modifying our processes in order to continuously improve quality and the effectiveness of our operations. +Research and Development +In 2006, our research and development activities focused primarily on the +development of a rapid HCV test using our OraQuick ® +technology platform, clinical and regulatory activities related to obtaining a CE mark for the OraQuick ADVANCE ® test, preliminary work to obtain FDA approval for use of OraQuick ADVANCE ® in the United States OTC market, and development of certain improvements to existing products in both the +Intercept ® and cryosurgical wart removal product +lines. +From time to time, we supplement our own research and +development activities by funding external research at universities and certain other entities. We may continue to fund external research. +8 +Table of Contents +Research and development expenses totaled $8.6 million in 2006, $5.3 million in 2005 and $6.1 million in +2004. These expenses include the costs associated with research and development, regulatory affairs, clinical trials and product support. +Sales and Marketing +We attempt to reach our major target markets through a combination of direct sales, strategic partnerships, and independent distributors. Our marketing +strategy is to raise awareness through a full array of marketing activities, which include trade shows, print advertising, special programs and distributor promotions, to support sales in each target market. +We market our products in the United States and internationally. Revenues +attributable to customers in the United States were $56.8 million, $59.9 million and $47.8 million in 2006, 2005 and 2004, respectively. Revenues attributable to international customers amounted to $11.4 million, $9.5 million and $6.2 million, or +17%, 14% and 11% of our total revenues, in 2006, 2005 and 2004, respectively. +Infectious Disease Testing +We market the OraQuick ADVANCE ® +rapid HIV-1/2 antibody test directly to customers in the public health market for HIV testing. This market consists of a broad range of clinics and laboratories and includes states, counties, the CDC, SAMHSA and other governmental agencies, family +planning clinics, colleges and universities, correctional facilities and the military. There are also a number of organizations in the public health market, such as AIDS service organizations and various community-based organizations set up +primarily for the purpose of encouraging and enabling HIV testing. +Abbott Laboratories (“Abbott”) was appointed as our exclusive distributor in the U.S. hospital market and as a non-exclusive distributor in the U.S. physicians’ office marketplace. As our exclusive distributor to hospitals, +Abbott sells OraQuick ADVANCE ® to federal +hospitals under the terms of our Federal Supply Schedule on file with the General Services Administration. Under our agreement with Abbott, we have retained exclusive rights for all other markets, including sales to the public health and criminal +justice markets, the military, the CDC, SAMHSA and other governmental agencies. We have a small sales force that supports Abbott in order to maximize the penetration of OraQuick ADVANCE ® in the hospital market. +Abbott recently announced that it will sell part of its diagnostics business, including its rights to distribute OraQuick +ADVANCE ® , to General Electric +(“GE”). This transaction is expected to close during the first half of 2007. We intend to meet with executives from GE to discuss their plans for the OraQuick ADVANCE ® product. +We currently distribute our OraQuick ® test in several foreign countries. We expect the number of countries to increase as we find new distributors, complete +registrations in additional countries and obtain a CE mark for this product. +We also market the OraSure ® oral fluid collection device for HIV-1 testing, separately and as a kit in combination with laboratory testing services. To better serve our public health customers, we have entered into agreements with two commercial +laboratories to provide prepackaged OraSure ® test +kits, with prepaid laboratory testing and specimen shipping costs included. We also sell the OraSure ® device in the international public health market. +Substance Abuse Testing +Our substance abuse testing products are marketed to laboratories serving the workplace testing, forensic toxicology, criminal justice and drug +rehabilitation markets. +We have entered into agreements for +the distribution of Intercept ® collection devices +and associated MICRO-PLATE assays for drugs-of-abuse testing in the workplace testing market in the United States and +9 +Table of Contents +Canada through several laboratory distributors, including Quest Diagnostics (“Quest”) and Clinical Reference Laboratory, and internationally for +workplace, criminal justice and forensic toxicology testing through Bio-Rad Laboratories, Concateno (which recently acquired Altrix HealthCare, plc) and other distributors. In some cases, we assist our laboratory customers in customizing their +testing services by selling them equipment required to test oral fluid specimens collected with the Intercept ® device. +The forensic toxicology market in the United States for our substance abuse testing products consists of 250—300 laboratories including federal, state and county crime laboratories, medical examiner laboratories and reference +laboratories. The criminal justice market consists of a wide variety of entities in the criminal justice system that require drug screening, such as pre-trial services, parole and probation officials, police forces, drug courts, prisons, drug +treatment programs and community/family service programs. +We +also distribute our Q.E.D. ® saliva alcohol test +primarily through various distributors in the United States and internationally. The markets for alcohol testing are relatively small and fragmented with a broad range of legal and procedural barriers to entry. Markets range from law enforcement +testing to workplace testing of employees in safety sensitive occupations. Typical usage situations include pre-employment, random, post-accident, reasonable-cause and return-to-duty testing. +Cryosurgical Systems +Most of our Histofreezer ® sales occur in the United States to distributors that, in turn, resell the product to +primary care physicians and podiatrists in the United States. Major U.S. distributors include Cardinal Healthcare, McKesson HBOC, Physicians Sales & Service, AmerisourceBergen Corporation, and Henry Schein. Internationally, we established a +sales office in Reeuwijk, The Netherlands, and we are selling the Histofreezer ® product through a network of distributors in more than 20 countries worldwide. +We sell Freeze Off ® , a product similar to Histofreezer ® , in the OTC market in the U.S. and Canada pursuant to a distribution agreement with Prestige Brands, the owner of the Compound W ® line of wart removal products. Additionally, we distribute cryosurgical wart removal +products in the OTC footcare market in Europe, Australia and New Zealand through our distributor, SSL, under its Scholl and Dr. Scholl tradenames, and in the OTC market in Mexico under the POINTTS tradename through our distributor, Genomma +Labs. For a description of our pending dispute with Prestige Brands, see Item 3, “Legal Proceedings,” in this Annual Report. +Insurance Risk Assessment +We currently market the OraSure ® oral fluid collection device for use in screening life insurance applicants in the United States and internationally to test for three of the most +important underwriting risk factors: HIV-1, cocaine and cotinine (a metabolite of nicotine). Devices are sold to insurance testing laboratories, including Quest Diagnostics, Heritage Labs and Clinical Reference Laboratory. These laboratories in turn +provide the devices to insurance companies, usually in combination with testing services. +We also maintain a direct sales force that promotes use of the OraSure ® device directly to insurance companies for life insurance risk assessment. Insurance companies then make their own decision regarding which laboratory to use to supply their collection +devices and testing services. Our OraSure ® Western +blot confirmatory test is distributed through BMX to laboratories and is used to confirm oral fluid specimens collected with our OraSure ® device that initially test positive for HIV-1. For a description of BMX’s recent election not to renew the Western blot agreements after +December 31, 2007, see the Section entitled, “Western blot HIV-1 Confirmatory Test,” in this Annual Report. +Because insurance companies are in various stages of their adoption of the OraSure ® device, there exists a wide range of policy limits where the product is being applied. Some insurance companies have +chosen to extend their testing to lower policy limits where they did not test at all before, while others have used OraSure ® to +10 +Table of Contents +replace some of their blood and urine-based testing. In general, most of our insurance company customers use the OraSure ® device in connection with life insurance policies having face amounts of up to +$250,000, with some customers using the device for policies of up to $500,000 in amount. +In recent years, we have experienced a decline in sales of OraSure ® and related assays for insurance testing, primarily due to a reduction in the number of applications for life insurance policies and changes in underwriting requirements, as well as some +consolidation in the industry leading to a reevaluation of testing methods. However, our sales force continues to encourage additional insurance companies to use OraSure ® and to extend the use of the product by existing customers. We believe there are several factors which could help +expand the use of our device, including increasing acceptance of the reliability of oral fluid testing, the high quality of test results, the low cost of oral fluid testing relative to blood tests and the ease of use of the OraSure ® device. +We also sell our AUTO-LYTE ® assays and reagents in the insurance testing market directly to laboratories, including +Heritage Labs and Clinical Reference Laboratory. +International Markets +We sell most of our +products into international markets primarily through distributors with knowledge of their local markets. Principal markets include physicians’ offices, insurance risk assessment, substance abuse, public health and laboratory testing. +We assist our international distributors in registering the +products and obtaining required regulatory approvals in each country, and we provide training and support materials. Our international marketing program includes direct assistance to distributors in arranging for laboratory services, cooperation +from screening test manufacturers and performance of Western blot confirmatory tests when necessary. +Significant Products and Customers +Several different products have contributed significantly to our financial performance, accounting for 10% or more of total revenues during the past three years. The OraSure ® and Intercept ® oral fluid collection devices, cryosurgical systems products, and OraQuick ® rapid HIV test accounted for total revenues of $15.1 million, $17.3 million and $25.6 +million in 2006, $15.9 million, $22.7 million and $21.6 million in 2005, and $14.6 million, $20.2 million and $10.2 million in 2004, respectively. As new products are developed and commercialized, we expect to receive a greater portion of our +revenues from these new products. +We currently have two +customers, Quest and Abbott, which accounted for 14% and 10% of our total revenues, respectively, during 2006. The loss of Quest or Abbott, or a significant decrease in the volume of products purchased by either customer, could have a material +adverse effect on our results. +Supply and Manufacturing +We manufacture our OraQuick ADVANCE ® test in our Bethlehem, Pennsylvania facility. In addition, we have entered +into a supply agreement for the assembly of the OraQuick ® device in Thailand, in order to supply certain international markets. This supply agreement had an initial term of one year, and automatically renews for additional annual periods unless either party provides a timely +notice of termination prior to the end of an annual period. We believe that other firms would be able to manufacture the OraQuick ® test on terms no less favorable than those set forth in the agreement if the Thailand contractor would be unable or unwilling to continue manufacturing +this product. +We can purchase the HIV antigen and the +nitrocellulose required for the OraQuick ® test only +from a limited number of sources. The antigen is currently purchased from a single contract supplier under a long-term agreement with an initial term ending in January 2010 and one-year automatic renewal terms thereafter. The +11 +Table of Contents +nitrocellulose used in the test is also provided by a single contract supplier, under a supply agreement with a five-year term ending in 2009. If for any +reason these suppliers are unwilling or no longer able to supply our antigen or nitrocellulose needs, we believe that alternative supplies could be obtained at a competitive cost. However, a change in the antigen or nitrocellulose would require FDA +approval and some additional development work. This in turn would require significant time to complete and could disrupt our ability to manufacture and sell the OraQuick ® device. +We manufacture both the OraSure ® and Intercept ® collection devices in our Bethlehem, Pennsylvania facility, and we expect to continue to do so for the foreseeable future. +The oral fluid Western blot HIV-1 confirmatory test is currently manufactured in our Bethlehem, Pennsylvania facility. The +HIV antigen needed to manufacture the Western blot test is currently available from only a limited number of sources. For many years, we have purchased the antigen for this product from BMX on an exclusive basis. BMX is also the exclusive +distributor of the Western blot test kits. Our agreements with BMX provide for the supply by BMX of the HIV-1 antigen and distribution of the oral fluid Western blot product by BMX on an exclusive worldwide basis. In March 2007, BMX notified us that +it will not renew the agreements under which it supplies the HIV-1 antigen and distributes that product on an exclusive, world-wide basis, beyond December 31, 2007. For a further description of BMX’s election not to renew the Western blot +agreements, see the Section entitled, “Western blot HIV-1 Confirmatory Test,” in this Annual Report. +Histofreezer ® is assembled in The Netherlands by Koninklijke, Utermöhlen, N.V. (“Utermöhlen”), the company from which we acquired the product in 1998. We purchase the product +pursuant to an exclusive production agreement. Utermöhlen also supplies Freeze Off ® , the OTC cryosurgical product for the U.S. and Canadian markets. Assuming minimum purchase requirements are met, our agreement with Utermöhlen will terminate at the end of 2008 with respect to the +Histofreezer ® product. The Utermöhlen +agreement was scheduled to terminate at the end of 2006 with respect to the Freeze Off ® product, subject to a minimum purchase requirement. However, we did not meet that requirement by the end of 2006 due to unexpectedly low purchases of the product by our distributor, Prestige. As a result, we +expect to continue to purchase product for the U.S. OTC market from Utermöhlen for the foreseeable future. The cryosurgical wart removal products distributed in international OTC markets are supplied by vendors located in the United States. +We believe that additional suppliers of all of our +cryosurgical products are available on terms no less favorable than the terms of our existing supply agreements in the event that our current suppliers would be unable or unwilling to continue manufacturing these products. +Our AUTO-LYTE ® and MICRO-PLATE assays are manufactured in our Bethlehem, Pennsylvania facility. These +tests require the production of highly specific and sensitive antibodies corresponding to the antigen of interest. Substantially all our antibody requirements are provided by contract suppliers. We believe that we have adequate reserves of antibody +supplies and that we have access to sufficient raw materials for these products. +The Q.E.D. ® saliva +alcohol test is manufactured and packaged for shipment in our Bethlehem, Pennsylvania facility. +Employees +As of +December 31, 2006, we had 250 full-time employees, including 66 in sales, marketing and client services; 26 in research and development; 105 in operations, manufacturing, quality control, information systems, purchasing and shipping; 19 in +regulatory affairs and quality assurance, and 34 in administration and finance. This compares to 233 employees as of December 31, 2005. Our employees are not currently represented by a collective bargaining agreement. +12 +Table of Contents +Competition +The diagnostic industry is a multi-billion dollar international industry and is intensely competitive. Many of our competitors are substantially larger +than we are, and they have greater financial, research, manufacturing and marketing resources. +Important competitive factors for our products include product quality, price, ease of use, customer service and reputation. Industry competition is based on the following: +• +Scientific and technological capability; +• +Proprietary know-how; +• +The ability to develop and market products and processes; +• +The ability to obtain FDA or other regulatory approvals; +• +The ability to manufacture products that meet applicable FDA requirements (i.e., good manufacturing practices); +• +Access to adequate capital; +• +The ability to attract and retain qualified personnel; and +• +The availability of patent protection. +A few large corporations produce a wide variety of diagnostic tests and other medical devices and equipment. A larger number of mid-size companies +generally compete only in the diagnostic industry and a significant number of small companies produce only a few diagnostic products. As a result, the diagnostic test industry is highly fragmented and segmented. +The future market for diagnostic tests is expected to be characterized by +consolidation, greater cost consciousness and tighter reimbursement policies. The purchasers of diagnostic products are expected to place increased emphasis on lowering costs, reducing inventory levels, automation, service and volume discounts. The +increased complexity of the market is expected to force many competitors to enter into joint ventures or license certain products or technologies. +We expect competition to intensify as technological advances are made and become more widely known, and as new products reach the market. Furthermore, new +testing methodologies could be developed in the future that render our products impractical, uneconomical or obsolete. There can be no assurance that our competitors will not succeed in developing or marketing technologies and products that are more +effective than those we develop or that would render our technologies and products obsolete or otherwise commercially unattractive. In addition, there can be no assurance that our competitors will not succeed in obtaining regulatory approval for +these products, or introduce or commercialize them before we can do so. These developments could have a material adverse effect on our business, financial condition and results of operations. +Several companies market or have announced plans to market oral specimen +collection devices and tests both within and outside the United States. We expect the number of devices competing with our Intercept ® , OraQuick ® and OraSure ® devices to increase as the benefits of oral specimen-based testing become more widely accepted. +Competition in the market for HIV testing is intense and is expected to increase. We believe that the principal competition will come from existing +laboratory-based blood tests, point-of-care rapid blood tests, laboratory-based urine assays, or other oral fluid-based tests that may be developed. Our competitors include specialized biotechnology firms, as well as pharmaceutical companies with +biotechnology divisions and medical diagnostic companies. +13 +Table of Contents +Significant competitors for our OraQuick +ADVANCE ® rapid test, such as the Ortho Diagnostics division of Johnson & Johnson, Bio-Rad Laboratories, Abbott and BMX, sell laboratory-based HIV-1/2 EIAs, +and Maxim Biomedical (formerly Calypte, Inc.) sells an HIV-1 screening test for urine, in the United States. MedMira and Trinity Biotech each sell competing rapid HIV-1 blood tests, and Bio-Rad Laboratories and Chembio sell competing rapid HIV-1/2 +blood tests in the United States. These tests compete with our OraQuick ADVANCE ® test in hospitals or other laboratory settings. In addition, Trinity Biotech and +Chembio have received CLIA waivers for their rapid HIV tests, and these tests compete with our OraQuick ADVANCE ® test in the markets outside of the traditional +hospital and laboratory settings. These companies, or others, may continue to expand the bodily fluids with which a rapid HIV test may be performed, or develop and commercialize new rapid HIV tests, which would provide further competition for our +OraQuick ADVANCE ® test. We believe other companies may also seek FDA approval to sell competing rapid HIV tests in the future. +Internationally, our OraQuick ADVANCE ® test competes against rapid HIV tests sold by a number of other entities, and +often these competing tests are sold at prices substantially below the prices we charge for our OraQuick ADVANCE ® test. Calypte has developed a rapid oral fluid HIV test which is now being sold in certain foreign countries. +The Intercept ® drug testing system competes with laboratory-based drug testing products and services +using testing matrices such as urine, hair, sweat and oral fluid. Major competitors include Ansys Technologies, Inc., Dade Behring, Psychemedics and Immunalysis. +Our MICRO-PLATE oral fluid drug assays, which are sold for use with the Intercept ® and OraSure ® collection devices, are expected to come under increasing competitive pressure from “home-brew” assays +developed internally by our laboratory customers. Our oral fluid MICRO-PLATE assays also compete with urine-based homogeneous assays that are run on fully-automated, random access analyzers. These tests provide strong competitive pressure because +they provide the benefits of automation, including lower costs and short turn-around times. In addition, we believe our competitors are developing oral fluid tests suitable for use on these fully automated homogeneous assay systems and these assays, +if and when they are developed and commercialized, will represent a significant competitive threat to our oral fluid MICRO-PLATE business. In order to meet this competition, we executed a letter of intent with Roche Diagnostics in October 2006 to +enter into an agreement for the joint development and commercialization of fully-automated homogeneous oral fluid drugs of abuse assays for use with our Intercept ® device. We expect final agreements with Roche to be executed during the first half of 2007. +Our MICRO-PLATE drugs-of-abuse reagents sold in the forensic toxicology +market are targeted to forensic testing laboratories where sensitivity, automation and “system solutions” are important. In the past, these laboratories have typically had to rely on radioimmunoassay test methods to provide an adequate +level of sensitivity. Radioimmunoassays require radioactive materials, which have a short shelf-life and disposal problems. Our MICRO-PLATE tests meet the laboratories’ sensitivity needs, run on automated equipment, are not radioimmunoassays, +and are offered to the laboratory as a complete system solution of reagents, instrumentation and software to meet the specific needs of each customer. We compete with both homogeneous and heterogeneous tests manufactured by many companies. +Significant competitors in the market for these assays include Microgenics, Inc., Roche Diagnostics and Immunalysis. +Sales of our AUTO-LYTE ® urine assays have declined substantially during the past several years, primarily due to competition from assays developed internally by our laboratory +customers (i.e., “home brews”), which can be produced at a cost lower than the price typically paid for our products. Many of our customers no longer purchase our AUTO-LYTE ® assays, and we eventually expect to stop selling this product line. +The Histofreezer ® product’s delivery system and operating temperature, which is warmer than liquid +nitrogen, provide us with the opportunity to target sales to primary care physicians, such as family practitioners, pediatricians and podiatrists. We do not generally target sales to dermatologists because they have the volume of +14 +Table of Contents +patients required to support the capital costs associated with a liquid nitrogen delivery system, which is also used to remove warts and other benign skin +lesions. There is limited competition for convenient cryosurgical products for wart removal in the primary care physician market. Major competitors for the Histofreezer ® product include Cryosurgery, Inc. in the United States and Wartner in Europe. Wartner may also eventually compete with +Histofreezer ® in the physician market in the United +States. +The Freeze Off ® product, sold by Prestige under its Compound W ® tradename, competes with other OTC wart removal products in the United States. +Schering-Plough sells a competing cryosurgical wart removal product under its Dr. Scholl’s brand and another competing cryosurgical wart removal product is sold in the OTC market under the Wartner ® name. Wartner also sells a product that competes with our cryosurgical product in the +European OTC footcare market. During 2006, Prestige acquired the Wartner ® product sold in the United States and Canada, and we believe this action constitutes a material breach of our agreement with Prestige. For a further discussion of our dispute with Prestige regarding this matter, see +Item 3, “Legal Proceedings,” in this Annual Report. +Q.E.D. ® has two direct competitors, Ansys +Technologies, Inc. and Chematics. These companies offer semi-quantitative saliva-based alcohol tests and have received DOT approval. Indirect competitors who offer breath testing equipment include Intoximeters, Dräger and CMI. Although there +are lower priced tests on the market that use oral fluid or breath as a test medium, these tests are qualitative tests that are believed to be substantially lower in quality and provide fewer benefits than our Q.E.D. ® test. +Patents and Proprietary Information +We seek patent and other intellectual property rights to protect and preserve our proprietary technology and our right to capitalize on the results of our +research and development activities. We also rely on trade secrets, know-how, continuing technological innovations and licensing opportunities to provide competitive advantages for our products in our markets and to accelerate new product +introductions. We regularly search for third-party patents in fields related to our business to shape our own patent and product commercialization strategies as effectively as possible and to identify licensing opportunities. United States patents +generally have a maximum term of 20 years from the date an application is filed. +We have 16 United States patents and numerous foreign patents for the OraSure ® and Intercept ® collection devices and technology relating to oral fluid collection, containers for oral fluids, methods to test oral fluid, formulations for the manufacture of synthetic oral fluid, and methods to control the volume +of oral fluid collected and dispersed. We have also applied for additional patents, in both the United States and certain foreign countries, on such products and technology. +We have one issued patent for our OraQuick ADVANCE ® rapid HIV-1/2 antibody test in the United States, and we received notice that the +claims of a related patent have been allowed. We also have several related patent applications pending for this product in the United States and internationally. We have obtained licenses to certain lateral flow patents and to certain HIV-1 and +HIV-2 patents held by other parties. We also have obtained a license to certain HCV patents which we intend to use to manufacture and sell a rapid HCV test on the OraQuick ® or other technology platform. We obtained these licenses through the payment of certain upfront fees and an agreement +to pay ongoing royalties. We believe these fees and royalties are comparable to those generally paid by other companies under similar arrangements. +We may need to obtain licenses or other rights under, or enter into distribution or other business arrangements in connection with, certain other +intellectual property patents in order to manufacture and sell the OraQuick ADVANCE ® test or other tests that use the same or similar technology platform. See Section 1A, entitled “Risk Factors,” for a further discussion of these issues. +We have five United States patents and numerous foreign patents issued for +apparatuses and methods for the topical removal of skin lesions relating to our cryosurgical wart removal products, and we have a pending patent +15 +Table of Contents +application related to these products. We have also licensed another patent relating to apparatuses and methods for the topical removal of skin lesions +relating to our cryosurgical wart removal products. +We have +four United States patents and numerous foreign patents and patent applications for the technology used in the Q.E.D. ® test. These patents are related to the analog-to-digital technology color control systems and methods, systems and devices for the test, and detection +of biochemical molecules. +We have one United States patent +relating to the method for detecting blood in urine specimens using our AUTO-LYTE ® products. +We require our +employees, consultants, outside collaborators and other advisors to execute confidentiality agreements upon the commencement of employment or consulting relationships with us. These agreements provide that all confidential information developed by +or made known to the individual during the course of the individual’s relationship with us, is to be kept confidential and not disclosed to third parties except in specific circumstances. In the case of employees, the agreements provide that +all inventions conceived by the individual during his or her tenure with us will be our exclusive property. +We own rights to trademarks and service marks that we believe are necessary to conduct our business as currently operated. In the United States, we own +the OraSure ® , Intercept ® , OraQuick ® , OraQuick ADVANCE ® , Histofreezer ® , Q.E.D. ® and AUTO-LYTE ® trademarks. We also own many of these marks and others in several foreign countries. The Compound W ® and Freeze Off ® trademarks are owned by Prestige, or its affiliates, in the United States and Canada, the Scholl and Dr. Scholl tradenames are owned by SSL in Europe, Australia, New Zealand and +other countries outside North and South America, and the POINTTS tradename is owned by Genomma Labs in Mexico. +Although important, the issuance of a patent or existence of trademark or trade secret protection does not in itself ensure the success of our business. +Competitors may be able to produce products competing with our patented products without infringing our patent rights. Issuance of a patent in one country generally does not prevent manufacture or sale of the patented product in other countries. The +issuance of a patent is not conclusive as to validity or as to the enforceable scope of the patent. The validity or enforceability of a patent can be challenged by litigation after its issuance. If the outcome of such litigation is adverse to the +owner of the patent, the owner’s rights could be diminished or withdrawn. Trade secret protection does not prevent independent discovery and exploitation of the secret product or technique. +Government Regulation +General +Most of our products are regulated by the FDA, certain state and local agencies and comparable regulatory bodies in other countries. This regulated +environment governs almost all aspects of development, production, and marketing, including product testing, authorizations to market, labeling, promotion, manufacturing and recordkeeping. +All of our FDA-regulated products require some form of action by the FDA +before they can be marketed in the United States. After approval or clearance by the FDA, we must continue to comply with other FDA requirements applicable to marketed products. Both before and after approval or clearance, failure to comply with the +FDA’s requirements can lead to significant penalties or could disrupt our ability to sell these products. In addition, the FDA could refuse permission to obtain certificates needed to export our products if the agency determines that we are not +in compliance. +Domestic Regulation +Most of our products are regulated in the United States as medical devices. +16 +Table of Contents +There are two mechanisms by which regulated medical devices can be placed on the market in the +United States. Some products may qualify for clearance under Section 510(k) of the Federal Food, Drug and Cosmetic Act. To obtain this clearance from the FDA, the manufacturer must provide a premarket notification that it intends to begin +marketing the product, and show that the product is substantially equivalent to another legally marketed product (i.e., that it has the same intended use and is as safe and effective as a legally marketed device and does not raise different +questions of safety and effectiveness). In some cases, the submission must include data from human clinical studies. Marketing may commence when the FDA issues a clearance letter finding substantial equivalence. An applicant must submit a 510(k) +application at least 90 days before marketing of the affected product commences. Although FDA clearance may be granted within that 90-day period, in some cases as much as a year or more may be required before clearance is obtained, if at all. +If the medical device does not qualify for the 510(k) +procedure (either because it is not substantially equivalent to a legally marketed device or because it is required by statute and the FDA’s regulations to have an approved premarket application), the FDA must approve a premarket application, +or PMA, before marketing can begin. PMAs must demonstrate, among other matters, that the medical device provides a reasonable assurance of safety and effectiveness. A PMA is typically a complex submission, including the results of preclinical and +clinical studies. Preparing a PMA is a detailed and time-consuming process. Once a PMA has been submitted, the FDA is required to review the submission within 180 days. However, the FDA’s review may, and often is, much longer, often requiring +one year or more, and may include requests for additional data and facility inspections before approval is granted, if at all. +Some of our products are used for non-medical purposes and many of our drugs-of-abuse products sold to state crime labs are for forensic use. The FDA does +not currently regulate products used for these purposes. +Every +company that manufactures medical devices distributed in the United States must comply with the FDA’s Quality System Regulations (“QSRs”). These regulations govern the manufacturing process, including design, manufacture, testing, +release, packaging, distribution, documentation and purchasing. In complying with QSRs, manufacturers must continue to expend time, money and effort in the area of production and quality assurance to ensure full technical compliance. Companies are +also subject to other post-market and general requirements, including restrictions imposed on marketed products, promotional standards and requirements for recordkeeping and reporting of certain adverse reactions. If there are any modifications made +to our marketed devices, a premarket notification or PMA may be required to be submitted to, and cleared or approved by, the FDA, before the modified device may be marketed. The FDA regularly inspects companies to determine compliance with QSRs and +other post-market requirements. Failure to comply with statutory requirements and the FDA’s regulations can result in warning letters, monetary penalties, suspension or withdrawal of regulatory approvals, operating restrictions, total or +partial suspension of production, injunctions, product recalls, seizure of products and criminal prosecution. +The Clinical Laboratory Improvements Amendments of 1988, or CLIA, prohibit laboratories from performing tests for the purpose of providing information for +the diagnosis, prevention or treatment of any disease or impairment of, or the assessment of, the health of human beings, unless there is in effect for such laboratories a certificate issued by the U.S. Department of Health and Human Services +applicable to the category of examination or procedure performed. We consider the applicability of the requirements of CLIA in the design and development of our products. We have obtained a waiver of the CLIA requirements for both our OraQuick +ADVANCE ® rapid HIV-1/2 antibody test and our +Q.E.D. ® alcohol saliva test and may seek similar +waivers for certain other products. A CLIA waiver allows certain customers to use the waived products that may not have been able to use them without complying with certain quality control and other requirements. +Certain of our products may also be affected by state regulations in the +United States. For example, there are several states that restrict or do not currently permit oral fluid drug testing in the workplace or other markets. In addition, several states prohibit or limit the use of rapid, point-of-care HIV testing. We +are presently working with legislators or regulators in certain of these states in an effort to modify or remove any restrictions affecting our ability to sell products. +17 +Table of Contents +International +We are also subject to regulations in foreign countries governing products, human clinical trials and marketing, and may +need to obtain approval from international public health agencies, such as the World Health Organization, in order to sell products in certain countries. Approval processes vary from country to country, and the length of time required for approval +or to obtain other clearances may in some cases be longer than that required for U.S. governmental approvals. We generally pursue approval only in those countries that we believe have a significant market opportunity. +The International Organization for Standardization (“ISO”) is a +worldwide federation of national standards bodies from some 130 countries, established in 1947. The mission of the ISO is to promote the development of standardization and related activities in the world with a view to facilitating the international +exchange of goods and services. ISO certification is a pre-requisite to use of the CE mark and indicates that our quality system complies with standards applicable to activities ranging from initial product design and development through production +and distribution. The CE mark is a European Union (“EU”) requirement to sell products that fall under the scope of the Medical Devices Directive (“MDD”) and the In Vitro Diagnostic Directive (“IVDD”). The CE mark is +evidence that the manufacturer and the product meet the requirements of all applicable directives, including the MDD and IVDD. +We received authorization to use the CE mark for the OraSure ® and Intercept ® collection devices and our Histofreezer ® product line, and SSL International has obtained authorization to use the CE mark for our cryosurgical wart removal product in the OTC European +footcare market. In addition, we are currently in the process of obtaining authorization to affix a CE mark to our OraQuick ADVANCE ® HIV-1/2 test. +We must also comply with certain registration requirements as dictated by Health Canada, prior to commencing sales in Canada. We have completed this +process for several of our current products and may do so with respect to other products in the future. In addition, Canadian law requires manufacturers of medical devices to have a quality management system that meets various ISO requirements in +order to obtain a license to sell their devices in Canada. +Anti-Kickback Laws +The Federal Anti-Kickback +Statute prohibits the knowing and willful offer, payment, solicitation, or receipt of any form of remuneration in return for, or to induce: +• +The referral of a person; +• +The furnishing or arranging for the furnishing of items or services reimbursable under Medicare, Medicaid or other governmental programs; or +• +The purchase, lease, or order of, or the arrangement or recommendation of the purchasing, leasing, or ordering of any item or service reimbursable under Medicare, +Medicaid, or other governmental programs. +Our products are or may be purchased by customers that will seek or receive reimbursement under Medicare, Medicaid or other governmental programs. Noncompliance with the federal anti-kickback legislation can result in exclusion from +Medicare, Medicaid, or other governmental programs, restrictions on our ability to operate in certain jurisdictions, as well as civil and criminal penalties, any of which could have an adverse effect on our business and results of operations. +The Federal Civil Monetary Penalties Law prohibits the +offering or transferring of remuneration to a Medicare or Medicaid beneficiary that the person knows or should know is likely to influence the beneficiary’s selection of a particular supplier of Medicare or Medicaid payable items or services. +Noncompliance can result in civil money penalties of up to $10,000 for each wrongful act, assessment of three times the amount claimed for each item or service and exclusion from the Federal healthcare programs. +18 +Table of Contents +Many states have also adopted some form of anti-kickback laws. A determination of liability under such +laws could result in fines and penalties and restrictions on our ability to operate in these jurisdictions. +We believe that we are operating in compliance with these laws. +Foreign Corrupt Practices Act +The U.S. Foreign Corrupt Practices Act (“FCPA”) prohibits corporations and individuals from engaging in certain activities to obtain or retain +business or to influence a person working in an official capacity. It is illegal to pay, offer to pay or authorize the payment of anything of value to any foreign government official, government staff member, political party or political candidate +in an attempt to obtain or retain business or to otherwise influence a person working in an official capacity. Our present and future business has and will continue to be subject to the FCPA and various other laws, rules and/or regulations +applicable to us as a result of our international sales. +Environmental Regulation +Because of the +nature of our current and proposed research, development, and manufacturing processes, we are subject to stringent federal, state and local laws, rules, regulations and policies governing the use, generation, manufacture, storage, air emission, +effluent discharge and handling and disposal of materials and wastes. We believe that we have complied with these laws and regulations in all material respects. +The foregoing discussion of our business should be read in conjunction with the Financial Statements and accompanying notes included in Item 15 of +this Annual Report. +ITEM 1A. Risk Factors +The following is a discussion of certain significant risk factors that could potentially negatively impact our financial condition, performance and prospects. +Regulatory Risks +The Need to Obtain Regulatory Approvals and Respond to Changes in +Regulatory Requirements Could Adversely Affect Our Business. +Many of our proposed and existing products are subject to regulation by the FDA and other governmental or public health agencies. In particular, we are subject to strict governmental controls on the development, manufacture, labeling, +distribution and marketing of our products. In addition, we are often required to obtain approval or registration with foreign governments or regulatory bodies before we can import and sell our products in foreign countries. +The process of obtaining required approvals or clearances from governmental +or public health agencies can involve lengthy and detailed laboratory testing, human clinical trials, sampling activities and other costly, time- consuming procedures. These approvals can require the submission of a large amount of clinical data +which may require significant time to obtain. It is also possible that a product will not perform at a level needed to generate the clinical data required to obtain an approval or clearance. The submission of an application to the FDA or other +regulatory authority does not guarantee that an approval or clearance to market the product will be received. Each authority may impose its own requirements and delay or refuse to grant approval or clearance, even though a product has been approved +in another country or by another agency. +Moreover, the +approval or clearance process for a new product can be complex and lengthy. This time span increases our costs to develop new products as well as the risk that we will not succeed in introducing or selling them in the United States or other +countries. +19 +Table of Contents +We are in the process of conducting clinical studies to support an application for FDA approval of our +OraQuick ADVANCE ® HIV-1/2 test for sale in +the United States OTC market. We also expect to conduct clinical trials in support of our application for FDA approval of our OraQuick ® HCV test for professional use. There can be no assurance that these clinical trials will generate sufficient data to support FDA approval of either +product or that FDA approval will be obtained. Failure to obtain or any delay in obtaining FDA approval for either product could significantly reduce future revenues and could adversely affect our financial performance. +Newly promulgated or changed regulations could also require us to undergo +additional trials or procedures, or could make it impractical or impossible for us to market our products for certain uses, in certain markets, or at all. For example, during 2004 SAMHSA, which is part of the U.S. Department of Health and Human +Services, issued proposed regulations for the use of oral fluid drug testing for federal workers. Although the SAMHSA regulations have been withdrawn, if and when they are issued in final form, they could permit us to market and sell our oral fluid +drug tests for use with federal workers only if certain modifications are made to our products. If we are unable to make these modifications, or if the modifications require significant time to develop, our ability to sell our oral fluid drug +testing products in that market could be limited. In addition, the extent to which the final SAMHSA regulations permit the sale of our oral fluid drug tests for use with federal workers may influence whether customers in the workplace, criminal +justice or other unregulated markets use our products. +The +regulations in some states may restrict our ability to sell products in those states. For example, certain states restrict or do not allow the testing of oral fluid for drugs of abuse or the rapid, point-of-care testing for HIV. While we intend to +work with state legislators and regulators to remove or modify any applicable restrictions, there is no guarantee we will be successful in these efforts. +In addition, all in vitro diagnostic products that are to be sold in the EU must bear the CE mark indicating conformance with the essential +requirements of the IVDD. We are not permitted to sell our products in the EU without a CE mark, which could lead to the termination of strategic alliances and agreements for sales of those products in the EU. We have obtained the CE mark for +several of our existing products and we intend to CE mark our OraQuick ADVANCE ® test and certain of our future products and are not aware of any material reason why we will be unable to do so. However, there can be no assurance that compliance with all provisions of the IVDD will be +demonstrated and the CE mark will be obtained for all products that we desire to sell in the EU. +The Inability to Extend the Shelf Life of Our OraQuick ADVANCE ® Test Could Adversely Affect Our Business. +The shelf life of a product is the period of time from the date of manufacture during which the product is expected to +perform in accordance with its specifications and labeling. In order to successfully sell our products, they need to have a shelf life that is long enough to cover the time required to distribute the product to a customer and provide the customer +with a reasonable period to use that product. +Where a product +has a short shelf life, our ability to sell that product may be adversely affected. In order to extend the shelf life, we may be required to submit real time stability data supporting such an extension to the FDA for approval. +Our OraQuick ADVANCE ® HIV-1/2 test has a shelf life of six months. While this shelf life has not prevented us +from selling into the public health and hospital markets in the United States, it has limited our ability to sell that test internationally. We also believe a shelf life of at least 12 months will be required to sell the OraQuick ADVANCE ® test successfully into the United States OTC market. +We are working to extend the shelf life of our OraQuick +ADVANCE ® test. However, there can be no +assurance that we will be successful in obtaining such an extension or its approval by the FDA. If we are unsuccessful in obtaining a shelf life extension, our ability to sell the OraQuick ® test may be adversely affected and we may not be able to sell it successfully into the +United States OTC market. +20 +Table of Contents +Failure to Comply With FDA or Other Regulatory Requirements May Require Us to Suspend Production of +Our Products or Institute a Recall Which Could Result in Higher Costs and a Loss of Revenues. +We can manufacture and sell many of our products, both in the United States and internationally, only if we comply with regulations of government agencies +such as the FDA. We have implemented quality assurance and other systems that are intended to comply with applicable regulations. +Although we believe that we have adequate processes in place to ensure compliance with these requirements, the FDA or other regulatory bodies could force +us to stop manufacturing or selling our products if it concludes that we are out of compliance with applicable regulations. The FDA and other regulatory bodies could also require us to recall products if we fail to comply with applicable +regulations, which could force us to stop manufacturing such products. Such actions by the FDA could adversely affect our revenues. See the Section entitled “Government Regulation” in Item 1 of this Annual Report for a further +discussion of applicable regulatory requirements. +Risks +Relating to Our Industry, Business and Strategy +Our +Ability to Sell Products Could be Affected by Competition From New and Existing Diagnostic Products and by Treatments or Other Non-Diagnostic Products Which May be Developed. +The diagnostic industry is focused on the testing of biological specimens in a laboratory or at the point of care and is +highly competitive and rapidly changing. Many of our principal competitors have considerably greater financial, technical and marketing resources. As new products enter the market, our products may become obsolete or a competitor’s products may +be more effective or more effectively marketed and sold than ours. If we fail to maintain and enhance our competitive position, our customers may decide to use products developed by competitors which could result in a loss of revenues. +We also face competition from products which may be sold at a lower price. +To the extent this competition arises, customers may choose to buy lower cost products from third parties or we may be forced to sell our products at a lower price, both of which could result in a loss of revenues or a lower gross margin +contribution from the sale of our products. +In addition, the +development and commercialization of products outside of the diagnostics industry could adversely affect sales of our product. For example, the development of a safe and effective vaccine to prevent HIV or preventative treatments for other diseases +or conditions that our products are designed to detect, could reduce, or eventually eliminate, the demand for our HIV or other diagnostic products and thereby result in a loss of revenues. +Our Research, Development and Commercialization Efforts May Not Succeed +and Our Competitors May Develop and Commercialize More Effective or Successful Diagnostic Products. +In order to remain competitive, we must regularly commit substantial resources to research and development and the commercialization of new products. +The research and development process generally takes a +significant amount of time from inception to commercial product launch. This process is conducted in various stages. During each stage there is a substantial risk that we will not achieve our goals on a timely basis, or at all, and we may have to +abandon a product in which we have invested substantial amounts. +During 2006, 2005 and 2004, we incurred $8.6 million, $5.3 million and $6.1 million, respectively, in research and development expenses. We expect to continue to incur significant costs from our research and development activities. +21 +Table of Contents +Successful products require significant development and investment, including testing, to demonstrate +their cost-effectiveness or other benefits prior to commercialization. In addition, regulatory approval must be obtained before most products may be sold. Additional development efforts on these products will be required before any regulatory +authority will review them. Regulatory authorities may not approve these products for commercial sale. In addition, even if a product is developed and all applicable regulatory approvals are obtained, there may be little or no market for the +product. Accordingly, if we fail to develop commercially successful products, or if competitors develop more effective products or a greater number of successful new products, customers may decide to use products developed by our competitors. This +would result in a loss of revenues and adversely affect our results of operations, cash flows and business. +If We Lose Our Key Personnel or Are Unable to Attract and Retain Qualified Personnel as Necessary, Our Business Could be Harmed. +Our success will depend to a large extent upon the contributions of our +executive officers, management and sales, marketing, operations and scientific staff. We may not be able to attract or retain qualified employees in the future due to the intense competition for qualified personnel among medical products businesses. +If we are not able to attract and retain the necessary +personnel to accomplish our business objectives, we may experience constraints that will adversely affect our ability to effectively manufacture, sell and market our products, to meet the demands of our strategic partners in a timely fashion, or to +support internal research and development programs. Although we believe we will be successful in attracting and retaining qualified personnel, competition for experienced scientists and other personnel from numerous companies and academic and other +research institutions may limit our ability to do so on acceptable terms. +Future Acquisitions or Investments Could Disrupt Our Ongoing Business, Distract Our Management, Increase Our Expenses and Adversely Affect Our Business. +We may consider strategic acquisitions or investments as a way to expand our +business in the future. These activities, and their impact on our business, are subject to the following risk factors: +• +Suitable acquisitions or investments may not be found or consummated on terms that are satisfactory to us; +• +We may be unable to successfully integrate an acquired company’s personnel, assets, management systems and technology into our business; +• +Acquisitions may require substantial expense and management time and could disrupt our business; +• +An acquisition and subsequent integration activities may require greater capital resources than originally anticipated at the time of acquisition; +• +An acquisition may result in the incurrence of unexpected expenses, the dilution of our earnings or our existing stockholders’ percentage ownership, or +potential losses from undiscovered liabilities not covered by an indemnification from the seller(s) of the acquired business; +• +An acquisition may result in the loss of existing key personnel or customers or the loss of the acquired company’s key personnel or customers; +• +The benefits expected to be derived from an acquisition may not materialize and could be affected by numerous factors, such as regulatory developments, general +economic conditions and increased competition; and +• +An acquisition of a foreign business may involve additional risks, including, but not limited to, foreign currency exposure, liability under foreign laws or +regulations and not being able to successfully assimilate differences in foreign business practices or overcome language or cultural barriers. +The occurrence of one or more of the above or other factors may prevent us from achieving all or a significant part of the benefits expected from an +acquisition or investment. This may adversely affect our +22 +Table of Contents +financial condition, results of operations and ability to grow our business or otherwise achieve our financial or strategic objectives. +Our Revenues Could be Affected by Third-Party Reimbursement Policies and +Potential Cost Constraints. +The end-users of our products +are expected to increasingly include hospitals, physicians and other healthcare providers. Use of our products could be adversely impacted if these end-users do not receive reimbursement for the cost of our products by their patients’ +healthcare insurers or payors. Our net sales could also be adversely affected by changes in reimbursement policies of governmental or private healthcare payors, including in particular the level of reimbursement for our products. In the United +States, healthcare providers such as hospitals and physicians who purchase diagnostic products generally rely on third-party payors, principally private health insurance plans, Medicare and Medicaid, to reimburse all or part of the cost of the +product and procedure. We believe that the overall escalating cost of medical products and services has led to, and will continue to lead to, increased pressures on the healthcare industry, both foreign and domestic, to reduce the cost of products +and services. Given the efforts to control and reduce healthcare costs in the United States in recent years, currently available levels of reimbursement may not continue to be available in the future for our existing products or products under +development. Third-party reimbursement and coverage may not be available or adequate in either the United States or foreign markets, current reimbursement amounts may be decreased in the future and future legislation, and regulation or reimbursement +policies of third-party payors may reduce the demand for our products or our ability to sell our products on a profitable basis. +Increases in Demand for Our Products Could Require Us to Expend Considerable Resources to Meet the Demand or Harm Our Customer Relationships if We are +Unable to Meet Demand. +If we experience significant or +unexpected increases in the demand for our products, we and our suppliers may not be able to meet that demand without expending additional capital resources. These capital resources could involve the cost of new machinery or even the cost of new +manufacturing facilities. This would increase our capital costs, which could adversely affect our earnings. Our suppliers may be unable or unwilling to expend the necessary capital resources or otherwise expand their capacity. In addition, new +manufacturing equipment or facilities may require FDA approval before they can be used to manufacture our products. To the extent we are unable to obtain or are delayed in obtaining such approvals, our ability to meet the demand for our products +could be adversely affected. +If we or our suppliers are unable +to develop necessary manufacturing capabilities in a timely manner, our net sales could be adversely affected. Failure to cost-effectively increase production volumes, if required, or lower than anticipated yields or production problems encountered +as a result of changes that we or our suppliers make in our manufacturing processes to meet increased demand, could result in shipment delays or interruptions and increased manufacturing costs, which could also have a material adverse effect on our +revenues and profitability. +Our inability to meet customer +demand for our products could also harm our customer relationships and impair our reputation within the industry. This, in turn, could have a material adverse effect on our business and prospects. +Risks Relating to Collaborators +Our Failure to Maintain Existing Distribution Channels, or Develop New +Distribution Channels, May Result in Lower Revenues. +We +have marketed many of our products by collaborating with laboratories, diagnostic companies and distributors. Our sales depend to a substantial degree on our ability to sell products to these customers and on the marketing abilities of the companies +with which we collaborate. +23 +Table of Contents +We currently sell our OraQuick ADVANCE ® rapid HIV-1/2 antibody test to the diagnostics division of Abbott Laboratories for +distribution into the United States hospital market on an exclusive basis. Abbott recently announced that it will sell a portion of its diagnostics business to General Electric (“GE”), including its rights to the OraQuick +ADVANCE ® product. This sale has not yet +closed, and it is unclear what, if any, effect it may have on sales of our OraQuick ADVANCE ® test in the hospital market. +Some of our distributors or other customers may not fulfill their contractual obligations to us. Although we will try to maintain and expand our business with our distributors and customers and require that they +fulfill their contractual obligations, there can be no assurance that such companies will continue to purchase or distribute our products, maintain historic order volumes or otherwise meet their purchase or other obligations, or that new +distribution channels will be available on satisfactory terms. The failure of these distributors or other customers to purchase our products could adversely affect our revenues. +In September 2006, Prestige Brands, Inc., the domestic distributor of the Freeze Off ® cryosurgical wart removal product, announced that it had acquired the Wartner ® cryosurgical product, which directly competes with the +Freeze Off ® product in the United States and +Canadian OTC markets. We believe this acquisition constitutes a material breach of our agreement with Prestige, and we are pursuing arbitration to resolve this matter. We believe we have already suffered significant damages from this breach and +Prestige’s actions may continue to impact future sales of the Freeze Off ® product. If we are unable to successfully resolve this matter with Prestige or find an alternative arrangement for distributing our cryosurgical product into the United States and Canada OTC markets, our revenues could +be negatively affected. +Some of our distributors have also +consolidated in recent years and such consolidation has had, and may continue to have, an adverse impact on the level of orders for our products. In addition, some distributors have experienced, and may continue to experience, pressure from their +customers to reduce the price of their products and testing services. For example, several of our insurance testing laboratories are facing this pressure and are using lower cost “home brew” insurance testing assays that they have +developed internally or purchased from our competitors. This has reduced our assay sales and is expected to lower sales of these products in 2007 and beyond. +The Use of Sole Supply Sources or Third Party Suppliers For Critical Components of Our Products Could Adversely Affect Our Business. +We currently purchase certain critical components of our products from sole +supply sources or other third party suppliers. For example, all of the HIV antigen and nitrocellulose required to make our OraQuick ADVANCE ® rapid HIV-1/2 antibody test is purchased from sole source suppliers. In addition, the conjugates used in our MICROPLATE oral fluid drugs of abuse +assays are obtained from third party suppliers. +If these +suppliers are unable or unwilling to supply the required component or if they make changes in the component or do not supply materials meeting our specifications, we may need to find another source and perform additional development work. We may +also need to obtain FDA or other regulatory approvals for the use of the alternative component for our products. Completing that development and obtaining such approvals could require significant time to complete and may not occur at all. The +availability of critical components from sole supply sources or other third parties could also reduce our control over pricing, quality and timely delivery. These events could either disrupt our ability to manufacture and sell certain of our +products, or completely prevent us from doing so or increase our costs. Any such event could have a material adverse effect on our results of operations, cash flows and business. +The Unavailability of Certain Products Distributed by a Third Party Could Adversely Affect Sales of Our OraSure ® Oral Fluid Collection Device. +In testing an oral fluid sample collected with an OraSure ® device for HIV-1 in the United States, our customers +must use an HIV-1 EIA screening test approved by the FDA for use with our OraSure ® device. Where +24 +Table of Contents +an oral fluid sample screens positive for HIV-1, our customers must then use our oral fluid Western blot HIV-1 confirmatory test, which has also been +approved by the FDA for use with our OraSure ® +device, to confirm that positive indication. +BMX currently +manufactures and sells the only oral fluid HIV-1 EIA screening test that has received FDA approval for use in detecting HIV-1 in an oral fluid specimen collected with our OraSure ® collection device. BMX also supplies the HIV-1 antigen used to manufacture our oral fluid Western blot HIV-1 +confirmatory test and is the exclusive world-wide distributor of that product. +In late 2006, BMX announced that it will discontinue manufacturing the HIV-1 EIA screening test during 2007 and that, due to quality problems, it may have difficulty supplying this screening test prior to the time it +ceases manufacturing. As a result, we are working with BMX, the FDA and CDC, our major laboratory customers and other potential suppliers to find or develop an alternative HIV-1 EIA screening test that can be used with oral fluid samples collected +with our OraSure ® device. +In March 2007, BMX notified us that it will not renew the agreement under +which it supplies the HIV-1 antigen used to manufacture our oral fluid Western blot HIV-1 confirmatory test or the agreement under which it distributes that product on an exclusive, world-wide basis. As a result, these agreements will terminate on +December 31, 2007. Pursuant to the terms of the antigen supply agreement, we have the right to purchase an additional two-year supply of the antigen following termination so that we can continue to manufacture and sell our oral fluid Western +blot test. When this additional two-year supply is combined with our existing inventory of the HIV-1 antigen, we believe we will have a suffucient supply of HIV-1 antigen to meet the demand for our Western blot test for three to four years after the +agreement terminates. We also intend to pursue a long-term supply agreement directly with the vendor (a former affiliate of BMX) used by BMX to manufacture the HIV-1 antigen. During 2006, sales of our oral fluid Western blot HIV-1 confirmatory test +totaled approximately $330,000. +If at some point in the future +our customers cannot obtain either an HIV-1 EIA screening test or a Western blot or other HIV-1 confirmatory test that has been approved by the FDA for use with our OraSure ® collection device, sales of our OraSure ® device could be negatively affected. +We May Need Strategic Partners to Assist in Developing and Commercializing Some of Our Diagnostic Products. +Although we intend to pursue some product opportunities +independently, opportunities that require a significant level of investment for development and commercialization or a distribution network beyond our existing sales force may necessitate involving one or more strategic partners. Our strategy for +development and commercialization of products may entail entering into arrangements with distributors or other corporate partners, universities, research laboratories, licensees and others. We may be required to transfer material rights to such +strategic partners, licensees and others. While we expect that our current and future partners, licensees and others have and will have an economic motivation to succeed in performing their contractual responsibilities, there is no assurance that +they will do so and the amount and timing of resources to be devoted to these activities will be controlled by others. Consequently, there can be no assurance that any revenues or profits will be derived from such arrangements. +We may need to collaborate with one or more third parties or find new product +distribution channels in order to commercialize our OraQuick ADVANCE ® HIV-1/2 test should we receive approval from the FDA for use in the United States OTC market. In order to successfully commercialize our OraQuick ADVANCE ® test in the OTC market, we may need to invest significantly in advertising and +promotion and obtain distribution channels to the OTC market. If we are unable to collaborate with a third party having sufficient resources to assist in these efforts or find alternative distribution channels to access the OTC market, we may need +to incur significant costs for advertising and promotion, and our ability to maximize our future revenues for this opportunity could be adversely affected. +25 +Table of Contents +Risks Relating to Our Financial Results, Structure and Need for Financing +We Have a History of Losses Prior to 2005. +We achieved our first full years of profitability in 2005 and 2006. However, +as of December 31, 2006, the Company had an accumulated deficit of $98.4 million. +Our ability to achieve continued profitability in the future will be dependent upon a number of factors including, without limitation, the following: +• +Creating market acceptance for and selling increasing volumes of our OraQuick ADVANCE ® rapid HIV-1/2 antibody test, Intercept ® drug testing product and OraSure ® collection device; +• +The degree to which certain of our new products may replace sales of our existing products and the financial impact of that change, including the degree to which +our OraQuick ADVANCE ® test will replace our +OraSure ® collection device for HIV-1 testing or +sales of our cryosurgical wart removal products in the OTC market will replace sales of our Histofreezer ® product to physicians’ offices or other professional markets; +• +The degree to which our major distributors comply with their contractual obligations, including minimum purchase commitments; +• +Whether we are able to extend the shelf life of our OraQuick ADVANCE ® HIV-1/2 test; +• +Our ability to successfully resolve claims or litigation, including patent infringement litigation; +• +The level of expenditures we are required to make in order to develop and obtain regulatory approvals for our new +products, including our OraQuick ADVANCE ® HIV-1/2 test for use in the OTC market +and an OraQuick ® HCV test for professional use; +• +Achieving growth in sales of our wart removal products in the OTC market and selling other products, such as our OraQuick ADVANCE ® HIV-1/2 test, in the OTC market; +• +Whether we are able to find a replacement for the BMX HIV-1 EIA screening test for use in connection with oral fluid samples collected with our OraSure ® device; +• +Achieving growth in international markets with our OraQuick ADVANCE ® HIV-1/2 test, cryosurgical wart removal products and other products; +• +Changes in the level of competition, such as would occur if larger and financially stronger competitors introduced new or lower priced products to compete with our +products; +• +Changes in economic conditions in domestic or international markets, such as economic downturns, reduced demand, inflation and currency fluctuations; +• +Failure to achieve our targets for growth in revenues; +• +Changes in distributor buying patterns or a buildup of significant quantities in our distributors’ inventories or distribution channels; and +• +Commercially developing, and obtaining regulatory approvals and creating market acceptance for new products in a time frame consistent with our objectives. +Even though we achieved profitability for +2005 and 2006, there can be no assurance that we will be able to sustain such profitability in the future. +Utilization of Our Deferred Tax Assets May Be Limited and is Dependent on Future Taxable Income. +As of December 31, 2006, we had federal net operating loss +(“NOL”) carryforwards of $53.0 million for federal income tax purposes. The Tax Reform Act of 1986 contains provisions under Section 382 of the Internal +26 +Table of Contents +Revenue Code that limit the NOLs that may be used in any given year in the event of specified occurrences, including significant ownership changes. If these +specified events occur, we may lose some or all of the tax benefits of these carryforwards. +During 2005, we determined, based on our assessment of both positive and negative evidence, which takes into consideration our forecasted taxable income, that it was more likely than not that we will benefit from the +use of a significant portion of our deferred tax assets, and therefore we reduced our valuation allowance on our deferred tax assets related to these NOLs. If in the future we determine, based on our assessment of both positive and negative +evidence, that it is more likely than not that we will not realize all or a portion of the deferred tax assets, we will record a valuation allowance on the deferred tax assets which would result in recognition of income tax expense. +We May Require Future Additional Capital. +Our future liquidity and ability to meet our future capital requirements +will depend on numerous factors, including, but not limited to, the following: +• +The costs and timing of the expansion of our manufacturing capacity; +• +The success of our research and product development efforts; +• +The magnitude of capital expenditures; +• +Changes in existing and potential relationships with distributors and other business partners; +• +The time and cost of obtaining regulatory approvals; +• +The costs involved in obtaining and enforcing patents, proprietary rights and necessary licenses; +• +The costs and liability associated with patent infringement or other types of litigation; +• +The costs and timing of expansion of sales and marketing activities; +• +The timing of the commercial launch of new products; +• +The extent to which existing and new products gain market acceptance; +• +The scope and results of clinical testing; +• +Competing technological and market developments; and +• +The scope and timing of strategic acquisitions. +If additional financing is needed, we may seek to raise funds through the sale of equity or other securities or through bank borrowings. There can be no +assurance that financing through the sale of securities, bank borrowings or otherwise, will be available to us on satisfactory terms, if at all. +An Economic Downturn, Terrorist Attacks or National Disasters May Adversely Affect Our Business. +Changes in economic conditions could adversely affect our business. For +example, in a difficult economic environment, customers may be unwilling or unable to invest in new diagnostic products, may elect to reduce the amount of their purchases or may perform less drug testing because of declining employment levels or the +issuance of fewer life insurance policies. A weakening business climate could also cause longer sales cycles and slower growth, and could expose us to increased business or credit risk in dealing with customers or suppliers adversely affected by +economic conditions. +Terrorist attacks such as those occurring +on September 11, 2001, or national disasters such as Hurricane Katrina, and subsequent governmental responses to these events could cause economic instability. These actions +27 +Table of Contents +could adversely affect economic conditions both within and outside the United States and reduce demand for our products. Terrorist attacks and natural +disasters could cause governments and regulatory agencies, such as the FDA or agencies that perform similar functions outside the United States, to focus their resources on other matters, such as relief efforts or vaccines or other products intended +to address the threat of biological or chemical warfare. This diversion of resources could eliminate or delay the bulk procurement of our products by government agencies or delay our ability to obtain regulatory approvals required to manufacture, +market or sell our products in the United States and other countries. These events could also disrupt the operations of our customers and suppliers and eliminate, reduce or delay our customers’ ability to purchase and use our products and our +suppliers’ ability to provide raw materials and finished products. +Our Stock Price Could Continue to be Volatile. +Our stock price has been volatile, has fluctuated substantially in the past and may be volatile in the future and could experience substantial declines. The following factors, among others, could have a significant impact on the market for +our Common Stock: +• +Future announcements concerning us or our products; +• +Future announcements concerning our competitors or industry; +• +Developments in patent or other proprietary rights; +• +Litigation or threatened litigation; +• +Public concern as to the performance or safety of products that we or others have developed or sold; +• +Failure to achieve, or changes in, financial estimates by securities analysts and comments or opinions about us by securities analysts or major stockholders; +• +Governmental regulation; +• +Clinical results with respect to our products in development or those of our competitors; +• +Changes in the level of competition; +• +Loss of or declines in sales to major distributors or customers; +• +The relatively low trading volume for our Common Stock; +• +Period to period fluctuations in our operating results; +• +General market and economic conditions; and +• +Terrorist attacks, civil unrest, war and national disasters. +Future Sales of Our Common Stock by Existing Stockholders, Executive Officers or Directors Could Depress the Market Price +of Our Common Stock and Make It More Difficult For Us to Sell Stock in the Future. +Sales of our Common Stock in the public market, or the perception that such sales could occur, could negatively impact the market price of our Common Stock. We are unable to estimate the number of shares of our Common +Stock that may actually be resold in the public market since this will depend on the market price for our Common Stock, the individual circumstances of the sellers and other factors. +We have a number of institutional stockholders that own significant blocks of our Common Stock. If one or more of these +stockholders sell large portions of their holdings in a relatively short time, for liquidity or other reasons, the prevailing market price of our Common Stock could be negatively affected. In addition, it is possible that one or more of our +executive officers or non-employee members of our Board of Directors could sell shares of our Common Stock during an open trading window under our Insider Trading Policy. These transactions and +28 +Table of Contents +the perceived reasons for these transactions could have a negative effect on the prevailing market price of our Common Stock. +Our Reported Financial Results May be Adversely Affected by Changes in +Accounting Principles Generally Accepted in the United States. +We prepare our financial statements in conformity with accounting principles generally accepted in the United States. These accounting principles are subject to creation or interpretation by the Financial Accounting Standards Board, the SEC +and various bodies formed to interpret and create appropriate accounting principles. A change in these principles or interpretations could have a significant effect on our reported financial results, and could affect the reporting of transactions +completed before the announcement of a change. +Risks +Relating to Intellectual Property +Our Success Depends +on Our Ability to Protect Our Proprietary Technology. +The +diagnostics industry places considerable importance on obtaining patent, trademark and trade secret protection, as well as other intellectual property rights, for new technologies, products and processes. Our success depends, in part, on our ability +to develop and maintain a strong intellectual property portfolio or obtain licenses to patents for products and technologies both in the United States and in other countries. +As appropriate, we intend to file patent applications and obtain patent protection for our proprietary technology. These +patent applications and patents will cover, as applicable, compositions of matter for our products, methods of making those products, methods of using those products and apparatus relating to the use or manufacture of those products. We will also +rely on trade secrets, know-how and continuing technological advancements to protect our proprietary technology. +We have entered, and will continue to enter, into confidentiality agreements with our employees, consultants, advisors and collaborators. However, these +parties may not honor these agreements and we may not be able to successfully protect our rights to unpatented trade secrets and know-how. Others may independently develop substantially equivalent proprietary information and techniques or otherwise +gain access to our trade secrets and know-how. +Many of our +employees, including scientific and management personnel, were previously employed by competing companies. Although we encourage and expect all of our employees to abide by any confidentiality agreement with a prior employer, competing companies may +allege trade secret violations and similar claims against us. +We may collaborate with universities and governmental research organizations which, as a result, may acquire part of the rights to any inventions or technical information derived from collaboration with them. +To facilitate development and commercialization of a proprietary technology +base, we may need to obtain licenses to patents or other proprietary rights from other parties. Obtaining and maintaining such licenses may require the payment of substantial amounts. In addition, if we are unable to obtain these types of licenses, +our product development and commercialization efforts may be delayed or precluded. +We may incur substantial costs and be required to expend substantial resources in asserting or protecting our intellectual property rights, or in defending suits against us related to intellectual property rights. +Disputes regarding intellectual property rights could substantially delay product development or commercialization activities. Disputes regarding intellectual property rights might include state, federal or foreign court litigation, as well as +patent interference, patent reexamination, patent reissue, or trademark opposition proceedings in the +29 +Table of Contents +United States Patent and Trademark Office. Opposition or revocation proceedings could be instituted in a foreign patent office. An adverse decision in any +proceeding regarding intellectual property rights could result in the loss or limitation of our rights to a patent, an invention or trademark. +We are Involved in Pending, and May Become Involved in Future, Intellectual Property Infringement Disputes, Which are Costly and Could Limit or +Eliminate Our Ability to Sell Our Products or Use Certain of Our Technologies in the Future. +From time to time, we may seek to enforce our patents or other intellectual property rights through litigation. In addition, there are a large number of +patents and patent applications in our product areas, and additional patents may be issued to third parties relating to our product areas. We may be sued for infringement of patents or misappropriation of other intellectual property rights with +respect to one or more of our products. Litigation in our industry regarding patent and other intellectual property rights is prevalent and is expected to continue. +Our involvement in litigation with respect to patents or other intellectual property or to determine rights in proprietary +technology, either as a plaintiff or defendant, could adversely affect our revenues, market share, results of operations and business because: +• +As is common with major litigation, it could consume a substantial portion of managerial and financial resources; +• +Its outcome would be uncertain and a court may find that our patents are invalid or unenforceable in response to claims by another party or that the third-party +patent claims are valid and infringed by our products; +• +An adverse outcome could subject us to the loss of the protection of our patents or to liability in the form of past royalty payments, penalties, special and +punitive damages, or future royalty payments significantly affecting our future earnings; +• +Failure to obtain a necessary license upon an adverse outcome could prevent us from selling our current products or other products we may develop or acquire; and +• +A court could award a preliminary and/or permanent injunction which would prevent us from selling our current or future products. +We have sued Schering-Plough for infringement of several of our patents +related to the technology for the cryosurgical removal of warts and other benign skin lesions. This litigation has been costly to prosecute, and there is no assurance that we will be successful in our obtaining either injunctive relief or an award +of damages in this matter. It is also possible, based on the defenses asserted by Schering-Plough, that one or more of our patents could be found to be invalid or unenforceable. For a further description of the Schering-Plough litigation, see +Item 3, “Legal Proceedings,” in this Annual Report. +The Sales Potential for OraQuick ADVANCE ® Could be Affected by Our Ability to Obtain Certain Licenses. +Our OraQuick ADVANCE ® test is a lateral flow assay device that tests for specific antibodies or other substances. The term “lateral flow” generally refers to a test strip through which a sample flows and which provides a +test result on a portion of the strip downstream from where the sample is applied. There are numerous patents in the United States and other countries which claim lateral flow assay methods and devices. Some of these patents may broadly cover the +technology used in the OraQuick ADVANCE ® test and are in force in the United States and other countries. We may not be able to make or sell the OraQuick +ADVANCE ® test in the United States or other countries where these patents are in force. +We have obtained licenses under several lateral flow patents, which +we believe should be sufficient to permit the manufacturing and sale of the OraQuick ADVANCE ® device as currently contemplated. However, +30 +Table of Contents +licenses under additional patents may be required and it is possible that a third party could seek to enforce one or more lateral flow patents against us. In +the event that we are unable to successfully defend against such litigation or it is determined that a license is required and it is not possible to negotiate or otherwise obtain a license agreement on reasonable terms under a necessary patent, our +ability to manufacture and sell the OraQuick ADVANCE ® device could be limited. In such case, we may be able to modify the OraQuick ADVANCE ® test such that a license would not be necessary. However, this alternative could delay or limit our ability to sell the OraQuick ADVANCE ® test in the United States and other markets, which would adversely affect our results of operations, cash flows and business. +Risks Relating to Products, Marketing and Sales +A Market for Our Products May Not Develop. +Our future success will depend, in part, on the market acceptance, and the timing of such acceptance, of our products such +as the OraQuick ADVANCE ® rapid HIV-1/2 +antibody test, the Intercept ® drug test and other +new products or technologies that may be developed or acquired. To achieve market acceptance, we must make substantial marketing efforts and spend significant funds to inform potential customers and the public of the perceived benefits of these +products. There may be limited evidence on which to evaluate the market reaction to products that may be developed, and there can be no assurance that any products will obtain market acceptance and fill the market need that is perceived to exist. +If Acceptance and Adoption of Our Oral Fluid Testing Does +Not Continue, Our Future Results May Suffer. +We have made +significant progress in gaining acceptance of oral fluid testing for HIV in the insurance, public health and other markets. We have also made significant progress in gaining acceptance of oral fluid testing for drugs of abuse in the workplace and +criminal justice testing markets. However, the ultimate degree of acceptance in these markets is uncertain, and other markets may resist the adoption of oral fluid testing as a replacement for other testing methods in use today. In addition, certain +state laws prohibit or restrict the use of oral fluid testing for drugs of abuse in certain markets or the rapid, point-of-care testing for HIV. As a result, there can be no assurance that we will be able to expand the use of our oral fluid testing +products in these or other markets. +We May be Sued for +Product Liabilities for Injuries Resulting From the Use of Our Products. +We may be held liable if any of our products, or any product which is made with the use or incorporation of any of our technologies, causes injury of any type or is found otherwise unsuitable during product testing, +manufacturing, marketing, sale or usage. Although we have obtained product liability insurance, this insurance may not fully cover potential liabilities. As we bring new products to market, we may need to increase our product liability coverage. +We are selling cryosurgical wart removal products in the +consumer or OTC market in the United States, Canada, and Europe. We expect to expand the OTC sales of these products to other countries and to eventually distribute other types of products in the domestic and international OTC markets, such as our +OraQuick ADVANCE ® HIV-1/2 test. We believe +the sale of products in the OTC market increases the risk of potential product liability exposure and possibly the required level of insurance coverage that we will need to maintain. Inability to obtain sufficient insurance coverage at an acceptable +cost or otherwise to protect against potential product liability claims could affect our decision to commercialize new products and our results of operations. +Performance of Our Products May Affect Our Revenues and Stock Price. +Our products are generally sold with labeling that contains performance claims approved or cleared by the FDA or other +regulators. If our products fail to perform in accordance with the applicable label claims or +31 +Table of Contents +otherwise in accordance with the expectations or needs of our customers, customers may switch to a competing product or otherwise stop using our products, +and our revenues could be adversely affected. In addition, poor performance by one or more of our products and publicity surrounding such performance could have an adverse effect on our reputation, our continuing ability to sell products and the +prevailing market price of our Common Stock. +Our Increasing +International Presence May be Affected by Regulatory, Cultural or Other Restraints. +We intend to increase revenue derived from international sales of our products. Our international sales accounted for $11.4 million or 17% of total revenues for 2006, $9.5 million or 14% of total revenues for 2005, +and $6.2 million or 11% of total revenues for 2004. +A number +of factors can slow or prevent international sales, or substantially increase the cost of international sales, including those set forth below: +• +Regulatory requirements (including compliance with applicable customs regulations) may slow, limit, or prevent the offering of products in foreign countries; +• +The unavailability of licenses to certain patents in force in a foreign country which cover our products may restrict our ability to sell into that country; +• +The inability to maintain ISO certification for our or our suppliers’ manufacturing facilities could preclude, interrupt or delay our ability to manufacture +products for sale in Europe or other international territories; +• +Our inability to obtain the CE mark on our products in a timely manner may preclude or delay our ability to sell products in the European Union; +• +Our inability to identify international distributors and negotiate acceptable terms for distribution agreements may delay or reduce our sales; +• +Cultural and political differences may make it difficult to effectively market, sell and gain acceptance of products in foreign countries; +• +Inexperience in international markets may slow or limit our ability to sell products in foreign countries; +• +Exchange rates, currency fluctuations, tariffs and other barriers, extended payment terms and dependence on and difficulties in managing international distributors +or representatives may affect our revenues even when product sales occur; +• +The creditworthiness of foreign distributors may be less certain and foreign accounts receivable collection may be more difficult; +• +Economic conditions, the absence of available funding sources, terrorism, civil unrest, war and natural disasters may slow or limit our ability to sell our products +in foreign countries; +• +Our exposure to liability under the Foreign Corrupt Practices Act and various other laws, rules and/or regulations applicable to us as a result of our international +sales may affect our ability to sell into international markets; +• +International markets often have long sales cycles, especially for sales to foreign governments, quasi-governmental agencies and international public health +agencies, thereby delaying or limiting our ability to sell our products; and +• +We may be at a disadvantage if competitors in foreign countries sell competing products at prices at or below such competitors’ or our cost. +In addition, we have entered into a contract +for the manufacture and supply of our OraQuick ® +HIV-1/2 test in Thailand, and the Histofreezer ® and +Freeze Off ® cryosurgical products are currently +manufactured in The +32 +Table of Contents +Netherlands. We may enter into agreements to manufacture other products in foreign countries as well. However, factors such as economic and political +conditions and foreign regulatory requirements may slow or prevent the manufacture of our products in countries other than the United States. Interruption of the supply of our products could reduce revenues or cause us to incur significant +additional expenses in finding an alternative source of supply. In addition, foreign currency fluctuations and economic conditions in foreign countries could increase the costs of manufacturing our products in foreign countries. +ITEM 1B. Unresolved Staff Comments. +Not Applicable. +ITEM 2. Properties. +We own a 48,000 square foot facility, which is our primary corporate office and manufacturing facility, and a second 31,700 square foot facility that houses our sales and marketing and research and development +offices. Both of these facilities are located in Bethlehem, Pennsylvania. These facilities were previously leased until we exercised our option to purchase them on June 30, 2006. +We also own an additional 33,500 square foot building in Bethlehem, Pennsylvania, which is used for manufacturing +activities. +We rent additional warehouse space on an as-needed +basis. We also lease space for a small sales office in Reeuwijk, The Netherlands. +We believe that the facilities described above are adequate for our current requirements. +ITEM 3. Legal Proceedings. +Schering-Plough Patent Infringement Litigation +On July 23, 2004, we filed a lawsuit against Schering-Plough for infringement of several of our patents relating to technology for the cryosurgical removal (i.e., freezing) of warts and other benign skin lesions. The suit was commenced +in the United States District Court for the Eastern District of Pennsylvania, and alleges that Schering-Plough’s manufacture and sale of its Dr. Scholls ® Freeze Away ® cryosurgical wart removal product in the United States OTC market infringes the following United States patents: Nos. 5,738,682; 6,092,527 and +4,865,028. We are requesting permanent injunctive relief and the payment of damages. Schering-Plough has asserted various defenses in this matter, including that its Dr. Scholls ® Freeze Away ® product does not infringe our patents and that one or more of our patents are invalid and unenforceable. +On November 2, 2005, an initial pretrial conference was held on this +matter, at which the Court heard oral argument on motions for summary judgment and certain evidentiary and other motions filed by the parties. Those motions remain pending. We expect the Court to set a final trial schedule once a decision on the +motions has been rendered. +Prestige Brands Dispute +Prestige, through an affiliate, is the exclusive distributor of our +cryosurgical wart removal product in the OTC market in the United States and Canada. Prestige distributes this product under its Compound W Freeze Off ® trade name. In September 2006, Prestige announced that it had acquired the Wartner ® cryosurgical wart removal product line, which directly competes with the Freeze +Off ® product in the OTC market. +Our distribution agreement with Prestige contains a covenant not to compete +which precludes Prestige from acquiring, manufacturing, distributing or selling a cryosurgical product that directly competes with the Freeze +33 +Table of Contents +Off ® product. We notified Prestige that its acquisition of the Wartner product constitutes a material breach of the distribution agreement and that certain of its other actions constitute +additional breaches under the agreement. +On September 27, +2006, we filed a special petition and application with the Supreme Court of the State of New York, New York County, for a preliminary injunction against Prestige pursuant to New York Civil Practice Law and Rules § 7502(c) in support of the +arbitration to be commenced between the parties. On November 8, 2006, the Court issued a decision dated October 30, 2006 finding that Prestige had breached the covenant not to compete, but denied our application. By decision dated +December 20, 2006, the Court denied our motion for reargument and reconsideration of its October 30 decision. We have since filed an appeal of the Court’s denial of our request for a preliminary injunction with the Appellate +Division—First Department of the New York Supreme Court and that appeal remains pending. +We have also initiated the alternative dispute resolution procedures required under our agreement with Prestige, which include mediation and binding arbitration. The parties’ efforts to resolve this matter +through mediation were not successful, and an arbitration pursuant to the rules of the American Arbitration Association has been commenced, pursuant to the terms of the agreement. +Unless we are able to resolve this matter with Prestige, we intend to vigorously enforce our rights and remedies under the +agreement, including seeking specific performance of the covenant not to compete. +ITEM 4. Submission of Matters to a Vote of Security Holders. +No matters were submitted to a vote of security holders during the fourth quarter of the year ended December 31, 2006. +34 +Table of Contents +PART II +ITEM 5. +Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities. +Market Information +Our Common Stock is listed for trading on the Global Market tier of The Nasdaq Stock Market LLC (“NASDAQ”) under +the symbol OSUR. High and low sales prices reported by NASDAQ during the periods indicated are shown below. +Year ended December 31, +2006 +2005 +High +Low +High +Low +First Quarter +$ +11.67 +$ +8.80 +$ +7.45 +$ +5.35 +Second Quarter +10.89 +7.89 +10.23 +6.91 +Third Quarter +10.16 +6.15 +11.83 +8.42 +Fourth Quarter +8.70 +7.27 +14.14 +7.74 +On March 1, 2007, +there were 578 holders of record and approximately 16,000 holders in street name of the Common Stock, and the closing price of the Common Stock was $7.76 per share. +Dividends +We have never paid any cash dividends and our Board of Directors does not anticipate paying cash dividends in the foreseeable future. We are generally not +permitted to pay dividends or make other distributions to our stockholders under the terms of our credit facilities with Comerica Bank, without first obtaining Comerica’s consent. We intend to retain any future earnings to provide funds for the +operation and expansion of our business. +35 +Table of Contents +Performance Graph +The following graph compares the cumulative total returns to investors in the Company’s Common Stock, the NASDAQ Composite Index and the NASDAQ +Biotechnology Index for the period from December 31, 2001 through December 31, 2006. The graph assumes that $100 was invested on December 31, 2001 in the Company’s Common Stock and in each of the above-mentioned indices, and that +all dividends were reinvested. +The NASDAQ Composite Index was +chosen because it is a broad index of companies whose equity securities are traded on the NASDAQ Stock Market. The NASDAQ Biotechnology Index was chosen because it includes a number of our competitors. Stockholders are cautioned that the graph shows +the returns to investors only as of the dates noted and may not be representative of the returns for any other past or future period. +12/2001 +12/2002 +12/2003 +12/2004 +12/2005 +12/2006 +OraSure Technologies, Inc. +100.00 +44.86 +65.51 +55.31 +72.59 +67.98 +NASDAQ Composite Index +100.00 +71.97 +107.18 +117.07 +120.50 +137.02 +NASDAQ Biotechnology Index +100.00 +62.08 +90.27 +99.08 +111.81 +110.06 +The performance +graph set forth above shall not be deemed “soliciting material” or “filed” for purposes of Section 18 of the Securities Exchange Act of 1934, as amended (the “Exchange Act”), or otherwise subject to liability under +that Section. This graph will not be deemed “incorporated by reference” into any filing under the Securities Act of 1933, as amended, or the Exchange Act, whether such filing occurs before or after the date hereof, regardless of any +general incorporation language in such filing. +36 +Table of Contents +ITEM 6. Selected Financial Data. +The following table sets forth selected financial data of the Company. This information should be read in conjunction with the Financial Statements and notes thereto included in Item 15 and the information set +forth in Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations.” +Selected Financial Data +(In +thousands, except per share data) +Year ended December 31, +2006 +2005 +2004 +2003 +2002 +Operating Results: +Revenues +$ +68,155 +$ +69,366 +$ +54,008 +$ +40,451 +$ +32,010 +Costs and expenses +62,692 +61,793 +55,365 +41,737 +35,550 +Operating income (loss) +5,463 +7,573 +(1,357 +) +(1,286 +) +(3,540 +) +Other income (expense), net +3,599 +2,146 +797 +177 +198 +Income tax provision (benefit) +3,794 +(17,729 +) 1 +— +27 +— +Net income (loss) +5,268 +27,448 +1 +(560 +) +(1,136 +) +(3,342 +) +Earnings (loss) per share +Basic +$ +0.11 +$ +0.61 +$ +(0.01 +) +$ +(0.03 +) +$ +(0.09 +) +Diluted +$ +0.11 +$ +0.59 +$ +(0.01 +) +$ +(0.03 +) +$ +(0.09 +) +Shares used in computing earnings (loss) per share +Basic +45,910 +45,110 +44,464 +39,794 +37,583 +Diluted +46,580 +46,147 +44,464 +39,794 +37,583 +Cash Flow: +Cash flow provided by (used in) operating activities +$ +16,886 +$ +10,392 +$ +3,438 +$ +2,702 +$ +(518 +) +December 31, +2006 +2005 +2004 +2003 +2002 +Financial Position: +Cash, cash equivalents, and short-term investments +$ +91,001 +$ +77,620 +$ +66,723 +$ +64,024 +$ +14,908 +Working capital +95,979 +90,670 +68,910 +67,171 +18,931 +Deferred tax asset +23,522 +26,708 +— +— +— +Total assets +156,565 +130,747 +88,064 +86,151 +35,737 +Long-term debt, excluding current portion +10,031 +884 +1,334 +2,456 +3,409 +Accumulated deficit +(98,414 +) +(103,682 +) +(131,130 +) +(130,570 +) +(129,435 +) +Stockholders’ equity +129,504 +118,919 +75,577 +73,509 +26,019 +1 +Includes an income tax benefit of $18,165 resulting from the elimination of a significant portion of the +valuation allowance on our deferred tax assets (see Note 9 to the Notes to Financial Statements). +37 +Table of Contents +ITEM 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations. +Statements below regarding future events or performance are “forward-looking statements” within the meaning of the Private Securities +Litigation Reform Act of 1995. Our actual results could be quite different from those expressed or implied by the forward-looking statements. Factors that could affect results are discussed more fully under the Item 1A, entitled “Risk +Factors,” and elsewhere in this Annual Report. Although forward-looking statements help to provide complete information about us, readers should keep in mind that forward-looking statements may not be reliable. Readers are cautioned not to +place undue reliance on the forward-looking statements. +The following discussion should be read in conjunction with the financial statements contained herein and the notes thereto, along with the Section entitled “Critical Accounting Policies and Estimates,” set forth below. +Overview +We operate primarily in the worldwide $22 billion in vitro diagnostics business. We develop, manufacture and market +oral fluid specimen collection devices using proprietary oral fluid technologies, diagnostic products including immunoassays, and other in vitro diagnostic tests. We also manufacture and sell medical devices for the removal of warts and other +benign skin lesions by cryosurgery, or freezing. +Our diagnostic product offerings primarily target the infectious disease and substance abuse +testing segments of the larger in vitro diagnostic market, and are used in both laboratories as well as the emerging, and rapidly growing, point-of-care marketplace. Our OraSure ® and Intercept ® oral fluid collection devices, and their related assays, are processed in a laboratory, while the OraQuick +ADVANCE ® rapid HIV-1/2 antibody test is designed for use at the point-of-care. Our cryosurgical products are also used at the point-of-care. +In vitro diagnostics have traditionally used blood or urine as the +bodily fluids upon which tests are conducted. However, we have targeted the use of oral fluid in our products as a differentiating factor and believe that it provides a significant competitive advantage over blood and urine. Our oral fluid tests +have sensitivity and specificity comparable to blood and/or urine tests. When combined with their ease of use, non-invasive and dignified nature, and cost effectiveness, our oral fluid tests represent a very competitive alternative to the more +traditional testing methods in the diagnostic space. +During +the year ended December 31, 2006, our total revenues were $68.2 million, which represents a 2% decrease from 2005. Our net income for 2006 was $5.3 million and includes a pre-tax charge of $3.4 million for stock options which are now +required to be expensed under the new accounting rules. Our liquidity continued to improve, as we reported $16.9 million in cash flow from operating activities in 2006 and a balance of $91.0 million in cash, cash equivalents and short-term +investments as of December 31, 2006. +Sales into the +infectious disease testing market segment increased significantly in 2006 due to the continued market acceptance of our OraQuick ADVANCE ® HIV-1/2 test. This increase resulted largely from sales directly to various public health organizations and sales through Abbott into the hospital +market. These increases were offset by the absence of government bulk purchases by SAMHSA and the CDC. +In February 2005, we entered into an agreement for the distribution of OraQuick ADVANCE ® with Abbott. Under this agreement, Abbott was appointed as our exclusive distributor in +the U.S. hospital market and as a non-exclusive distributor in the U.S. physicians’ office marketplace. As our exclusive distributor to hospitals, Abbott sells OraQuick ADVANCE ® to federal hospitals under the terms and conditions of our Federal Supply Schedule that +is on file with the U.S. General Services Administration. We have retained exclusive rights to all other markets, including the public health and criminal justice markets, the military, the CDC, SAMHSA and other government agencies. We utilize a +small internal sales force to support Abbott and work together with them to maximize the penetration of OraQuick ADVANCE ® in the hospital market. +38 +Table of Contents +Competition in the market for HIV testing is intense and is expected to increase. We believe that the +principal competition will come from existing laboratory-based blood tests, point-of-care rapid blood tests, laboratory-based urine assays or other oral fluid-based tests that may be developed. Our competitors include specialized biotechnology +firms, as well as pharmaceutical companies with biotechnology divisions and medical diagnostic companies. +Significant competitors for our OraQuick ADVANCE ® rapid test, such as the Ortho Diagnostics division of Johnson & Johnson, Bio-Rad Laboratories, Abbott and BMX, sell laboratory-based +HIV-1/2 EIAs, and Maxim Biomedical (formerly Calypte, Inc.) sells an HIV-1 screening test for urine, in the United States. MedMira and Trinity Biotech each sell competing rapid HIV-1 blood tests, and Bio-Rad Laboratories and Chembio sell competing +rapid HIV-1/2 blood tests in the United States. These tests compete with our OraQuick ADVANCE ® test in hospitals or other laboratory settings. In addition, Trinity Biotech and Chembio have received CLIA waivers for their rapid HIV tests and these tests compete with our OraQuick +ADVANCE ® test in the markets outside of the +traditional hospital and laboratory settings. These companies, or others, may continue to expand the bodily fluids with which a rapid HIV test may be performed, or develop and commercialize new rapid HIV tests, which would provide further +competition for our OraQuick ADVANCE ® test. +We believe other companies may also seek FDA approval to sell competing rapid HIV tests in the future. +Sales to the substance abuse testing market also increased during 2006, reflecting the growing acceptance of our Intercept ® collection device and related oral fluid drug assays, as both domestic and +international corporate customers continued to adopt oral fluid based drug testing and shift away from traditional urine-based drug testing. We expect continued growth in the utilization of our Intercept ® product line, primarily in the United States. +In April 2004, SAMHSA published proposed guidelines that would, if adopted, +include oral fluid testing as an accepted drug testing method for federal employees. During the summer of 2006, these proposed guidelines were withdrawn with no action taken and it is unclear when further action, if any, will be taken to permit the +use of oral fluid as an accepted drug testing method in this market. +Sales to the cryosurgical systems market declined during 2006. The cryosurgical systems market represents sales of Histofreezer ® into both the domestic and international physicians’ office markets and sales of the OTC formulation of this product to our domestic distributor, +Prestige, and our international distributor, SSL. Prestige distributes our cryosurgical wart removal product under its Compound W Freeze Off ® tradenames in the OTC market in the United States and Canada. SSL distributes a similar product under its Scholl’s and Dr. Scholl trademarks +in the OTC footcare market in several European countries. Sales in the U.S. OTC cryosurgery marketplace declined primarily as a result of the disappointing performance by Prestige. Sales to Prestige for 2006 were $5.2 million, or more than 50% less +than the $11.6 million in sales recorded for 2005. +In +September 2006, Prestige announced that it had acquired the Wartner ® cryosurgical wart removal product line, which directly competes with the Freeze Off ® product in the OTC market. Our distribution agreement with Prestige contains a covenant not to compete which precludes Prestige from acquiring, +manufacturing, distributing or selling a cryosurgical product that directly competes with the Freeze Off ® product. We notified Prestige that its acquisition of the Wartner product constitutes a material breach of the distribution agreement and that certain of its other actions constitute +additional breaches under the agreement. We initiated the alternative dispute resolution procedures required under the agreement, which include mediation and binding arbitration. The parties’ efforts to resolve this matter through mediation +were not successful and an arbitration pursuant to the rules of the American Arbitration Association has been commenced, pursuant to the terms of the agreement. We are evaluating alternative arrangements for distributing this product in the event a +resolution with Prestige cannot be reached. As a result of this ongoing dispute, it is not possible to predict at this time the potential impact this matter may have on sales of Freeze Off ® in 2007 or beyond. +In July 2004, we filed a lawsuit against Schering-Plough for infringement of several of our patents relating to the +technology for the cryosurgical removal (i.e., freezing) of warts and other benign skin lesions. The suit was +39 +Table of Contents +commenced in the United States District Court for the Eastern District of Pennsylvania and alleges that Schering- Plough’s manufacture and sale of its +Dr. Scholl’s ® Freeze Away ® cryosurgical wart removal product in the OTC market +infringes three of our patents. We are seeking injunctive relief and the payment of damages and Schering-Plough has raised several defenses, including that their Freeze Away ® device does not infringe our patents and that one or more of our patents are either invalid or unenforceable. On +November 2, 2005, a pretrial conference was held in this matter, at which the Court heard oral argument on motions for summary judgment filed by the parties. These motions remain pending. We expect a new trial schedule to be set after the Court +rules on these motions. +Sales to the insurance risk assessment +market continued to decline in 2006, primarily because of a reduction in the number of applications for life insurance and changes in underwriting requirements. For higher face-value policies, it appears insurance companies are more likely to use a +blood test for multiple risk factors, rather than an oral-fluid test. We currently expect that our 2007 revenues in this market will decline, or at best, remain at approximately the levels attained in 2006. +Because of the regulatory approvals needed for most of our products, we often +are required to rely on sole source providers for critical components and materials and on related products supplied by third parties. This is particularly true for our OraQuick ADVANCE ® test, our OraSure ® oral fluid collection device and our oral fluid Western blot HIV-1 confirmatory product. If we are unable to obtain +necessary components or materials from these sole sources, the time required to develop replacements and obtain the required FDA approvals could disrupt our ability to sell the affected products. +BMX currently manufactures and sells the only oral fluid HIV-1 screening test +that has received FDA approval for use in detecting HIV-1 in an oral fluid specimen collected with our OraSure ® collection device. BMX also supplies the HIV-1 antigen used to manufacture our oral fluid Western blot HIV-1 confirmatory test and is the exclusive world-wide distributor of that +product. BMX recently notified us that they intend to discontinue manufacturing their HIV-1 EIA screening test during 2007. BMX also notified us that it has elected not to renew the Western blot agreements beyond December 31, 2007. We are +working closely with BMX, the FDA and CDC, our main laboratory customers and other potential suppliers to find or develop an alternative HIV-1 EIA screening test and confirmatory test for use with our OraSure ® collection device. If our customers cannot obtain an HIV-1 EIA screening test or a +confirmatory test that has been approved by the FDA for use in connection with our OraSure ® collection device, these customers would likely stop purchasing our OraSure ® device and our revenues would be adversely affected. +We also rely heavily on distributors to purchase and resell many of our products. For example, Prestige has exclusive distribution rights to the Freeze +Off ® product in the OTC markets in United States +and Canada and SSL has exclusive rights to a similar product in the OTC footcare market in Europe, Australia and New Zealand. Similarly, Abbott has exclusive rights to distribute our OraQuick ADVANCE ® test to hospitals in the U.S. We expect to enter into additional distribution +agreements for new and future products, for distribution in the U.S. and internationally. If our distributors are unable or unwilling to meet the minimum purchase commitments set forth in their agreements or otherwise substantially reduce the volume +of their purchases, our revenues and results of operations could be adversely affected. +We generated 83% of our 2006 revenues in the U.S. marketplace. Consequently, we are evaluating strategies to increase our sales penetration in markets outside the U.S. As our business in foreign countries increases, +we could be exposed to other economic, political, exchange rate, regulatory and cultural risks. +Results of Operations +Year Ended +December 31, 2006 Compared to December 31, 2005 +Total revenues decreased by 2% to $68.2 million in 2006 from $69.4 million in 2005, primarily as a result of declines in domestic OTC cryosurgical product revenues and insurance risk assessment revenues, partially +40 +Table of Contents +offset by increased sales of our OraQuick ADVANCE ® rapid HIV-1/2 antibody test, our Intercept ® oral fluid collection device and related drug assays, and our international cryosurgical products. Revenues derived from products sold in countries +outside the U.S. were $11.4 million and $9.5 million, or 17% and 14% of total revenues, for the years ended December 31, 2006 and 2005, respectively. +The table below shows the amount of our total revenues (in thousands, except %) generated in each of our principal markets and by licensing and product +development activities. +Year ended December 31, +Dollars +% +Change +Percentage of +Total Revenues +Market +2006 +2005 +2006 +2005 +Infectious disease testing +$ +29,180 +$ +25,988 +12 +% +43 +% +37 +% +Substance abuse testing +15,752 +13,519 +17 +23 +19 +Cryosurgical systems +17,333 +22,744 +(24 +) +25 +33 +Insurance risk assessment +5,565 +6,815 +(18 +) +8 +10 +Product revenues +67,830 +69,066 +(2 +) +99 +99 +Licensing and product development +325 +300 +8 +1 +1 +Total revenues +$ +68,155 +$ +69,366 +(2 +)% +100 +% +100 +% +Sales to the +infectious disease testing market increased 12% to $29.2 million in 2006, primarily as a result of higher sales of our OraQuick ® HIV-1/2 test in both the public health and hospital markets through our distributor, Abbott. OraQuick ® and OraSure ® sales during 2006 totaled $25.6 million and $3.6 million, as compared to $21.6 million and $4.4 million in 2005, +respectively. +The table below shows a breakdown of our total +OraQuick ® revenues (in thousands, except %) during +2006 and 2005. +Years ended +December 31, +% +Change +Customers +2006 +2005 +Direct to U.S. Public Health +$ +15,268 +$ +8,292 +84 +% +Abbott +6,897 +4,929 +40 +SAMHSA +406 +3,741 +(89 +) +CDC +1,291 +2,322 +(44 +) +International +1,694 +1,530 +11 +Direct to Hospitals +— +740 +— +Total OraQuick ® revenues +$25,556 +$21,554 +19% +During 2006, +OraQuick ® revenue derived from direct sales to the +U.S. public health market increased by 84% as compared to 2005. This increase is the result of continued growth in usage of the OraQuick ADVANCE ® rapid HIV-1/2 antibody test in public health settings, including city-wide testing programs. +For the year ended December 31, 2006, sales to our hospital distributor, +Abbott, grew 40% to $6.9 million, as compared to $4.9 million in 2005. This increase is a result of continued penetration of the hospital market by Abbott. Abbott recently announced that it will sell part of its diagnostics business, including its +rights to distribute OraQuick ADVANCE ® , to +General Electric (“GE”). This transaction is expected to close during the first half of 2007. We intend to meet with executives from GE to discuss their plans for the OraQuick ADVANCE ® product. +During 2006, we shipped a total of $1.7 million in OraQuick ADVANCE ® HIV-1/2 tests to the CDC and SAMHSA, as compared to $6.1 million in 2005. We believe +that federal, state and other governmental agencies +41 +Table of Contents +may make future bulk purchases of OraQuick ADVANCE ® for further distribution to the public health and other markets throughout the United States. There is no assurance, however, that +comparable-size bulk purchase orders from these governmental entities or others will be received in the future. Likewise, any delay in receiving or deploying such bulk orders could adversely affect our financial performance. +We believe that our OraQuick ADVANCE ® device, which is FDA-approved for detecting antibodies to both HIV-1 and HIV-2 +in oral fluid, finger-stick and venous whole blood, and plasma samples, and is CLIA-waived for use with all sample types except plasma, provides a significant competitive advantage, thereby enabling us to fully implement a strategy for selling +OraQuick ® internationally. We recently received +notification that our OraQuick ADVANCE ® +product will be recommended to receive a CE mark, pending successful completion of a facility inspection. CE-marking will allow us to sell our product in Europe. Our goal is to complete the facility inspection in the immediate future, secure a CE +mark for OraQuick ADVANCE ® , and then obtain +several country-specific registrations in order to permit the launch of this product in Europe as soon as possible. +We are beginning to see evidence that sales of OraQuick ADVANCE ® are negatively impacting sales of our OraSure ® oral fluid collection device in the infectious disease testing market. Some customers who have purchased our +OraSure ® device for laboratory HIV-1 testing in the +past are now electing instead to purchase our OraQuick ADVANCE ® test. It is not possible at this time to estimate the extent of such change in purchasing patterns or the financial impact of replacing OraSure ® sales with sales of our OraQuick ADVANCE ® test. +Sales to the substance abuse testing market increased 17% to $15.8 million in 2006, as a result of +increased sales of both our Intercept ® oral fluid drug testing service and our Q.E.D. ® rapid oral +fluid alcohol test. Intercept ® sales increased as a result of continued growth for this product, especially in the workplace and international markets. Increased sales of +our Q.E.D. ® test are attributed to a change in government regulations, which increased demand for this product. +The table below shows a breakdown of our total Intercept ® revenues (in thousands, except %) generated in each market during 2006 and 2005. +Years ended +December 31, +% +Change +Market +2006 +2005 +Workplace testing +$ +6,616 +$ +5,661 +17 +% +Criminal Justice +2,398 +2,269 +6 +International +2,314 +1,956 +18 +Direct +728 +563 +29 +Total Intercept ® revenues +$ +12,056 +$ +10,449 +15 +% +We expect continued +growth in Intercept ® sales in 2007 as customers +continue to shift from urine-based to oral-fluid based testing methods. However, our microplate oral fluid drug assays, which are sold for use with the Intercept ® collection device, are expected to come under increasing competitive pressure in the future from “home-brew” +assays developed internally by our laboratory customers. In addition, our oral fluid microplate assays compete with urine-based homogeneous assays that are run on fully-automated, random access analyzers. We believe our competitors are developing +oral fluid tests suitable for use on these fully automated homogeneous assay systems and these assays, if and when they are developed and commercialized, could represent a significant competitive threat to our oral fluid microplate business. In +order to meet this competition, we recently signed a letter of intent to negotiate an agreement with Roche Diagnostics to jointly develop and commercialize fully-automated homogeneous oral fluid drugs of abuse assays for use with our Intercept ® device. +Sales of our products in the cryosurgical systems market (which includes both +the physicians’ office and OTC markets) decreased 24% to $17.3 million in 2006. This decrease was primarily the result of lower sales of our domestic OTC and professional cryosurgical products when compared to 2005. +42 +Table of Contents +The table below shows a breakdown of our total cryosurgery revenues (in thousands, except %) generated in +each market during 2006 and 2005. +Years ended +December 31, +% +Market +2006 +2005 +Change +Professional domestic +$ +5,360 +$ +5,888 +(9 +)% +Professional international +2,284 +2,018 +13 +OTC domestic +5,174 +10,560 +(51 +) +OTC international +4,515 +4,278 +6 +Total cryosurgery revenues +$ +17,333 +$ +22,744 +(24 +)% +Our domestic OTC cryosurgical product, called Freeze Off ® , is distributed in the United States and Canada by Prestige, owner of the Compound +W ® line of wart removal products. In September 2006, Prestige announced that it had acquired the Wartner ® cryosurgical wart removal product line, which directly competes with the Freeze Off ® product in the OTC market. Our distribution +agreement with Prestige contains a covenant not to compete which precludes Prestige from acquiring, manufacturing, distributing or selling a cryosurgical product that directly competes with the Freeze Off ® product. We notified Prestige that its acquisition of the Wartner product constitutes a material breach of the distribution agreement and that certain of its other actions constitute additional breaches under +the agreement. Efforts to resolve this matter through mediation were not successful and an arbitration pursuant to the rules of the American Arbitration Association has been commenced, pursuant to the terms of the agreement. Sales to Prestige were +$5.2 million and $11.6 million, in 2006 and 2005, respectively. We are evaluating alternative arrangements for distributing this product in the event a resolution with Prestige cannot be reached. As a result of this ongoing dispute, it is not +possible to predict at this time the potential impact this matter may have on sales of Freeze Off ® in 2007 or beyond. +In June 2005, we entered into an agreement with SSL under which we +manufacture and supply, and SSL distributes on an exclusive basis, the Company’s cryosurgical wart removal product in the OTC footcare market in Europe, Australia and New Zealand. The product is manufactured and sold under SSL’s Scholl and +Dr. Scholl trademarks and initially was made available for retail purchase in pharmacies and other outlets in several European countries during the fourth quarter of 2005. Sales to SSL under the distribution agreement were $4.5 million and +$3.2 million in 2006 and 2005, respectively. SSL continues to build distribution networks in pharmacies and mass merchandisers throughout Europe and expects to launch the OTC product in additional countries during 2007. We expect revenues +from SSL to increase significantly in 2007. During 2007, we have agreed to co-invest in SSL’s marketing activities and will reimburse SSL for certain out-of-pocket costs of advertising and promoting this product in the international OTC market. +We have also launched our OTC cryosurgical wart removal +product in Mexico and intend to establish distributor relationships for similar products in OTC markets in other Latin American countries. +Sales of our Histofreezer ® product to physicians’ offices in the United States decreased 9% to $5.4 million in 2006, as compared to $5.9 million in 2005. Sales of +Histofreezer ® in the international market increased +13% to $2.3 million in 2006, as compared to $2.0 million in 2005. We believe these changes were due to fluctuations in distributor ordering patterns and inventory levels during 2006 and, in the case of domestic Histofreezer ® sales, increased competition. +We are beginning to see some evidence that sales of our OTC cryosurgical +products may reduce the number of individuals that will seek to obtain treatment of their warts by a physician, which in turn could negatively affect sales of our Histofreezer ® product in the professional market. However, it is not possible at this time to estimate the magnitude of the financial +impact of this change. +43 +Table of Contents +Sales to the insurance risk assessment market declined by 18% to $5.6 million in 2006 from $6.8 million +in 2005, primarily because of a reduction in the number of applications for life insurance and changes in underwriting requirements. For higher face-value policies, it appears insurance companies are more likely to use a blood test for multiple risk +factors, rather than an oral fluid test. We currently expect that our 2007 revenues in this market will decline, or at best, remain at approximately the levels attained in 2006. +Licensing and product development revenues increased 8% to $325,000 in 2006, from $300,000 in 2005. Licensing and product +development revenues in both years were primarily related to our collaborative oral fluid research project with the University of Pennsylvania and New York University, under a grant awarded by the National Institutes of Health. This grant expired in +June 2006. In January 2007, the Company entered into a collaboration agreement with Schering-Plough Corporation, for the development and promotion of a rapid oral fluid test for the detection of antibodies to the hepatitis C virus (HCV). As a result +of this agreement, licensing and product development revenues are expected to increase to approximately $2.0 million during 2007. +Quest and Abbott accounted for 14% and 10% of total revenues for 2006, respectively. +The Company’s gross margin was 64% in 2006, compared to 60% in 2005. Our 2006 gross margin was positively impacted by +the absence of a $1.5 million charge related to the Company’s UP link ® assets, which was recorded in 2005, and increased efficiencies in manufacturing operations. +Research and development expenses increased 64% to $8.6 million in 2006, from $5.3 million in 2005, primarily as a result of costs associated with the +development of an OraQuick ® HCV test, preparation +for OTC clinical trials for our OraQuick ADVANCE ® HIV-1/2 test, a $1.0 million charge for acquired in-process research and development related to future HIV-related products, costs related to additional research personnel hired during 2006 and charges for stock-based +compensation expense. Research and development costs are expected to increase by approximately $8.0 million in 2007. The vast majority of this expected increase is related to the clinical trial work associated with the development of our OraQuick +ADVANCE ® HIV-1/2 OTC test and our +OraQuick ® HCV test. This amount also includes costs +expected to be incurred for FDA approval of new cryosurgical offerings, product registrations in foreign countries and development of fully-automated homogeneous oral fluid drugs of abuse assays. +Sales and marketing expenses decreased 1% to $15.9 million in 2006 from $16.1 +million in 2005. This decrease was primarily the result of lower market research, commission, consulting and advertising expenses, partially offset by higher staffing costs and charges for stock-based compensation expense. Included in advertising +expense was $540,000 and $1.8 million for 2006 and 2005, respectively, paid to Prestige as reimbursement for marketing expenses incurred for the Compound W ® Freeze Off ® product. We expect that sales and marketing expenses will increase in 2007 as we add sales personnel for the infectious disease market in order to +drive OraQuick ADVANCE ® sales in the public +health, hospital and international markets. During 2007, we also expect to co-invest in SSL’s marketing activities and reimburse SSL for certain out-of-pocket costs of advertising and promoting our cryosurgical product in the international OTC +market. +General and administrative expenses increased 7% to +$13.4 million in 2006 from $12.5 million in 2005. This increase was primarily attributable to charges for stock-based compensation expense, higher staffing costs and certain consulting costs related to implementation of a new enterprise resource +planning system. This increase was partially offset by a reduction in legal fees associated with delays in the Schering-Plough litigation and a reduction in rent expense due to the purchase of two of our Bethlehem, PA facilities in June 2006. +General and administrative expenses are expected to increase in 2007, as a result of increased legal expense related to both the Prestige dispute and the Schering-Plough patent infringement matter, as well as increased costs related to full-year +staffing levels. +Interest expense increased to $405,000 in +2006 from $97,000 in 2005, as a result of higher outstanding debt balances during the second half of the year, resulting from the financing for our purchase of two previously +44 +Table of Contents +leased facilities in Bethlehem, PA in June 2006. Interest expense will increase in 2007, as our borrowings for the building purchase will be outstanding for +a full year. Interest income increased to $4.1 million in 2006 from $2.2 million in 2005, as a result of higher yields on our investment portfolio and larger balances available for investment. +We purchase some of our cryosurgical products from, or utilize the services +of, vendors located in The Netherlands. As a result of the decline in the exchange rate between the United States dollar and the Euro, we recorded a $94,000 loss on foreign currency transactions for the year ended December 31, 2006, versus a +$57,000 gain on foreign currency transactions recorded for the year ended December 31, 2005. +During 2006, we provided for income taxes at a rate equivalent to our estimated combined federal and state effective rates. As such, we recorded a $3.8 +million provision for income taxes in 2006, which represents a 41.9% effective tax rate. During 2005, a net income tax benefit of $17.7 million was recorded, which reflected the release of a significant portion of the previous valuation allowance on +our deferred tax asset. At December 31, 2005, the Company had federal net operating loss (“NOL”) carryforwards of $66.6 million. Prior to December 31, 2005, a valuation allowance had been established for the full amount of the +deferred tax asset created by these carryforwards and other items. Based on taxable income in 2005 and future forecasted taxable earnings, a significant portion of the valuation allowance was released in the fourth quarter of 2005. This resulted in +the recognition of $26.7 million of the deferred tax asset, of which $18.2 million was recorded as an income tax benefit in the statement of operations and $8.5 million was recorded directly as an increase in stockholders’ equity. Partially +offsetting this benefit was an income tax provision of $436,000 that was recorded for the year ended December 31, 2005. +Year Ended December 31, 2005 Compared to December 31, 2004 +Total revenues increased 28% to $69.4 million in 2005 from $54.0 million in 2004, primarily as a result of increased sales of our OraQuick +ADVANCE ® rapid HIV-1/2 antibody test, our +Intercept ® oral fluid collection device and related +drug assays, and our international OTC cryosurgical product, partially offset by declines in domestic OTC cryosurgical product revenues and revenues in the insurance risk assessment market. Revenues derived from products sold in countries outside +the U.S. were $9.5 million and $6.2 million, or 14% and 11% of total revenues for the years ended December 31, 2005 and 2004, respectively. +The table below shows the amount of our total revenues (in thousands, except %) generated in each of our principal markets and by licensing and product +development activities. +Years ended December 31, +Dollars +% +Change +Percentage of +Total Revenues +Market +2005 +2004 +2005 +2004 +Infectious disease testing +$ +25,988 +$ +15,526 +67 +% +37 +% +29 +% +Substance abuse testing +13,519 +10,108 +34 +19 +19 +Cryosurgical systems +22,744 +20,193 +13 +33 +37 +Insurance risk assessment +6,815 +7,777 +(12 +) +10 +14 +Product revenues +69,066 +53,604 +29 +99 +99 +Licensing and product development +300 +404 +(26 +) +1 +1 +Total revenues +$ +69,366 +$ +54,008 +28 +% +100 +% +100 +% +Sales to the +infectious disease testing market increased 67% to $26.0 million in 2005, primarily as a result of higher sales of our OraQuick ® rapid HIV-1/2 antibody test. OraQuick ® and OraSure ® sales during 2005 totaled $21.6 million and $4.4 million, respectively, as compared to $10.2 million and $5.3 million, respectively, for 2004. +45 +Table of Contents +The table below shows a breakdown of our total OraQuick ® revenues (in thousands, except %) during 2005 and 2004. +Years ended +December 31, +% +Change +Customers +2005 +2004 +Direct to U.S. Public Health +$ +8,292 +$ +4,093 +103 +% +Abbott +4,929 +1,983 +149 +SAMHSA +3,741 +— +N/A +CDC +2,322 +2,327 +— +International +1,530 +1,178 +30 +Direct to Hospitals +740 +649 +14 +Total OraQuick ® revenues +$ +21,554 +$ +10,230 +111 +% +During 2004, we +received a total of $6.3 million in purchase orders from the CDC and SAMHSA for OraQuick ADVANCE ® rapid HIV-1/2 antibody tests, of which $6.1 million and $72,000 were shipped in 2005 and 2004, respectively. +Sales to the substance abuse testing market increased 34% to $13.5 million in 2005, as a result of higher sales of our +Intercept ® oral fluid collection device and related +drug assays in all marketplaces. +The table below shows a +breakdown of our total Intercept ® revenues (in +thousands, except %) generated in each market during 2005 and 2004. +Years ended +December 31, +% +Change +Market +2005 +2004 +Workplace testing +$ +5,661 +$ +3,030 +87 +% +Criminal Justice +2,269 +1,566 +45 +International +1,956 +1,684 +16 +Direct +563 +378 +49 +Total Intercept ® revenues +$ +10,449 +$ +6,658 +57 +% +Revenues from our +UP link ® rapid point-of-care oral fluid drug +detection system were $286,000 and $564,000 in 2005 and 2004, respectively. As part of a strategic business review we completed in late 2004, we concluded that the roadside drugs-of-abuse testing market for UP link ® may not be as attractive as a number of other opportunities we are pursuing. +During the first half of 2005, we explored our options with respect to the UP link ® product, including transitioning the manufacturing of the product to our distribution partner, Dräger Safety. Throughout this period, we were not able to reach an agreement with Dräger Safety or +determine an alternative outlet for this product. In addition, we were advised that Dräger will no longer promote the sale of the UP link ® product. As a result, we recorded a $1.5 million charge in June 2005 to reflect a provision on inventory and fixed assets related to our +UP link ® product. We subsequently terminated +our existing research, development and distribution agreements with Dräger for the UP link ® product. +Sales of our products in the cryosurgical systems market (which includes both the physicians’ office and OTC markets) increased 13% to $22.7 million in 2005. +46 +Table of Contents +The table below shows a breakdown of our total cryosurgery revenues (in thousands, except %) generated in +each market during 2005 and 2004. +Years ended +December 31, +% +Change +Market +2005 +2004 +Professional domestic +$ +5,888 +$ +5,225 +13 +% +Professional international +2,018 +1,634 +24 +OTC domestic +10,560 +13,334 +(21 +) +OTC international +4,278 +— +N/A +Total cryosurgery revenues +$ +22,744 +$ +20,193 +13 +% +The increase in total +cryosurgery revenues was primarily due to the international launch of our OTC cryosurgical product pursuant to our agreement with SSL, the launch of the Freeze Off ® product by Prestige in Canada, and an increase in sales of Histofreezer ® to both United States and international physicians’ offices. This increase was +partially offset by a reduction in sales of the Freeze Off ® product to Prestige for distribution in the United States, to $10.6 million in 2005, compared to $13.3 million during 2004. +The Freeze Off ® product is being sold under Prestige’s Compound W ® trademark. The distribution agreement with Prestige, which was initiated in 2003, requires minimum purchases of at least $2.0 million each year over +the life of the contract in order for Prestige to maintain its exclusive distribution rights to the OTC market in the United States. During the second half of 2005, Prestige also launched our OTC cryosurgical product in Canada. Sales of our +cryosurgical product to Prestige for distribution in Canada were $1.0 million in 2005. +In June 2005, we entered into an agreement with SSL under which we manufacture and supply, and SSL distributes on an exclusive basis, the Company’s cryosurgical wart removal product in the OTC footcare market in +Europe, Australia and New Zealand. The product is manufactured and sold under SSL’s Scholl and Dr. Scholl trademarks, and was made initially available for retail purchase in pharmacies and retail outlets in several European countries +during the fourth quarter of 2005. Sales to SSL under the distribution agreement were $3.2 million in 2005. +Sales of our Histofreezer ® product to physicians’ offices in the U.S. and international markets increased 13% and 24% to $5.9 million and $2.0 million, respectively, in +2005, when compared to 2004, primarily as a result of higher distributor purchases. +Sales to the insurance risk assessment market declined by 12% to $6.8 million in 2005 from $7.8 million in 2004, primarily as a result of decreased OraSure ® device purchases by our insurance lab testing partners. We believe this decrease was a +result of an overall reduction in life insurance application activity in the United States and changes in underwriting requirements. +Licensing and product development revenues decreased 26% to $300,000 in 2005, from $404,000 in the comparable period in 2004. Licensing and product +development revenues in both years were primarily related to our collaborative oral fluid research project with the University of Pennsylvania and New York University, under a grant awarded by the National Institutes of Health. +We had two customers, Prestige and Quest, which accounted for 17% and 13% of +total revenues for 2005, respectively. +The Company’s +gross margin was 60% in 2005, compared to 59% in 2004. Our 2005 gross margin was positively impacted by more efficient utilization of the Company’s manufacturing capacity and renegotiated terms for the assembly and supply of the U.S. OTC +cryosurgical product, offset by a less favorable product sales mix and the $1.5 million charge related to the Company’s UP link ® assets. +47 +Table of Contents +Research and development expenses decreased 13% to $5.3 million in 2005, from $6.1 million in 2004, +primarily as a result of lower overall staffing costs and lower expenses for clinical trials, partially offset by fees paid and restricted stock granted to recruit and relocate the Company’s new Chief Science Officer and Senior Vice President, +Regulatory Affairs/Quality Assurance. +Sales and marketing +expenses increased 6% to $16.1 million in 2005 from $15.2 million in 2004. This increase was primarily the result of increased levels of staffing, market research, travel and commission expenses, partially offset by lower advertising expenses. +Included in advertising expenses was $1.8 million and $2.9 million for 2005 and 2004, respectively, paid to Prestige as reimbursement for marketing expenses incurred for the Compound W ® Freeze Off ® product. +General and administrative expenses increased 4% to $12.5 million in 2005 from $12.0 million in 2004. This increase was primarily attributable to legal +fees associated with the Schering-Plough litigation, increased amortization of restricted stock grants to management, and increased staffing related expenses. This increase was partially offset by a reduction in consulting expenses, a reduction in +transition expenses related to the Company’s former Chief Executive Officer, and a reduction in rent expense due to the expiration of the lease for our Oregon facilities in January 2005. Legal fees associated with the Schering-Plough patent +infringement litigation were $2.4 million and $1.2 million in 2005 and 2004, respectively. +Interest expense decreased to $97,000 in 2005 from $134,000 in 2004, as a result of lower outstanding debt balances. Interest income increased to $2.2 million in 2005 from $984,000 in 2004, as a result of higher +yields on our investment portfolio and larger balances available for investment. +A gain on foreign currency transactions of $57,000 was recorded for the year ended December 31, 2005, versus a loss on foreign currency transactions of $53,000 recorded for the year ended December 31, 2004. +During the year ended December 31, 2005, a net income tax +benefit of $17.7 million was recorded, while no provision or benefit was recorded in 2004. The tax benefit recorded during 2005 reflects the release of a significant portion of the valuation allowance on our deferred tax asset. At December 31, +2005, the Company had federal net operating loss (“NOL”) carryforwards of $66.6 million. Our ability to use the NOLs and tax credit carryforwards to offset future income tax obligations could be limited by changes in the ownership of the +Company’s capital stock. Internal Revenue Code Section 382 (“Section 382”) contains provisions that limit the amount of NOLs and tax credit carryforwards that can be used in any given year, in the event of a significant ownership +change. In the fourth quarter of 2005, the Company engaged in an analysis, with the assistance of independent tax specialists, to determine if any Section 382 ownership changes have occurred that would limit the amount of NOLs that could be +utilized to offset future taxable income. As a result of this analysis, the Company concluded that prior period ownership changes may impose a limitation on the amount of NOLs that can be utilized in a given year. The Company does not believe, +however, that this limitation will impair our future ability to utilize NOLs to offset our forecasted taxable income or to realize the related deferred tax asset. +Prior to December 31, 2005, a valuation allowance had been established for the full amount of the deferred tax asset +created by these carryforwards and other items. Based on the 2005 and forecasted taxable earnings, a significant portion of the valuation allowance was released in the fourth quarter of 2005, resulting in the recognition of $26.7 million of the +deferred tax asset of which $18.2 million was recorded as an income tax benefit in the statement of operations and $8.5 million was recorded directly as an increase in stockholders’ equity. Partially offsetting this benefit was an income tax +provision of $436,000 that was recorded for the year ended December 31, 2005 related to certain state income taxes and federal alternative minimum tax. +48 +Table of Contents +Liquidity and Capital Resources +December 31, +2006 +December 31, +2005 +(In thousands) +Cash and cash equivalents +$ +19,950 +$ +32,827 +Short-term investments +71,051 +44,793 +Working capital +95,979 +90,670 +Our cash, cash +equivalents and short-term investments increased $13.4 million during 2006 to $91.0 million at December 31, 2006, primarily as a result of $16.9 million in positive cash flow from operating activities, $10.0 million in borrowings of +long-term debt, and $457,000 in proceeds from the exercise of stock options, partially offset by $701,000 of debt repayments, $12.6 million of property and equipment purchases, and $632,000 associated with the retirement of common stock to pay +minimum tax withholding obligations on the vesting of restricted shares. At December 31, 2006, our working capital was $96.0 million. +Net cash provided by operating activities was $16.9 million in 2006, primarily generated by our net income of $5.3 million for the year, non-cash charges +for depreciation and amortization of $1.9 million, stock-based compensation expense of $5.6 million, and a deferred income tax provision of $3.1 million resulting from utilization of our NOL carryforwards. Other factors which contributed to the +$16.9 million in net cash provided by operating activities at December 31, 2006, also included a non-cash provision for excess and obsolete inventories of $750,000, $1.0 million in acquired in-process technology, an increase of $600,000 in +accounts payable and accrued expenses primarily related to increased accruals for royalties, legal fees and customer prepayments, and a decrease in accounts receivable of $1.3 million resulting from increased collection efforts and lower outstanding +balances due from Prestige and SSL. Offsetting these sources of operating cash were a $2.2 million increase in inventories primarily related to higher levels of raw material purchases associated with our OTC cryosurgical product for SSL and our +OraQuick ADVANCE ® test, and a $453,000 +increase in prepaid expenses resulting from the timing of prepayments for insurance and real estate taxes. +Net cash used in investing activities during 2006 was $38.9 million, of which $26.1 million was for the purchase of short-term investments. We invested +$12.6 million in additions to property and equipment, of which $9.1 million related to the purchase of our two previously leased facilities in Bethlehem, PA. We also paid $200,000 for certain acquired in-process technology. +During the year ending December 31, 2007, we expect to invest $7.5 +million in capital expenditures, primarily to purchase additional equipment, upgrade certain older equipment and make improvements to our facilities. +Net cash provided by financing activities was $9.1 million for the year ended December 31 2006, reflecting the $10.0 million in new borrowings from +Comerica Bank to finance the purchase of our two previously leased facilities and $457,000 received from the exercise of stock options. Partially offsetting these sources of cash were $701,000 of loan principal repayments and $632,000 used for the +purchase and retirement of common stock. +During 2006, we had +in place an $11.9 million credit facility (the “Credit Facility”) with Comerica Bank, which is comprised of an $887,000 mortgage loan, a $3.0 million term loan, a $4.0 million non-revolving line of credit for the purchase of both capital +equipment and software, and a $4.0 million revolving working capital line of credit. Interest on outstanding borrowings under the non-revolving line of credit accrues at a rate, selected at our option, equal to the bank’s prime rate, 180-day or +360-day LIBOR plus 2.625%, or the 4-year Treasury Note rate plus 2.30%, determined at the time of initial borrowing. Interest on outstanding borrowings under the revolving working capital line of credit accrues at a rate, selected at our option, +equal to the bank’s prime rate less 0.25%, or 30-day LIBOR plus 2.55%, determined at the time of initial borrowing. +On June 27, 2006, we executed an amendment to our Credit Facility, pursuant to which we are permitted to borrow up to an additional $15.0 million in +advances in order to fund the purchase and future expansion of two +49 +Table of Contents +previously leased facilities in Bethlehem, Pennsylvania. On June 29, 2006, we borrowed $10.0 million under the terms of this Credit Facility, as +amended, and purchased our two Bethlehem facilities. We can borrow the remaining $5.0 million at any time before June 30, 2007. At our option, interest on outstanding borrowings is payable monthly at either a fixed rate equal to the +five-year U.S. Treasury Note rate plus 1.03% to 1.73%, or a variable rate equal to the 30, 180, or 360-day LIBOR rate plus 0.55% to 1.25%. In each case, the interest rate is determined at the date of the advance and is based upon the amount of cash +and cash equivalents we invest and retain at Comerica Securities, Inc. We can also choose the fixed rate option, without penalty, at the expiration of a previously elected LIBOR period. Principal is repayable in periodic installments, based upon the +rate option that we elect, with the remaining balance of unpaid principal due on June 27, 2011. This amendment also extended the maturity date of our $4.0 million revolving working capital line of credit to June 29, 2007. All other terms +of the Credit Facility, as previously amended, remain in effect, except for our financial covenant related to liquidity, which was modified to require a minimum liquidity, as defined by Comerica, of not less than $25.0 million, of which at +least $15.0 million must be held by Comerica or its affiliates. +At December 31, 2006, interest on the new $10.0 million borrowing was payable monthly, at the 360-day LIBOR rate plus 0.9%, or 6.1894%. Principal is repayable in installments, due at the end of each LIBOR rate period, based upon a +twenty-year amortization schedule and the number of months in the expiring LIBOR rate period. Accordingly, on December 27, 2007, we will be required to make a $500,000 principal repayment and the interest rate on this loan will reset. The +outstanding balance of the loan at December 31, 2006 was $9.75 million. +As of December 31, 2006, we had no outstanding borrowings under the $3.0 million term loan, the $4.0 million non-revolving line of credit, or the $4.0 million revolving working capital line of credit. +All borrowings under the Credit Facility are collateralized by +a first priority security interest in all of our assets, including present and future accounts receivable, chattel paper, contracts and contract rights, equipment and accessories, general intangibles, investments, instruments, inventories, and a +mortgage on our three facilities in Bethlehem, Pennsylvania. Borrowings under the equipment and software non-revolving line and the revolving working capital line are limited to commercially standard percentages of equipment and software purchases +and accounts receivable, respectively. The Credit Facility contains certain covenants that set forth minimum requirements for our quick ratio, liquidity and tangible net worth. We were in full compliance with all covenants at December 31, 2006 +and expect to remain in compliance with all covenants during 2007. The Credit Facility also restricts our ability to pay dividends, to make certain investments, to incur additional indebtedness, to sell or otherwise dispose of a substantial portion +of assets and to merge or consolidate operations with an unaffiliated entity, without the consent of Comerica. +At December 31, 2006, we had NOL carryforwards of $53.0 million for federal income tax purposes. During the fourth quarter of 2005, the Company +retained independent tax specialists to perform an ownership change study and analysis to determine the annual limitation amount applicable to utilization of the NOL carryforwards due to past ownership changes, as defined in Section 382 of the +Internal Revenue Code. As a result of this study, we do not believe that the ownership change limitations would impair our ability to use our NOLs against our current forecasted taxable income. +The combination of our current cash position, cash flow from operations and +available borrowings under our Credit Facility is expected to be sufficient to fund our operating and capital needs for at least the next twelve months. However, our cash requirements may vary materially from those now planned due to many factors, +including, but not limited to, the scope and timing of strategic acquisitions, the cost and timing of the expansion of our manufacturing capacity, the progress of our research and development programs, the scope and results of clinical testing, the +magnitude of capital expenditures, changes in existing and potential relationships with business partners, the time and cost of obtaining regulatory approvals, the costs involved in obtaining and enforcing patents, proprietary rights and any +necessary licenses, the cost and timing of expansion of sales and marketing activities, the timing of market launch of new products, market acceptance of new products, competing technological and market developments and other factors. +50 +Table of Contents +Recent Accounting Pronouncements +In July 2006, the Financial Accounting Standards Board (“FASB”) issued FASB Interpretation (“FIN”) +No. 48, “Accounting for Uncertainty in Income Taxes—an Interpretation of FASB Statement No. 109,” which clarifies what criteria must be met prior to recognition of the financial statement benefit of a position taken in a tax +return. FIN No. 48 will require companies to include additional qualitative and quantitative disclosures within their financial statements. The disclosures will include potential tax benefits from positions recognized for tax return purposes +but not recognized for financial reporting purposes, as well as a tabular presentation of significant changes in such benefits during each period. The disclosures will also include a discussion of the nature of uncertainties, factors that could +cause a change, and an estimated range of reasonably possible changes in tax uncertainties. FIN No. 48 will require a company to recognize a financial statement benefit for a position taken for tax return purposes when it will be +more-likely-than-not that the position will be sustained. FIN No. 48 is effective for fiscal years beginning after December 15, 2006. We are currently assessing the impact FIN No. 48 will have on our financial statements. +In September 2006, the United States Securities and +Exchange Commission (“SEC”) issued Staff Accounting Bulletin (“SAB”) No. 108, “Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements.” SAB +No. 108 requires companies to evaluate the materiality of identified unadjusted errors using both the income statement approach and the balance sheet approach. In the initial year of adoption, if a company determines that an adjustment to prior +year financial statements is required under either approach, SAB No. 108 allows for a one-time cumulative-effect adjustment to beginning retained earnings. SAB No. 108 is effective for interim periods of the first fiscal year ending after +November 15, 2006. The adoption of SAB No. 108 did not have any impact on our financial statements. +In September 2006, the FASB issued Statement of Financial Accounting Standards (“SFAS”) No. 157, “ Fair Value +Measurements.” This Statement defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles, and expands disclosures about fair value measurements. SFAS No. 157 is effective for +financial statements issued for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years. We are currently assessing the impact, if any, that SFAS No. 157 will have on our financial statements. +In February 2007, the FASB issued SFAS No. 159, “The +Fair Value Option for Financial Assets and Financial Liabilities—Including an amendment of FASB Statement No. 115.” SFAS No. 159 permits entities to elect to measure many financial instruments and certain other items at fair +value. Unrealized gains and losses on items for which the fair value option has been elected will be recognized in earnings at each subsequent reporting date. SFAS No. 159 is effective for fiscal years beginning after November 15, 2007. We +are currently assessing the impact SFAS No. 159 will have on our financial statements. +Contractual Obligations and Commercial Commitments . The following sets forth our approximate aggregate obligations at December 31, 2006 for future payments under contracts and other +contingent commitments, for the years 2007 and beyond: +Contractual Obligations +Total +Payments due by December 31, +2007 +2008 +2009 +2010 +2011 +Thereafter +Long-term debt 1 +$ +10,639,136 +$ +608,595 +$ +593,087 +$ +597,346 +$ +552,670 +$ +7,796,730 +$ +490,708 +Operating leases 2 +161,759 +81,866 +68,480 +11,413 +— +— +Employment contracts 3 +2,529,425 +1,804,625 +724,800 +— +— +— +— +Purchase obligations 4 +5,349,799 +5,349,799 +— +— +— +— +— +Minimum commitments under contracts 5 +5,791,667 +500,000 +500,000 +500,000 +500,000 +500,000 +3,291,667 +Total contractual obligations +$ +24,471,786 +$ +8,344,885 +$ +1,886,367 +$ +1,108,759 +$ +1,052,670 +$ +8,296,730 +$ +3,782,375 +51 +Table of Contents +1 +Represents principal repayments required under notes payable to our lenders. See Note 8 to the financial statements included herein. +2 +Represents payments required under our operating leases. +3 +Represents salary payments payable under the terms of employment agreements executed by us with certain executives. See Note 11 to the financial statements included herein. +4 +Represents payments required by non-cancellable purchase orders related to inventory, capital expenditures and other goods or services. See Note 11 to the financial statements +included herein. +5 +Represents payments required pursuant to certain, licensing agreements executed by the Company. These agreements are cancellable within a specified number of days after +communication by the Company of its intent to terminate. See Note 11 to the financial statements included herein. Additional payments of up to $5,500,000 may be required pursuant to one of these licensing agreements for the achievement of specific +development and/or commercial milestones. +Off-Balance Sheet Arrangements . We do not have any off-balance sheet arrangements, as defined in Item 303(a) (4) (ii) of Regulation S-K under the Securities Exchange Act of 1934, as amended. +Critical Accounting Policies and Estimates +This Management’s Discussion and Analysis of Financial Condition and +Results of Operations discusses our financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires that we make +estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenues and expenses during the reporting +period. On an on-going basis, we evaluate our judgments and estimates, including those related to bad debts, inventories, investments, intangible assets, income taxes, revenue recognition, restructuring costs, contingencies and litigation. We base +our judgments and estimates on historical experience and on various other factors that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying value of assets and liabilities +that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. +Our significant accounting policies are described in Note 2 to the financial statements included in Item 15 of this Annual Report. We consider the +following accounting estimates, which have been discussed with our Audit Committee, to be most critical in understanding the more complex judgments that are involved in preparing our financial statements and the uncertainties that could impact our +results of operations, financial condition and cash flows. +Revenue Recognition . We follow SAB No. 104, “Revenue Recognition.” This bulletin draws on existing accounting rules and provides specific guidance on revenue recognition for up-front +non-refundable licensing and development fees. We license certain products or technology to outside third parties, in return for which we receive up-front licensing fees. Some of these fees can be significant. In accordance with SAB No. 104, we +recognize this revenue ratably over the related license period. +We also enter into research and development contracts with corporate, government and/or private entities. These contracts generally provide for payments to us upon achievement of certain research or development milestones. Product +development revenues from these contracts are recognized only if the specified milestone is achieved and accepted by the customer and payment from the customer is probable. Any amounts received prior to the performance of product development efforts +are recorded as deferred revenues. Recognition of revenue under these contracts can be sporadic, as it is the result of achieving specific research and development milestones. Furthermore, revenue from future milestone payments will not be +recognized if the underlying research and development milestone is not achieved. +52 +Table of Contents +We recognize product revenues when there is persuasive evidence that an arrangement exists, the price is +fixed or determinable, title has passed and collection is reasonably assured. Product revenues are net of allowances for any discounts or rebates. We do not grant price protection or product return rights to our customers, except for warranty +returns. Where a product fails to comply with its limited warranty, we can either replace the product or provide the customer with a refund of the purchase price or credit against future purchases. Historically, returns arising from warranty issues +have been infrequent and immaterial. Accordingly, we expense warranty returns as incurred. While such returns have been immaterial in the past, we cannot guarantee that we will continue to experience the same rate of warranty claims as we have in +the past. Any significant increase in product warranty claims could have a material adverse impact on our operating results for the period in which the claims occur. +Allowance for Uncollectible Accounts Receivable . Accounts receivable are reduced by an +estimated allowance for amounts that may become uncollectible in the future. On an ongoing basis, we perform credit evaluations of our customers and adjust credit limits based upon the customer’s payment history and creditworthiness, as +determined by a review of their current credit information. We also continuously monitor collections and payments from our customers. +Based upon historical experience and any specific customer collection issues that are identified, we use our judgment to establish and evaluate the +adequacy of our allowance for estimated credit losses, which was $200,094 at December 31, 2006. While credit losses have been within our expectations and the allowance provided, these losses can vary from period to period ($16,022, ($4,771), +and $3,541 in 2006, 2005 and 2004, respectively). Furthermore, there is no assurance that we will experience credit losses at the same rates as we have in the past. Also, at December 31, 2006, $4.5 million, or 44% of our accounts receivable, +was due from four major customers. Any significant changes in the liquidity or financial position of these customers, or others, could have a material adverse impact on the collectibility of our accounts receivable and future operating results. +Inventories . Our inventories are valued at the lower of cost or market, determined on a first-in, first-out basis, and include the cost of raw materials, labor and overhead. The majority of our inventories are +subject to expiration dating. We continually evaluate the carrying value of our inventories and when, in the opinion of management, factors indicate that impairment has occurred, either a reserve is established against the inventories’ carrying +value or the inventories are completely written off. We base these decisions on the level of inventories on hand in relation to our estimated forecast of product demand, production requirements over the next twelve months and the expiration dates of +raw materials and finished goods. During 2006, 2005 and 2004, we wrote-off inventory which had a cost of $751,000, $2.1 million and $839,000, respectively, as a result of scrap and product expiration issues and a $1.3 million provision for loss on +our UP link ® product in 2005. Although we make every effort to ensure the accuracy of our forecasts of future product demand, any significant unanticipated changes in +demand could have a significant impact on the carrying value of our inventories and reported operating results. +Stock-based Compensation . Commencing January 1, 2006, we adopted SFAS No. 123 (revised 2004), “Share-Based +Payment,” which requires us to recognize the fair value of equity-based awards as compensation expense in our statement of operations. The fair value of our stock option awards was estimated using a Black-Scholes option valuation model. This +valuation model incorporates highly subjective assumptions, such as the expected stock price volatility and the estimated life of each award, in the model’s computations. The fair value of awards, after considering the effect of expected +forfeitures, is then amortized, generally on a straight-line basis, over the related vesting period of the award. +Long-lived and Intangible Assets . Our long-lived assets are comprised of property and equipment and an investment in a +nonaffiliated entity, and our intangible assets primarily consist of patents and product rights. Together, these assets have a net book value of $24.0 million, or 15.4% of our total assets, at December 31, 2006. +53 +Table of Contents +Our investment in a privately-held nonaffiliated company is recorded under the cost method of accounting because we do not have a controlling interest in +this company, nor do we have the ability to exert significant influence over the operating and financial policies of this investee company. Property and equipment, patents and product rights are depreciated or amortized on a straight-line basis over +their useful lives, which we determine based upon our estimate of the period of time over which each asset will generate revenues. In August 2005, we recorded a $1.5 million intangible asset related to a payment under a license agreement to certain +patents related to the Hepatitis C Virus. We recorded an additional $3.0 million related to this license in 2006. Management’s intent in executing this license is to provide for various alternatives for use, including uses in the international +market that would not require additional research and development efforts or regulatory approvals. This $4.5 million asset was capitalized based on management’s estimate of the cash flows to be received from future product sales in these +international markets. A similar analysis of estimated future cash flows will be prepared upon payment of additional license fees under this agreement, or upon changes in circumstances, to determine the appropriate accounting treatment for payments +under this license agreement. An impairment of long-lived or intangible assets could occur whenever events or changes in circumstances indicate that the net book value of these assets may not be recoverable. Events which could trigger an asset +impairment include significant underperformance relative to expected historical or projected future operating results, significant changes in the manner of our use of an asset or in our overall business strategy, significant negative industry or +economic trends, shortening of product life-cycles or changes in technology, and negative financial performance of the nonaffiliated investee company. If we believe impairment of an asset has occurred, we measure the amount of such impairment by +comparing the net book value of the affected assets to the fair value of these assets, which is generally determined based upon the present value of the expected cash flows associated with the use of these assets. If the net book value exceeds the +fair value of the impaired assets, we would incur an impairment expense equal to this difference. In June 2005, we recorded a $196,000 provision for loss on our UP link ® fixed assets as a result of our inability to reach an agreement to transfer these assets to our distribution partner or +determine an alternative outlet for these assets. We currently believe the future cash flows to be received from all other long-lived and intangible assets will exceed their book value and, as such, we have not recognized any additional impairment +losses through December 31, 2006. Any unanticipated significant impairment in the future, however, could have a material adverse impact to our balance sheet and future operating results. +Deferred Tax Assets. At December 31, 2006, +we had federal NOL carryforwards of $53.0 million. The net deferred tax asset associated with these NOLs and other temporary differences was $23.5 million at December 31, 2006. In assessing the realizability of deferred tax assets, we consider +whether it is more likely than not that some portion or all of the deferred tax assets will not be realized. The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income during the period in which those +temporary differences become deductible or the NOLs and credit carryforwards can be utilized. We consider the scheduled reversal of deferred tax liabilities, projected future taxable income and tax planning strategies in making this assessment. +Our ability to use our NOL carryforwards to offset future +federal income tax obligations, could be limited by changes in the ownership of our stock. Internal Revenue Code (“IRC”) Section 382 contains provisions that limit the amount of federal NOL carryforwards that can be used in any given +year in the event of specified occurrences, including significant ownership changes. In the fourth quarter of 2005, the Company completed an analysis, with the assistance of independent tax specialists, to determine if any IRC Section 382 +ownership changes have occurred that would limit the amount of NOLs that could be utilized to offset future taxable income. As a result of this analysis, the Company concluded that prior period ownership changes may impose a limitation on the amount +of NOLs that can be utilized in a given year. The Company does not believe, however, that this limitation will impair our future ability to utilize NOLs to offset our forecasted taxable income or to realize the related deferred tax asset. +Prior to December 31, 2005, a valuation allowance had +been established for the full amount of the deferred tax asset created by these carryforwards and other items. Based on our 2005 results and our projections for future taxable income over the periods in which the deferred tax assets are deductible +or the NOLs and credit carryforwards can be utilized, we believe a significant portion of the deferred tax asset was realizable at +54 +Table of Contents +December 31, 2005. As such, we recorded the estimated net realizable value of the deferred tax asset at December 31, 2005 and have begun providing +for income taxes at a rate equal to our combined federal and state effective rates. Subsequent revisions to the estimated net realizable value of the deferred tax asset could cause our provision for income taxes to vary significantly from period to +period. +Contingencies . In the +ordinary course of business, we have entered into various contractual relationships with strategic corporate partners, customers, distributors, research laboratories and universities, licensors, licensees, suppliers, vendors and other parties. As +such, we could be subject to litigation, claims or assessments arising from any or all of these relationships. We account for contingencies such as these in accordance with SFAS No. 5, “Accounting for Contingencies.” SFAS No. 5 +requires us to record an estimated loss contingency when information available prior to issuance of our financial statements indicates that it is probable that an asset has been impaired or a liability has been incurred at the date of the financial +statements and the amount of the loss can be reasonably estimated. Accounting for contingencies arising from contractual or legal proceedings requires that we use our best judgment when estimating an accrual related to such contingencies. As +additional information becomes known, our accrual for a loss contingency could fluctuate, thereby creating variability in our results of operations from period to period. Likewise, an actual loss arising from a loss contingency which significantly +exceeds the amount accrued for in our financial statements could have a material adverse impact on our operating results for the period in which such actual loss becomes known. +ITEM 7A. Quantitative and Qualitative Disclosures About Market Risk. +We do not hold any amounts of derivative financial instruments or derivative commodity instruments and, accordingly, we have no material derivative risk +to report under this Item. +A significant portion of our assets +is comprised of certificates of deposit, commercial paper, U.S. government and agency obligations, and U.S. corporate bonds. All such instruments are classified as available-for-sale securities. The primary objective of our investment activities is +to preserve principal while maximizing the related income without significantly increasing risk. Even so, some of the securities in which we invest may be subject to market risk. Market risk is the risk that a change in prevailing interest rates may +cause the fair value of an investment to fluctuate. As interest rates increase, the fair value of a debt instrument would be expected to decrease. Correspondingly, if interest rates decrease the fair value of a debt instrument would be expected to +increase. To minimize market risk, we have the ability to hold such debt instruments to maturity, at which time the debt instrument would be redeemed at its stated or face value. We also typically invest in the shorter end of the maturity spectrum. +As such, we do not believe that we have a material exposure to market risk. +At December 31, 2006, approximately $10.5 million of the Company’s long-term debt bears interest at a variable or floating rate tied to either the United States prime rate or the London Interbank Offered +Rate. A one percentage point increase in these interest rates would cost the Company approximately $105,000 in additional interest expense. +As of December 31, 2006, we did not have any foreign currency exchange contracts or purchase currency options to hedge local currency cash flows. We +have operations in The Netherlands, which are subject to foreign currency fluctuations. As currency rates change, translation of revenues and expenses for these operations from euros to U.S. dollars affects year-to-year comparability of operating +results. Sales denominated in a foreign currency represented approximately $135,000 of our total revenues for the year ended December 31, 2006. We do not expect the risk of foreign currency fluctuations to be material in the near future. +ITEM 8. Financial Statements and Supplementary Data. +Information with respect to this Item is contained in our Financial Statements included in Item 15 of this Annual Report on Form 10-K. +55 +Table of Contents +ITEM 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure. +Not applicable. +ITEM 9A. Controls and Procedures. +(a) Evaluation of Disclosure Controls and Procedures. +The Company’s management, with the participation of the Company’s Chief Executive Officer and Chief Financial Officer, has evaluated the effectiveness of the Company’s disclosure controls and procedures +(as defined in Rules 13a-15(e) and 15d-15(e) of the Securities Exchange Act of 1934) as of December 31, 2006. Based on that evaluation, the Company’s management, including such officers, concluded that the Company’s disclosure +controls and procedures are adequate and effective to ensure that information required to be disclosed by the Company in the reports that we file or submit under the Securities Exchange Act of 1934 is accumulated and communicated to the +Company’s management, including the Chief Executive Officer and Chief Financial Officer, to allow timely decisions regarding required disclosure and is recorded, processed, summarized, and reported within the time periods specified in the rules +and forms of the Securities and Exchange Commission. +(b) +Management’s Report on Internal Control Over Financial Reporting. +The Company’s management is responsible for establishing and maintaining adequate internal control over financial reporting, as such term is defined in Rule 13a(f) and 15d-15(f) under the Securities Exchange Act +of 1934. Under the supervision and with the participation of the Company’s management, including our principal executive officer and principal financial officer, we conducted an evaluation of the effectiveness of our internal control over +financial reporting based on the framework in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on our evaluation under the framework, our management concluded +that our internal control over financial reporting was effective to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted +accounting principles as of December 31, 2006. +Our +management’s assessment of the effectiveness of our internal control over financial reporting as of December 31, 2006 has been audited by KPMG LLP, an independent registered public accounting firm, as stated in their report, which is +included below. +Because of its inherent limitations, internal +control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that +the degree of compliance with the policies or procedures may deteriorate. +(c) Changes in Internal Control Over Financial Reporting. +There was no change in the Company’s internal control over financial reporting identified in connection with the evaluation referred to in paragraph +(a) above that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting. +(d) Report of Independent Registered Public Accounting Firm +The Board of Directors and Stockholders +OraSure Technologies, Inc.: +We have audited +management’s assessment, included in the accompanying Management’s Report on Internal Control over Financial Reporting, that OraSure Technologies, Inc. maintained effective internal control over financial reporting as of December 31, +2006, based on criteria established in Internal Control—Integrated +56 +Table of Contents +Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). OraSure Technologies, Inc.’s management is +responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on management’s assessment and +an opinion on the effectiveness of the Company’s internal control over financial reporting based on our audit. +We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we +plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial +reporting, evaluating management’s assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit +provides a reasonable basis for our opinion. +A company’s +internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted +accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions +and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that +receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized +acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements. +Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any +evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. +In our opinion, management’s assessment that OraSure Technologies, Inc. +maintained effective internal control over financial reporting as of December 31, 2006, is fairly stated, in all material respects, based on criteria established in Internal Control—Integrated Framework issued by the Committee of +Sponsoring Organizations of the Treadway Commission (COSO). Also, in our opinion, OraSure Technologies, Inc. maintained, in all material respects, effective internal control over financial reporting as of December 31, 2006, based on criteria +established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). +We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the balance sheets of OraSure +Technologies, Inc. as of December 31, 2006 and 2005, and the related statements of operations, stockholders’ equity and comprehensive income (loss), and cash flows for each of the years in the three-year period ended December 31, +2006, and our report dated March 16, 2007 expressed an unqualified opinion on those financial statements. +/s/ KPMG LLP +Philadelphia, Pennsylvania +March 16, 2007 +ITEM 9B. Other Information. +Not applicable. +57 +Table of Contents +PART III +We have omitted from +Part III the information that will appear in our Definitive Proxy Statement for our 2007 Annual Meeting of Stockholders (the “Proxy Statement”), which will be filed within 120 days after the end of our fiscal year pursuant to Regulation +14A. +ITEM 10. Directors, Executive Officers and Corporate Governance. +Certain information required by this Item is incorporated by reference to the information under the captions, “Corporate Governance—Committees +of the Board—Audit Committee,” “Election of Directors,” “Executive Officers,” and “Section 16(a) Beneficial Ownership Reporting Compliance,” in the Proxy Statement. +Our Board of Directors has adopted a Code of Business Conduct and Ethics that +applies to our principal executive officer, principal financial officer and principal accounting officer, as well as to the members of our Board of Directors and our other officers and employees. This Code of Business Conduct and Ethics is available +on our website at www.orasure.com. We intend to satisfy the amendment and waiver disclosure requirements under applicable securities regulations by posting any amendments of, or waivers to, the Code of Business Conduct and Ethics on our website. +ITEM 11. Executive Compensation. +The information required by this Item is incorporated by reference to the information under the caption, “Executive Compensation,” in the Proxy Statement. +ITEM 12. Security +Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters. +The information required by this Item with respect to the securities ownership of certain beneficial owners and management, +and equity compensation plan information, is incorporated by reference to the information under the captions, “Principal Stockholders” and “Equity Compensation Plan Information,” respectively, in the Proxy Statement. +ITEM 13. Certain Relationships and Related Transactions, and Director Independence. +The information required by this Item is incorporated by reference to the information under the captions, “Transactions with Related Persons” +and “Corporate Governance—Director Independence,” in the Proxy Statement. +ITEM 14. Principal Accountant Fees and Services. +The information required by this Item is incorporated by reference to the information under the caption, “Audit Fees; Audit-Related Fees; Tax Fees; +All Other Fees,” in the Proxy Statement. +58 +Table of Contents +PART IV +ITEM 15. Exhibits and Financial Statement Schedules. +(a)(1) and (a)(2). Financial Statements and Schedules . For a list of the Financial Statements filed herewith, see the Index +to Financial Statements following the signature page to this Annual Report. No schedules are included with the Financial Statements because the required information is inapplicable or is presented in the Financial Statements or related notes +thereto. +(a)(3). Exhibits . See +Index to Exhibits following the Financial Statements in this Annual Report. +59 +Table of Contents +SIGNATURES +Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be +signed on its behalf by the undersigned, thereunto duly authorized, on March 16, 2007. +ORASURE TECHNOLOGIES, INC. +By: +/s/ D OUGLAS A. M ICHELS +Douglas A. Michels +President and Chief Executive Officer +Pursuant to +the requirements of the Securities Exchange Act of 1934, this report has been signed on March 16, 2007, by the following persons on behalf of the Registrant and in the capacities indicated. +SIGNATURE +TITLE +/s/ D OUGLAS A. M ICHELS +Douglas A. Michels +President, Chief Executive Officer and Director (Principal Executive Officer) +/s/ R ONALD H. S PAIR +Ronald H. Spair +Chief Operating Officer, Chief Financial Officer and Director (Principal Financial Officer) +/s/ M ARK L. K UNA +Mark L. Kuna +Senior Vice President, Finance and Controller (Principal Accounting Officer) +*M ICHAEL C ELANO +Michael Celano +Director +*J ACK G OLDSTEIN , P H .D. +Jack Goldstein, Ph.D. +Director +Frank G. Hausmann +Director +*R ONNY B. L ANCASTER +Ronny B. Lancaster +Director +*C HARLES W. P ATRICK +Charles W. Patrick +Director +*R OGER L. P RINGLE +Roger L. Pringle +Director +*D OUGLAS G. W ATSON +Douglas G. Watson +Director +*By: +/s/ J ACK E. J ERRETT +Jack E. Jerrett +(Attorney-in-Fact) +60 +Table of Contents +INDEX TO FINANCIAL STATEMENTS +Page +Report of Independent Registered Public Accounting Firm +F-2 +Balance Sheets +F-3 +Statements of Operations +F-4 +Statements of Stockholders’ Equity and Comprehensive Income (Loss) +F-5 +Statements of Cash Flows +F-6 +Notes to the Financial Statements +F-7 +F-1 +Table of Contents +REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM +The Board of Directors and Stockholders +OraSure Technologies, Inc.: +We have audited the accompanying balance sheets of OraSure Technologies, Inc. as of December 31, 2006 and 2005, and the related +statements of operations, stockholders’ equity and comprehensive income (loss), and cash flows for each of the years in the three-year period ended December 31, 2006. These financial statements are the responsibility of the Company’s +management. Our responsibility is to express an opinion on these financial statements based on our audits. +We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance +about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting +principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. +In our opinion, the financial statements referred to above present fairly, in all material +respects, the financial position of OraSure Technologies, Inc. as of December 31, 2006 and 2005, and the results of its operations and its cash flows for each of the years in the three-year period ended December 31, 2006, in conformity +with U.S. generally accepted accounting principles. +As discussed in Note 2 to +the financial statements, effective January 1, 2006, the Company adopted the fair value method of accounting for stock-based compensation as required by Statement of Financial Accounting Standards No. 123R, Share-Based Payment . +We also have audited, in accordance with the standards of the Public Company +Accounting Oversight Board (United States), the effectiveness of OraSure Technologies, Inc.’s internal control over financial reporting as of December 31, 2006, based on criteria established in Internal Control—Integrated +Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), and our report dated March 16, 2007 expressed an unqualified opinion on management’s assessment of, and the effective operation of, +internal control over financial reporting. +/s/ KPMG LLP +Philadelphia, +Pennsylvania +March 16, 2007 +F-2 +Table of Contents +ORASURE TECHNOLOGIES, INC. +BALANCE SHEETS +December 31, +2006 +2005 +ASSETS +CURRENT ASSETS: +Cash and cash equivalents +$ +19,949,821 +$ +32,826,740 +Short-term investments +71,051,482 +44,793,046 +Accounts receivable, net of allowance for doubtful accounts of $200,094 +and $278,066 +10,357,287 +11,602,127 +Inventories +5,534,567 +4,128,029 +Deferred income taxes +3,675,785 +6,503,946 +Prepaid expenses and other +1,989,882 +1,553,545 +Total current assets +112,558,824 +101,407,433 +PROPERTY AND EQUIPMENT, net +17,374,718 +5,815,233 +PATENTS AND PRODUCT RIGHTS, net +6,328,344 +2,879,958 +DEFERRED INCOME TAXES +19,845,789 +20,204,352 +OTHER ASSETS +457,788 +440,227 +$ +156,565,463 +$ +130,747,203 +LIABILITIES AND STOCKHOLDERS’ EQUITY +CURRENT LIABILITIES: +Current portion of long-term debt +$ +608,595 +$ +456,541 +Accounts payable +3,311,968 +2,546,621 +Accrued expenses and other +12,659,149 +7,733,941 +Total current liabilities +16,579,712 +10,737,103 +LONG-TERM DEBT +10,030,541 +884,021 +OTHER LIABILITIES +451,235 +207,037 +COMMITMENTS AND CONTINGENCIES (Note 11) +STOCKHOLDERS’ EQUITY: +Preferred stock, par value $0.000001; 25,000,000 shares authorized, +none issued +— +— +Common stock, par value $0.000001; 120,000,000 shares authorized, 45,994,752 and 45,775,625 shares issued and outstanding +46 +46 +Additional paid-in capital +228,069,433 +226,218,469 +Deferred compensation +— +(3,334,792 +) +Accumulated other comprehensive loss +(151,197 +) +(282,825 +) +Accumulated deficit +(98,414,307 +) +(103,681,856 +) +Total stockholders’ equity +129,503,975 +118,919,042 +$ +156,565,463 +$ +130,747,203 +The accompanying notes +are an integral part of these statements. +F-3 +Table of Contents +ORASURE TECHNOLOGIES, INC. +STATEMENTS OF OPERATIONS +For the year ended December 31, +2006 +2005 +2004 +REVENUES: +Product +$ +67,830,561 +$ +69,066,152 +$ +53,604,124 +Licensing and product development +324,359 +300,040 +404,140 +68,154,920 +69,366,192 +54,008,264 +COST OF PRODUCTS SOLD +24,756,195 +27,973,907 +22,143,190 +Gross profit +43,398,725 +41,392,285 +31,865,074 +OPERATING EXPENSES: +Research and development +8,647,484 +5,269,083 +6,062,275 +Sales and marketing +15,921,467 +16,060,413 +15,154,174 +General and administrative +13,367,111 +12,490,074 +12,005,309 +37,936,062 +33,819,570 +33,221,758 +Operating income (loss) +5,462,663 +7,572,715 +(1,356,684 +) +INTEREST EXPENSE +(404,680 +) +(96,632 +) +(133,652 +) +INTEREST INCOME +4,097,860 +2,185,486 +983,841 +FOREIGN CURRENCY GAIN (LOSS) +(94,390 +) +57,329 +(53,147 +) +Income (loss) before income taxes +9,061,453 +9,718,898 +(559,642 +) +INCOME TAX PROVISION (BENEFIT) +3,793,904 +(17,729,189 +) +— +NET INCOME (LOSS) +$ +5,267,549 +$ +27,448,087 +$ +(559,642 +) +EARNINGS (LOSS) PER SHARE +BASIC +$ +0.11 +$ +0.61 +$ +(0.01 +) +DILUTED +$ +0.11 +$ +0.59 +$ +(0.01 +) +SHARES USED IN COMPUTING EARNINGS (LOSS) PER SHARE +BASIC +45,909,990 +45,109,580 +44,463,861 +DILUTED +46,580,266 +46,146,612 +44,463,861 +The accompanying notes +are an integral part of these statements. +F-4 +Table of Contents +ORASURE TECHNOLOGIES, INC. +STATEMENTS OF STOCKHOLDERS’ EQUITY AND COMPREHENSIVE INCOME (LOSS) +For the years ended December 31, 2006, 2005 and 2004 +Common Stock +Additional +Paid-in +Capital +Deferred +Compensation +Accumulated +Other +Comprehensive +Loss +Accumulated +Deficit +Total +Shares +Amount +Balance at January 1, 2004 +44,260,931 +$ +44 +$ +204,867,765 +$ +(614,515 +) +$ +(173,704 +) +$ +(130,570,301 +) +$ +73,509,289 +Common stock issued upon exercise +of options +370,800 +1 +1,904,160 +— +— +— +1,904,161 +Restricted stock grants to employees +— +— +3,176,150 +(3,176,150 +) +— +— +— +Amortization of deferred compensation expense +— +— +— +874,162 +— +— +874,162 +Comprehensive loss: +Net loss +— +— +— +— +— +(559,642 +) +(559,642 +) +Currency translation adjustment +— +— +— +— +(12,983 +) +— +(12,983 +) +Net unrealized loss on marketable securities +— +— +— +— +(137,982 +) +— +(137,982 +) +Total comprehensive loss +(710,607 +) +Balance at December 31, 2004 +44,631,731 +45 +209,948,075 +(2,916,503 +) +(324,669 +) +(131,129,943 +) +75,577,005 +Common stock issued upon exercise +of options +1,009,794 +1 +6,067,868 +— +— +— +6,067,869 +Compensation expense for stock option grants +— +— +123,916 +— +— +— +123,916 +Vesting of restricted stock +197,180 +— +— +— +— +— +— +Restricted stock grants to employees +— +— +1,918,343 +(1,918,343 +) +— +— +— +Purchase and retirement of treasury shares +(63,080 +) +— +(601,347 +) +— +— +— +(601,347 +) +Amortization of deferred compensation expense +— +— +— +1,500,054 +— +— +1,500,054 +Deferred taxes related to stock options +— +— +8,761,614 +— +— +— +8,761,614 +Comprehensive income: +Net income +— +— +— +— +— +27,448,087 +27,448,087 +Currency translation adjustment +— +— +— +— +(39,095 +) +— +(39,095 +) +Unrealized gain on marketable securities, net of tax provision of $26,268 +— +— +— +— +80,939 +— +80,939 +Total comprehensive income +27,489,931 +Balance at December 31, 2005 +45,775,625 +46 +226,218,469 +(3,334,792 +) +(282,825 +) +(103,681,856 +) +118,919,042 +Reclassification of deferred compensation +— +— +(3,334,792 +) +3,334,792 +— +— +— +Reclassification of liability-classified awards +— +— +(230,659 +) +— +— +— +(230,659 +) +Common stock issued upon exercise +of options +85,013 +— +457,334 +— +— +— +457,334 +Vesting of restricted stock +199,633 +— +— +— +— +— +— +Purchase and retirement of treasury shares +(65,519 +) +— +(631,509 +) +— +— +— +(631,509 +) +Compensation cost for restricted stock +— +— +1,969,178 +— +— +1,969,178 +Compensation cost for stock option grants +— +— +3,621,412 +— +— +— +3,621,412 +Comprehensive income: +Net income +— +— +— +— +— +5,267,549 +5,267,549 +Currency translation adjustment +— +— +— +— +6,787 +— +6,787 +Unrealized gain on marketable securities, net of tax provisions of $72,979 +— +— +— +— +124,841 +— +124,841 +Total comprehensive income +5,399,177 +Balance at December 31, 2006 +45,994,752 +$ +46 +$ +228,069,433 +$ +— +$ +(151,197 +) +$ +(98,414,307 +) +$ +129,503,975 +The accompanying notes +are an integral part of these statements +F-5 +Table of Contents +ORASURE TECHNOLOGIES, INC. +STATEMENTS OF CASH FLOWS +For the year ended December 31, +2006 +2005 +2004 +OPERATING ACTIVITIES: +Net income (loss) +$ +5,267,549 +$ +27,448,087 +$ +(559,642 +) +Adjustments to reconcile net income (loss) to net cash provided by operating activities: +Deferred income taxes +3,113,745 +(18,165,068 +) +— +Stock-based compensation +5,590,590 +1,623,970 +874,162 +Depreciation and amortization +1,923,275 +2,346,861 +2,487,121 +Acquired in-process technology +1,000,000 +— +— +Provision for loss on property and equipment, net +— +196,011 +4,339 +Provision for excess and obsolete inventories +750,542 +2,062,855 +839,130 +Changes in assets and liabilities: +Accounts receivable +1,250,552 +(4,553,469 +) +1,159,881 +Inventories +(2,156,302 +) +(1,240,049 +) +(1,787,590 +) +Prepaid expenses and other +(452,502 +) +(360,945 +) +(272,265 +) +Accounts payable +465,344 +457,543 +(1,066,064 +) +Accrued expenses and other liabilities +133,011 +576,540 +1,759,144 +Net cash provided by operating activities +16,885,804 +10,392,336 +3,438,216 +INVESTING ACTIVITIES: +Purchases of property and equipment +(12,643,266 +) +(2,048,167 +) +(912,144 +) +Proceeds from the sale of property and equipment +— +— +66,427 +Purchase of patents, product rights, or acquired in-process technology +(200,000 +) +(1,800,000 +) +(600,000 +) +Purchases of short-term investments +(91,494,215 +) +(54,071,801 +) +(65,638,600 +) +Proceeds from maturities and redemptions of short-term investments +65,433,600 +65,935,674 +42,226,980 +(Increase) decrease in other assets +— +(24,801 +) +80,160 +Net cash (used in) provided by investing activities +(38,903,881 +) +7,990,905 +(24,777,177 +) +FINANCING ACTIVITIES: +Borrowings of long-term debt +10,000,000 +— +— +Repayments of long-term debt +(701,426 +) +(1,116,129 +) +(1,126,186 +) +Proceeds from issuance of common stock +457,334 +6,067,869 +1,904,161 +Purchase and retirement of common stock +(631,509 +) +(601,347 +) +— +Net cash provided by financing activities +9,124,399 +4,350,393 +777,975 +EFFECT OF FOREIGN EXCHANGE RATE CHANGES ON CASH +16,759 +(28,102 +) +(12,983 +) +NET (DECREASE) INCREASE IN CASH AND CASH EQUIVALENTS +(12,876,919 +) +22,705,532 +(20,573,969 +) +CASH AND CASH EQUIVALENTS, BEGINNING OF YEAR +32,826,740 +10,121,208 +30,695,177 +CASH AND CASH EQUIVALENTS, END OF YEAR +$ +19,949,821 +$ +32,826,740 +$ +10,121,208 +The accompanying notes +are an integral part of these statements. +F-6 +Table of Contents +ORASURE TECHNOLOGIES, INC. +NOTES TO THE FINANCIAL STATEMENTS +1. +THE COMPANY: +We develop, manufacture and market oral specimen collection devices using our proprietary oral fluid technologies, diagnostic products including in +vitro diagnostic tests, and other medical devices. These products are sold in the United States and internationally to various clinical laboratories, hospitals, clinics, community-based organizations and other public health organizations, +distributors, government agencies, physicians’ offices, and commercial and industrial entities. One of our products is also sold in the over-the-counter or consumer retail markets in the United States, Canada, Europe and Mexico. +2. +SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES: +Use of Estimates +The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to +make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the +reporting period. Actual results could differ from those estimates. +Cash and Cash Equivalents +We consider all +highly liquid investments with a purchased maturity of ninety days or less to be cash equivalents. As of December 31, 2006 and 2005, cash equivalents consisted of commercial paper, U.S. government agency obligations, state and local government +agency obligations, corporate bonds, and certificates of deposit. +Short-term Investments +We consider all +short-term investments to be available-for-sale securities, in accordance with Statement of Financial Accounting Standards (“SFAS”) No. 115, “Accounting for Certain Investments in Debt and Equity Securities.” These +securities are comprised of certificates of deposits, commercial paper, U.S. government and agency obligations, state and local government agency obligations, and corporate bonds, all with purchased maturities greater than ninety days. +Available-for-sale securities are carried at fair value, based upon quoted market prices, with unrealized gains and losses reported in stockholders’ equity as a component of accumulated other comprehensive loss. There were no securities held as +of December 31, 2006 in a continuous unrealized loss position for twelve or more months. +F-7 +Table of Contents +The following is a summary of our available-for-sale securities at December 31, 2006 and 2005: +Amortized +Cost +Gross +Unrealized +Gains +Gross +Unrealized +Losses +Fair Value +December 31, 2006 +Certificates of deposit +$ +800,000 +$ +— +$ +— +$ +800,000 +Commercial paper +28,079,352 +165,064 +— +28,244,416 +Government and agency bonds +3,331,455 +— +(4,618 +) +3,326,837 +Corporate bonds +38,713,921 +2,264 +(35,956 +) +38,680,229 +Total available-for-sale securities +$ +70,924,728 +$ +167,328 +$ +(40,574 +) +$ +71,051,482 +December 31, 2005 +Certificates of deposit +$ +10,385,000 +$ +— +$ +(464 +) +$ +10,384,536 +Commercial paper +1,984,999 +— +(1,059 +) +1,983,940 +Government and agency bonds +18,544,871 +— +(43,851 +) +18,501,020 +State and local government agency obligations +75,000 +— +— +75,000 +Corporate bonds +13,874,242 +1,261 +(26,953 +) +13,848,550 +Total available-for-sale securities +$ +44,864,112 +$ +1,261 +$ +(72,327 +) +$ +44,793,046 +At December 31, 2006, maturities of our available-for-sale securities were as follows: +Less than one year +$ +67,851,766 +$ +165,064 +$ +(40,574 +) +$ +67,976,256 +One to two years +3,072,962 +2,264 +— +3,075,226 +Total available-for-sale securities +$ +70,924,728 +$ +167,328 +$ +(40,574 +) +$ +71,051,482 +Supplemental Cash +Flow Information +In 2006, 2005, and 2004, we paid +interest of $350,535, $99,728, and $137,112, respectively. +In +2006 and 2005, we paid federal and state income taxes of $695,765 and $170,000, respectively. No income tax payments were made in 2004. +For 2006, 2005, and 2004, we recorded through the statement of operations a reduction in our allowance for doubtful accounts of $61,950, $71,962, and +$10,360, respectively. We had write-offs/(recoveries) of $16,022, $(4,771), and $3,541 against the allowance for doubtful accounts in 2006, 2005, and 2004, respectively. +For 2006, 2005, and 2004, we recorded accruals for purchases of property and equipment of $346,258, $57,923, and $72,394, +respectively. +In 2006, we recorded a $4,000,000 accrual +related to two licensing agreements. In 2004, we recorded a $300,000 accrual related to a new license agreement. +Accounts Receivable +Accounts receivable have been reduced by an allowance for amounts that may become uncollectible in the future. This estimated allowance is based primarily +on management’s evaluation of specific balances as the balances become past due, the financial condition of our customers and our historical experience related to write-offs. If not reserved through these specific examination procedures, our +policy is to reserve for uncollectible accounts by applying fixed percentages to the aging categories of accounts receivable. +F-8 +Table of Contents +Inventories +Inventories are stated at the lower of cost or market determined on a first-in, first-out basis, and include the cost of raw +materials, labor and overhead. The majority of our inventories are subject to expiration dating. We continually evaluate quantities on hand and the carrying value of our inventories to determine the need for reserves for excess and obsolete +inventories, based primarily on the estimated forecast of product sales. When factors indicate that impairment has occurred, either a reserve is established against the inventories’ carrying value or the inventories are completely written off, +as in the case of lapsing expiration dates. In addition to reserving for these items identified through specific identification procedures, we also reserve for unidentified scrap or spoilage under a fixed-formula methodology. We currently buy a +portion of our cryosurgical product line from a foreign vendor, with such purchases payable in Euros. Changes in the exchange rate of the Euro will impact our product cost. +Property and Equipment +Property and equipment are stated at cost. Additions or improvements are capitalized, while repairs and maintenance are charged to expense. Depreciation +and amortization are provided using the straight-line method over the estimated useful lives of the related assets. Buildings are depreciated over 20-40 years, while computer equipment, machinery and equipment, and furniture and fixtures are +depreciated over three to ten years. Building improvements are amortized over their estimated useful lives. When assets are sold or otherwise disposed of, the related property amounts are relieved from the accounts, and any gain or loss is recorded +in the statement of operations. +Patents and Product Rights +Patents and product rights consist of costs associated +with the acquisition of patents, licenses and product distribution rights. Patents and product rights are amortized using the straight-line method over their estimated useful lives of three to ten years. +Other Assets +Included in other assets is a $337,253 investment, representing a 7.7% +ownership interest in a privately-held nonaffiliated company. We do not have a controlling interest in this company, nor do we have an ownership or voting interest which allows us to exert significant influence over the operating and financial +policies of this investee company. Accordingly, we have accounted for this investment using the cost method of accounting. In January, 2007, this privately-held nonaffiliated company was sold, and we received approximately $1,750,000 for our +ownership interest. +Impairment of Long-Lived Assets +In accordance with SFAS No. 144, “Accounting +for the Impairment or Disposal of Long-Lived Assets,” if indicators of impairment exist, we assess the recoverability of the affected long-lived assets, which include property and equipment and patents and product rights, by determining whether +the carrying value of such assets can be recovered through the sum of the undiscounted future cash flows from the use and eventual disposition of the asset. If impairment is indicated, we measure the amount of such impairment by comparing the +carrying value of the assets to the fair value of these assets, which is generally determined based on the present value of the expected future cash flows associated with the use of the asset. During 2005, we recorded a $196,011 impairment on +certain equipment because its carrying value exceeded the future cash flows to be received from those assets. We believe the future cash flows to be received from our long-lived assets will exceed the assets’ carrying value, and accordingly we +have not recognized any additional impairment losses through December 31, 2006. +F-9 +Table of Contents +Revenue Recognition +We recognize product revenues when there is persuasive evidence that an arrangement exists, the price is fixed or +determinable, title has passed and collection is reasonably assured. Product revenues are recorded net of allowances for any discounts or rebates. We do not grant price protection or product return rights to our customers, except for warranty +returns. Historically, returns arising from warranty issues have been infrequent and immaterial. Accordingly, we expense warranty returns as incurred. +Up-front licensing fees are deferred and recognized ratably over the related license period. Product development revenues are recognized over the period +in which the related product development efforts are performed. Amounts received prior to the performance of product development efforts are recorded as deferred revenues. Grant revenue is recognized as the related work is performed and costs are +incurred. We record shipping and handling charges billed to our customers as product revenue and the related expense as cost of products sold. +Significant Customer Concentration +During 2006, Quest Diagnostics, including its wholly-owned subsidiary, Lab One , Inc. (“Quest”), and Abbott Laboratories +(“Abbott”) accounted for 14 percent and 10 percent of our total revenues, respectively. +Additionally, four customers each accounted for more than 10 percent of our accounts receivable at December 31, 2006. Prestige Brands Holdings, Inc. +(“Prestige”), Quest, SSL International plc, and Abbott accounted for 12 percent, 11 percent, 10 percent and 11 percent, respectively, of our accounts receivable at December 31, 2006. +During 2005 and 2004, two of our customers accounted for more than 10 percent +of our total revenues. Prestige accounted for 17% and 25% of total revenues for 2005 and 2004, respectively. Quest accounted for 13% and 14% of our total revenues for 2005 and 2004, respectively. +At December 31, 2005, Prestige and SSL International plc accounted for +15% and 20% of our accounts receivable, respectively. +Research and Development +Research and +development costs are charged to expense as incurred. +Advertising Expenses +Advertising costs are +charged to expense as incurred. During 2006, 2005, and 2004, we incurred $805,936, $2,232,945, and $3,512,037, respectively, in advertising expenses. Included in advertising expenses for 2006, 2005 and 2004 were $539,856, $1,820,022 and $2,883,145, +respectively, in reimbursement for marketing expenses incurred for the Compound W ® Freeze Off ® product. +Stock-Based Compensation +Prior to 2006, we accounted for stock-based compensation to employees and +directors using the intrinsic value method in accordance with Accounting Principles Board (“APB”) Opinion No. 25, “Accounting for Stock Issued to Employees,” and related interpretations. Under APB Opinion No. 25, no +stock-based compensation expense was recognized for stock options granted to employees or directors, as the exercise price was equal to the market price of our common stock on the date of grant. We account for stock-based compensation to +nonemployees using the fair value method in accordance with SFAS No. 123 (revised 2004), (“SFAS No. 123R”), “Share-Based Payment,” and Emerging Issues Task Force (“EITF”) Issue No. 96-18, +“Accounting for Equity Instruments That Are Issued to Other Than Employees for Acquiring, or in Conjunction with Selling, Goods or Services.” +F-10 +Table of Contents +Effective January 1, 2006, we adopted SFAS No. 123R, which eliminated the ability to account +for stock-based compensation under APB Opinion No. 25 and requires us to recognize compensation expense based on the fair value of our stock-based awards. We elected the modified prospective transition method as permitted by SFAS No. 123R. +Accordingly, results from prior periods have not been restated. Under this transition method, stock-based compensation expense for the year ended December 31, 2006 includes: +(a) +compensation expense for all stock-based awards granted prior to January 1, 2006, but not yet vested, based on the grant date fair value previously estimated in accordance with +the original provisions of SFAS No. 123, “Accounting for Stock-Based Compensation,” and +(b) +compensation expense for all stock-based awards granted, modified or settled subsequent to January 1, 2006, based on the grant-date fair value estimated in accordance with the +provisions of SFAS No. 123R. +Upon the +adoption of SFAS No. 123R, our deferred compensation balance of $3,334,792 was reclassified against additional paid-in capital. Consistent with our past practice under the disclosure requirements of SFAS No. 123, we have elected to +recognize compensation expense for stock option awards issued to employees and directors on a straight-line basis over the requisite service period of the award. To satisfy the exercise of options or to issue new restricted stock, we normally issue +new shares rather than purchase shares on the open market. +Pursuant to the disclosure requirements of SFAS No. 123, the table below illustrates the effect on net income (loss) and earnings (loss) per share had compensation expense for our stock-based awards been determined based upon the fair +value of the awards at the date of grant for the years ended December 31, 2005 and 2004: +Year ended December 31, +2005 +2004 +Net income (loss): +As reported +$ +27,448,087 +$ +(559,642 +) +Add: stock-based employee compensation expense included in net income (loss), net of tax +945,634 +874,162 +Deduct: total stock-based employee compensation expense determined under the fair value-based method for all awards, net of +tax +(3,004,813 +) +(5,921,957 +) +Pro forma +$ +25,388,908 +$ +(5,607,437 +) +Earnings (loss) per share: +Basic +As reported +$ +0.61 +$ +(0.01 +) +Pro forma +$ +0.56 +$ +(0.13 +) +Diluted +As reported +$ +0.59 +$ +(0.01 +) +Pro forma +$ +0.55 +$ +(0.13 +) +Income Taxes +We follow the asset and liability method for accounting +for income taxes. Under this method, deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and the +respective tax basis of assets and liabilities, and operating loss and credit carryforwards. Deferred tax assets and liabilities are measured using enacted tax rates that are expected to apply to taxable income in the years in which those temporary +differences and operating loss and credit +F-11 +Table of Contents +carryforwards are expected to be recovered, settled or utilized. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in +income in the period that includes the enactment date. +Foreign Currency Translation +Pursuant to SFAS +No. 52, “Foreign Currency Translation,” the assets and liabilities of our foreign operations are translated from Euros into U.S. dollars at current exchange rates as of the balance sheet date, and revenues and expenses are translated +at average exchange rates for the period. Resulting translation adjustments are reflected in accumulated other comprehensive loss, which is a separate component of stockholders’ equity. +Earnings (Loss) Per Share +We have presented basic and diluted earnings (loss) per share pursuant to +SFAS No. 128, “Earnings per Share.” In accordance with SFAS No. 128, basic earnings (loss) per share is computed by dividing net income (loss) by the weighted-average number of shares of common stock outstanding during the +period. Diluted earnings per share is computed in a manner similar to basic earnings per share except that the weighted average number of shares outstanding is increased to include incremental shares from the assumed vesting or exercise of dilutive +securities, such as common stock options, warrants and unvested restricted stock. The number of incremental shares is calculated by assuming that outstanding stock options and warrants were exercised and unvested restricted shares were vested, and +the proceeds from such exercises or vesting were used to acquire shares of common stock at the average market prices during the reporting period. +The computations of basic and diluted earnings (loss) per share are as follows: +Year ended December 31, +2006 +2005 +2004 +Net income (loss) +$ +5,267,549 +$ +27,448,087 +$ +(559,642 +) +Weighted average shares of common stock outstanding: +Basic +45,909,990 +45,109,580 +44,463,861 +Dilutive effect of stock options, warrants and restricted shares +670,276 +1,037,032 +— +Diluted +46,580,266 +46,146,612 +44,463,861 +Earnings (loss) per share: +Basic +$ +0.11 +$ +0.61 +$ +(0.01 +) +Diluted +$ +0.11 +$ +0.59 +$ +(0.01 +) +For the years ended +December 31, 2006, 2005, and 2004, outstanding common stock options, warrants and unvested restricted stock representing 1,308,809, 1,069,181, and 5,479,504 shares, respectively, were excluded from the computation of diluted earnings (loss) per +share as their inclusion would have been anti-dilutive. +Other Comprehensive Income (Loss) +We follow +SFAS No. 130, “Reporting Comprehensive Income.” This statement requires the classification of items of other comprehensive income (loss) by their nature and disclosure of the accumulated balance of other comprehensive income (loss), +separately from accumulated deficit and additional paid-in capital, in the stockholders’ equity section of our balance sheet. +Fair Value of Financial Instruments +As of December 31, 2006, the carrying values of cash and cash equivalents, short-term investments, accounts receivable, accounts payable, and accrued +expenses approximate their respective fair values based on +F-12 +Table of Contents +their short-term nature. In addition, we believe the carrying value of our debt instruments, which do not have readily ascertainable market values, +approximate their fair values, given that the interest rates on outstanding borrowings approximate market rates. +Recent Accounting Pronouncements +In July 2006, the Financial Accounting Standards Board (“FASB”) issued FASB Interpretation (“FIN”) No. 48, “Accounting for +Uncertainty in Income Taxes—an Interpretation of FASB Statement No. 109,” which clarifies what criteria must be met prior to recognition of the financial statement benefit of a position taken in a tax return. FIN No. 48 will +require companies to include additional qualitative and quantitative disclosures within their financial statements. The disclosures will include potential tax benefits from positions recognized for tax return purposes but not recognized for +financial reporting purposes, as well as a tabular presentation of significant changes in such benefits during each period. The disclosures will also include a discussion of the nature of uncertainties, factors that could cause a change, and an +estimated range of reasonably possible changes in tax uncertainties. FIN No. 48 will require a company to recognize a financial statement benefit for a position taken for tax return purposes when it will be more-likely-than-not that the +position will be sustained. FIN No. 48 is effective for fiscal years beginning after December 15, 2006. We are currently assessing the impact FIN No. 48 will have on our financial statements. +In September 2006, the United States Securities and Exchange Commission +issued Staff Accounting Bulletin No. 108 (“SAB No. 108”) “Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements.” SAB No. 108 requires companies to +evaluate the materiality of identified unadjusted errors using both the income statement approach and the balance sheet approach. In the initial year of adoption, if a company determines that an adjustment to prior year financial statements is +required under either approach, SAB No. 108 allows for a one-time cumulative-effect adjustment to beginning retained earnings. SAB No. 108 is effective for interim periods of the first fiscal year ending after November 15, 2006. The +adoption of SAB No. 108 did not have any impact on our financial statements. +In September 2006, the FASB issued SFAS No. 157, “ Fair Value Measurements.” This Statement defines fair value, establishes a framework for measuring fair value in generally accepted +accounting principles, and expands disclosures about fair value measurements. SFAS No. 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007, and interim periods within those fiscal +years. We are currently assessing the impact, if any, that SFAS No. 157 will have on our financial statements. +In February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities—Including an +amendment of FASB Statement No. 115.” SFAS No. 159 permits entities to elect to measure many financial instruments and certain other items at fair value. Unrealized gains and losses on items for which the fair value option has been +elected will be recognized in earnings at each subsequent reporting date. SFAS No. 159 is effective for fiscal years beginning after November 15, 2007. We are currently assessing the impact SFAS No. 159 will have on our financial +statements. +3. +INVENTORIES: +December 31, +2006 +2005 +Raw materials +$ +3,868,301 +$ +2,625,889 +Work in process +533,470 +718,804 +Finished goods +1,132,796 +783,336 +$ +5,534,567 +$ +4,128,029 +In 2005, we recorded a +$1,288,655 provision on our UP link ® +inventory as a result of the inability to determine an alternative use for this product and the termination of an agreement with our distribution partner. +F-13 +Table of Contents +4. +PROPERTY AND EQUIPMENT: +December 31, +2006 +2005 +Land +$ +1,117,788 +$ +— +Buildings and improvements +13,454,065 +4,895,253 +Machinery and equipment +8,623,415 +7,855,947 +Computer equipment +1,577,073 +2,052,741 +Furniture and fixtures +781,103 +847,512 +Construction in progress +3,672,005 +1,966,125 +29,225,449 +17,617,578 +Less—Accumulated depreciation +(11,850,731 +) +(11,802,345 +) +$ +17,374,718 +$ +5,815,233 +On June 30, 2006, +we exercised purchase options contained in the commercial leases for two of our facilities located in Bethlehem, Pennsylvania and acquired both facilities for an aggregate purchase price of approximately $9,100,000, including settlement costs. As a +result of these purchases, the leases for these facilities, which required minimum annual rental payments of $1,051,000, were terminated. +Depreciation expense was $1,371,400, $1,573,852, and $1,739,733 for 2006, 2005, and 2004, respectively. In addition, we retired or disposed of $1,323,014 +of fully depreciated assets during 2006. No gain or loss was recognized on these disposals. +5. +PATENTS, PRODUCT RIGHTS AND ACQUIRED IN-PROCESS TECHNOLOGY: +Patents product rights and licenses were as follows: +December 31, +2006 +2005 +HIV-related +$ +1,900,000 +$ +1,900,000 +HCV-related +4,500,000 +1,500,000 +Lateral flow-related +1,500,000 +500,000 +Cryosurgery-related +2,548,620 +2,548,620 +10,488,620 +6,448,620 +Less accumulated amortization +(4,120,276 +) +(3,568,662 +) +$ +6,328,344 +$ +2,879,958 +Amortization expense +for 2006, 2005, and 2004 was $551,614, $700,377, and $705,808, respectively. Amortization expense for each of the five succeeding fiscal years is estimated at $1,066,565 for 2007, $896,619 for 2008, $789,515 for 2009, $789,515 for 2010, and $789,515 +for 2011. +In June 1998, we acquired the patents and exclusive +worldwide distribution rights to our cryosurgical product line. The purchase price of $2,548,620, including transaction costs, has been recorded as patents and product rights and is being amortized using the straight-line method over an estimated +useful life of ten years. In connection with this acquisition, we also entered into a product purchase agreement with the manufacturer of the cryosurgical product line, with a current term extending through 2008. +In June 2004, we entered into a sublicense agreement with a third party, +pursuant to which we have been granted a limited, worldwide, non-exclusive sublicense to certain HIV-2 patents held by such party. The agreement required us to pay the third party a one-time non-refundable license fee of $900,000, which was +F-14 +Table of Contents +recorded as patent and product rights on our balance sheet and is being amortized through June 30, 2014. This agreement also contained an option to +expand the application of this sublicense to other immunoassay platforms, in addition to our OraQuick ® platform. In June 2006, we exercised this option, which requires us to pay the third party a non-refundable license fee of $600,000, of which $200,000 was paid in July 2006. Two +remaining contractually obligated payments of $200,000 each are due in July 2007 and 2008. As of December 31, 2006, $200,000 of this obligation is included in accrued expenses, with the remaining $200,000 included in other liabilities. We have +recognized this $600,000 license fee as acquired in-process technology, which is included in research and development expense in our statement of operations, because other immunoassay platforms for the detection of HIV-2 will require additional +research and development efforts and subsequent regulatory approvals. +In August 2005, we entered into a license agreement with third parties, pursuant to which we have been granted a limited, personal, non-transferable, non-exclusive license related to certain Hepatitis C Virus (“HCV”) patents held +by such parties. The agreement required us to pay the third parties a one-time non-refundable license fee of $1,500,000, which was paid in August 2005. In December 2006, an additional milestone payment of $3,000,000 was due and is included in +accrued expenses as of December 31, 2006. We may also be required to pay additional license fees of up to $5,500,000, upon the achievement of specific development and/or commercial milestones. +Management’s intent in executing the HCV license agreement is to provide +for various alternatives for use of the licensed patents. Some of these uses require additional research and development efforts and regulatory approvals, while others, specifically in the international market, do not require additional research and +development efforts or regulatory approvals. Based on management’s estimate of the cash flows to be received from future product sales in international markets, we capitalized both the $1,500,000 and $3,000,000 license fees in the accompanying +balance sheet. We are amortizing these amounts to cost of products sold on a straight-line basis over ten years, which represents management’s estimate of the remaining useful life of the licensed patents. +Under the terms of the HCV license agreement, we are also obligated to pay +royalties based on our net sales of certain products, which incorporate the technology covered by the licensed patents. Royalties under the license agreement vary based upon the geographical territory where the product is sold. No sales have been +made under the terms of this license agreement through December 31, 2006. +In December 2006, we amended a license agreement with third parties, pursuant to which we have been granted a limited, non-exclusive license to certain lateral flow technology patents held by such parties. The +amendment provides for the renewal of our license to certain lateral flow patents held by these parties, the expansion of these patents to future product applications to be developed by our Company, and the settlement of prior royalty obligations +arising prior to the amendment date. It requires us to pay the third parties a one-time non-refundable fee of $1,750,000. We allocated the $1,750,000 fee based upon the relative fair values of the items contained in the agreement. Accordingly, at +December 31, 2006, we capitalized $1,000,000 as patent and product rights and will amortize this amount through December 2011. Of the remaining $750,000, we recognized $400,000 as acquired in-process technology as such amount was allocated to +royalties for future product applications that will require additional research and development efforts and regulatory approvals. The remaining $350,000 was recorded as a reduction of the accrued prior royalty obligations, which resulted in the +reversal of $738,983 of royalty expense during 2006. The $1,750,000 fee is included in accrued expenses at December 31, 2006. +F-15 +Table of Contents +6. +ACCRUED EXPENSES AND OTHER: +December 31, +2006 +2005 +Payroll and related benefits +$ +2,117,630 +$ +2,510,240 +Deferred revenue +1,877,546 +1,302,791 +Professional fees +681,850 +487,712 +Royalties +2,813,102 +1,925,679 +Advertising +201,509 +757,906 +License fees +4,200,000 +— +Laboratory testing fees +155,996 +210,604 +Other +611,516 +539,009 +$ +12,659,149 +$ +7,733,941 +At December 31, +2006, accrued payroll and related benefits decreased primarily as a result of a decrease in annual bonuses. Deferred revenue includes customer prepayments of $1,727,546 and $1,012,891 at December 31, 2006 and 2005, respectively. Professional +fees at December 31, 2006 increased primarily as a result of legal fees related to current litigation. Accrued royalties and advertising expenses at December 31, 2006 and 2005 are primarily related to our OraQuick ® and Freeze Off ® products, respectively. License fees at December 31, 2006 are related to the +sublicense agreements, which we entered into in December 2006, as discussed in Note 5. +7. +CREDIT FACILITIES: +On June 27, 2006, we executed an amendment to our existing $11,900,000 credit facility (the “Credit Facility”) with Comerica Bank +(“Comerica”). This amendment permitted us to borrow up to an additional $15,000,000 in advances in order to fund the purchase and future expansion of two leased facilities in Bethlehem, Pennsylvania. The original Credit Facility was +comprised of an $887,000 mortgage loan, a $3,000,000 term loan, a $4,000,000 non-revolving line of credit for the purchase of both capital equipment and software, and a $4,000,000 revolving working capital line of credit. On June 29, 2006, we +borrowed $10,000,000 under the terms of this Credit Facility, as amended, and purchased our two Bethlehem facilities. We can borrow the remaining $5,000,000 at any time before June 30, 2007. At our option, interest on outstanding borrowings is +payable monthly at either a fixed rate equal to the five-year U.S. Treasury Note rate plus 1.03% to 1.73%, or a variable rate equal to the 30, 180, or 360-day LIBOR rate plus 0.55% to 1.25%. In each case, the interest rate is determined at the date +of the advance and is based upon the amount of cash and cash equivalents we invest and retain at Comerica Securities, Inc. We also can choose the fixed rate option, without penalty, at the expiration of a previously elected LIBOR period. Principal +is repayable in periodic installments, based upon the rate option that we elect, with the remaining balance of unpaid principal due on June 27, 2011. This amendment also extended the maturity date of our $4,000,000 revolving working capital +line of credit to June 29, 2007. All other terms of the Credit Facility, as previously amended, remain in effect, except for our financial covenant related to liquidity, which was modified to require a minimum liquidity, as defined by Comerica, +of not less than $25,000,000, of which at least $15,000,000 must be held by Comerica or its affiliates. +As of December 31, 2006, we had no outstanding borrowings under the $3,000,000 term loan, the $4,000,000 non-revolving line of credit, or the +$4,000,000 revolving working capital line of credit. +At +December 31, 2006, interest on the new $10,000,000 borrowing is payable monthly, at the 360-day LIBOR rate plus 0.9%, or 6.1894%. Principal is repayable in installments, due at the end of each LIBOR rate period, based upon a twenty-year +amortization schedule and the number of months in the expiring LIBOR rate period. Accordingly, on December 27, 2007, we will be required to make a $500,000 principal repayment and the interest rate on this loan will reset. +F-16 +Table of Contents +All borrowings under the Credit Facility are collateralized by a first priority security interest in all +of our assets, including present and future accounts receivable, chattel paper, contracts and contract rights, equipment and accessories, general intangibles, investments, instruments, inventories, and a mortgage on our three facilities in +Bethlehem, Pennsylvania. Borrowings under the revolving working capital line of credit are limited to commercially standard percentages of accounts receivable. The Credit Facility contains certain covenants that set forth minimum requirements for +our quick ratio, liquidity, and tangible net worth. We were in full compliance with all covenants at December 31, 2006. The Credit Facility also restricts our ability to pay dividends, to make certain investments, to incur additional +indebtedness, to sell or otherwise dispose of a substantial portion of assets, and to merge or consolidate operations with an unaffiliated entity, without the consent of Comerica. +8. +LONG-TERM DEBT: +December 31, +2006 +2005 +Note payable to bank, interest payable monthly at the 360-day LIBOR rate plus 0.9%, (6.1894% at December 31, 2006), principal payments +due at the end of each LIBOR rate period through June 2011, at which time the remaining unpaid principal balance is payable, secured by a first priority security interest in all of our assets. +$ +9,750,000 +$ +— +Mortgage loan payable to bank, interest at an annual floating rate equal to the bank’s prime rate (8.25% at December 31, 2006), +fixed monthly installments of principal and interest of $7,426 through September 2007, at which time the interest rate and fixed monthly repayment amount is reset for the remaining sixty monthly installments, secured by our building. +689,442 +722,233 +Notes payable to bank, matured in 2006. +— +311,210 +Note payable to bank, interest at an annual floating rate equal to the bank’s prime rate (8.25% at December 31, 2006), monthly +principal installments of $2,144, plus interest, through June 2007, secured by certain equipment +12,863 +38,590 +Note payable to bank, interest at an annual floating rate equal to the bank’s prime rate (8.25% at December 31, 2006), monthly +principal installments of $2,264, plus interest, through March 2007, secured by certain equipment. +6,793 +33,963 +Note payable to Pennsylvania Industrial Development Authority, interest at 2%, monthly installments of principal and interest of $4,893 +through March 2010, secured by a second lien on our building. +180,038 +234,566 +10,639,136 +1,340,562 +Less—Current portion +(608,595 +) +(456,541 +) +$ +10,030,541 +$ +884,021 +Long-term debt +maturities as of December 31, 2006 are as follows: +2007 +$ +608,595 +2008 +593,087 +2009 +597,346 +2010 +552,670 +2011 +7,796,730 +Thereafter +490,708 +$ +10,639,136 +Certain of these notes +payable require, among other items, the maintenance of certain financial covenants. We were in compliance with these covenants as of December 31, 2006. +F-17 +Table of Contents +9. +INCOME TAXES: +The components of the provision (benefit) for income taxes for the years ended December 31, 2006, 2005 and 2004 are as follows: +2006 +2005 +2004 +Current +Federal +$ +251,074 +$ +224,153 +$ +— +State +429,085 +211,726 +— +680,159 +435,879 +— +Deferred +Federal +2,976,992 +3,285,740 +(123,009 +) +State +136,753 +495,298 +(18,823 +) +3,113,745 +3,781,038 +(141,832 +) +Change in valuation allowance +— +(21,946,106 +) +141,832 +3,113,745 +(18,165,068 +) +— +Total provision (benefit) +$ +3,793,904 +$ +(17,729,189 +) +$ +— +A reconciliation of +the statutory United States federal tax rate to our effective tax rate for the year ended December 31, is as follows: +2006 +2005 +2004 +Statutory U.S. federal tax rate—expense (benefit) +34.0 +% +34.0 +% +(34.0 +)% +State income taxes, net of federal benefit +4.1 +4.8 +(2.2 +) +Nondeductible expenses and other +3.8 +4.6 +10.9 +Net change in valuation allowance, federal and state +— +(225.8 +) +25.3 +Effective tax rate +41.9 +% +(182.4 +)% +— +% +Deferred income taxes +reflect the tax effects of temporary differences between the basis of assets and liabilities recognized for financial reporting purposes and tax purposes, and net operating loss and tax credit carryforwards. Significant components of our total +deferred tax asset as of December 31, 2006 and 2005 are as follows: +2006 +2005 +Net operating loss carryforwards +$ +18,019,056 +$ +22,827,988 +Inventory +1,315,262 +1,165,890 +Capitalized research and development costs +552,740 +665,353 +Accruals and reserves currently not deductible +573,819 +579,584 +Patent costs +764,311 +579,347 +Depreciation and amortization +472,586 +391,677 +Stock-based compensation +1,418,655 +359,573 +Alternative minimum tax credit carryforwards +405,145 +138,886 +Total deferred tax asset +$ +23,521,574 +$ +26,708,298 +F-18 +Table of Contents +In assessing the realizability of our deferred tax asset, we follow the guidance contained within +SFAS No. 109, “Accounting for Income Taxes,” which requires that deferred income tax assets be reduced by a valuation allowance, if after considering all relevant positive and negative evidence, it is more likely than not that +some portion or all of the deferred income tax assets will not be realized. The realization of the gross deferred tax assets is dependent on several factors, including the generation of sufficient taxable income prior to the expiration of the net +operating loss (“NOL”) carry forwards. We conclude that it is more likely than not that we will generate sufficient taxable income to recognize the deferred tax assets. Our federal NOL carryforwards expire as follows: +Year of Expiration +NOLs +2008 +$ +596,830 +2009 +7,053,000 +2010 +795,394 +2011 +7,731,587 +2017-2021 +30,428,371 +2022-2025 +6,383,686 +$ +52,988,868 +The Tax Reform Act of +1986 contains provisions that limit the annual amount of NOLs available to be used in any given year in the event of a significant change in ownership. On September 29, 2000, two separate companies, STC Technologies, Inc. and Epitope, Inc. +merged to form our Company. A significant change in ownership, as defined by Section 382 of the Internal Revenue Code, occurred in connection with this merger. As such, the utilization of NOLs generated prior to September 29, 2000 is +limited to approximately $13,700,000 per year. We do not believe that this limitation will have a material adverse impact on the utilization of our NOL carryforwards. +At the end of 2005, we concluded that it was more likely than not that the majority of our deferred tax asset would be +recovered. Accordingly, we reduced our valuation allowance by approximately $26,700,000. Included in the 2005 reduction of the valuation allowance was approximately $8,500,000 related to prior years’ tax benefits associated with the exercise of +employee stock options. This amount was recognized as an increase to additional paid-in capital in 2005. A tax benefit of approximately $245,000 associated with employee exercises of non-qualified stock options and disqualifying dispositions of +stock acquired with incentive stock options during the year ended December 31, 2005 was also recorded as additional paid-in capital during 2005. +10. +STOCKHOLDERS’ EQUITY: +Stock-based Awards +We grant stock-based awards under the OraSure Technologies, Inc. 2000 Stock Award Plan, as amended and restated (the “2000 Plan”). The 2000 Plan +permits stock-based awards to employees, outside directors and consultants or other third-party advisors. Awards which may be granted under the 2000 Plan include qualified incentive stock options, nonqualified stock options, stock appreciation +rights, restricted awards, performance awards and other stock-based awards. +Under the terms of the 2000 Plan, qualified incentive stock options for shares of our common stock may be granted to eligible employees, including our officers. To date, options generally have been granted with +ten-year exercise periods and an exercise price not less than the fair market value on the date of grant. Options generally vest over four years, with one quarter of the options vesting one year after grant and the remainder vesting on a monthly +basis over the next three years. The 2000 Plan also provides that nonqualified options may be granted at a price not less than 75 percent of the fair market value of a share of common stock on the date of grant. The option term and vesting schedule +of such awards may either be unlimited or have a specified period in which to vest and be exercised. +F-19 +Table of Contents +As of December 31, 2006, 2,749,391 shares were available for future grants under the 2000 Plan. +The fair value of each stock option was estimated on the date +of the grant using the Black-Scholes option-pricing model using the following weighted-average assumptions: +Year Ended +December 31, +Black-Scholes Option Valuation Assumptions +2006 +2005 +2004 +Risk-free interest rate(1) +4.53 +% +3.72 +% +3.21 +% +Expected dividend yield +— +— +— +Expected stock price volatility(2) +56 +% +58 +% +65 +% +Expected life of stock options (in years)(3) +5 +4 +5 +(1) +Based on the Treasury Securities constant maturity interest rate whose term is consistent with the expected life of our stock options. +(2) +Expected stock price volatility is based upon historical experience. +(3) +Expected life of stock options is based upon historical experience. +The weighted-average grant date fair value of stock options granted during the years ended December 31, 2006, 2005 and 2004 was $4.85, $3.17 and +$4.60, respectively. +Amounts recognized in the financial +statements related to stock options were as follows: +Year Ended +December 31, 2006 +Total compensation cost during the year +$ +3,621,412 +Amounts capitalized into inventory and property and equipment during the year +(468,754 +) +Amounts recognized in cost of products sold for amounts previously capitalized +264,038 +Amounts charged against income, before income tax benefit +$ +3,416,696 +Amount of related income tax benefit +$ +842,239 +As a result of +adopting SFAS No. 123R, the Company’s income before income taxes and net income for the year ended December 31, 2006 were $3,416,696 and $2,574,457 lower, respectively, than if it had continued to account for share-based +compensation under APB Opinion No. 25. Basic and diluted earnings per share for the year ended December 31, 2006 would have been $0.06 per share higher if the Company had not adopted SFAS No. 123R. +As a result of modifying the vesting provisions of two grants made to former +members of the Company’s Board of Directors, the Company recognized $123,916 in compensation cost related to these modifications in the year ended December 31, 2005. +The aggregate intrinsic value of options (the amount by which the market price of the stock on the date of exercise exceeded +the exercise price) exercised during the years ended December 31, 2006, 2005 and 2004 was $332,261, $4,338,143, and $1,326,796, respectively. +F-20 +Table of Contents +The following table summarizes the stock option activity under the 2000 Plan: +Options +Weighted-Average +Exercise Price +Per +Share +Weighted-Average +Remaining +Contractual Term +(in years) +Aggregate +Intrinsic +Value +Outstanding on January 1, 2004 +3,935,463 +$ +6.42 +Granted +1,629,891 +8.07 +Exercised +(370,800 +) +5.14 +Forfeited +(320,050 +) +7.89 +Outstanding on December 31, 2004 +4,874,504 +6.98 +Granted +778,572 +6.60 +Exercised +(1,009,794 +) +6.01 +Forfeited +(426,497 +) +7.55 +Outstanding on December 31, 2005 +4,216,785 +7.08 +Granted +801,900 +9.22 +Exercised +(85,013 +) +5.38 +Forfeited +(145,254 +) +7.99 +Balance, December 31, 2006 +4,788,418 +$ +7.44 +7.57 +$ +4,409,463 +Vested or expected to vest as of December 31, 2006 +4,638,197 +$ +7.44 +7.57 +$ +4,271,130 +Exercisable on December 31, 2006 +3,536,575 +$ +7.12 +7.23 +$ +4,366,963 +As of +December 31, 2006, there was $4,637,882 of unrecognized compensation expense related to unvested option awards that is expected to be recognized over a weighted-average period of 1.7 years. +Net cash proceeds from the exercise of stock options were $457,334, +$6,067,869 and $1,904,161 for the years ended December 31, 2006, 2005 and 2004, respectively. As a result of the Company’s net operating loss carryforward position, no actual income tax benefit was realized from stock option exercises for +these periods. +The following table summarizes information +about stock options outstanding at December 31, 2006: +Options outstanding +Options exercisable +Range of exercise prices +Number +outstanding +Weighted- +average +remaining +life, in +years +Weighted- +average +exercise +price +Number +exercisable +Weighted- +average +exercise +price +$ 0.80–$5.60 +858,895 +11.91 +$ +4.75 +679,406 +$ +4.53 +$ 5.76–$6.84 +486,953 +5.23 +5.96 +480,160 +5.96 +$6.87 +63,333 +5.39 +6.87 +63,333 +6.87 +$6.96 +509,452 +6.08 +6.96 +501,251 +6.96 +$ 6.98–$7.77 +863,943 +5.91 +7.49 +669,359 +7.42 +$ 7.90–$8.18 +106,000 +8.23 +8.05 +32,603 +8.03 +$8.20 +711,448 +7.04 +8.20 +563,156 +8.20 +$ 8.36–$9.56 +818,184 +8.55 +9.26 +230,643 +9.18 +$ 9.78–$12.23 +365,210 +5.54 +10.57 +311,664 +10.63 +$12.69 +5,000 +4.68 +12.69 +5,000 +12.69 +4,788,418 +7.57 +$ +7.44 +3,536,575 +$ +7.12 +F-21 +Table of Contents +The 2000 Plan also permits us to grant restricted shares of our common stock to eligible employees, +including officers. Generally, these shares are nontransferable and are subject to three-year vesting requirements or forfeiture, as determined by the Compensation Committee of our Board of Directors. The market value of these shares at the date of +grant is recognized on a straight-line basis over the period during which the restrictions lapse. Compensation cost of $1,969,178, $1,500,054 and $874,162 related to restricted shares was recognized during the years ended December 31, 2006, +2005 and 2004, respectively. +The following table summarizes +restricted stock award activity under the 2000 Plan: +Shares +Weighted-Average +Grant Date +Fair Value +Issued and unvested, January 1, 2004 +75,000 +$ +8.68 +Granted +410,000 +7.75 +Vested +— +— +Forfeited +— +— +Issued and unvested, December 31, 2004 +485,000 +7.89 +Granted +332,188 +6.00 +Vested +(197,180 +) +9.26 +Forfeited +(13,563 +) +5.60 +Issued and unvested, December 31, 2005 +606,445 +6.90 +Granted +465,313 +9.16 +Vested +(199,633 +) +6.99 +Forfeited +(65,071 +) +7.56 +Issued and unvested, December 31, 2006 +807,054 +$ +8.13 +Issued and expected to vest, December 31, 2006 +802,242 +$ +8.08 +As of +December 31, 2006, there was $5,136,029 of unrecognized compensation expense related to unvested restricted stock awards that is expected to be recognized over a weighted average period of 3.7 years. +In connection with the vesting of restricted shares during the years ended +December 31, 2006 and 2005, we purchased and immediately retired 65,519 and 63,080 shares with aggregate values of $631,509 and $601,347, respectively, in satisfaction of minimum tax withholding obligations. No shares were purchased and retired +during the year ended December 31, 2004. +SFAS +No. 123R addresses the accounting for awards issued as part of share-based payment arrangements in exchange for employee services. Certain of the Company’s share-based payment arrangements are outside the scope of SFAS No. 123R and +are subject to EITF Issue No. 00-19, “Accounting for Derivative Financial Instruments Indexed to, and Potentially Settled in, a Company’s Own Stock,” which requires that vested stock options held by certain nonemployee consultants be +accounted for as liability-classified awards. The fair value of these vested and unexercised awards was estimated using the Black-Scholes option pricing model and $109,080 was reclassified from equity to other liabilities as of January 1, 2006. +An additional $121,579 was reclassified for options that vested during 2006. The fair value of these awards are remeasured at each financial reporting date until the awards are settled or expire. As of December 31, 2006, $228,475 was included +in other liabilities for stock options to acquire 63,000 shares of common stock which remained unexercised. +Common Stock Warrants +As of December 31, 2006, warrants to purchase 120,000 shares of common stock at $6.13 per share were outstanding. These warrants were issued on +September 30, 1998 and expire on September 30, 2008. +F-22 +Table of Contents +11. +COMMITMENTS AND CONTINGENCIES: +Sublicense Agreement +In June 2004, we entered into a sublicense agreement with a third party, pursuant to which we have been granted a limited, worldwide, non-exclusive +sublicense to certain HIV-2 patents held by such party. Under the terms of this sublicense agreement, we are obligated to pay royalties based on a percentage of our net sales of certain products, which incorporate the technology covered by the +licensed patents. Future minimum payments under this agreement are as follows: +2007 +$ +500,000 +2008 +500,000 +2009 +500,000 +2010 +500,000 +2011 +500,000 +Thereafter +3,291,667 +$ +5,791,667 +Royalties from our +commercial sale of products covered by the sublicense can be credited against these minimum royalty obligations. +License Agreement +In August 2005, we entered into a license agreement with third parties, pursuant to which we have been granted a limited, personal, non-transferable, +non-exclusive license related to certain HCV patents held by such parties. Under the terms of the HCV license agreement, we are also obligated to pay royalties based on our net sales of certain products which incorporate the technology covered by +the licensed patents. Royalties under the license agreement vary based upon the geographical territory where the product is sold. No minimum payments are required under this agreement in 2007 or thereafter. We may, however, be required to pay +additional license fees of up to $5,500,000, upon the achievement of specific development and/or commercial milestones. +Leases +We lease office and warehouse facilities under operating lease agreements. Future payments required under these non-cancelable leases are as follows: +2007 +$ +81,866 +2008 +68,480 +2009 +11,413 +$ +161,759 +Rent expense for 2006, +2005 and 2004 was $624,479, $1,146,697, and $1,690,858, respectively. +Purchase Commitments +As of December 31, +2006, we had outstanding non-cancelable purchase commitments in the amount of $5,349,799, of which $3,749,692, $198,340 and $1,401,767 are related to inventory, capital expenditures, and other goods or services, respectively. +F-23 +Table of Contents +Employment Agreements +Under terms of employment agreements with certain executive officers, extending through 2008, we are required to pay each +individual a base salary for continuing employment with our Company. The agreements require payments of $1,804,625 and $724,800 in 2007 and 2008, respectively. +Litigation +From time-to-time, we are involved in certain legal actions arising in the ordinary course of business. In management’s opinion, based upon the +advice of counsel, the outcome of such actions are not expected to have a material adverse effect on our future financial position or results of operations. +12. +RETIREMENT PLANS: +Substantially all employees of the Company are eligible to participate in the OraSure Technologies, Inc. 401(k) Plan (the “401(k) Plan”). The +401(k) Plan permits voluntary employee contributions to be excluded from an employee’s current taxable income under provisions of Internal Revenue Code Section 401(k) and the regulations thereunder. The 401(k) Plan also provides for us to +match employee contributions up to $4,000 per year. Contributions to the 401(k) Plan, net of forfeitures, were $397,970, $361,629, and $330,552 in 2006, 2005, and 2004, respectively. +13. +GEOGRAPHIC INFORMATION: +Based on guidance in SFAS No. 131, “Disclosures about Segments of an Enterprise and Related Information,” we believe we operate within one +reportable segment. Our products are sold principally in the United States and Europe. Segmentation of operating income and identifiable assets is not applicable since our revenues outside the United States are export sales, and we do not have +significant operating assets outside the United States. +The +following table represents total revenues by geographic area, based on the location of the customer (amounts in thousands): +2006 +2005 +2004 +United States +$ +56,780 +$ +59,859 +$ +47,843 +Europe +9,521 +7,868 +4,318 +Other regions +1,854 +1,639 +1,847 +$ +68,155 +$ +69,366 +$ +54,008 +F-24 +Table of Contents +14. +QUARTERLY DATA (Unaudited): +The following tables summarize the quarterly results of operations for each of the quarters in 2006 and 2005. These quarterly results are unaudited, but +in the opinion of management, have been prepared on the same basis as our audited financial information and include all adjustments (consisting only of normal recurring adjustments) necessary for a fair presentation of the information set forth +herein (all amounts in thousands, except per share amounts). +2006 Results +Three months ended +Year ended +December 31, +2006 +March 31, +2006 +June 30, +2006 +September 30, +2006 +December 31, +2006 +Revenues +$ +15,217 +$ +17,564 +$ +17,639 +$ +17,735 +$ +68,155 +Costs and expenses +14,331 +16,261 +15,160 +16,940 +62,692 +Operating income +886 +1,303 +2,479 +795 +5,463 +Other income (expense), net +791 +896 +920 +992 +3,599 +Income before income taxes +1,677 +2,199 +3,399 +1,787 +9,062 +Income tax provision +777 +991 +1,265 +761 +3,794 +Net income +$ +900 +$ +1,208 +$ +2,134 +$ +1,026 +$ +5,268 +Earnings per share(1) +Basic +$ +0.02 +$ +0.03 +$ +0.05 +$ +0.02 +$ +0.11 +Diluted +$ +0.02 +$ +0.03 +$ +0.05 +$ +0.02 +$ +0.11 +2005 Results +Three months ended +Year ended +December 31, +2005 +March 31, +2005 +June 30, +2005 +September 30, +2005 +December 31, +2005 +Revenues +$ +15,828 +$ +17,430 +$ +18,077 +$ +18,031 +$ +69,366 +Costs and expenses +14,613 +16,468 +14,863 +15,849 +61,793 +Operating Income +1,215 +962 +3,214 +2,182 +7,573 +Other income (expense), net +346 +481 +594 +725 +2,146 +Income before income taxes +1,561 +1,443 +3,808 +2,907 +9,719 +Income taxes (benefit) +— +— +— +(17,729 +) +(17,729 +) +Net income +$ +1,561 +$ +1,443 +$ +3,808 +$ +20,636 +$ +27,448 +Earnings per share (1) +Basic +$ +0.03 +$ +0.03 +$ +0.08 +$ +0.45 +$ +0.61 +Diluted +$ +0.03 +$ +0.03 +$ +0.08 +$ +0.44 +$ +0.59 +(1) +The summation of the quarterly amounts may not equal the year-end amounts due to the use of weighted-average shares for each period. +F-25 +Table of Contents +INDEX TO EXHIBITS +Exhibit +Number +Exhibit +3.1.1 +Certificate of Incorporation of OraSure Technologies, Inc. is incorporated by reference to Exhibit 3.1 to the Company’s Registration Statement on Form S-4 (No. 333-39210), filed June 14, +2000. +3.1.2 +Certificate of Amendment to Certificate of Incorporation dated May 23, 2000 is incorporated by reference to Exhibit 3.1.1 to the Company’s Registration Statement on Form S-4 (No. +333-39210), filed June 14, 2000. +3.1.3 +Certificate of Designation of Series A Preferred Stock of OraSure Technologies (filed as Exhibit A to the Rights Agreement referred to in Exhibit 4.1). +3.2 +Amended and Restated Bylaws of OraSure Technologies, effective as of February 4, 2003, are incorporated by reference to Exhibit 3.2 to the Company’s Annual Report on Form 10-K for the +year ended December 31, 2002. +4.1 +Rights Agreement, dated as of May 6, 2000, between OraSure Technologies, Inc. and ChaseMellon Shareholder Service, L.L.C. (now called Mellon Investor Services LLC), as Rights Agent, is +incorporated by reference to Exhibit 4.2 to Amendment No. 1 to the Company’s Registration Statement on Form S-4 (No. 333-39210), filed August 8, 2000. +10.1 +Form of Indemnification Agreement (and list of parties to such agreement) is incorporated by reference to Exhibit 10.1 to Amendment No. 3 to the Company’s Registration Statement on Form +S-4 (No. 333-39210), filed August 30, 2000.* +10.2 +Employment Agreement, dated as of June 22, 2004, between OraSure Technologies, Inc. and Douglas A. Michels, is incorporated by reference to Exhibit 10.3 to the Company’s Quarterly Report +on Form 10-Q for the quarter ended June 30, 2004.* +10.3 +Employment Agreement, dated as of July 1, 2004, between OraSure Technologies, Inc. and Ronald H. Spair, is incorporated by reference to Exhibit 10.4 to the Company’s Quarterly Report on +Form 10-Q for the quarter ended June 30, 2004.* +10.4 +Employment Agreement, dated September 23, 2005, between OraSure Technologies, Inc. and Stephen R. Lee, Ph.D., is incorporated herein by reference to Exhibit 99 to the Company’s Current +Report on Form 8-K filed September 28, 2005.* +10.5 +Employment Agreement, dated as of July 1, 2004, between OraSure Technologies, Inc. and P. Michael Formica, is incorporated by reference to Exhibit 10.5 to the Company’s Quarterly +Report on Form 10-Q for the quarter ended June 30, 2004.* +10.6 +Employment Agreement, dated as of July 1, 2004, between OraSure Technologies, Inc. and Joseph E. Zack, is incorporated by reference to Exhibit 10.6 to the Company’s Quarterly Report on +Form 10-Q for the quarter ended June 30, 2004.* +10.7 +Employment Agreement, dated as of July 1, 2004, between OraSure Technologies, Inc. and Jack E. Jerrett, is incorporated by reference to Exhibit 10.7 to the Company’s Quarterly Report on +Form 10-Q for the quarter ended June 30, 2004.* +10.8 +Employment Agreement, dated as of October 2, 2006, between Mark L. Kuna and OraSure Technologies, Inc., is incorporated by reference to Exhibit 99.1 to the Company’s Current Report on +Form 8-K filed October 5, 2006.* +10.9 +Description of Nonemployee Director Compensation Policy, as amended as of November 15, 2005, is incorporated by reference to Exhibit 10.8 to the Company’s Annual Report on Form 10-K for +the year ended December 31, 2005.* +10.10 +Amended and Restated Epitope, Inc. 1991 Stock Award Plan is incorporated by reference to Exhibit 10.9 to the Company’s Annual Report on Form 10-K for the year ended +December 31, 2002.* +Table of Contents +Exhibit +Number +Exhibit +10.11 +OraSure Technologies, Inc. Employee Incentive and Non-Qualified Stock Option Plan, as amended and restated effective September 29, 2000, is incorporated by reference to Exhibit 10.12 to the +Company’s Annual Report on Form 10-K for the year ended December 31, 2000.* +10.12 +OraSure Technologies, Inc. 2000 Stock Award Plan, as amended and restated effective as of May 16, 2006, is incorporated by reference to Exhibit 10 to the Company’s Current Report on Form +8-K filed May 18, 2006.* +10.13 +Form of Restricted Share Grant Agreement is incorporated by reference to Exhibit 10.2.1 to the Company’s Quarterly Report on Form 10-Q for the quarter ended June 30, +2004.* +10.14 +Incentive Stock Option General Terms and Conditions (Officers and Employees) is incorporated by reference to Exhibit 10.12 to the Company’s Annual Report on Form 10-K for the year ended +December 31, 2004.* +10.15 +Nonqualified Stock Option Award General Terms and Conditions (Officers and Employees) is incorporated by reference to Exhibit 10.13 to the Company’s Annual Report on Form 10-K for the +year ended December 31, 2004.* +10.16 +Nonqualified Stock Option Award General Terms and Conditions (Non-Employee Directors) is incorporated by reference to Exhibit 10.14 to the Company’s Annual Report on Form 10-K for the +year ended December 31, 2004.* +10.17 +Description of the OraSure Technologies, Inc. 2007 Management Incentive Plan is incorporated by reference to Item 5.02 to the Company’s Current Report on Form 8-K filed February 8, +2007.* +10.18 +Description of the OraSure Technologies, Inc. 2006 Self-Funding Management Incentive Plan is incorporated by reference to Exhibit 10.17 to the Company’s Annual Report on Form 10-K for +the year ended December 31, 2005.* +10.19 +Description of the OraSure Technologies, Inc. Management Stock Award Guidelines dated January 26, 2005 is incorporated by reference to Exhibit 10.16 to the Company’s Annual Report on +Form 10-K for the year ended December 31, 2004.* +10.20 +Description of the OraSure Technologies, Inc. 2007 Stock Guidelines is incorporated by reference to Item 5.02 to the Company’s Current Report on Form 8-K filed February 8, +2007.* +10.21 +Distribution Agreement, dated as of April 24, 2003, between OraSure Technologies, Inc. and Medtech Holdings, Inc., is incorporated by reference to Exhibit 10.1 to the Company’s Quarterly +Report on Form 10-Q for the quarter ended June 30, 2004. +10.22 +Amendment No. 1 to Distribution Agreement, dated as of February 10, 2006, among OraSure Technologies, Inc., Medtech Holdings, Inc., Medtech Products, Inc. (as assignee of Medtech Holdings, +Inc.) and Prestige Brands Holdings, Inc., as guarantor, is incorporated by reference to Exhibit 10.1 to the Company’s Quarterly Report on Form 10-Q for the quarter ended March 31, 2006. +10.23 +Distribution Agreement, dated as of June 1, 2005, between OraSure Technologies, Inc. and SSL International plc, is incorporated by reference to Exhibit 10.1 to the Company’s Quarterly +Report on Form 10-Q for the quarter ended June 30, 2005. +10.24 +Loan and Security Agreement, dated as of September 10, 2002, between Comerica Bank—California and OraSure Technologies, Inc., is incorporated by reference to Exhibit 10.1 to the +Company’s Quarterly Report on Form 10-Q for the quarter ended September 30, 2002. +10.25 +First Amendment to Loan and Security Agreement, dated as of May 23, 2003, between OraSure Technologies, Inc. and Comerica Bank – California, is incorporated by reference to Exhibit 10.24 +to the Company’s Annual Report on Form 10-K for the year ended December 31, 2003. +Table of Contents +Exhibit +Number +Exhibit +10.26 +Second Amendment to Loan and Security Agreement, dated as of September 12, 2003, between OraSure Technologies, Inc. and Comerica Bank, is incorporated by reference to Exhibit 99.1 to the +Company’s Current Report on Form 8-K, dated September 17, 2003. +10.27 +Third Amendment to Loan and Security Agreement, dated as of April 21, 2005, between OraSure Technologies, Inc. and Comerica Bank, is incorporated by reference to Exhibit 10 to the +Company’s Current Report on Form 8-K filed April 27, 2005. +10.28 +Fourth Amendment to Loan and Security Agreement, dated as of June 27, 2006, between OraSure Technologies, Inc. and Comerica Bank, is incorporated by reference to Exhibit 10 to the +Company’s Current Report on Form 8-K filed June 30, 2006. +10.29 +Supply and Distribution Agreement, dated as of February 11, 2005, between Abbott Laboratories and OraSure Technologies, Inc.** +10.30 +Amendment No. 1 to Supply and Distribution Agreement, dated as of July 21, 2005, between Abbott Laboratories and OraSure Technologies, Inc.** +23 +Consent of KPMG LLP, Independent Registered Public Accounting Firm. +24 +Powers of Attorney. +31.1 +Certification of Douglas A. Michels required by Rule 13a-14(a) or Rule 15d-14(a) under the Securities Exchange Act of 1934, as amended. +31.2 +Certification of Ronald H. Spair required by Rule 13a-14(a) or Rule 15d-14(a) under the Securities Exchange Act of 1934, as amended. +32.1 +Certification of Douglas A. Michels required by Rule 13a-14(b) or Rule 15a-14(b) under the Securities Exchange Act of 1934, as amended, and 18 U.S.C. Section 1350, as Adopted Pursuant to +Section 906 of the Sarbanes-Oxley Act of 2002. +32.2 +Certification of Ronald H. Spair required by Rule 13a-14(b) or Rule 15a-14(b) under the Securities Exchange Act of 1934, as amended, and 18 U.S.C. Section 1350, as Adopted Pursuant to Section +906 of the Sarbanes-Oxley Act of 2002. +* +Management contract or compensatory plan or arrangement. +** +Portions of this exhibit were omitted pursuant to an application for confidential treatment and filed separately with the Securities and Exchange Commission. \ No newline at end of file diff --git a/raw/filings/0001116463/2006/0001193125-07-057268/filing_metadata.csv b/raw/filings/0001116463/2006/0001193125-07-057268/filing_metadata.csv new file mode 100644 index 0000000000000000000000000000000000000000..8465b86d7be4e614ca0ef5119e7bc01782da0e43 --- /dev/null +++ b/raw/filings/0001116463/2006/0001193125-07-057268/filing_metadata.csv @@ -0,0 +1,2 @@ +cik,ticker,company_name,form,filing_date,report_date,acceptance_datetime,accession_number,primary_document,primary_doc_description,size,is_xbrl,is_inline_xbrl,document_url,filing_index_url,year,fiscal_year,is_primary_filing +0001116463,OSUR,ORASURE TECHNOLOGIES INC,10-K,2007-03-16,2006-12-31,2007-03-16T21:15:41.000Z,0001193125-07-057268,d10k.htm,FORM 10-K,1573212,0,0,https://www.sec.gov/Archives/edgar/data/1116463/000119312507057268/d10k.htm,https://www.sec.gov/Archives/edgar/data/1116463/000119312507057268/,2006,2006,1 diff --git a/raw/filings/0001116463/2006/0001193125-07-057268/item1.txt b/raw/filings/0001116463/2006/0001193125-07-057268/item1.txt new file mode 100644 index 0000000000000000000000000000000000000000..4813ba870d24d89593dec9245851160f31224633 --- /dev/null +++ b/raw/filings/0001116463/2006/0001193125-07-057268/item1.txt @@ -0,0 +1,595 @@ +ITEM 1. Business. +Our business principally involves the development, manufacture, marketing and sale of oral fluid specimen collection devices using our proprietary oral fluid technologies, as well as other diagnostic products +including immunoassays and other in vitro diagnostic tests that are used on other specimen types, and other medical devices. Our diagnostic products include tests which are processed in a laboratory and tests which are performed on a rapid +basis at the point of care. These products are sold in the United States and internationally to various clinical laboratories, hospitals, clinics, community-based organizations and other public health organizations, distributors, government +agencies, physicians’ offices, and commercial and industrial entities. One of our products is also sold in the over-the-counter (“OTC”) or consumer retail market in the United States, Canada, Europe, Australia and certain other +foreign countries. +In vitro diagnostic testing is the +process of analyzing oral fluid, blood, urine and other bodily fluids or tissue for the presence of specific substances or markers for infectious diseases, drugs of abuse or other conditions. In vitro diagnostic tests are performed outside +the body, in contrast to in vivo tests, which are performed directly on or within the body. The substance or marker that a diagnostic test is intended to detect is generally referred to as an analyte. +Immunodiagnostic testing is the leading method of in vitro testing for +antigens and antibodies. When an infectious disease is caused by pathogens, such as bacteria, viruses and fungi, or other substances are present, the body responds by producing an antibody. Substances that stimulate production of antibodies are +generally referred to as antigens. An antibody binds specifically with an antigen in a lock-and-key fashion that initiates a biochemical reaction to attempt to neutralize and, ultimately, eliminate the antigen. The ability of an antibody to bind +with a specific antigen provides the basis for immunodiagnostic testing. +Our Company was formed in May 2000 under Delaware law solely for the purposes of combining two companies, STC Technologies, Inc. (“STC” or “STC Technologies”) and Epitope, Inc. +(“Epitope”), and changing the state of incorporation of Epitope from Oregon to Delaware. STC Technologies and Epitope were merged into our Company on September 29, 2000. Our principal offices are located at 220 East First Street, +Bethlehem, Pennsylvania 18015, and our telephone number is (610) 882-1820. +Additional information about us can be found on our website. Our website address is www.orasure.com. We make available free of charge through a link provided at such website our Annual Reports on Form 10-K, our +1 +Table of Contents +Quarterly Reports on Form 10-Q and our Current Reports on Form 8-K, as well as any amendments to those Reports. These Reports are made available as soon as +reasonably practicable after they are filed or furnished to the Securities and Exchange Commission. Our Internet website and the information contained in or connected to that website are not intended to be incorporated by reference into this Annual +Report. +Products +The following is a summary of our principal products and their regulatory +and commercial status: +Product +Description +Regulatory Status +Commercial +Status +OraQuick +ADVANCE ® HIV-1/2 +A rapid, point-of-care test for antibodies to the Human Immunodeficiency Virus Type 1 (“HIV-1”) and Type 2 (“HIV-2” and together with HIV-1, “HIV-1/2”) that can be +visually read at the point of care in approximately 20 minutes. +Premarket approval (“PMA”) approved by the U.S. Food and Drug Administration (“FDA”) (March 2004—June 2004) for use with oral fluid, finger-stick and venous whole blood, +and plasma. CLIA (Clinical Laboratory Improvement Amendments of 1988) waived for use with oral fluid, finger-stick and venous whole blood (June 2004). +Marketed +CE mark application filed. +Pending +Registered in Mexico. +Marketed +OraQuick ADVANCE ® OTC +In development. +OraQuick ® HCV +A rapid, point-of-care test for antibodies to the hepatitis C virus (“HCV”) +In development. +OraSure ® +Oral fluid collection device for the detection of antibodies to HIV-1 in an oral fluid sample in a laboratory setting. +PMA approved by FDA in December 1994. +Marketed +Also FDA 510(k) cleared for use in detecting cocaine and cotinine (an indicator of nicotine) in oral fluid. +Marketed +CE marked and registered in the United Kingdom. Also registered in Mexico, Canada, Columbia, South Africa, Afghanistan, Argentina, Brazil and Trinidad. +Marketed +Intercept ® +Oral fluid collection device, along with nine related immunoassays, for oral fluid drugs of abuse (“DOA”) testing in a laboratory setting. +Collection device—FDA 510(k) cleared in 2000. +Marketed +MICRO-PLATE DOA Assays +Used to detect the following drugs in an oral fluid sample: marijuana, cocaine, opiates, amphetamines, methamphetamines, PCP, benzodiazepines, barbiturates and methadone. +Nine drug assays—FDA 510(k) cleared during 2000-2001. +Marketed +Intercept ® device CE marked and registered in the United Kingdom. Various assays are CE marked and registered in the United Kingdom, Austria, Belgium, Denmark, Finland, France, +Germany, Ireland, Italy, Luxembourg, Mexico, Netherlands, Portugal, Spain, Sweden, Korea, Canada, Afghanistan and Brazil. +Marketed +2 +Table of Contents +Product +Description +Regulatory Status +Commercial +Status +Homogeneous DOA Assays +Homogeneous fully-automated oral fluid DOA assays. +In development. +Cryosurgical Systems—Professional +Cryosurgical system for the removal of warts and other benign skin lesions, marketed under the Histofreezer ® tradename primarily to the physicians’ office +market. +Nine indications—FDA 510(k) cleared during 1991—1999. +Marketed +CE marked and registered in Europe, Venezuela, Thailand, New Zealand, Hong Kong, Brazil, Mexico, Canada and Afghanistan. +Marketed +Cryosurgical Systems—OTC +Cryosurgical (freezing) system for the removal of common and plantar warts, sold in the OTC markets in the United States and Canada under the Compound W Freeze Off ® +tradename by Prestige Brands Holdings, Inc., in Europe, Australia and New Zealand under the Scholl and Dr. Scholl Freeze Spray tradenames by SSL International plc. and in Mexico under the POINTTS tradename by Genomma Labs. +FDA 510(k) cleared for two Freeze Off ® indications in February 2003. +Freeze Off ® registered in Canada. +Scholl Freeze Spray CE marked and registered in several European countries. +POINTTS registered in Mexico. +Marketed +Marketed +Marketed +Marketed +Cryosurgical Systems—OTC Product Line Extensions +Cryosurgical system for an indication other than common warts or plantar warts. +In development. +Cryosurgical system combined with salicylic acid. +In development. +In addition to the +above products, we also sell certain immunoassay tests and reagents for insurance risk assessment, substance abuse testing and forensic toxicology applications; an oral fluid Western blot HIV-1 confirmatory test approved by the FDA for confirming +positive HIV-1 test results obtained from the use of our OraSure ® collection device; and the FDA 510(k) cleared Q.E.D. ® point-of-care saliva alcohol test. +OraQuick ® Rapid +Test Platform +OraQuick ® is our rapid test platform designed to test oral fluid, whole blood (i.e., +both finger-stick and venous) and plasma samples for the presence of various antibodies or analytes. The device uses a porous flat pad to collect an oral fluid specimen. After collection, the pad is inserted into a vial containing a pre-measured +amount of developer solution and allowed to develop. When whole blood or plasma is to be tested, a loop collection device is used to collect a drop of blood or plasma and mix it in the developer solution, after which the collection pad is inserted +into the solution and allowed to develop. In all cases, the specimen and developer solution then flow through the testing device where test results are observable in approximately 20 minutes. The OraQuick ® device is a screening test and requires a confirmation test where an initial positive +result is obtained. +We have commercialized this technology in +the form of our OraQuick ADVANCE ® rapid +HIV-1/2 antibody test. This is a rapid, point-of-care test which has received FDA approval for the detection of antibodies to both HIV-1 and HIV-2 in oral fluid, finger-stick and venous whole blood and plasma. This test is available for use by the +nearly 40,000 locations in the United States certified under the Clinical Laboratory Improvements Amendment of 1988 (“CLIA”) to perform moderately complex tests. We have also received a CLIA waiver for use of the OraQuick +ADVANCE ® test with oral fluid and +finger-stick and venous whole blood. As a result, the test can be used by approximately 140,000 additional sites in the United States not certified under CLIA to perform moderately complex tests, such as outreach clinics, community-based +organizations and physicians’ offices. +3 +Table of Contents +On the international front, we are in the process of obtaining a CE mark for our OraQuick +ADVANCE ® test so that we will be able to +sell this product in Europe. We have a distributor in place for the United Kingdom and are pursuing distribution arrangements in several additional European countries. We are selling OraQuick ® in Mexico and Africa and are completing registrations of our OraQuick ® test in several countries in Latin America, Asia, the +Middle East and Russia. We are aggressively seeking to expand our distribution network for this product throughout the world. +We believe that the OraQuick ADVANCE ® device, because it is approved for detecting antibodies to both HIV-1 and HIV-2 in finger-stick and venous whole blood, oral fluid and plasma samples, +provides a significant competitive advantage in the market for rapid HIV testing in the United States and elsewhere around the world. Demand for OraQuick ADVANCE ® has quickly grown since the launch of that product in late 2004. +OraSure ® /Intercept ® Collection Devices +Our OraSure ® oral fluid collection device is used in conjunction with screening and confirmatory tests for HIV-1 antibodies and other analytes. This device consists of a small, treated cotton-fiber +pad on a handle that is placed in a person’s mouth for two to five minutes. The device collects oral mucosal transudate (“OMT”), a serum-derived fluid that contains higher concentrations of certain antibodies and analytes than saliva. +As a result, OMT testing is a highly accurate method for detecting HIV-1 infection and other analytes. +We believe that oral fluid testing has several significant advantages over blood or urine-based systems for infectious disease testing, for both health +care professionals and the individuals being tested. These advantages include eliminating the risk of needle-stick accidents, providing a non-invasive collection technique, requiring minimal training to administer, providing rapid and efficient +collection in almost any setting, and reducing the cost of administration by a trained health care professional. +We have received premarket approval from the FDA to sell the OraSure ® collection device for use with a laboratory-based enzyme immunoassay (“EIA”) screening test for HIV-1 +antibody detection. This EIA screening test has been approved by the FDA for use with our OraSure ® device and is manufactured and sold by bioMerieux, Inc. (“BMX”). +HIV-1 antibody detection using the OraSure ® collection device involves three steps: +• +Collection of an oral fluid specimen using the OraSure ® device; +• +Screening of the specimen for HIV-1 antibodies at a laboratory with an EIA screening test approved by the FDA for use with the OraSure ® device; and +• +Laboratory confirmation of any positive screening test results with our oral fluid Western blot HIV-1 confirmatory test (described below). +A trained health care professional then +conveys test results and provides appropriate counseling to the individual who was tested. We have also received FDA 510(k) clearance for use of the OraSure ® collection device with EIAs to test for cocaine and cotinine (a metabolite of nicotine) in oral fluid specimens primarily for insurance risk +assessment purposes. +In late 2006, BMX announced that it will +discontinue manufacturing the HIV-1 EIA screening test during 2007 and that, due to quality problems, it may have difficulty supplying this screening test prior to the time it ceases manufacturing. As a result, we are working with BMX, the FDA and +Centers for Disease Control and Prevention (“CDC”), our major laboratory customers and other potential suppliers to find or develop an alternative HIV-1 EIA screening test that can be used with oral fluid samples collected with our +OraSure ® device. +A collection device that is substantially similar to the OraSure ® device is sold under the name Intercept ® , and is used to collect OMT for oral fluid drug +testing. We have received FDA 510(k) clearance to use the +4 +Table of Contents +Intercept ® collection device with laboratory-based EIAs to test for drugs of abuse commonly identified by the National Institute for Drug Abuse (“NIDA”) as the NIDA-5 (i.e., cannabinoids +(marijuana), cocaine, opiates, amphetamines/methamphetamines and phencyclidine (“PCP”)), and for barbiturates, methadone and benzodiazepines. Each of these EIAs is also FDA 510(k) cleared for use with the Intercept ® device. +We have received a CE mark for the Intercept ® and OraSure ® devices and both are distributed in Canada, the United Kingdom and Mexico. The +OraSure ® device and our oral fluid drugs of abuse +assays are also sold in several other foreign countries. +We +believe that the Intercept ® device has several +advantages over competing urine and other drugs-of-abuse testing products, including its lower total testing cost, its non-invasive nature, mobility and accuracy, the ease of maintaining a chain-of-custody, the treatment of test subjects with +greater dignity, no requirement for specially-prepared collection facilities and difficulty of sample adulteration. The availability of an oral fluid test is intended to allow our customers to test for drug impairment, eliminate scheduling costs and +inconvenience, and thereby streamline the testing process. +Cryosurgical Systems (Skin Lesion Removal Products) +The Histofreezer ® cryosurgical removal +system is a low-cost alternative to liquid nitrogen and other methods for removal of warts and other benign skin lesions by physicians. The Histofreezer ® product mixes two environmentally friendly cryogenic gases in a small aerosol canister. When released, these gases are delivered to a +specially designed foam bud, cooling the bud to a maximum of –50°C to –55°C. The frozen bud is then applied to the wart or lesion for 15 to 40 seconds (depending on the type of lesion) creating localized destruction of the target +area by freezing. We have received 510(k) clearance for use of the Histofreezer ® product to remove common warts and eight other types of benign skin lesions, and this product has been CE marked and registered for distribution throughout Europe. +We have also received FDA 510(k) clearance to market and sell a cryosurgical +product similar to the Histofreezer ® product in the +OTC or retail market for the removal of common and plantar warts only. This product is being distributed in the United States and Canadian OTC markets under the name Freeze Off ® by Prestige Brands Holdings, Inc. (“Prestige”), the owner of the Compound W ® line of wart removal products. Prestige is the owner of both the Freeze +Off ® and Compound W ® tradenames. In September 2006, Prestige announced that it had acquired the +Wartner ® cryosurgical wart removal product line, +which competes with the Freeze Off ® product in the +U.S. and Canadian OTC markets. Because we believe that the Wartner acquisition constitutes a breach of our agreement with Prestige, we have initiated an arbitration proceeding against Prestige. As a result, it is uncertain whether Prestige will +continue to distribute the Freeze Off ® product +after 2007. For a more detailed description of our dispute with Prestige, see Item 3, “Legal Proceedings,” in this Annual Report. +Internationally, we distribute a similar CE marked cryosurgical wart removal product into the OTC footcare market in Europe, Australia and New Zealand +through our distributor, SSL International plc (“SSL”), under the Scholl and Dr. Scholl trademarks. SSL is the owner of the Scholl and Dr. Scholl trademarks in countries outside North and South America. We have also launched an +OTC cryosurgical product in Mexico through our distributor Genomma Labs, under the POINTTS tradename. +Immunoassay Tests and Reagents +We develop and sell immunoassay tests in two formats, known as MICRO-PLATE and AUTO-LYTE ® , to meet the specific needs of our customers. +In a MICRO-PLATE kit, the sample to be tested is placed into a small plastic +receptacle, called a microwell, along with the reagents. The result of the test is determined by the color of the microwell upon completion of the reaction. Controlling the reaction involves the use of a variety of reagents by laboratory personnel. +Test results +5 +Table of Contents +are analyzed by any of a variety of commercially available laboratory instruments, which we may also provide to our laboratory customers. MICRO-PLATE tests +can be performed on commonly used instruments and can detect drugs in urine, serum and sweat specimens. MICRO-PLATE tests are also used as part of the Intercept ® product line to detect drugs of abuse in oral fluid specimens. +AUTO-LYTE ® tests are sold in the form of bottles of liquid reagents. These reagents are run on +commercially available laboratory-based automated analytical instruments, which are manufactured by a variety of third parties. AUTO-LYTE ® is typically used in high volume, automated, commercial reference insurance laboratories to detect certain drugs or chemicals in urine. Test results +are produced quickly, allowing for high throughput. In recent years, sales of our AUTO-LYTE ® tests have been substantially reduced largely because of competition from cheaper “home-brew” tests used by our laboratory customers. As a result, we eventually expect to stop +selling our AUTO-LYTE ® tests. +Western blot HIV-1 Confirmatory Test +We sell an oral fluid Western blot HIV-1 confirmatory test that received +premarket approval from the FDA in 1996. This test uses the original specimen collected with the OraSure ® oral fluid collection device to confirm positive results of initial oral fluid HIV-1 EIA screening tests. The oral fluid Western blot HIV-1 confirmatory test is currently marketed under +an exclusive arrangement with BMX. +In March 2007, BMX notified +us that it will not renew the agreement under which it supplies the HIV-1 antigen used to manufacture our oral fluid Western blot HIV-1 confirmatory test or the agreement under which it distributes that product on an exclusive, world-wide basis. As +a result, these agreements will terminate on December 31, 2007. Pursuant to the terms of the antigen supply agreement, we have the right to purchase an additional two-year supply of the antigen following termination so that we can continue to +manufacture and sell our oral fluid Western blot test. When this additional two-year supply is combined with our existing inventory of the HIV-1 antigen, we believe we will have a sufficient supply of HIV-1 antigen to meet the demand for our Western +blot test for three to four years after the agreement terminates. We also intend to pursue a long-term supply agreement directly with the vendor (a former affiliate of BMX) used by BMX to manufacture the HIV-1 antigen. During 2006, sales of our oral +fluid Western blot HIV-1 confirmatory test totaled approximately $330,000. +Q.E.D. ® Saliva +Alcohol Test +Our Q.E.D. ® saliva alcohol test is a point-of-care test device that is a cost-effective +alternative to breath or blood alcohol testing. The test is a quantitative, saliva-based method for the detection of ethanol, has been cleared for sale by the FDA and has received a CLIA waiver. The U.S. Department of Transportation +(“DOT”) has also approved the test for purchase. +Each Q.E.D. ® test kit contains a +collection stick that is used to collect a sample of saliva and a disposable detection device that displays results in a format similar to a thermometer. The Q.E.D. ® device is easy to operate and instrumentation is not required to read the result. The product has a testing range of 0 +to 0.145% blood alcohol and produces results in approximately two minutes. +Products Under Development +OraQuick ® Platform +We believe that OraQuick ® has significant potential as a point-of-care testing platform for clinics and other +public health entities, hospitals, physicians’ offices and other markets. Because the OraQuick ® platform is simple to use and can operate in a non-invasive manner with oral fluid, we believe it will be suitable for use by consumers without the assistance of a doctor or other +medical professional. We also believe that OraQuick ® provides a platform technology that can be modified for detection of a variety of infectious diseases in addition to HIV, such as viral hepatitis and certain sexually transmitted diseases. +6 +Table of Contents +We are currently devoting significant resources to obtaining FDA approval to sell our OraQuick +ADVANCE ® HIV-1/2 test in the United States +OTC market. We have completed several laboratory-based operational studies and have initiated and will continue to perform additional clinical studies, including label comprehension studies, in support of our application for FDA approval. We are +also developing a counseling and referral system and product packaging and labeling suitable for the OTC market, all of which will be key components of our clinical studies. We expect this clinical work to continue during 2007 and early 2008, after +which we intend to submit an application for FDA approval. +During 2005, we obtained a license from Ortho-Clinical Diagnostics and Chiron Corporation to patents relating to the Hepatitis C virus, or HCV, and we have made substantial progress in developing a rapid HCV test using the OraQuick ® platform. In addition, in late 2006 we entered into an +agreement with Schering-Plough Corporation (“Schering-Plough”) to collaborate on the development and promotion of our OraQuick ® HCV test for use with oral fluid. Under the terms of our agreement, we will be reimbursed by Schering-Plough for a portion of our costs to develop the +test, and Schering-Plough will provide detailing and other promotional support for the test in the U.S. physicians’ office market, once the test is approved by the FDA. We are also in negotiations to obtain rights to a rapid HCV test +manufactured by a third party that we intend to distribute into international markets. +OraSure ® /Intercept ® +Applications +Oral mucosal transudate, or OMT, contains +many constituents found in blood and serum, although in lower concentrations. We believe the OraSure ® and Intercept ® devices are a platform technology with a wide variety of potential applications, where laboratory testing is available. For example, the OraSure ® device may be useful for the collection of a variety of antibodies or markers for infectious diseases or conditions in +addition to HIV-1, such as antibodies to viral hepatitis. +In +2004, the Substance Abuse and Mental Health Services Administration (“SAMHSA”) issued proposed regulations for oral fluid drug testing for federal workers. When issued in final form, these regulations may require certain modifications to +our Intercept ® product in order to permit its use +by federal workers. As a result, we are developing modifications to the Intercept ® collection device that we anticipate will be required by these regulations or are otherwise likely to be desired by our customers. +We are also currently developing additional drugs of abuse assays for use with our Intercept ® collection device. In October 2006, we signed a letter of intent with Roche +Diagnostics to negotiate a joint development and commercialization agreement for homogeneous fully-automated oral fluid drugs of abuse assays that can be run on random access chemistry analyzers. The oral fluid assays will be developed for use with +our Intercept ® collection device and Roche’s +KIMS (kinetic information of microparticles in solution) technology. The assays will be designed to run on various automated analyzers and to allow oral fluid samples to be processed with the same efficiency currently achieved with urine-based drug +tests. The parties are in the process of negotiating a definitive joint development and commercialization agreement. +In light of BMX’s announced decision to cease production of the HIV-1 EIA screening assay used with our OraSure ® device, we are working with BMX, the FDA and CDC, our major laboratory customers and +other potential suppliers to find or develop an alternative HIV-1 EIA screening test that can be used with our OraSure ® device. +OTC Cryosurgical Systems Products +We currently sell our Histofreezer ® cryosurgical systems product in the physicians’ office or professional market. This product has been approved by the FDA for the treatment of a +total of nine different types of benign skin lesions. Our OTC cryosurgical product has been approved by the FDA for two types of skin lesions—common warts and plantar warts. +7 +Table of Contents +We believe that one or more of the seven remaining Histofreezer ® indications may be attractive to the OTC market. We are developing an OTC cryosurgical +product for one of these indications, and we intend to seek FDA 510(k) clearance of that product during 2007. In addition, we are developing an extension of our existing OTC cryosurgical wart removal product in order to sell that product in +combination with salicylic acid for the treatment of common and plantar warts. We also intend to seek FDA clearance of this product extension in 2007. +Business Strategy +We have adopted a multi-part growth strategy, pursuant to which we intend to leverage our extensive diagnostic experience in order to maximize the +available opportunities from our existing products and technologies, and supplement our existing product pipeline by accessing other technologies and products. We intend to follow a disciplined approach to maximize the value of our business for the +benefit of our stockholders. +Our overall vision is to become a +recognized global leader focused on providing innovative diagnostic solutions that add substantial value to existing and emerging healthcare needs. In order to achieve this vision, our business strategy includes the following key elements: +• +Extension of Base Businesses . We intend to maximize the sales potential of our existing product lines and technologies in the markets +where they are currently sold, with a focus on expanding, where possible, the number of our oral fluid product offerings. Under this part of the strategy, we intend to fully capitalize on the potential market reach of our OraQuick ® , OraSure ® , Intercept ® , Histofreezer ® and Freeze Off ® products by investing in our sales and marketing efforts where appropriate, making product improvements and enhancements, and optimizing our distribution channels. We also intend to +expand the reach of our existing products and technology platforms into new markets and will focus specifically on expanding into international markets. +• +Infectious Disease Testing . We will pursue new products and technology platforms in the infectious disease, point-of-care testing +business to supplement our existing product pipeline. This may include either the development of new infectious disease products or the acquisition of new technologies or products. One new product we are pursuing is the development of a rapid HCV +test on our OraQuick ® platform. +• +OTC Opportunities . We intend to identify or develop products that can be sold in the OTC or retail marketplace. A significant +opportunity that we are pursuing under this part of our strategy is to seek FDA approval to sell our OraQuick ADVANCE ® rapid HIV-1/2 antibody test in the United States OTC market. We are also working to expand the distribution of our OTC cryosurgical product +internationally beyond Europe, Australia, New Zealand and Mexico where the product is currently distributed. +• +Operational Improvements . We intend to remain focused on the continuous improvement of our operations. These improvements will +include, but not be limited to, expanding the use of automated manufacturing for our product lines as demand increases, expanding the global sourcing of components and assemblies to achieve efficiencies and cost improvements, making infrastructure +and information technology investments as needed to improve effectiveness and productivity, and modifying our processes in order to continuously improve quality and the effectiveness of our operations. +Research and Development +In 2006, our research and development activities focused primarily on the +development of a rapid HCV test using our OraQuick ® +technology platform, clinical and regulatory activities related to obtaining a CE mark for the OraQuick ADVANCE ® test, preliminary work to obtain FDA approval for use of OraQuick ADVANCE ® in the United States OTC market, and development of certain improvements to existing products in both the +Intercept ® and cryosurgical wart removal product +lines. +From time to time, we supplement our own research and +development activities by funding external research at universities and certain other entities. We may continue to fund external research. +8 +Table of Contents +Research and development expenses totaled $8.6 million in 2006, $5.3 million in 2005 and $6.1 million in +2004. These expenses include the costs associated with research and development, regulatory affairs, clinical trials and product support. +Sales and Marketing +We attempt to reach our major target markets through a combination of direct sales, strategic partnerships, and independent distributors. Our marketing +strategy is to raise awareness through a full array of marketing activities, which include trade shows, print advertising, special programs and distributor promotions, to support sales in each target market. +We market our products in the United States and internationally. Revenues +attributable to customers in the United States were $56.8 million, $59.9 million and $47.8 million in 2006, 2005 and 2004, respectively. Revenues attributable to international customers amounted to $11.4 million, $9.5 million and $6.2 million, or +17%, 14% and 11% of our total revenues, in 2006, 2005 and 2004, respectively. +Infectious Disease Testing +We market the OraQuick ADVANCE ® +rapid HIV-1/2 antibody test directly to customers in the public health market for HIV testing. This market consists of a broad range of clinics and laboratories and includes states, counties, the CDC, SAMHSA and other governmental agencies, family +planning clinics, colleges and universities, correctional facilities and the military. There are also a number of organizations in the public health market, such as AIDS service organizations and various community-based organizations set up +primarily for the purpose of encouraging and enabling HIV testing. +Abbott Laboratories (“Abbott”) was appointed as our exclusive distributor in the U.S. hospital market and as a non-exclusive distributor in the U.S. physicians’ office marketplace. As our exclusive distributor to hospitals, +Abbott sells OraQuick ADVANCE ® to federal +hospitals under the terms of our Federal Supply Schedule on file with the General Services Administration. Under our agreement with Abbott, we have retained exclusive rights for all other markets, including sales to the public health and criminal +justice markets, the military, the CDC, SAMHSA and other governmental agencies. We have a small sales force that supports Abbott in order to maximize the penetration of OraQuick ADVANCE ® in the hospital market. +Abbott recently announced that it will sell part of its diagnostics business, including its rights to distribute OraQuick +ADVANCE ® , to General Electric +(“GE”). This transaction is expected to close during the first half of 2007. We intend to meet with executives from GE to discuss their plans for the OraQuick ADVANCE ® product. +We currently distribute our OraQuick ® test in several foreign countries. We expect the number of countries to increase as we find new distributors, complete +registrations in additional countries and obtain a CE mark for this product. +We also market the OraSure ® oral fluid collection device for HIV-1 testing, separately and as a kit in combination with laboratory testing services. To better serve our public health customers, we have entered into agreements with two commercial +laboratories to provide prepackaged OraSure ® test +kits, with prepaid laboratory testing and specimen shipping costs included. We also sell the OraSure ® device in the international public health market. +Substance Abuse Testing +Our substance abuse testing products are marketed to laboratories serving the workplace testing, forensic toxicology, criminal justice and drug +rehabilitation markets. +We have entered into agreements for +the distribution of Intercept ® collection devices +and associated MICRO-PLATE assays for drugs-of-abuse testing in the workplace testing market in the United States and +9 +Table of Contents +Canada through several laboratory distributors, including Quest Diagnostics (“Quest”) and Clinical Reference Laboratory, and internationally for +workplace, criminal justice and forensic toxicology testing through Bio-Rad Laboratories, Concateno (which recently acquired Altrix HealthCare, plc) and other distributors. In some cases, we assist our laboratory customers in customizing their +testing services by selling them equipment required to test oral fluid specimens collected with the Intercept ® device. +The forensic toxicology market in the United States for our substance abuse testing products consists of 250—300 laboratories including federal, state and county crime laboratories, medical examiner laboratories and reference +laboratories. The criminal justice market consists of a wide variety of entities in the criminal justice system that require drug screening, such as pre-trial services, parole and probation officials, police forces, drug courts, prisons, drug +treatment programs and community/family service programs. +We +also distribute our Q.E.D. ® saliva alcohol test +primarily through various distributors in the United States and internationally. The markets for alcohol testing are relatively small and fragmented with a broad range of legal and procedural barriers to entry. Markets range from law enforcement +testing to workplace testing of employees in safety sensitive occupations. Typical usage situations include pre-employment, random, post-accident, reasonable-cause and return-to-duty testing. +Cryosurgical Systems +Most of our Histofreezer ® sales occur in the United States to distributors that, in turn, resell the product to +primary care physicians and podiatrists in the United States. Major U.S. distributors include Cardinal Healthcare, McKesson HBOC, Physicians Sales & Service, AmerisourceBergen Corporation, and Henry Schein. Internationally, we established a +sales office in Reeuwijk, The Netherlands, and we are selling the Histofreezer ® product through a network of distributors in more than 20 countries worldwide. +We sell Freeze Off ® , a product similar to Histofreezer ® , in the OTC market in the U.S. and Canada pursuant to a distribution agreement with Prestige Brands, the owner of the Compound W ® line of wart removal products. Additionally, we distribute cryosurgical wart removal +products in the OTC footcare market in Europe, Australia and New Zealand through our distributor, SSL, under its Scholl and Dr. Scholl tradenames, and in the OTC market in Mexico under the POINTTS tradename through our distributor, Genomma +Labs. For a description of our pending dispute with Prestige Brands, see Item 3, “Legal Proceedings,” in this Annual Report. +Insurance Risk Assessment +We currently market the OraSure ® oral fluid collection device for use in screening life insurance applicants in the United States and internationally to test for three of the most +important underwriting risk factors: HIV-1, cocaine and cotinine (a metabolite of nicotine). Devices are sold to insurance testing laboratories, including Quest Diagnostics, Heritage Labs and Clinical Reference Laboratory. These laboratories in turn +provide the devices to insurance companies, usually in combination with testing services. +We also maintain a direct sales force that promotes use of the OraSure ® device directly to insurance companies for life insurance risk assessment. Insurance companies then make their own decision regarding which laboratory to use to supply their collection +devices and testing services. Our OraSure ® Western +blot confirmatory test is distributed through BMX to laboratories and is used to confirm oral fluid specimens collected with our OraSure ® device that initially test positive for HIV-1. For a description of BMX’s recent election not to renew the Western blot agreements after +December 31, 2007, see the Section entitled, “Western blot HIV-1 Confirmatory Test,” in this Annual Report. +Because insurance companies are in various stages of their adoption of the OraSure ® device, there exists a wide range of policy limits where the product is being applied. Some insurance companies have +chosen to extend their testing to lower policy limits where they did not test at all before, while others have used OraSure ® to +10 +Table of Contents +replace some of their blood and urine-based testing. In general, most of our insurance company customers use the OraSure ® device in connection with life insurance policies having face amounts of up to +$250,000, with some customers using the device for policies of up to $500,000 in amount. +In recent years, we have experienced a decline in sales of OraSure ® and related assays for insurance testing, primarily due to a reduction in the number of applications for life insurance policies and changes in underwriting requirements, as well as some +consolidation in the industry leading to a reevaluation of testing methods. However, our sales force continues to encourage additional insurance companies to use OraSure ® and to extend the use of the product by existing customers. We believe there are several factors which could help +expand the use of our device, including increasing acceptance of the reliability of oral fluid testing, the high quality of test results, the low cost of oral fluid testing relative to blood tests and the ease of use of the OraSure ® device. +We also sell our AUTO-LYTE ® assays and reagents in the insurance testing market directly to laboratories, including +Heritage Labs and Clinical Reference Laboratory. +International Markets +We sell most of our +products into international markets primarily through distributors with knowledge of their local markets. Principal markets include physicians’ offices, insurance risk assessment, substance abuse, public health and laboratory testing. +We assist our international distributors in registering the +products and obtaining required regulatory approvals in each country, and we provide training and support materials. Our international marketing program includes direct assistance to distributors in arranging for laboratory services, cooperation +from screening test manufacturers and performance of Western blot confirmatory tests when necessary. +Significant Products and Customers +Several different products have contributed significantly to our financial performance, accounting for 10% or more of total revenues during the past three years. The OraSure ® and Intercept ® oral fluid collection devices, cryosurgical systems products, and OraQuick ® rapid HIV test accounted for total revenues of $15.1 million, $17.3 million and $25.6 +million in 2006, $15.9 million, $22.7 million and $21.6 million in 2005, and $14.6 million, $20.2 million and $10.2 million in 2004, respectively. As new products are developed and commercialized, we expect to receive a greater portion of our +revenues from these new products. +We currently have two +customers, Quest and Abbott, which accounted for 14% and 10% of our total revenues, respectively, during 2006. The loss of Quest or Abbott, or a significant decrease in the volume of products purchased by either customer, could have a material +adverse effect on our results. +Supply and Manufacturing +We manufacture our OraQuick ADVANCE ® test in our Bethlehem, Pennsylvania facility. In addition, we have entered +into a supply agreement for the assembly of the OraQuick ® device in Thailand, in order to supply certain international markets. This supply agreement had an initial term of one year, and automatically renews for additional annual periods unless either party provides a timely +notice of termination prior to the end of an annual period. We believe that other firms would be able to manufacture the OraQuick ® test on terms no less favorable than those set forth in the agreement if the Thailand contractor would be unable or unwilling to continue manufacturing +this product. +We can purchase the HIV antigen and the +nitrocellulose required for the OraQuick ® test only +from a limited number of sources. The antigen is currently purchased from a single contract supplier under a long-term agreement with an initial term ending in January 2010 and one-year automatic renewal terms thereafter. The +11 +Table of Contents +nitrocellulose used in the test is also provided by a single contract supplier, under a supply agreement with a five-year term ending in 2009. If for any +reason these suppliers are unwilling or no longer able to supply our antigen or nitrocellulose needs, we believe that alternative supplies could be obtained at a competitive cost. However, a change in the antigen or nitrocellulose would require FDA +approval and some additional development work. This in turn would require significant time to complete and could disrupt our ability to manufacture and sell the OraQuick ® device. +We manufacture both the OraSure ® and Intercept ® collection devices in our Bethlehem, Pennsylvania facility, and we expect to continue to do so for the foreseeable future. +The oral fluid Western blot HIV-1 confirmatory test is currently manufactured in our Bethlehem, Pennsylvania facility. The +HIV antigen needed to manufacture the Western blot test is currently available from only a limited number of sources. For many years, we have purchased the antigen for this product from BMX on an exclusive basis. BMX is also the exclusive +distributor of the Western blot test kits. Our agreements with BMX provide for the supply by BMX of the HIV-1 antigen and distribution of the oral fluid Western blot product by BMX on an exclusive worldwide basis. In March 2007, BMX notified us that +it will not renew the agreements under which it supplies the HIV-1 antigen and distributes that product on an exclusive, world-wide basis, beyond December 31, 2007. For a further description of BMX’s election not to renew the Western blot +agreements, see the Section entitled, “Western blot HIV-1 Confirmatory Test,” in this Annual Report. +Histofreezer ® is assembled in The Netherlands by Koninklijke, Utermöhlen, N.V. (“Utermöhlen”), the company from which we acquired the product in 1998. We purchase the product +pursuant to an exclusive production agreement. Utermöhlen also supplies Freeze Off ® , the OTC cryosurgical product for the U.S. and Canadian markets. Assuming minimum purchase requirements are met, our agreement with Utermöhlen will terminate at the end of 2008 with respect to the +Histofreezer ® product. The Utermöhlen +agreement was scheduled to terminate at the end of 2006 with respect to the Freeze Off ® product, subject to a minimum purchase requirement. However, we did not meet that requirement by the end of 2006 due to unexpectedly low purchases of the product by our distributor, Prestige. As a result, we +expect to continue to purchase product for the U.S. OTC market from Utermöhlen for the foreseeable future. The cryosurgical wart removal products distributed in international OTC markets are supplied by vendors located in the United States. +We believe that additional suppliers of all of our +cryosurgical products are available on terms no less favorable than the terms of our existing supply agreements in the event that our current suppliers would be unable or unwilling to continue manufacturing these products. +Our AUTO-LYTE ® and MICRO-PLATE assays are manufactured in our Bethlehem, Pennsylvania facility. These +tests require the production of highly specific and sensitive antibodies corresponding to the antigen of interest. Substantially all our antibody requirements are provided by contract suppliers. We believe that we have adequate reserves of antibody +supplies and that we have access to sufficient raw materials for these products. +The Q.E.D. ® saliva +alcohol test is manufactured and packaged for shipment in our Bethlehem, Pennsylvania facility. +Employees +As of +December 31, 2006, we had 250 full-time employees, including 66 in sales, marketing and client services; 26 in research and development; 105 in operations, manufacturing, quality control, information systems, purchasing and shipping; 19 in +regulatory affairs and quality assurance, and 34 in administration and finance. This compares to 233 employees as of December 31, 2005. Our employees are not currently represented by a collective bargaining agreement. +12 +Table of Contents +Competition +The diagnostic industry is a multi-billion dollar international industry and is intensely competitive. Many of our competitors are substantially larger +than we are, and they have greater financial, research, manufacturing and marketing resources. +Important competitive factors for our products include product quality, price, ease of use, customer service and reputation. Industry competition is based on the following: +• +Scientific and technological capability; +• +Proprietary know-how; +• +The ability to develop and market products and processes; +• +The ability to obtain FDA or other regulatory approvals; +• +The ability to manufacture products that meet applicable FDA requirements (i.e., good manufacturing practices); +• +Access to adequate capital; +• +The ability to attract and retain qualified personnel; and +• +The availability of patent protection. +A few large corporations produce a wide variety of diagnostic tests and other medical devices and equipment. A larger number of mid-size companies +generally compete only in the diagnostic industry and a significant number of small companies produce only a few diagnostic products. As a result, the diagnostic test industry is highly fragmented and segmented. +The future market for diagnostic tests is expected to be characterized by +consolidation, greater cost consciousness and tighter reimbursement policies. The purchasers of diagnostic products are expected to place increased emphasis on lowering costs, reducing inventory levels, automation, service and volume discounts. The +increased complexity of the market is expected to force many competitors to enter into joint ventures or license certain products or technologies. +We expect competition to intensify as technological advances are made and become more widely known, and as new products reach the market. Furthermore, new +testing methodologies could be developed in the future that render our products impractical, uneconomical or obsolete. There can be no assurance that our competitors will not succeed in developing or marketing technologies and products that are more +effective than those we develop or that would render our technologies and products obsolete or otherwise commercially unattractive. In addition, there can be no assurance that our competitors will not succeed in obtaining regulatory approval for +these products, or introduce or commercialize them before we can do so. These developments could have a material adverse effect on our business, financial condition and results of operations. +Several companies market or have announced plans to market oral specimen +collection devices and tests both within and outside the United States. We expect the number of devices competing with our Intercept ® , OraQuick ® and OraSure ® devices to increase as the benefits of oral specimen-based testing become more widely accepted. +Competition in the market for HIV testing is intense and is expected to increase. We believe that the principal competition will come from existing +laboratory-based blood tests, point-of-care rapid blood tests, laboratory-based urine assays, or other oral fluid-based tests that may be developed. Our competitors include specialized biotechnology firms, as well as pharmaceutical companies with +biotechnology divisions and medical diagnostic companies. +13 +Table of Contents +Significant competitors for our OraQuick +ADVANCE ® rapid test, such as the Ortho Diagnostics division of Johnson & Johnson, Bio-Rad Laboratories, Abbott and BMX, sell laboratory-based HIV-1/2 EIAs, +and Maxim Biomedical (formerly Calypte, Inc.) sells an HIV-1 screening test for urine, in the United States. MedMira and Trinity Biotech each sell competing rapid HIV-1 blood tests, and Bio-Rad Laboratories and Chembio sell competing rapid HIV-1/2 +blood tests in the United States. These tests compete with our OraQuick ADVANCE ® test in hospitals or other laboratory settings. In addition, Trinity Biotech and +Chembio have received CLIA waivers for their rapid HIV tests, and these tests compete with our OraQuick ADVANCE ® test in the markets outside of the traditional +hospital and laboratory settings. These companies, or others, may continue to expand the bodily fluids with which a rapid HIV test may be performed, or develop and commercialize new rapid HIV tests, which would provide further competition for our +OraQuick ADVANCE ® test. We believe other companies may also seek FDA approval to sell competing rapid HIV tests in the future. +Internationally, our OraQuick ADVANCE ® test competes against rapid HIV tests sold by a number of other entities, and +often these competing tests are sold at prices substantially below the prices we charge for our OraQuick ADVANCE ® test. Calypte has developed a rapid oral fluid HIV test which is now being sold in certain foreign countries. +The Intercept ® drug testing system competes with laboratory-based drug testing products and services +using testing matrices such as urine, hair, sweat and oral fluid. Major competitors include Ansys Technologies, Inc., Dade Behring, Psychemedics and Immunalysis. +Our MICRO-PLATE oral fluid drug assays, which are sold for use with the Intercept ® and OraSure ® collection devices, are expected to come under increasing competitive pressure from “home-brew” assays +developed internally by our laboratory customers. Our oral fluid MICRO-PLATE assays also compete with urine-based homogeneous assays that are run on fully-automated, random access analyzers. These tests provide strong competitive pressure because +they provide the benefits of automation, including lower costs and short turn-around times. In addition, we believe our competitors are developing oral fluid tests suitable for use on these fully automated homogeneous assay systems and these assays, +if and when they are developed and commercialized, will represent a significant competitive threat to our oral fluid MICRO-PLATE business. In order to meet this competition, we executed a letter of intent with Roche Diagnostics in October 2006 to +enter into an agreement for the joint development and commercialization of fully-automated homogeneous oral fluid drugs of abuse assays for use with our Intercept ® device. We expect final agreements with Roche to be executed during the first half of 2007. +Our MICRO-PLATE drugs-of-abuse reagents sold in the forensic toxicology +market are targeted to forensic testing laboratories where sensitivity, automation and “system solutions” are important. In the past, these laboratories have typically had to rely on radioimmunoassay test methods to provide an adequate +level of sensitivity. Radioimmunoassays require radioactive materials, which have a short shelf-life and disposal problems. Our MICRO-PLATE tests meet the laboratories’ sensitivity needs, run on automated equipment, are not radioimmunoassays, +and are offered to the laboratory as a complete system solution of reagents, instrumentation and software to meet the specific needs of each customer. We compete with both homogeneous and heterogeneous tests manufactured by many companies. +Significant competitors in the market for these assays include Microgenics, Inc., Roche Diagnostics and Immunalysis. +Sales of our AUTO-LYTE ® urine assays have declined substantially during the past several years, primarily due to competition from assays developed internally by our laboratory +customers (i.e., “home brews”), which can be produced at a cost lower than the price typically paid for our products. Many of our customers no longer purchase our AUTO-LYTE ® assays, and we eventually expect to stop selling this product line. +The Histofreezer ® product’s delivery system and operating temperature, which is warmer than liquid +nitrogen, provide us with the opportunity to target sales to primary care physicians, such as family practitioners, pediatricians and podiatrists. We do not generally target sales to dermatologists because they have the volume of +14 +Table of Contents +patients required to support the capital costs associated with a liquid nitrogen delivery system, which is also used to remove warts and other benign skin +lesions. There is limited competition for convenient cryosurgical products for wart removal in the primary care physician market. Major competitors for the Histofreezer ® product include Cryosurgery, Inc. in the United States and Wartner in Europe. Wartner may also eventually compete with +Histofreezer ® in the physician market in the United +States. +The Freeze Off ® product, sold by Prestige under its Compound W ® tradename, competes with other OTC wart removal products in the United States. +Schering-Plough sells a competing cryosurgical wart removal product under its Dr. Scholl’s brand and another competing cryosurgical wart removal product is sold in the OTC market under the Wartner ® name. Wartner also sells a product that competes with our cryosurgical product in the +European OTC footcare market. During 2006, Prestige acquired the Wartner ® product sold in the United States and Canada, and we believe this action constitutes a material breach of our agreement with Prestige. For a further discussion of our dispute with Prestige regarding this matter, see +Item 3, “Legal Proceedings,” in this Annual Report. +Q.E.D. ® has two direct competitors, Ansys +Technologies, Inc. and Chematics. These companies offer semi-quantitative saliva-based alcohol tests and have received DOT approval. Indirect competitors who offer breath testing equipment include Intoximeters, Dräger and CMI. Although there +are lower priced tests on the market that use oral fluid or breath as a test medium, these tests are qualitative tests that are believed to be substantially lower in quality and provide fewer benefits than our Q.E.D. ® test. +Patents and Proprietary Information +We seek patent and other intellectual property rights to protect and preserve our proprietary technology and our right to capitalize on the results of our +research and development activities. We also rely on trade secrets, know-how, continuing technological innovations and licensing opportunities to provide competitive advantages for our products in our markets and to accelerate new product +introductions. We regularly search for third-party patents in fields related to our business to shape our own patent and product commercialization strategies as effectively as possible and to identify licensing opportunities. United States patents +generally have a maximum term of 20 years from the date an application is filed. +We have 16 United States patents and numerous foreign patents for the OraSure ® and Intercept ® collection devices and technology relating to oral fluid collection, containers for oral fluids, methods to test oral fluid, formulations for the manufacture of synthetic oral fluid, and methods to control the volume +of oral fluid collected and dispersed. We have also applied for additional patents, in both the United States and certain foreign countries, on such products and technology. +We have one issued patent for our OraQuick ADVANCE ® rapid HIV-1/2 antibody test in the United States, and we received notice that the +claims of a related patent have been allowed. We also have several related patent applications pending for this product in the United States and internationally. We have obtained licenses to certain lateral flow patents and to certain HIV-1 and +HIV-2 patents held by other parties. We also have obtained a license to certain HCV patents which we intend to use to manufacture and sell a rapid HCV test on the OraQuick ® or other technology platform. We obtained these licenses through the payment of certain upfront fees and an agreement +to pay ongoing royalties. We believe these fees and royalties are comparable to those generally paid by other companies under similar arrangements. +We may need to obtain licenses or other rights under, or enter into distribution or other business arrangements in connection with, certain other +intellectual property patents in order to manufacture and sell the OraQuick ADVANCE ® test or other tests that use the same or similar technology platform. See Section 1A, entitled “Risk Factors,” for a further discussion of these issues. +We have five United States patents and numerous foreign patents issued for +apparatuses and methods for the topical removal of skin lesions relating to our cryosurgical wart removal products, and we have a pending patent +15 +Table of Contents +application related to these products. We have also licensed another patent relating to apparatuses and methods for the topical removal of skin lesions +relating to our cryosurgical wart removal products. +We have +four United States patents and numerous foreign patents and patent applications for the technology used in the Q.E.D. ® test. These patents are related to the analog-to-digital technology color control systems and methods, systems and devices for the test, and detection +of biochemical molecules. +We have one United States patent +relating to the method for detecting blood in urine specimens using our AUTO-LYTE ® products. +We require our +employees, consultants, outside collaborators and other advisors to execute confidentiality agreements upon the commencement of employment or consulting relationships with us. These agreements provide that all confidential information developed by +or made known to the individual during the course of the individual’s relationship with us, is to be kept confidential and not disclosed to third parties except in specific circumstances. In the case of employees, the agreements provide that +all inventions conceived by the individual during his or her tenure with us will be our exclusive property. +We own rights to trademarks and service marks that we believe are necessary to conduct our business as currently operated. In the United States, we own +the OraSure ® , Intercept ® , OraQuick ® , OraQuick ADVANCE ® , Histofreezer ® , Q.E.D. ® and AUTO-LYTE ® trademarks. We also own many of these marks and others in several foreign countries. The Compound W ® and Freeze Off ® trademarks are owned by Prestige, or its affiliates, in the United States and Canada, the Scholl and Dr. Scholl tradenames are owned by SSL in Europe, Australia, New Zealand and +other countries outside North and South America, and the POINTTS tradename is owned by Genomma Labs in Mexico. +Although important, the issuance of a patent or existence of trademark or trade secret protection does not in itself ensure the success of our business. +Competitors may be able to produce products competing with our patented products without infringing our patent rights. Issuance of a patent in one country generally does not prevent manufacture or sale of the patented product in other countries. The +issuance of a patent is not conclusive as to validity or as to the enforceable scope of the patent. The validity or enforceability of a patent can be challenged by litigation after its issuance. If the outcome of such litigation is adverse to the +owner of the patent, the owner’s rights could be diminished or withdrawn. Trade secret protection does not prevent independent discovery and exploitation of the secret product or technique. +Government Regulation +General +Most of our products are regulated by the FDA, certain state and local agencies and comparable regulatory bodies in other countries. This regulated +environment governs almost all aspects of development, production, and marketing, including product testing, authorizations to market, labeling, promotion, manufacturing and recordkeeping. +All of our FDA-regulated products require some form of action by the FDA +before they can be marketed in the United States. After approval or clearance by the FDA, we must continue to comply with other FDA requirements applicable to marketed products. Both before and after approval or clearance, failure to comply with the +FDA’s requirements can lead to significant penalties or could disrupt our ability to sell these products. In addition, the FDA could refuse permission to obtain certificates needed to export our products if the agency determines that we are not +in compliance. +Domestic Regulation +Most of our products are regulated in the United States as medical devices. +16 +Table of Contents +There are two mechanisms by which regulated medical devices can be placed on the market in the +United States. Some products may qualify for clearance under Section 510(k) of the Federal Food, Drug and Cosmetic Act. To obtain this clearance from the FDA, the manufacturer must provide a premarket notification that it intends to begin +marketing the product, and show that the product is substantially equivalent to another legally marketed product (i.e., that it has the same intended use and is as safe and effective as a legally marketed device and does not raise different +questions of safety and effectiveness). In some cases, the submission must include data from human clinical studies. Marketing may commence when the FDA issues a clearance letter finding substantial equivalence. An applicant must submit a 510(k) +application at least 90 days before marketing of the affected product commences. Although FDA clearance may be granted within that 90-day period, in some cases as much as a year or more may be required before clearance is obtained, if at all. +If the medical device does not qualify for the 510(k) +procedure (either because it is not substantially equivalent to a legally marketed device or because it is required by statute and the FDA’s regulations to have an approved premarket application), the FDA must approve a premarket application, +or PMA, before marketing can begin. PMAs must demonstrate, among other matters, that the medical device provides a reasonable assurance of safety and effectiveness. A PMA is typically a complex submission, including the results of preclinical and +clinical studies. Preparing a PMA is a detailed and time-consuming process. Once a PMA has been submitted, the FDA is required to review the submission within 180 days. However, the FDA’s review may, and often is, much longer, often requiring +one year or more, and may include requests for additional data and facility inspections before approval is granted, if at all. +Some of our products are used for non-medical purposes and many of our drugs-of-abuse products sold to state crime labs are for forensic use. The FDA does +not currently regulate products used for these purposes. +Every +company that manufactures medical devices distributed in the United States must comply with the FDA’s Quality System Regulations (“QSRs”). These regulations govern the manufacturing process, including design, manufacture, testing, +release, packaging, distribution, documentation and purchasing. In complying with QSRs, manufacturers must continue to expend time, money and effort in the area of production and quality assurance to ensure full technical compliance. Companies are +also subject to other post-market and general requirements, including restrictions imposed on marketed products, promotional standards and requirements for recordkeeping and reporting of certain adverse reactions. If there are any modifications made +to our marketed devices, a premarket notification or PMA may be required to be submitted to, and cleared or approved by, the FDA, before the modified device may be marketed. The FDA regularly inspects companies to determine compliance with QSRs and +other post-market requirements. Failure to comply with statutory requirements and the FDA’s regulations can result in warning letters, monetary penalties, suspension or withdrawal of regulatory approvals, operating restrictions, total or +partial suspension of production, injunctions, product recalls, seizure of products and criminal prosecution. +The Clinical Laboratory Improvements Amendments of 1988, or CLIA, prohibit laboratories from performing tests for the purpose of providing information for +the diagnosis, prevention or treatment of any disease or impairment of, or the assessment of, the health of human beings, unless there is in effect for such laboratories a certificate issued by the U.S. Department of Health and Human Services +applicable to the category of examination or procedure performed. We consider the applicability of the requirements of CLIA in the design and development of our products. We have obtained a waiver of the CLIA requirements for both our OraQuick +ADVANCE ® rapid HIV-1/2 antibody test and our +Q.E.D. ® alcohol saliva test and may seek similar +waivers for certain other products. A CLIA waiver allows certain customers to use the waived products that may not have been able to use them without complying with certain quality control and other requirements. +Certain of our products may also be affected by state regulations in the +United States. For example, there are several states that restrict or do not currently permit oral fluid drug testing in the workplace or other markets. In addition, several states prohibit or limit the use of rapid, point-of-care HIV testing. We +are presently working with legislators or regulators in certain of these states in an effort to modify or remove any restrictions affecting our ability to sell products. +17 +Table of Contents +International +We are also subject to regulations in foreign countries governing products, human clinical trials and marketing, and may +need to obtain approval from international public health agencies, such as the World Health Organization, in order to sell products in certain countries. Approval processes vary from country to country, and the length of time required for approval +or to obtain other clearances may in some cases be longer than that required for U.S. governmental approvals. We generally pursue approval only in those countries that we believe have a significant market opportunity. +The International Organization for Standardization (“ISO”) is a +worldwide federation of national standards bodies from some 130 countries, established in 1947. The mission of the ISO is to promote the development of standardization and related activities in the world with a view to facilitating the international +exchange of goods and services. ISO certification is a pre-requisite to use of the CE mark and indicates that our quality system complies with standards applicable to activities ranging from initial product design and development through production +and distribution. The CE mark is a European Union (“EU”) requirement to sell products that fall under the scope of the Medical Devices Directive (“MDD”) and the In Vitro Diagnostic Directive (“IVDD”). The CE mark is +evidence that the manufacturer and the product meet the requirements of all applicable directives, including the MDD and IVDD. +We received authorization to use the CE mark for the OraSure ® and Intercept ® collection devices and our Histofreezer ® product line, and SSL International has obtained authorization to use the CE mark for our cryosurgical wart removal product in the OTC European +footcare market. In addition, we are currently in the process of obtaining authorization to affix a CE mark to our OraQuick ADVANCE ® HIV-1/2 test. +We must also comply with certain registration requirements as dictated by Health Canada, prior to commencing sales in Canada. We have completed this +process for several of our current products and may do so with respect to other products in the future. In addition, Canadian law requires manufacturers of medical devices to have a quality management system that meets various ISO requirements in +order to obtain a license to sell their devices in Canada. +Anti-Kickback Laws +The Federal Anti-Kickback +Statute prohibits the knowing and willful offer, payment, solicitation, or receipt of any form of remuneration in return for, or to induce: +• +The referral of a person; +• +The furnishing or arranging for the furnishing of items or services reimbursable under Medicare, Medicaid or other governmental programs; or +• +The purchase, lease, or order of, or the arrangement or recommendation of the purchasing, leasing, or ordering of any item or service reimbursable under Medicare, +Medicaid, or other governmental programs. +Our products are or may be purchased by customers that will seek or receive reimbursement under Medicare, Medicaid or other governmental programs. Noncompliance with the federal anti-kickback legislation can result in exclusion from +Medicare, Medicaid, or other governmental programs, restrictions on our ability to operate in certain jurisdictions, as well as civil and criminal penalties, any of which could have an adverse effect on our business and results of operations. +The Federal Civil Monetary Penalties Law prohibits the +offering or transferring of remuneration to a Medicare or Medicaid beneficiary that the person knows or should know is likely to influence the beneficiary’s selection of a particular supplier of Medicare or Medicaid payable items or services. +Noncompliance can result in civil money penalties of up to $10,000 for each wrongful act, assessment of three times the amount claimed for each item or service and exclusion from the Federal healthcare programs. +18 +Table of Contents +Many states have also adopted some form of anti-kickback laws. A determination of liability under such +laws could result in fines and penalties and restrictions on our ability to operate in these jurisdictions. +We believe that we are operating in compliance with these laws. +Foreign Corrupt Practices Act +The U.S. Foreign Corrupt Practices Act (“FCPA”) prohibits corporations and individuals from engaging in certain activities to obtain or retain +business or to influence a person working in an official capacity. It is illegal to pay, offer to pay or authorize the payment of anything of value to any foreign government official, government staff member, political party or political candidate +in an attempt to obtain or retain business or to otherwise influence a person working in an official capacity. Our present and future business has and will continue to be subject to the FCPA and various other laws, rules and/or regulations +applicable to us as a result of our international sales. +Environmental Regulation +Because of the +nature of our current and proposed research, development, and manufacturing processes, we are subject to stringent federal, state and local laws, rules, regulations and policies governing the use, generation, manufacture, storage, air emission, +effluent discharge and handling and disposal of materials and wastes. We believe that we have complied with these laws and regulations in all material respects. +The foregoing discussion of our business should be read in conjunction with the Financial Statements and accompanying notes included in Item 15 of +this Annual Report. \ No newline at end of file diff --git a/raw/filings/0001116463/2006/0001193125-07-057268/item13.txt b/raw/filings/0001116463/2006/0001193125-07-057268/item13.txt new file mode 100644 index 0000000000000000000000000000000000000000..26c164a7bfa509fd650685da4bdc73157cc42c22 --- /dev/null +++ b/raw/filings/0001116463/2006/0001193125-07-057268/item13.txt @@ -0,0 +1,3 @@ +ITEM 13. Certain Relationships and Related Transactions, and Director Independence. +The information required by this Item is incorporated by reference to the information under the captions, “Transactions with Related Persons” +and “Corporate Governance—Director Independence,” in the Proxy Statement. \ No newline at end of file diff --git a/raw/filings/0001116463/2006/0001193125-07-057268/item9a.txt b/raw/filings/0001116463/2006/0001193125-07-057268/item9a.txt new file mode 100644 index 0000000000000000000000000000000000000000..008dd92925c2f2e4fceb8487dc143ce481fbf531 --- /dev/null +++ b/raw/filings/0001116463/2006/0001193125-07-057268/item9a.txt @@ -0,0 +1,56 @@ +ITEM 9A. Controls and Procedures. +(a) Evaluation of Disclosure Controls and Procedures. +The Company’s management, with the participation of the Company’s Chief Executive Officer and Chief Financial Officer, has evaluated the effectiveness of the Company’s disclosure controls and procedures +(as defined in Rules 13a-15(e) and 15d-15(e) of the Securities Exchange Act of 1934) as of December 31, 2006. Based on that evaluation, the Company’s management, including such officers, concluded that the Company’s disclosure +controls and procedures are adequate and effective to ensure that information required to be disclosed by the Company in the reports that we file or submit under the Securities Exchange Act of 1934 is accumulated and communicated to the +Company’s management, including the Chief Executive Officer and Chief Financial Officer, to allow timely decisions regarding required disclosure and is recorded, processed, summarized, and reported within the time periods specified in the rules +and forms of the Securities and Exchange Commission. +(b) +Management’s Report on Internal Control Over Financial Reporting. +The Company’s management is responsible for establishing and maintaining adequate internal control over financial reporting, as such term is defined in Rule 13a(f) and 15d-15(f) under the Securities Exchange Act +of 1934. Under the supervision and with the participation of the Company’s management, including our principal executive officer and principal financial officer, we conducted an evaluation of the effectiveness of our internal control over +financial reporting based on the framework in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on our evaluation under the framework, our management concluded +that our internal control over financial reporting was effective to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted +accounting principles as of December 31, 2006. +Our +management’s assessment of the effectiveness of our internal control over financial reporting as of December 31, 2006 has been audited by KPMG LLP, an independent registered public accounting firm, as stated in their report, which is +included below. +Because of its inherent limitations, internal +control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that +the degree of compliance with the policies or procedures may deteriorate. +(c) Changes in Internal Control Over Financial Reporting. +There was no change in the Company’s internal control over financial reporting identified in connection with the evaluation referred to in paragraph +(a) above that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting. +(d) Report of Independent Registered Public Accounting Firm +The Board of Directors and Stockholders +OraSure Technologies, Inc.: +We have audited +management’s assessment, included in the accompanying Management’s Report on Internal Control over Financial Reporting, that OraSure Technologies, Inc. maintained effective internal control over financial reporting as of December 31, +2006, based on criteria established in Internal Control—Integrated +56 +Table of Contents +Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). OraSure Technologies, Inc.’s management is +responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on management’s assessment and +an opinion on the effectiveness of the Company’s internal control over financial reporting based on our audit. +We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we +plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial +reporting, evaluating management’s assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit +provides a reasonable basis for our opinion. +A company’s +internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted +accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions +and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that +receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized +acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements. +Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any +evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. +In our opinion, management’s assessment that OraSure Technologies, Inc. +maintained effective internal control over financial reporting as of December 31, 2006, is fairly stated, in all material respects, based on criteria established in Internal Control—Integrated Framework issued by the Committee of +Sponsoring Organizations of the Treadway Commission (COSO). Also, in our opinion, OraSure Technologies, Inc. maintained, in all material respects, effective internal control over financial reporting as of December 31, 2006, based on criteria +established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). +We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the balance sheets of OraSure +Technologies, Inc. as of December 31, 2006 and 2005, and the related statements of operations, stockholders’ equity and comprehensive income (loss), and cash flows for each of the years in the three-year period ended December 31, +2006, and our report dated March 16, 2007 expressed an unqualified opinion on those financial statements. +/s/ KPMG LLP +Philadelphia, Pennsylvania +March 16, 2007 \ No newline at end of file diff --git a/raw/filings/0001116463/2006/0001193125-07-057268/rp_note.txt b/raw/filings/0001116463/2006/0001193125-07-057268/rp_note.txt new file mode 100644 index 0000000000000000000000000000000000000000..e69de29bb2d1d6434b8b29ae775ad8c2e48c5391 diff --git a/raw/filings/0001116463/2006/0001193125-07-057268/rpt_disclosure.txt b/raw/filings/0001116463/2006/0001193125-07-057268/rpt_disclosure.txt new file mode 100644 index 0000000000000000000000000000000000000000..fb1ac2d9d68ef460d04316aef2a62b8a9f3c2d21 --- /dev/null +++ b/raw/filings/0001116463/2006/0001193125-07-057268/rpt_disclosure.txt @@ -0,0 +1,7 @@ +Transactions With Related Persons +Since January 1, 2007, there have been no transactions with related persons which would require disclosure in this Proxy Statement. The Audit Committee is required to review and approve in advance all +transactions with related persons involving the Company. The Audit Committee may approve a related party transaction if the transaction is on terms comparable to those that could be obtained in arms’ length dealings with an unrelated third +party. The Audit Committee also reviews any public disclosures of a related party transaction contained in our SEC filings. These responsibilities are described in the Audit Committee’s charter, a copy of which is available on our website at +www.orasure.com . +Information regarding employment and severance agreements between our executive officers and the Company is set +forth in the Section entitled, “Employment Agreements and Potential Payments Upon Termination or Change in Control,” in this Proxy Statement. \ No newline at end of file diff --git a/raw/filings/0001116463/2008/0001193125-09-049845/filing.txt b/raw/filings/0001116463/2008/0001193125-09-049845/filing.txt new file mode 100644 index 0000000000000000000000000000000000000000..53c934b9a72dc5c315409bf745a51825196f36d5 --- /dev/null +++ b/raw/filings/0001116463/2008/0001193125-09-049845/filing.txt @@ -0,0 +1,5052 @@ +10-K +1 +d10k.htm +FORM 10-K +Form 10-K +Table of Contents +UNITED STATES +SECURITIES AND EXCHANGE COMMISSION +Washington, D.C. 20549 +FORM 10-K +ANNUAL REPORT PURSUANT +TO SECTION 13 OR 15(d) OF THE +SECURITIES EXCHANGE ACT OF 1934 +(Mark One) +x +ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 +For the fiscal year ended December 31, 2008 +OR +¨ +TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 +For the transition period from to +Commission File No. 001-16537 +ORASURE TECHNOLOGIES, INC. +(Exact Name of Registrant as Specified in Its Charter) +Delaware +36-4370966 +(State or Other Jurisdiction of +Incorporation or Organization) +(I.R.S. Employer Identification No.) +220 East First Street +Bethlehem, Pennsylvania +18015 +(Address of Principal Executive Offices) +(Zip Code) +(610) 882-1820 +(Registrant’s Telephone Number, Including Area Code) +Securities registered pursuant to +Section 12(b) of the Act: +Title of Each Class +Name of Each Exchange on Which Registered +Common Stock $0.000001 par value per share +The NASDAQ Stock Market LLC +Securities registered pursuant to Section 12(g) of the Act: None +Indicate by check mark if the Registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes ¨ +No x +Indicate by check mark if the Registrant is not required to file +reports pursuant to Section 13 or Section 15(d) of the Exchange Act. Yes ¨ No x +Indicate by check mark whether the Registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange +Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No ¨ +Indicate by check mark if disclosure of +delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of Registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this +Form 10-K or any amendment to this Form 10-K. ¨ +Indicate by check mark whether the Registrant is a large +accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of +the Exchange Act. (Check one): +Large accelerated filer ¨ +Accelerated filer x +Non-accelerated filer ¨ +Smaller reporting company ¨ +(Do not check if a smaller reporting company) +Indicate by check mark whether the Registrant is a shell company (as defined in Rule 12b-2 of the +Exchange Act). Yes ¨ No x +State the aggregate +market value of the voting and non-voting common equity held by nonaffiliates, computed by reference to the price at which the common equity was last sold, or the average bid and asked price of such common equity, as of the last business day of the +Registrant’s most recently completed second fiscal quarter (June 30, 2008): $173,253,510 +Indicate the number of shares outstanding of +each of the Registrant’s classes of common stock, as of March 4, 2009: 45,861,222 shares. +Documents Incorporated by Reference: +Portions of the Registrant’s Definitive Proxy Statement for the 2009 Annual Meeting of Stockholders are incorporated by reference +into Part III of this Report. +Table of Contents +Table of Contents +Page +PART I +ITEM 1. +Business +1 +ITEM 1A. +Risk Factors +20 +ITEM 1B. +Unresolved Staff Comments +37 +ITEM 2. +Properties +37 +ITEM 3. +Legal Proceedings +38 +ITEM 4. +Submission of Matters to a Vote of Security Holders +38 +PART II +ITEM 5. +Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities +39 +ITEM 6. +Selected Financial Data +41 +ITEM 7. +Management’s Discussion and Analysis of Financial Condition and Results of Operations +42 +ITEM 7A. +Quantitative and Qualitative Disclosures About Market Risk +57 +ITEM 8. +Financial Statements and Supplementary Data +58 +ITEM 9. +Changes in and Disagreements with Accountants on Accounting and Financial Disclosure +58 +ITEM 9A. +Controls and Procedures +58 +ITEM 9B. +Other Information +60 +PART III +ITEM 10. +Directors, Executive Officers and Corporate Governance +61 +ITEM 11. +Executive Compensation +61 +ITEM 12. +Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters +61 +ITEM 13. +Certain Relationships and Related Transactions, and Director Independence +61 +ITEM 14. +Principal Accountant Fees and Services +61 +PART IV +ITEM 15. +Exhibits and Financial Statement Schedules +62 +Table of Contents +This Report contains certain “forward-looking statements,” within the meaning of the Federal +securities laws. These may include statements about our expected revenues, earnings, expenses or other financial performance, future product performance or development, expected regulatory filings and approvals, planned business transactions, +expected manufacturing performance, views of future industry, competitive or market conditions, and other factors that could affect our future operations, results of operations or financial position. These statements often include words, such as +“believes,” “expects,” “anticipates,” “intends,” “plans,” “estimates,” “may,” “will,” “should,” “could,” or similar expressions. +Forward-looking statements are not guarantees of future performance or results. Known and unknown factors could cause actual performance or results to +be materially different from those expressed or implied in these statements. Factors that could affect our results are discussed more fully under Item 1A., entitled “Risk Factors,” and elsewhere in this Annual Report. Although +forward-looking statements help to provide complete information about us, readers should keep in mind that forward-looking statements may not be reliable. Readers are cautioned not to place undue reliance on the forward-looking statements. The +forward-looking statements are made as of the date of this Annual Report and we undertake no duty to update these statements. +PART I +ITEM 1. Business. +Our business principally involves the development, manufacture, marketing and sale of oral fluid diagnostic products and specimen collection devices using +our proprietary oral fluid technologies, as well as other diagnostic products including immunoassays and other in vitro diagnostic tests that are used on other specimen types, and other medical devices. Our diagnostic products include tests +which are performed on a rapid basis at the point of care and tests which are processed in a laboratory. These products are sold in the United States and internationally to various clinical laboratories, hospitals, clinics, community-based +organizations and other public health organizations, distributors, government agencies, physicians’ offices, and commercial and industrial entities. One of our products has been sold in the over-the-counter (“OTC”) or consumer retail +markets in the United States, Canada, Europe, Mexico and Australia. +In vitro diagnostic testing is the process of analyzing oral +fluid, blood, urine and other bodily fluids or tissue for the presence of specific substances or markers for infectious diseases, drugs of abuse or other conditions. In vitro diagnostic tests are performed outside the body, in contrast to +in vivo tests, which are performed directly on or within the body. The substance or marker that a diagnostic test is intended to detect is generally referred to as an analyte. +Immunodiagnostic testing is the leading method of in vitro testing for antigens and antibodies. When an infectious disease is caused by pathogens, +such as bacteria, viruses and fungi, or other substances are present, the body responds by producing an antibody. Substances that stimulate production of antibodies are generally referred to as antigens. An antibody binds specifically with an +antigen in a lock-and-key fashion that initiates a biochemical reaction to attempt to neutralize and, ultimately, eliminate the antigen. The ability of an antibody to bind with a specific antigen provides the basis for immunodiagnostic testing. +Our Company was formed in May 2000 under Delaware law solely for the purposes of combining two companies, STC Technologies, Inc. +(“STC” or “STC Technologies”) and Epitope, Inc. (“Epitope”), and changing the state of incorporation of Epitope from Oregon to Delaware. STC Technologies and Epitope were merged into our Company on September 29, +2000. Our principal offices are located at 220 East First Street, Bethlehem, Pennsylvania 18015, and our telephone number is (610) 882-1820. +Additional information about us can be found on our website. Our website address is www.orasure.com . We make available free of charge through a link provided at such website our Annual Reports on Form 10-K, our +1 +Table of Contents +Quarterly Reports on Form 10-Q, our Current Reports on Form 8-K and our other filings with the Securities and Exchange Commission (“SEC”), as well +as any amendments to those Reports and filings. These Reports and filings are made available as soon as reasonably practicable after they are filed or furnished to the SEC. Our Internet website and the information contained in or connected to that +website are not intended to be incorporated by reference into this Annual Report. +Products +The following is a summary of our principal products and their regulatory and commercial status: +Product +Description +Regulatory Status +Commercial Status +OraQuick +ADVANCE ® HIV-1/2 +A rapid, point-of-care test for antibodies to the Human Immunodeficiency Virus Type 1 (“HIV-1”) and Type 2 (“HIV-2” and together with HIV-1, “HIV-1/2”) that can be +visually read at the point of care in approximately 20 minutes. +Premarket approval (“PMA”) approved by the U.S. Food and Drug Administration (“FDA”) for use with oral fluid, finger-stick and venous whole blood, and plasma. CLIA (Clinical +Laboratory Improvement Amendments of 1988) waived for use with oral fluid, finger-stick and venous whole blood. Twelve month shelf life approved in December 2008. +Marketed +CE mark (European Union) approved. +Marketed +Registered in the United Kingdom, Ireland, Spain, Mexico, Brazil, and Peru. +Marketed +Registrations filed in Colombia, Argentina, Romania, Croatia, Bosnia and Herzegovina. +Pending +OraQuick ® HIV-1/2 OTC +A rapid, point-of-care oral fluid HIV-1/2 test intended to be sold in various OTC markets. +Clinical trials initiated. Data from observed user study submitted to FDA. +Pending +OraQuick ® HCV +A rapid, point-of-care test for antibodies to the hepatitis C virus (“HCV”). +PMA submitted to FDA in October 2008. Clinical studies for CE mark are in process. +Pending +OraSure ® +Oral fluid collection device for the detection of antibodies to HIV-1 in an oral fluid sample in a laboratory setting. +PMA approved by FDA. +Marketed +FDA 510(k) cleared for use in detecting cocaine and cotinine (an indicator of nicotine) in oral fluid. +Marketed +CE marked and registered in the United Kingdom. Also registered in Mexico, Canada, Columbia, South Africa, Afghanistan, Argentina, Brazil and Trinidad. +Marketed +Intercept ® +Oral fluid collection device, along with nine related immunoassays, for oral fluid drugs of abuse (“DOA”) testing in a laboratory setting. +Collection device—FDA 510(k) cleared. +Marketed +2 +Table of Contents +Product +Description +Regulatory Status +Commercial Status +MICRO-PLATE DOA Assays +Used to detect the following drugs in an oral fluid sample: marijuana, cocaine, opiates, amphetamines, methamphetamines, PCP, benzodiazepines, barbiturates and methadone. +Nine drug assays—FDA 510(k) cleared. +Marketed +Intercept ® device CE marked and registered in the United Kingdom. Various assays are CE marked and registered in the United Kingdom, Austria, Belgium, Denmark, Finland, France, +Germany, Ireland, Italy, Luxembourg, Mexico, Netherlands, Portugal, Spain, Sweden, Korea, Canada, Afghanistan and Brazil. +Marketed +Homogeneous DOA Assays +Homogeneous fully-automated oral fluid DOA assays. +Collaboration with Roche Diagnostics. +In Development +Cryosurgical Systems— Professional +Cryosurgical (freezing) system for the removal of warts and other benign skin lesions, marketed under the Histofreezer ® tradename primarily to the physicians’ +office market. +Nine indications—FDA 510(k) cleared. +Marketed +CE marked and registered in Europe, Canada, Venezuela, Thailand, New Zealand, Hong Kong, Brazil, Mexico, Canada and Afghanistan. +Marketed +Cryosurgical Systems—OTC +Cryosurgical system for the removal of common and plantar warts, sold in various OTC markets. +FDA 510(k) cleared. Sold under new national brand, Freeze ‘n Clear Skin Clinic ™ . +Marketed +Registered in Canada. +Marketed +CE marked and registered in several European countries under Scholl Freeze Spray name. +Marketed +Registered in Mexico, Argentina, Guatemala, Costa Rica, El Salvador and Chile under POINTTS name. +Marketed +Registrations filed in Ecuador, Peru, Brazil, Honduras, and Colombia. +Pending +Cryosurgical Systems—OTC Product Line Extension +Cryosurgical system for an indication other than common warts or plantar warts. +Registrations applied for under POINTTS name in certain South and Central American countries and South Africa. +Pending +FDA 510(k) filed. +Pending +In addition to the above products, we also +sell certain immunoassay tests and reagents for insurance risk assessment, substance abuse testing and forensic toxicology applications; an oral fluid Western blot HIV-1 confirmatory test approved by the FDA for confirming positive HIV-1 test +results obtained from the use of our OraSure ® collection device; and the FDA 510(k) cleared Q.E.D. ® point-of-care saliva alcohol +test. +OraQuick ® +Rapid Test Platform +OraQuick ® is our rapid test platform designed to test oral fluid, whole blood (i.e., both finger-stick and venous), plasma and serum samples for the presence of various antibodies or analytes. The device uses a porous flat pad +to collect an oral fluid specimen. After collection, the pad is inserted into a vial containing a pre-measured amount of developer solution and allowed to develop. When whole blood or plasma is to be tested, a loop collection device is used to +collect a drop of blood or plasma and mix it in the developer solution, after which the collection pad is inserted into the solution and allowed to develop. In all cases, the specimen and +3 +Table of Contents +developer solution then flow through the testing device where test results are observable in approximately 20 minutes. The OraQuick ® device is a screening test and requires a confirmation test where an initial positive result is obtained. +We have commercialized this technology in the form of our OraQuick ADVANCE ® rapid HIV-1/2 antibody test. This is a rapid, point-of-care test which has received FDA approval for the detection of antibodies to both HIV-1 and HIV-2 in oral fluid, finger-stick and venous +whole blood and plasma. This test is available for use by the nearly 40,000 locations in the United States certified under the Clinical Laboratory Improvements Amendment of 1988 (“CLIA”) to perform moderately complex tests. We have also +received a CLIA waiver for use of the OraQuick ADVANCE ® test with oral fluid and finger-stick and venous whole blood. As a result, the test can be used by approximately 140,000 +additional sites in the United States not certified under CLIA to perform moderately complex tests, such as outreach clinics, community-based organizations and physicians’ offices. +On the international front, we have obtained a CE mark for our OraQuick ADVANCE ® test so that we can sell this product in Europe and other countries accepting the CE mark for commercialization. We have distributors in place for the United Kingdom, Ireland, Spain, Russia and +France and are pursuing distribution arrangements in several additional European countries. We are selling the OraQuick ® HIV-1/2 test in Mexico and Africa and are completing registrations +in several countries in Latin America, Asia and the Middle East. We are seeking to expand our distribution network for this product throughout the world. +In late 2008, the FDA approved our request to increase the shelf life for OraQuick +ADVANCE ® to twelve months from the date of manufacture. This approval was based on enhancements we made to the manufacturing process and product packaging for this product and +represented a substantial increase in shelf life from the six months approved for the OraQuick ADVANCE ® test then on the market. OraQuick ® product with twelve month dating became available in the U.S. market in February 2009. In June 2008, we began to sell OraQuick ® tests with twelve month +dating in certain international markets and have submitted the new dating for approval in Europe. +We believe that the OraQuick ADVANCE ® device, because it is approved for detecting antibodies to both HIV-1 and HIV-2 in finger-stick and venous whole +blood, oral fluid and plasma samples, provides a significant competitive advantage in the market for rapid HIV testing in the United States and elsewhere around the world. We also believe the twelve month shelf life recently approved by the FDA +further strengthens the competitiveness of this product. +OraSure ® /Intercept ® Collection Devices +Our OraSure ® oral fluid collection +device is used in conjunction with screening and confirmatory tests for HIV-1 antibodies and other analytes. This device consists of a small, treated cotton-fiber pad on a handle that is placed in a person’s mouth for two to five minutes. The +device collects oral mucosal transudate (“OMT”), a serum-derived fluid that contains higher concentrations of certain antibodies and analytes than saliva. As a result, OMT testing is a highly accurate method for detecting HIV-1 infection +and other analytes. +We believe that oral fluid testing has several significant advantages over blood or urine-based systems for infectious +disease testing, for both health care professionals and the individuals being tested. These advantages include eliminating the risk of needle-stick accidents, providing a non-invasive collection technique, requiring minimal training to administer, +providing rapid and efficient collection in almost any setting, and reducing the cost of administration by a trained health care professional. +HIV-1 antibody detection using the OraSure ® +collection device involves three steps: +• +Collection of an oral fluid specimen using the OraSure ® +device; +4 +Table of Contents +• +Screening of the specimen for HIV-1 antibodies at a laboratory with an enzyme immunoassay (“EIA”) screening +test approved by the FDA for use with the OraSure ® device; and +• +Laboratory confirmation of any positive screening test results with our oral fluid Western blot HIV-1 confirmatory test (described below). +A trained health care professional then conveys test results and provides appropriate counseling to the individual who was tested. +We have received premarket approval from the FDA to sell the OraSure ® collection device for use with a laboratory-based EIA screening test for HIV-1 antibody detection. In the past, this EIA screening test was manufactured and sold by bioMerieux, Inc. +(“BMX”). We have also received FDA 510(k) clearance for use of the OraSure ® collection device with EIAs to test for cocaine and cotinine (a metabolite of nicotine) in oral fluid +specimens primarily for insurance risk assessment purposes. +In 2007, BMX +discontinued manufacturing the HIV-1 EIA screening test. As a result, we are performing clinical studies and plan to seek FDA approval of an alternative HIV-1 EIA screening test for use with oral fluid samples collected with our OraSure ® device. +A collection device +that is substantially similar to the OraSure ® device is sold by us under the name Intercept ® , and is used to collect OMT for oral +fluid drug testing. We have received FDA 510(k) clearance to use the Intercept ® collection device with laboratory-based EIAs to test for drugs of abuse commonly identified by the National +Institute for Drug Abuse (“NIDA”) as the NIDA-5 (i.e., cannabinoids (marijuana), cocaine, opiates, amphetamines/methamphetamines and phencyclidine (“PCP”)), and for barbiturates, methadone and benzodiazepines. Each of these EIAs +is also FDA 510(k) cleared for use with the Intercept ® device. +We have received a CE mark for the Intercept ® +and OraSure ® devices and our oral fluid assays, all of which are distributed in Canada, the United Kingdom and Mexico. The OraSure ® device and our oral fluid drugs of abuse assays are also sold in several other foreign countries. +We believe that the Intercept ® device +has several advantages over competing urine and other drugs-of-abuse testing products, including its lower total testing cost, its non-invasive nature, mobility and accuracy, the ease of maintaining a chain-of-custody, the treatment of test subjects +with greater dignity, no requirement for specially-prepared collection facilities and difficulty of sample adulteration. The availability of an oral fluid test is intended to allow our customers to test for drug impairment, eliminate scheduling +costs and inconvenience, and thereby streamline the testing process. +Cryosurgical Systems (Skin Lesion Removal Products) +The Histofreezer ® +cryosurgical removal system is a low-cost alternative to liquid nitrogen and other methods for removal of warts and other benign skin lesions by physicians. The Histofreezer ® product mixes +three environmentally friendly cryogenic gases in a small aerosol canister. When released, these gases are delivered to a specially designed foam bud, cooling the bud to a maximum of –50°C to –55°C. The frozen bud is then applied +to the wart or lesion for 15 to 40 seconds (depending on the type of lesion) creating localized destruction of the target area by freezing. We have received 510(k) clearance for use of the Histofreezer ® product to remove common warts and eight other types of benign skin lesions, and this product has been CE marked and registered for distribution in Canada, throughout Europe and in certain other foreign countries. +We have also received FDA 510(k) clearance to market and sell a cryosurgical +product similar to the Histofreezer ® product in the OTC or retail market for the removal of common and plantar warts only. Prior to 2008, this product was distributed for us in the United +States and Canadian OTC markets under the name Freeze Off ® by Prestige Brands Holdings, Inc. (“Prestige”), the owner of the Compound W ® line of wart removal products. As a result of a decision in arbitration proceedings with respect to Prestige’s acquisition of the +5 +Table of Contents +competing Wartner ® cryosurgical product line, our agreement with Prestige terminated on +December 31, 2007. In early 2009, we launched our OTC cryosurgical wart product in the U.S. under a new national brand called Freeze ‘n Clear Skin Clinic™. This launch has started with one major retailer, and we will look to expand to +other retailers in the future. +Internationally, we distribute a CE marked cryosurgical wart removal product into the OTC footcare market in +Europe, Australia and New Zealand through our distributor, SSL International plc (“SSL”), under the Scholl and Dr. Scholl trademarks. SSL is the owner of the Scholl and Dr. Scholl trademarks in countries outside North and South +America. We also distribute an OTC cryosurgical product through our distributor Genomma Labs, under the POINTTS tradename, in Mexico, a number of South and Central American countries, and South Africa. +Immunoassay Tests and Reagents +We develop and sell immunoassay tests in two formats, known as MICRO-PLATE and AUTO-LYTE ® , to meet the specific needs of our customers. +In a MICRO-PLATE kit, the sample to be tested is placed into a small plastic receptacle, called a microwell, along with the reagents. The result of the test is determined by the color of the microwell upon completion +of the reaction. Controlling the reaction involves the use of reagents by laboratory personnel. Test results are analyzed by any of a variety of commercially available laboratory instruments, which we may also provide to our laboratory customers. +MICRO-PLATE tests can be performed on commonly used instruments and can detect drugs in urine, serum and sweat specimens. MICRO-PLATE tests are also used as part of the Intercept ® product +line to detect drugs of abuse in oral fluid specimens. +AUTO-LYTE ® tests are sold in the form of bottles of liquid reagents. These reagents are run on commercially available laboratory-based automated analytical instruments, which are manufactured by a variety +of third parties. AUTO-LYTE ® is typically used in high volume, automated, commercial reference insurance laboratories to detect certain drugs or chemicals in urine. Test results are +produced quickly, allowing for high throughput. In recent years, sales of our AUTO-LYTE ® tests have been substantially reduced largely because of competition from cheaper +“home-brew” tests used by our laboratory customers. As a result, we expect to eventually stop selling our AUTO-LYTE ® tests. +Western blot HIV-1 Confirmatory Test +We sell an oral fluid Western blot HIV-1 confirmatory test that received premarket approval from +the FDA in 1996. This test uses the original specimen collected with the OraSure ® oral fluid collection device to confirm positive results of initial oral fluid HIV-1 EIA screening tests. +Our oral fluid Western blot HIV-1 confirmatory test was previously marketed under an exclusive arrangement with BMX. +At the end of 2007, +BMX terminated the agreement under which it supplied the HIV-1 antigen used to manufacture our oral fluid Western blot HIV-1 confirmatory test and the agreement under which it distributed that product on an exclusive, world-wide basis. As a result, +we are now supplying this test directly to our laboratory customers. Pursuant to the terms of our antigen supply agreement with BMX, we purchased an additional two-year supply of the antigen from BMX so that we can continue to manufacture and sell +our oral fluid Western blot test. When this additional two-year supply is combined with our existing inventory of the HIV-1 antigen, we believe we have a sufficient supply of HIV-1 antigen to meet the demand for our Western blot test for at least +the next several years. +Q.E.D. ® Saliva Alcohol Test +Our Q.E.D. ® saliva alcohol test is a point-of-care test device that is a cost-effective alternative to breath or blood alcohol testing. The test is a quantitative, saliva-based method for the detection of +ethanol, has been +6 +Table of Contents +cleared for sale by the FDA and has received a CLIA waiver. The U.S. Department of Transportation (“DOT”) has also approved the test for purchase. +Each Q.E.D. ® test kit +contains a collection stick that is used to collect a sample of saliva and a disposable detection device that displays results in a format similar to a thermometer. The Q.E.D. ® device is +easy to operate and instrumentation is not required to read the result. The product has a testing range of 0 to 0.145% blood alcohol and produces results in approximately two minutes. +Products Under Development +OraQuick ® Platform +We believe that +OraQuick ® has significant potential as a point-of-care testing platform for clinics and other public health entities, hospitals, physicians’ offices and other markets. Because the +OraQuick ® platform is simple to use and can operate in a non-invasive manner with oral fluid, we believe it will be suitable for use by consumers without the assistance of a doctor or other +medical professional. We also believe that OraQuick ® provides a platform technology that can be modified for detection of a variety of infectious diseases in addition to HIV, such as viral +hepatitis and certain sexually transmitted diseases. +We are currently devoting +significant resources to obtaining FDA approval to sell our OraQuick ® HIV-1/2 test in the United States OTC market. We have completed an observed user study and submitted our data to the +FDA. We have also developed an information and referral system and product packaging and labeling suitable for the OTC market. We expect to conduct additional clinical work through 2009, and we intend to submit an application for FDA approval after +our clinical studies are completed. +We have developed a rapid test on the +OraQuick ® platform which can detect antibodies to the Hepatitis C virus, or HCV, in oral fluid, blood, serum and plasma samples. A PMA application for this test was submitted to the FDA in +October 2008. Additional clinical studies required to obtain a CE mark are underway. In addition, during 2008, we obtained rights to a rapid HCV test manufactured by a third party for distribution into certain developing foreign countries. +We have entered into agreements with Schering-Plough Corporation +(“Schering-Plough”) to collaborate on the development and promotion of our OraQuick ® HCV test for use with oral fluid. Under the terms of these agreements, we have been and may be +reimbursed by Schering-Plough for a portion of our costs to develop the test and obtain regulatory approvals, and Schering-Plough will provide detailing and other promotional support for the test in the physicians’ office market in the United +States and internationally. +OraSure ® /Intercept ® Applications +Oral mucosal transudate, or OMT, contains many constituents found in blood and serum, although in +lower concentrations. We believe the OraSure ® and Intercept ® devices are a platform technology with a wide variety of potential +applications, where laboratory testing is available. For example, the OraSure ® device may be useful for the collection of a variety of antibodies or markers for infectious diseases or +conditions in addition to HIV-1, such as antibodies to viral hepatitis. +In 2004, +the Substance Abuse and Mental Health Services Administration (“SAMHSA”) issued proposed regulations for oral fluid drug testing for federal workers. These proposed regulations have since been withdrawn. If and when reissued in final form, +these regulations may require certain modifications to our Intercept ® product in order to permit its use by federal workers. As a result, we are developing modifications to the +Intercept ® collection device that we anticipate will be required by these regulations or are otherwise likely to be desired by our customers. +We are also currently developing additional drugs of abuse assays for use with our Intercept ® collection device. In 2008, we signed a development agreement with Roche Diagnostics for homogeneous fully-automated +7 +Table of Contents +oral fluid drugs of abuse assays that can be run on random access chemistry analyzers. The oral fluid assays are being developed for use with our +Intercept ® collection device and Roche’s KIMS (kinetic information of microparticles in solution) technology. The assays will run on various automated analyzers to allow oral fluid +samples to be processed with the same efficiency currently achieved with urine-based drug tests. Assays for cocaine, opiates, methamphetamine, amphetamine, PCP and cannabinoids (marijuana) have been developed and are being transferred to +manufacturing by Roche. We are currently negotiating a commercialization agreement with Roche pursuant to which a drug testing system comprised of our Intercept ® device and the newly +developed homogeneous assays will be marketed and sold on a worldwide basis. +OTC Cryosurgical Systems Products +We currently sell our Histofreezer ® +cryosurgical systems product in the physicians’ office or professional market. This product has been approved by the FDA for the treatment of a total of nine different types of benign skin lesions. Our OTC cryosurgical product has been approved +by the FDA for two types of skin lesions – common warts and plantar warts. +We +believe that one or more of the seven remaining Histofreezer ® indications may be attractive to the OTC market. We have submitted an application for FDA 510(k) clearance of an OTC +cryosurgical product for one of these indications and that application remains pending before the FDA. +Business Strategy +We have adopted a multi-part growth strategy, pursuant to which we intend to leverage our extensive diagnostic experience in order to maximize the +available opportunities from our existing products and technologies, and supplement our existing product pipeline by accessing other technologies and products. We intend to follow a disciplined approach to maximize the value of our business for the +benefit of our stockholders. +Our overall vision is to become a recognized global leader focused on providing innovative diagnostic +solutions that add substantial value to existing and emerging healthcare needs. In order to achieve this vision, our business strategy includes the following key elements: +• +Extension of Base Businesses . We intend to maximize the sales potential of our existing +product lines and technologies in the markets where they are currently sold, with a focus on expanding, where possible, the number of our oral fluid product offerings. Under this part of the strategy, we intend to fully capitalize on the potential +market reach of our OraQuick ® , OraSure ® , Intercept ® , +Histofreezer ® and OTC cryosurgical products by investing in our sales and marketing efforts where appropriate, making product improvements and enhancements, and optimizing our distribution +channels. We also intend to expand the reach of our existing products and technology platforms into new markets and will focus specifically on expanding into international markets. +• +Infectious Disease Testing . We will pursue new products and technology platforms in the +infectious disease, point-of-care testing business to supplement our existing product pipeline. This may include either the development of new infectious disease products or the acquisition of new technologies or products. An important new product +that we recently developed is a rapid HCV test on our OraQuick ® platform and we have acquired distribution rights in certain African countries to a rapid HCV test manufactured by a third +party. +• +OTC Opportunities . We intend to identify or develop products that can be sold in the OTC +or retail marketplace. A significant opportunity that we are pursuing as part of this strategy is to seek FDA approval to sell our OraQuick ® rapid HIV-1/2 antibody test in the United States +OTC market. We have also relaunched our OTC cryosurgical product in the United States on a limited basis under our new national brand, Freeze ‘n Clear Skin Clinic™, and plan to expand the international sale of our OTC cryosurgical product. +8 +Table of Contents +• +Operational Improvements . We intend to remain focused on the continuous improvement of our operations. These improvements will +include, but not be limited to, expanding the use of automated manufacturing for our product lines as demand increases, expanding the global sourcing of components and assemblies to achieve efficiencies and cost improvements, making infrastructure +and information technology investments as needed to improve effectiveness and productivity, and modifying our processes in order to continuously improve quality and the effectiveness of our operations. +Research and Development +In 2008, our research and development activities focused primarily on the development of a rapid HCV test using our OraQuick ® technology platform, clinical +and regulatory activities related to obtaining PMA approval for our OraQuick ® HCV test, clinical work to obtain FDA approval for use of an OraQuick ® HIV test in the United States OTC market, and development of certain improvements to existing products in the OraQuick ® , Intercept ® and cryosurgical wart removal product lines. +From time to time, we may also +contract with third parties to conduct research and development activities and we may continue to do so in the future. +Research and +development expenses totaled $20.3 million in 2008, $14.1 million in 2007 and $8.6 million in 2006. These expenses include our costs associated with research and development, regulatory affairs, clinical trials and product support. +Sales and Marketing +We attempt to reach our major +target markets through a combination of direct sales, strategic partnerships and independent distributors. Our marketing strategy is to create or raise awareness through a full array of marketing activities, which include trade shows, print +advertising, special programs and distributor promotions, in order to stimulate sales in each target market. +We market our products in the +United States and internationally. Revenues attributable to customers in the United States were $57.4 million, $64.6 million and $56.8 million in 2008, 2007 and 2006, respectively. Revenues attributable to international customers amounted to $13.7 +million, $18.1 million and $11.4 million, or 19%, 22% and 17% of our total revenues, in 2008, 2007 and 2006, respectively. +Infectious +Disease Testing +We market the OraQuick ADVANCE ® rapid HIV-1/2 antibody test directly to customers in the public health market for HIV testing. This market consists of a broad range of clinics and laboratories and includes states, counties, +the Centers for Disease Control and Prevention (“CDC”), SAMHSA and other governmental agencies, family planning clinics, colleges and universities, correctional facilities and the military. There are also a number of organizations in the +public health market, such as AIDS service organizations and various community-based organizations set up primarily for the purpose of encouraging and enabling HIV testing. +Since November 2002, Abbott Laboratories (“Abbott”) had been our exclusive distributor +of OraQuick ® in the U.S. hospital market and non-exclusive distributor in the U.S. physicians’ office marketplace. Our agreement with Abbott was terminated at the end of 2008. As a +result, we are now selling OraQuick ADVANCE ® directly to U.S. hospitals and will continue to sell to U.S. physician offices through distributors. In anticipation of the transition of +this business, we increased the size of our hospital sales force and added additional inside sales, customer service and sales support resources. In addition to selling OraQuick ADVANCE ® +to hospitals, we expect our hospital sales force to eventually sell new products to this market, including our OraQuick ® HCV test, once FDA approval is obtained. +9 +Table of Contents +We currently distribute our OraQuick ® test in several foreign countries. During 2007, we obtained a CE mark for this product and launched sales in the United Kingdom, Ireland and Spain. We expect to increase the number of countries +where this product is sold as we find new distributors and complete registrations in additional countries. +We also market the OraSure ® oral fluid collection device for HIV-1 testing, on its own and as a kit in combination with laboratory testing services. To +better serve our public health customers, we have contracted with two commercial laboratories to provide prepackaged OraSure ® test kits, with prepaid laboratory testing and specimen +shipping costs included. We also sell the OraSure ® device in the international public health market. +In October 2008, we submitted a PMA application with the FDA for approval of a rapid HCV test +using the OraQuick ® platform, and plan to apply for CLIA waiver, a CE mark and other international registrations. We intend to sell this product on a worldwide basis. We have entered into +agreements with Schering-Plough to collaborate on the development and promotion of our OraQuick ® HCV test for use with oral fluid. Under the terms of these agreements, we have been and may +be reimbursed by Schering-Plough for a portion of our costs to develop the test and obtain regulatory approvals, and Schering-Plough will provide detailing and other promotional support for the test in the physicians’ office market in the +United States and internationally. +Substance Abuse Testing +Our substance abuse testing products are marketed to laboratories serving the workplace testing, forensic toxicology, criminal justice and drug +rehabilitation markets. +We have entered into agreements for the distribution of +Intercept ® collection devices and associated MICRO-PLATE assays for drugs-of-abuse testing in the workplace testing market in the United States and Canada through several laboratory +distributors, including Quest Diagnostics (“Quest”) and Clinical Reference Laboratory, and internationally for workplace, criminal justice and forensic toxicology testing through Bio-Rad Laboratories, Concateno (which acquired our prior +distributor, Altrix HealthCare, plc) and other distributors. In some cases, we assist our laboratory customers in customizing their testing services by selling them equipment required to test oral fluid specimens collected with the Intercept ® device. +We also market the +Intercept ® collection device on its own and as a kit in combination with laboratory testing services. To better serve our workplace customers, we have contracted with two commercial +laboratories to provide prepackaged OraSure ® test kits, with prepaid laboratory testing and specimen shipping costs included. +The criminal justice market in the United States for our substance abuse testing products consists of a wide variety of entities in the criminal justice +system that require drug screening, such as pre-trial services, parole and probation officials, police forces, drug courts, prisons, drug treatment programs and community/family service programs. The forensic toxicology market consists of several +hundred laboratories including federal, state and county crime laboratories, medical examiner laboratories and reference laboratories. +We also distribute our Q.E.D. ® saliva +alcohol test primarily through various distributors in the United States and internationally. The markets for alcohol testing are relatively small and fragmented with a broad range of legal and procedural barriers to entry. Markets range from law +enforcement testing to workplace testing of employees in safety sensitive occupations. Typical usage situations include pre-employment, random, post-accident, reasonable-cause and return-to-duty testing. +Cryosurgical Systems +Most of our Histofreezer ® sales occur +in the United States to distributors that, in turn, resell the product to primary care physicians and podiatrists in the United States. Our major U.S. distributors include Cardinal Healthcare, McKesson HBOC, Physicians Sales & Service, +AmerisourceBergen Corporation, and Henry Schein. Internationally, we sell the Histofreezer ® product through a network of distributors in more than 20 countries worldwide. +10 +Table of Contents +In past years, we sold a cryosurgical wart removal +product similar to Histofreezer ® in the OTC market in the United States and Canada pursuant to a distribution agreement with Prestige, the owner of the Compound W ® line of wart removal products. That distribution agreement terminated at the end of 2007. In early 2009, we launched our OTC cryosurgical wart product in the U.S. under a new national +proprietary brand called Freeze ‘n Clear Skin Clinic™. This launch has started with one major retailer, and we intend to expand to other retailers in the future. +Additionally, we distribute cryosurgical wart removal products in the OTC footcare market in Europe, Australia and New Zealand through our distributor, +SSL, under its Scholl and Dr. Scholl tradenames, and in the OTC markets in Mexico and several Central and South American countries under the POINTTS tradename through our distributor, Genomma Labs. +Insurance Risk Assessment +We currently market the OraSure ® oral +fluid collection device for use in screening life insurance applicants in the United States and internationally to test for three of the most important underwriting risk factors: HIV-1, cocaine and cotinine (a metabolite of nicotine). Devices are +sold to insurance testing laboratories, including Quest, Heritage Labs and Clinical Reference Laboratory. These laboratories in turn provide the devices to insurance companies, usually in combination with testing services. +We also promote use of the OraSure ® +device directly to insurance companies for life insurance risk assessment. Insurance companies then make their own decision regarding which laboratory to use to supply their collection devices and testing services. Our OraSure ® Western blot confirmatory test was previously distributed through BMX to laboratories and is used to confirm oral fluid specimens collected with our OraSure ® device that initially test positive for HIV-1. Because BMX elected not to renew the Western blot agreements after December 31, 2007, we now distribute the Western blot test directly to our laboratory customers. +Because insurance companies are in various stages of their adoption of the +OraSure ® device, there exists a wide range of policy limits where the product is being applied. Some insurance companies have chosen to extend their testing to lower policy limits where +they did not test at all before, while others have used OraSure ® to replace some of their blood and urine-based testing. In general, most of our insurance company customers use the +OraSure ® device in connection with life insurance policies having face amounts of up to $250,000, with some customers using the device for policies of up to $500,000 in amount. +In recent years, we have experienced a decline in sales of OraSure ® and related assays for insurance testing, primarily due to a reduction in the number of applications for life insurance policies and changes in underwriting requirements, as well as some consolidation in the industry +leading to a reevaluation of testing methods. +We also sell our AUTO-LYTE ® assays and reagents in the insurance testing market directly to laboratories, including Heritage Labs and Clinical Reference Laboratory. +International Markets +We sell most +of our products into international markets primarily through distributors with knowledge of their local markets. Principal markets include foreign governments, physicians’ offices, insurance risk assessment, substance abuse, public health and +laboratory testing. +We assist our international distributors in registering the products and obtaining required regulatory approvals in +each country, and we provide training and support materials. Our international marketing program includes direct assistance to distributors in arranging for laboratory services, cooperation from screening test manufacturers and performance of +Western blot confirmatory tests when necessary. +11 +Table of Contents +Significant Products and Customers +Several different products have contributed significantly to our financial performance, accounting +for 10% or more of our total revenues during the past three years. The OraQuick ® rapid HIV testing products, the cryosurgical systems products, and the OraSure ® and Intercept ® oral fluid collection devices accounted for total revenues of $35.3 million, $10.7 million and $13.6 million in 2008, $32.7 million, $23.5 +million and $15.5 million in 2007, and $25.6 million, $17.3 million and $15.1 million in 2006, respectively. +We had two customers, Quest and Abbott, which each accounted for 10% of our total revenues during 2008. Our distribution agreement with Abbott terminated at the end of 2008, and we are now selling OraQuick +ADVANCE ® directly to hospitals and other customers previously served by Abbott. The loss of Quest, or a significant decrease in the volume of products purchased by this customer, +could have a material adverse effect on our financial results. +Revenue by Segment +We operate our business within one reportable segment and all of our revenues are generated from this one segment. Our net revenue is generated by our +product sales and licensing and product development activities. For more information about our revenues from external customers, income and total assets, please see the sections entitled “Selected Financial Data” and +“Management’s Discussion and Analysis of Financial Condition and Results of Operations” and Note 13 to the financial statements, included elsewhere in this Annual Report. +Supply and Manufacturing +We manufacture our +OraQuick ADVANCE ® test in our Bethlehem, Pennsylvania facility. In addition, we have contracted with a third party in Thailand for the assembly of the OraQuick ® device, in order to supply certain international markets. This supply agreement had an initial term of one year, and automatically renews for additional annual periods unless either party +provides a timely notice of termination prior to the end of an annual period. We believe that other firms would be able to manufacture the OraQuick ® test on terms no less favorable than +those set forth in the agreement if the Thailand contractor would be unable or unwilling to continue manufacturing this product. +We can purchase the HIV antigen and the nitrocellulose required for the OraQuick ® test only from a limited number of sources. We currently purchase the antigen from a single contract supplier under a long-term agreement with an initial term ending in 2010 and one-year +automatic renewal terms thereafter. We also purchase the nitrocellulose used in the test from a single vendor, under a supply agreement with a five-year term ending in 2009. We intend to renew this agreement prior to its expiration. If for any +reason these suppliers are unwilling or no longer able to supply our antigen or nitrocellulose needs, we believe that alternative supplies could be obtained at a competitive cost. However, a change in the antigen or nitrocellulose would require FDA +approval and some additional development work. This in turn would require significant time to complete and could disrupt our ability to manufacture and sell the OraQuick ® device. +We manufacture both the OraSure ® and Intercept ® collection devices in our Bethlehem, Pennsylvania facility, and we expect to continue to do so for the foreseeable future. +The oral fluid Western blot HIV-1 confirmatory test is currently manufactured in our Bethlehem, Pennsylvania facility. The HIV antigen needed to +manufacture the Western blot test is currently available from only a limited number of sources. For many years, we purchased the antigen for this product from BMX on an exclusive basis. Our agreement with BMX for the supply of HIV-1 antigen +terminated on December 31, 2007. As a result, we purchased an additional two-year supply of the antigen from BMX as permitted under the agreement. When this additional supply is combined with our existing inventory of the HIV-1 antigen, we +believe we have a sufficient supply of the HIV-1 antigen to meet the demand for our Western blot test for at least the next several years. +12 +Table of Contents +Histofreezer ® is assembled in The Netherlands by Koninklijke, Utermöhlen, N.V. (“Utermöhlen”), the company from which we acquired the product in 1998. We purchase the product pursuant to an exclusive production +agreement. The cryosurgical wart removal products distributed in OTC markets are supplied by vendors located in the United States. We believe that additional suppliers of all of our cryosurgical products are available on terms no less favorable than +the terms of our existing supply agreements in the event that our current suppliers would be unable or unwilling to continue manufacturing these products. +Our AUTO-LYTE ® and MICRO-PLATE assays +are manufactured in our Bethlehem, Pennsylvania facility. These tests require the production of highly specific and sensitive antibodies corresponding to the antigen of interest. Substantially all our antibody requirements are provided by contract +suppliers. We believe that we have adequate reserves of antibody supplies and that we have access to sufficient raw materials for these products. +The Q.E.D. ® saliva alcohol test is +manufactured and packaged for shipment in our Bethlehem, Pennsylvania facility. +Employees +As of December 31, 2008, we had 287 full-time employees, including 84 in sales, marketing and client services; 16 in research and development; 136 in +operations, manufacturing, quality control, information systems, purchasing and shipping; 24 in regulatory affairs; and 27 in administration and finance. This compares to 290 employees as of December 31, 2007. Our employees are not currently +represented by a collective bargaining agreement. +In light of the ongoing negative +economic conditions, we re-examined our staffing levels and, in December 2008, we eliminated 18 positions in order to reduce our future costs. At the same time, we refocused our resources on parts of our business having the greatest strategic +impact. A primary example was the expansion of our sales force and related support functions needed to implement a direct hospital sales model for our OraQuick ADVANCE ® HIV-1/2 test. +We believe these actions were necessary to lower our costs where possible while taking steps to ensure the future success of our business. +Competition +The diagnostic industry is a multi-billion dollar international industry and is intensely competitive. Many of our competitors are +substantially larger than we are, and they have greater financial, research, manufacturing and marketing resources. +Important competitive +factors for our products include product quality, performance, price, ease of use, customer service and reputation. Industry competition is based on the following: +• +Scientific and technological capability; +• +Proprietary know-how; +• +The ability to develop and market products and processes; +• +The ability to obtain FDA or other regulatory approvals; +• +The ability to manufacture products that meet applicable FDA requirements (i.e., good manufacturing practices); +• +Access to adequate capital; +• +The ability to attract and retain qualified personnel; and +• +The availability of patent protection. +13 +Table of Contents +A few large corporations produce a wide variety of diagnostic tests and other medical devices and +equipment. A larger number of mid-size companies generally compete only in the diagnostic industry and a significant number of small companies produce only a few diagnostic products. As a result, the diagnostic test industry is highly fragmented and +segmented. +The future market for diagnostic tests is expected to be characterized by consolidation, greater cost consciousness and tighter +reimbursement policies. The purchasers of diagnostic products are expected to place increased emphasis on lowering costs, reducing inventory levels, automation, service and volume discounts. The increased complexity of the market is expected to +force many competitors to enter into joint ventures or license certain products or technologies. +We expect competition to intensify as +technological advances are made and become more widely known, and as new products reach the market. Furthermore, new testing methodologies could be developed in the future that render our products impractical, uneconomical or obsolete. There can be +no assurance that our competitors will not succeed in developing or marketing technologies and products that are more effective than those we develop or that would render our technologies and products obsolete or otherwise commercially unattractive. +In addition, there can be no assurance that our competitors will not succeed in obtaining regulatory approval for these products, or introduce or commercialize them, before we can do so. These developments could have a material adverse effect on our +business, financial condition and results of operations. +Several companies market +or have announced plans to market oral specimen collection devices and tests both within and outside the United States. We expect the number of devices competing with our Intercept ® , +OraQuick ® and OraSure ® devices to increase as the benefits of oral fluid-based testing become more widely accepted. +Competition in the HIV testing market is intense and is expected to increase. We believe that the principal competition will come from existing +laboratory-based blood tests, point-of-care rapid blood tests, laboratory-based urine assays or other oral fluid-based tests that may be developed. Our competitors include specialized biotechnology firms, as well as pharmaceutical companies with +biotechnology divisions and medical diagnostic companies. +Significant competitors +for our OraQuick ADVANCE ® rapid test, such as the Ortho Diagnostics division of Johnson & Johnson, Bio-Rad Laboratories and Abbott, sell laboratory-based HIV-1/2 EIAs, and +Maxim Biomedical (formerly Calypte, Inc.) sells an HIV-1 screening test for urine, in the United States. MedMira and Trinity Biotech each sell competing rapid HIV-1 blood tests, and Bio-Rad Laboratories and Inverness Medical/Chembio sell competing +rapid HIV-1/2 blood tests in the United States. These tests compete with our OraQuick ADVANCE ® test in hospitals and other laboratory settings. In addition, Trinity Biotech and +Inverness Medical/ Chembio have received CLIA waivers for their rapid HIV tests, and these tests compete with our OraQuick ADVANCE ® test in the markets outside of the traditional +hospital and laboratory settings. These companies, or others, may continue to expand the bodily fluids with which a rapid HIV test may be performed, or develop and commercialize new rapid HIV tests, which would provide further competition for our +OraQuick ADVANCE ® test. We believe other companies may also seek FDA approval to sell competing rapid HIV tests in the future. +Internationally, our OraQuick ADVANCE ® +test competes against rapid HIV tests sold by a number of other entities, and often these competing tests are sold at prices substantially below the prices we charge for our OraQuick ADVANCE ® test. Inverness Medical sells a rapid HIV-1/2 blood test outside the United States and Calypte has developed a rapid oral fluid HIV test which is now being sold in certain foreign countries. Lower priced rapid HIV +blood tests are also sold internationally by various third parties. +The +Intercept ® drug testing system competes with laboratory-based drug testing products and services using testing matrices such as urine, hair, sweat and oral fluid. Major competitors include +Ansys Technologies, Inc., Dade Behring, Psychemedics and Immunalysis. +14 +Table of Contents +Our MICRO-PLATE oral fluid drug assays, which are +sold for use with the Intercept ® and OraSure ® collection devices, continue to come under increasing competitive pressure from +“home-brew” assays developed internally by our laboratory customers. Our oral fluid MICRO-PLATE assays also compete with urine-based homogeneous assays that are run on fully-automated, random access analyzers. These tests provide strong +competitive pressure because they provide the benefits of automation, including lower costs and short turn-around times. In addition, we believe our competitors are developing oral fluid tests suitable for use on these fully automated homogeneous +assay systems and these assays, if and when they are developed and commercialized, will represent a significant competitive threat to our oral fluid MICRO-PLATE business. In order to meet this competition, we are developing fully-automated +homogeneous oral fluid drugs of abuse assays with Roche Diagnostics for use with our Intercept ® device. +Our MICRO-PLATE drugs-of-abuse reagents sold in the forensic toxicology market are targeted to forensic testing laboratories where sensitivity, automation and “system solutions” are important. In the past, +these laboratories have typically had to rely on radioimmunoassay test methods to provide an adequate level of sensitivity. Radioimmunoassays require radioactive materials, which have a short shelf-life and disposal problems. Our MICRO-PLATE tests +meet the laboratories’ sensitivity needs, run on automated equipment, are not radioimmunoassays, and are offered to the laboratory as a complete system solution of reagents, instrumentation and software to meet the specific needs of each +customer. We compete with both homogeneous and heterogeneous tests manufactured by many companies. Significant competitors in the market for these assays include Microgenics, Inc., Roche Diagnostics and Immunalysis. +Sales of our AUTO-LYTE ® urine assays +have declined substantially during the past several years, primarily due to competition from “home-brew” assays developed internally by our laboratory customers, which can be produced at a cost lower than the price typically paid for our +products. Many of our customers no longer purchase our AUTO-LYTE ® assays, and we eventually expect to stop selling this product line. +The Histofreezer ® product’s +delivery system and operating temperature, which is warmer than liquid nitrogen, provide us with the opportunity to target sales to primary care physicians, such as family practitioners, pediatricians and podiatrists. We do not generally target +sales to dermatologists because they have the volume of patients required to support the capital costs associated with a liquid nitrogen delivery system, which is also used to remove warts and other benign skin lesions. Major competitors for the +Histofreezer ® product include Cryosurgery, Inc. in the United States and Wartner in Europe. +Competition in the United States and Canadian OTC markets comes primarily from cryosurgical +products sold by Schering-Plough under the Dr. Scholl’s ® brand and by Prestige under the Compound W ® and Wartner ® tradenames. Salicylic acid wart removal products also compete against our OTC cryosurgical product. Internationally, our OTC products compete against cryosurgical products sold by Wartner and +several other firms. +Q.E.D. ® +has two direct competitors, Ansys Technologies, Inc. and Chematics. These companies offer semi-quantitative saliva-based alcohol tests and have received DOT approval. Indirect competitors who offer breath testing equipment include +Intoximeters, Dräger and CMI. Although there are lower priced tests on the market that use oral fluid or breath as a test medium, these tests are qualitative tests that are believed to be substantially lower in quality and provide fewer +benefits than our Q.E.D. ® test. +Patents and Proprietary Information +We seek patents and other intellectual property rights to protect and preserve our proprietary technology and our right to capitalize on the results of +our research and development activities. We also rely on trade secrets, know-how, continuing technological innovations and licensing opportunities to provide competitive advantages for our products in our markets and to accelerate new product +introductions. We regularly search for third-party patents in fields related to our business to shape our own patent and product commercialization strategies as +15 +Table of Contents +effectively as possible and to identify licensing opportunities. United States patents generally have a maximum term of 20 years from the date an application +is filed. +We have ten United States patents and numerous foreign patents for the +OraSure ® and Intercept ® collection devices and technology relating to oral fluid collection, containers for oral fluids, methods +to test oral fluid, formulations for the manufacture of synthetic oral fluid, and methods to control the volume of oral fluid collected and dispersed. The patents expire from April 2009 to March 2018. We have also applied for additional patents, in +both the United States and certain foreign countries, on such products and technology. +We have two United States patents for our OraQuick ADVANCE ® rapid HIV-1/2 antibody test, and we have several related patent applications pending for this product in the +United States and internationally. These patents expire from March to April 2019. We have obtained licenses to certain lateral flow patents and to certain HIV-1 and HIV-2 patents held by other parties. We also have obtained a license to certain HCV +patents which we intend to use to manufacture and sell a rapid HCV test on the OraQuick ® or other technology platforms. We obtained these licenses through the payment of certain upfront +fees and an agreement to pay ongoing royalties. We believe these fees and royalties are comparable to those generally paid by other companies under similar arrangements. +We may need to obtain licenses or other rights under, or enter into distribution or other business +arrangements in connection with, certain other intellectual property patents in order to manufacture and sell the OraQuick ADVANCE ® test or other tests that use the same or similar +technology platform. See Section 1A, entitled “Risk Factors,” for a further discussion of these issues. +We have four United +States patents and numerous foreign patents issued for apparatuses and methods for the topical removal of skin lesions relating to our cryosurgical wart removal products, and we have pending patent applications related to these products in the +United States and in certain foreign countries. These patents expire from July 2012 to August 2013. We have also licensed another patent relating to apparatuses and methods for the topical removal of skin lesions relating to our cryosurgical wart +removal products. +We have two United States patents and numerous foreign patents +and patent applications for the technology used in the Q.E.D. ® test. These patents expire from May to August 2009. These patents are related to the analog-to-digital technology color +control systems and methods, systems and devices for the test, and detection of biochemical molecules. +We require our employees, +consultants, outside collaborators and other advisors to execute confidentiality agreements upon the commencement of employment or consulting relationships with us. These agreements provide that all confidential information developed by or made +known to the individual during the course of the individual’s relationship with us is to be kept confidential and not disclosed to third parties except in specific circumstances. In the case of employees, the agreements provide that all +inventions conceived by the individual during his or her tenure with us will be our exclusive property. +We own rights to trademarks and service marks that we believe are necessary to conduct our business as currently operated. In the United States, we own the OraSure ® +, Intercept ® , OraQuick ® , OraQuick ADVANCE ® , +Histofreezer ® , Freeze ‘n Clear Skin Clinic™, Q.E.D. ® and AUTO-LYTE ® trademarks. We also own many of these marks and others in several foreign countries. With respect to our international OTC cryosurgical products, the Scholl and Dr. Scholl tradenames are owned by SSL in Europe, +Australia, New Zealand and other countries outside North and South America, and the POINTTS tradename is owned by Genomma Labs. +Although +important, the issuance of a patent or existence of trademark or trade secret protection does not in itself ensure the success of our business. Competitors may be able to produce products competing with our patented products without infringing our +patent rights. Issuance of a patent in one country generally does not prevent manufacture or sale of the patented product in other countries. The issuance of a patent is not conclusive +16 +Table of Contents +as to validity or as to the enforceable scope of the patent. The validity or enforceability of a patent can be challenged by litigation after its issuance. +If the outcome of such litigation is adverse to the owner of the patent, the owner’s rights could be diminished or withdrawn. Trade secret protection does not prevent independent discovery and exploitation of the secret product or technique. +Government Regulation +General +Most of our products are regulated by the FDA, certain state and local agencies and comparable regulatory bodies in other countries. This +regulated environment governs almost all aspects of development, production and marketing, including product testing, authorizations to market, labeling, promotion, manufacturing and recordkeeping. +All of our FDA-regulated products require some form of action by the FDA before they can be marketed in the United States. After approval or clearance by +the FDA, we must continue to comply with other FDA requirements applicable to marketed products. Both before and after approval or clearance, failure to comply with the FDA’s requirements can lead to significant penalties or could disrupt our +ability to manufacture and sell these products. In addition, the FDA could refuse permission to obtain certificates needed to export our products if the agency determines that we are not in compliance. +Domestic Regulation +Most of our +products are regulated in the United States as medical devices. +There are two mechanisms by which regulated medical devices can be placed +on the market in the United States. Some products may qualify for clearance under Section 510(k) of the Federal Food, Drug and Cosmetic Act. To obtain this clearance from the FDA, the manufacturer must provide a premarket notification that it +intends to begin marketing the product, and show that the product is substantially equivalent to another legally marketed product (i.e., that it has the same intended use and is as safe and effective as a legally marketed device and does not raise +different questions of safety and effectiveness). In some cases, the submission must include data from human clinical studies. Marketing may only commence when the FDA issues a clearance letter finding substantial equivalence. An applicant must +submit a 510(k) application at least 90 days before marketing of the affected product commences. Although FDA clearance may be granted within that 90-day period, in some cases as much as a year or more may be required before clearance is obtained, +if at all. +If the medical device does not qualify for the 510(k) procedure (either because it is not substantially equivalent to a legally +marketed device or because it is required by statute and the FDA’s regulations to have an approved premarket application, or PMA), the FDA must approve a PMA before marketing can begin. PMAs must demonstrate, among other matters, that the +medical device provides a reasonable assurance of safety and effectiveness. A PMA is typically a complex submission, including the results of preclinical and clinical studies. Preparing a PMA is a detailed and time-consuming process. Once a PMA has +been submitted, the FDA is required to review the submission within 180 days. However, the FDA’s review may, and often is, much longer, often requiring one year or more, and may include requests for additional data and facility inspections +before approval is granted, if at all. +Some of our products are used for non-medical purposes and many of our drugs-of-abuse products sold +to state crime laboratories are for forensic use. The FDA does not currently regulate products used for these purposes. +Every company that +manufactures medical devices distributed in the United States must comply with the FDA’s Quality System Regulations (“QSRs”). These regulations govern the manufacturing process, including +17 +Table of Contents +design, manufacture, testing, release, packaging, distribution, documentation and purchasing. In complying with the QSRs, manufacturers must continue to +expend time, money and effort in the area of production and quality to ensure full technical compliance. Companies are also subject to other post-market and general requirements, including restrictions imposed on marketed products, promotional +standards and requirements for recordkeeping and reporting of certain adverse reactions. If there are any modifications made to our marketed devices, a premarket notification or PMA may be required to be submitted to, and cleared or approved by, the +FDA, before the modified device may be marketed. The FDA regularly inspects companies to determine compliance with the QSRs and other post-market requirements. Failure to comply with statutory requirements and the FDA’s regulations can result +in warning letters, monetary penalties, suspension or withdrawal of regulatory approvals, operating restrictions, total or partial suspension of production, injunctions, product recalls, seizure of products and criminal prosecution. +The Clinical Laboratory Improvements Amendments of 1988, or CLIA, prohibit laboratories from +performing tests for the purpose of providing information for the diagnosis, prevention or treatment of any disease or impairment of, or the assessment of, the health of human beings, unless there is in effect for such laboratories a certificate +issued by the U.S. Department of Health and Human Services applicable to the category of examination or procedure performed. We consider the applicability of the requirements of CLIA in the design and development of our products. We have obtained a +waiver of the CLIA requirements for both our OraQuick ADVANCE ® rapid HIV-1/2 antibody test and our Q.E.D. ® alcohol saliva +test and may seek similar waivers for certain other products. A CLIA waiver allows certain customers to use the waived products that may not have been able to use them without complying with certain quality control and other requirements. +Certain of our products may also be affected by state regulations in the United States. For example, there are several states that +restrict or do not currently permit oral fluid drug testing in the workplace or other markets. In addition, several states prohibit or limit the use of rapid, point-of-care HIV testing. We are presently working with legislators or regulators in +certain of these states in an effort to modify or remove any restrictions affecting our ability to sell products. +International +We are also subject to regulations in foreign countries governing products, human clinical trials and marketing, and may need to obtain +approval from international public health agencies, such as the World Health Organization, in order to sell products in certain countries. Approval processes vary from country to country, and the length of time required for approval or to obtain +other clearances may in some cases be longer than that required for U.S. governmental approvals. We generally pursue approval only in those countries that we believe have a significant market opportunity. +The International Organization for Standardization (“ISO”) is a worldwide federation of national standards bodies from some 130 countries, +established in 1947. The mission of the ISO is to promote the development of standardization and related activities in the world with a view to facilitating the international exchange of goods and services. ISO certification is a pre-requisite to +use of the CE mark and indicates that our quality system complies with standards applicable to activities ranging from initial product design and development through production and distribution. The CE mark is a European Union (“EU”) +requirement to sell products that fall under the scope of the Medical Devices Directive (“MDD”) and the In Vitro Diagnostic Directive (“IVDD”). The CE mark is evidence that the manufacturer and the product meet the requirements +of all applicable directives, including the MDD and IVDD. +We received authorization +to use the CE mark for the OraQuick ADVANCE ® rapid HIV-1/2 test, the OraSure ® and Intercept ® collection devices and our Histofreezer ® product line, and SSL has obtained authorization to use the CE mark for our cryosurgical wart removal product in +the OTC European footcare market. +18 +Table of Contents +We must also comply with certain registration requirements as dictated by Health Canada, prior to +commencing sales in Canada. We have completed this process for several of our current products and may do so with respect to other products in the future. In addition, Canadian law requires manufacturers of medical devices to have a quality +management system that meets various ISO requirements in order to obtain a license to sell their devices in Canada. +Anti-Kickback Laws +The Federal Anti-Kickback Statute prohibits the knowing and willful offer, payment, solicitation, or receipt of any form of +remuneration in return for, or to induce: +• +The referral of a person; +• +The furnishing or arranging for the furnishing of items or services reimbursable under Medicare, Medicaid or other governmental programs; or +• +The purchase, lease, or order of, or the arrangement or recommendation of the purchasing, leasing, or ordering of any item or service reimbursable under Medicare, +Medicaid, or other governmental programs. +Our products are or may be purchased by customers that will seek or receive +reimbursement under Medicare, Medicaid or other governmental programs. Noncompliance with the federal anti-kickback legislation can result in exclusion from Medicare, Medicaid or other governmental programs, and/or restrictions on our ability to +operate in certain jurisdictions, as well as civil and criminal penalties, any of which could have an adverse effect on our business and results of operations. +The Federal Civil Monetary Penalties Law prohibits the offering or transferring of remuneration to a Medicare or Medicaid beneficiary that the person knows or should know is likely to influence the beneficiary’s +selection of a particular supplier of Medicare or Medicaid payable items or services. Noncompliance can result in civil money penalties of up to $10,000 for each wrongful act, assessment of three times the amount claimed for each item or service and +exclusion from the Federal healthcare programs. +Many states have also adopted some form of anti-kickback laws. A determination of +liability under such laws could result in fines and penalties and restrictions on our ability to operate in these jurisdictions. +Foreign Corrupt Practices Act +The U.S. Foreign Corrupt Practices Act (“FCPA”) prohibits corporations and +individuals from engaging in certain activities to obtain or retain business or to influence a person working in an official capacity. It is illegal to pay, offer to pay or authorize the payment of anything of value to any foreign government +official, government staff member, political party or political candidate in an attempt to obtain or retain business or to otherwise influence a person working in an official capacity. Our present and future business has and will continue to be +subject to the FCPA and various other laws, rules and/or regulations applicable to us as a result of our international sales. +Environmental Regulation +Because of the nature of our current and proposed research, development, and manufacturing +processes, we are subject to stringent federal, state and local laws, rules, regulations and policies governing the use, generation, manufacture, storage, air emission, effluent discharge and handling and disposal of materials and wastes. +The foregoing discussion of our business should be read in conjunction with the Financial Statements and accompanying notes included in +Item 15 of this Annual Report. +19 +Table of Contents +ITEM 1A. Risk Factors +You should carefully consider the risks and uncertainties described below, together with all of the other information included in this Annual Report +and our other SEC filings, in considering our business and prospects. The risks and uncertainties described below are not the only ones facing us. Additional risks and uncertainties not disclosed or not presently known to us or that we currently +deem immaterial also may impair our business operations. The occurrence of any of the following risks could harm our business, financial condition or results of operations. +Regulatory Risks +The Need to Obtain Regulatory Approvals Could Increase Our +Costs and Adversely Affect Our Financial Performance. +Many of our proposed and existing products are subject to regulation by the FDA +and other governmental or public health agencies. In particular, we are subject to strict governmental controls on the development, manufacture, labeling, distribution and marketing of our products. In addition, we are often required to obtain +approval or registration with foreign governments or regulatory bodies before we can import and sell our products in foreign countries. +The process of obtaining required approvals or clearances from governmental or public health agencies can involve lengthy and detailed laboratory testing, human clinical trials, sampling activities and other costly, time-consuming +procedures. These approvals can require the submission of a large amount of clinical data which can be expensive and may require significant time to obtain. It is also possible that a product will not perform at a level needed to generate the +clinical data required to obtain an approval or clearance. The submission of an application to the FDA or other international regulatory authority does not guarantee that an approval or clearance to market the product will be received. Each +authority may impose its own requirements and delay or refuse to grant approval or clearance, even though a product has been approved in another country or by another agency. +Moreover, the approval or clearance process for a new product can be complex and lengthy. This time span increases our costs to develop new products as +well as the risk that we will not succeed in introducing or selling them in the United States or other countries. Our future performance depends on, among other things, our estimates as to when and at what cost we will receive regulatory approvals +for new products. +We are conducting clinical studies to support an application for +FDA approval of our OraQuick ® HIV-1/2 test for sale in the United States OTC market. We have also conducted clinical trials and submitted a PMA application for FDA approval of our +OraQuick ® HCV test for professional use. There can be no assurance that these clinical trials will support FDA approval of either product or that FDA approval will be obtained. Failure to +obtain or any delay in obtaining FDA approval for either product could significantly reduce future revenues, increase our costs and adversely affect our financial performance. +In addition, all in vitro diagnostic products that are to be sold in the EU must bear the CE mark indicating conformance with the essential +requirements of the IVDD. We are not permitted to sell our products in the EU without a CE mark, which could lead to the termination of strategic alliances and agreements for sales of those products in the EU. We have obtained the CE mark for +several of our existing products. We also intend to obtain CE mark for certain of our future products and are not aware of any material reason why we will be unable to do so. However, there can be no assurance that compliance with all provisions of +the IVDD will be demonstrated and the CE mark will be obtained or maintained for all products that we desire to sell in the EU. +Our +Ability to Respond to Changes in Regulatory Requirements Could Adversely Affect Our Business. +Newly promulgated or changed regulations +could require changes to our products, necessitate additional clinical trials or procedures, or could make it impractical or impossible for us to market our products for certain uses, in certain markets, or at all. +20 +Table of Contents +For example, during 2004 SAMHSA, which is part of the U.S. Department of Health and Human Services, +issued proposed regulations for the use of oral fluid drug testing for federal workers. Although the SAMHSA regulations have been withdrawn, if and when they are issued in final form, they could permit us to market and sell our oral fluid drug tests +for use with federal workers only if certain modifications are made to our products. If we are unable to make these modifications, or if the modifications require significant time to develop, our ability to sell our oral fluid drug testing products +in that market could be limited. In addition, the extent to which the final SAMHSA regulations permit the sale of our oral fluid drug tests for use with federal workers may influence whether customers in the workplace, criminal justice or other +unregulated markets use our products. +Failure to Comply With FDA or Other Regulatory Requirements May Require Us to Suspend Production +of Our Products or Institute a Recall Which Could Result in Higher Costs and a Loss of Revenues. +Our businesses are extensively +regulated by the FDA and other federal, state and foreign regulatory agencies. Our suppliers and distributors often are subject to similar regulation. These regulations impact many aspects of our operations, and the operations of our suppliers and +distributors, including manufacturing, labeling, packaging, adverse event reporting, storage, advertising, promotion and record keeping. For example, our manufacturing facilities and those of our suppliers and distributors are, or can be, subject to +periodic regulatory inspections. The FDA and foreign regulatory agencies may require post-marketing testing and surveillance to monitor the effects of approved products or place conditions on any product approvals that could restrict the commercial +applications of those products. In addition, the subsequent discovery of previously unknown problems with a product may result in restrictions on the product, including withdrawal of the product from the market. We are also subject to routine +inspection by the FDA and certain state agencies for compliance with Quality System Requirement and Medical Device Reporting requirements in the United States and other applicable regulations worldwide, including but not limited to ISO regulations. +Although we believe that we have adequate processes in place to ensure compliance with these requirements, the FDA or other regulatory +bodies could force us to stop manufacturing, selling or exporting our products if it concludes that we are out of compliance with applicable regulations. The ability of our suppliers to supply critical components or materials and of our distributors +to sell our products could be adversely affected if their operations are determined to be out of compliance. The FDA and other regulatory bodies could also require us to recall products if we fail to comply with applicable regulations, which could +force us to stop manufacturing such products. Such actions by the FDA and other regulatory bodies could adversely affect our revenues. +In +the ordinary course of business, we must frequently make subjective judgments with respect to compliance with applicable laws and regulations. If regulators subsequently disagree with the manner in which we have sought to comply with these +regulations, we could be subjected to substantial civil and criminal penalties, as well as product recall, seizure or injunction with respect to the sale of our products. The assessment of any civil and criminal penalties against us could severely +impair our reputation within the industry and any limitation on our ability to manufacture and market our products could have a material adverse effect on our business. +We Are Subject to Numerous Government Regulations in Addition to FDA Requirements, Which Could Increase Our Costs or Affect Our Operations. +In addition to FDA and other regulations described previously, the regulations in some states may restrict our ability to sell products in those states. +For example, certain states restrict or do not allow the testing of oral fluid for drugs of abuse or the rapid, point-of-care testing for HIV. While we intend to work with state legislators and regulators to remove or modify any applicable +restrictions, there is no guarantee we will be successful in these efforts. +We must also comply with numerous laws relating to such +matters as safe working conditions, manufacturing practices, environmental protection, fire hazard control, disposal of hazardous substances and +21 +Table of Contents +labor or employment practices. Compliance with these laws or any new or changed laws regulating our business could result in substantial costs. Because of +the number and extent of the laws and regulations affecting our industry, and the number of governmental agencies whose actions could affect our operations, it is impossible to reliably predict the full nature and impact of these requirements. To +the extent the costs and procedures associated with complying with these laws and requirements are substantial or it is determined that we do not comply, our business and results of operations could be adversely affected. +Risks Relating to Our Industry, Business and Strategy +Our Ability to Sell Products Could be Adversely Affected by Competition From New and Existing Diagnostic Products and by Treatments or Other Non-Diagnostic Products Which May be Developed. +The diagnostic industry is focused on the testing of biological specimens in a laboratory or at the point of care and is highly competitive and rapidly +changing. Many of our principal competitors have considerably greater financial, technical and marketing resources. As new products enter the market, our products may become obsolete or a competitor’s products may be more effective or more +effectively marketed and sold than ours. If we fail to maintain and enhance our competitive position, our customers may decide to use products developed by competitors which could result in a loss of revenues. +We also face competition from products which may be sold at a lower price. To the extent this competition arises, customers may choose to buy lower cost +products from third parties or we may be forced to sell our products at a lower price, both of which could result in a loss of revenues or a lower gross margin contribution from the sale of our products. +In addition, the development and commercialization of products outside of the diagnostics industry could adversely affect sales of our product. For +example, the development of a safe and effective vaccine to prevent HIV or preventative treatments for other diseases or conditions that our products are designed to detect, could reduce, or eventually eliminate, the demand for our HIV or other +diagnostic products and thereby result in a loss of revenues. +Our Research, Development and Commercialization Efforts May Not Succeed +and Our Competitors May Develop and Commercialize More Effective or Successful Diagnostic Products. +In order to remain competitive, we +must regularly commit substantial resources to research and development and the commercialization of new products. The research and development process generally takes a significant amount of time from inception to commercial product launch. This +process is conducted in various stages. During each stage there is a substantial risk that we will not achieve our goals on a timely basis, or at all, and we may have to abandon a product in which we have invested substantial amounts. +During 2008, 2007 and 2006, we incurred $20.3 million, $14.1 million and $8.6 million, respectively, in research and development expenses. We expect to +continue to incur significant costs from our research and development activities. +Successful products require significant development and +investment, including testing, to demonstrate their cost-effectiveness or other benefits prior to commercialization. In addition, regulatory approval must be obtained before most products may be sold. Additional development efforts on these products +will be required before any regulatory authority will review them. Regulatory authorities may not approve these products for commercial sale. In addition, even if a product is developed and all applicable regulatory approvals are obtained, there may +be little or no market for the product. Accordingly, if we fail to develop or gain commercial acceptance for our products, or if competitors develop more effective products or a greater number of successful new products, customers may decide to use +products developed by our competitors. This would result in a loss of revenues and adversely affect our results of operations, cash flows and business. +22 +Table of Contents +Failure to Achieve Our Financial and Strategic Objectives Could Have a Material Adverse Impact on Our +Business Prospects. +As a result of any number of risk factors identified in this +Annual Report, no assurance can be given that we will be successful in implementing our financial and strategic objectives, including our clinical development programs for a rapid HIV OTC test and/or a rapid HCV test using the OraQuick ® technology platform. In addition, the funds for the foregoing projects have in the past come primarily from our business operations. If our business slows and we become less profitable, and as +a result have less money available to fund research and development and clinical programs, we will have to decide at that time which programs to cut, and by how much. Similarly, if adequate financial, personnel, equipment or other resources are not +available, we may be required to delay or scale back our strategic efforts. Our operations will be adversely affected if our total revenue and gross profits do not correspondingly increase or if our technology, product, clinical and market +development efforts are unsuccessful or delayed. Furthermore, our failure to successfully introduce new products and develop new markets could have a material adverse effect on our business and prospects. +If We Lose Our Key Personnel or Are Unable to Attract and Retain Qualified Personnel as Necessary, Our Business Could be Harmed. +Our success depends to a large extent upon the contributions of our executive officers, management and sales, marketing, operations and scientific staff. +We may not be able to attract or retain qualified employees in the future due to the intense competition for qualified personnel among medical products businesses. +If we are not able to attract and retain the necessary personnel to accomplish our business objectives, we may experience constraints that will adversely affect our ability to effectively manufacture, sell and market +our products, to meet the demands of our strategic partners in a timely fashion, or to support internal research and development programs. Although we believe we will be successful in attracting and retaining qualified personnel, competition for +experienced scientists and other personnel from numerous companies and academic and other research institutions may limit our ability to do so on acceptable terms. +Future Acquisitions or Investments Could Disrupt Our Ongoing Business, Distract Our Management, Increase Our Expenses and Adversely Affect Our Business. +We may consider strategic acquisitions or investments as a way to expand our business in the future. These activities, and their impact on our business, +are subject to many risk factors, including the following: +• +Suitable acquisitions or investments may not be found or consummated on terms or schedules that are satisfactory to us; +• +We may be unable to successfully integrate an acquired company’s personnel, assets, management systems and technology into our business; +• +Acquisitions may require substantial expense and management time and could disrupt our business; +• +An acquisition and subsequent integration activities may require greater capital resources than originally anticipated at the time of acquisition; +• +An acquisition may result in the incurrence of unexpected expenses, the dilution of our earnings or our existing stockholders’ percentage ownership, or +potential losses from undiscovered liabilities not covered by an indemnification from the seller(s) of the acquired business; +• +An acquisition may result in the loss of existing key personnel or customers or the loss of the acquired company’s key personnel or customers; +• +The benefits expected to be derived from an acquisition may not materialize and could be affected by numerous factors, such as regulatory developments, general +economic conditions, increased competition and our ability to complete the acquisition and integrate the acquired entity’s operations and business; and +23 +Table of Contents +• +An acquisition of a foreign business may involve additional risks, including, but not limited to, foreign currency exposure, liability or restrictions under foreign +laws or regulations and our inability to successfully assimilate differences in foreign business practices or overcome language or cultural barriers. +The occurrence of one or more of the above or other factors may prevent us from achieving all or a significant part of the benefits expected from an acquisition or investment. This may adversely affect our financial +condition, results of operations and ability to grow our business or otherwise achieve our financial or strategic objectives. +Our +Revenues Could be Affected by Third-Party Reimbursement Policies and Potential Cost Constraints. +The end-users of our products are +expected to increasingly include hospitals, physicians and other healthcare providers. Use of our products could be adversely impacted if end-users do not receive adequate reimbursement for the cost of our products from their patients’ +healthcare insurers or payors. Our net sales could also be adversely affected by changes in reimbursement policies of governmental or private healthcare payors, including in particular the level of reimbursement for our products. In the United +States, healthcare providers such as hospitals and physicians who purchase diagnostic products generally rely on third-party payors, principally private health insurance plans, Medicare and Medicaid, to reimburse all or part of the cost of the +product and procedure. We believe that the overall escalating cost of medical products and services has led to, and will continue to lead to, increased pressures on the healthcare industry, both foreign and domestic, to reduce the cost of products +and services. Given the efforts to control and reduce healthcare costs in the United States in recent years, currently available levels of reimbursement may not continue to be available in the future for our existing products or products under +development. Third-party reimbursement and coverage may not be available or adequate in either the United States or foreign markets, current reimbursement amounts may be decreased in the future and future legislation, and regulation or reimbursement +policies of third-party payors, may reduce the demand for our products or our ability to sell our products on a profitable basis. +Increases in Demand for Our Products Could Require Us to Expend Considerable Resources to Meet the Demand or Harm Our Customer Relationships if We are Unable to Meet That Demand. +If we experience significant or unexpected increases in the demand for our products, we and our suppliers may not be able to meet that demand without +expending additional capital resources. These capital resources could involve the cost of new machinery or even the cost of new manufacturing facilities. This would increase our capital costs, which could adversely affect our earnings. Our suppliers +may be unable or unwilling to expend the necessary capital resources or otherwise expand their capacity. In addition, new manufacturing equipment or facilities may require FDA approval before they can be used to manufacture our products. To the +extent we are unable to obtain or are delayed in obtaining such approvals, our ability to meet the demand for our products could be adversely affected. +If we or our suppliers are unable to develop necessary manufacturing capabilities in a timely manner, our sales could be adversely affected. If we fail to increase production volumes cost effectively or if we +experience lower than anticipated yields or production problems as a result of changes that we or our suppliers make in our manufacturing processes to meet increased demand, we could experience shipment delays or interruptions and increased +manufacturing costs, which could also have a material adverse effect on our revenues and profitability. +Unexpected increases in demand for +our products could also require us to obtain additional raw materials in order to manufacture products to meet the demand. Some raw materials require significant ordering lead time and some are currently obtained from a sole supplier or a limited +group of suppliers. We have long-term supply agreements with many of these suppliers, but these long-term agreements involve risks for us, such as our potential inability to obtain an adequate supply of raw materials and components and our reduced +control over +24 +Table of Contents +pricing, quality and timely delivery. It is also possible that one or more of these suppliers may become unwilling or unable to deliver materials to us. Any +shortfall in our supply of raw materials and components, and our inability to quickly and cost-effectively obtain alternative sources for this supply, could have a material adverse effect on our total revenue or cost of sales and related profits. +Our inability to meet customer demand for our products could also harm our customer relationships and impair our reputation within the +industry. This, in turn, could have a material adverse effect on our business and prospects. +Risks Relating to Collaborators +Our Failure to Maintain Existing Distribution Channels, or Develop New Distribution Channels, May Result in Lower Revenues. +We have marketed many of our products by collaborating with laboratories, diagnostic companies and distributors. Our sales depend to a +substantial degree on our ability to sell products to these customers and on the marketing abilities of the companies with which we collaborate. +Some of our distributors or other customers may not fulfill their contractual obligations to us or otherwise market and distribute our products in the manner or at the levels we expect. Although we will try to maintain and expand our +business with distributors and customers and require that they fulfill their contractual obligations, there can be no assurance that such companies will continue to purchase or distribute our products, maintain historic order volumes or otherwise +meet their purchase or other obligations or our expectations, or that new distribution channels will be available on satisfactory terms. The failure of these distributors or other customers to purchase our products could adversely affect our +revenues. +Some of our distributors have also consolidated in recent years and such consolidation has had, and may continue to have, an +adverse impact on the level of orders for our products. In addition, some distributors have experienced, and may continue to experience, pressure from their customers to reduce the price of their products and testing services. This may cause +customers to stop using our products or to purchase or manufacture lower cost alternatives. +The Use of Sole Supply Sources or Third +Party Suppliers For Critical Components of Our Products Could Adversely Affect Our Business. +We currently purchase certain critical components of our products from sole supply sources or other third party suppliers. For example, all of the HIV antigen and nitrocellulose required to make our OraQuick +ADVANCE ® rapid HIV-1/2 antibody test is purchased from sole source suppliers. In addition, the conjugates used in our MICROPLATE oral fluid drugs of abuse assays are obtained from +third party suppliers. +If these suppliers are unable or unwilling to supply the required component or if they make changes in the +component or do not supply materials meeting our specifications, we may need to find another source and perform additional development work. We may also need to obtain FDA or other regulatory approvals for the use of the alternative component for +our products. Completing that development and obtaining such approvals could require significant time and may not occur at all. The availability of critical components from sole supply sources or other third parties could also reduce our control +over pricing, quality and timely delivery. These events could either disrupt our ability to manufacture and sell certain of our products, or completely prevent us from doing so or increase our costs. Any such event could have a material adverse +effect on our results of operations, cash flows and business. +25 +Table of Contents +The Unavailability of Certain Products +Distributed by a Third Party Could Adversely Affect Sales of Our OraSure ® Oral Fluid Collection Device. +In testing an oral fluid sample collected with an OraSure ® device for HIV-1 in the United States, our customers must use an HIV-1 EIA screening test approved by the FDA for use with our OraSure ® device. Where an +oral fluid sample screens positive for HIV-1, our customers must then use our oral fluid Western blot HIV-1 confirmatory test, which has also been approved by the FDA for use with our OraSure ® +device, to confirm that positive indication. +Historically, BMX manufactured +and sold the only oral fluid HIV-1 EIA screening test that has received FDA approval for use in detecting HIV-1 in an oral fluid specimen collected with our OraSure ® collection device. BMX +also supplied the HIV-1 antigen used to manufacture our oral fluid Western blot HIV-1 confirmatory test and was the exclusive world-wide distributor of that product. +BMX discontinued manufacturing the HIV-1 EIA screening test in 2007. As a result, we will be +conducting clinical trials and intend to seek FDA approval of an alternative HIV-1 EIA screening test manufactured by a third party for use with oral fluid samples collected with our OraSure ® device. +If at some point in the future our +customers cannot obtain either an HIV-1 EIA screening test or a Western blot or other HIV-1 confirmatory test that has been approved by the FDA for use with our OraSure ® collection device, +sales of our OraSure ® device could be negatively affected. +We May Need +Strategic Partners to Assist in Developing and Commercializing Some of Our Diagnostic Products. +Although we intend to pursue some +product opportunities independently, opportunities that require a significant level of investment for development and commercialization or a distribution network beyond our existing sales force may necessitate involving one or more strategic +partners. Our strategy for development and commercialization of products may entail entering into arrangements with distributors or other corporate partners, universities, research laboratories, licensees and others. We may be required to transfer +material rights to such strategic partners, licensees and others. While we expect that our current and future partners, licensees and others have and will have an economic motivation to succeed in performing their contractual responsibilities, there +is no assurance that they will do so and the amount and timing of resources to be devoted to these activities will be controlled by others. Consequently, there can be no assurance that any revenues or profits will be derived from such arrangements. +We may need to collaborate with one or more third parties or find new product +distribution channels in order to commercialize our OraQuick ® HIV-1/2 test in the United States OTC market should we receive approval from the FDA. In order to successfully commercialize +our OraQuick ® test in the OTC market, we and/or our distributors may need to invest significantly in advertising and promotion in order to sell this product into the OTC market. If we are +unable to collaborate with a third party having sufficient resources to assist in these efforts or find alternative distribution channels to access the OTC market, we may need to incur significant costs for advertising and promotion, and our ability +to maximize our future revenues for this opportunity could be adversely affected. +Risks Relating to Intellectual Property +Our Success Depends on Our Ability to Protect Our Proprietary Technology. +The diagnostics industry places considerable importance on obtaining patent, trademark and trade secret protection, as well as other intellectual property +rights, for new technologies, products and processes. Our +26 +Table of Contents +success depends, in part, on our ability to develop and maintain a strong intellectual property portfolio or obtain licenses to patents for products and +technologies both in the United States and in other countries. +As appropriate, we intend to file patent applications and obtain patent +protection for our proprietary technology. These patent applications and patents will cover, as applicable, compositions of matter for our products, methods of making those products, methods of using those products and apparatus relating to the use +or manufacture of those products. We will also rely on trade secrets, know-how and continuing technological advancements to protect our proprietary technology. +We have entered, and will continue to enter, into confidentiality agreements with our employees, consultants, advisors and collaborators. However, these parties may not honor these agreements and we may not be able to +successfully protect our rights to unpatented trade secrets and know-how. Others may independently develop substantially equivalent proprietary information and techniques or otherwise gain access to our trade secrets and know-how. +Many of our employees, including scientific and management personnel, were previously employed by competing companies. Although we encourage and expect +all of our employees to abide by any confidentiality agreement with a prior employer, competing companies may allege trade secret violations and similar claims against us. +We may collaborate with universities and governmental research organizations which, as a result, may acquire part of the rights to any inventions or +technical information derived from our collaboration with them. +To facilitate development and commercialization of a proprietary +technology base, we may need to obtain licenses to patents or other proprietary rights from other parties. Obtaining and maintaining such licenses may require the payment of substantial amounts. In addition, if we are unable to obtain these types of +licenses, our product development and commercialization efforts may be delayed or precluded. +We may incur substantial costs and be +required to expend substantial resources in asserting or protecting our intellectual property rights, or in defending suits against us related to intellectual property rights. Disputes regarding intellectual property rights could substantially delay +product development or commercialization activities. Disputes regarding intellectual property rights might include state, federal or foreign court litigation, as well as patent interference, patent reexamination, patent reissue, or trademark +opposition proceedings in the United States Patent and Trademark Office. Opposition or revocation proceedings could be instituted in a foreign patent office. An adverse decision in any proceeding regarding intellectual property rights could result +in the loss or limitation of our rights to a patent, an invention or trademark. +We May Become Involved in Intellectual Property +Infringement Disputes, Which Could Increase our Costs and Limit or Eliminate Our Ability to Sell Our Products or Use Certain of Our Technologies in the Future. +From time to time, we may seek to enforce our patents or other intellectual property rights through litigation. In addition, there are a large number of patents and patent applications in our product areas, and +additional patents may be issued to third parties relating to our product areas. We or our customers may be sued for infringement of patents or misappropriation of other intellectual property rights with respect to one or more of our products. +Litigation in our industry regarding patent and other intellectual property rights is prevalent and is expected to continue. +Our industry +is characterized by a large number of patents, claims of which appear to overlap in many cases. As a result, there is a significant amount of uncertainty regarding the extent of patent protection and infringement. Companies may have pending patent +applications, which are typically confidential for the first eighteen months following filing, that cover technologies we incorporate in our products. Accordingly, we may +27 +Table of Contents +be subjected to substantial damages for past infringement or be required to modify our products or stop selling them if it is ultimately determined that our +products infringe a third party’s proprietary rights. +Our involvement in litigation with respect to patents or other intellectual +property or to determine rights in proprietary technology, either as a plaintiff or defendant, could adversely affect our revenues, market share, results of operations and business because: +• +As is common with major litigation, it could consume a substantial portion of managerial and financial resources; +• +Its outcome would be uncertain and a court may find that our patents are invalid or unenforceable in response to claims by another party or that the third-party +patent claims are valid and infringed by our products; +• +An adverse outcome could subject us to the loss of the protection of our patents or to liability in the form of past royalty payments, penalties, special and +punitive damages, or future royalty payments significantly affecting our future earnings; +• +Failure to obtain a necessary license upon an adverse outcome could prevent us from selling our current products or other products we may develop or acquire; +• +The pendency of any litigation may in and of itself cause our distributors and customers to reduce purchases of our products; and +• +A court could award a preliminary and/or permanent injunction, which would prevent us from selling our current or future products. +In addition to the foregoing, we may also indemnify some customers and strategic partners under our agreements with such parties if our products or +activities have actually or allegedly infringed upon, misappropriated or misused another party’s proprietary rights. Further, our products may contain technology provided to us by other parties, such as contractors, suppliers or customers, and +we may have little or no ability to determine in advance whether such technology infringes the intellectual property rights of a third party. +The Sales Potential for Our OraQuick ® Products Could be Affected by Our Ability to Obtain Certain Licenses and by Current or Future Litigation. +Our OraQuick ® test platform is a +lateral flow assay that tests for specific antibodies or other substances. The term “lateral flow” generally refers to a test strip through which a sample flows and which provides a test result on a portion of the strip downstream from +where the sample is applied. There are numerous patents in the United States and other countries which claim lateral flow assay methods and devices. Some of these patents may broadly cover the technology used in the OraQuick ® test and are in force in the United States and other countries. We may not be able to make or sell the OraQuick ® test in the United +States or other countries where these patents are in force. +We have obtained +licenses under several lateral flow patents, which we believe should be sufficient to permit the manufacturing and sale of the OraQuick ® device as currently contemplated. However, licenses +under additional patents may be required and it is possible that a third party could seek to enforce one or more lateral flow patents against us. We are currently involved in patent infringement litigation filed by Inverness Medical and +Church & Dwight, which alleges that the manufacture and sale of our OraQuick ADVANCE ® test infringes a lateral flow patent held by these parties. In the event that we are +unable to successfully defend against the current litigation or future similar litigation or it is determined that a license is required and it is not possible to negotiate or otherwise obtain a license agreement on reasonable terms under a +necessary patent, our ability to manufacture and sell OraQuick ® devices could be limited and we may incur increased costs or damages. In such case, we may be able to modify the +OraQuick ® test to avoid the claim of infringement or the need for a license. However, this alternative could delay or limit our ability to sell the OraQuick ® test in the United States and other markets, which would adversely affect our results of operations, cash flows and business. +28 +Table of Contents +Risks Relating to Products, Marketing and Sales +A Market for Our Products May Not Develop. +Our future success will depend, in part, on the market acceptance, and the timing of such +acceptance, of new products such as an OraQuick ® rapid HIV-1/2 antibody test for home use, an OraQuick ® HCV test for professional +use, and other new products or technologies that may be developed or acquired. To achieve market acceptance, we and/or our distributors will likely be required to undertake substantial marketing efforts and spend significant funds to inform +potential customers and the public of the perceived benefits of these products. There may be limited evidence on which to evaluate the market reaction to products that may be developed. There can be no assurance that any products will obtain market +acceptance and fill the market need that is perceived to exist. +If Acceptance and Adoption of Our Oral Fluid Testing Does Not Continue, +Our Future Results May Suffer. +We have made significant progress in gaining acceptance of oral fluid testing for HIV in the public +health, hospital, insurance and other markets. We have also made significant progress in gaining acceptance of oral fluid testing for drugs of abuse in the workplace and criminal justice testing markets. However, the ultimate degree of acceptance in +these markets is uncertain, and other markets may resist the adoption of oral fluid testing as a replacement for other testing methods in use today. In addition, certain state laws prohibit or restrict the use of oral fluid testing for drugs of +abuse in certain markets or the rapid, point-of-care testing for HIV. As a result, there can be no assurance that we will be able to expand the use of our oral fluid testing products in these or other markets. +If Our Direct Selling Efforts For Our Products Fail, Our Business Expansion Plans Could Suffer, and Our Ability to Generate Revenue Will be +Diminished. +We have a relatively small sales force compared to many of our +competitors. At the end of 2008, we terminated our agreement with Abbott, and we are now selling the OraQuick ADVANCE ® HIV-1/2 test directly into the U.S. hospital market. If our +direct sales force is not successful or new additions to our sales team fail to gain traction among our customers, we may not be able to increase market awareness and sales of our products in hospitals and elsewhere. In addition, if any hospital +customers elect to use a competitor’s product as a result of the transition from Abbott or we are otherwise unable to retain Abbott’s hospital customers as our own or attract new hospital customers, our sales could be negatively affected. +Our Customers May Resist Adoption of Rapid Point-of-Care Diagnostic Testing. +We expect sales of our rapid point-of-care diagnostic products, such as our OraQuick +ADVANCE ® HIV-1/2 test, to become an increasingly important part of our business. Hospitals, clinical reference laboratories, physicians and other customers may resist the adoption of +rapid point-of-care tests and instead may choose to use or continue to use competing laboratory tests. Our failure to achieve initial or additional market acceptance of our rapid point-of-care diagnostic tests with customers would have a negative +effect on our future sales growth. +Our Sales Cycles Can be Lengthy and May Depend on Public Funding, Which Can Cause Variability and +Unpredictability in Our Operating Results. +The sales cycles for certain of our products can be lengthy and unpredictable, which makes +it more difficult to accurately forecast revenues in a given period and may cause revenues and operating results to vary from period to period. Sales of our products often involve purchasing decisions by large public and private institutions, may +require many levels of approval and may be dependent on economic or political conditions and the availability of grants or other funding from governmental agencies which can vary from period to period in both +29 +Table of Contents +amount and timing. For example, in past years our OraQuick ADVANCE ® HIV-1/2 test has been +purchased through bulk procurement or other funding provided by the CDC, SAMHSA, city or state governments and other governmental agencies. On an international basis, our OraQuick ® HIV-1/2 +test has been purchased with funds provided by the President’s Emergency Plan for AIDS Relief and other international agencies. There can be no assurance that purchases or funding from these agencies will continue at the same or higher levels +or at all, especially if current negative economic conditions continue or intensify. As a result, we may expend considerable resources on unsuccessful sales efforts or we may not be able to complete transactions at all or on a schedule and in an +amount consistent with our objectives. +We May be Sued for Product Liabilities for Injuries Resulting From the Use of Our Products. +We may be held liable if any of our products, or any product which is made with the use or incorporation of any of our technologies, causes +injury of any type or is found otherwise unsuitable during product testing, manufacturing, marketing, sale or usage. Product liability claims could result in liabilities, lost revenues and damage to our image and the reputation of our products. +Although we have obtained product liability insurance, this insurance may not fully cover potential liabilities. As we bring new products to market, we may need to increase our product liability coverage. +We are selling cryosurgical wart removal products in the consumer or OTC market in various +countries. We expect to expand the OTC sales of these products to other countries and to eventually distribute other types of products in the domestic and international OTC markets, such as our OraQuick ® HIV-1/2 test. We believe the sale of products in the OTC market increases the risk of potential product liability exposure and possibly the required level of insurance coverage that we will need to maintain. +Inability to obtain sufficient insurance coverage at an acceptable cost or otherwise to protect against potential product liability claims could affect our decision to commercialize new products and our results of operations. +We Could Suffer Monetary Damages, Incur Substantial Costs or be Prevented From Using Technologies Important to Our Products as a Result of Legal +Proceedings. +We have been and in the future may become involved in various legal proceedings arising out of our businesses. These may +include commercial disputes, negligence claims or various other lawsuits arising in the ordinary course of our business, including employment matters. Such lawsuits can seek damages, sometimes in substantial amounts, for commercial or personal +injuries allegedly suffered and can include claims for punitive or other special damages. An adverse ruling or rulings in one or more such lawsuits could, individually or in the aggregate, result in the termination or modification of a material +contract or otherwise have a material adverse effect on our sales, operations or financial performance. +Performance of Our Products May +Affect Our Revenues, Stock Price and Reputation. +Our products are generally sold with labeling that contains performance claims +approved or cleared by the FDA or other regulators. If our products fail to perform in accordance with the applicable label claims or otherwise in accordance with the expectations or needs of our customers, customers may switch to a competing +product or otherwise stop using our products, and our revenues could be adversely affected. In addition, poor performance by one or more of our products and publicity surrounding such performance could have an adverse effect on our reputation, our +continuing ability to sell products and the prevailing market price of our Common Stock. +Our Inability to Manufacture Products in +Accordance With Applicable Specifications, Performance Standards or Quality Requirements Could Adversely Affect Our Business. +The +materials and processes used to manufacture our products must meet detailed specifications, performance standards and quality requirements to ensure our products will perform in accordance with their label claims, our customers’ expectations +and applicable regulatory requirements. As a result, our products and +30 +Table of Contents +the materials used in their manufacture or assembly undergo regular inspections and quality testing. Factors such as defective materials or processes, +mechanical failures, human errors, environmental conditions, changes in materials or production methods by our vendors, and other events or conditions could cause our products or the materials used to produce or assemble our products to fail +inspections and quality testing. Any failure or delay in our ability to meet the applicable specifications, performance standards or quality requirements could adversely affect our ability to manufacture and sell our products or comply with +regulatory requirements. These events could, in turn, adversely affect our business and financial performance. +Our Increasing +International Presence May Increase Our Risks and Expose Our Business to Regulatory, Cultural or Other Restraints. +We intend to +increase revenue derived from international sales of our products. Our international sales accounted for $13.7 million or 19% of total revenues for 2008, $18.1 million or 22% of total revenues for 2007, and $11.4 million or 17% of total revenues for +2006. +A number of factors can slow or prevent international sales, or substantially increase the cost of international sales, including +those set forth below: +• +Regulatory requirements (including compliance with applicable customs regulations) and the need for reimbursement approvals may slow, limit, or prevent the offering +of products in foreign countries; +• +The unavailability of licenses to certain patents in force in a foreign country which cover our products may restrict our ability to sell into that country; +• +Reduced protection for, or enforcement of, our patents and other intellectual property rights in foreign countries; +• +The inability to maintain ISO certification for our or our suppliers’ manufacturing facilities could preclude, interrupt or delay our ability to manufacture +products for sale in Europe or other international territories; +• +Our inability to obtain or maintain the CE mark on our products may preclude or delay our ability to sell products in the European Union; +• +Our inability to identify international distributors and negotiate acceptable terms for distribution agreements may delay or reduce our sales; +• +Cultural and political differences may favor local competitors or make it difficult to effectively market, sell and gain acceptance of products in foreign +countries; +• +Inexperience in international markets and difficulties in staffing and managing foreign operations may slow or limit our ability to sell products in foreign +countries; +• +Exchange rates, currency fluctuations, tariffs and other barriers, extended payment terms and dependence on and difficulties in finding and managing international +distributors or representatives may affect our revenues even when product shipments occur; +• +The creditworthiness of foreign distributors and customers may be less certain and foreign accounts receivable collection may be more difficult; +• +It may be more difficult to enforce contractual obligations or recover damages under foreign legal systems; +• +Economic conditions, the absence of available funding sources, terrorism, civil unrest, war and natural disasters may slow or limit our ability to sell our products +in foreign countries; +• +Our exposure to liability under the Foreign Corrupt Practices Act and various other laws, rules and/or regulations applicable to us as a result of our international +sales may affect our ability to sell into international markets; +31 +Table of Contents +• +International markets often have long sales cycles, especially for sales to foreign governments, quasi-governmental agencies and international public health +agencies, thereby delaying or limiting our ability to sell our products; and +• +We may be at a disadvantage if competitors in foreign countries sell competing products at prices at or below such competitors’ or our cost. +Currently, most of our international sales are negotiated for and paid in U.S. dollars. Nevertheless, these sales are +subject to currency risks since the changes in the values of foreign currencies relative to the value of the U.S. dollar can render our products comparatively more expensive. These exchange rate fluctuations could negatively impact international +sales of our products, as could changes in the general economic conditions in those markets. +In addition, we have entered into a contract for the manufacture and supply of our OraQuick ® HIV-1/2 test in Thailand, and the Histofreezer ® cryosurgical product is currently manufactured in The Netherlands. We may enter into agreements to manufacture other products in foreign countries as well. However, economic, cultural and political conditions and +foreign regulatory requirements may slow or prevent the manufacture of our products in countries other than the United States. Interruption of the supply of our products could reduce revenues or cause us to incur significant additional expenses in +finding an alternative source of supply. Foreign currency fluctuations and economic conditions in foreign countries could also increase the costs of manufacturing our products in foreign countries. +Risks Relating to the Economy, Our Financial Results, Investments, Stock Price, Credit Facilities and Need for Financing +The Economic Downturn, Which May Continue Indefinitely or Intensify, Could Adversely Affect Our Results of Operations, Cash Flows and Financial +Condition or Those of Our Customers and Suppliers. +The current economic downturn, including disruptions in the capital and credit +markets, may continue indefinitely and intensify, and could adversely affect our results of operations, cash flows and financial condition or those of our customers and suppliers. These circumstances could adversely affect our access to liquidity +needed to conduct or expand our business or conduct acquisitions or make other discretionary investments. These circumstances could adversely affect our ability to draw on existing credit facilities, which depend on the ability of the bank that is a +party to that facility to meet its funding commitments to us. A bank may not be able to meet its funding commitments if it experiences shortages of capital and liquidity. These circumstances may also adversely impact the capital needs of our +customers and suppliers, which, in turn, could adversely affect their ability to purchase our products or supply us with necessary equipment, raw materials or components. A weakening business climate could cause longer sales cycles and slower +growth, and could expose us to increased business or credit risk in dealing with customers or suppliers adversely affected by economic conditions. Our ability to collect accounts receivable may be delayed or precluded if our customers are unable to +pay their obligations. +We Have a History of Losses and May Not Be Able to Achieve Sustained Profitability. +Although we achieved profitability in 2005, 2006 and 2007, we experienced a net loss of $31.3 million in 2008. In addition, as of December 31, 2008, +the Company had an accumulated deficit of $127.3 million. Even though we achieved profitability in the past, there can be no assurance that we will be able to achieve or sustain profitability in the future. +Our ability to achieve and sustain profitability in the future will be dependent upon a number of factors including, without limitation, the following: +• +Creating market acceptance for and selling increasing volumes of our OraQuick ADVANCE ® rapid HIV-1/2 antibody test, Intercept ® drug testing product, cryosurgical products and OraSure ® +collection device; +32 +Table of Contents +• +Our ability to successfully launch new products after receipt of required regulatory approvals; +• +The degree to which certain of our new products may replace sales of our existing products and the financial impact of +that change, including the degree to which our OraQuick ADVANCE ® test will replace our OraSure ® collection device for +HIV-1 testing or sales of our cryosurgical wart removal products in the OTC market will replace sales of our Histofreezer ® product to physicians’ offices or other professional markets; +• +The degree to which our major distributors comply with their contractual obligations, including minimum purchase commitments; +• +Our ability to successfully resolve claims or litigation, including patent infringement litigation; +• +The level of expenditures we are required to make in order to develop and obtain regulatory approvals for our new +products, including our OraQuick ® HIV-1/2 test for use in the OTC market and an OraQuick ® HCV test for professional use; +• +Whether we are successful in obtaining and maintaining required regulatory approvals and registrations for our new products; +• +Achieving growth in sales of our wart removal and other cryosurgical products in the OTC market and selling other +products, such as our OraQuick ® HIV-1/2 test, in the OTC market; +• +Whether we are able to obtain FDA approval of a replacement for the BMX HIV-1 EIA screening test for use in connection +with oral fluid samples collected with our OraSure ® device; +• +Achieving growth in international markets with our OraQuick ADVANCE ® HIV-1/2 test, cryosurgical removal products and other products; +• +Changes in the level of competition, such as would occur if larger and financially stronger competitors introduced new or lower priced products to compete with our +products; +• +Changes in economic conditions in domestic or international markets, such as economic downturns, reduced demand, inflation and currency fluctuations; +• +Failure to achieve our targets for growth in revenues; +• +Changes in distributor buying patterns or a buildup of significant quantities in our distributors’ inventories or distribution channels; +• +Commercially developing, and obtaining regulatory approvals and creating market acceptance for, new products in a time frame consistent with our objectives; and +• +The costs and results of patent infringement and other litigation or claims asserted against us. +We May Experience Fluctuations in Our Financial Results or Fail to Meet Our Financial Projections. +Our operating results can fluctuate from quarter to quarter and year to year, which could cause our growth or financial performance to fall below the +expectations of investors and securities analysts. Our financial projections for future periods are based on a number of assumptions, including estimated demand for our products. However, sales to our distributors and other customers may fall short +of expectations because of less than estimated customer demand or other factors, including those described elsewhere in this Annual Report. Infrequent, unusual or unexpected revenues or costs could also contribute to the variability of our financial +results. In addition, our products provide different contributions to our gross margin and our operating results could also fluctuate and be affected depending on the mix of products sold and the relative prices and gross margin contribution of +those products. Failure to achieve operating results consistent with the expectations of investors and securities analysts could adversely affect our reputation and the price of our Common Stock. +33 +Table of Contents +Our Portfolio Investments May Be Subject to Volatility and Uncertainty in the Financial Markets and +Other Risks. +At December 31, 2008, we had $82.5 million in cash, cash equivalents and short-term investments. We invest our cash +in a variety of financial instruments, consisting principally of investments in certificates of deposit, commercial paper, U.S. government and agency obligations, and U.S. corporate bonds. These investments are denominated in U.S. dollars. +We account for our investment instruments in accordance with Statement of Financial Accounting Standards No. 115 (“SFAS +No. 115”), Accounting for Certain Investments in Debt and Equity Securities . All of the cash equivalents and marketable securities are treated as “available-for-sale” under SFAS No. 115. Investments in both fixed rate +and floating rate interest earning instruments carry a degree of interest rate risk. Fixed rate debt securities may have their market value adversely impacted due to a rise in interest rates, while floating rate securities may produce less income +than expected if interest rates fall. Due in part to these factors, our future investment income may fall short of expectations due to changes in interest rates. We may also suffer losses in principal if we are forced to sell securities that decline +in market value due to changes in interest rates. However, because any debt securities we hold are classified as “available-for-sale,” no gains or losses are recognized due to changes in interest rates unless such securities are sold prior +to maturity. +Recent U.S. sub-prime mortgage defaults have had a significant impact across various sectors of the financial markets, +causing global credit and liquidity issues. The short-term funding markets have experienced instability during 2007 and 2008, leading to liquidity disruption in asset-backed commercial paper and failed auctions of auction rate securities. Further +deterioration of the global credit market could adversely impact certain financial institutions that may have invested in or offered such securities. To the extent that we hold corporate bonds issued by those financial institutions in our portfolio, +we could be adversely impacted and we could determine that some of our investments are impaired, which could adversely impact our financial results. As of December 31, 2008, we had not been adversely affected by these credit and liquidity +issues. +If Our Estimates or Judgments Relating to Our Critical Accounting Policies Are Based on Assumptions That Change or Prove to be +Incorrect, Our Operating Results Could Fall Below Expectations of Securities Analysts and Investors, Resulting in a Decline in Our Stock Price. +Our discussion and analysis of financial condition and results of operations is based on our financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of +financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. On an ongoing basis, we +evaluate significant estimates used in preparing our financial statements, including those related to: +• +Revenue recognition; +• +Allowance for uncollectible accounts receivable; +• +Reserve for inventory write-downs; +• +Stock-based compensation; +• +Potential impairment of long-lived and intangible assets; +• +Clinical trial accruals; and +• +Contingencies. +We base our +estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances, as provided in our discussion and analysis of financial condition and results of operations, the results of which form the +basis for making judgments about the carrying values of assets and +34 +Table of Contents +liabilities that are not readily apparent from other sources. Actual results may differ from these and other estimates if our assumptions change or if actual +circumstances differ from those in our assumptions, which could cause our operating results to fall below the expectations of securities analysts and investors, resulting in a decline in our stock price. +In 2005 and 2006, we made payments totaling $4.5 million under a license agreement to certain HCV patents and we capitalized these payments as intangible +assets to be amortized over their estimated useful lives. We determined that these costs should be capitalized rather than expensed for two primary reasons. First, our intent in executing the HCV patent license was to provide for various +alternatives for use of the license, including the sale or distribution of third party produced HVC products in the international marketplace that would not require additional research and development efforts or regulatory approvals. Second, we +estimated that the present value of the cash flows to be received from future product sales in these international markets will exceed the net book value of the license payments. It is possible, however, that events or circumstances may occur which +could cause us to lower the estimated value of these future cash flows. As of December 31, 2008, there had been no sales of HCV product in the international markets. If we are not successful in selling an HCV product in the international marketplace +or such sales are significantly less than forecasted, the cash flows actually received from these sales could be significantly less than planned or nonexistent. If this occurs and we conclude that the present value of the future cash flows is less +than the net book value of the license payments, we would be required to record an impairment charge equal to such difference, up to the entire remaining book value of this intangible asset ($3,277,288 at December 31, 2008). Any significant +impairment charges that we are required to incur in the future could have a material adverse impact on our balance sheet and future operating results. +Our Credit Facilities Contain Certain Financial Covenants Which, if Not Satisfied, Could Result in the Acceleration of the Amounts Due Under These Facilities and Limit Our Ability to Borrow in the Future. +Our credit facility with Comerica Bank contains various financial and other covenants with which we must comply on an ongoing or +periodic basis. Although we do not expect to violate these covenants and obligations, if such a violation were to occur, the outstanding debt under our credit facility could become immediately due and payable, our lender could proceed against any +collateral securing such indebtedness and our ability to borrow additional funds in the future may be adversely affected. +We May Require Future +Additional Capital. +Our future liquidity and ability to meet our future capital requirements will depend on numerous factors, +including, but not limited to, the following: +• +The costs and timing of the expansion of our manufacturing capacity; +• +The success of our research and product development efforts; +• +The magnitude of capital expenditures; +• +Changes in existing and potential relationships with distributors and other business partners; +• +The time, cost and degree of success of conducting clinical trials and obtaining regulatory approvals; +• +The costs involved in obtaining and enforcing patents, proprietary rights and necessary licenses; +• +The costs and liability associated with patent infringement or other types of litigation; +• +The costs and timing of expansion of sales and marketing activities; +• +The timing of the commercial launch of new products; +• +The extent to which existing and new products gain market acceptance; +• +The scope and results of clinical testing; +• +Competing technological and market developments; and +• +The scope and timing of strategic acquisitions. +35 +Table of Contents +If additional financing is needed, we may seek to raise funds through the sale of equity or other +securities or through bank borrowings. There can be no assurance that financing through the sale of securities, bank borrowings or otherwise, will be available to us on satisfactory terms, if at all. +Terrorist Attacks or National Disasters May Adversely Affect Our Business. +Terrorist attacks or natural disasters, and subsequent governmental responses to these events, could cause economic instability. These actions could +adversely affect economic conditions both within and outside the United States and reduce demand for our products. These events could disrupt the operations of our customers and suppliers and eliminate, reduce or delay our customers’ ability to +purchase and use our products and our suppliers’ ability to provide raw materials and finished products. +Our manufacturing facilities +are located in Bethlehem, Pennsylvania. Although we have business interruption insurance, our facilities and some pieces of manufacturing equipment are difficult to replace and could require substantial replacement lead-time. Various types of +disasters, including earthquakes, fires, floods and acts of terrorism, may affect our manufacturing facilities. In the event our existing manufacturing facilities or equipment is affected by man-made or natural disasters, we may be unable to +manufacture products for sale or meet customer demands or sales projections. If our manufacturing operations were curtailed or ceased, it would seriously harm our business. +Risks Relating to Our Common Stock +Our Stock Price Could Continue to be +Volatile. +Our stock price has been volatile, has fluctuated substantially in the past and may be volatile in the future and could +experience substantial declines. The following factors, among others, could have a significant impact on the market for our Common Stock: +• +Future announcements concerning us or our products; +• +Future announcements concerning our competitors or industry; +• +Developments in patent or other proprietary rights; +• +Litigation or threatened litigation; +• +Public concern as to the performance or safety of products that we or others have developed or sold; +• +Failure to achieve, or changes in, financial estimates by securities analysts and comments or opinions about us by securities analysts or major stockholders; +• +Governmental regulation; +• +Clinical results with respect to our products in development or those of our competitors; +• +Timing of completion of clinical studies and receipt of required regulatory approvals; +• +Changes in the level of competition; +• +Loss of or declines in sales to major distributors or customers or changes in the mix of products sold; +• +The relatively low trading volume for our Common Stock; +• +Period to period fluctuations in our operating results; +• +Additions or departures of key personnel; +• +General market and economic conditions; and +• +Terrorist attacks, civil unrest, war and national disasters. +36 +Table of Contents +Future Sales of Our Common Stock by Existing Stockholders, Executive Officers or Directors Could +Depress the Market Price of Our Common Stock and Make It More Difficult For Us to Sell Stock in the Future. +Sales of our Common Stock +in the public market, or the perception that such sales could occur, could negatively impact the market price of our Common Stock. We are unable to estimate the number of shares of our Common Stock that may actually be resold in the public market +since this will depend on the market price for our Common Stock, the individual circumstances of the sellers and other factors. +We have a +number of institutional stockholders that own significant blocks of our Common Stock. If one or more of these stockholders sell large portions of their holdings in a relatively short time, for liquidity or other reasons, the prevailing market price +of our Common Stock could be negatively affected. In addition, it is possible that one or more of our executive officers or non-employee members of our Board of Directors could sell shares of our Common Stock during an open trading window under our +Insider Trading Policy. These transactions and the perceived reasons for these transactions could have a negative effect on the prevailing market price of our Common Stock. +Investor Confidence and Share Value May be Adversely Impacted if We and/or Our Independent Registered Public Accounting Firm Conclude That Our +Internal Control Over Financial Reporting is Not Effective. +As directed by Section 404 of the Sarbanes-Oxley Act of 2002, the SEC +adopted rules requiring us, as a public company, to include a report of management in our Annual Reports on Form 10-K that contains an assessment by management of the effectiveness of our internal control over financial reporting. In addition, our +independent registered public accounting firm must report on the effectiveness of these internal controls. +We expect that our internal +controls will continue to evolve as our business activities change. Although we seek to diligently and vigorously review our internal control over financial reporting in an effort to ensure compliance with the Section 404 requirements, any +control system, regardless of how well designed, operated and evaluated, can provide only reasonable, not absolute, assurance that its objectives will be met. If, during any year, our independent registered public accounting firm is not satisfied +with our internal control over financial reporting or the level at which our controls are documented, designed, operated, tested or assessed, or if the independent registered public accounting firm interprets the requirements, rules or regulations +differently than we do, then it may issue a report that is qualified. This could result in an adverse reaction in the financial marketplace due to a loss of investor confidence in the reliability of our financial statements and effectiveness of our +internal controls, which ultimately could negatively impact the market price of our Common Stock. +Anti-Takeover Provisions in Our +Certificate of Incorporation, Bylaws and Stockholder Rights Plan and Under Delaware Law Could Make a Third Party Acquisition of Us Difficult. +Our Certificate of Incorporation, Bylaws and Stockholder Rights Plan contain provisions that could make it more difficult for a third party to acquire us, even if doing so would be beneficial to our stockholders. We are also subject to +certain provisions of Delaware law that could delay, deter or prevent a change in control of us. These provisions could limit the price investors might be willing to pay in the future for shares of our Common Stock. +ITEM 1B. Unresolved +Staff Comments. +Not Applicable. +ITEM 2. Properties. +We own a 48,000 square foot facility which is our primary corporate office and manufacturing facility, a 31,700 square foot facility that houses our sales and marketing and research and development offices, and a +33,500 square foot facility which is used for manufacturing activities. Each of these facilities is located in Bethlehem, Pennsylvania and is subject to a mortgage in favor of Comerica Bank. +37 +Table of Contents +We rent additional warehouse space on an as-needed basis. We also lease space for a small sales office in +Reeuwijk, The Netherlands. +We believe that the facilities described above are adequate for our current requirements. +ITEM 3. Legal Proceedings. +On April 22, 2008, a complaint was filed against us in the United States District Court for +the District of New Jersey by Inverness Medical Innovations, Inc., Inverness Medical Switzerland GmbH and Church & Dwight Co., Inc., alleging that we infringed U.S. Patent No. 6,485,982. The complaint specifically refers to our +OraQuick ADVANCE ® Rapid HIV-1/2 Antibody Test. The complaint seeks injunctive relief, damages and an award of attorneys’ fees. We have filed our Answer responding to the +allegations in the Complaint and asserting various defenses and counterclaims. +On October 10, 2008, the plaintiffs filed a motion for +summary judgment of infringement in this case, pursuant to a schedule previously established by the Court. We have filed our response to this motion and briefing is now complete. +We believe that none of our products, including the OraQuick ADVANCE ® HIV test, infringe the patent asserted in this lawsuit or any other party’s intellectual property rights. We also believe that the patent asserted in this matter is invalid or +unenforceable, and we intend to defend this lawsuit vigorously. We are unable at this time to determine the impact, if any, that this lawsuit may have on our business or prospects. +ITEM 4. +Submission of Matters to a Vote of Security Holders. +No matters were submitted to a vote of security holders during the fourth quarter of the year ended December 31, 2008. +38 +Table of Contents +PART II +ITEM 5. +Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities. +Market Information +Our Common Stock is listed for +trading on the Global Select Market tier of The Nasdaq Stock Market LLC (“NASDAQ”) under the symbol OSUR. High and low sales prices reported by NASDAQ during the periods indicated are shown below. +Year ended December 31, +2008 +2007 +High +Low +High +Low +First Quarter +$ +9.23 +$ +6.37 +$ +9.00 +$ +6.50 +Second Quarter +7.81 +3.74 +8.49 +6.92 +Third Quarter +6.25 +3.69 +10.20 +7.89 +Fourth Quarter +4.96 +2.18 +10.57 +8.13 +On March 4, 2009, there were 554 holders of record and approximately 12,000 holders in street +name of our Common Stock, and the closing price of our Common Stock was $2.43 per share. +Dividends +We have never paid any cash dividends and our Board of Directors does not anticipate paying cash dividends in the foreseeable future. We are generally not +permitted to pay dividends or make other distributions to our stockholders under the terms of our credit facilities with Comerica Bank, without first obtaining Comerica’s consent. We intend to retain any future earnings to provide funds for the +operation and expansion of our business. +Share Repurchases and Retirements +The following is a summary of share repurchase activity during the three months ended December 31, 2008. +Pursuant to our 2000 Stock Award Plan and in connection with the vesting of restricted shares, we retired 135,432 shares to satisfy minimum tax +withholding obligations. +In addition, on August 5, 2008, our Board of Directors approved a share repurchase program pursuant to which +we are permitted to acquire up to $25.0 million of outstanding shares. +Period +Total +Number +of Shares +Purchased +Average +Price +Paid +per +Share +Total +Number of +Shares +Purchased +as part of a +publicly +Announced +Plan or +Program 1 +Maximum +Dollar Value +of Shares that +may yet be +Purchased +Under the +Plan or +Program 2 +October 1, 2008—October 31, 2008 +384,925 +$ +4.13 +384,925 +$ +20,357,484 +November 1, 2008—November 30, 2008 +127,360 +3.55 +127,360 +19,905,880 +December 1, 2008—December 31, 2008 +11,885 +3.11 +9,060 +19,878,893 +Total +524,170 +$ +3.97 +521,345 +1 +These shares were purchased under our $25.0 million stock +repurchase program. +2 +Under our stock repurchase program, we are authorized to spend up to an aggregate of $25.0 million for stock +repurchases. This column represents the amount that remains available under the $25.0 million stock repurchase program, as of the end of the period indicated. We have made no commitment to purchase any shares, and purchases may be discontinued at +any time. +39 +Table of Contents +Performance Graph +The performance graph set forth below shall not be deemed “soliciting material” or “filed” for purposes of Section 18 of the Securities Exchange Act of 1934, as amended (the “Exchange +Act”), or otherwise subject to liability under that Section. This graph will not be deemed “incorporated by reference” into any filing under the Securities Act of 1933, as amended, or the Exchange Act, whether such filing occurs +before or after the date hereof, regardless of any general incorporation language in such filing. +The following graph compares the +cumulative total returns to investors in the Company’s Common Stock, the NASDAQ Composite Index and the NASDAQ Biotechnology Index for the period from December 31, 2003 through December 31, 2008. The graph assumes that $100 was +invested on December 31, 2003 in the Company’s Common Stock and in each of the above-mentioned indices, and that all dividends, if any, were reinvested. +The NASDAQ Composite Index was chosen because it is a broad index of companies whose equity securities are traded on the NASDAQ Stock Market. The NASDAQ Biotechnology Index was chosen because it includes a number of +our competitors. Stockholders are cautioned that the graph shows the returns to investors only as of the dates noted and may not be representative of the returns for any other past or future period. +* +$100 invested on 12/31/03 in stock & index-including reinvestment of dividends. Fiscal year ended December 31. +12/03 +12/04 +12/05 +12/06 +12/07 +12/08 +OraSure Technologies, Inc. +100.00 +84.42 +110.80 +103.77 +111.68 +46.23 +NASDAQ Composite +100.00 +110.08 +112.88 +126.51 +138.13 +80.47 +NASDAQ Biotechnology +100.00 +112.17 +130.53 +130.05 +132.24 +122.10 +40 +Table of Contents +ITEM 6. +Selected Financial Data +The following table sets forth selected financial data of the Company. This information should be read in conjunction with the Financial Statements and notes thereto included in Item 15 and the information set forth in Item 7, +“Management’s Discussion and Analysis of Financial Condition and Results of Operations.” +Selected Financial Data +(In thousands, except per share data) +Year ended December 31, +2008 +2007 +2006 +2005 +2004 +Operating Results: +Revenues +$ +71,104 +$ +82,686 +$ +68,155 +$ +69,366 +$ +54,008 +Costs and expenses +87,435 +83,905 +62,692 +61,793 +55,365 +Operating income (loss) +(16,331 +) +(1,219 +) +5,463 +7,573 +(1,357 +) +Other income (expense), net +7,583 +5,513 +3,599 +2,146 +797 +Income tax provision (benefit) +22,527 +1 +1,821 +3,794 +(17,729 +) 2 +— +Net income (loss) +(31,275 +) 1 +2,472 +5,268 +27,448 +2 +(560 +) +Earnings (loss) per share +Basic +$ +(0.67 +) +$ +0.05 +$ +0.11 +$ +0.61 +$ +(0.01 +) +Diluted +$ +(0.67 +) +$ +0.05 +$ +0.11 +$ +0.59 +$ +(0.01 +) +Shares used in computing earnings (loss) per share +Basic +46,550 +46,325 +45,910 +45,110 +44,464 +Diluted +46,550 +46,878 +46,580 +46,147 +44,464 +Cash Flow: +Cash flows provided by (used in) operating activities +$ +(2,460 +) +$ +11,584 +$ +16,886 +$ +10,392 +$ +3,438 +December 31, +2008 +2007 +2006 +2005 +2004 +Financial Position: +Cash, cash equivalents, and short-term investments +$ +82,523 +$ +95,566 +$ +91,001 +$ +77,620 +$ +66,723 +Working capital +90,936 +105,620 +95,979 +90,670 +68,910 +Deferred tax assets +— +22,327 +23,522 +26,708 +— +Total assets +131,918 +167,353 +156,565 +130,747 +88,064 +Long-term debt, excluding current portion +8,301 +8,818 +10,031 +884 +1,334 +Accumulated deficit +(127,275 +) +(96,000 +) +(98,414 +) +(103,682 +) +(131,130 +) +Stockholders’ equity +108,325 +140,055 +129,504 +118,919 +75,577 +1 +Includes an income tax provision of $25,978 resulting from the establishment of a full valuation allowance on our net +deferred tax assets (see Note 8 to the financial statements). +2 +Includes an income tax benefit of $18,165 resulting from the elimination of a significant portion of the valuation +allowance on our net deferred tax assets. +41 +Table of Contents +ITEM 7. Management’s Discussion and Analysis of Financial +Condition and Results of Operations. +Statements below regarding future events or performance are “forward-looking +statements” within the meaning of the Private Securities Litigation Reform Act of 1995. Our actual results could be quite different from those expressed or implied by the forward-looking statements. Factors that could affect results are +discussed more fully under the Item 1A, entitled “Risk Factors,” and elsewhere in this Annual Report. Although forward-looking statements help to provide complete information about us, readers should keep in mind that forward-looking +statements may not be reliable. Readers are cautioned not to place undue reliance on the forward-looking statements. +The following +discussion should be read in conjunction with the financial statements contained herein and the notes thereto, along with the Section entitled “Critical Accounting Policies and Estimates,” set forth below. +Overview +We operate primarily in the in vitro +diagnostic business. Our business principally involves the development, manufacture, marketing and sale of oral fluid diagnostic products and specimen collection devices using our proprietary oral fluid technologies, as well as other diagnostic +products including immunoassays and other in vitro diagnostic tests that are used on other specimen types, and other medical devices used for the removal of warts and other benign skin lesions by cryosurgery, or freezing. Our diagnostic +products include tests which are performed on a rapid basis at the point of care and tests which are processed in a laboratory. These products are sold in the United States and internationally to various clinical laboratories, hospitals, clinics, +community-based organizations and other public health organizations, distributors, government agencies, physicians’ offices, and commercial and industrial entities. One of our products has been sold in the OTC or consumer retail market in the +United States, Canada, Europe, Mexico and Australia. +In vitro diagnostic testing is the process of analyzing oral fluid, blood, +urine and other bodily fluids or tissue for the presence of specific substances or markers for infectious diseases, drugs of abuse or other conditions. However, we have targeted the use of oral fluid in our products as a differentiating factor and +believe that it provides a significant competitive advantage over blood and urine. Our oral fluid tests have sensitivity and specificity comparable to blood and/or urine tests. In vitro diagnostic tests are performed outside the body, in +contrast to in vivo tests, which are performed directly on or within the body. When combined with their ease of use, non-invasive and dignified nature, and cost effectiveness, our oral fluid tests represent a very competitive alternative to +the more traditional testing methods in the diagnostic space. +During the year ended +December 31, 2008, our total revenues were $71.1 million, which represents a 14% decrease from the $82.7 million we reported in 2007. We recorded a net loss of $31.3 million for the year ended December 31, 2008, which includes a non-cash +charge of $26.0 million in our income tax provision for the establishment of a full valuation allowance against our net deferred tax assets. This compares to net income of $2.5 million for the year ended December 31, 2007. During 2008, we +continued to invest in our research and development efforts to obtain FDA approval to sell our OraQuick ® HIV test over the counter, to develop our rapid HCV test and to develop homogeneous +fully automated drugs of abuse assays for use with our Intercept oral fluid collection device in collaboration with Roche Diagnostics. As a result, research and development expenses increased $6.1 million in 2008 compared to the prior year. Our +liquidity position remains strong, as we had $82.5 million in cash, cash equivalents and short-term investments at December 31, 2008. +Revenues from the infectious disease testing market continued to grow in 2008 as result of sales +of our OraQuick ADVANCE ® HIV-1/2 test. Sales to public health benefited from the growth in our base business and from the incremental sales driven by the CDC’s efforts to +increase HIV testing. +We terminated our distribution agreement with Abbott for the +sale of OraQuick ADVANCE ® at the end of 2008 as a result of our decision to sell OraQuick ADVANCE ® directly to US +hospitals and reference laboratories +42 +Table of Contents +starting on January 1, 2009. Sales to Abbott decreased in 2008 as a direct result of the reduction of Abbott purchases in the latter months of 2008 in +anticipation of the agreement termination at year end and increased competition in the hospital market. Under our former distribution agreement, Abbott was our exclusive distributor in the U.S. hospital market and a non-exclusive distributor in the +U.S. physicians’ office marketplace. +Competition in the market for HIV testing is intense and is expected to increase. We believe +that the principal competition will come from existing laboratory-based blood tests, point-of-care rapid blood tests, laboratory-based urine assays or other oral fluid-based tests that may be developed. Our competitors include specialized +biotechnology firms, as well as pharmaceutical companies with biotechnology divisions and medical diagnostic companies. +Revenues from our cryosurgical products decreased significantly in 2008, primarily due to the +absence of sales in the U.S. OTC market, reduced sales in certain European and Mexican OTC markets, and a decrease in product sales in the domestic professional market. The cryosurgical systems market is comprised of Histofreezer ® sales into both the domestic and international physicians’ office markets and sales of our OTC product formulation to our international distributors, SSL and Genomma Labs. SSL distributes +our wart removal product under its Scholl’s and Dr. Scholl trademarks in the OTC footcare market in several European countries. Genomma Labs has distribution rights to a similar product in the OTC footcare market in Mexico, Argentina, +Brazil, and various other Central and South American countries. +Genomma Labs reduced its purchasing levels in 2008, in response to an +increase in product returns from retailers due to overstocking during the winter months of 2007. Sales to SSL declined due to lower revenues experienced by SSL in key markets outside of the United Kingdom. The absence of U.S. OTC sales in 2008 +resulted from the termination of our domestic distribution relationship with Prestige Brands at the end of 2007. As a result, we have developed our own proprietary nationally branded wart removal product which we started selling in the U.S. OTC +market in early 2009. It is not possible to predict at this time how well the new branded product will perform. +Our combined cryosurgical sales to physician offices also experienced a decline in 2008 as the business was negatively impacted by the diversion of some lower-priced Histofreezer ® product from international sources back into the U.S. professional market. We addressed this diversion issue by increasing our international pricing, changing product labeling and packaging, and enforcing contractual +rights against certain international distributors. We believe this diversion issue was largely confined to 2008, and we do not expect it to have a material impact on 2009 revenues. +Revenues from the substance abuse testing market decreased in 2008 as sales of our Intercept ® drug testing system were directly impacted by the decline in pre-employment testing in domestic markets. Pre-employment drug screening represents approximately 50% of our workplace drug testing +business. As a result of the decline in the U.S. economy, the related decrease in hiring has had a direct impact on this segment of our business. +Because of the regulatory approvals needed for most of our products, we often are required to rely +on sole source providers for critical components and materials and on related products supplied by third parties. This is particularly true for our OraQuick ADVANCE ® test, our +OraSure ® oral fluid collection device and our oral fluid Western blot HIV-1 confirmatory product. If we are unable to obtain necessary components or materials from these sole sources, the +time required to develop replacements and obtain the required FDA approvals could disrupt our ability to sell the affected products. +In past years, BMX manufactured and sold the only oral fluid HIV-1 screening test that had +received FDA approval for use in detecting HIV-1 in an oral fluid specimen collected with our OraSure ® collection device. BMX also supplied the HIV-1 antigen used to manufacture our oral +fluid Western blot HIV-1 confirmatory test and was the exclusive world-wide distributor of that product. BMX discontinued manufacturing their HIV-1 EIA screening test during 2007. As a result, we intend to seek FDA approval of an alternative HIV-1 +EIA screening +43 +Table of Contents +test for use with our OraSure ® collection device. BMX also elected not to renew our Western blot +agreements beyond December 31, 2007, and we are now selling the Western blot oral fluid HIV-1 confirmatory test directly to our laboratory customers. +We also rely heavily on distributors to purchase and resell many of our products. For example, SSL +has exclusive rights to our wart removal product in the OTC footcare market in Europe, Australia and New Zealand. We granted Genomma Labs exclusive rights to distribute our wart removal product in the OTC market in Mexico, Argentina, Brazil, and +various other Central and South American countries. We have contracted with several distributors to sell our OraQuick ADVANCE ® HIV-1/2 test to the U.S. physician office market and +our Intercept ® and OraSure ® product lines are sold by several laboratory distributors. +We expect to enter into additional distribution agreements for new and future products, for distribution in the U.S. and internationally. If our +distributors are unable or unwilling to meet the minimum purchase commitments set forth in their agreements or otherwise substantially reduce the volume of their purchases, our revenues and results of operations could be adversely affected. +We generated 81% of our 2008 revenues in the U.S. marketplace compared to 78% in 2007. We are continuously evaluating strategies to +increase our sales penetration in markets outside the U.S. As our business in foreign countries increases, we could be exposed to other economic, political, exchange rate, regulatory and cultural risks. +The current economic downturn, including disruptions in the capital and credit markets, may continue indefinitely and intensify, and could adversely +affect our financial performance and condition or those of our customers and suppliers. These circumstances could adversely affect our access to liquidity needed to conduct or expand our business or conduct acquisitions or make other discretionary +investments. These circumstances may also adversely impact the capital needs of our customers and suppliers, which, in turn, could adversely affect their ability to purchase our products or supply us with necessary equipment, raw materials or +components. +Results of Operations +Year Ended +December 31, 2008 Compared to December 31, 2007 +Total revenues decreased 14% to $71.1 million in 2008 from $82.7 million in +2007. Increased sales in both the infectious disease and insurance risk assessment markets, together with an increase in licensing and product development revenues, were more than offset by declines in sales of our cryosurgical wart removal and +substance abuse testing products. Revenues derived from products sold to customers outside the United States were $13.7 million and $18.1 million or 19% and 22% of total revenues for the years ended December 31, 2008 and 2007, respectively. The +majority of our international sales are transactions in U.S. dollars. As such, the impact of foreign currencies has not been material to our operating results. +The table below shows the amount of our total revenues (in thousands, except %) generated in each of our principal markets and by licensing and product development activities. +Year Ended December 31, +Dollars +% +Change +Percentage of +Total Revenues +Market +2008 +2007 +2008 +2007 +Infectious disease testing +$ +38,096 +$ +35,791 +6 +% +54 +% +43 +% +Substance abuse testing +14,006 +15,789 +(11 +) +20 +19 +Cryosurgical systems +10,655 +23,533 +(55 +) +15 +28 +Insurance risk assessment +6,085 +5,464 +11 +8 +7 +Product revenues +68,842 +80,577 +(15 +) +97 +97 +Licensing and product development +2,262 +2,109 +7 +3 +3 +Total revenues +$ +71,104 +$ +82,686 +(14 +)% +100 +% +100 +% +44 +Table of Contents +Sales to the infectious disease testing market +increased 6% to $38.1 million in 2008, primarily as a result of the continued strong performance of our OraQuick ADVANCE ® rapid HIV-1/2 antibody test in an increasingly competitive +environment. OraQuick ® and OraSure ® sales during 2008 totaled $35.3 million and $2.8 million, respectively, as compared to $32.7 +million and $3.1 million in 2007, respectively. +The table below shows a breakdown +of our total OraQuick ® revenues (in thousands, except %) during 2008 and 2007. +Year ended +December 31, +% +Change +Customers +2008 +2007 +Direct to U.S. Public Health +$ +25,438 +$ +19,799 +28 +% +Abbott +6,625 +8,102 +(18 +) +International +3,234 +3,291 +(2 +) +SAMHSA / CDC +12 +1,464 +(99 +) +Total OraQuick ® revenues +$ +35,309 +$ +32,656 +8 +% +During 2008, OraQuick ® revenue derived from direct sales to the U.S. public health market increased by 28% as compared to 2007. This increase is the result of continued growth in our base business and from +incremental sales driven by the CDC’s efforts to increase HIV testing. In September 2007, the CDC awarded incremental funding to expand HIV testing and prevention programs in populations disproportionately affected by HIV, primarily African +Americans. These funds were allocated to targeted state and public health agencies, for utilization during 2008. +For the year ended December 31, 2008, sales to our former hospital distributor, Abbott, decreased 18% to $6.6 million, as compared to $8.1 million in 2007. This decrease was largely the result of Abbott’s +ordering patterns, the impact of negotiations to end our distribution agreement at the end of 2008, and increased competition in the hospital market. As previously discussed, commencing in 2009, we began selling our OraQuick ADVANCE ® rapid HIV-1/2 antibody test directly into the U.S. hospital market. +Revenues derived from the CDC and SAMHSA declined significantly in 2008 when compared to 2007. In +2007, the CDC and SAMHSA placed bulk purchase orders directly with the Company for OraQuick ADVANCE ® devices and related testing materials, for further distribution to various public +health entities. However, both the CDC and SAMHSA did not place new bulk orders in 2008 and are not currently engaging in bulk procurement and distribution activities. As such, it is not expected that comparable-sized bulk purchase orders from these +governmental entities or others will be received in the future. +We believe that our +OraQuick ADVANCE ® device, which is FDA-approved for detecting antibodies to both HIV-1 and HIV-2 in oral fluid, finger-stick and venous whole blood, and plasma samples, and is +CLIA-waived for use with all sample types except plasma, provides a significant competitive advantage, thereby enabling us to fully implement a strategy for selling OraQuick ® in the U.S. +and internationally. We received CE mark approval for our OraQuick ADVANCE ® test and we currently sell small quantities of this product in Europe. We have established distribution +channels in several European countries and are pursuing other distributors elsewhere in the European Union and in other countries. +International sales of our OraQuick ® +test remained relatively flat at $3.2 million in both 2008 and 2007, with sales in Africa contributing $2.4 and $2.5 million of those revenues in 2008 and 2007, respectively. +We have continued to see evidence that sales of OraQuick ADVANCE ® are negatively impacting sales of our OraSure ® oral fluid collection device in the infectious disease testing market in the U.S. +During 2008, our sales of OraSure ® declined $348,000 from $3.1 million in 2007 to $2.8 million in 2008. Some customers who have purchased our OraSure ® device for laboratory HIV-1 testing in the past are now electing to purchase our +45 +Table of Contents +OraQuick ADVANCE ® test. We believe this is the result of customers recognizing the +benefits of rapid HIV testing, especially with oral fluid, and the CDC’s efforts to increase rapid HIV testing in healthcare settings. While it is not possible at this time to estimate the extent of such ongoing change in purchasing patterns, +we expect the decline in OraSure ® sales to continue. +Sales to the substance abuse testing market decreased 11% in 2008 as the use of our Intercept ® device for workplace testing was impacted by the continuing +adverse economic conditions. The table below shows a breakdown of our total Intercept ® revenues (in thousands, except %) generated in each market during 2008 and 2007. +Year ended +December 31, +% +Change +Market +2008 +2007 +Workplace testing +$ +4,750 +$ +6,650 +(29 +)% +Criminal justice +2,663 +2,570 +4 +International +2,168 +2,188 +(1 +) +Direct +1,204 +1,003 +20 +Total Intercept ® revenues +$ +10,785 +$ +12,411 +(13 +)% +Our workplace testing business decreased +29% from $6.7 million in 2007 to $4.8 million in 2008. Pre-employment drug screening represents approximately 50% of our workplace testing business and the current decline in the domestic economy and rising unemployment has had a direct impact on +this segment of our business. Accordingly, we do not expect renewed growth in our Intercept ® business until employment conditions in the U.S. improve. +In addition, the microplate oral fluid drug assays, which are sold for use with the Intercept ® collection device, are expected to come under increasing competitive pressure in the future from “home-brew” assays developed internally by our laboratory customers. Our oral fluid +microplate assays also compete with urine-based homogeneous assays that are run on fully-automated, random access analyzers. We believe our competitors are developing oral fluid tests suitable for use on these fully automated homogeneous assay +systems and these assays, if and when they are developed and commercialized, could represent a significant competitive threat to our oral fluid microplate business. In order to meet this competition, we are jointly developing and intend to +commercialize fully-automated homogeneous oral fluid drugs of abuse assays with Roche Diagnostics for use with our Intercept ® device. +Sales of our products in the cryosurgical systems market (which includes both the physicians’ office and OTC markets) decreased 55% to $10.7 million +in 2008 from $23.5 million in 2007. This decrease was primarily the result of a significant decline in sales of our domestic and international OTC cryosurgical products when compared to 2007. +The table below shows a breakdown of our total cryosurgery revenues (in thousands, except %) generated in each market during 2008 and 2007. +Year ended +December 31, +% +Change +Market +2008 +2007 +Professional domestic +$ +3,911 +$ +5,247 +(25 +)% +Professional international +2,529 +2,349 +8 +OTC domestic +— +6,237 +(100 +) +OTC international +4,215 +9,700 +(57 +) +Total cryosurgical systems revenues +$ +10,655 +$ +23,533 +(55 +)% +46 +Table of Contents +Our domestic OTC cryosurgical product was +previously distributed in the United States and Canada by Prestige, owner of the Compound W ® line of wart removal products. Our distribution agreement with Prestige terminated on +December 31, 2007, and as a result, no sales were made to Prestige in 2008 or will be made in the future to this distributor. Sales to Prestige were $6.2 million in 2007. In 2008, we developed our own proprietary nationally branded wart removal +product and began selling this product in the U.S. OTC market in early 2009. It is not possible to predict at this time how successful our new brand will be in the domestic OTC marketplace. +We have an agreement with SSL under which we manufacture and supply, and SSL distributes on an exclusive basis, our cryosurgical wart removal product in +the OTC footcare market in Europe, Australia and New Zealand. The product is manufactured and sold under SSL’s Scholl and Dr. Scholl trademarks. Sales to SSL were $3.8 million and $5.3 million in 2008 and 2007, respectively. The $1.5 +million sales decline in the current year is due to lower than expected outsales by SSL in key markets outside of the United Kingdom, primarily resulting from intense competition from an already-existing brand and new market entrants. +We have granted Genomma Labs exclusive distribution rights to our cryosurgical wart removal product in the OTC markets in Mexico, Argentina, Brazil, and +various other Central and South American countries. Sales to Genomma Labs were approximately $400,000 in 2008 and $4.4 million in 2007. During 2008, Genomma Labs reduced its purchases from us, in response to an increase in product returns from +retailers in Mexico who overstocked during the winter months of 2007. Throughout 2008, Genomma worked to reduce its excess inventory position, and accordingly did not purchase additional product from us. We believe these markets represent potential +future sales opportunities for our cryosurgical products; however, the full realization of such sales will take time. +Sales of our Histofreezer ® product to +physicians’ offices in the United States decreased 25% to $3.9 million in 2008, as compared to $5.2 million in 2007. Sales of Histofreezer ® in the international market increased 8% to +$2.5 million from $2.3 million in 2007. On a combined basis, however, cryosurgical sales in the professional market declined in 2008, as this business was affected by the diversion of some lower-priced Histofreezer ® product from international sources into the U.S. professional market. The selling prices for our Histofreezer ® product are lower in some foreign countries +due to differences in the healthcare systems in those countries. During 2008, some distributors in these countries purchased English-labeled Histofreezer ® product and resold it into the +domestic distribution network to distributors who employ alternate sourcing programs. We aggressively addressed this diversion issue by increasing our international pricing, changing product labeling and packaging, and enforcing contractual rights +against certain international distributors. We believe this diversion issue was largely confined to 2008 and we do not expect it to have a material impact on 2009 revenues. +We are beginning to see some evidence that sales of our OTC cryosurgical products may reduce the +number of individuals that will seek to obtain treatment of their warts by a physician, which in turn could negatively affect sales of our Histofreezer ® product in the professional market. +It is not possible at this time to estimate the extent of the financial impact of this change. +Sales to the insurance risk assessment +market increased 11% from $5.5 million in 2007 to $6.1 million in 2008, primarily as a result of an increase in revenues associated with our oral fluid Western blot HIV-1 confirmatory test. BMX discontinued the distribution of our Western blot HIV-1 +confirmatory test and, as a result, we are now selling this product directly to our laboratory customers. Overall, we expect our 2009 revenues in this market will remain at levels comparable to those attained in 2008. +Licensing and product development revenues increased to $2.3 million in 2008, from $2.1 million in +2007. In January 2008, we entered into a license and settlement agreement with Schering-Plough in which they agreed to pay us royalties on sales of their Freeze Away TM product. Pursuant to the terms of that licensing agreement, during 2008, we recorded $2.3 million in royalty payments from Schering-Plough. In December 2006, we entered into a collaboration agreement with +Schering-Plough Corporation, for the development and promotion of a rapid oral fluid test for the detection of antibodies to HCV. During 2007, we recognized $2.0 million in revenues associated with funded research and development under this +agreement. +47 +Table of Contents +The Company’s gross margin was 58% in 2008, +compared to 61% in 2007. Our 2008 gross margin was negatively impacted by the significant decline in higher-margin cryosurgical sales and by increases in manufacturing scrap and spoilage expense. Scrap expense increased from $1.3 million in 2007 to +$2.0 million in 2008. Although scrap and spoilage expense exceeded 2007 levels, OraQuick ® scrap and spoilage was down sequentially in each quarter of 2008, as we identified its root cause +and made the appropriate adjustments. We expect overall OraQuick ® scrap and spoilage expense to be significantly lower in 2009 when compared to 2008, primarily due to the OraQuick ® product and manufacturing process enhancements and twelve-month shelf life recently approved by the FDA. +Research and development expenses increased 43% to $20.3 million in 2008, from $14.1 million in +2007, primarily as a result of increased product and clinical development costs for our OraQuick ® HCV test, costs associated with our continued efforts to obtain FDA approval to sell our +OraQuick ® HIV test over the counter, and costs to develop our homogeneous fully-automated drugs of abuse assays for use with our Intercept ® oral fluid collection device in collaboration with Roche Diagnostics. Also included in the current year expense is a $1.0 million patent license milestone payment required as a result of our filing of a premarket +approval application with the FDA for our OraQuick ® HCV device. We believe the majority of the product development and clinical trial costs associated with the OraQuick ® HCV device have already been incurred. As such, we expect our research and development costs to decrease in 2009. +Sales and marketing expenses increased 4% to $20.9 million in 2008 from $20.1 million in 2007. This increase was primarily the result of incremental salaries, benefits, and recruiting and relocation expenses related +to hiring additional direct sales personnel for the hospital market, as we prepared to assume control of this distribution channel from Abbott in 2009. These increases were partially offset by a decrease in distributor advertising and promotional +costs. We expect 2009 sales and marketing expenses to remain at approximately the 2008 level. +General and administrative expenses +decreased 6% to $16.3 million in 2008 from $17.3 million in 2007. This decrease was primarily attributable to lower cash and stock compensation costs, bank charges, consulting fees and legal expenses. In 2009, we expect general and administrative +costs to increase slightly due to increased staffing costs and legal expenses associated with the patent infringement lawsuit filed against us by Inverness Medical and Church & Dwight. +Interest expense decreased to $346,000 in 2008 from $520,000 in 2007, as a result of lower outstanding debt balances and our election to fix the interest +rate on our primary facilities advance at 4.15% until its maturity in June 2011. Interest income decreased to $3.1 million in 2008 from $4.7 million in 2007 primarily as a result of lower yields earned on our investment portfolio, usage of some +previously-invested cash to fund inventory purchases, capital expenditures, and the stock repurchase program initiated during 2008, and an overall conservative, shorter-term investment approach. +As a result of the license and settlement agreement we entered into with Schering-Plough to resolve our patent infringement litigation, we received a +payment of $4.9 million during the first quarter of 2008, which was recorded as other income. In January 2007, we sold our ownership interest in a privately-held nonaffiliated company and recorded a $1.4 million pre-tax gain on the sale of this +investment. +We purchase some of our cryosurgical products from, or utilize the services of, vendors located in The Netherlands. As a +result of the weakness of the United States dollar in relation to the Euro, we recorded a net loss on foreign currency transactions in the amount of $36,000 and $105,000 for the years ended December 31, 2008 and 2007, respectively. +During 2008, we recorded a $3.5 million net federal and state tax benefit associated with the pretax loss of $8.7 million for that same period. In the +fourth quarter of 2008, however, as global economic conditions worsened, we also re-evaluated whether or not we would realize the benefits associated with our total net deferred tax asset in the future. Given the uncertainty surrounding the +magnitude and length of the current economic recession, our loss in 2008, and our projection of a loss in 2009, we determined that it is more likely +48 +Table of Contents +than not that we will not realize the benefits associated with our net deferred tax assets in the immediate future. Accordingly, in accordance with Statement +of Financial Accounting Standards (“SFAS 109”), “Accounting for Income Taxes, we recorded an income tax charge of $26.0 million in the fourth quarter of 2008 in order to establish a full valuation allowance against our net deferred +tax asset. +During 2007, we recorded provisions for federal and state income taxes of $1.8 million, which reflect a 42% effective tax rate. +Our effective rate reflects the impact of permanent differences, generated by items which are not deductible on our income tax returns. In addition, during the fourth quarter of 2007, we recorded an income tax benefit of $289,000 related to the +inclusion of a federal research and development tax credit. +Year Ended December 31, 2007 Compared to December 31, 2006 +Total revenues increased by 21% to $82.7 million in 2007 from $68.2 million in 2006, primarily as a +result of increased sales of our OraQuick ADVANCE ® rapid HIV-1/2 antibody test and our OTC cryosurgical products, together with an increase in funded research and development related +to our OraQuick ® rapid HCV test. +The table below shows the amount of our total +revenues (in thousands, except %) generated in each of our principal markets and by licensing and product development activities. +Year Ended December 31, +Dollars +% +Change +Percentage of +Total Revenues +2007 +2006 +2007 +2006 +Infectious disease testing +$ +35,791 +$ +29,180 +23 +% +43 +% +43 +% +Substance abuse testing +15,789 +15,752 +— +19 +23 +Cryosurgical systems +23,533 +17,333 +36 +28 +25 +Insurance risk assessment +5,464 +5,565 +(2 +) +7 +8 +Product revenues +80,577 +67,830 +19 +97 +99 +Licensing and product development +2,109 +325 +549 +3 +1 +Total revenues +$ +82,686 +$ +68,155 +21 +% +100 +% +100 +% +Sales to the infectious disease testing +market increased 23% to $35.8 million in 2007, primarily as a result of the increasing strength of our OraQuick ADVANCE ® rapid HIV-1/2 antibody test. OraQuick ® and OraSure ® sales during 2007 totaled $32.7 million and $3.1 million, respectively, as compared to $25.6 million and $3.6 million in +2006, respectively. +The table below shows a breakdown of our total OraQuick ® revenues (in thousands, except %) during 2007 and 2006. +Year ended +December 31, +% +Change +Customers +2007 +2006 +Direct to U.S. Public Health +$ +19,799 +$ +15,268 +30 +% +Abbott +8,103 +6,897 +17 +SAMHSA +339 +406 +(17 +) +CDC +1,125 +1,291 +(13 +) +International +3,291 +1,694 +94 +Total OraQuick ® revenues +$ +32,657 +$ +25,556 +28 +% +During 2007, OraQuick ® revenue derived from direct sales to the U.S. public health market increased by 30% as compared to 2006. This increase was the result of continued growth in usage of the OraQuick +49 +Table of Contents +ADVANCE ® rapid HIV-1/2 antibody test in public health settings, including city-wide +testing programs. Revenue in 2007 from HIV testing initiatives in various cities around the country more than doubled from 2006, increasing to over $1.7 million. +For the year ended December 31, 2007, sales to our hospital distributor, Abbott, grew 17% to $8.1 million, as compared to $6.9 million in 2006. This increase was the result of continued penetration of the U.S. +hospital market by Abbott in collaboration with our hospital sales team. +In +previous periods, the CDC and SAMHSA have placed bulk purchases orders for OraQuick ADVANCE ® devices and related testing materials directly with the Company. It is not likely that +comparable-sized bulk purchase orders from these governmental entities or others will be received in the future. +International sales of our OraQuick ® test increased 94% to $3.3 million in 2007 compared to $1.7 million in 2006. The largest contributor of growth was our +African business which experienced a 76% increase in sales to almost $2.5 million. +During 2007, our sales of OraSure ® declined $500,000 from $3.6 million in 2006 to $3.1 million in 2007. +Sales to the substance abuse testing market remained flat in 2007 at $15.8 million, as sales of +our Intercept ® device for workplace testing were impacted by a decrease in employment rates domestically and a decrease in funding internationally. The international market experienced a +decrease in public sector funding which had slowed the implementation of criminal justice testing. +The table below shows a breakdown of our total Intercept ® revenues (in thousands, except %) generated in each market during 2007 and 2006. +Year ended +December 31, +% +Change +Market +2007 +2006 +Workplace testing +$ +6,650 +$ +6,616 +1 +% +Criminal justice +2,570 +2,398 +7 +International +2,188 +2,314 +(5 +) +Direct +1,003 +728 +38 +Total Intercept ® revenues +$ +12,411 +$ +12,056 +3 +% +Sales of our products in the cryosurgical systems market (which includes both the physicians’ +office and OTC markets) increased 36% to $23.5 million in 2007 from $17.3 million in 2006. This increase was primarily the result of increased sales of our international and domestic OTC cryosurgical products when compared to 2006. +The table below shows a breakdown of our total cryosurgery revenues (in thousands, except %) generated in each market during 2007 and 2006. +Year ended +December 31, +% +Change +Market +2007 +2006 +Professional domestic +$ +5,247 +$ +5,360 +(2 +)% +Professional international +2,349 +2,284 +3 +OTC domestic +6,237 +5,174 +21 +OTC international +9,700 +4,515 +115 +Total cryosurgical systems revenues +$ +23,533 +$ +17,333 +36 +% +50 +Table of Contents +Our domestic OTC cryosurgical product, called +Freeze Off ® , was distributed in the United States and Canada by Prestige, owner of the Compound W ® line of wart removal products. +In September 2006, Prestige announced that it had acquired the Wartner ® cryosurgical wart removal product line, which directly competed with the Freeze Off ® product in the OTC market. Our distribution agreement with Prestige contained a covenant not to compete which precluded Prestige from acquiring, manufacturing, distributing or selling a cryosurgical product that +directly competed with the Freeze Off ® product. We notified Prestige that its acquisition of the Wartner ® product constituted a +material breach of the distribution agreement and that certain of its other actions constituted additional breaches under the agreement. Efforts to resolve this matter through mediation were not successful and arbitration commenced. Our distribution +agreement with Prestige terminated on December 31, 2007 as a result of the arbitration proceeding. Sales to Prestige were $6.2 million and $5.2 million, in 2007 and 2006, respectively +We have an agreement with SSL under which we manufacture and supply, and SSL distributes on an exclusive basis, the Company’s cryosurgical wart +removal product in the OTC footcare market in Europe, Australia and New Zealand. The product is manufactured and sold under SSL’s Scholl and Dr. Scholl trademarks. Sales to SSL under the distribution agreement were $5.3 million and $4.5 +million in 2007 and 2006, respectively. +Early in 2007, we entered into an agreement with Genomma Labs pursuant to which Genomma +distributes on an exclusive basis our cryosurgical wart removal product in the OTC market in Mexico. Sales to Genomma under this new distribution agreement were approximately $4.4 million in 2007. +Sales of our Histofreezer ® product to +physicians’ offices in the United States decreased 2% to $5.2 million in 2007, as compared to $5.4 million in 2006. Sales of Histofreezer ® in the international market remained +relatively flat at $2.3 million. +Sales to the insurance risk assessment market declined by 2% to $5.5 million in 2007 from $5.6 million in +2006, primarily because of a reduction in the number of applications for life insurance and changes in underwriting requirements. For higher face-value policies, it appears insurance companies are more likely to use a blood test for multiple risk +factors, rather than an oral fluid test. +Licensing and product development revenues increased to $2.1 million in 2007, from $325,000 in +2006. In December 2006, we entered into a collaboration agreement with Schering-Plough, for the development and promotion of a rapid oral fluid test for the detection of antibodies to HCV. During 2007, we recognized $2.0 million in revenues +associated with funded research and development under this agreement. We do not expect to recognize any additional licensing and product development revenues pursuant to this agreement. +The Company’s gross margin was 61% in 2007, compared to 64% in 2006. Our 2007 gross margin was negatively impacted primarily from increased scrap +expense, higher product support costs and a less favorable product mix. Scrap expense increased from $762,000 in 2006 to $1.3 million in 2007. +Research and development expenses increased 63% to $14.1 million in 2007, from $8.6 million in +2006, primarily as a result of product and clinical development costs for our OraQuick ® HCV test, costs associated with OTC clinical trials for our OraQuick ® HIV-1/2 test, and a clinical study to gain FDA approval for a product line extension in our OTC cryosurgery business. +Sales and marketing expenses increased 26% to $20.1 million in 2007 from $15.9 million in 2006. This increase was primarily the result of higher salaries and commissions, incremental salaries, benefits, recruiting and +relocation expenses associated with additional sales personnel, increases in reimbursable distributor advertising and promotion costs, and increased travel, consulting, and advertising expenses. +General and administrative expenses increased 29% to $17.3 million in 2007 from $13.4 million in 2006. This increase was primarily attributable to higher +staffing costs associated with new personnel and increased +51 +Table of Contents +charges for stock-based compensation. This increase was also attributable to increased legal expenses associated with the Prestige and Schering-Plough legal +proceedings. +Interest expense increased to $520,000 in 2007 from $405,000 in 2006, as a result of higher outstanding debt balances during +the current period, resulting from financing the purchase of our Bethlehem facilities in June 2006, partially offset by interest capitalized for construction in progress during 2007. Interest income increased to $4.7 million in 2007 from $4.1 +million in 2006, as a result of higher yields on our investment portfolio and larger balances available for investment. +In January 2007, +we sold our ownership interest in a privately-held nonaffiliated company and recorded a $1.4 million pre-tax gain on the sale of this investment. +We purchase some of our cryosurgical products from, or utilize the services of, vendors located in The Netherlands. As a result of the decline in the exchange rate between the United States dollar and the Euro, we recorded a $105,000 loss +on foreign currency transactions for the year ended December 31, 2007, and a $94,000 loss for the year ended December 31, 2006. +During 2007 and 2006, we recorded provisions for federal and state income taxes of $1.8 million and $3.8 million, respectively, which reflect a 42% effective tax rate in each period. Our effective rate reflects the impact of permanent +differences, generated by items which are not deductible on our income tax returns. In addition, during the fourth quarter of 2007, we recorded an income tax benefit of $289,000 related to the inclusion of a federal research and development tax +credit. +Liquidity and Capital Resources +December 31, +2008 +2007 +(In thousands) +Cash and cash equivalents +$ +39,565 +$ +32,230 +Short-term investments +42,957 +63,336 +Working capital +90,936 +105,620 +Our cash, cash equivalents and short-term investments decreased $13.0 million to $82.5 million at +December 31, 2008, primarily as a result of using $2.5 million in cash to fund operations, $5.1 million to buy back shares under our stock repurchase plan, $2.6 million for property and equipment purchases, $1.2 million for payments related to +patents and product rights, $515,000 for debt repayments, and $995,000 associated with the retirement of common stock to pay minimum tax withholding obligations on the vesting of restricted shares. +Net cash used in operating activities was $2.5 million in 2008, resulting from our net loss of $31.3 million for the year offset by the net non-cash +change in our deferred tax asset balance of $22.3 million. Other factors which contributed to the $2.5 million utilization of cash in the current period included non-cash charges for depreciation and amortization of $3.4 million, non-cash +stock-based compensation expense of $5.5 million, a provision for scrap and spoilage of $1.6 million and a $1.0 million charge for acquired in-process technology, all offset by a decrease in prepaid expenses and other assets of $1.1 million. At +December 31, 2007, we had recorded $930,000 in prepayments to contract research organizations (“CROs”) for clinical work they were to perform in 2008. These services were rendered by the CROs and, accordingly, we expensed these +prepayments in 2008. Also contributing to the use of cash was an increase of $2.9 million in inventories, primarily related to raw material purchases for our cryosurgical product line, a $274,000 increase in accounts receivable, and decreases in +accounts payable of $1.7 million and accrued expenses of $1.1 million, largely due to payments of our 2007 year-end royalty, legal, and other accruals. +52 +Table of Contents +Net cash provided by investing activities during 2008 was $16.3 million. Payments of $1.2 million for +certain patent and product rights and $2.6 million for additions to property and equipment, were offset by $20.2 million of net proceeds from maturities and redemptions of short-term investments. +During the year ending December 31, 2009, we expect to invest between $3 and $4 million in capital expenditures, primarily to purchase additional +equipment, upgrade certain older equipment and make improvements to our facilities. +Net cash used in financing activities was $6.5 million +for the year ended December 31 2008 primarily as a result of the purchase of 1,147,730 shares of common stock, at an aggregate cost of $5.1 million, under our stock repurchase plan which was approved by our Board of Directors on August 5, +2008, partially offset by $93,000 received from the exercise of stock options. Additional uses of cash for financing activities were $515,000 in loan principal repayments and $995,000 used for the purchase and retirement of common stock. +At December 31, 2008, we had in place a $14,000,000 credit facility (the “Credit Facility”) with Comerica Bank (“Comerica”) +which is comprised of a $10,000,000 facilities advance and a $4,000,000 revolving working capital line of credit. At our option, interest on the facilities advance is payable monthly at either a fixed rate equal to the five-year U.S. Treasury Note +rate plus 1.03% to 1.73%, or a variable rate equal to the 30, 180, or 360-day LIBOR plus 0.55% to 1.25%. In each case, the interest rate is determined at the date of the advance and is based upon the amount of cash and cash equivalents we invest and +retain at Comerica Securities, Inc. We also can choose the fixed rate option, without penalty, at the expiration of a previously elected LIBOR period. Principal is repayable in periodic installments, based upon the rate option that we elect, with +the remaining balance of unpaid principal due on June 27, 2011. Interest on any advances under the revolving working capital line of credit is payable at either the U.S. prime rate less 0.25% or 30-day LIBOR pus 2.55%, in each case determined +at the time of funding. In January 2008, we elected to fix the interest rate on the facilities advance at 4.15% until its maturity, with principal and interest payable on a monthly basis. +As of December 31, 2008, we had $8,791,679 in outstanding borrowings under the facilities advance and no outstanding borrowings under the $4,000,000 +revolving working capital line of credit, which has a maturity date of June 29, 2009. +All borrowings under the Credit Facility are +collateralized by a first priority security interest in all of our assets, including present and future accounts receivable, chattel paper, contracts and contract rights, equipment and accessories, general intangibles, investments, instruments, +inventories, and a mortgage on our three facilities in Bethlehem, Pennsylvania. Borrowings under the revolving working capital line of credit are limited to commercially standard percentages of accounts receivable. The Credit Facility contains +certain covenants that set forth minimum requirements for our quick ratio, liquidity, and tangible net worth. We were in full compliance with all covenants at December 31, 2008. The Credit Facility also restricts our ability to pay dividends, +to make certain investments, to incur additional indebtedness, to sell or otherwise dispose of a substantial portion of assets, and to merge or consolidate operations with an unaffiliated entity, without the consent of Comerica. +At December 31, 2008, we had NOL carryforwards of $49.5 million for federal income tax purposes. During the fourth quarter of 2005, the Company +retained independent tax specialists to perform an ownership change study and analysis to determine the annual limitation amount applicable to utilization of the NOL carryforwards due to past ownership changes, as defined in Section 382 of the +Internal Revenue Code. We continue to review ownership changes on an annual basis. We do not believe that ownership change limitations would impair our ability to utilize our NOLs against taxable income that we may generate in the future. In the +fourth quarter of 2008, we recorded a full valuation allowance against the deferred tax asset generated by these NOLs. Establishment of this valuation allowance does not change our view of the Company’s long-term financial outlook or the +expected utilization of our NOL carryforwards. +The combination of our current cash, cash equivalents, short-term investments, and +available borrowings under our Credit Facility, is expected to be more than sufficient to fund our operating and capital needs through +53 +Table of Contents +2009. Our cash requirements, however, may vary materially from those now planned due to many factors, including, but not limited to, the scope and timing of +strategic acquisitions, the cost and timing of the expansion of our manufacturing capacity, the progress of our research and development programs, the scope and results of clinical testing, the magnitude of capital expenditures, changes in existing +and potential relationships with business partners, the time and cost of obtaining regulatory approvals, the costs involved in obtaining and enforcing patents, proprietary rights and any necessary licenses, the cost and timing of expansion of sales +and marketing activities, the timing of market launch of new products, market acceptance of new products, competing technological and market developments and other factors. +Contractual Obligations and Commercial Commitments +The following sets forth our approximate +aggregate obligations at December 31, 2008 for future payments under contracts and other contingent commitments, for the year 2009 and beyond: +Contractual Obligations +Total +Payments due by December 31, +2009 +2010 +2011 +2012 +2013 +Thereafter +Long-term debt 1 +$ +8,859,337 +$ +557,897 +$ +509,761 +$ +7,791,679 +$ +— +$ +— +$ +— +Operating leases 2 +71,356 +71,356 +— +— +— +— +— +Employment contracts 3 +2,781,250 +1,901,875 +879,375 +— +— +— +— +Purchase obligations 4 +3,098,586 +1,519,376 +1,579,210 +— +— +— +— +Minimum commitments under contracts 5 +4,791,667 +500,000 +500,000 +500,000 +500,000 +500,000 +2,291,667 +Total contractual obligations +$ +19,602,196 +$ +4,550,504 +$ +3,468,346 +$ +8,291,679 +$ +500,000 +$ +500,000 +$ +2,291,667 +1 +Represents principal repayments required under notes payable to our lenders. See Note 7 to the financial statements included herein. +2 +Represents payments required under our operating leases. +3 +Represents salary payments payable under the terms of employment agreements executed by us with certain executives. See Note 10 to the financial statements included herein. +4 +Represents payments required by non-cancellable purchase orders related to inventory, capital expenditures and other goods or services. See Note 10 to the financial statements +included herein. +5 +Represents payments required pursuant to certain, licensing agreements executed by the Company. These agreements are cancellable within a specified number of days after +communication by the Company of its intent to terminate. See Note 10 to the financial statements included herein. Additional payments of up to $4,500,000 may be required pursuant to one of these licensing agreements for the achievement of specific +development and/or commercial milestones. +Off-Balance Sheet Arrangements. We do not have any +off-balance sheet arrangements, as defined in Item 303(a) (4) (ii) of Regulation S-K under the Securities Exchange Act of 1934, as amended. +Critical Accounting Policies and Estimates +This Management’s Discussion and Analysis of Financial Condition and +Results of Operations discusses our financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires that we make +estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenues and expenses during the reporting +period. On an on-going basis, we evaluate our judgments and estimates, including those related to bad debts, inventories, investments, intangible assets, income taxes, revenue recognition, clinical trial accruals, contingencies and litigation. We +base our judgments and estimates on historical experience and on various other +54 +Table of Contents +factors that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying value of +assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. +Our significant accounting policies are described in Note 2 to the financial statements included in Item 15 of this Annual Report. We consider the following accounting estimates, which have been discussed with +our Audit Committee, to be most critical in understanding the more complex judgments that are involved in preparing our financial statements and the uncertainties that could impact our results of operations, financial condition and cash flows. +Revenue Recognition. We follow SAB No. 104, “Revenue Recognition.” This bulletin draws on +existing accounting rules and provides specific guidance on revenue recognition for up-front non-refundable licensing and development fees. We license certain products or technology to outside third parties, in return for which we receive up-front +licensing fees. Some of these fees can be significant. In accordance with SAB No. 104, we recognize this revenue ratably over the related license period. +We also enter into research and development contracts with corporate, government and/or private entities. These contracts generally provide for payments to us upon achievement of certain research or development +milestones. Product development revenues from these contracts are recognized only if the specified milestone is achieved and accepted by the customer and payment from the customer is probable. Any amounts received prior to the performance of product +development efforts are recorded as deferred revenues. Recognition of revenue under these contracts can be sporadic, as it is the result of achieving specific research and development milestones. Furthermore, revenue from future milestone payments +will not be recognized if the underlying research and development milestones are not achieved. +We recognize product revenues when there is +persuasive evidence that an arrangement exists, the price is fixed or determinable, title has passed and collection is reasonably assured. Product revenues are net of allowances for any discounts or rebates. We do not grant price protection or +product return rights to our customers, except for warranty returns. Where a product fails to comply with its limited warranty, we can either replace the product or provide the customer with a refund of the purchase price or credit against future +purchases. Historically, returns arising from warranty issues have been infrequent and immaterial. Accordingly, we expense warranty returns as incurred. While such returns have been immaterial in the past, we cannot guarantee that we will continue +to experience the same rate of warranty claims as we have in the past. +Royalty income from the grant of license rights is recognized +during the period in which the revenue is earned and the amount is determinable from the licensee. +Allowance for Uncollectible Accounts +Receivable. Accounts receivable are reduced by an estimated allowance for amounts that may become uncollectible in the future. On an ongoing basis, we perform credit evaluations of our customers and adjust credit limits +based upon the customer’s payment history and creditworthiness, as determined by a review of their current credit information. We also continuously monitor collections and payments from our customers. +Based upon historical experience and any specific customer collection issues that are identified, we use our judgment to establish and evaluate the +adequacy of our allowance for estimated credit losses, which was $163,100 at December 31, 2008. While credit losses have been within our expectations and the allowance provided, these losses can vary from period to period ($101,412, $40,914 and +$16,022 in 2008, 2007 and 2006, respectively). Furthermore, there is no assurance that we will experience credit losses at the same rates as we have in the past. The current economic downturn, including disruptions in the capital and credit markets, +may continue indefinitely and intensify, and could adversely affect the operations, cash flows and financial condition of our customers. These circumstances may adversely impact the liquidity or financial position of our customers and could have a +material impact on the collectability of our accounts receivable and future operating results. +55 +Table of Contents +Inventories. Our inventories are valued at the lower of cost or market, +determined on a first-in, first-out basis, and include the cost of raw materials, labor and overhead. The majority of our inventories are subject to expiration dating. We continually evaluate the carrying value of our inventories and when, in the +opinion of management, factors indicate that impairment has occurred, either a reserve is established against the inventories’ carrying value or the inventories are completely written off. We base these decisions on the level of inventories on +hand in relation to our estimated forecast of product demand, production requirements over the next twelve months and the expiration dates of raw materials and finished goods. During 2008, 2007 and 2006, we wrote-off inventory which had a cost of +$1.6 million, $922,000 and $751,000, respectively, as a result of scrap and product expiration issues. Although we make every effort to ensure the accuracy of our forecasts of future product demand, any significant unanticipated changes in demand +could have a significant impact on the carrying value of our inventories and reported operating results. +Stock-based +Compensation. We follow SFAS No. 123 (revised 2004), “Share-Based Payment,” which requires us to recognize the fair value of equity-based awards as compensation expense in our statement of operations. The +fair value of our stock option awards was estimated using a Black-Scholes option valuation model. This valuation model’s computations incorporate highly subjective assumptions, such as the expected stock price volatility and the estimated life +of each award. The fair value of awards, after considering the effect of expected forfeitures, is then amortized, generally on a straight-line basis, over the related vesting period of the award. +Long-lived and Intangible Assets. Our long-lived assets are comprised of property and equipment and our intangible assets +primarily consist of patents and product rights. Together, these assets had a net book value of $25.6 million, or 19% of our total assets, at December 31, 2008. Property and equipment and patents and product rights are depreciated or amortized +on a straight-line basis over their estimated useful lives, which we determine based upon our estimate of the period of time over which each asset will generate revenues. In August 2005, we recorded a $1.5 million intangible asset related to a +payment under a license agreement to certain patents related to the Hepatitis C Virus or HCV. We recorded an additional $3.0 million related to this license in 2006. Management’s intent in executing this license was to provide for various +alternatives for use, including uses in the international market that would not require additional research and development efforts or regulatory approvals. This $4.5 million asset was capitalized based on management’s estimate of the cash +flows to be received from future product sales in these international markets. No sales of HCV products had been made in the international markets as of December 31, 2008. A similar analysis of estimated future cash flows will be prepared upon +payment of additional license fees under this agreement, or upon changes in circumstances, to determine the appropriate accounting treatment for payments under this license agreement. An impairment of long-lived or intangible assets could occur +whenever events or changes in circumstances indicate that the net book value of these assets may not be recoverable. Events which could trigger asset impairment include significant underperformance relative to expected historical or projected future +operating results, significant changes in the manner of our use of an asset or in our overall business strategy, significant negative industry or economic trends, and shortening of product life-cycles or changes in technology. If we believe +impairment of an asset has occurred, we measure the amount of such impairment by comparing the net book value of the affected assets to the fair value of these assets, which is generally determined based upon the present value of the expected cash +flows associated with the use of these assets. If the net book value exceeds the fair value of the impaired assets, we would incur an impairment expense equal to this difference. We currently believe the future cash flows to be received from all +long-lived and intangible assets will exceed their book value and, as such, we have not recognized any impairment losses for the years ended December 31, 2008, 2007 and 2006. Any unanticipated significant impairment in the future, however, +could have a material adverse impact to our balance sheet and future operating results. +Deferred Tax +Assets. At December 31, 2008, we had federal NOL carryforwards of $49.5 million. The net deferred tax asset associated with these NOLs and other temporary differences was $25.9 million at December 31, 2008. In +assessing the realizability of net deferred tax assets, we consider whether it is more likely than not that some portion or all of the deferred tax assets will not be realized. The ultimate realization of deferred tax assets is dependent upon the +generation of future taxable income during the period in which those +56 +Table of Contents +temporary differences become deductible or the NOLs and credit carryforwards can be utilized. We consider the scheduled reversal of deferred tax liabilities, +projected future taxable income and tax planning strategies in making this assessment. +During the fourth quarter of 2008, we evaluated our +ability to realize our net deferred tax asset, in order to determine if a valuation allowance should be recorded against it. According to SFAS No. 109, a cumulative loss in recent years is significant piece of negative evidence to be considered +when evaluating the need for a valuation allowance and this evidence is difficult to overcome. Given the uncertainty surrounding the magnitude and length of the current economic recession, our loss in 2008, and our projection of a loss in 2009, we +determined that it is more likely than not that we will not realize the benefits associated with our net deferred tax asset in the immediate future. Accordingly, in accordance with SFAS 109, we recorded an income tax charge of $26.0 million in the +fourth quarter of 2008 in order to establish a full valuation allowance against our net deferred tax asset. +Our ability to use our NOL +carryforwards to offset future federal income tax obligations could be limited by changes in the ownership of our stock. Internal Revenue Code (“IRC”) Section 382 contains provisions that limit the amount of federal NOL carryforwards +that can be used in any given year in the event of specified occurrences, including significant ownership changes. During the fourth quarter of 2005, the Company completed an analysis, with the assistance of independent tax specialists, to determine +if any IRC Section 382 ownership changes had occurred that would limit the amount of NOLs that could be utilized to offset future taxable income. As a result of this analysis, the Company concluded that prior period ownership changes may impose +a limitation on the amount of NOLs that can be utilized in a given year. The Company does not believe, however, that this limitation will impair our future ability to utilize NOLs to offset our future taxable income. The Company continues to review +ownership changes on an annual basis. +Clinical Trial Accruals. Some of our research and development is +conducted by third parties, including contract research and development service providers. All such costs are charged to research and development expense systematically as incurred, which may be measured by patient enrollment or the passage of time. +At the end of each quarter, we compare the payments made to each service provider to the estimated progress toward completion of the research or development objectives. Such estimates are subject to change as additional information becomes +available. Depending on the timing of payments to the service providers and the estimated service provided, we record net prepaid or accrued expense relating to these costs. +Contingencies. In the ordinary course of business, we have entered into various contractual relationships with strategic +corporate partners, customers, distributors, research laboratories and universities, licensors, licensees, suppliers, vendors and other parties. As such, we could be subject to litigation, claims or assessments arising from any or all of these +relationships. We account for contingencies such as these in accordance with SFAS No. 5, “Accounting for Contingencies.” SFAS No. 5 requires us to record an estimated loss contingency when information available prior to issuance +of our financial statements indicates that it is probable that an asset has been impaired or a liability has been incurred at the date of the financial statements and the amount of the loss can be reasonably estimated. Accounting for contingencies +arising from contractual or legal proceedings requires that we use our best judgment when estimating an accrual related to such contingencies. As additional information becomes known, our accrual for a loss contingency could fluctuate, thereby +creating variability in our results of operations from period to period. Likewise, an actual loss arising from a loss contingency which significantly exceeds the amount accrued for in our financial statements could have a material adverse impact on +our operating results for the period in which such actual loss becomes known. +ITEM 7A. +Quantitative and Qualitative Disclosures About Market Risk. +We do not hold any amounts of derivative financial instruments or derivative commodity instruments and, accordingly, we have no material derivative risk +to report under this Item. +A significant portion of our assets is comprised of certificates of deposit, commercial paper, U.S. government +and agency obligations, and U.S. corporate bonds. All such instruments are classified as +57 +Table of Contents +available-for-sale securities. The primary objective of our investment policy is to preserve principal while maximizing the related income without +significantly increasing risk. Even so, some of the securities in which we invest may be subject to market risk. Market risk is the risk that a change in prevailing interest rates may cause the fair value of an investment to fluctuate. As interest +rates increase, the fair value of a debt instrument would be expected to decrease. Correspondingly, if interest rates decrease the fair value of a debt instrument would be expected to increase. To minimize market risk, we have the ability to hold +such debt instruments to maturity, at which time the debt instrument would be redeemed at its stated or face value. To further mitigate market risk, we also typically invest in the shorter end of the maturity spectrum. As such, we do not believe +that we have a material exposure to market risk. +In January 2008 we elected to fix the interest rate at 4.15% on our long-term debt until +the debt’s maturity in June 2011. As a result, we have no exposure to interest rate changes. +As of December 31, 2008, we did not +have any foreign currency exchange contracts or purchase currency options to hedge local currency cash flows. We have operations in Europe and Africa, which are subject to foreign currency fluctuations. As currency rates change, translation of +revenues and expenses for these operations from foreign currencies to U.S. dollars affects year-to-year comparability of operating results. Sales denominated in a foreign currency represented approximately $108,000 of our total revenues for the year +ended December 31, 2008. We do not expect the risk of foreign currency fluctuations to be material in the near future. +ITEM 8. Financial Statements and Supplementary Data. +Information with +respect to this Item is contained in our Financial Statements included in Item 15 of this Annual Report on Form 10-K. +ITEM 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure. +Not applicable. +ITEM 9A Controls and Procedures. +(a) Evaluation of Disclosure Controls and Procedures. +The Company’s management, with the participation of the Company’s Chief Executive Officer and Chief Financial Officer, has evaluated the effectiveness of the Company’s disclosure controls and procedures +(as defined in Rules 13a-15(e) and 15d-15(e) of the Securities Exchange Act of 1934) as of December 31, 2008. Based on that evaluation, the Company’s management, including such officers, concluded that the Company’s disclosure +controls and procedures are adequate and effective to ensure that information required to be disclosed by the Company in the reports that we file or submit under the Securities Exchange Act of 1934 is accumulated and communicated to the +Company’s management, including the Chief Executive Officer and Chief Financial Officer, to allow timely decisions regarding required disclosure and is recorded, processed, summarized, and reported within the time periods specified in the rules +and forms of the Securities and Exchange Commission. +(b) Management’s Report on Internal Control Over Financial Reporting. +The Company’s management is responsible for establishing and maintaining adequate internal control over financial reporting, as such +term is defined in Rule 13a-15(f) and 15d-15(f) under the Securities Exchange Act of 1934. Under the supervision and with the participation of the Company’s management, including our principal executive officer and principal financial officer, +we conducted an evaluation of the effectiveness of our internal control over financial reporting based on the framework in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway +Commission. Based on our evaluation under the framework, our management concluded that our internal control over financial reporting was effective to provide reasonable assurance regarding the reliability of financial reporting and the preparation +of financial statements for external purposes in accordance with generally accepted accounting principles as of December 31, 2008. +58 +Table of Contents +The effectiveness of our internal control over financial reporting as of December 31, 2008 has been +audited by KPMG LLP, an independent registered public accounting firm, as stated in their report, which is included below. +Because of its +inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of +changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. +(c) Changes in Internal +Control Over Financial Reporting. +There was no change in the Company’s internal control over financial reporting during the three +months ended December 31, 2008 that was identified in connection with the evaluation referred to in paragraph (b) above that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over +financial reporting. +(d) Report of Independent Registered Public Accounting Firm +The Board of Directors and Stockholders +OraSure Technologies, Inc.: +We have audited OraSure Technologies, Inc.’s internal control over financial reporting as of December 31, 2008, based on +criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). OraSure Technologies, Inc.’s management is responsible for maintaining effective +internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Management’s Report on Internal Control Over Financial Reporting. Our +responsibility is to express an opinion on the Company’s internal control over financial reporting based on our audit. +We conducted +our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over +financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and +operating effectiveness of internal control based on the assessed risk. Our audit also included performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion. +A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability +of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures +that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as +necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors +of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements. +Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections +of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. +59 +Table of Contents +In our opinion, OraSure Technologies, Inc. maintained, in all material respects, effective internal +control over financial reporting as of December 31, 2008, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). +We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the balance sheets of OraSure +Technologies, Inc. as of December 31, 2008 and 2007, and the related statements of operations, stockholders’ equity and comprehensive income (loss), and cash flows for each of the years in the three-year period ended December 31, +2008, and our report dated March 10, 2009 expressed an unqualified opinion on those financial statements. +/s/ KPMG LLP +Philadelphia, Pennsylvania +March 10, 2009 +ITEM 9B. Other +Information. +Not applicable. +60 +Table of Contents +PART III +We have omitted from Part III the information that will appear in our Definitive Proxy Statement for our 2009 Annual Meeting of Stockholders (the “Proxy Statement”), which will be filed within 120 days after +the end of our fiscal year pursuant to Regulation 14A. +ITEM 10. Directors, Executive Officers and +Corporate Governance. +Certain information required by this Item is incorporated by reference to the information under the captions, +“Corporate Governance—Committees of the Board—Audit Committee,” “Election of Directors,” “Executive Officers,” and “Section 16(a) Beneficial Ownership Reporting Compliance,” in the Proxy Statement. +Our Board of Directors has adopted a Code of Business Conduct and Ethics that applies to our principal executive officer, principal +financial officer and principal accounting officer, as well as to the members of our Board of Directors and our other officers and employees. This Code of Business Conduct and Ethics is available on our website at www.orasure.com . We intend +to satisfy the amendment and waiver disclosure requirements under applicable securities regulations by posting any amendments of, or waivers to, the Code of Business Conduct and Ethics on our website. +ITEM 11. Executive Compensation. +The information required by this Item is incorporated by reference to the information under the caption, “Executive Compensation,” in the Proxy +Statement. +ITEM 12. Security +Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters. +The information required by this Item with respect to the securities ownership of certain beneficial owners and management, and equity compensation plan +information, is incorporated by reference to the information under the captions, “Principal Stockholders” and “Equity Compensation Plan Information,” respectively, in the Proxy Statement. +ITEM 13. Certain Relationships and Related Transactions, and Director Independence. +The information required by this Item is incorporated by reference to the information under the captions, “Transactions with Related Persons” +and “Corporate Governance—Director Independence,” in the Proxy Statement. +ITEM 14. Principal +Accountant Fees and Services. +The information +required by this Item is incorporated by reference to the information under the caption, “Audit Fees; Audit-Related Fees; Tax Fees; All Other Fees,” in the Proxy Statement. +61 +Table of Contents +PART IV +ITEM 15. Exhibits +and Financial Statement Schedules. +(a)(1) and +(a)(2). Financial Statements and Schedules . For a list of the Financial Statements filed herewith, see the Index to Financial Statements following the signature page to this Annual Report. No schedules are included with +the Financial Statements because the required information is inapplicable or is presented in the Financial Statements or related notes thereto. +(a)(3). Exhibits . See Index to Exhibits following the Financial Statements in this Annual Report. +62 +Table of Contents +SIGNATURES +Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized, +on March 10, 2009. +ORASURE TECHNOLOGIES, INC. +By: +/s/ D OUGLAS A. M ICHELS +Douglas A. Michels +President and Chief Executive Officer +Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been +signed on March 10, 2009, by the following persons on behalf of the Registrant and in the capacities indicated. +SIGNATURE +TITLE +/s/ D OUGLAS A. M ICHELS +Douglas A. Michels +President, Chief Executive Officer and Director +(Principal Executive Officer) +/s/ R ONALD H. S PAIR +Ronald H. Spair +Chief Operating Officer, Chief Financial Officer and +Director (Principal Financial Officer) +/s/ M ARK L. K UNA +Mark L. Kuna +Senior Vice President, Finance and Controller +(Principal Accounting Officer) +*M ICHAEL C ELANO +Michael Celano +Director +*J ACK G OLDSTEIN , P H .D. +Jack Goldstein, Ph.D. +Director +*R ONNY B. L ANCASTER +Ronny B. Lancaster +Director +*C HARLES W. P ATRICK +Charles W. Patrick +Director +*R OGER L. P RINGLE +Roger L. Pringle +Director +*D OUGLAS G. W ATSON +Douglas G. Watson +Director +*By: +/s/ J ACK E. J ERRETT +Jack E. Jerrett +(Attorney-in-Fact) +63 +Table of Contents +INDEX TO FINANCIAL STATEMENTS +Page +Report of Independent Registered Public Accounting Firm +F-2 +Balance Sheets +F-3 +Statements of Operations +F-4 +Statements of Stockholders’ Equity and Comprehensive Income (Loss) +F-5 +Statements of Cash Flows +F-6 +Notes to the Financial Statements +F-7 +F-1 +Table of Contents +REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM +The Board of Directors and Stockholders +OraSure Technologies, Inc.: +We have audited the accompanying balance sheets of OraSure Technologies, Inc. as of December 31, 2008 and 2007, and the related statements of +operations, stockholders’ equity and comprehensive income (loss), and cash flows for each of the years in the three-year period ended December 31, 2008. These financial statements are the responsibility of the Company’s management. +Our responsibility is to express an opinion on these financial statements based on our audits. +We conducted our audits in accordance with the standards of +the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes +examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall +financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. +In our opinion, the financial statements referred +to above present fairly, in all material respects, the financial position of OraSure Technologies, Inc. as of December 31, 2008 and 2007, and the results of its operations and its cash flows for each of the years in the three-year period ended +December 31, 2008, in conformity with U.S. generally accepted accounting principles. +We also have audited, in accordance with the standards of the +Public Company Accounting Oversight Board (United States), OraSure Technologies, Inc.’s internal control over financial reporting as of December 31, 2008, based on criteria established in Internal Control—Integrated Framework +issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), and our report dated March 10, 2009 expressed an unqualified opinion on the effectiveness of the Company’s internal control over financial reporting. +/s/ KPMG LLP +Philadelphia, Pennsylvania +March 10, 2009 +F-2 +Table of Contents +ORASURE TECHNOLOGIES, INC. +BALANCE SHEETS +December 31, +2008 +2007 +ASSETS +CURRENT ASSETS: +Cash and cash equivalents +$ +39,565,218 +$ +32,229,697 +Short-term investments +42,957,467 +63,336,408 +Accounts receivable, net of allowance for doubtful accounts of $163,100 and $186,468 +11,571,048 +11,296,355 +Inventories +10,704,088 +9,409,743 +Deferred income taxes +— +5,060,974 +Prepaid expenses and other +1,418,171 +2,455,534 +Total current assets +106,215,992 +123,788,711 +PROPERTY AND EQUIPMENT, net +21,235,367 +20,911,157 +PATENTS AND PRODUCT RIGHTS, net +4,380,540 +5,279,471 +DEFERRED INCOME TAXES +— +17,265,591 +OTHER ASSETS +86,290 +107,586 +$ +131,918,189 +$ +167,352,516 +LIABILITIES AND STOCKHOLDERS’ EQUITY +CURRENT LIABILITIES: +Current portion of long-term debt +$ +557,897 +$ +556,751 +Accounts payable +3,925,662 +5,615,998 +Accrued expenses and other +10,795,955 +11,995,710 +Total current liabilities +15,279,514 +18,168,459 +LONG-TERM DEBT +8,301,440 +8,817,669 +OTHER LIABILITIES +11,985 +311,799 +COMMITMENTS AND CONTINGENCIES (Note 10) +STOCKHOLDERS’ EQUITY: +Preferred stock, par value $.000001, 25,000,000 shares authorized, none issued +— +— +Common stock, par value $.000001, 120,000,000 shares authorized, 45,769,221 and 46,644,046 shares issued and outstanding +46 +47 +Additional paid-in capital +235,862,999 +236,293,489 +Accumulated other comprehensive loss +(262,442 +) +(238,896 +) +Accumulated deficit +(127,275,353 +) +(96,000,051 +) +Total stockholders’ equity +108,325,250 +140,054,589 +$ +131,918,189 +$ +167,352,516 +The accompanying notes are an integral part of these statements. +F-3 +Table of Contents +ORASURE TECHNOLOGIES, INC. +STATEMENTS OF OPERATIONS +For the year ended December 31, +2008 +2007 +2006 +REVENUES: +Product +$ +68,842,755 +$ +80,576,622 +$ +67,830,561 +Licensing and product development +2,261,712 +2,109,254 +324,359 +71,104,467 +82,685,876 +68,154,920 +COST OF PRODUCTS SOLD +29,976,120 +32,402,794 +24,756,195 +Gross profit +41,128,347 +50,283,082 +43,398,725 +OPERATING EXPENSES: +Research and development +20,255,451 +14,136,019 +8,647,484 +Sales and marketing +20,916,718 +20,061,685 +15,921,467 +General and administrative +16,286,907 +17,304,615 +13,367,111 +57,459,076 +51,502,319 +37,936,062 +Operating income (loss) +(16,330,729 +) +(1,219,237 +) +5,462,663 +INTEREST EXPENSE +(345,767 +) +(520,002 +) +(404,680 +) +INTEREST INCOME +3,080,950 +4,709,771 +4,097,860 +OTHER INCOME +4,883,714 +1,428,691 +— +FOREIGN CURRENCY LOSS +(36,136 +) +(105,448 +) +(94,390 +) +Income (loss) before income taxes +(8,747,968 +) +4,293,775 +9,061,453 +INCOME TAX PROVISION +22,527,334 +1,821,336 +3,793,904 +NET INCOME (LOSS) +$ +(31,275,302 +) +$ +2,472,439 +$ +5,267,549 +EARNINGS (LOSS) PER SHARE: +BASIC +$ +(0.67 +) +$ +0.05 +$ +0.11 +DILUTED +$ +(0.67 +) +$ +0.05 +$ +0.11 +SHARES USED IN COMPUTING EARNINGS (LOSS) PER SHARE: +BASIC +46,549,739 +46,325,338 +45,909,990 +DILUTED +46,549,739 +46,878,143 +46,580,266 +The accompanying notes are +an integral part of these statements. +F-4 +Table of Contents +ORASURE TECHNOLOGIES, INC. +STATEMENTS OF STOCKHOLDERS’ EQUITY AND COMPREHENSIVE INCOME (LOSS) +For the years ended December 31, 2008, 2007 and 2006 +Common Stock +Additional +Paid-in +Capital +Deferred +Compensation +Accumulated +Other +Comprehensive +Loss +Accumulated +Deficit +Total +Shares +Amount +Balance at January 1, 2006 +45,775,625 +$ +46 +$ +226,218,469 +$ +(3,334,792 +) +$ +(282,825 +) +$ +(103,681,856 +) +$ +118,919,042 +Reclassification of deferred compensation +— +— +(3,334,792 +) +3,334,792 +— +— +— +Reclassification of liability-classified awards +— +— +(230,659 +) +— +— +— +(230,659 +) +Common stock issued upon exercise of options +85,013 +— +457,334 +— +— +— +457,334 +Vesting of restricted stock +199,633 +— +— +— +— +— +— +Purchase and retirement of common stock +(65,519 +) +— +(631,509 +) +— +— +— +(631,509 +) +Compensation cost for restricted stock +— +— +1,969,178 +— +— +— +1,969,178 +Compensation cost for stock option grants +— +— +3,621,412 +— +— +— +3,621,412 +Comprehensive income: +Net income +— +— +— +— +— +5,267,549 +5,267,549 +Currency translation adjustment +— +— +— +— +6,787 +— +6,787 +Unrealized gain on marketable securities, net of tax provision of $72,979 +— +— +— +— +124,841 +— +124,841 +Total comprehensive income +5,399,177 +Balance at December 31, 2006 +45,994,752 +46 +228,069,433 +— +(151,197 +) +(98,414,307 +) +129,503,975 +Adoption of FIN 48 +— +— +— +— +— +(58,183 +) +(58,183 +) +Reclassification of liability-classified awards +— +— +51,550 +— +— +— +51,550 +Common stock issued upon exercise of options +481,647 +1 +3,100,036 +— +— +— +3,100,037 +Vesting of restricted stock +258,093 +— +— +— +— +— +— +Purchase and retirement of common stock +(90,446 +) +— +(785,908 +) +— +— +— +(785,908 +) +Compensation cost for restricted stock +— +— +2,877,463 +— +— +— +2,877,463 +Compensation cost for stock option grants +— +— +2,980,915 +— +— +— +2,980,915 +Comprehensive income: +Net income +— +— +— +— +— +2,472,439 +2,472,439 +Currency translation adjustment +— +— +— +— +1,650 +— +1,650 +Unrealized loss on marketable securities, net of tax benefit of $52,287 +— +— +— +— +(89,349 +) +— +(89,349 +) +Total comprehensive income +2,384,740 +Balance at December 31, 2007 +46,644,046 +47 +236,293,489 +— +(238,896 +) +(96,000,051 +) +140,054,589 +Common stock issued upon exercise of options +14,786 +— +92,517 +— +— +— +92,517 +Vesting of restricted stock +393,551 +— +— +— +— +— +— +Purchase and retirement of common stock +(135,432 +) +— +(995,367 +) +— +— +— +(995,367 +) +Shares purchased and retired pursuant to the stock repurchase plan +(1,147,730 +) +(1 +) +(5,121,107 +) +— +— +(5,121,108 +) +Compensation cost for restricted stock +— +— +3,352,876 +— +— +— +3,352,876 +Compensation cost for stock option grants +— +— +2,240,591 +— +— +— +2,240,591 +Comprehensive loss: +Net loss +— +— +— +— +— +(31,275,302 +) +(31,275,302 +) +Currency translation adjustment +— +— +— +— +(36,201 +) +— +(36,201 +) +Unrealized gain on marketable securities +— +— +— +— +12,655 +— +12,655 +Total comprehensive loss +(31,298,848 +) +Balance at December 31, 2008 +45,769,221 +$ +46 +$ +235,862,999 +$ +— +$ +(262,442 +) +$ +(127,275,353 +) +$ +108,325,250 +The accompanying notes are an integral part of these statements. +F-5 +Table of Contents +ORASURE TECHNOLOGIES, INC. +STATEMENTS OF CASH FLOWS +For the year ended December 31, +2008 +2007 +2006 +OPERATING ACTIVITIES: +Net income (loss) +$ +(31,275,302 +) +$ +2,472,439 +$ +5,267,549 +Adjustments to reconcile net income (loss) to net cash provided by (used in) operating activities: +Gain on sale of investment in nonaffiliated company +— +(1,428,691 +) +— +Deferred income taxes +22,305,250 +1,313,839 +3,113,745 +Stock-based compensation +5,456,135 +5,830,770 +5,590,590 +Depreciation and amortization +3,386,670 +2,735,999 +1,923,275 +Acquired in-process technology +1,000,000 +— +1,000,000 +Provision for excess and obsolete inventories +1,575,910 +922,433 +750,542 +Changes in assets and liabilities: +Accounts receivable +(274,284 +) +(937,622 +) +1,250,552 +Inventories +(2,870,255 +) +(4,797,609 +) +(2,156,302 +) +Prepaid expenses and other +1,070,168 +(463,674 +) +(452,502 +) +Accounts payable +(1,686,143 +) +2,584,439 +465,344 +Accrued expenses and other liabilities +(1,148,491 +) +3,351,556 +133,011 +Net cash provided by (used in ) operating activities +(2,460,342 +) +11,583,879 +16,885,804 +INVESTING ACTIVITIES: +Purchase of property and equipment +(2,643,270 +) +(5,503,770 +) +(12,643,266 +) +Proceeds from sale of investment in nonaffiliated company +— +1,765,943 +— +Purchase of patents, product rights, or acquired in-process technology +(1,200,000 +) +(4,200,000 +) +(200,000 +) +Purchase of short-term investments +(67,125,962 +) +(93,953,103 +) +(91,494,215 +) +Proceeds from maturities and redemptions of short-term investments +87,315,645 +101,526,541 +65,433,600 +Net cash provided by (used in) investing activities +16,346,413 +(364,389 +) +(38,903,881 +) +FINANCING ACTIVITIES: +Proceeds from long-term debt +— +— +10,000,000 +Repayments of long-term debt +(515,083 +) +(1,264,716 +) +(701,426 +) +Proceeds from issuance of common stock +92,517 +3,100,037 +457,334 +Purchase and retirement of common stock +(5,121,108 +) +— +— +Withholding and retirement of common stock +(995,367 +) +(785,908 +) +(631,509 +) +Net cash provided by (used in) financing activities +(6,539,041 +) +1,049,413 +9,124,399 +EFFECT OF FOREIGN EXCHANGE RATE CHANGES ON CASH +(11,509 +) +10,973 +16,759 +NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS +7,335,521 +12,279,876 +(12,876,919 +) +CASH AND CASH EQUIVALENTS, BEGINNING OF YEAR +32,229,697 +19,949,821 +32,826,740 +CASH AND CASH EQUIVALENTS, END OF YEAR +$ +39,565,218 +$ +32,229,697 +$ +19,949,821 +The accompanying notes are an integral part of these statements. +F-6 +Table of Contents +ORASURE TECHNOLOGIES, INC. +NOTES TO THE FINANCIAL STATEMENTS +1. +THE COMPANY: +We develop, manufacture and market +oral fluid diagnostic products and specimen collection devices using our proprietary oral fluid technologies, as well as other diagnostic products, including in vitro diagnostic tests that are used on other specimen types, and other medical +devices used for the removal of warts and other benign skin lesions by cryosurgery, or freezing. Our diagnostic products include tests which are performed on a rapid basis at the point of care and tests which are processed in a laboratory. These +products are sold in the United States and internationally to various clinical laboratories, hospitals, clinics, community-based organizations and other public health organizations, distributors, government agencies, physicians’ offices, and +commercial and industrial entities. One of our products has been sold in the over-the-counter or consumer retail markets in the United States, Canada, Europe, Mexico and Australia. +The current economic downturn, including disruptions in the capital and credit markets, may continue indefinitely and intensify, and could adversely +affect our results of operations, cash flows and financial condition or those of our customers and suppliers. These circumstances could adversely affect our access to liquidity needed to conduct or expand our business or conduct acquisitions or make +other discretionary investments. These circumstances could adversely affect our ability to draw on existing credit facilities, which depend on the ability of the bank that is a party to that facility to meet its funding commitments to us. A bank may +not be able to meet its funding commitments if it experiences shortages of capital and liquidity. These circumstances may also adversely impact the capital needs of our customers and suppliers, which, in turn, could adversely affect their ability to +purchase our products or supply us with necessary equipment, raw materials or components. This could adversely affect our results of operations, cash flows and financial condition. A weakening business climate could cause longer sales cycles and +slower growth, and could expose us to increased business or credit risk in dealing with customers or suppliers adversely affected by economic conditions. Our ability to collect accounts receivable may be delayed or precluded if our customers are +unable to pay their obligations. +2. +SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES: +Use +of Estimates +The preparation of financial statements in conformity with accounting principles generally accepted in the United States +of America requires management to make estimates and assumptions about future events. These estimates and underlying assumptions affect the amounts of assets and liabilities reported, disclosures about contingent assets and liabilities, and reported +amounts of revenues and expenses. Such estimates include the valuation of accounts receivable, inventories and intangible assets, as well as calculations related to contingencies, accruals and indemnifications, among others. These estimates and +assumptions are based on management’s best estimates and judgment. Management evaluates its estimates and assumptions on an ongoing basis, using historical experience and other factors which management believes to be reasonable under the +circumstances, including the current economic environment. We adjust such estimates and assumptions when facts and circumstances dictate. Illiquid credit markets, volatile equity, foreign currency, and energy markets, and declines in consumer +spending have combined to increase the uncertainty inherent in such estimates and assumptions. As future events and their effects cannot be determined with precision, actual results could differ significantly from these estimates. Changes in those +estimates resulting from continuing changes in the economic environment, will be reflected in the financial statements in those future periods. +Cash and Cash Equivalents +We consider all highly liquid investments with a purchased maturity of ninety days or less to be +cash equivalents. As of December 31, 2008 and 2007, cash equivalents consisted of money market accounts, commercial paper and U.S. government agency obligations. +F-7 +Table of Contents +Short-term Investments +We consider all short-term investments to be available-for-sale securities, in accordance with Statement of Financial Accounting Standards +(“SFAS”) No. 115, “Accounting for Certain Investments in Debt and Equity Securities.” These securities are comprised of certificates of deposits, commercial paper, U.S. government and agency obligations, and corporate bonds, +all with purchased maturities greater than ninety days. Available-for-sale securities are carried at fair value, based upon quoted market prices, with unrealized gains and losses reported in stockholders’ equity as a component of accumulated +other comprehensive income (loss). There were no securities held as of December 31, 2008 in a continuous unrealized loss position for twelve or more months. +Recent U.S. sub-prime mortgage defaults have had a significant impact across various sectors of the financial markets, causing global credit and liquidity issues. The short-term funding markets have experienced +instability during 2007 and 2008, leading to liquidity disruption in asset-backed commercial paper and failed auctions of auction rate securities. Further deterioration of the global credit market could adversely impact certain financial +institutions that may have invested in or offered such securities. To the extent that we hold corporate bonds issued by those financial institutions in our portfolio, we could be adversely impacted and we could determine that some of our investments +are impaired, which could adversely impact our financial results. As of December 31, 2008, we had not been adversely affected by these credit and liquidity issues. +The following is a summary of our available-for-sale securities at December 31, 2008 and 2007: +Amortized +Cost +Gross +Unrealized +Gains +Gross +Unrealized +Losses +Fair Value +December 31, 2008 +Certificates of deposit +$ +6,098,000 +$ +8,401 +$ +— +$ +6,106,401 +Commercial paper +2,894,609 +4,425 +— +2,899,034 +Government and agency bonds +11,229,287 +106,173 +— +11,335,460 +Corporate bonds +22,730,229 +8,639 +(122,296 +) +22,616,572 +Total available-for-sale securities +$ +42,952,125 +$ +127,638 +$ +(122,296 +) +$ +42,957,467 +December 31, 2007 +Certificates of deposit +$ +2,721,321 +$ +3,759 +$ +(6,925 +) +$ +2,718,155 +Commercial paper +4,383,327 +1,158 +(92 +) +4,384,393 +Government and agency bonds +5,541,885 +15,681 +— +5,557,566 +Corporate bonds +50,704,757 +24,104 +(52,567 +) +50,676,294 +Total available-for-sale securities +$ +63,351,290 +$ +44,702 +$ +(59,584 +) +$ +63,336,408 +At December 31, 2008, maturities of our available-for-sale securities were as follows: +Less than one year +$ +39,446,846 +$ +112,412 +$ +(122,296 +) +$ +39,436,962 +One to two years +3,505,279 +15,226 +— +3,520,505 +Total available-for-sale securities +$ +42,952,125 +$ +127,638 +$ +(122,296 +) +$ +42,957,467 +Supplemental Cash Flow Information +In 2008, 2007 and 2006, we paid interest of $409,902, $663,127, and $350,535, respectively. In 2008 and 2007, we capitalized interest of $47,463 and +$131,738, respectively. +In 2008, 2007 and 2006, we paid federal and state income taxes of $381,950, $500,529, and $695,765, respectively. +F-8 +Table of Contents +In 2008 and 2007, we recorded through the statement of operations an increase in our allowance for +doubtful accounts of $78,044 and $27,288, respectively. In 2006 we recorded a reduction in our allowance for doubtful accounts of $61,950. We had write-offs of $101,412, $40,914, and $16,022 against the allowance for doubtful accounts in 2008, 2007, +and 2006, respectively. +In 2008, 2007, and 2006, we recorded accruals for purchases of property and equipment of $25,250, $66,053, and +$346,258, respectively. +In 2006, we recorded a $4,000,000 accrual related to two licensing agreements. +Accounts Receivable +Accounts +receivable have been reduced by an allowance for amounts that may become uncollectible in the future. This estimated allowance is based primarily on management’s evaluation of specific balances as the balances become past due; the financial +condition of our customers; and our historical experience related to write-offs. If not reserved or exempted through these specific examination procedures, our policy is to reserve 100% of accounts receivable in aging categories greater than 120 +days. +Inventories +Inventories are stated at the lower of cost or market determined on a first-in, first-out basis, and include the cost of raw materials, labor and overhead. The majority of our inventories are subject to expiration dating. We continually +evaluate quantities on hand and the carrying value of our inventories to determine the need for reserves for excess and obsolete inventories, based primarily on the estimated forecast of product sales. When factors indicate that impairment has +occurred, either a reserve is established against the inventories’ carrying value or the inventories are completely written off, as in the case of lapsing expiration dates. In addition to reserving for these items identified through specific +identification procedures, we also reserve for unidentified scrap or spoilage under a fixed-formula methodology. We currently buy a portion of our cryosurgical product line from a foreign vendor and pay for such purchases in Euros. Changes in the +exchange rate of the Euro will impact our product cost. +Property and Equipment +Property and equipment are stated at cost. Additions or improvements are capitalized, while repairs and maintenance are charged to expense. Depreciation +and amortization are provided using the straight-line method over the estimated useful lives of the related assets. Buildings are depreciated over 20-40 years, while computer equipment, machinery and equipment, and furniture and fixtures are +depreciated over three to ten years. Building improvements are amortized over their estimated useful lives. When assets are sold or otherwise disposed of, the related property amounts are relieved from the accounts, and any gain or loss is recorded +in the statement of operations. +Patents and Product Rights +Patents and product rights consist of costs associated with the acquisition of patents, licenses and product distribution rights. Patents and product +rights are amortized using the straight-line method over their estimated useful lives of three to ten years. +Impairment of Long-Lived +Assets +In accordance with SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets,” if indicators +of impairment exist, we assess the recoverability of the affected long-lived assets, which include property and equipment and patents and product rights, by determining whether the carrying value of such assets +F-9 +Table of Contents +can be recovered through the sum of the undiscounted future cash flows from the use and eventual disposition of the asset. If impairment is indicated, we +measure the amount of such impairment by comparing the carrying value of the assets to the fair value of these assets, which is generally determined based on the present value of the expected future cash flows associated with the use of the asset. +We believe the future cash flows to be received from our long-lived assets will exceed the assets’ carrying value, and accordingly we have not recognized any impairment losses for the years ended December 31, 2008, 2007, and 2006. +Revenue Recognition +We recognize product revenues when there is persuasive evidence that an arrangement exists, the price is fixed or determinable, title has passed and collection is reasonably assured. Product revenues are recorded net of allowances for any +discounts or rebates. We do not grant price protection or product return rights to our customers, except for warranty returns. Historically, returns arising from warranty issues have been infrequent and immaterial. Accordingly, we expense warranty +returns as incurred. +Royalty income from the grant of license rights is recognized during the period in which the revenue is earned and +the amount is determinable from the licensee. +Up-front licensing fees are deferred and recognized ratably over the related license period. +Product development revenues are recognized over the period in which the related product development efforts are performed. Amounts received prior to the performance of product development efforts are recorded as deferred revenues. Grant revenue is +recognized as the related work is performed and costs are incurred. We record shipping and handling charges billed to our customers as product revenue and the related expense as cost of products sold. Taxes assessed by governmental authorities, such +as sales or value-added taxes, are excluded from product revenues. +Significant Customer Concentration +We had the following significant concentrations in revenue and accounts receivable: +Percentage of Total Revenues +For the years ended December 31, +Customer +2008 +2007 +2006 +Quest Diagnostics, Incorporated +10 +% +11 +% +14 +% +Abbott Laboratories +10 +10 +10 +Percentage of +Accounts Receivable +at December 31, +2008 +2007 +Quest Diagnostics, Incorporated +8 +% +11 +% +SSL International plc +10 +13 +National Aids Control Program +15 +4 +Our distribution agreement with Abbott +Laboratories terminated at the end of 2008. Effective January 1, 2009, we began selling the OraQuick ADVANCE ® rapid HIV-1/2 test directly to U.S. hospitals and other customers +previously served by Abbott. +Research and Development +Research and development expenses consist of costs incurred in performing research and development activities including salaries and benefits, facilities expenses, overhead expenses, clinical trial and related +clinical manufacturing expenses, contract services and other outside expenses. Research and development costs are charged +F-10 +Table of Contents +to expense as incurred. Clinical trial expenses include expenses associated with contract research organizations, or CROs. The invoicing from CROs can +precede the services provided or can lag the service period by several months. Invoices paid prior to service being provided are recorded as a prepaid expense and then expensed appropriately as services are provided. We accrue the cost of services +rendered but unbilled by CRO’s based on purchase order estimates provided by the CRO. Differences between actual and estimated clinical trial expenses recorded are generally not material and would be adjusted for in the period in which they +become known. +Advertising Expenses +Advertising costs are charged to expense as incurred. During 2008, 2007, and 2006, we incurred $893,279, $1,261,356, and $805,936, respectively, in advertising expenses. Included in advertising expenses for 2008, 2007 +and 2006 were $687,308, $1,164,294 and $539,856, respectively, in reimbursement for marketing expenses incurred for our OTC cryosurgical products. +Stock-Based Compensation +We account for stock-based compensation to employees and directors using the fair value method in +accordance with SFAS No. 123 (revised 2004), “Share-Based Payment” (“SFAS No. 123R”), and stock-based compensation to nonemployees in accordance with SFAS No. 123R and Emerging Issues Task Force (“EITF”) +Issue No. 96-18, “Accounting for Equity Instruments That Are Issued to Other Than Employees for Acquiring, or in Conjunction with Selling, Goods or Services.” +Upon the adoption of SFAS No. 123R on January 1, 2006, our deferred compensation balance of $3,334,792 was reclassified against additional +paid-in capital. We have elected to recognize compensation expense for stock option awards issued to employees and directors on a straight-line basis over the requisite service period of the award. To satisfy the exercise of options or to issue new +restricted stock, we normally issue new shares rather than purchase shares on the open market. +Income Taxes +We follow the asset and liability method for accounting for income taxes. Under this method, deferred tax assets and liabilities are recognized for the +future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and the respective tax basis of assets and liabilities, and operating loss and credit carryforwards. Deferred tax +assets and liabilities are measured using enacted tax rates that are expected to apply to taxable income in the years in which those temporary differences and operating loss and credit carryforwards are expected to be recovered, settled or utilized. +The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. +In assessing the realizability of our net deferred tax assets, we follow the guidance contained within SFAS No. 109, “Accounting for Income Taxes,” which requires net deferred tax assets to be reduced by a valuation allowance if, +after considering all relevant positive and negative evidence, it is more likely than not that some portion or all of the net deferred tax assets will not be realized. The realization of the net deferred tax assets is dependent on several factors, +including the generation of sufficient taxable income prior to the expiration of the net operating loss carryforwards. We assess the realizability of our net deferred tax assets on a quarterly basis. +Foreign Currency Translation +Pursuant to SFAS No. 52, “Foreign Currency Translation,” the assets and liabilities of our foreign operations are translated from Euros into U.S. dollars at current exchange rates as of the balance sheet date, and revenues +and expenses are translated at average exchange rates for the period. Resulting translation adjustments are reflected in accumulated other comprehensive loss, which is a separate component of stockholders’ equity. +F-11 +Table of Contents +Earnings (Loss) Per Share +We have presented basic and diluted earnings (loss) per share pursuant to SFAS No. 128, “Earnings per Share.” In accordance with SFAS +No. 128, basic earnings (loss) per share is computed by dividing net income (loss) by the weighted-average number of shares of common stock outstanding during the period. Diluted earnings per share is computed in a manner similar to basic +earnings per share except that the weighted average number of shares outstanding is increased to include incremental shares from the assumed vesting or exercise of dilutive securities, such as common stock options, warrants and unvested restricted +stock. The number of incremental shares is calculated by assuming that outstanding stock options and warrants were exercised and unvested restricted shares were vested, and the proceeds from such exercises or vesting were used to acquire shares of +common stock at the average market prices during the reporting period. +The computations of basic and diluted earnings (loss) per share are +as follows: +Year ended December 31, +2008 +2007 +2006 +Net income (loss) +$ +(31,275,302 +) +$ +2,472,439 +$ +5,267,549 +Weighted average shares of common stock outstanding: +Basic +46,549,739 +46,325,338 +45,909,990 +Dilutive effect of stock options, warrants and restricted stock +— +552,805 +670,276 +Diluted +46,549,739 +46,878,143 +46,580,266 +Earnings (loss) per share: +Basic +$ +(0.67 +) +$ +0.05 +$ +0.11 +Diluted +$ +(0.67 +) +$ +0.05 +$ +0.11 +For the years ended December 31, 2008, 2007, and 2006, outstanding common stock options, +warrants and unvested restricted stock representing 4,489,227, 1,827,712, and 1,308,809 shares, respectively, were excluded from the computation of diluted earnings per share as their inclusion would have been anti-dilutive. +Other Comprehensive Income (Loss) +We +follow SFAS No. 130, “Reporting Comprehensive Income.” This statement requires the classification of items of other comprehensive income (loss) by their nature and disclosure of the accumulated balance of other comprehensive income +(loss), separately from accumulated deficit and additional paid-in capital, in the stockholders’ equity section of our balance sheet. +Fair Value of Financial Instruments +As of December 31, 2008, the carrying values of cash and cash equivalents, +short-term investments, accounts receivable, accounts payable and accrued expenses approximate their respective fair values based on their short-term nature. In addition, we believe the carrying value of our debt instruments, which do not have +readily ascertainable market values, approximate their fair values, given that the interest rates on outstanding borrowings approximate market rates. +We adopted SFAS No. 157, “Fair Value Measurements,” effective January 1, 2008, which establishes a framework for measuring fair value in generally accepted accounting principles, and expands +disclosures about fair value measurements. SFAS No. 157 applies to all financial assets and liabilities that are being measured and +F-12 +Table of Contents +reported on a fair value basis. Upon adoption of SFAS No. 157, there was no impact to our consolidated financial statements. The statement requires that +fair value measurements be classified and disclosed in one of the following three categories: +Level 1: +Unadjusted quoted prices in active markets that are accessible at the measurement date for identical, unrestricted assets or liabilities; +Level 2: +Quoted prices in markets that are not active, or inputs which are observable, either directly or indirectly, for substantially the full term of the asset or liability; and +Level 3: +Prices or valuation techniques that require inputs that are both significant to the fair value measurement and unobservable (i.e., supported by little or no market activity). +All our available for sale securities were classified and measured as Level 1 instruments. +Recent Accounting Pronouncements +On February 8, 2008, the Financial Accounting Standards Board (“FASB”) issued Staff Position 157-2, “Effective Date of FASB 157” (“FSP 157-2”), which deferred the provisions of SFAS +No. 157 to annual periods beginning after November 15, 2008 for non-financial assets and liabilities. Non-financial assets include fair value measurements associated with business acquisitions and impairment testing of tangible and +intangible assets. +3. +INVENTORIES: +December 31, +2008 +2007 +Raw materials +$ +6,721,102 +$ +4,924,139 +Work in process +390,259 +386,535 +Finished goods +3,592,727 +4,099,069 +$ +10,704,088 +$ +9,409,743 +4. +PROPERTY AND EQUIPMENT: +December 31, +2008 +2007 +Land +$ +1,117,788 +$ +1,117,788 +Buildings and improvements +15,571,279 +14,550,060 +Machinery and equipment +14,383,479 +10,501,812 +Computer equipment and software +3,791,012 +3,331,647 +Furniture and fixtures +1,455,965 +1,227,152 +Construction in progress +682,955 +3,674,054 +37,002,478 +34,402,513 +Less accumulated depreciation +(15,767,111 +) +(13,491,356 +) +$ +21,235,367 +$ +20,911,157 +Depreciation expense was $2,278,257, $1,687,126, and $1,371,400 for 2008, 2007, and 2006, +respectively. +F-13 +Table of Contents +5. +PATENTS, PRODUCT RIGHTS AND ACQUIRED IN-PROCESS TECHNOLOGY: +Patents product rights and licenses were as follows: +December 31, +2008 +2007 +HIV-related +$ +1,900,000 +$ +1,900,000 +HCV-related +4,500,000 +4,500,000 +Lateral flow-related +1,500,000 +1,500,000 +Cryosurgery-related +2,548,620 +2,548,620 +10,448,620 +10,448,620 +Less accumulated amortization +(6,068,080 +) +(5,169,149 +) +$ +4,380,540 +$ +5,279,471 +Amortization expense for 2008, 2007, and 2006 was $898,931, $1,048,873, and $551,614, +respectively. +Amortization expense for each of the five succeeding fiscal years is estimated as follows: +2009 +$ +791,826 +2010 +791,826 +2011 +791,826 +2012 +719,077 +2013 +497,826 +In June 1998, we acquired the patents and exclusive worldwide distribution rights to our +cryosurgical product line. The purchase price of $2,548,620, including transaction costs, has been recorded as patents and product rights and is being amortized using the straight-line method over an estimated useful life of ten years. In connection +with this acquisition, we also entered into a product purchase agreement with the manufacturer of the cryosurgical product line, with a current term extending through 2009. +In June 2004, we entered into a sublicense agreement with a third party, pursuant to which we have +been granted a limited, worldwide, non-exclusive sublicense to certain HIV-2 patents held by such party. The agreement required us to pay the third party a one-time non-refundable license fee of $900,000, which was recorded as patent and product +rights on our balance sheet and is being amortized through June 30, 2014. This agreement also contained an option to expand the application of this sublicense to other immunoassay platforms, in addition to our OraQuick ® platform. In June 2006, we exercised this option, which required us to pay the third party a non-refundable license fee of $600,000, in $200,000 increments in July of 2008, 2007, and 2006. We +recognized this $600,000 license fee as acquired in-process technology, which was included in research and development expense in our 2006 statement of operations, because other immunoassay platforms for the detection of HIV-2 will require +additional research and development efforts and subsequent regulatory approvals. +In +August 2005, we entered into a license agreement with third parties, pursuant to which we have been granted a limited, personal, non-transferable, non-exclusive license related to certain Hepatitis C Virus (“HCV”) patents held by such +parties. The agreement required us to pay the third parties a one-time non-refundable license fee of $1,500,000, which was paid in August 2005. In December 2006, the first milestone was achieved and $3,000,000 was paid in 2007. In November 2008, we +achieved a second milestone upon filing our OraQuick ® HCV pre-market approval application with the FDA and paid a $1,000,000 license fee. This fee was recognized as acquired in-process +technology and included in research and development expense in our 2008 statement of operations as additional research and development efforts and regulatory approval is required in order to commercialize this product in the U.S. domestic market. +Under the terms of the license agreement, we may also be required to pay additional license fees of up to $4,500,000, upon the achievement of specific development and/or commercial milestones. +F-14 +Table of Contents +Management’s intent in executing the HCV license agreement is to provide for various alternatives +for use of the licensed patents. Some of these uses require additional research and development efforts and regulatory approvals, while others, specifically in the international market, do not require additional research and development efforts or +regulatory approvals. Based on management’s estimate of the cash flows to be received from future product sales in international markets, we capitalized both the $1,500,000 and $3,000,000 license fees in the accompanying balance sheet. We are +amortizing these amounts to cost of products sold on a straight-line basis over ten years, which represents management’s estimate of the remaining useful life of the licensed patents. +Under the terms of the HCV license agreement, we are also obligated to pay royalties based on our net sales of certain products, which incorporate the +technology covered by the licensed patents. Royalties under the license agreement vary based upon the geographical territory where the product is sold. No sales have been made under the terms of this license agreement through December 31, 2008. +In December 2006, we amended a license agreement with third parties, pursuant to which we have been granted a limited, non-exclusive +license to certain lateral flow technology patents held by such parties. The amendment provided for the renewal of our license to certain lateral flow patents held by these parties, the expansion of these patents to future product applications to be +developed by us, and the settlement of prior royalty obligations arising prior to the amendment date. It required us to pay the third parties a one-time non-refundable fee of $1,750,000. We allocated the $1,750,000 fee based upon the relative fair +values of the items contained in the agreement. Accordingly, at December 31, 2006, we capitalized $1,000,000 as patent and product rights and are amortizing this amount to cost of products sold through December 2011. Of the remaining $750,000, +we recognized $400,000 as acquired in-process technology in our 2006 statement of operations as such amount was allocated to royalties for future product applications that will require additional research and development efforts and regulatory +approvals. The remaining $350,000 was recorded as a reduction of the accrued prior royalty obligations, which resulted in the reversal of $738,983 of royalty expense during 2006. The $1,750,000 fee was paid in 2007. +6. +ACCRUED EXPENSES AND OTHER: +December 31, +2008 +2007 +Payroll and related benefits +$ +3,513,124 +$ +3,771,489 +Royalties +2,481,466 +2,485,869 +Deferred revenue +1,951,921 +2,841,640 +Professional fees +472,969 +1,371,850 +Advertising +365,313 +288,020 +Clinical research obligations +348,459 +191,903 +Other +1,662,703 +1,044,939 +$ +10,795,955 +$ +11,995,710 +Deferred revenue includes customer prepayments of $1,824,721 and $2,726,440 at December 31, +2008 and 2007, respectively. +F-15 +Table of Contents +7. +LONG-TERM DEBT: +December 31, +2008 +2007 +Note payable to bank, principal and interest payable monthly at 4.15% through June 2011, at which time the remaining unpaid principal balance +is payable, secured by a first priority security interest in all of our assets. +$ +8,791,679 +$ +9,250,012 +Note payable to Pennsylvania Industrial Development Authority, interest at 2% monthly installments of principal and interest of $4,893 through +March 2010, secured by a second lien on one of our buildings. +67,658 +124,408 +8,859,337 +9,374,420 +Less current portion +(557,897 +) +(556,751 +) +$ +8,301,440 +$ +8,817,669 +At December 31, 2008, we had in place a $14,000,000 credit facility (the “Credit +Facility”) with Comerica Bank (“Comerica”) which is comprised of a $10,000,000 facility advance and a $4,000,000 revolving working capital line of credit. At our option, interest on the facility advance is payable monthly at either a +fixed rate equal to the five-year U.S. Treasury Note rate plus 1.03% to 1.73%, or a variable rate equal to the 30, 180, or 360-day London Interbank Offered Rate (“LIBOR”), plus 0.55% to 1.25%. In each case, the interest rate is determined +at the date of the advance and is based upon the amount of cash and cash equivalents we invest and retain at Comerica Securities, Inc. We also can choose the fixed rate option, without penalty, at the expiration of a previously elected LIBOR period. +Principal is repayable in periodic installments, based upon the rate option that we elect, with the remaining balance of unpaid principal due on June 27, 2011. In January 2008, we elected to fix the interest rate on the facilities advance at +4.15% until its maturity in June 2011, with principal and interest payable on a monthly basis. As of December 31, 2008, we had $8,791,679 in outstanding borrowings under the facility advance and we had no outstanding borrowings under the +$4,000,000 revolving working capital line of credit. +All borrowings under the Credit Facility are collateralized by a first priority +security interest in all of our assets, including present and future accounts receivable, chattel paper, contracts and contract rights, equipment and accessories, general intangibles, investments, instruments, inventories, and a mortgage on our +three facilities in Bethlehem, Pennsylvania. Borrowings under the revolving working capital line of credit are limited to commercially standard percentages of accounts receivable. The Credit Facility contains certain covenants that set forth minimum +requirements for our quick ratio, liquidity, and tangible net worth. We were in full compliance with all covenants at December 31, 2008. The Credit Facility also restricts our ability to pay dividends, to make certain investments, to incur +additional indebtedness, to sell or otherwise dispose of a substantial portion of assets, and to merge or consolidate operations with an unaffiliated entity, without the consent of Comerica. +Long-term debt maturities as of December 31, 2008 are as follows: +2009 +$ +557,897 +2010 +509,761 +2011 +7,791,679 +$ +8,859,337 +F-16 +Table of Contents +8. +INCOME TAXES: +The components of the provision for +income taxes for the years ended December 31, 2008, 2007 and 2006 are as follows: +2008 +2007 +2006 +Current +Federal +$ +9,590 +$ +137,520 +$ +251,074 +State +212,494 +369,977 +429,085 +222,084 +507,497 +680,159 +Deferred +Federal +(3,200,853 +) +1,417,925 +2,976,992 +State +(472,064 +) +(104,086 +) +136,753 +(3,672,917 +) +1,313,839 +3,113,745 +Valuation allowance +25,978,167 +— +— +22,305,250 +1,313,839 +3,113,745 +Total provision +$ +22,527,334 +$ +1,821,336 +$ +3,793,904 +A reconciliation of the statutory United States federal income tax rate to our effective tax rate +for each of the years ended December 31, 2008, 2007, and 2006 is as follows: +2008 +2007 +2006 +Statutory U.S. federal income tax rate +34.0 +% +34.0 +% +34.0 +% +State income taxes, net of federal benefit +2.8 +4.1 +4.1 +Nondeductible expenses and other +(3.4 +) +11.0 +3.8 +Research and development credits +6.1 +(6.7 +) +— +Change in valuation allowance, federal and state +(297.0 +) +— +— +Effective tax rate +(257.5 +)% +42.4 +% +41.9 +% +Deferred income taxes reflect the tax effects of temporary differences between the basis of assets +and liabilities recognized for financial reporting purposes and tax purposes, and net operating loss and tax credit carryforwards. Significant components of our net deferred tax asset as of December 31, 2008 and 2007 are as follows: +2008 +2007 +Deferred tax assets (liabilities): +Net operating loss carryforwards +$ +17,006,767 +$ +15,458,795 +Inventory +1,424,523 +1,776,780 +Capitalized research and development costs +1,445,495 +449,572 +Accruals and reserves currently not deductible +657,761 +411,328 +Patent costs +1,193,265 +896,212 +Depreciation and amortization +(451,061 +) +37,750 +Stock-based compensation +3,240,047 +2,451,303 +Research and development tax credit carryforward +827,689 +289,106 +Alternative minimum tax credit carryforwards +633,681 +555,719 +Net deferred tax asset +25,978,167 +22,326,565 +Valuation allowance +(25,978,167 +) +— +Net deferred tax asset +$ +— +$ +22,326,565 +F-17 +Table of Contents +In assessing the realizability of our net deferred tax asset, we follow the guidance contained within +SFAS No. 109, “Accounting for Income Taxes,” which requires deferred income tax assets to be reduced by a valuation allowance, if after considering all relevant positive and negative evidence, it is more likely than not that some +portion or all of the deferred income tax assets will not be realized. The realization of the gross deferred tax assets is dependent on several factors, including the generation of sufficient taxable income prior to the expiration of the net +operating loss (“NOL”) carryforwards. At December 31, 2007, we concluded that it was more likely than not that we would generate sufficient taxable income in future years to recognize our deferred tax assets. +During the second quarter of 2008, we began to incur quarterly pre-tax losses, which continued through the end of 2008, as global economic conditions +worsened and our research and development expenses continued to increase. For the year ended December 31, 2008, we recorded a pre-tax loss of $8,747,968. On a quarterly basis, we evaluate our ability to realize the benefits associated with our +net deferred tax asset in order to determine if any valuation allowance is required. Pursuant to SFAS No. 109, a cumulative three-year pre-tax loss is a significant piece of negative evidence in considering whether net deferred tax assets are +realizable. Based upon our pre-tax loss in 2008, our expectation of a pre-tax loss in 2009 and the continued volatility and uncertainty in the global economy, we concluded that it is more likely than not that our net deferred tax assets will not be +realized in the immediate future. Accordingly, we recorded a charge of $25,978,167 in order to establish a full valuation allowance against our net deferred tax assets as of December 31, 2008. +Our federal NOL carryforwards expire as follows: +Year of Expiration +NOLs +2011 +$ +5,765,731 +2017-2021 +30,428,371 +2022-2028 +13,330,221 +$ +49,524,323 +The Tax Reform Act of 1986 contains provisions that limit the annual amount of NOLs available to +be used in any given year in the event of a significant change in ownership. On September 29, 2000, two separate companies, STC Technologies, Inc. and Epitope, Inc., merged to form our Company. A significant change in ownership, as defined by +Section 382 of the Internal Revenue Code, occurred in connection with this merger. As such, the utilization of NOLs generated prior to September 29, 2000 is limited to approximately $13,700,000 per year. We do not believe that this +limitation will have a material adverse impact on the utilization of our NOL carryforwards in future years. +In July 2006, the FASB issued +FASB Interpretation (“FIN”) No. 48, “Accounting for Uncertainty in Income Taxes—an Interpretation of FASB Statement No. 109,” which clarifies what criteria must be met prior to recognition of the financial +statement benefit of a position taken in a tax return. FIN No. 48 also provides guidance on derecognition of tax benefits, classification on the balance sheet, interest and penalties, accounting in interim periods, disclosure and transition. We +adopted FIN No. 48 effective January 1, 2007, and pursuant to its provisions, decided to classify interest and penalties as a component of tax expense. As a result of the implementation of FIN No. 48, we recognized a $58,183 net +increase in our liability for unrecognized tax benefits, which was accounted for as a reduction to the January 1, 2007 balance of retained earnings. +We had gross unrecognized tax benefits of $2,184,370 and $2,370,526 as of December 31, 2008 and 2007, respectively, which if recognized, $2,151,345 and $2,292,624, respectively, would result in a reduction to our +effective tax rate. Interest and penalties were immaterial at December 31, 2008 and 2007. As a result of our net operating loss carryforward position, we are subject to audit by the Internal Revenue Service since our inception, as well as by +several state jurisdictions for the years ended December 31, 2000 through 2008. +F-18 +Table of Contents +A reconciliation of the beginning and ending amount of unrecognized tax benefits is as follows: +2008 +2007 +Balance at January 1 +$ +2,370,526 +$ +2,370,300 +Additions based on tax positions related to the current period +46,836 +40,000 +Additions for tax positions of prior periods +28,021 +60,226 +Reductions for tax positions of prior periods +(105,729 +) +(100,000 +) +Settlements +(155,284 +) +— +Balance at December 31 +$ +2,184,370 +$ +2,370,526 +9. +STOCKHOLDERS’ EQUITY: +Stock-Based Awards +We grant stock-based awards under the OraSure Technologies, Inc. 2000 Stock Award Plan, as amended and restated (the “2000 +Plan”). The 2000 Plan permits stock-based awards to employees, outside directors and consultants or other third-party advisors. Awards which may be granted under the 2000 Plan include qualified incentive stock options, nonqualified stock +options, stock appreciation rights, restricted awards, performance awards and other stock-based awards. We recognize compensation expense for stock option awards issued to employees and directors on a straight-line basis over the requisite service +period of the award. To satisfy the exercise of options or to issue new restricted stock, we normally issue new shares rather than purchase shares on the open market. +Under the terms of the 2000 Plan, qualified incentive stock options for shares of our common stock may be granted to eligible employees, including our officers. To date, options generally have been granted with +ten-year exercise periods and an exercise price not less than the fair market value on the date of grant. Options generally vest over four years, with one quarter of the options vesting one year after grant and the remainder vesting on a monthly +basis over the next three years. The 2000 Plan also provides that nonqualified options may be granted at a price not less than 75 percent of the fair market value of a share of common stock on the date of grant. The option term and vesting schedule +of such awards may be either unlimited or have a specified period in which to vest and be exercised. +In May 2008, the plan was amended to +increase the number of authorized shares available for grant by 2,500,000 shares. As of December 31, 2008, 3,732,346 shares were available for future grants under the 2000 Plan. +The fair value of each stock option was estimated on the date of the grant using the Black-Scholes option-pricing model using the following +weighted-average assumptions: +Year Ended +December 31, +Black-Scholes Option Valuation Assumptions +2008 +2007 +2006 +Risk-free interest rate (1) +2.50 +% +4.79 +% +4.53 +% +Expected dividend yield +— +— +— +Expected stock price volatility (2) +46 +% +49 +% +56 +% +Expected life of stock options (in years) (3) +4 +4 +5 +(1) +Based on the constant maturity interest rate of U.S. Treasury securities whose term is consistent with the expected life +of our stock options. +(2) +Expected stock price volatility is based upon historical experience. +(3) +Expected life of stock options is based upon historical experience. +The weighted-average grant date fair value of stock options granted during the years ended December 31, 2008, 2007 and 2006 was $2.84, $3.62 and +$4.85, respectively. +F-19 +Table of Contents +Amounts recognized in the financial statements related to stock options were as follows: +Year Ended +December 31, +2008 +2007 +Total compensation cost during the year +$ +2,103,259 +$ +2,953,307 +Amounts capitalized into inventory during the year +(142,965 +) +(303,472 +) +Amounts recognized in cost of products sold for amounts previously capitalized +229,860 +280,283 +Amounts charged against income, before income tax benefit +$ +2,190,154 +$ +2,930,118 +Amount of related income tax benefit +$ +— +$ +802,300 +The aggregate intrinsic value of options (the amount by which the market price of the stock on the +date of exercise exceeded the exercise price) exercised during the years ended December 31, 2008, 2007 and 2006 was $31,037, $1,284,319, and $332,261, respectively. +The following table summarizes the stock option activity under the 2000 Plan: +Options +Weighted-Average +Exercise Price +Per Share +Weighted-Average +Remaining +Contractual Term +(in years) +Aggregate +Intrinsic +Value +Outstanding on January 1, 2006 +4,216,785 +$ +7.08 +Granted +801,900 +9.22 +Exercised +(85,013 +) +5.38 +Forfeited +(145,254 +) +7.99 +Outstanding on December 31, 2006 +4,788,418 +7.44 +Granted +519,566 +8.37 +Exercised +(481,647 +) +6.43 +Forfeited +(99,796 +) +8.22 +Outstanding on December 31, 2007 +4,726,541 +7.63 +Granted +604,049 +7.27 +Exercised +(14,786 +) +6.26 +Forfeited +(185,097 +) +7.86 +Outstanding on December 31, 2008 +5,130,707 +$ +7.58 +6.11 +$ +112,038 +Vested or expected to vest as of December 31, 2008 +4,973,507 +$ +7.58 +6.11 +$ +108,605 +Exercisable on December 31, 2008 +4,318,302 +$ +7.54 +5.65 +$ +112,038 +As of December 31, 2008, there was $2,297,037 of unrecognized compensation expense related to +unvested option awards that is expected to be recognized over a weighted-average period of 1.6 years. +Net cash proceeds from the exercise +of stock options were $92,517, $3,100,037 and $457,334 for the years ended December 31, 2008, 2007 and 2006, respectively. As a result of our net operating loss carryforward position, no actual income tax benefit was realized from stock option +exercises for these periods. +F-20 +Table of Contents +The following table summarizes information about stock options outstanding at December 31, 2008: +Options outstanding +Options exercisable +Range of exercise prices +Number +Outstanding +Weighted- +average +remaining +life, in +years +Weighted- +average +exercise +price +Number +exercisable +Weighted- +average +exercise +price +$0.80–$5.60 +822,403 +9.51 +$ +4.76 +701,350 +$ +4.81 +$5.76–$6.96 +855,696 +3.68 +6.51 +853,196 +6.51 +$6.98–$7.77 +806,850 +4.22 +7.53 +766,849 +7.53 +$7.90–$8.18 +501,483 +8.49 +8.05 +185,061 +8.04 +$8.20 +590,735 +5.04 +8.20 +590,735 +8.20 +$8.28–$8.97 +619,665 +7.27 +8.48 +442,879 +8.51 +$9.04–$9.56 +583,915 +6.88 +9.40 +436,399 +9.43 +$9.78–$12.23 +344,960 +3.47 +10.59 +336,833 +10.59 +$12.69 +5,000 +2.68 +12.69 +5,000 +12.69 +5,130,707 +6.11 +$ +7.58 +4,318,302 +$ +7.54 +The 2000 Plan also permits us to grant restricted shares of our common stock to eligible +employees, including officers. Generally, these shares are nontransferable and are subject to three-year vesting requirements or forfeiture, as determined by the Compensation Committee of our Board of Directors. The market value of these shares at +the date of grant is recognized on a straight-line basis over the period during which the restrictions lapse. Compensation cost of $3,352,876, $2,877,463 and $1,969,178 related to restricted shares was recognized during the years ended +December 31, 2008, 2007 and 2006, respectively. +The following table summarizes restricted stock award activity under the 2000 Plan: +Shares +Weighted-Average +Grant Date +Fair Value +Issued and unvested, January 1, 2006 +606,445 +$ +6.90 +Granted +465,313 +9.16 +Vested +(199,633 +) +6.99 +Forfeited +(65,071 +) +7.56 +Issued and unvested, December 31, 2006 +807,054 +8.13 +Granted +348,655 +8.29 +Vested +(258,093 +) +7.91 +Forfeited +(14,655 +) +8.10 +Issued and unvested, December 31, 2007 +882,961 +8.24 +Granted +418,565 +7.83 +Vested +(393,551 +) +8.08 +Forfeited +(76,487 +) +8.31 +Issued and unvested, December 31, 2008 +831,488 +$ +8.11 +Issued and expected to vest, December 31, 2008 +831,488 +$ +8.11 +As of December 31, 2008, there was $4,323,317 of unrecognized compensation expense related to +unvested restricted stock awards that is expected to be recognized over a weighted average period of 2.7 years. +In connection with the +vesting of restricted shares during the years ended December 31, 2008, 2007 and 2006, we purchased and immediately retired 135,432, 90,446 and 65,519 shares with aggregate values of $995,367, $785,908 and $631,509, respectively, in satisfaction +of minimum tax withholding obligations. +F-21 +Table of Contents +SFAS No. 123R addresses accounting for awards issued as part of share-based payment arrangements in +exchange for employee services. Certain of our share-based payment arrangements are outside the scope of SFAS No. 123R and are subject to EITF Issue No. 00-19, “Accounting for Derivative Financial Instruments Indexed to, and Potentially +Settled in, a Company’s Own Stock,” which requires that vested stock options held by certain nonemployee consultants be accounted for as liability-classified awards. The fair value of these vested and unexercised awards was estimated using +the Black-Scholes option pricing model and $109,080 was reclassified from equity to other liabilities as of January 1, 2006 upon the adoption of SFAS No. 123R. An additional $121,579 was reclassified for options that vested during 2006. +The fair value of these awards is remeasured at each financial reporting date until the awards are settled or expire. During 2007, $51,500 was reclassified from a liability to equity upon the settlement of 20,000 options. No options held by +nonemployees were settled in 2008. As of December 31, 2008 and 2007, $11,985 and $149,317, respectively, was included in other liabilities for stock options to acquire 63,000 shares of common stock which remain unexercised. For the years ended +December 31, 2008, 2007 and 2006, the mark-to-market adjustment recorded as a reduction of compensation costs in the statements of operations was $137,332, $27,608 and $2,183, respectively. +Share Repurchase Program +On +August 5, 2008, our Board of Directors approved a share repurchase program pursuant to which we are permitted to acquire up to $25,000,000 of our outstanding common shares. During the year ended December 31, 2008, we purchased and retired +1,147,730 shares of common stock at an average price of $4.46 per share. +10. +COMMITMENTS AND CONTINGENCIES: +Sublicense +Agreement +In June 2004, we entered into a sublicense agreement with a third party, pursuant to which we have been granted a limited, +worldwide, non-exclusive sublicense to certain HIV-2 patents held by such party. Under the terms of this sublicense agreement, we are obligated to pay royalties based on a percentage of our net sales of certain products, which incorporate the +technology covered by the licensed patents. Future minimum payments under this agreement are as follows: +2009 +$ +500,000 +2010 +500,000 +2011 +500,000 +2012 +500,000 +2013 +500,000 +Thereafter +2,291,667 +$ +4,791,667 +Royalties from our commercial sale of products covered by the sublicense can be credited against +these minimum royalty obligations. +License Agreement +In August 2005, we entered into a license agreement with third parties, pursuant to which we have been granted a limited, personal, non-transferable, non-exclusive license related to certain HCV patents held by such +parties. Under the terms of the HCV license agreement, we are also obligated to pay royalties based on our net sales of certain products which incorporate the technology covered by the licensed patents. Royalties under the license agreement vary +based upon the geographical territory where the product is sold. No minimum payments are required under this agreement in 2009 or thereafter. We may, however, be required to pay additional license fees of up to $4,500,000, upon the achievement of +specific development and/or commercial milestones. +F-22 +Table of Contents +Leases +We lease office and warehouse facilities under operating lease agreements. Future payments required under these non-cancelable leases are $71,356 for 2009. +Rent expense for 2008, 2007 and 2006 was $184,128, $186,714, and $624,479, respectively. +Purchase Commitments +As of +December 31, 2008, we had outstanding non-cancelable purchase commitments in the amount of $3,098,586 related to inventory, capital expenditures, and other goods or services. +Employment Agreements +Under terms of +employment agreements with certain executive officers, extending through 2010, we are required to pay each individual a base salary for continuing employment with us. The agreements require payments of $1,901,875 and $879,375 in 2009 and 2010, +respectively. +Litigation +From time-to-time, we are involved in certain legal actions arising in the ordinary course of business. In management’s opinion, based upon the advice of counsel, the outcome of such actions are not expected to have a material adverse +effect on our future financial position or results of operations. +On April 22, +2008, a complaint was filed against us in the United States District Court for the District of New Jersey by Inverness Medical Innovations, Inc., Inverness Medical Switzerland GmbH and Church & Dwight Co., Inc., alleging that we infringed +U.S. Patent No. 6,485,982. The complaint specifically refers to our OraQuick ADVANCE ® Rapid HIV-1/2 Antibody Test. The complaint seeks injunctive relief, damages and an award of +attorneys’ fees. We have filed our Answer responding to the allegations in the Complaint and asserting various defenses and counterclaims. +On October 10, 2008, the plaintiffs filed a motion for summary judgment of infringement in this case, pursuant to a schedule previously established by the Court. We have filed our response to this motion and briefing is now complete. +We believe that none of our products, including the OraQuick ADVANCE ® HIV test, infringe the patent asserted in this lawsuit or any other party’s intellectual property rights. We also believe that the patent asserted in this matter is invalid or +unenforceable, and we intend to defend this lawsuit vigorously. We are unable at this time to determine the impact, if any, that this lawsuit may have on our business or prospects. +11. +RETIREMENT PLANS: +Substantially all of our +employees are eligible to participate in the OraSure Technologies, Inc. 401(k) Plan (the “401(k) Plan”). The 401(k) Plan permits voluntary employee contributions to be excluded from an employee’s current taxable income under +provisions of Internal Revenue Code Section 401(k) and the regulations thereunder. The 401(k) Plan also provides for us to match employee contributions up to $4,000 per year. Contributions to the 401(k) Plan, net of forfeitures, were $579,592, +$477,390, and $397,970 in 2008, 2007, and 2006, respectively. +12. +OTHER INCOME: +On January 11, 2008, we entered +into a settlement and license agreement with Schering-Plough Healthcare Products, Inc. (“Schering”) to resolve our patent infringement litigation against Schering. Under the terms of the agreement, Schering was required to make a payment +of $4,883,714 to us. This payment was received during the first quarter of 2008 and recorded in other income. +F-23 +Table of Contents +In January 2007, we sold our shares in a privately-held nonaffiliated company that had a carrying value +of $337,252 and we received $1,765,943 for our ownership interest. Accordingly, in 2007, we recorded a $1,428,691 pre-tax gain on the sale of this investment in other income. +13. +GEOGRAPHIC INFORMATION: +Based on guidance in SFAS +No. 131, “Disclosures about Segments of an Enterprise and Related Information,” we believe we operate within one reportable segment. Our products are sold principally in the United States and Europe. Segmentation of operating income +and identifiable assets is not applicable since our revenues outside the United States are export sales, and we do not have significant operating assets outside the United States. +The following table represents total revenues by geographic area, based on the location of the customer (amounts in thousands): +2008 +2007 +2006 +United States +$ +57,391 +$ +64,587 +$ +56,780 +Europe +7,746 +9,618 +9,521 +Other regions +5,967 +8,481 +1,854 +$ +71,104 +$ +82,686 +$ +68,155 +14 . +QUARTERLY DATA (Unaudited): +The following tables +summarize the quarterly results of operations for each of the quarters in 2008 and 2007. These quarterly results are unaudited, but in the opinion of management, have been prepared on the same basis as our audited financial information and include +all adjustments (consisting only of normal recurring adjustments) necessary for a fair presentation of the information set forth herein (all amounts in thousands, except per share amounts). +2008 Results +Three months ended +Year ended +December 31, +2008 +March 31, +2008 +June 30, +2008 +September 30, +2008 +December 31, +2008 +Revenues +$ +18,089 +$ +18,946 +$ +16,860 +$ +17,209 +$ +71,104 +Costs and expenses +21,100 +22,754 +20,200 +23,381 +87,435 +Operating loss +(3,011 +) +(3,808 +) +(3,340 +) +(6,172 +) +(16,331 +) +Other income, net +5,745 +744 +587 +507 +7,583 +Income (loss) before income taxes +2,734 +(3,064 +) +(2,753 +) +(5,665 +) +(8,748 +) +Income tax provision (benefit) +732 +(820 +) +(991 +) +23,606 +22,527 +Net income (loss) +$ +2,002 +$ +(2,244 +) +$ +(1,762 +) +$ +(29,271 +) +$ +(31,275 +) +Earnings (loss) per share(1) +Basic +$ +0.04 +$ +(0.05 +) +$ +(0.04 +) +$ +(0.64 +) +$ +(0.67 +) +Diluted +$ +0.04 +$ +(0.05 +) +$ +(0.04 +) +$ +(0.64 +) +$ +(0.67 +) +F-24 +Table of Contents +2008 Results +Three months ended +Year ended +December 31, +2008 +March 31, +2008 +June 30, +2008 +September 30, +2008 +December 31, +2008 +Revenues +$ +20,109 +$ +21,352 +$ +21,415 +$ +19,810 +$ +82,686 +Costs and expenses +19,513 +20,768 +22,373 +21,251 +83,905 +Operating income (loss) +596 +584 +(958 +) +(1,441 +) +(1,219 +) +Other income, net +2,389 +970 +1,086 +1,068 +5,513 +Income (loss) before income taxes +2,985 +1,554 +128 +(373 +) +4,294 +Income tax provision (benefit) +1,499 +599 +124 +(401 +) +1,821 +Net income +$ +1,486 +$ +955 +$ +4 +$ +28 +$ +2,473 +Earnings per share +Basic +$ +0.03 +$ +0.02 +$ +— +$ +— +$ +0.05 +Diluted +$ +0.03 +$ +0.02 +$ +— +$ +— +$ +0.05 +(1) +The summation of the quarterly amounts may not equal the year-end amounts due to the use of weighted-average shares for each period. +F-25 +Table of Contents +INDEX TO EXHIBITS +Exhibit +Number +Exhibit +3.1.1 +Certificate of Incorporation of OraSure Technologies, Inc. is incorporated by reference to Exhibit 3.1 to the Company’s Registration Statement on Form S-4 (No. 333-39210), filed June 14, +2000. +3.1.2 +Certificate of Amendment to Certificate of Incorporation dated May 23, 2000 is incorporated by reference to Exhibit 3.1.1 to the Company’s Registration Statement on Form S-4 (No. +333-39210), filed June 14, 2000. +3.1.3 +Certificate of Designation of Series A Preferred Stock of OraSure Technologies (filed as Exhibit A to the Rights Agreement referred to in Exhibit 4.1). +3.2 +Bylaws of OraSure Technologies, amended and restated as of August 19, 2008, are incorporated by reference to Exhibit 3 to the Company’s Current Report on Form 8-K filed August 22, 2008. +4.1 +Rights Agreement, dated as of May 6, 2000, between OraSure Technologies, Inc. and ChaseMellon Shareholder Service, L.L.C. (now called BNY Mellon Shareowner Services), as Rights Agent, is +incorporated by reference to Exhibit 4.2 to Amendment No. 1 to the Company’s Registration Statement on Form S-4 (No. 333-39210), filed August 8, 2000. +10.1 +Form of Indemnification Agreement (and list of parties to such agreement) is incorporated by reference to Exhibit 10.1 to Amendment No. 3 to the Company’s Registration Statement on Form S-4 +(No. 333-39210), filed August 30, 2000.* +10.2 +Employment Agreement, dated as of June 22, 2004, between OraSure Technologies, Inc. and Douglas A. Michels, is incorporated by reference to Exhibit 10.3 to the Company’s Quarterly Report on +Form 10-Q for the quarter ended June 30, 2004.* +10.3 +Amendment No. 1 to Employment Agreement, dated as of December 16, 2008, between the Company and Douglas A. Michels, is incorporated by reference to Exhibit 10.2 to the Company’s Current +Report on Form 8-K filed December 19, 2008.* +10.4 +Employment Agreement, dated as of July 1, 2004, between OraSure Technologies, Inc. and Ronald H. Spair, is incorporated by reference to Exhibit 10.4 to the Company’s Quarterly Report on +Form 10-Q for the quarter ended June 30, 2004.* +10.5 +Amendment No. 1 to Employment Agreement, dated as of December 16, 2008, between the Company and Ronald H. Spair, is incorporated by reference to Exhibit 10.3 to the Company’s Current Report +on Form 8-K filed December 19, 2008.* +10.6 +Employment Agreement, dated September 23, 2005, between OraSure Technologies, Inc. and Stephen R. Lee, Ph.D., is incorporated herein by reference to Exhibit 99 to the Company’s Current +Report on Form 8-K filed September 28, 2005.* +10.7 +Amendment No. 1 to Employment Agreement, dated as of December 16, 2008, between the Company and Stephen R. Lee, Ph.D., is incorporated by reference to Exhibit 10.5 to the Company’s Current +Report on Form 8-K filed December 19, 2008.* +10.8 +Employment Agreement, dated as of July 1, 2004, between OraSure Technologies, Inc. and P. Michael Formica, is incorporated by reference to Exhibit 10.5 to the Company’s Quarterly Report on +Form 10-Q for the quarter ended June 30, 2004.* +10.9 +Amendment No. 1 to Employment Agreement, dated as of December 16, 2008, between the Company and P. Michael Formica, is incorporated by reference to Exhibit 10.4 to the Company’s Current +Report on Form 8-K filed December 19, 2008.* +10.10 +Employment Agreement, dated as of July 1, 2004, between OraSure Technologies, Inc. and Jack E. Jerrett, is incorporated by reference to Exhibit 10.7 to the Company’s Quarterly Report +on Form 10-Q for the quarter ended June 30, 2004.* +Table of Contents +Exhibit +Number +Exhibit +10.11 +Amendment No. 1 to Employment Agreement, dated as of December 16, 2008, between the Company and Jack E. Jerrett, is incorporated by reference to Exhibit 10.6 to the Company’s Current Report +on Form 8-K filed December 19, 2008.* +10.12 +Employment Agreement, dated as of October 2, 2006, between Mark L. Kuna and OraSure Technologies, Inc., is incorporated by reference to Exhibit 99.1 to the Company’s Current Report on Form +8-K filed October 5, 2006.* +10.13 +Amendment No. 1 to Employment Agreement, dated as of December 16, 2008, between the Company and Mark L. Kuna, is incorporated by reference to Exhibit 10.7 to the Company’s Current Report on +Form 8-K filed December 19, 2008.* +10.14 +Description of Nonemployee Director Compensation Policy, as amended as of February 1, 2007, is incorporated by reference to Exhibit 10.9 to the Company’s Annual Report on Form 10-K for the +year ended December 31, 2007.* +10.15 +Amended and Restated Epitope, Inc. 1991 Stock Award Plan is incorporated by reference to Exhibit 10.9 to the Company’s Annual Report on Form 10-K for the year ended December 31, +2002.* +10.16 +OraSure Technologies, Inc. Employee Incentive and Non-Qualified Stock Option Plan, as amended and restated effective September 29, 2000, is incorporated by reference to Exhibit 10.12 to the +Company’s Annual Report on Form 10-K for the year ended December 31, 2000.* +10.17 +OraSure Technologies, Inc. 2000 Stock Award Plan, as amended and restated effective as of May 13, 2008, is incorporated by reference to Exhibit 10 to the Company’s Current Report on Form +8-K filed May 19, 2008.* +10.18 +Form of Restricted Share Grant Agreement (Officers and Employees) is incorporated by reference to Exhibit 10.2.1 to the Company’s Quarterly Report on Form 10-Q for the quarter ended June +30, 2004.* +10.19 +Form of Restricted Share Grant Agreement (Non-Employee Directors).* +10.20 +Incentive Stock Option General Terms and Conditions (Officers and Employees) is incorporated by reference to Exhibit 10.12 to the Company’s Annual Report on Form 10-K for the year ended +December 31, 2004.* +10.21 +Nonqualified Stock Option Award General Terms and Conditions (Officers and Employees) is incorporated by reference to Exhibit 10.13 to the Company’s Annual Report on Form 10-K for the year +ended December 31, 2004.* +10.22 +Nonqualified Stock Option Award General Terms and Conditions (Non-Employee Directors) is incorporated by reference to Exhibit 10.14 to the Company’s Annual Report on Form 10-K for the year +ended December 31, 2004.* +10.23 +Description of the OraSure Technologies, Inc. 2009 Self-Funding Management Incentive Plan is incorporated by reference to Item 5.02 to the Company’s Current Report on Form 8-K filed +February 24, 2009.* +10.24 +Description of the OraSure Technologies, Inc. 2008 Self-Funding Management Incentive Plan is incorporated by reference to Item 5.02 to the Company’s Current Report on Form 8-K filed +February 25, 2008.* +10.25 +Description of the OraSure Technologies, Inc. 2009 Stock Award Guidelines is incorporated by reference to Item 5.02 to the Company’s Current Report on Form 8-K filed February 24, +2009.* +10.26 +Description of the OraSure Technologies, Inc. 2008 Stock Award Guidelines is incorporated by reference to Item 5.02 to the Company’s Current Report on Form 8-K filed February 25, 2008.* +Table of Contents +Exhibit +Number +Exhibit +10.27 +Loan and Security Agreement, dated as of September 10, 2002, between Comerica Bank—California and OraSure Technologies, Inc., is incorporated by reference to Exhibit 10.1 to the +Company’s Quarterly Report on Form 10-Q for the quarter ended September 30, 2002. +10.28 +First Amendment to Loan and Security Agreement, dated as of May 23, 2003, between OraSure Technologies, Inc. and Comerica Bank—California, is incorporated by reference to Exhibit 10.24 to +the Company’s Annual Report on Form 10-K for the year ended December 31, 2003. +10.29 +Second Amendment to Loan and Security Agreement, dated as of September 12, 2003, between OraSure Technologies, Inc. and Comerica Bank, is incorporated by reference to Exhibit 99.1 to the +Company’s Current Report on Form 8-K, dated September 17, 2003. +10.30 +Third Amendment to Loan and Security Agreement, dated as of April 21, 2005, between OraSure Technologies, Inc. and Comerica Bank, is incorporated by reference to Exhibit 10 to the Company’s +Current Report on Form 8-K filed April 27, 2005. +10.31 +Fourth Amendment to Loan and Security Agreement, dated as of June 27, 2006, between OraSure Technologies, Inc. and Comerica Bank, is incorporated by reference to Exhibit 10 to the Company’s +Current Report on Form 8-K filed June 30, 2006. +10.32 +Fifth Amendment to Loan and Security Agreement, dated as of June 28, 2007, between OraSure Technologies, Inc. and Comerica Bank, is incorporated by reference to Exhibit 10 to the Company’s +Current Report on Form 8-K filed July 5, 2007. +10.33 +Supply and Distribution Agreement, dated as of February 11, 2005, between Abbott Laboratories and OraSure Technologies, Inc., is incorporated by reference to Exhibit 10.29 to the Company’s +Annual Report on Form 10-K for the year ended December 31, 2006.** +10.34 +Amendment No. 1 to Supply and Distribution Agreement, dated as of July 21, 2005, between Abbott Laboratories and OraSure Technologies, Inc., is incorporated by reference to Exhibit 10.30 to the +Company’s Annual Report on Form 10-K for the year ended December 31, 2006.** +10.35 +Termination and Transition Agreement, dated as of October 31, 2008, between Abbott Laboratories and OraSure Technologies, Inc.** +23 +Consent of KPMG LLP, Independent Registered Public Accounting Firm. +24 +Powers of Attorney. +31.1 +Certification of Douglas A. Michels required by Rule 13a-14(a) or Rule 15d-14(a) under the Securities Exchange Act of 1934, as amended. +31.2 +Certification of Ronald H. Spair required by Rule 13a-14(a) or Rule 15d-14(a) under the Securities Exchange Act of 1934, as amended. +32.1 +Certification of Douglas A. Michels required by Rule 13a-14(b) or Rule 15a-14(b) under the Securities Exchange Act of 1934, as amended, and 18 U.S.C. Section 1350, as Adopted Pursuant to Section +906 of the Sarbanes-Oxley Act of 2002. +32.2 +Certification of Ronald H. Spair required by Rule 13a-14(b) or Rule 15a-14(b) under the Securities Exchange Act of 1934, as amended, and 18 U.S.C. Section 1350, as Adopted Pursuant to +Section 906 of the Sarbanes-Oxley Act of 2002. +* +Management contract or compensatory plan or arrangement. +** +Portions of this exhibit were omitted pursuant to an application for confidential treatment and filed separately with the Securities and Exchange Commission. \ No newline at end of file diff --git a/raw/filings/0001116463/2008/0001193125-09-049845/filing_metadata.csv b/raw/filings/0001116463/2008/0001193125-09-049845/filing_metadata.csv new file mode 100644 index 0000000000000000000000000000000000000000..011baf18e326a7dac88b7a7dcc8ea368852a18a4 --- /dev/null +++ b/raw/filings/0001116463/2008/0001193125-09-049845/filing_metadata.csv @@ -0,0 +1,2 @@ +cik,ticker,company_name,form,filing_date,report_date,acceptance_datetime,accession_number,primary_document,primary_doc_description,size,is_xbrl,is_inline_xbrl,document_url,filing_index_url,year,fiscal_year,is_primary_filing +0001116463,OSUR,ORASURE TECHNOLOGIES INC,10-K,2009-03-10,2008-12-31,2009-03-10T21:02:07.000Z,0001193125-09-049845,d10k.htm,FORM 10-K,1376426,0,0,https://www.sec.gov/Archives/edgar/data/1116463/000119312509049845/d10k.htm,https://www.sec.gov/Archives/edgar/data/1116463/000119312509049845/,2008,2008,1 diff --git a/raw/filings/0001116463/2008/0001193125-09-049845/item1.txt b/raw/filings/0001116463/2008/0001193125-09-049845/item1.txt new file mode 100644 index 0000000000000000000000000000000000000000..61115a24d36af40ecdfe936c3d10ae1574fc8c6a --- /dev/null +++ b/raw/filings/0001116463/2008/0001193125-09-049845/item1.txt @@ -0,0 +1,613 @@ +ITEM 1. Business. +Our business principally involves the development, manufacture, marketing and sale of oral fluid diagnostic products and specimen collection devices using +our proprietary oral fluid technologies, as well as other diagnostic products including immunoassays and other in vitro diagnostic tests that are used on other specimen types, and other medical devices. Our diagnostic products include tests +which are performed on a rapid basis at the point of care and tests which are processed in a laboratory. These products are sold in the United States and internationally to various clinical laboratories, hospitals, clinics, community-based +organizations and other public health organizations, distributors, government agencies, physicians’ offices, and commercial and industrial entities. One of our products has been sold in the over-the-counter (“OTC”) or consumer retail +markets in the United States, Canada, Europe, Mexico and Australia. +In vitro diagnostic testing is the process of analyzing oral +fluid, blood, urine and other bodily fluids or tissue for the presence of specific substances or markers for infectious diseases, drugs of abuse or other conditions. In vitro diagnostic tests are performed outside the body, in contrast to +in vivo tests, which are performed directly on or within the body. The substance or marker that a diagnostic test is intended to detect is generally referred to as an analyte. +Immunodiagnostic testing is the leading method of in vitro testing for antigens and antibodies. When an infectious disease is caused by pathogens, +such as bacteria, viruses and fungi, or other substances are present, the body responds by producing an antibody. Substances that stimulate production of antibodies are generally referred to as antigens. An antibody binds specifically with an +antigen in a lock-and-key fashion that initiates a biochemical reaction to attempt to neutralize and, ultimately, eliminate the antigen. The ability of an antibody to bind with a specific antigen provides the basis for immunodiagnostic testing. +Our Company was formed in May 2000 under Delaware law solely for the purposes of combining two companies, STC Technologies, Inc. +(“STC” or “STC Technologies”) and Epitope, Inc. (“Epitope”), and changing the state of incorporation of Epitope from Oregon to Delaware. STC Technologies and Epitope were merged into our Company on September 29, +2000. Our principal offices are located at 220 East First Street, Bethlehem, Pennsylvania 18015, and our telephone number is (610) 882-1820. +Additional information about us can be found on our website. Our website address is www.orasure.com . We make available free of charge through a link provided at such website our Annual Reports on Form 10-K, our +1 +Table of Contents +Quarterly Reports on Form 10-Q, our Current Reports on Form 8-K and our other filings with the Securities and Exchange Commission (“SEC”), as well +as any amendments to those Reports and filings. These Reports and filings are made available as soon as reasonably practicable after they are filed or furnished to the SEC. Our Internet website and the information contained in or connected to that +website are not intended to be incorporated by reference into this Annual Report. +Products +The following is a summary of our principal products and their regulatory and commercial status: +Product +Description +Regulatory Status +Commercial Status +OraQuick +ADVANCE ® HIV-1/2 +A rapid, point-of-care test for antibodies to the Human Immunodeficiency Virus Type 1 (“HIV-1”) and Type 2 (“HIV-2” and together with HIV-1, “HIV-1/2”) that can be +visually read at the point of care in approximately 20 minutes. +Premarket approval (“PMA”) approved by the U.S. Food and Drug Administration (“FDA”) for use with oral fluid, finger-stick and venous whole blood, and plasma. CLIA (Clinical +Laboratory Improvement Amendments of 1988) waived for use with oral fluid, finger-stick and venous whole blood. Twelve month shelf life approved in December 2008. +Marketed +CE mark (European Union) approved. +Marketed +Registered in the United Kingdom, Ireland, Spain, Mexico, Brazil, and Peru. +Marketed +Registrations filed in Colombia, Argentina, Romania, Croatia, Bosnia and Herzegovina. +Pending +OraQuick ® HIV-1/2 OTC +A rapid, point-of-care oral fluid HIV-1/2 test intended to be sold in various OTC markets. +Clinical trials initiated. Data from observed user study submitted to FDA. +Pending +OraQuick ® HCV +A rapid, point-of-care test for antibodies to the hepatitis C virus (“HCV”). +PMA submitted to FDA in October 2008. Clinical studies for CE mark are in process. +Pending +OraSure ® +Oral fluid collection device for the detection of antibodies to HIV-1 in an oral fluid sample in a laboratory setting. +PMA approved by FDA. +Marketed +FDA 510(k) cleared for use in detecting cocaine and cotinine (an indicator of nicotine) in oral fluid. +Marketed +CE marked and registered in the United Kingdom. Also registered in Mexico, Canada, Columbia, South Africa, Afghanistan, Argentina, Brazil and Trinidad. +Marketed +Intercept ® +Oral fluid collection device, along with nine related immunoassays, for oral fluid drugs of abuse (“DOA”) testing in a laboratory setting. +Collection device—FDA 510(k) cleared. +Marketed +2 +Table of Contents +Product +Description +Regulatory Status +Commercial Status +MICRO-PLATE DOA Assays +Used to detect the following drugs in an oral fluid sample: marijuana, cocaine, opiates, amphetamines, methamphetamines, PCP, benzodiazepines, barbiturates and methadone. +Nine drug assays—FDA 510(k) cleared. +Marketed +Intercept ® device CE marked and registered in the United Kingdom. Various assays are CE marked and registered in the United Kingdom, Austria, Belgium, Denmark, Finland, France, +Germany, Ireland, Italy, Luxembourg, Mexico, Netherlands, Portugal, Spain, Sweden, Korea, Canada, Afghanistan and Brazil. +Marketed +Homogeneous DOA Assays +Homogeneous fully-automated oral fluid DOA assays. +Collaboration with Roche Diagnostics. +In Development +Cryosurgical Systems— Professional +Cryosurgical (freezing) system for the removal of warts and other benign skin lesions, marketed under the Histofreezer ® tradename primarily to the physicians’ +office market. +Nine indications—FDA 510(k) cleared. +Marketed +CE marked and registered in Europe, Canada, Venezuela, Thailand, New Zealand, Hong Kong, Brazil, Mexico, Canada and Afghanistan. +Marketed +Cryosurgical Systems—OTC +Cryosurgical system for the removal of common and plantar warts, sold in various OTC markets. +FDA 510(k) cleared. Sold under new national brand, Freeze ‘n Clear Skin Clinic ™ . +Marketed +Registered in Canada. +Marketed +CE marked and registered in several European countries under Scholl Freeze Spray name. +Marketed +Registered in Mexico, Argentina, Guatemala, Costa Rica, El Salvador and Chile under POINTTS name. +Marketed +Registrations filed in Ecuador, Peru, Brazil, Honduras, and Colombia. +Pending +Cryosurgical Systems—OTC Product Line Extension +Cryosurgical system for an indication other than common warts or plantar warts. +Registrations applied for under POINTTS name in certain South and Central American countries and South Africa. +Pending +FDA 510(k) filed. +Pending +In addition to the above products, we also +sell certain immunoassay tests and reagents for insurance risk assessment, substance abuse testing and forensic toxicology applications; an oral fluid Western blot HIV-1 confirmatory test approved by the FDA for confirming positive HIV-1 test +results obtained from the use of our OraSure ® collection device; and the FDA 510(k) cleared Q.E.D. ® point-of-care saliva alcohol +test. +OraQuick ® +Rapid Test Platform +OraQuick ® is our rapid test platform designed to test oral fluid, whole blood (i.e., both finger-stick and venous), plasma and serum samples for the presence of various antibodies or analytes. The device uses a porous flat pad +to collect an oral fluid specimen. After collection, the pad is inserted into a vial containing a pre-measured amount of developer solution and allowed to develop. When whole blood or plasma is to be tested, a loop collection device is used to +collect a drop of blood or plasma and mix it in the developer solution, after which the collection pad is inserted into the solution and allowed to develop. In all cases, the specimen and +3 +Table of Contents +developer solution then flow through the testing device where test results are observable in approximately 20 minutes. The OraQuick ® device is a screening test and requires a confirmation test where an initial positive result is obtained. +We have commercialized this technology in the form of our OraQuick ADVANCE ® rapid HIV-1/2 antibody test. This is a rapid, point-of-care test which has received FDA approval for the detection of antibodies to both HIV-1 and HIV-2 in oral fluid, finger-stick and venous +whole blood and plasma. This test is available for use by the nearly 40,000 locations in the United States certified under the Clinical Laboratory Improvements Amendment of 1988 (“CLIA”) to perform moderately complex tests. We have also +received a CLIA waiver for use of the OraQuick ADVANCE ® test with oral fluid and finger-stick and venous whole blood. As a result, the test can be used by approximately 140,000 +additional sites in the United States not certified under CLIA to perform moderately complex tests, such as outreach clinics, community-based organizations and physicians’ offices. +On the international front, we have obtained a CE mark for our OraQuick ADVANCE ® test so that we can sell this product in Europe and other countries accepting the CE mark for commercialization. We have distributors in place for the United Kingdom, Ireland, Spain, Russia and +France and are pursuing distribution arrangements in several additional European countries. We are selling the OraQuick ® HIV-1/2 test in Mexico and Africa and are completing registrations +in several countries in Latin America, Asia and the Middle East. We are seeking to expand our distribution network for this product throughout the world. +In late 2008, the FDA approved our request to increase the shelf life for OraQuick +ADVANCE ® to twelve months from the date of manufacture. This approval was based on enhancements we made to the manufacturing process and product packaging for this product and +represented a substantial increase in shelf life from the six months approved for the OraQuick ADVANCE ® test then on the market. OraQuick ® product with twelve month dating became available in the U.S. market in February 2009. In June 2008, we began to sell OraQuick ® tests with twelve month +dating in certain international markets and have submitted the new dating for approval in Europe. +We believe that the OraQuick ADVANCE ® device, because it is approved for detecting antibodies to both HIV-1 and HIV-2 in finger-stick and venous whole +blood, oral fluid and plasma samples, provides a significant competitive advantage in the market for rapid HIV testing in the United States and elsewhere around the world. We also believe the twelve month shelf life recently approved by the FDA +further strengthens the competitiveness of this product. +OraSure ® /Intercept ® Collection Devices +Our OraSure ® oral fluid collection +device is used in conjunction with screening and confirmatory tests for HIV-1 antibodies and other analytes. This device consists of a small, treated cotton-fiber pad on a handle that is placed in a person’s mouth for two to five minutes. The +device collects oral mucosal transudate (“OMT”), a serum-derived fluid that contains higher concentrations of certain antibodies and analytes than saliva. As a result, OMT testing is a highly accurate method for detecting HIV-1 infection +and other analytes. +We believe that oral fluid testing has several significant advantages over blood or urine-based systems for infectious +disease testing, for both health care professionals and the individuals being tested. These advantages include eliminating the risk of needle-stick accidents, providing a non-invasive collection technique, requiring minimal training to administer, +providing rapid and efficient collection in almost any setting, and reducing the cost of administration by a trained health care professional. +HIV-1 antibody detection using the OraSure ® +collection device involves three steps: +• +Collection of an oral fluid specimen using the OraSure ® +device; +4 +Table of Contents +• +Screening of the specimen for HIV-1 antibodies at a laboratory with an enzyme immunoassay (“EIA”) screening +test approved by the FDA for use with the OraSure ® device; and +• +Laboratory confirmation of any positive screening test results with our oral fluid Western blot HIV-1 confirmatory test (described below). +A trained health care professional then conveys test results and provides appropriate counseling to the individual who was tested. +We have received premarket approval from the FDA to sell the OraSure ® collection device for use with a laboratory-based EIA screening test for HIV-1 antibody detection. In the past, this EIA screening test was manufactured and sold by bioMerieux, Inc. +(“BMX”). We have also received FDA 510(k) clearance for use of the OraSure ® collection device with EIAs to test for cocaine and cotinine (a metabolite of nicotine) in oral fluid +specimens primarily for insurance risk assessment purposes. +In 2007, BMX +discontinued manufacturing the HIV-1 EIA screening test. As a result, we are performing clinical studies and plan to seek FDA approval of an alternative HIV-1 EIA screening test for use with oral fluid samples collected with our OraSure ® device. +A collection device +that is substantially similar to the OraSure ® device is sold by us under the name Intercept ® , and is used to collect OMT for oral +fluid drug testing. We have received FDA 510(k) clearance to use the Intercept ® collection device with laboratory-based EIAs to test for drugs of abuse commonly identified by the National +Institute for Drug Abuse (“NIDA”) as the NIDA-5 (i.e., cannabinoids (marijuana), cocaine, opiates, amphetamines/methamphetamines and phencyclidine (“PCP”)), and for barbiturates, methadone and benzodiazepines. Each of these EIAs +is also FDA 510(k) cleared for use with the Intercept ® device. +We have received a CE mark for the Intercept ® +and OraSure ® devices and our oral fluid assays, all of which are distributed in Canada, the United Kingdom and Mexico. The OraSure ® device and our oral fluid drugs of abuse assays are also sold in several other foreign countries. +We believe that the Intercept ® device +has several advantages over competing urine and other drugs-of-abuse testing products, including its lower total testing cost, its non-invasive nature, mobility and accuracy, the ease of maintaining a chain-of-custody, the treatment of test subjects +with greater dignity, no requirement for specially-prepared collection facilities and difficulty of sample adulteration. The availability of an oral fluid test is intended to allow our customers to test for drug impairment, eliminate scheduling +costs and inconvenience, and thereby streamline the testing process. +Cryosurgical Systems (Skin Lesion Removal Products) +The Histofreezer ® +cryosurgical removal system is a low-cost alternative to liquid nitrogen and other methods for removal of warts and other benign skin lesions by physicians. The Histofreezer ® product mixes +three environmentally friendly cryogenic gases in a small aerosol canister. When released, these gases are delivered to a specially designed foam bud, cooling the bud to a maximum of –50°C to –55°C. The frozen bud is then applied +to the wart or lesion for 15 to 40 seconds (depending on the type of lesion) creating localized destruction of the target area by freezing. We have received 510(k) clearance for use of the Histofreezer ® product to remove common warts and eight other types of benign skin lesions, and this product has been CE marked and registered for distribution in Canada, throughout Europe and in certain other foreign countries. +We have also received FDA 510(k) clearance to market and sell a cryosurgical +product similar to the Histofreezer ® product in the OTC or retail market for the removal of common and plantar warts only. Prior to 2008, this product was distributed for us in the United +States and Canadian OTC markets under the name Freeze Off ® by Prestige Brands Holdings, Inc. (“Prestige”), the owner of the Compound W ® line of wart removal products. As a result of a decision in arbitration proceedings with respect to Prestige’s acquisition of the +5 +Table of Contents +competing Wartner ® cryosurgical product line, our agreement with Prestige terminated on +December 31, 2007. In early 2009, we launched our OTC cryosurgical wart product in the U.S. under a new national brand called Freeze ‘n Clear Skin Clinic™. This launch has started with one major retailer, and we will look to expand to +other retailers in the future. +Internationally, we distribute a CE marked cryosurgical wart removal product into the OTC footcare market in +Europe, Australia and New Zealand through our distributor, SSL International plc (“SSL”), under the Scholl and Dr. Scholl trademarks. SSL is the owner of the Scholl and Dr. Scholl trademarks in countries outside North and South +America. We also distribute an OTC cryosurgical product through our distributor Genomma Labs, under the POINTTS tradename, in Mexico, a number of South and Central American countries, and South Africa. +Immunoassay Tests and Reagents +We develop and sell immunoassay tests in two formats, known as MICRO-PLATE and AUTO-LYTE ® , to meet the specific needs of our customers. +In a MICRO-PLATE kit, the sample to be tested is placed into a small plastic receptacle, called a microwell, along with the reagents. The result of the test is determined by the color of the microwell upon completion +of the reaction. Controlling the reaction involves the use of reagents by laboratory personnel. Test results are analyzed by any of a variety of commercially available laboratory instruments, which we may also provide to our laboratory customers. +MICRO-PLATE tests can be performed on commonly used instruments and can detect drugs in urine, serum and sweat specimens. MICRO-PLATE tests are also used as part of the Intercept ® product +line to detect drugs of abuse in oral fluid specimens. +AUTO-LYTE ® tests are sold in the form of bottles of liquid reagents. These reagents are run on commercially available laboratory-based automated analytical instruments, which are manufactured by a variety +of third parties. AUTO-LYTE ® is typically used in high volume, automated, commercial reference insurance laboratories to detect certain drugs or chemicals in urine. Test results are +produced quickly, allowing for high throughput. In recent years, sales of our AUTO-LYTE ® tests have been substantially reduced largely because of competition from cheaper +“home-brew” tests used by our laboratory customers. As a result, we expect to eventually stop selling our AUTO-LYTE ® tests. +Western blot HIV-1 Confirmatory Test +We sell an oral fluid Western blot HIV-1 confirmatory test that received premarket approval from +the FDA in 1996. This test uses the original specimen collected with the OraSure ® oral fluid collection device to confirm positive results of initial oral fluid HIV-1 EIA screening tests. +Our oral fluid Western blot HIV-1 confirmatory test was previously marketed under an exclusive arrangement with BMX. +At the end of 2007, +BMX terminated the agreement under which it supplied the HIV-1 antigen used to manufacture our oral fluid Western blot HIV-1 confirmatory test and the agreement under which it distributed that product on an exclusive, world-wide basis. As a result, +we are now supplying this test directly to our laboratory customers. Pursuant to the terms of our antigen supply agreement with BMX, we purchased an additional two-year supply of the antigen from BMX so that we can continue to manufacture and sell +our oral fluid Western blot test. When this additional two-year supply is combined with our existing inventory of the HIV-1 antigen, we believe we have a sufficient supply of HIV-1 antigen to meet the demand for our Western blot test for at least +the next several years. +Q.E.D. ® Saliva Alcohol Test +Our Q.E.D. ® saliva alcohol test is a point-of-care test device that is a cost-effective alternative to breath or blood alcohol testing. The test is a quantitative, saliva-based method for the detection of +ethanol, has been +6 +Table of Contents +cleared for sale by the FDA and has received a CLIA waiver. The U.S. Department of Transportation (“DOT”) has also approved the test for purchase. +Each Q.E.D. ® test kit +contains a collection stick that is used to collect a sample of saliva and a disposable detection device that displays results in a format similar to a thermometer. The Q.E.D. ® device is +easy to operate and instrumentation is not required to read the result. The product has a testing range of 0 to 0.145% blood alcohol and produces results in approximately two minutes. +Products Under Development +OraQuick ® Platform +We believe that +OraQuick ® has significant potential as a point-of-care testing platform for clinics and other public health entities, hospitals, physicians’ offices and other markets. Because the +OraQuick ® platform is simple to use and can operate in a non-invasive manner with oral fluid, we believe it will be suitable for use by consumers without the assistance of a doctor or other +medical professional. We also believe that OraQuick ® provides a platform technology that can be modified for detection of a variety of infectious diseases in addition to HIV, such as viral +hepatitis and certain sexually transmitted diseases. +We are currently devoting +significant resources to obtaining FDA approval to sell our OraQuick ® HIV-1/2 test in the United States OTC market. We have completed an observed user study and submitted our data to the +FDA. We have also developed an information and referral system and product packaging and labeling suitable for the OTC market. We expect to conduct additional clinical work through 2009, and we intend to submit an application for FDA approval after +our clinical studies are completed. +We have developed a rapid test on the +OraQuick ® platform which can detect antibodies to the Hepatitis C virus, or HCV, in oral fluid, blood, serum and plasma samples. A PMA application for this test was submitted to the FDA in +October 2008. Additional clinical studies required to obtain a CE mark are underway. In addition, during 2008, we obtained rights to a rapid HCV test manufactured by a third party for distribution into certain developing foreign countries. +We have entered into agreements with Schering-Plough Corporation +(“Schering-Plough”) to collaborate on the development and promotion of our OraQuick ® HCV test for use with oral fluid. Under the terms of these agreements, we have been and may be +reimbursed by Schering-Plough for a portion of our costs to develop the test and obtain regulatory approvals, and Schering-Plough will provide detailing and other promotional support for the test in the physicians’ office market in the United +States and internationally. +OraSure ® /Intercept ® Applications +Oral mucosal transudate, or OMT, contains many constituents found in blood and serum, although in +lower concentrations. We believe the OraSure ® and Intercept ® devices are a platform technology with a wide variety of potential +applications, where laboratory testing is available. For example, the OraSure ® device may be useful for the collection of a variety of antibodies or markers for infectious diseases or +conditions in addition to HIV-1, such as antibodies to viral hepatitis. +In 2004, +the Substance Abuse and Mental Health Services Administration (“SAMHSA”) issued proposed regulations for oral fluid drug testing for federal workers. These proposed regulations have since been withdrawn. If and when reissued in final form, +these regulations may require certain modifications to our Intercept ® product in order to permit its use by federal workers. As a result, we are developing modifications to the +Intercept ® collection device that we anticipate will be required by these regulations or are otherwise likely to be desired by our customers. +We are also currently developing additional drugs of abuse assays for use with our Intercept ® collection device. In 2008, we signed a development agreement with Roche Diagnostics for homogeneous fully-automated +7 +Table of Contents +oral fluid drugs of abuse assays that can be run on random access chemistry analyzers. The oral fluid assays are being developed for use with our +Intercept ® collection device and Roche’s KIMS (kinetic information of microparticles in solution) technology. The assays will run on various automated analyzers to allow oral fluid +samples to be processed with the same efficiency currently achieved with urine-based drug tests. Assays for cocaine, opiates, methamphetamine, amphetamine, PCP and cannabinoids (marijuana) have been developed and are being transferred to +manufacturing by Roche. We are currently negotiating a commercialization agreement with Roche pursuant to which a drug testing system comprised of our Intercept ® device and the newly +developed homogeneous assays will be marketed and sold on a worldwide basis. +OTC Cryosurgical Systems Products +We currently sell our Histofreezer ® +cryosurgical systems product in the physicians’ office or professional market. This product has been approved by the FDA for the treatment of a total of nine different types of benign skin lesions. Our OTC cryosurgical product has been approved +by the FDA for two types of skin lesions – common warts and plantar warts. +We +believe that one or more of the seven remaining Histofreezer ® indications may be attractive to the OTC market. We have submitted an application for FDA 510(k) clearance of an OTC +cryosurgical product for one of these indications and that application remains pending before the FDA. +Business Strategy +We have adopted a multi-part growth strategy, pursuant to which we intend to leverage our extensive diagnostic experience in order to maximize the +available opportunities from our existing products and technologies, and supplement our existing product pipeline by accessing other technologies and products. We intend to follow a disciplined approach to maximize the value of our business for the +benefit of our stockholders. +Our overall vision is to become a recognized global leader focused on providing innovative diagnostic +solutions that add substantial value to existing and emerging healthcare needs. In order to achieve this vision, our business strategy includes the following key elements: +• +Extension of Base Businesses . We intend to maximize the sales potential of our existing +product lines and technologies in the markets where they are currently sold, with a focus on expanding, where possible, the number of our oral fluid product offerings. Under this part of the strategy, we intend to fully capitalize on the potential +market reach of our OraQuick ® , OraSure ® , Intercept ® , +Histofreezer ® and OTC cryosurgical products by investing in our sales and marketing efforts where appropriate, making product improvements and enhancements, and optimizing our distribution +channels. We also intend to expand the reach of our existing products and technology platforms into new markets and will focus specifically on expanding into international markets. +• +Infectious Disease Testing . We will pursue new products and technology platforms in the +infectious disease, point-of-care testing business to supplement our existing product pipeline. This may include either the development of new infectious disease products or the acquisition of new technologies or products. An important new product +that we recently developed is a rapid HCV test on our OraQuick ® platform and we have acquired distribution rights in certain African countries to a rapid HCV test manufactured by a third +party. +• +OTC Opportunities . We intend to identify or develop products that can be sold in the OTC +or retail marketplace. A significant opportunity that we are pursuing as part of this strategy is to seek FDA approval to sell our OraQuick ® rapid HIV-1/2 antibody test in the United States +OTC market. We have also relaunched our OTC cryosurgical product in the United States on a limited basis under our new national brand, Freeze ‘n Clear Skin Clinic™, and plan to expand the international sale of our OTC cryosurgical product. +8 +Table of Contents +• +Operational Improvements . We intend to remain focused on the continuous improvement of our operations. These improvements will +include, but not be limited to, expanding the use of automated manufacturing for our product lines as demand increases, expanding the global sourcing of components and assemblies to achieve efficiencies and cost improvements, making infrastructure +and information technology investments as needed to improve effectiveness and productivity, and modifying our processes in order to continuously improve quality and the effectiveness of our operations. +Research and Development +In 2008, our research and development activities focused primarily on the development of a rapid HCV test using our OraQuick ® technology platform, clinical +and regulatory activities related to obtaining PMA approval for our OraQuick ® HCV test, clinical work to obtain FDA approval for use of an OraQuick ® HIV test in the United States OTC market, and development of certain improvements to existing products in the OraQuick ® , Intercept ® and cryosurgical wart removal product lines. +From time to time, we may also +contract with third parties to conduct research and development activities and we may continue to do so in the future. +Research and +development expenses totaled $20.3 million in 2008, $14.1 million in 2007 and $8.6 million in 2006. These expenses include our costs associated with research and development, regulatory affairs, clinical trials and product support. +Sales and Marketing +We attempt to reach our major +target markets through a combination of direct sales, strategic partnerships and independent distributors. Our marketing strategy is to create or raise awareness through a full array of marketing activities, which include trade shows, print +advertising, special programs and distributor promotions, in order to stimulate sales in each target market. +We market our products in the +United States and internationally. Revenues attributable to customers in the United States were $57.4 million, $64.6 million and $56.8 million in 2008, 2007 and 2006, respectively. Revenues attributable to international customers amounted to $13.7 +million, $18.1 million and $11.4 million, or 19%, 22% and 17% of our total revenues, in 2008, 2007 and 2006, respectively. +Infectious +Disease Testing +We market the OraQuick ADVANCE ® rapid HIV-1/2 antibody test directly to customers in the public health market for HIV testing. This market consists of a broad range of clinics and laboratories and includes states, counties, +the Centers for Disease Control and Prevention (“CDC”), SAMHSA and other governmental agencies, family planning clinics, colleges and universities, correctional facilities and the military. There are also a number of organizations in the +public health market, such as AIDS service organizations and various community-based organizations set up primarily for the purpose of encouraging and enabling HIV testing. +Since November 2002, Abbott Laboratories (“Abbott”) had been our exclusive distributor +of OraQuick ® in the U.S. hospital market and non-exclusive distributor in the U.S. physicians’ office marketplace. Our agreement with Abbott was terminated at the end of 2008. As a +result, we are now selling OraQuick ADVANCE ® directly to U.S. hospitals and will continue to sell to U.S. physician offices through distributors. In anticipation of the transition of +this business, we increased the size of our hospital sales force and added additional inside sales, customer service and sales support resources. In addition to selling OraQuick ADVANCE ® +to hospitals, we expect our hospital sales force to eventually sell new products to this market, including our OraQuick ® HCV test, once FDA approval is obtained. +9 +Table of Contents +We currently distribute our OraQuick ® test in several foreign countries. During 2007, we obtained a CE mark for this product and launched sales in the United Kingdom, Ireland and Spain. We expect to increase the number of countries +where this product is sold as we find new distributors and complete registrations in additional countries. +We also market the OraSure ® oral fluid collection device for HIV-1 testing, on its own and as a kit in combination with laboratory testing services. To +better serve our public health customers, we have contracted with two commercial laboratories to provide prepackaged OraSure ® test kits, with prepaid laboratory testing and specimen +shipping costs included. We also sell the OraSure ® device in the international public health market. +In October 2008, we submitted a PMA application with the FDA for approval of a rapid HCV test +using the OraQuick ® platform, and plan to apply for CLIA waiver, a CE mark and other international registrations. We intend to sell this product on a worldwide basis. We have entered into +agreements with Schering-Plough to collaborate on the development and promotion of our OraQuick ® HCV test for use with oral fluid. Under the terms of these agreements, we have been and may +be reimbursed by Schering-Plough for a portion of our costs to develop the test and obtain regulatory approvals, and Schering-Plough will provide detailing and other promotional support for the test in the physicians’ office market in the +United States and internationally. +Substance Abuse Testing +Our substance abuse testing products are marketed to laboratories serving the workplace testing, forensic toxicology, criminal justice and drug +rehabilitation markets. +We have entered into agreements for the distribution of +Intercept ® collection devices and associated MICRO-PLATE assays for drugs-of-abuse testing in the workplace testing market in the United States and Canada through several laboratory +distributors, including Quest Diagnostics (“Quest”) and Clinical Reference Laboratory, and internationally for workplace, criminal justice and forensic toxicology testing through Bio-Rad Laboratories, Concateno (which acquired our prior +distributor, Altrix HealthCare, plc) and other distributors. In some cases, we assist our laboratory customers in customizing their testing services by selling them equipment required to test oral fluid specimens collected with the Intercept ® device. +We also market the +Intercept ® collection device on its own and as a kit in combination with laboratory testing services. To better serve our workplace customers, we have contracted with two commercial +laboratories to provide prepackaged OraSure ® test kits, with prepaid laboratory testing and specimen shipping costs included. +The criminal justice market in the United States for our substance abuse testing products consists of a wide variety of entities in the criminal justice +system that require drug screening, such as pre-trial services, parole and probation officials, police forces, drug courts, prisons, drug treatment programs and community/family service programs. The forensic toxicology market consists of several +hundred laboratories including federal, state and county crime laboratories, medical examiner laboratories and reference laboratories. +We also distribute our Q.E.D. ® saliva +alcohol test primarily through various distributors in the United States and internationally. The markets for alcohol testing are relatively small and fragmented with a broad range of legal and procedural barriers to entry. Markets range from law +enforcement testing to workplace testing of employees in safety sensitive occupations. Typical usage situations include pre-employment, random, post-accident, reasonable-cause and return-to-duty testing. +Cryosurgical Systems +Most of our Histofreezer ® sales occur +in the United States to distributors that, in turn, resell the product to primary care physicians and podiatrists in the United States. Our major U.S. distributors include Cardinal Healthcare, McKesson HBOC, Physicians Sales & Service, +AmerisourceBergen Corporation, and Henry Schein. Internationally, we sell the Histofreezer ® product through a network of distributors in more than 20 countries worldwide. +10 +Table of Contents +In past years, we sold a cryosurgical wart removal +product similar to Histofreezer ® in the OTC market in the United States and Canada pursuant to a distribution agreement with Prestige, the owner of the Compound W ® line of wart removal products. That distribution agreement terminated at the end of 2007. In early 2009, we launched our OTC cryosurgical wart product in the U.S. under a new national +proprietary brand called Freeze ‘n Clear Skin Clinic™. This launch has started with one major retailer, and we intend to expand to other retailers in the future. +Additionally, we distribute cryosurgical wart removal products in the OTC footcare market in Europe, Australia and New Zealand through our distributor, +SSL, under its Scholl and Dr. Scholl tradenames, and in the OTC markets in Mexico and several Central and South American countries under the POINTTS tradename through our distributor, Genomma Labs. +Insurance Risk Assessment +We currently market the OraSure ® oral +fluid collection device for use in screening life insurance applicants in the United States and internationally to test for three of the most important underwriting risk factors: HIV-1, cocaine and cotinine (a metabolite of nicotine). Devices are +sold to insurance testing laboratories, including Quest, Heritage Labs and Clinical Reference Laboratory. These laboratories in turn provide the devices to insurance companies, usually in combination with testing services. +We also promote use of the OraSure ® +device directly to insurance companies for life insurance risk assessment. Insurance companies then make their own decision regarding which laboratory to use to supply their collection devices and testing services. Our OraSure ® Western blot confirmatory test was previously distributed through BMX to laboratories and is used to confirm oral fluid specimens collected with our OraSure ® device that initially test positive for HIV-1. Because BMX elected not to renew the Western blot agreements after December 31, 2007, we now distribute the Western blot test directly to our laboratory customers. +Because insurance companies are in various stages of their adoption of the +OraSure ® device, there exists a wide range of policy limits where the product is being applied. Some insurance companies have chosen to extend their testing to lower policy limits where +they did not test at all before, while others have used OraSure ® to replace some of their blood and urine-based testing. In general, most of our insurance company customers use the +OraSure ® device in connection with life insurance policies having face amounts of up to $250,000, with some customers using the device for policies of up to $500,000 in amount. +In recent years, we have experienced a decline in sales of OraSure ® and related assays for insurance testing, primarily due to a reduction in the number of applications for life insurance policies and changes in underwriting requirements, as well as some consolidation in the industry +leading to a reevaluation of testing methods. +We also sell our AUTO-LYTE ® assays and reagents in the insurance testing market directly to laboratories, including Heritage Labs and Clinical Reference Laboratory. +International Markets +We sell most +of our products into international markets primarily through distributors with knowledge of their local markets. Principal markets include foreign governments, physicians’ offices, insurance risk assessment, substance abuse, public health and +laboratory testing. +We assist our international distributors in registering the products and obtaining required regulatory approvals in +each country, and we provide training and support materials. Our international marketing program includes direct assistance to distributors in arranging for laboratory services, cooperation from screening test manufacturers and performance of +Western blot confirmatory tests when necessary. +11 +Table of Contents +Significant Products and Customers +Several different products have contributed significantly to our financial performance, accounting +for 10% or more of our total revenues during the past three years. The OraQuick ® rapid HIV testing products, the cryosurgical systems products, and the OraSure ® and Intercept ® oral fluid collection devices accounted for total revenues of $35.3 million, $10.7 million and $13.6 million in 2008, $32.7 million, $23.5 +million and $15.5 million in 2007, and $25.6 million, $17.3 million and $15.1 million in 2006, respectively. +We had two customers, Quest and Abbott, which each accounted for 10% of our total revenues during 2008. Our distribution agreement with Abbott terminated at the end of 2008, and we are now selling OraQuick +ADVANCE ® directly to hospitals and other customers previously served by Abbott. The loss of Quest, or a significant decrease in the volume of products purchased by this customer, +could have a material adverse effect on our financial results. +Revenue by Segment +We operate our business within one reportable segment and all of our revenues are generated from this one segment. Our net revenue is generated by our +product sales and licensing and product development activities. For more information about our revenues from external customers, income and total assets, please see the sections entitled “Selected Financial Data” and +“Management’s Discussion and Analysis of Financial Condition and Results of Operations” and Note 13 to the financial statements, included elsewhere in this Annual Report. +Supply and Manufacturing +We manufacture our +OraQuick ADVANCE ® test in our Bethlehem, Pennsylvania facility. In addition, we have contracted with a third party in Thailand for the assembly of the OraQuick ® device, in order to supply certain international markets. This supply agreement had an initial term of one year, and automatically renews for additional annual periods unless either party +provides a timely notice of termination prior to the end of an annual period. We believe that other firms would be able to manufacture the OraQuick ® test on terms no less favorable than +those set forth in the agreement if the Thailand contractor would be unable or unwilling to continue manufacturing this product. +We can purchase the HIV antigen and the nitrocellulose required for the OraQuick ® test only from a limited number of sources. We currently purchase the antigen from a single contract supplier under a long-term agreement with an initial term ending in 2010 and one-year +automatic renewal terms thereafter. We also purchase the nitrocellulose used in the test from a single vendor, under a supply agreement with a five-year term ending in 2009. We intend to renew this agreement prior to its expiration. If for any +reason these suppliers are unwilling or no longer able to supply our antigen or nitrocellulose needs, we believe that alternative supplies could be obtained at a competitive cost. However, a change in the antigen or nitrocellulose would require FDA +approval and some additional development work. This in turn would require significant time to complete and could disrupt our ability to manufacture and sell the OraQuick ® device. +We manufacture both the OraSure ® and Intercept ® collection devices in our Bethlehem, Pennsylvania facility, and we expect to continue to do so for the foreseeable future. +The oral fluid Western blot HIV-1 confirmatory test is currently manufactured in our Bethlehem, Pennsylvania facility. The HIV antigen needed to +manufacture the Western blot test is currently available from only a limited number of sources. For many years, we purchased the antigen for this product from BMX on an exclusive basis. Our agreement with BMX for the supply of HIV-1 antigen +terminated on December 31, 2007. As a result, we purchased an additional two-year supply of the antigen from BMX as permitted under the agreement. When this additional supply is combined with our existing inventory of the HIV-1 antigen, we +believe we have a sufficient supply of the HIV-1 antigen to meet the demand for our Western blot test for at least the next several years. +12 +Table of Contents +Histofreezer ® is assembled in The Netherlands by Koninklijke, Utermöhlen, N.V. (“Utermöhlen”), the company from which we acquired the product in 1998. We purchase the product pursuant to an exclusive production +agreement. The cryosurgical wart removal products distributed in OTC markets are supplied by vendors located in the United States. We believe that additional suppliers of all of our cryosurgical products are available on terms no less favorable than +the terms of our existing supply agreements in the event that our current suppliers would be unable or unwilling to continue manufacturing these products. +Our AUTO-LYTE ® and MICRO-PLATE assays +are manufactured in our Bethlehem, Pennsylvania facility. These tests require the production of highly specific and sensitive antibodies corresponding to the antigen of interest. Substantially all our antibody requirements are provided by contract +suppliers. We believe that we have adequate reserves of antibody supplies and that we have access to sufficient raw materials for these products. +The Q.E.D. ® saliva alcohol test is +manufactured and packaged for shipment in our Bethlehem, Pennsylvania facility. +Employees +As of December 31, 2008, we had 287 full-time employees, including 84 in sales, marketing and client services; 16 in research and development; 136 in +operations, manufacturing, quality control, information systems, purchasing and shipping; 24 in regulatory affairs; and 27 in administration and finance. This compares to 290 employees as of December 31, 2007. Our employees are not currently +represented by a collective bargaining agreement. +In light of the ongoing negative +economic conditions, we re-examined our staffing levels and, in December 2008, we eliminated 18 positions in order to reduce our future costs. At the same time, we refocused our resources on parts of our business having the greatest strategic +impact. A primary example was the expansion of our sales force and related support functions needed to implement a direct hospital sales model for our OraQuick ADVANCE ® HIV-1/2 test. +We believe these actions were necessary to lower our costs where possible while taking steps to ensure the future success of our business. +Competition +The diagnostic industry is a multi-billion dollar international industry and is intensely competitive. Many of our competitors are +substantially larger than we are, and they have greater financial, research, manufacturing and marketing resources. +Important competitive +factors for our products include product quality, performance, price, ease of use, customer service and reputation. Industry competition is based on the following: +• +Scientific and technological capability; +• +Proprietary know-how; +• +The ability to develop and market products and processes; +• +The ability to obtain FDA or other regulatory approvals; +• +The ability to manufacture products that meet applicable FDA requirements (i.e., good manufacturing practices); +• +Access to adequate capital; +• +The ability to attract and retain qualified personnel; and +• +The availability of patent protection. +13 +Table of Contents +A few large corporations produce a wide variety of diagnostic tests and other medical devices and +equipment. A larger number of mid-size companies generally compete only in the diagnostic industry and a significant number of small companies produce only a few diagnostic products. As a result, the diagnostic test industry is highly fragmented and +segmented. +The future market for diagnostic tests is expected to be characterized by consolidation, greater cost consciousness and tighter +reimbursement policies. The purchasers of diagnostic products are expected to place increased emphasis on lowering costs, reducing inventory levels, automation, service and volume discounts. The increased complexity of the market is expected to +force many competitors to enter into joint ventures or license certain products or technologies. +We expect competition to intensify as +technological advances are made and become more widely known, and as new products reach the market. Furthermore, new testing methodologies could be developed in the future that render our products impractical, uneconomical or obsolete. There can be +no assurance that our competitors will not succeed in developing or marketing technologies and products that are more effective than those we develop or that would render our technologies and products obsolete or otherwise commercially unattractive. +In addition, there can be no assurance that our competitors will not succeed in obtaining regulatory approval for these products, or introduce or commercialize them, before we can do so. These developments could have a material adverse effect on our +business, financial condition and results of operations. +Several companies market +or have announced plans to market oral specimen collection devices and tests both within and outside the United States. We expect the number of devices competing with our Intercept ® , +OraQuick ® and OraSure ® devices to increase as the benefits of oral fluid-based testing become more widely accepted. +Competition in the HIV testing market is intense and is expected to increase. We believe that the principal competition will come from existing +laboratory-based blood tests, point-of-care rapid blood tests, laboratory-based urine assays or other oral fluid-based tests that may be developed. Our competitors include specialized biotechnology firms, as well as pharmaceutical companies with +biotechnology divisions and medical diagnostic companies. +Significant competitors +for our OraQuick ADVANCE ® rapid test, such as the Ortho Diagnostics division of Johnson & Johnson, Bio-Rad Laboratories and Abbott, sell laboratory-based HIV-1/2 EIAs, and +Maxim Biomedical (formerly Calypte, Inc.) sells an HIV-1 screening test for urine, in the United States. MedMira and Trinity Biotech each sell competing rapid HIV-1 blood tests, and Bio-Rad Laboratories and Inverness Medical/Chembio sell competing +rapid HIV-1/2 blood tests in the United States. These tests compete with our OraQuick ADVANCE ® test in hospitals and other laboratory settings. In addition, Trinity Biotech and +Inverness Medical/ Chembio have received CLIA waivers for their rapid HIV tests, and these tests compete with our OraQuick ADVANCE ® test in the markets outside of the traditional +hospital and laboratory settings. These companies, or others, may continue to expand the bodily fluids with which a rapid HIV test may be performed, or develop and commercialize new rapid HIV tests, which would provide further competition for our +OraQuick ADVANCE ® test. We believe other companies may also seek FDA approval to sell competing rapid HIV tests in the future. +Internationally, our OraQuick ADVANCE ® +test competes against rapid HIV tests sold by a number of other entities, and often these competing tests are sold at prices substantially below the prices we charge for our OraQuick ADVANCE ® test. Inverness Medical sells a rapid HIV-1/2 blood test outside the United States and Calypte has developed a rapid oral fluid HIV test which is now being sold in certain foreign countries. Lower priced rapid HIV +blood tests are also sold internationally by various third parties. +The +Intercept ® drug testing system competes with laboratory-based drug testing products and services using testing matrices such as urine, hair, sweat and oral fluid. Major competitors include +Ansys Technologies, Inc., Dade Behring, Psychemedics and Immunalysis. +14 +Table of Contents +Our MICRO-PLATE oral fluid drug assays, which are +sold for use with the Intercept ® and OraSure ® collection devices, continue to come under increasing competitive pressure from +“home-brew” assays developed internally by our laboratory customers. Our oral fluid MICRO-PLATE assays also compete with urine-based homogeneous assays that are run on fully-automated, random access analyzers. These tests provide strong +competitive pressure because they provide the benefits of automation, including lower costs and short turn-around times. In addition, we believe our competitors are developing oral fluid tests suitable for use on these fully automated homogeneous +assay systems and these assays, if and when they are developed and commercialized, will represent a significant competitive threat to our oral fluid MICRO-PLATE business. In order to meet this competition, we are developing fully-automated +homogeneous oral fluid drugs of abuse assays with Roche Diagnostics for use with our Intercept ® device. +Our MICRO-PLATE drugs-of-abuse reagents sold in the forensic toxicology market are targeted to forensic testing laboratories where sensitivity, automation and “system solutions” are important. In the past, +these laboratories have typically had to rely on radioimmunoassay test methods to provide an adequate level of sensitivity. Radioimmunoassays require radioactive materials, which have a short shelf-life and disposal problems. Our MICRO-PLATE tests +meet the laboratories’ sensitivity needs, run on automated equipment, are not radioimmunoassays, and are offered to the laboratory as a complete system solution of reagents, instrumentation and software to meet the specific needs of each +customer. We compete with both homogeneous and heterogeneous tests manufactured by many companies. Significant competitors in the market for these assays include Microgenics, Inc., Roche Diagnostics and Immunalysis. +Sales of our AUTO-LYTE ® urine assays +have declined substantially during the past several years, primarily due to competition from “home-brew” assays developed internally by our laboratory customers, which can be produced at a cost lower than the price typically paid for our +products. Many of our customers no longer purchase our AUTO-LYTE ® assays, and we eventually expect to stop selling this product line. +The Histofreezer ® product’s +delivery system and operating temperature, which is warmer than liquid nitrogen, provide us with the opportunity to target sales to primary care physicians, such as family practitioners, pediatricians and podiatrists. We do not generally target +sales to dermatologists because they have the volume of patients required to support the capital costs associated with a liquid nitrogen delivery system, which is also used to remove warts and other benign skin lesions. Major competitors for the +Histofreezer ® product include Cryosurgery, Inc. in the United States and Wartner in Europe. +Competition in the United States and Canadian OTC markets comes primarily from cryosurgical +products sold by Schering-Plough under the Dr. Scholl’s ® brand and by Prestige under the Compound W ® and Wartner ® tradenames. Salicylic acid wart removal products also compete against our OTC cryosurgical product. Internationally, our OTC products compete against cryosurgical products sold by Wartner and +several other firms. +Q.E.D. ® +has two direct competitors, Ansys Technologies, Inc. and Chematics. These companies offer semi-quantitative saliva-based alcohol tests and have received DOT approval. Indirect competitors who offer breath testing equipment include +Intoximeters, Dräger and CMI. Although there are lower priced tests on the market that use oral fluid or breath as a test medium, these tests are qualitative tests that are believed to be substantially lower in quality and provide fewer +benefits than our Q.E.D. ® test. +Patents and Proprietary Information +We seek patents and other intellectual property rights to protect and preserve our proprietary technology and our right to capitalize on the results of +our research and development activities. We also rely on trade secrets, know-how, continuing technological innovations and licensing opportunities to provide competitive advantages for our products in our markets and to accelerate new product +introductions. We regularly search for third-party patents in fields related to our business to shape our own patent and product commercialization strategies as +15 +Table of Contents +effectively as possible and to identify licensing opportunities. United States patents generally have a maximum term of 20 years from the date an application +is filed. +We have ten United States patents and numerous foreign patents for the +OraSure ® and Intercept ® collection devices and technology relating to oral fluid collection, containers for oral fluids, methods +to test oral fluid, formulations for the manufacture of synthetic oral fluid, and methods to control the volume of oral fluid collected and dispersed. The patents expire from April 2009 to March 2018. We have also applied for additional patents, in +both the United States and certain foreign countries, on such products and technology. +We have two United States patents for our OraQuick ADVANCE ® rapid HIV-1/2 antibody test, and we have several related patent applications pending for this product in the +United States and internationally. These patents expire from March to April 2019. We have obtained licenses to certain lateral flow patents and to certain HIV-1 and HIV-2 patents held by other parties. We also have obtained a license to certain HCV +patents which we intend to use to manufacture and sell a rapid HCV test on the OraQuick ® or other technology platforms. We obtained these licenses through the payment of certain upfront +fees and an agreement to pay ongoing royalties. We believe these fees and royalties are comparable to those generally paid by other companies under similar arrangements. +We may need to obtain licenses or other rights under, or enter into distribution or other business +arrangements in connection with, certain other intellectual property patents in order to manufacture and sell the OraQuick ADVANCE ® test or other tests that use the same or similar +technology platform. See Section 1A, entitled “Risk Factors,” for a further discussion of these issues. +We have four United +States patents and numerous foreign patents issued for apparatuses and methods for the topical removal of skin lesions relating to our cryosurgical wart removal products, and we have pending patent applications related to these products in the +United States and in certain foreign countries. These patents expire from July 2012 to August 2013. We have also licensed another patent relating to apparatuses and methods for the topical removal of skin lesions relating to our cryosurgical wart +removal products. +We have two United States patents and numerous foreign patents +and patent applications for the technology used in the Q.E.D. ® test. These patents expire from May to August 2009. These patents are related to the analog-to-digital technology color +control systems and methods, systems and devices for the test, and detection of biochemical molecules. +We require our employees, +consultants, outside collaborators and other advisors to execute confidentiality agreements upon the commencement of employment or consulting relationships with us. These agreements provide that all confidential information developed by or made +known to the individual during the course of the individual’s relationship with us is to be kept confidential and not disclosed to third parties except in specific circumstances. In the case of employees, the agreements provide that all +inventions conceived by the individual during his or her tenure with us will be our exclusive property. +We own rights to trademarks and service marks that we believe are necessary to conduct our business as currently operated. In the United States, we own the OraSure ® +, Intercept ® , OraQuick ® , OraQuick ADVANCE ® , +Histofreezer ® , Freeze ‘n Clear Skin Clinic™, Q.E.D. ® and AUTO-LYTE ® trademarks. We also own many of these marks and others in several foreign countries. With respect to our international OTC cryosurgical products, the Scholl and Dr. Scholl tradenames are owned by SSL in Europe, +Australia, New Zealand and other countries outside North and South America, and the POINTTS tradename is owned by Genomma Labs. +Although +important, the issuance of a patent or existence of trademark or trade secret protection does not in itself ensure the success of our business. Competitors may be able to produce products competing with our patented products without infringing our +patent rights. Issuance of a patent in one country generally does not prevent manufacture or sale of the patented product in other countries. The issuance of a patent is not conclusive +16 +Table of Contents +as to validity or as to the enforceable scope of the patent. The validity or enforceability of a patent can be challenged by litigation after its issuance. +If the outcome of such litigation is adverse to the owner of the patent, the owner’s rights could be diminished or withdrawn. Trade secret protection does not prevent independent discovery and exploitation of the secret product or technique. +Government Regulation +General +Most of our products are regulated by the FDA, certain state and local agencies and comparable regulatory bodies in other countries. This +regulated environment governs almost all aspects of development, production and marketing, including product testing, authorizations to market, labeling, promotion, manufacturing and recordkeeping. +All of our FDA-regulated products require some form of action by the FDA before they can be marketed in the United States. After approval or clearance by +the FDA, we must continue to comply with other FDA requirements applicable to marketed products. Both before and after approval or clearance, failure to comply with the FDA’s requirements can lead to significant penalties or could disrupt our +ability to manufacture and sell these products. In addition, the FDA could refuse permission to obtain certificates needed to export our products if the agency determines that we are not in compliance. +Domestic Regulation +Most of our +products are regulated in the United States as medical devices. +There are two mechanisms by which regulated medical devices can be placed +on the market in the United States. Some products may qualify for clearance under Section 510(k) of the Federal Food, Drug and Cosmetic Act. To obtain this clearance from the FDA, the manufacturer must provide a premarket notification that it +intends to begin marketing the product, and show that the product is substantially equivalent to another legally marketed product (i.e., that it has the same intended use and is as safe and effective as a legally marketed device and does not raise +different questions of safety and effectiveness). In some cases, the submission must include data from human clinical studies. Marketing may only commence when the FDA issues a clearance letter finding substantial equivalence. An applicant must +submit a 510(k) application at least 90 days before marketing of the affected product commences. Although FDA clearance may be granted within that 90-day period, in some cases as much as a year or more may be required before clearance is obtained, +if at all. +If the medical device does not qualify for the 510(k) procedure (either because it is not substantially equivalent to a legally +marketed device or because it is required by statute and the FDA’s regulations to have an approved premarket application, or PMA), the FDA must approve a PMA before marketing can begin. PMAs must demonstrate, among other matters, that the +medical device provides a reasonable assurance of safety and effectiveness. A PMA is typically a complex submission, including the results of preclinical and clinical studies. Preparing a PMA is a detailed and time-consuming process. Once a PMA has +been submitted, the FDA is required to review the submission within 180 days. However, the FDA’s review may, and often is, much longer, often requiring one year or more, and may include requests for additional data and facility inspections +before approval is granted, if at all. +Some of our products are used for non-medical purposes and many of our drugs-of-abuse products sold +to state crime laboratories are for forensic use. The FDA does not currently regulate products used for these purposes. +Every company that +manufactures medical devices distributed in the United States must comply with the FDA’s Quality System Regulations (“QSRs”). These regulations govern the manufacturing process, including +17 +Table of Contents +design, manufacture, testing, release, packaging, distribution, documentation and purchasing. In complying with the QSRs, manufacturers must continue to +expend time, money and effort in the area of production and quality to ensure full technical compliance. Companies are also subject to other post-market and general requirements, including restrictions imposed on marketed products, promotional +standards and requirements for recordkeeping and reporting of certain adverse reactions. If there are any modifications made to our marketed devices, a premarket notification or PMA may be required to be submitted to, and cleared or approved by, the +FDA, before the modified device may be marketed. The FDA regularly inspects companies to determine compliance with the QSRs and other post-market requirements. Failure to comply with statutory requirements and the FDA’s regulations can result +in warning letters, monetary penalties, suspension or withdrawal of regulatory approvals, operating restrictions, total or partial suspension of production, injunctions, product recalls, seizure of products and criminal prosecution. +The Clinical Laboratory Improvements Amendments of 1988, or CLIA, prohibit laboratories from +performing tests for the purpose of providing information for the diagnosis, prevention or treatment of any disease or impairment of, or the assessment of, the health of human beings, unless there is in effect for such laboratories a certificate +issued by the U.S. Department of Health and Human Services applicable to the category of examination or procedure performed. We consider the applicability of the requirements of CLIA in the design and development of our products. We have obtained a +waiver of the CLIA requirements for both our OraQuick ADVANCE ® rapid HIV-1/2 antibody test and our Q.E.D. ® alcohol saliva +test and may seek similar waivers for certain other products. A CLIA waiver allows certain customers to use the waived products that may not have been able to use them without complying with certain quality control and other requirements. +Certain of our products may also be affected by state regulations in the United States. For example, there are several states that +restrict or do not currently permit oral fluid drug testing in the workplace or other markets. In addition, several states prohibit or limit the use of rapid, point-of-care HIV testing. We are presently working with legislators or regulators in +certain of these states in an effort to modify or remove any restrictions affecting our ability to sell products. +International +We are also subject to regulations in foreign countries governing products, human clinical trials and marketing, and may need to obtain +approval from international public health agencies, such as the World Health Organization, in order to sell products in certain countries. Approval processes vary from country to country, and the length of time required for approval or to obtain +other clearances may in some cases be longer than that required for U.S. governmental approvals. We generally pursue approval only in those countries that we believe have a significant market opportunity. +The International Organization for Standardization (“ISO”) is a worldwide federation of national standards bodies from some 130 countries, +established in 1947. The mission of the ISO is to promote the development of standardization and related activities in the world with a view to facilitating the international exchange of goods and services. ISO certification is a pre-requisite to +use of the CE mark and indicates that our quality system complies with standards applicable to activities ranging from initial product design and development through production and distribution. The CE mark is a European Union (“EU”) +requirement to sell products that fall under the scope of the Medical Devices Directive (“MDD”) and the In Vitro Diagnostic Directive (“IVDD”). The CE mark is evidence that the manufacturer and the product meet the requirements +of all applicable directives, including the MDD and IVDD. +We received authorization +to use the CE mark for the OraQuick ADVANCE ® rapid HIV-1/2 test, the OraSure ® and Intercept ® collection devices and our Histofreezer ® product line, and SSL has obtained authorization to use the CE mark for our cryosurgical wart removal product in +the OTC European footcare market. +18 +Table of Contents +We must also comply with certain registration requirements as dictated by Health Canada, prior to +commencing sales in Canada. We have completed this process for several of our current products and may do so with respect to other products in the future. In addition, Canadian law requires manufacturers of medical devices to have a quality +management system that meets various ISO requirements in order to obtain a license to sell their devices in Canada. +Anti-Kickback Laws +The Federal Anti-Kickback Statute prohibits the knowing and willful offer, payment, solicitation, or receipt of any form of +remuneration in return for, or to induce: +• +The referral of a person; +• +The furnishing or arranging for the furnishing of items or services reimbursable under Medicare, Medicaid or other governmental programs; or +• +The purchase, lease, or order of, or the arrangement or recommendation of the purchasing, leasing, or ordering of any item or service reimbursable under Medicare, +Medicaid, or other governmental programs. +Our products are or may be purchased by customers that will seek or receive +reimbursement under Medicare, Medicaid or other governmental programs. Noncompliance with the federal anti-kickback legislation can result in exclusion from Medicare, Medicaid or other governmental programs, and/or restrictions on our ability to +operate in certain jurisdictions, as well as civil and criminal penalties, any of which could have an adverse effect on our business and results of operations. +The Federal Civil Monetary Penalties Law prohibits the offering or transferring of remuneration to a Medicare or Medicaid beneficiary that the person knows or should know is likely to influence the beneficiary’s +selection of a particular supplier of Medicare or Medicaid payable items or services. Noncompliance can result in civil money penalties of up to $10,000 for each wrongful act, assessment of three times the amount claimed for each item or service and +exclusion from the Federal healthcare programs. +Many states have also adopted some form of anti-kickback laws. A determination of +liability under such laws could result in fines and penalties and restrictions on our ability to operate in these jurisdictions. +Foreign Corrupt Practices Act +The U.S. Foreign Corrupt Practices Act (“FCPA”) prohibits corporations and +individuals from engaging in certain activities to obtain or retain business or to influence a person working in an official capacity. It is illegal to pay, offer to pay or authorize the payment of anything of value to any foreign government +official, government staff member, political party or political candidate in an attempt to obtain or retain business or to otherwise influence a person working in an official capacity. Our present and future business has and will continue to be +subject to the FCPA and various other laws, rules and/or regulations applicable to us as a result of our international sales. +Environmental Regulation +Because of the nature of our current and proposed research, development, and manufacturing +processes, we are subject to stringent federal, state and local laws, rules, regulations and policies governing the use, generation, manufacture, storage, air emission, effluent discharge and handling and disposal of materials and wastes. +The foregoing discussion of our business should be read in conjunction with the Financial Statements and accompanying notes included in +Item 15 of this Annual Report. +19 +Table of Contents \ No newline at end of file diff --git a/raw/filings/0001116463/2008/0001193125-09-049845/item13.txt b/raw/filings/0001116463/2008/0001193125-09-049845/item13.txt new file mode 100644 index 0000000000000000000000000000000000000000..26c164a7bfa509fd650685da4bdc73157cc42c22 --- /dev/null +++ b/raw/filings/0001116463/2008/0001193125-09-049845/item13.txt @@ -0,0 +1,3 @@ +ITEM 13. Certain Relationships and Related Transactions, and Director Independence. +The information required by this Item is incorporated by reference to the information under the captions, “Transactions with Related Persons” +and “Corporate Governance—Director Independence,” in the Proxy Statement. \ No newline at end of file diff --git a/raw/filings/0001116463/2008/0001193125-09-049845/item9a.txt b/raw/filings/0001116463/2008/0001193125-09-049845/item9a.txt new file mode 100644 index 0000000000000000000000000000000000000000..534006d37a6c8732bfb01e4f8bb8a7811fad2cd3 --- /dev/null +++ b/raw/filings/0001116463/2008/0001193125-09-049845/item9a.txt @@ -0,0 +1,53 @@ +ITEM 9A Controls and Procedures. +(a) Evaluation of Disclosure Controls and Procedures. +The Company’s management, with the participation of the Company’s Chief Executive Officer and Chief Financial Officer, has evaluated the effectiveness of the Company’s disclosure controls and procedures +(as defined in Rules 13a-15(e) and 15d-15(e) of the Securities Exchange Act of 1934) as of December 31, 2008. Based on that evaluation, the Company’s management, including such officers, concluded that the Company’s disclosure +controls and procedures are adequate and effective to ensure that information required to be disclosed by the Company in the reports that we file or submit under the Securities Exchange Act of 1934 is accumulated and communicated to the +Company’s management, including the Chief Executive Officer and Chief Financial Officer, to allow timely decisions regarding required disclosure and is recorded, processed, summarized, and reported within the time periods specified in the rules +and forms of the Securities and Exchange Commission. +(b) Management’s Report on Internal Control Over Financial Reporting. +The Company’s management is responsible for establishing and maintaining adequate internal control over financial reporting, as such +term is defined in Rule 13a-15(f) and 15d-15(f) under the Securities Exchange Act of 1934. Under the supervision and with the participation of the Company’s management, including our principal executive officer and principal financial officer, +we conducted an evaluation of the effectiveness of our internal control over financial reporting based on the framework in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway +Commission. Based on our evaluation under the framework, our management concluded that our internal control over financial reporting was effective to provide reasonable assurance regarding the reliability of financial reporting and the preparation +of financial statements for external purposes in accordance with generally accepted accounting principles as of December 31, 2008. +58 +Table of Contents +The effectiveness of our internal control over financial reporting as of December 31, 2008 has been +audited by KPMG LLP, an independent registered public accounting firm, as stated in their report, which is included below. +Because of its +inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of +changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. +(c) Changes in Internal +Control Over Financial Reporting. +There was no change in the Company’s internal control over financial reporting during the three +months ended December 31, 2008 that was identified in connection with the evaluation referred to in paragraph (b) above that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over +financial reporting. +(d) Report of Independent Registered Public Accounting Firm +The Board of Directors and Stockholders +OraSure Technologies, Inc.: +We have audited OraSure Technologies, Inc.’s internal control over financial reporting as of December 31, 2008, based on +criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). OraSure Technologies, Inc.’s management is responsible for maintaining effective +internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Management’s Report on Internal Control Over Financial Reporting. Our +responsibility is to express an opinion on the Company’s internal control over financial reporting based on our audit. +We conducted +our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over +financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and +operating effectiveness of internal control based on the assessed risk. Our audit also included performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion. +A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability +of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures +that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as +necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors +of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements. +Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections +of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. +59 +Table of Contents +In our opinion, OraSure Technologies, Inc. maintained, in all material respects, effective internal +control over financial reporting as of December 31, 2008, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). +We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the balance sheets of OraSure +Technologies, Inc. as of December 31, 2008 and 2007, and the related statements of operations, stockholders’ equity and comprehensive income (loss), and cash flows for each of the years in the three-year period ended December 31, +2008, and our report dated March 10, 2009 expressed an unqualified opinion on those financial statements. +/s/ KPMG LLP +Philadelphia, Pennsylvania +March 10, 2009 \ No newline at end of file diff --git a/raw/filings/0001116463/2008/0001193125-09-049845/rp_note.txt b/raw/filings/0001116463/2008/0001193125-09-049845/rp_note.txt new file mode 100644 index 0000000000000000000000000000000000000000..e69de29bb2d1d6434b8b29ae775ad8c2e48c5391 diff --git a/raw/filings/0001116463/2008/0001193125-09-049845/rpt_disclosure.txt b/raw/filings/0001116463/2008/0001193125-09-049845/rpt_disclosure.txt new file mode 100644 index 0000000000000000000000000000000000000000..7b79e8172e95790f321ff1999f943f0e95820348 --- /dev/null +++ b/raw/filings/0001116463/2008/0001193125-09-049845/rpt_disclosure.txt @@ -0,0 +1,9 @@ +Transactions With Related Persons +Since January 1, 2009, there have been no transactions with related persons which would require disclosure in this Proxy Statement. The +Audit Committee is required to review and approve in advance all transactions with related persons involving the Company. The Audit Committee may approve a related party transaction if the transaction is on terms comparable to those that could be +obtained in arms’ length dealings with an unrelated third party. The Audit Committee also reviews any public disclosures of a related party transaction contained in our SEC filings. These responsibilities are described in the Audit +Committee’s charter, a copy of which is available on our website at www.orasure.com . +Information regarding +employment and severance agreements between our executive officers and the Company is set forth in the Section entitled, “Employment Agreements and Potential Payments Upon Termination or Change in Control,” in this Proxy Statement. +12 +Table of Contents \ No newline at end of file diff --git a/raw/filings/0001116463/2009/0001193125-10-057039/filing.txt b/raw/filings/0001116463/2009/0001193125-10-057039/filing.txt new file mode 100644 index 0000000000000000000000000000000000000000..bacde432695afe92f8e5dbeb66706e506f0c528e --- /dev/null +++ b/raw/filings/0001116463/2009/0001193125-10-057039/filing.txt @@ -0,0 +1,5103 @@ +10-K +1 +d10k.htm +FORM 10-K +Form 10-K +Table of Contents +UNITED STATES +SECURITIES AND EXCHANGE COMMISSION +Washington, D.C. 20549 +FORM 10-K +ANNUAL REPORT PURSUANT +TO SECTION 13 OR 15(d) OF THE +SECURITIES EXCHANGE ACT OF 1934 +(Mark One) +x +ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 +For the fiscal year ended December 31, 2009 +OR +¨ +TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 +For the transition period from to +Commission File No. 001-16537 +ORASURE TECHNOLOGIES, INC. +(Exact Name of Registrant as Specified in Its Charter) +Delaware +36-4370966 +(State or Other Jurisdiction of +Incorporation or Organization) +(I.R.S. Employer Identification No.) +220 East First Street +Bethlehem, Pennsylvania +18015 +(Address of Principal Executive Offices) +(Zip Code) +(610) +882-1820 +(Registrant’s Telephone Number, Including Area Code) +Securities registered pursuant to Section 12(b) of the Act: +Title of Each Class +Name of Each Exchange on Which Registered +Common Stock $0.000001 par value per share +The NASDAQ Stock Market LLC +Securities registered pursuant to Section 12(g) of the Act: None +Indicate by check mark if the Registrant +is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes ¨ No x +Indicate by check mark if the Registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Exchange +Act. Yes ¨ No x +Indicate by check mark whether the Registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for +such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No ¨ +Indicate by check mark whether the Registrant has submitted electronically and +posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405) during the preceding 12 months (or for such shorter period that the Registrant was +required to submit and post such files). Yes ¨ No ¨ +Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of Registrant’s knowledge, in +definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. x +Indicate by check mark whether the Registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller +reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. +Large accelerated filer ¨ +Accelerated filer x +Non-accelerated filer ¨ +Smaller reporting company ¨ +(Do not check if a smaller reporting company) +Indicate by check mark whether the Registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ¨ No x +State the aggregate market value of the voting and non-voting common equity held +by nonaffiliates, computed by reference to the price at which the common equity was last sold, or the average bid and asked price of such common equity, as of the last business day of the Registrant’s most recently completed second fiscal +quarter (June 30, 2009): $111,509,155 +Indicate the number of shares outstanding of each of the Registrant’s classes of +common stock, as of March 11, 2010: 46,191,178 shares. +Documents Incorporated by Reference: +Portions of the Registrant’s Definitive Proxy Statement for the 2010 Annual Meeting of Stockholders are incorporated by reference into +Part III of this Report. +Table of Contents +Table of Contents +Page +PART I +ITEM 1. +Business +1 +ITEM 1A. +Risk Factors +18 +ITEM 1B. +Unresolved Staff Comments +38 +ITEM 2. +Properties +38 +ITEM 3. +Legal Proceedings +38 +ITEM 4. +(Removed and Reserved) +39 +PART II +ITEM 5. +Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities +40 +ITEM 6. +Selected Financial Data +42 +ITEM 7. +Management’s Discussion and Analysis of Financial Condition and Results of +Operations +43 +ITEM 7A. +Quantitative and Qualitative Disclosures About Market Risk +61 +ITEM 8. +Financial Statements and Supplementary Data +62 +ITEM 9. +Changes in and Disagreements with Accountants on Accounting and Financial +Disclosure +62 +ITEM 9A. +Controls and Procedures +62 +ITEM 9B. +Other Information +64 +PART III +ITEM 10. +Directors, Executive Officers and Corporate Governance +65 +ITEM 11. +Executive Compensation +65 +ITEM 12. +Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters +65 +ITEM 13. +Certain Relationships and Related Transactions, and Director Independence +65 +ITEM 14. +Principal Accountant Fees and Services +65 +PART IV +ITEM 15. +Exhibits and Financial Statement Schedules +66 +Table of Contents +This Report contains certain “forward-looking statements,” within the meaning +of the Federal securities laws. These may include statements about our expected revenues, earnings, expenses or other financial performance, future product performance or development, expected regulatory filings and approvals, planned business +transactions, expected manufacturing performance, views of future industry, competitive or market conditions, and other factors that could affect our future operations, results of operations or financial position. These statements often include +words, such as “believes,” “expects,” “anticipates,” “intends,” “plans,” “estimates,” “may,” “will,” “should,” “could,” or similar expressions. +Forward-looking statements are not guarantees of future performance or results. Known and unknown factors could cause +actual performance or results to be materially different from those expressed or implied in these statements. Factors that could affect our results are discussed more fully under Item 1A., entitled “Risk Factors,” and elsewhere in +this Annual Report. Although forward-looking statements help to provide complete information about us, readers should keep in mind that forward-looking statements may not be reliable. Readers are cautioned not to place undue reliance on the +forward-looking statements. The forward-looking statements are made as of the date of this Annual Report and we undertake no duty to update these statements. +PART I +ITEM 1. Business. +Our business principally involves the development, manufacture, marketing and sale of oral fluid diagnostic products and +specimen collection devices using our proprietary oral fluid technologies, as well as other diagnostic products including immunoassays and other in vitro diagnostic tests that are used on other specimen types, and other medical devices used +for the removal of benign skin lesions by cryosurgery or freezing. Our diagnostic products include tests which are performed on a rapid basis at the point of care and tests which are processed in a laboratory. These products are sold in the United +States and internationally to various clinical laboratories, hospitals, clinics, community-based organizations and other public health organizations, distributors, government agencies, physicians’ offices, and commercial and industrial +entities. One of our products is sold in the over-the-counter (“OTC”) or consumer retail markets in North America, Europe, Central and South America, and Australia. +In vitro diagnostic testing is the process of analyzing oral fluid, blood, urine and other bodily fluids or tissue for the presence +of specific substances or markers for infectious diseases, drugs of abuse or other conditions. We have targeted the use of oral fluid in our products as a differentiating factor and believe that it provides a significant competitive advantage over +blood and urine. Our oral fluid tests have sensitivity and specificity comparable to blood and/or urine tests. When combined with their ease of use, non-invasive nature, and cost effectiveness, our oral fluid tests represent a very competitive +alternative to the more traditional testing methods in the diagnostic space. +Our Company was formed in May 2000 under +Delaware law solely for the purposes of combining two companies, STC Technologies, Inc. (“STC Technologies”) and Epitope, Inc. (“Epitope”), and changing the state of incorporation of Epitope from Oregon to Delaware. STC +Technologies and Epitope were merged into our Company on September 29, 2000. Our principal offices are located at 220 East First Street, Bethlehem, Pennsylvania 18015, and our telephone number is (610) 882-1820. +Additional information about us can be found on our website. Our website address is www.orasure.com . We make available free of charge +through a link provided at such website our Annual Reports on Form 10-K, our Quarterly Reports on Form 10-Q, our Current Reports on Form 8-K and our other filings with the Securities and Exchange Commission (“SEC”), as well as any +amendments to those Reports and filings. These Reports and filings are made available as soon as reasonably practicable after they are filed or furnished to the SEC. Our Internet website and the information contained in or connected to that website +are not intended to be incorporated by reference into this Annual Report. +1 +Table of Contents +Products +The following is a summary of our principal products and their regulatory and commercial status: +Product +Description +Regulatory Status +Commercial Status +OraQuick +ADVANCE ® +HIV-1/2 +A rapid, point-of-care test for antibodies to the Human Immunodeficiency Virus Type 1 (“HIV-1”) and Type 2 (“HIV-2” and together with HIV-1, “HIV-1/2”) +that can be visually read at the point of care in approximately 20 minutes. +Premarket approval (“PMA”) by the U.S. Food and Drug Administration (“FDA”) for use with oral fluid, finger-stick +and venous whole blood, and plasma. +CLIA (Clinical Laboratory Improvement Amendments of 1988) waived for use with oral fluid, finger-stick and +venous whole blood. Twelve-month shelf life approved in December 2008. +Marketed +CE mark (European Union) approved. Also registered in various countries. +Marketed +OraQuick ® HIV-1/2 OTC +A rapid, point-of-care oral fluid HIV-1/2 test intended to be sold in various OTC markets. +Clinical trials are in process. Data from observed user study submitted to FDA. +Not Marketed +OraQuick ® HCV +A rapid, point-of-care test for antibodies to the hepatitis C virus (“HCV”). +CE mark (European Union) approved. Individual country registrations in process. +Marketed +PMA submitted to FDA. Additional clinical studies are in process. +Not Marketed +OraSure ® +Oral fluid collection device for the detection of antibodies to HIV-1 in an oral fluid sample in a laboratory setting. +PMA approved by FDA. +Marketed +FDA 510(k) cleared for use in detecting cocaine and cotinine (an indicator of nicotine) in oral fluid. +Marketed +CE marked and registered in various countries. +Marketed +Intercept ® +Oral fluid collection device, along with nine related immunoassays, for oral fluid drugs of abuse (“DOA”) testing in a laboratory setting. +Collection device—FDA 510(k) cleared. +Marketed +MICRO-PLATE DOA Assays +Used to detect the following drugs in an oral fluid sample: marijuana, cocaine, opiates, amphetamines, methamphetamines, PCP, benzodiazepines, barbiturates and +methadone. +Nine drug assays—FDA 510(k) cleared. +Marketed +Intercept ® device and various assays CE marked and +registered in certain countries. +Marketed +Homogeneous DOA Assays +Homogeneous fully-automated oral fluid DOA assays jointly developed with Roche Diagnostics for use with Intercept ® collection device. +510(k) applications submitted to FDA for opiates, amphetamines, methamphetamines and PCP. +Not Marketed +2 +Table of Contents +Product +Description +Regulatory Status +Commercial Status +Cryosurgical Systems—Professional +Cryosurgical (freezing) system for the removal of warts and other benign skin lesions, marketed under the Histofreezer ® tradename primarily to the physicians’ office market. +Nine indications—FDA 510(k) cleared. +Marketed +CE marked and registered in certain countries. +Marketed +Cryosurgical Systems—OTC +Cryosurgical system for the removal of common and plantar warts, sold in various OTC markets. +FDA 510(k) cleared. Sold under Freeze ‘n Clear Skin Clinic ™ brand. +Marketed +Registered in Canada. +Marketed +CE marked and registered in certain countries under Scholl Freeze Spray ® and POINTTS ® names. +Marketed +In addition to the above products, we also sell certain immunoassay tests and reagents for insurance risk assessment, substance abuse testing and forensic toxicology applications; an oral fluid Western blot HIV-1 confirmatory test for +confirming positive HIV-1 test results obtained from the use of our OraSure ® collection device; and the FDA +510(k) cleared Q.E.D. ® rapid point-of-care saliva alcohol test. +OraQuick ® Rapid HIV Test +OraQuick ® is our rapid test platform designed to test oral fluid, whole blood (i.e., both finger-stick +and venous), plasma and serum samples for the presence of various antibodies or analytes. The device uses a porous flat pad to collect an oral fluid specimen. After collection, the pad is inserted into a vial containing a pre-measured amount of +developer solution and allowed to develop. When whole blood or plasma is to be tested, a loop collection device is used to collect a drop of blood or plasma and mix it in the developer solution, after which the collection pad is inserted into the +solution and allowed to develop. In all cases, the specimen and developer solution then flow through the testing device where test results are observable in approximately 20 minutes. The OraQuick ® device is a screening test and generally requires a confirmation test where an initial positive result is obtained. +We have commercialized this technology in the form of our OraQuick ADVANCE ® rapid HIV-1/2 antibody test. This is a rapid, point-of-care test which has received FDA approval for the detection +of antibodies to both HIV-1 and HIV-2 in oral fluid, finger-stick whole blood, venous whole blood and plasma. This test is available for use by laboratories located in the United States certified under the Clinical Laboratory Improvements Amendment +of 1988 (“CLIA”) to perform moderately complex tests. We have also received a CLIA waiver for use of the OraQuick ADVANCE ® test with oral fluid and finger-stick and venous whole blood. As a result, the test can be used by numerous additional sites in the United States not certified under +CLIA to perform moderately complex tests, such as outreach clinics, community-based organizations and physicians’ offices. +On the international front, we have obtained a CE mark for our OraQuick ADVANCE ® test so that we can sell this product in Europe and other countries accepting the CE mark for commercialization. We have distributors in place for certain countries +and are seeking to expand our distribution network for this product throughout the world. +In late 2008, +the FDA approved our request to increase the shelf life for OraQuick ADVANCE ® to twelve months from the +date of manufacture. This approval was based on enhancements we made to the manufacturing process and product packaging for this product and represented a substantial increase in shelf life from the six months approved for the OraQuick +ADVANCE ® test then on the market. OraQuick ® product with twelve month dating became available in the U.S. market in February 2009. In June 2008, we began to sell OraQuick ® tests with twelve month dating in certain international markets and received approval for the new dating in Europe. +Additional real-time stability testing is being performed for this product, and we expect to seek future approval for shelf life extensions beyond 12 months in both the U.S. and international markets. +3 +Table of Contents +We believe that the OraQuick ADVANCE ® device, because it is approved for detecting antibodies to both HIV-1 and HIV-2 in finger-stick and venous whole +blood, oral fluid and plasma samples, provides a significant competitive advantage in the market for rapid HIV testing in the United States and elsewhere around the world. We also believe the twelve month shelf life approved by the FDA further +strengthens the competitiveness of this product. +OraSure ® /Intercept ® +Collection Devices +Our OraSure ® oral fluid collection device is used in conjunction with screening and confirmatory tests for HIV-1 antibodies and other analytes. This device consists of a small, +treated cotton-fiber pad on a handle that is placed in a person’s mouth for two to five minutes. The device collects oral mucosal transudate (“OMT”), a serum-derived fluid that contains higher concentrations of certain antibodies and +analytes than saliva. As a result, OMT testing is a highly accurate method for detecting HIV-1 infection and other analytes. +We believe that oral fluid testing has several significant advantages over blood or urine-based systems for infectious disease testing, for both health care professionals and the individuals being tested. These advantages include +eliminating the risk of needle-stick accidents, providing a non-invasive collection technique, requiring minimal training to administer, providing rapid and efficient collection in almost any setting, and reducing the cost of administration by a +trained health care professional. +HIV-1 antibody detection using the OraSure ® collection device involves three steps: +• +Collection of an oral fluid specimen using the OraSure ® device; +• +Screening of the specimen for HIV-1 antibodies at a laboratory with an enzyme immunoassay (“EIA”) screening test approved by the FDA for use +with the OraSure ® device; and +• +Laboratory confirmation of any positive screening test results with our oral fluid Western blot HIV-1 confirmatory test (described below). +A trained health care professional then conveys test results and provides appropriate counseling to the individual who was +tested. +In past years, the HIV-1 EIA test approved by the FDA for use with our OraSure ® device was manufactured and sold by bioMerieux, Inc. (“BMX”). In 2007, however, BMX discontinued this +product. During 2009, Avioq, Inc., a company that had acquired a license from BMX to manufacture and sell a new HIV-1 EIA test originally developed by BMX, obtained FDA approval of this new product for use with the OraSure ® test. This new HIV-1 EIA is now commercially available to our OraSure ® customers. +A collection device that is substantially similar to the OraSure ® device is sold by us under the name +Intercept ® , and is used to collect OMT for oral fluid drug testing. We have received FDA 510(k) clearance to use +the Intercept ® collection device with laboratory-based EIAs to test for drugs of abuse commonly identified by +the National Institute for Drug Abuse (“NIDA”) as the NIDA-5 (i.e., cannabinoids (marijuana), cocaine, opiates, amphetamines/methamphetamines and phencyclidine (“PCP”)), and for barbiturates, methadone and benzodiazepines. Each +of these EIAs is also FDA 510(k) cleared for use with the Intercept ® device. +We have received a CE mark for the Intercept ® and OraSure ® devices and our +oral fluid assays, all of which are distributed in Canada, the United Kingdom and Mexico. The OraSure ® device +and our oral fluid drugs of abuse assays are also sold in several other foreign countries. +We believe +that the Intercept ® device has several advantages over competing urine and other drugs-of-abuse testing +products, including its lower total testing cost, its non-invasive nature, mobility and accuracy, the ease of maintaining a chain-of-custody, the treatment of test subjects with greater dignity, no requirement for specially-prepared collection +facilities and difficulty of sample adulteration. The availability of an oral fluid test is intended to allow our customers to test for drug impairment, eliminate scheduling costs and inconvenience, and thereby streamline the testing process. +4 +Table of Contents +Cryosurgical Systems (Skin Lesion Removal Products) +The Histofreezer ® cryosurgical removal system is a low-cost alternative to liquid nitrogen and other methods for removal of warts and other benign skin lesions by physicians. The +Histofreezer ® product mixes three environmentally friendly cryogenic gases in a small aerosol canister. When +released, these gases are delivered to a specially designed foam bud, cooling the bud to a maximum of –50°C to –55°C. The frozen bud is then applied to the wart or lesion for 15 to 40 seconds (depending on the type of lesion) +creating localized destruction of the target area by freezing. We have received 510(k) clearance for use of the Histofreezer ® product to remove common warts and eight other types of benign skin lesions, and this product has been CE marked and registered for distribution in Canada, throughout +Europe and in certain other foreign countries. +We have also received FDA 510(k) clearance to market and +sell a cryosurgical product similar to the Histofreezer ® product in the OTC or retail market for the removal of +common and plantar warts only. This product was initially sold in the United States and Canadian OTC markets by a third party distributor under that party’s trade name. As a result of the termination of our agreement with this party on +December 31, 2007, we re-launched our OTC cryosurgical wart product in the U.S. in 2009 under our own new national brand called Freeze ‘n Clear Skin Clinic™. +Internationally, we distribute an OTC cryosurgical product through our distributor Genomma Labs, under the POINTTS tradename, in Mexico and +a number of South and Central American countries. We also distribute a CE marked cryosurgical wart removal product into the OTC footcare market in Europe, Australia and New Zealand through our distributor, SSL International plc (“SSL”), +under the Scholl and Dr. Scholl trademarks. SSL is the owner of the Scholl and Dr. Scholl trademarks in countries outside North and South America. +Immunoassay Tests and Reagents +We develop and sell +immunoassay tests in two formats, known as MICRO-PLATE and AUTO-LYTE ® , to meet the specific needs of our +customers. +In a MICRO-PLATE kit, the sample to be tested is placed into a small plastic receptacle, +called a microwell, along with the reagents. The result of the test is determined by the color of the microwell upon completion of the reaction. Controlling the reaction involves the use of reagents by laboratory personnel. Test results are analyzed +by any of a variety of commercially available laboratory instruments, which we may also provide to our laboratory customers. MICRO-PLATE tests can be performed on commonly used instruments and can detect drugs in urine, serum and sweat specimens. +MICRO-PLATE tests are also used as part of the Intercept ® product line to detect drugs of abuse in oral fluid +specimens. +AUTO-LYTE ® tests are sold in the form of bottles of liquid reagents. These reagents are run on commercially available laboratory-based automated analytical instruments, which +are manufactured by a variety of third parties. AUTO-LYTE ® is typically used in high volume, automated, +commercial reference insurance laboratories to detect certain drugs or chemicals in urine. Test results are produced quickly, allowing for high throughput. Our AUTO-LYTE ® tests continue to face strong competition from cheaper “home-brew” tests developed internally by our laboratory customers. As a result, we expect to +eventually stop selling our AUTO-LYTE ® tests. +Western blot HIV-1 Confirmatory Test +We sell an oral fluid Western blot HIV-1 confirmatory test that received premarket approval from the FDA in 1996. This +test uses the original specimen collected with the OraSure ® oral fluid collection device to confirm positive +results of initial oral fluid HIV-1 EIA screening tests. Our oral fluid Western blot HIV-1 confirmatory test was previously marketed under an exclusive arrangement with BMX. +At the end of 2007, BMX terminated the agreement under which it supplied the HIV-1 antigen used to manufacture our oral fluid Western blot +HIV-1 confirmatory test and the agreement under which it distributed +5 +Table of Contents +that product on an exclusive, world-wide basis. As a result, we are now supplying this test directly to our laboratory customers. Pursuant to the terms of our antigen supply agreement with BMX, +we purchased an additional two-year supply of the antigen from BMX so that we could continue to manufacture and sell our oral fluid Western blot test. The antigen was historically manufactured by a subcontractor to BMX and we expect that this party +will be able to meet our future needs for HIV-1 antigen. +Q.E.D. ® Saliva Alcohol Test +Our Q.E.D. ® saliva alcohol test is a point-of-care test device that is a cost-effective alternative to breath or blood alcohol testing. The test is a quantitative, saliva-based +method for the detection of ethanol, has been cleared for sale by the FDA and has received a CLIA waiver. The U.S. Department of Transportation (“DOT”) has also approved the test for purchase. +Each Q.E.D. ® test kit contains a collection stick that is used to collect a sample of saliva and a disposable detection device that displays results in a format similar to a +thermometer. The Q.E.D. ® device is easy to operate and instrumentation is not required to read the result. The +product has a testing range of 0 to 0.145% blood alcohol and produces results in approximately two minutes. +Products Under Development +OraQuick ® Platform +We believe +that OraQuick ® has significant potential as a point-of-care testing platform for clinics and other public health +entities, hospitals, physicians’ offices and other markets. Because the OraQuick ® platform is simple to use +and can operate in a non-invasive manner with oral fluid, we believe it will be suitable for use by consumers without the assistance of a doctor or other medical professional. We also believe that OraQuick ® provides a platform technology that can be modified for detection of a variety of infectious diseases in addition to HIV, such as viral hepatitis and +certain sexually transmitted diseases. +We are currently devoting significant resources to obtaining FDA +approval to sell our OraQuick ® HIV-1/2 test in the United States OTC market. We have completed an observed user +study and submitted our data to the FDA. We have also developed an information and referral system and product packaging and labeling suitable for the OTC market. We expect to conduct additional clinical work in 2010 and 2011, and we intend to +submit an application for FDA approval after our clinical studies are completed. +We have developed a +rapid test on the OraQuick ® platform which can detect antibodies to the Hepatitis C virus, or HCV, in oral fluid +and other sample types. A PMA application for this test was originally submitted to the FDA in October 2008. In response to comments on our submission received from the FDA, we have provided additional clinical data to the FDA in support of a whole +blood claim for this product. We are also conducting an additional clinical study requested by the FDA in support of oral fluid and finger-stick whole blood claims. In late 2009, we received authorization to affix a CE mark to this product for all +sample types, and this product is now available for sale in Europe. +We have entered into agreements with +Merck & Co. Inc. (“Merck,” formerly Schering-Plough) to collaborate on the development and promotion of our OraQuick ® HCV test for use with oral fluid. Under the terms of these agreements, we have been and may be reimbursed by Merck for a portion of our costs to develop the test and +obtain regulatory approvals, and Merck will provide detailing and other promotional support for the test in the physicians’ office market in the United States and internationally. +OraSure ® /Intercept ® Applications +Oral mucosal transudate, or OMT, contains many constituents found in blood and serum, although in lower +concentrations. We believe the OraSure ® and Intercept ® devices are a platform technology with a wide variety of +6 +Table of Contents +potential applications, where laboratory testing is available. For example, the OraSure ® device may be useful for the collection of a variety of antibodies or markers for infectious diseases or conditions in addition to HIV-1, such as antibodies to viral +hepatitis. +In 2004, the Substance Abuse and Mental Health Services Administration (“SAMHSA”) +issued proposed regulations for oral fluid drug testing for federal workers. These proposed regulations have since been withdrawn. If and when reissued in final form, these regulations may require certain modifications to our Intercept ® product in order to permit its use by federal workers. As a result, we are developing modifications to the +Intercept ® collection device that we anticipate will be required by these regulations or are otherwise likely to +be desired by our customers. +We are also currently collaborating on the development of additional drugs +of abuse assays for use with our Intercept ® collection device. Pursuant to a development agreement with Roche +Diagnostics, homogeneous fully-automated oral fluid drugs of abuse assays are being developed for use with our Intercept ® collection device. The assays use Roche’s KIMs (kinetic interaction of micro-particles in solution) technology and will run on various automated analyzers to +allow oral fluid samples to be processed with the same efficiency currently achieved with urine-based drug tests. Applications for 510(k) clearance of assays to detect opiates, methamphetamine, amphetamine and PCP in oral samples collected with our +Intercept ® device have been submitted to the FDA, and we expect that submissions for assays detecting cocaine +and cannabinoids (marijuana) will be filed in 2010. We have also entered into a commercialization agreement with Roche pursuant to which a drug testing system comprised of our Intercept ® device and the newly developed homogeneous assays will be marketed and sold on a worldwide basis. +Research and Development +In 2009, our research and +development activities focused primarily on clinical and regulatory activities related to obtaining PMA and CE approval for our OraQuick ® HCV test, discussions and planning to obtain FDA approval for use of an OraQuick ® HIV test in the United States OTC market, and development of certain improvements to existing products in the OraQuick ® and Intercept ® +product lines. +From time to time, we have contracted with third parties to conduct research and development activities and we +may do so in the future. +Research and development expenses were $13.4 million in 2009, $20.3 million in 2008 and $14.1 +million in 2007. These expenses include our costs associated with research and development, regulatory affairs, clinical trials and product support. +Sales and Marketing +We attempt to reach our major target markets through a combination of direct sales, +strategic collaborations and independent distributors. Our marketing strategy is to create or raise awareness through a full array of marketing activities, which include trade shows, print advertising, special programs and distributor promotions, in +order to stimulate sales in each target market. +We market our products in the United States and internationally. Revenues +attributable to customers in the United States were $62.2 million, $57.4 million and $64.6 million in 2009, 2008 and 2007, respectively. Revenues attributable to international customers amounted to $14.8 million, $13.7 million and $18.1 million, or +19%, 19% and 22% of our total revenues, in 2009, 2008 and 2007, respectively. +7 +Table of Contents +Infectious Disease Testing +We market the OraQuick ADVANCE ® rapid HIV-1/2 antibody test directly to customers in the public health market for HIV testing. This market consists of a broad range of clinics and laboratories and +includes states, counties, and other governmental agencies, family planning clinics, colleges and universities, correctional facilities and the military. There are also a number of organizations in the public health market, such as AIDS service +organizations and various community-based organizations set up primarily for the purpose of encouraging and enabling HIV testing. +As a result of the termination of our agreement with Abbott Laboratories (“Abbott”) at the end of 2008 for the distribution of the OraQuick ADVANCE ® HIV test primarily in U.S. hospitals, we are now selling OraQuick ADVANCE ® directly to this market. In anticipation of the transition of this business, we increased the size of our hospital +sales force and added additional inside sales, customer service and sales support resources. In addition to selling OraQuick ADVANCE ® to hospitals, we expect our hospital sales force to eventually sell new products to this market, including our OraQuick ® HCV test once FDA approval is obtained. We also sell OraQuick ® to the U.S. physician market primarily through distributors. +We currently distribute our OraQuick ® test in several foreign +countries. During 2007, we obtained a CE mark for this product and have since launched sales in several European countries. We expect to increase the number of countries where this product is sold as we find new distributors and complete +registrations in additional countries. +We market the OraSure ® oral fluid collection device for HIV-1 testing, on its own and as a kit in combination with laboratory testing services. To better serve our public +health customers, we have contracted with two commercial laboratories to provide prepackaged OraSure ® test kits, +with prepaid laboratory testing and specimen shipping costs included. We also sell the OraSure ® device in the +international public health market. +A PMA application is pending for FDA approval of our OraQuick ® HCV test, and we plan to apply for CLIA waiver for this product. In late 2009, we received approval to affix the CE +mark to this test and intend to sell this product on a worldwide basis. We previously entered into agreements with Merck to collaborate on the development and promotion of our OraQuick ® HCV test for use with oral fluid. Under the terms of these agreements, we have been and may be reimbursed by Merck for a portion of our costs to develop the test and +obtain regulatory approvals, and Merck will provide detailing and other promotional support for the test in the physicians’ office market in the United States and internationally. +Substance Abuse Testing +Our substance abuse testing products are marketed to laboratories serving the workplace testing, forensic toxicology, criminal justice and drug rehabilitation markets. +We have entered into agreements for the distribution of Intercept ® collection devices and associated MICRO-PLATE assays for drugs-of-abuse testing in the workplace testing market in the United States and Canada through several +laboratory distributors, including Quest Diagnostics (“Quest”) and Clinical Reference Laboratory (“CRL”), and internationally for workplace, criminal justice and forensic toxicology testing through other distributors. In some +cases, we assist our laboratory customers in customizing their testing services by selling them equipment required to test oral fluid specimens collected with the Intercept ® device. +We also market +the Intercept ® collection device on its own and as a kit in combination with laboratory testing services. To +better serve our workplace customers, we have contracted with two commercial laboratories to provide prepackaged Intercept ® test kits, with prepaid laboratory testing and specimen shipping costs included. +The criminal justice market in the United States for our substance abuse testing products consists of a wide variety of entities in the criminal justice system that require drug screening, such as +pre-trial services, parole and +8 +Table of Contents +probation officials, police forces, drug courts, prisons, drug treatment programs and community/family service programs. The forensic toxicology market consists of several hundred laboratories +including federal, state and county crime laboratories, medical examiner laboratories and reference laboratories. +We also distribute our Q.E.D. ® saliva alcohol test primarily through various distributors in the United +States and internationally. The markets for alcohol testing are relatively small and fragmented with a broad range of legal and procedural barriers to entry. Markets range from law enforcement testing to workplace testing of employees in safety +sensitive occupations. Typical usage situations include pre-employment, random, post-accident, reasonable-cause and return-to-duty testing. +Cryosurgical Systems +Most of our Histofreezer ® sales occur in the United States to distributors that, in turn, resell the product to primary care physicians and +podiatrists in the United States. Our major U.S. distributors include Cardinal Healthcare, McKesson HBOC, Physicians Sales & Service, AmerisourceBergen Corporation, and Henry Schein. We recently entered into agreements with two +manufacturers’ representative organizations under which a contract sales force will be provided to help our U.S. distributors promote and sell Histofreezer ® . Internationally, we sell the Histofreezer ® product through a network of distributors in more than 20 countries worldwide. +We distribute cryosurgical wart removal products in the OTC footcare market in Europe, Australia and New Zealand through our distributor, SSL, under its Scholl and Dr. Scholl tradenames, and in the +OTC markets in Mexico and several Central and South American countries under the POINTTS tradename through our distributor, Genomma Labs. In early 2009, we re-launched our OTC cryosurgical wart product in the U.S. under our own proprietary national +brand called Freeze ‘n Clear Skin Clinic™. This launch started with one major retailer, and we are beginning to expand to other retail outlets. +Insurance Risk Assessment +We currently market the +OraSure ® oral fluid collection device for use in screening life insurance applicants in the United States and +internationally to test for three of the most important underwriting risk factors: HIV-1, cocaine and cotinine (a metabolite of nicotine). Devices are sold to insurance testing laboratories, including Quest, Heritage Labs and CRL. These laboratories +in turn provide the devices to insurance companies, usually in combination with testing services. +We also +promote use of the OraSure ® device directly to insurance companies for life insurance risk assessment. Insurance +companies then make their own decision regarding which laboratory to use to supply their collection devices and testing services. We sell our OraSure ® Western blot confirmatory test directly to insurance testing laboratories for use in confirming oral fluid specimens collected with our OraSure ® device that initially test positive for HIV-1. +There exists a wide range of policy limits where our OraSure ® product is being used. In general, most of our insurance company customers use the OraSure ® device in connection with life insurance policies having face amounts of up to $250,000, with some customers using the device for policies of up to $500,000 in +amount. Some insurance companies have chosen to extend their testing to lower policy limits where they did not test at all before, while others have used OraSure ® to replace some of their blood and urine-based testing. +We also sell our AUTO-LYTE ® assays and reagents in the insurance +testing market directly to laboratories, including Heritage Labs and CRL. +9 +Table of Contents +International Markets +We sell most of our products into international markets primarily through distributors with knowledge of their local markets. Principal +markets include foreign governments, physicians’ offices, insurance risk assessment, substance abuse, public health and laboratory testing. +We assist our international distributors in registering the products and obtaining required regulatory approvals in each country, and we provide training and support materials. +Significant Products and Customers +Several different products have contributed significantly to our financial performance, accounting for 10% or more of our total revenues during the past three years. The OraQuick ® rapid HIV testing products, the cryosurgical systems products, and the OraSure ® and Intercept ® oral fluid collection devices accounted for total revenues of $43.8 million, $10.9 million and $11.7 million in 2009, $35.3 million, $10.7 million and $13.6 million +in 2008 and $32.7 million, $23.5 million and $15.5 million in 2007, respectively. +We had one customer, Quest, which accounted +for 9% of our total revenues during 2009. The loss of Quest, or a significant decrease in the volume of products purchased by this customer, could have a material adverse effect on our financial results. +Revenue by Segment +We +operate our business within one reportable segment and all of our revenues are generated from this one segment. Our revenue is generated by our product sales and licensing and product development activities. For more information about our revenues +from external customers, income and total assets, please see the sections entitled “Selected Financial Data” and “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and Note 14 to the +financial statements, included elsewhere in this Annual Report. +Supply and Manufacturing +We manufacture the OraQuick ADVANCE ® HIV test in our Bethlehem, Pennsylvania facility. In addition, we have contracted with a third party in Thailand for the assembly of the OraQuick ® HIV device, in order to supply certain international markets. This supply agreement had an initial term of one year, +and automatically renews for additional annual periods unless either party provides a timely notice of termination prior to the end of an annual period. We believe that other firms would be able to manufacture the OraQuick ® test on terms no less favorable than those set forth in the agreement if the Thailand contractor would be unable or +unwilling to continue manufacturing this product. +We can purchase the HIV antigen and the nitrocellulose +required for the OraQuick ® test only from a limited number of sources. For the past ten years, we purchased the +antigen from a single contract supplier under an exclusive long-term agreement. We recently negotiated a buy-out of our obligations under this agreement, including the right to purchase the antigen from other third parties. We are now purchasing the +antigen from a subcontractor historically used by the original supplier, and we expect to enter into a long-term supply agreement with this subcontractor in the near future. We also purchase the nitrocellulose used in the test from a single vendor, +under a supply agreement which was recently renewed through 2014. If for any reason these suppliers are unwilling or no longer able to supply our antigen or nitrocellulose needs, we believe that alternative supplies could be obtained at a +competitive cost. However, a change in the antigen or nitrocellulose would require FDA approval and some additional development work. This in turn could require significant time to complete and could disrupt our ability to manufacture and sell the +OraQuick ® device. +The OraQuick ® HCV test that is available for sale in Europe is manufactured in our Bethlehem, Pennsylvania facility. +10 +Table of Contents +We manufacture both the OraSure ® and Intercept ® +collection devices and our assays in our Bethlehem, Pennsylvania facility, and we expect to continue to do so for the foreseeable future. +The oral fluid Western blot HIV-1 confirmatory test is currently manufactured in our Bethlehem, Pennsylvania facility. The HIV antigen needed to manufacture the Western blot test is currently available +from only a limited number of sources. For many years, we purchased the antigen for this product from BMX on an exclusive basis. Our agreement with BMX for the supply of HIV-1 antigen terminated on December 31, 2007. As a result, we purchased +an additional two-year supply of the antigen from BMX as permitted under the agreement. The antigen was historically manufactured by a subcontractor to BMX. We have continued to purchase antigen directly from this subcontractor and we expect that +this party will be able to meet our future needs for this product. +Histofreezer ® is assembled in The Netherlands by Koninklijke, Utermöhlen, N.V. (“Utermöhlen”), the company +from which we acquired the product in 1998. We purchase the product pursuant to an exclusive production agreement. The cryosurgical wart removal products distributed in OTC markets are supplied by vendors located in the United States. We believe +that additional suppliers of all of our cryosurgical products are available on terms no less favorable than the terms of our existing supply agreements in the event that our current suppliers would be unable or unwilling to continue manufacturing +these products. +Our AUTO-LYTE ® and MICRO-PLATE assays are manufactured in our Bethlehem, Pennsylvania facility. These tests require the production of highly specific and sensitive antibodies +corresponding to the antigen of interest. Substantially all our antibody requirements are provided by contract suppliers. We believe that we have adequate reserves of antibody supplies and that we have access to sufficient raw materials for these +products. +The Q.E.D. ® saliva alcohol test is manufactured and packaged for shipment in our Bethlehem, Pennsylvania facility. +Employees +As of December 31, 2009, we had 280 full-time employees, +including 82 in sales, marketing and client services; 19 in research and development; 130 in operations, manufacturing, quality control, information systems, purchasing and shipping; 22 in regulatory affairs; and 27 in administration and finance. +This compares to 287 employees as of December 31, 2008. Our employees are not currently represented by a collective bargaining agreement. +Competition +The diagnostic industry is a multi-billion dollar international industry and is intensely +competitive. Many of our competitors are substantially larger than we are, and they have greater financial, research, manufacturing and marketing resources. +Important competitive factors for our products include product quality, performance, price, ease of use, customer service and reputation. Industry competition is based on the following: +• +Scientific and technological capability; +• +Proprietary know-how; +• +The ability to develop and market products and processes; +• +The ability to obtain FDA or other regulatory approvals; +• +The ability to manufacture products that meet applicable FDA requirements (i.e., good manufacturing practices); +• +Commercial execution and strength of distribution; +• +Access to adequate capital; +11 +Table of Contents +• +The ability to attract and retain qualified personnel; and +• +The availability of patent protection. +A few large corporations produce a wide variety of diagnostic tests and other medical devices and equipment. A larger number of mid-size companies generally compete only in the diagnostic industry and a +significant number of small companies produce only a few diagnostic products. As a result, the diagnostic test industry is highly fragmented and segmented. +The future market for diagnostic tests is expected to be characterized by consolidation, greater cost consciousness and tighter reimbursement policies. The purchasers of diagnostic products are expected +to place increased emphasis on lowering costs, reducing inventory levels, automation, service and volume discounts. The increased complexity of the market is expected to force many competitors to enter into joint ventures or license certain products +or technologies. +We expect competition to intensify as technological advances are made and become more widely known, and as +new products reach the market. Furthermore, new testing methodologies could be developed in the future that render our products impractical, uneconomical or obsolete. There can be no assurance that our competitors will not succeed in developing or +marketing technologies and products that are more effective than those we develop or that would render our technologies and products obsolete or otherwise commercially unattractive. In addition, there can be no assurance that our competitors will +not succeed in obtaining regulatory approval for these products, or introduce or commercialize them, before we can do so. These developments could have a material adverse effect on our business, financial condition and results of operations. +Several companies market or have announced plans to market oral specimen collection devices and tests +both within and outside the United States. We expect the number of devices competing with our Intercept ® , +OraQuick ® and OraSure ® devices to increase as the benefits of oral fluid-based testing become more widely accepted. +Competition in the HIV testing market is intense and is expected to increase. We believe that the principal competition will come from +existing laboratory-based blood tests, point-of-care rapid blood tests, laboratory-based urine assays or other oral fluid-based tests that may be developed. Our competitors include specialized biotechnology firms, as well as pharmaceutical companies +with biotechnology divisions and medical diagnostic companies. +Significant competitors for our OraQuick +ADVANCE ® rapid HIV-1/2 test, such as the Ortho Diagnostics division of Johnson & Johnson, +Bio-Rad Laboratories and Abbott, sell laboratory-based HIV-1/2 EIAs, and Maxim Biomedical (formerly Calypte, Inc.) sells an HIV-1 screening test for urine, in the United States. MedMira and Trinity Biotech each sell competing rapid HIV-1 blood +tests, and Bio-Rad Laboratories and Inverness Medical/Chembio sell competing rapid HIV-1/2 blood tests in the United States. These tests compete with our OraQuick ADVANCE ® test in hospitals and other laboratory settings. In addition, Trinity Biotech and Inverness Medical/Chembio have received CLIA waivers for their rapid HIV tests, and +these tests compete with our OraQuick ADVANCE ® test in the markets outside of the traditional hospital +and laboratory settings. These companies, or others, may continue to expand the bodily fluids with which a rapid HIV test may be performed, or develop and commercialize new rapid HIV tests, which would provide further competition for our OraQuick +ADVANCE ® test. We believe other companies may also seek FDA approval to sell competing rapid HIV tests in +the future. +Internationally, our OraQuick ADVANCE ® HIV test competes against rapid HIV tests sold by a number of other entities, and often these competing tests are sold at prices substantially below the +prices we charge for our OraQuick ADVANCE ® test. Inverness Medical and Trinity Biotech sell rapid HIV-1/2 +blood tests outside the United States and Calypte has developed a rapid oral fluid HIV test which is now being sold in certain foreign countries. Lower priced rapid HIV blood tests are also sold internationally by various third parties. +12 +Table of Contents +The OraQuick ® HCV test that is now available in Europe is expected to compete primarily against laboratory-based HCV blood tests. Major suppliers of these competing tests are +Abbott Labs, Seimens, Ortho-Clinical Diagnostics, Roche and Bio-Rad. In non-U.S. countries outside of Europe, we expect that our OraQuick ® HCV test will compete against other rapid HCV blood tests in addition to the laboratory-based tests. +The Intercept ® drug testing system competes with laboratory-based drug testing products and services using testing matrices such as urine, hair, sweat and oral fluid. Major +competitors include Ansys Technologies, Inc., Dade Behring, Psychemedics and Immunalysis. +Our MICRO-PLATE +oral fluid drug assays, which are sold for use with the Intercept ® and OraSure ® collection devices, continue to come under increasing competitive pressure from “home-brew” assays +developed internally by our laboratory customers. Our oral fluid MICRO-PLATE assays also compete with urine-based homogeneous assays that are run on fully-automated, random access analyzers. These tests provide strong competitive pressure because +they provide the benefits of automation, including lower costs and short turn-around times. In addition, we believe our competitors are developing oral fluid tests suitable for use on these fully automated homogeneous assay systems and these assays, +if and when they are developed and commercialized, will represent a significant competitive threat to our oral fluid MICRO-PLATE business. In order to meet this competition, we are developing and intend to commercialize fully-automated homogeneous +oral fluid drugs of abuse assays with Roche Diagnostics for use with our Intercept ® device. +Our MICRO-PLATE drugs-of-abuse reagents sold in the forensic toxicology market are targeted to forensic testing laboratories where +sensitivity, automation and “system solutions” are important. In the past, these laboratories have typically had to rely on radioimmunoassay test methods to provide an adequate level of sensitivity. Radioimmunoassays require radioactive +materials, which have a short shelf-life and disposal problems. Our MICRO-PLATE tests meet the laboratories’ sensitivity needs, run on automated equipment, are not radioimmunoassays, and are offered to the laboratory as a complete system +solution of reagents, instrumentation and software to meet the specific needs of each customer. We compete with both homogeneous and heterogeneous tests manufactured by many companies. Significant competitors in the market for these assays include +Microgenics, Inc., Roche Diagnostics and Immunalysis. +Sales of our AUTO-LYTE ® urine assays have declined substantially during the past several years, primarily due to competition from +“home-brew” assays developed internally by our laboratory customers, which can be produced at a cost lower than the price typically paid for our products. Many of our customers no longer purchase our AUTO-LYTE ® assays, and we eventually expect to stop selling this product line. +The Histofreezer ® product’s delivery system and operating temperature, which is warmer than liquid nitrogen, provide us with the opportunity to target sales to primary care +physicians, such as family practitioners, pediatricians and podiatrists. We do not generally target sales to dermatologists because they have the volume of patients required to support the capital costs associated with a liquid nitrogen delivery +system, which is also used to remove warts and other benign skin lesions. Major competitors for the Histofreezer ® product include Cryosurgery, Inc. in the United States and Wartner in Europe. +Competition in the United States and Canadian OTC markets comes primarily from cryosurgical products sold by Merck under +the Dr. Scholl’s ® brand and by Prestige Brands under the Compound W ® and Wartner ® tradenames. Salicylic acid wart removal products also compete against our OTC cryosurgical product. Internationally, our OTC products compete against cryosurgical +products sold by Wartner and several other firms. +Q.E.D. ® has two primary competitors, Ansys Technologies, Inc. and Chematics. These companies offer semi-quantitative saliva-based alcohol tests and have +received DOT approval. Indirect competitors who offer breath testing equipment include Intoximeters, Dräger and CMI. Although there are lower priced tests on the market that use oral fluid or breath as a test medium, these tests are qualitative +tests that are believed to be substantially lower in quality and provide fewer benefits than our Q.E.D. ® test. +13 +Table of Contents +Patents and Proprietary Information +We seek patents and other intellectual property rights to protect and preserve our proprietary technology and our right to capitalize on the +results of our research and development activities. We also rely on trade secrets, know-how, continuing technological innovations and licensing opportunities to provide competitive advantages for our products in our markets and to accelerate new +product introductions. We regularly search for third-party patents in fields related to our business to shape our own patent and product commercialization strategies as effectively as possible and to identify licensing opportunities. United States +patents generally have a maximum term of 20 years from the date an application is filed. +We have nine +United States patents and numerous foreign patents for the OraSure ® and Intercept ® collection devices and technology relating to oral fluid collection, containers for oral fluids, methods to test +oral fluid, formulations for the manufacture of synthetic oral fluid, and methods to control the volume of oral fluid collected and dispersed. The patents expire from January 2013 to March 2018. We have also applied for additional patents, in both +the United States and certain foreign countries, on such products and technology. +We have three United +States patents for our OraQuick ® platform, and we have several related patent applications pending in the United +States and internationally. These patents expire from March to April 2019. We have obtained licenses to certain lateral flow patents and to certain HIV-1 and HIV-2 patents held by other parties. We also have obtained a license to certain HCV patents +which we use to manufacture and sell a rapid HCV test on the OraQuick ® or other technology platforms. We +obtained these licenses through the payment of certain upfront fees and an agreement to pay ongoing royalties. We believe these fees and royalties are comparable to those generally paid by other companies under similar arrangements. +We may need to obtain licenses or other rights under, or enter into distribution or other business arrangements in +connection with, certain other intellectual property patents in order to manufacture and sell the OraQuick ADVANCE ® HIV test or other tests that use the same or similar technology platform. See Section 1A, entitled “Risk Factors,” for a further discussion of these +issues. +We have three United States patents and numerous foreign patents issued for apparatuses and methods for the topical +removal of skin lesions relating to our cryosurgical wart removal products, and we have pending patent applications related to these products in the United States and in certain foreign countries. These patents expire from July 2012 to August 2013. +We have also licensed another patent relating to apparatuses and methods for the topical removal of skin lesions relating to our cryosurgical wart removal products. +We require our employees, consultants, outside collaborators and other advisors to execute confidentiality agreements upon the commencement of employment or consulting relationships with us. These +agreements provide that all confidential information developed by or made known to the individual during the course of the individual’s relationship with us is to be kept confidential and not disclosed to third parties except in specific +circumstances. In the case of employees, the agreements provide that all inventions conceived by the individual during his or her tenure with us will be our exclusive property. +We own rights to trademarks and service marks that we believe are necessary to conduct our business as currently +operated. In the United States, we own a number of trademarks, including the OraSure ® , Intercept ® , OraQuick ® , OraQuick ADVANCE ® , +Histofreezer ® , Freeze ‘n Clear Skin Clinic™, Q.E.D. ® and AUTO-LYTE ® +trademarks. We also own many of these marks and others in several foreign countries. With respect to our international OTC cryosurgical products, the Scholl and Dr. Scholl tradenames are owned by SSL in Europe, Australia, New Zealand and other +countries outside North and South America, and the POINTTS tradename is owned by Genomma Labs. +Although important, the +issuance of a patent or existence of trademark or trade secret protection does not in itself ensure the success of our business. Competitors may be able to produce products competing with our patented products without infringing our patent rights. +Issuance of a patent in one country generally does not +14 +Table of Contents +prevent manufacture or sale of the patented product in other countries. The issuance of a patent is not conclusive as to validity or as to the enforceable scope of the patent. The validity or +enforceability of a patent can be challenged by litigation after its issuance. If the outcome of such litigation is adverse to the owner of the patent, the owner’s rights could be diminished or withdrawn. Trade secret protection does not +prevent independent discovery and exploitation of the secret product or technique. +Government Regulation +General +Most of our products are regulated by the FDA, certain state and local agencies and comparable regulatory bodies in other countries. This regulated environment governs almost all aspects of development, production and marketing, including +product testing, authorizations to market, labeling, promotion, manufacturing and recordkeeping. +All of our FDA-regulated +products require some form of action by the FDA before they can be marketed in the United States. After approval or clearance by the FDA, we must continue to comply with other FDA requirements applicable to marketed products. Both before and after +approval or clearance, failure to comply with the FDA’s requirements can lead to significant penalties or could disrupt our ability to manufacture and sell these products. In addition, the FDA could refuse permission to obtain certificates +needed to export our products if the agency determines that we are not in compliance. +Domestic Regulation +Most of our products are regulated in the United States as medical devices. +There are two mechanisms by which regulated medical devices can be placed on the market in the United States. Some products may qualify for +clearance under Section 510(k) of the Federal Food, Drug and Cosmetic Act. To obtain this clearance from the FDA, the manufacturer must provide a premarket notification that it intends to begin marketing the product, and show that the product +is substantially equivalent to another legally marketed product (i.e., that it has the same intended use and is as safe and effective as a legally marketed device and does not raise different questions of safety and effectiveness). In some cases, +the submission must include data from human clinical studies. Marketing may only commence when the FDA issues a clearance letter finding substantial equivalence. An applicant must submit a 510(k) application at least 90 days before marketing of the +affected product commences. Although FDA clearance may be granted within that 90-day period, in some cases as much as a year or more may be required before clearance is obtained, if at all. +If the medical device does not qualify for the 510(k) procedure (either because it is not substantially equivalent to a legally marketed +device or because it is required by statute and the FDA’s regulations to have an approved premarket application, or PMA), the FDA must approve a PMA before marketing can begin. PMAs must demonstrate, among other matters, that the medical device +provides a reasonable assurance of safety and effectiveness. A PMA is typically a complex submission, including the results of preclinical and clinical studies. Preparing a PMA is a detailed and time-consuming process. Once a PMA has been submitted, +the FDA is required to review the submission within 180 days. However, the FDA’s review may, and often is, much longer, often requiring one year or more, and may include requests for additional data and facility inspections before approval is +granted, if at all. +Some of our products are used for non-medical purposes and many of our drugs-of-abuse products sold to +state crime laboratories are for forensic use. The FDA does not currently regulate products used for these purposes. +Every +company that manufactures medical devices distributed in the United States must comply with the FDA’s Quality System Regulations (“QSRs”). These regulations govern the manufacturing process, including +15 +Table of Contents +design, manufacture, testing, release, packaging, distribution, documentation and purchasing. In complying with the QSRs, manufacturers must continue to expend time, money and effort in the area +of production and quality to ensure full technical compliance. Companies are also subject to other post-market and general requirements, including restrictions imposed on marketed products, promotional standards and requirements for recordkeeping +and reporting of certain adverse reactions. If there are any modifications made to our marketed devices, a premarket notification or PMA may be required to be submitted to, and cleared or approved by, the FDA, before the modified device may be +marketed. The FDA regularly inspects companies to determine compliance with the QSRs and other post-market requirements. Failure to comply with statutory requirements and the FDA’s regulations can result in warning letters, monetary penalties, +suspension or withdrawal of regulatory approvals, operating restrictions, total or partial suspension of production, injunctions, product recalls, seizure of products and criminal prosecution. +The Clinical Laboratory Improvements Amendments of 1988, or CLIA, prohibit any facility that does laboratory testing on +specimens derived from humans from providing information for the diagnosis, prevention or treatment of any disease or impairment of, or the assessment of, the health of human beings, unless there is in effect for such facility a certificate issued +by the U.S. Department of Health and Human Services applicable to the category of examination or procedure performed. Tests may be waived from this regulatory oversight if they meet certain requirements established under CLIA. We consider the +applicability of the requirements of CLIA in the design and development of our products. We have obtained a waiver of the CLIA requirements for both our OraQuick ADVANCE ® rapid HIV-1/2 antibody test and our Q.E.D. ® alcohol saliva test and may seek similar waivers for certain other products. A CLIA waiver allows certain customers to use the waived products that may not have been +able to use them without complying with applicable quality control and other requirements. +Certain of our products may also +be affected by state regulations in the United States. For example, there are several states that restrict or do not currently permit oral fluid drug testing in the workplace or other markets. In addition, several states prohibit or limit the use of +rapid, point-of-care HIV testing. We are presently working with legislators or regulators in certain of these states in an effort to modify or remove any restrictions affecting our ability to sell products. +International +We are also subject to regulations in foreign countries governing products, human clinical trials and marketing, and may need to obtain approval from international public health agencies, such as the World Health Organization, in order to +sell products in certain countries. Approval processes vary from country to country, and the length of time required for approval or to obtain other clearances may in some cases be longer than that required for U.S. governmental approvals. We +generally pursue approval only in those countries that we believe have a significant market opportunity. +The International +Organization for Standardization (“ISO”) is a worldwide federation of national standards bodies from some 130 countries, established in 1947. The mission of the ISO is to promote the development of standardization and related activities in +the world with a view to facilitating the international exchange of goods and services. ISO certification is a pre-requisite to use of the CE mark and indicates that our quality system complies with standards applicable to activities ranging from +initial product design and development through production and distribution. The CE mark is a European Union (“EU”) requirement to sell products that fall under the scope of the Medical Devices Directive (“MDD”) and the In Vitro +Diagnostic Directive (“IVDD”). The CE mark is evidence that the manufacturer and the product meet the requirements of all applicable directives, including the MDD and IVDD. +We received authorization to use the CE mark for the OraQuick ADVANCE ® rapid HIV-1/2 test, the OraQuick ® rapid HCV test, the OraSure ® +and Intercept ® collection devices and our Histofreezer ® product line, and SSL has obtained authorization to use the CE mark for our cryosurgical wart removal product in the OTC European footcare market. +16 +Table of Contents +We must also comply with certain registration requirements as dictated by Health Canada, +prior to commencing sales in Canada. We have completed this process for several of our current products and may do so with respect to other products in the future. In addition, Canadian law requires manufacturers of medical devices to have a quality +management system that meets various ISO requirements in order to obtain a license to sell their devices in Canada. +Anti-Kickback and Other Fraud and Abuse Laws +The Federal Anti-Kickback Statute prohibits the knowing and +willful offer, payment, solicitation, or receipt of any form of remuneration in return for, or to induce: +• +The referral of a person; +• +The furnishing or arranging for the furnishing of items or services reimbursable under Medicare, Medicaid or other governmental programs; or +• +The purchase, lease, or order of, or the arrangement or recommendation of the purchasing, leasing, or ordering of any item or service reimbursable +under Medicare, Medicaid, or other governmental programs. +Our products are or may be purchased by customers +that will seek or receive reimbursement under Medicare, Medicaid or other governmental programs. Noncompliance with the federal anti-kickback legislation can result in exclusion from Medicare, Medicaid or other governmental programs, and/or +restrictions on our ability to operate in certain jurisdictions, as well as civil and criminal penalties, any of which could have an adverse effect on our business and results of operations. +The Federal Civil Monetary Penalties Law prohibits the offering or transferring of remuneration to a Medicare or Medicaid beneficiary that +the person knows or should know is likely to influence the beneficiary’s selection of a particular supplier of Medicare or Medicaid payable items or services. Noncompliance can result in civil money penalties of up to $10,000 for each wrongful +act, assessment of three times the amount claimed for each item or service and exclusion from the Federal healthcare programs. +Many states have also adopted some form of anti-kickback laws. A determination of liability under such laws could result in fines and penalties and restrictions on our ability to operate in these jurisdictions. +We are also subject to other federal and state laws targeting fraud and abuse in the healthcare industry, including false claims laws and +marketing conduct laws and laws constraining the sales, marketing and other promotional activities of manufacturers of medical devices by limiting the kinds of financial arrangements, including sales programs, with physicians, hospitals, +laboratories and other potential purchasers of medical devices. Violations of these laws may be punishable by criminal or civil sanctions, including substantial fines, imprisonment and exclusion from participation in government healthcare programs +such as Medicare and Medicaid. These laws and regulations are wide ranging and subject to changing interpretation and application. In recent years, there has been greater scrutiny of marketing practices in the medical device industry which has +resulted in several government investigations by various government authorities and the introduction and/or passage of federal and state legislation regulating interactions between medical device manufacturers and healthcare professionals and +providers and requiring the disclosure by medical device manufacturers of gifts or other payments to healthcare professionals and providers. To be in compliance with such disclosure laws, we have implemented necessary systems for accurately tracking +gifts and other payments. +We are in the process of adopting a written Policy on Interactions with Health Care Professionals +and will train our personnel on this policy, which is based on the Code of Conduct for Interactions with Health Care Professionals promulgated by the Advanced Medical Technology Association, or AdvaMed, a leading trade association representing +medical device manufacturers. The Policy is intended to comply with applicable state and federal laws, regulations and government guidance. The Policy addresses interactions related to sales and +17 +Table of Contents +marketing practices, research and development, product training and education, grants and charitable contributions, support of third-party educational conferences, and consulting arrangements. +Foreign Corrupt Practices Act +The U.S. Foreign Corrupt Practices Act (“FCPA”) prohibits corporations and individuals from engaging in certain activities to obtain or retain business or to influence a person working in an +official capacity. It is illegal to pay, offer to pay or authorize the payment of anything of value to any foreign government official, government staff member, political party or political candidate in an attempt to obtain or retain business or to +otherwise influence a person working in an official capacity. Our present and future business has and will continue to be subject to the FCPA and various other laws, rules and/or regulations applicable to us as a result of our international sales. +Environmental Regulation +Because of the nature of our current and proposed research, development, and manufacturing processes, we are subject to stringent federal, state and local laws, rules, regulations and policies governing +the use, generation, manufacture, storage, air emission, effluent discharge and handling and disposal of materials and wastes. +The foregoing discussion of our business should be read in conjunction with the Financial Statements and accompanying notes included in Item 15 of this Annual Report. +ITEM 1A. +Risk Factors +You +should carefully consider the risks and uncertainties described below, together with all of the other information included in this Annual Report and our other SEC filings, in considering our business and prospects. The risks and uncertainties +described below are not the only ones facing us. Additional risks and uncertainties not disclosed or not presently known to us or that we currently deem immaterial also may impair our business operations. The occurrence of any of the following risks +could harm our business, financial condition or results of operations. +Regulatory Risks +The Need to Obtain Regulatory Approvals Could Increase Our Costs and Adversely Affect Our Financial Performance. +Many of our proposed and existing products are subject to regulation by the FDA and other governmental or public health agencies. In +particular, we are subject to strict governmental controls on the development, manufacture, labeling, distribution and marketing of our products. In addition, we are often required to obtain approval or registration with foreign governments or +regulatory bodies before we can import and sell our products in foreign countries. +The process of obtaining required +approvals or clearances from governmental or public health agencies can involve lengthy and detailed laboratory testing, human clinical trials, sampling activities and other costly, time-consuming procedures. These approvals can require the +submission of a large amount of clinical data which can be expensive and may require significant time to obtain. It is also possible that a product will not perform at a level needed to generate the clinical data required to obtain an approval or +clearance. The submission of an application to the FDA or other international regulatory authority does not guarantee that an approval or clearance to market the product will be received. A regulatory authority may impose its own requirements as a +condition to granting an approval or clearance, may include significant restrictions or limitations as part of any approval or clearance it grants and may delay or refuse to grant approval or clearance, even though a product has been approved +without restrictions or limitations in another country or by another agency. +18 +Table of Contents +The process required for approval or clearance of our new products can be lengthy and may +increase the costs associated with developing those products, as well as the risk that we will not succeed in introducing or selling them in the United States or other countries. Our future performance depends on, among other things, our estimates +as to when and at what cost we will receive regulatory approvals and clearances for new products. +We are +conducting clinical studies to support an application for FDA approval of our OraQuick ® HIV-1/2 test for sale in +the United States OTC market. Since a rapid HIV test has never before been approved by the FDA for OTC use, its approval will depend on our further discussions with the FDA and its advisory committees. We have also conducted clinical trials and +submitted a PMA application for FDA approval of our OraQuick ® HCV test for professional use, and we are +conducting an additional clinical study in response to feedback from the FDA for certain specimen applications. There can be no assurance that our clinical trials will support FDA approval of either product or that FDA approval will ultimately be +obtained. Failure to obtain or any delay in obtaining FDA approval for either product could significantly reduce future revenues, increase our costs and adversely affect our financial performance and prospects. +In addition, all in vitro diagnostic products that are to be sold in the EU must bear the CE mark indicating conformance with the +essential requirements of the IVDD. We are not permitted to sell our products in the EU without a CE mark. We have obtained the CE mark for several of our existing products. We also intend to obtain CE mark for certain of our future products and are +not aware of any material reason why we will be unable to do so. However, there can be no assurance that compliance with all provisions of the IVDD will be demonstrated and the CE mark will be obtained or maintained for all products that we desire +to sell in the EU. The failure to obtain or maintain the CE mark for one or more of our products could lead to the termination of strategic alliances and agreements for sales of those products in the EU. +Our Ability to Respond to Changes in Regulatory Requirements Could Adversely Affect Our Business. +Newly promulgated or changed regulations could require changes to our products, necessitate additional clinical trials or procedures, or +could make it impractical or impossible for us to market our products for certain uses, in certain markets, or at all. For example, during 2004 SAMHSA, which is part of the U.S. Department of Health and Human Services, issued proposed regulations +for the use of oral fluid drug testing for federal workers. Although the SAMHSA regulations have been withdrawn, if and when they are issued in final form, they could permit us to market and sell our oral fluid drug tests for use with federal +workers only if certain modifications are made to our products. If we are unable to make these modifications, or if the modifications require significant time to develop, our ability to sell our oral fluid drug testing products in that market could +be limited. In addition, the extent to which the final SAMHSA regulations permit the sale of our oral fluid drug tests for use with federal workers may influence whether customers in the workplace, criminal justice or other unregulated markets use +our products. +In addition, the FDA and other regulatory authorities have the ability to change the requirements for obtaining +product approval and/or impose new or additional requirements for such approval. These changes or new or additional requirements may occur after the completion of substantial clinical work and other costly development activities. The implementation +of such changes or new or additional requirements may result in additional clinical trials and substantial additional costs and can delay or make it more difficult or complicated to obtain product approvals. +Failure to Comply With FDA or Other Regulatory Requirements May Require Us to Suspend Production of Our Products or Institute a Recall +Which Could Result in Higher Costs and a Loss of Revenues. +Our businesses are extensively regulated by the FDA and other +federal, state and foreign regulatory agencies. Our suppliers and distributors often are subject to similar regulation. These regulations impact many aspects of our operations, and the operations of our suppliers and distributors, including +manufacturing, labeling, packaging, adverse event reporting, storage, advertising, promotion and record keeping. For example, our +19 +Table of Contents +manufacturing facilities and those of our suppliers and distributors are, or can be, subject to periodic regulatory inspections. The FDA and foreign regulatory agencies may require post-marketing +testing and surveillance to monitor the effects of approved products or place conditions on any product approvals that could restrict the commercial applications of those products. In addition, the subsequent discovery of previously unknown problems +with a product may result in restrictions on the product, including withdrawal of the product from the market. We are also subject to routine inspection by the FDA and certain state agencies for compliance with Quality System Requirement and Medical +Device Reporting requirements in the United States and other applicable regulations worldwide, including but not limited to ISO regulations. +Although we believe that we have adequate processes in place to ensure compliance with these requirements, the FDA or other regulatory bodies could force us to stop manufacturing, selling or exporting our +products if it concludes that we are out of compliance with applicable regulations. The ability of our suppliers to supply critical components or materials and of our distributors to sell our products could be adversely affected if their operations +are determined to be out of compliance. The FDA and other regulatory bodies could also require us to recall products if we fail to comply with applicable regulations, which could force us to stop manufacturing such products. Such actions by the FDA +and other regulatory bodies could adversely affect our revenues and results of operations. +In the ordinary course of +business, we must frequently make subjective judgments with respect to compliance with applicable laws and regulations. If regulators subsequently disagree with the manner in which we have sought to comply with these regulations, we could be +subjected to substantial civil and criminal penalties, as well as product recall, seizure or injunction with respect to the sale of our products. The assessment of any civil and criminal penalties against us could severely impair our reputation +within the industry and any limitation on our ability to manufacture and market our products could have a material adverse effect on our business. +Our Inability to Manufacture Products in Accordance With Applicable Specifications, Performance Standards or Quality Requirements Could Adversely Affect Our Business. +The materials and processes used to manufacture our products must meet detailed specifications, performance standards and quality +requirements to ensure our products will perform in accordance with their label claims, our customers’ expectations and applicable regulatory requirements. As a result, our products and the materials used in their manufacture or assembly +undergo regular inspections and quality testing. Factors such as defective materials or processes, mechanical failures, human errors, environmental conditions, changes in materials or production methods by our vendors, and other events or conditions +could cause our products or the materials used to produce or assemble our products to fail inspections and quality testing. +Any failure or delay in our ability to meet the applicable specifications, performance standards or quality requirements could adversely affect our ability to manufacture and sell our products or comply with regulatory requirements. These +events could, in turn, adversely affect our revenues and results of operations. +We Are Subject to Numerous Government +Regulations in Addition to FDA Requirements, Which Could Increase Our Costs or Affect Our Operations. +In addition to FDA +and other regulations described previously, the regulations in some states may restrict our ability to sell products in those states. For example, certain states restrict or do not allow the testing of oral fluid for drugs of abuse or the rapid, +point-of-care testing for HIV. While we intend to work with state legislators and regulators to remove or modify any applicable restrictions, there is no guarantee we will be successful in these efforts. +We must also comply with numerous laws relating to such matters as safe working conditions, manufacturing practices, environmental +protection, fire hazard control, disposal of hazardous substances and +20 +Table of Contents +labor or employment practices. Compliance with these laws or any new or changed laws regulating our business could result in substantial costs. Because of the number and extent of the laws and +regulations affecting our industry, and the number of governmental agencies whose actions could affect our operations, it is impossible to reliably predict the full nature and impact of these requirements. To the extent the costs and procedures +associated with complying with these laws and requirements are substantial or it is determined that we do not comply, our business and results of operations could be adversely affected. +Compliance With Regulations Governing Public Company Corporate Governance and Reporting is Complex and Expensive. +Many laws and regulations, notably those adopted in connection with the Sarbanes-Oxley Act of 2002 by the SEC and the NASDAQ Global Market, +impose obligations on public companies, such as ours, which have increased the scope, complexity and cost of corporate governance, reporting and disclosure practices. Our implementation of these reforms and enhanced new disclosures has required and +will continue to require substantial management time and oversight and requires us to incur significant additional accounting and legal costs. +Federal and State Laws Pertaining to Healthcare Fraud and Abuse Could Materially Adversely Affect Our Business, Financial Condition and Results of Operations. +We are subject to various federal and state laws targeting fraud and abuse in the healthcare industry, including anti-kickback laws, false +claims laws and marketing conduct laws, including laws constraining the sales, marketing and other promotional activities of manufacturers of medical devices by limiting the kinds of financial arrangements, including sales programs, with physicians, +hospitals, laboratories and other potential purchasers of medical devices. Violations of these laws are punishable by criminal or civil sanctions, including substantial fines, imprisonment and exclusion from participation in government healthcare +programs such as Medicare and Medicaid. Many of the existing requirements are new and have not been definitively interpreted by state authorities or courts, and available guidance is limited. Unless and until we are in full compliance with these +laws, we could face enforcement action and fines and other penalties, and could receive adverse publicity, all of which could materially harm our business. In addition, changes in these laws, regulations, or administrative or judicial +interpretations, may require us to further change our business practices or subject our existing business practices to legal challenges, which could have a material adverse effect on our business, financial condition and results of operations. +Risks Relating to Our Industry, Business and Strategy +Our Ability to Sell Products Could be Adversely Affected by Competition From New and Existing Diagnostic Products and by Treatments or +Other Non-Diagnostic Products Which May be Developed. +The diagnostic industry is focused on the testing of biological +specimens in a laboratory or at the point of care and is highly competitive and rapidly changing. Many of our principal competitors have considerably greater financial, technical and marketing resources. As new products enter the market, our +products may become obsolete or a competitor’s products may be more effective or more effectively marketed and sold than ours. If we fail to maintain and enhance our competitive position, our customers may decide to use products developed by +competitors which could result in a loss of revenues. +We also face competition from products which may be sold at a lower +price. To the extent this competition arises, customers may choose to buy lower cost products from third parties or we may be forced to sell our products at a lower price, both of which could result in a loss of revenues or a lower gross margin +contribution from the sale of our products. We may also be required to increase our marketing efforts in order to compete effectively, which would increase our costs and reduce our margins. +21 +Table of Contents +In addition, the development and commercialization of products outside of the diagnostics +industry could adversely affect sales of our product. For example, the development of a safe and effective vaccine to prevent HIV or preventative treatments for other diseases or conditions that our products are designed to detect, could reduce, or +eventually eliminate, the demand for our HIV or other diagnostic products and thereby result in a loss of revenues. +Our +Research, Development and Commercialization Efforts May Not Succeed and Our Competitors May Develop and Commercialize More Effective or Successful Diagnostic Products. +In order to remain competitive, we must regularly commit substantial resources to research and development and the commercialization of new or enhanced products. The research and development process +generally takes a significant amount of time from product inception to commercial launch. This process is conducted in various stages. During each stage there is a substantial risk that we will not achieve our goals on a timely basis, or at all, and +we may have to abandon a new or enhanced product in which we have invested substantial time and money. +During 2009, 2008 and +2007, we incurred $13.4 million, $20.3 million and $14.1 million, respectively, in research and development expenses. We expect to continue to incur significant costs related to our research and development activities. +Successful products require significant development and investment, including testing, to demonstrate their cost-effectiveness or other +benefits prior to commercialization. In addition, regulatory approval must be obtained before most products may be sold. Additional development efforts on these products can be required before any regulatory authority will review them. As noted +above, regulatory authorities may not approve these products for commercial sale or can substantially delay approval. In addition, even if a product is developed and all applicable regulatory approvals are obtained, there may be little or no market +for the product. Accordingly, if we fail to develop and gain commercial acceptance for our products, or if competitors develop more effective products or a greater number of successful new products, customers may decide to use products developed by +our competitors. This would result in a loss of revenues and adversely affect our results of operations, cash flow and business. +Failure to Achieve Our Financial and Strategic Objectives Could Have a Material Adverse Impact on Our Business Prospects. +As a result of any number of risk factors identified in this Annual Report, no assurance can be given that we will be successful in implementing our financial and strategic objectives, including our +clinical development programs for a rapid HIV OTC test and/or a rapid HCV test using the OraQuick ® technology +platform. In addition, the funds for the foregoing projects have in the past come primarily from our business operations. If our business slows and we have less money available to fund research and development and clinical programs, we will have to +decide at that time which programs to cut, and by how much. Similarly, if adequate financial, personnel, equipment or other resources are not available, we may be required to delay or scale back our strategic efforts. Our operations will be +adversely affected if our total revenue and gross profits do not correspondingly increase or if our technology, product, clinical and market development efforts are unsuccessful or delayed. Furthermore, our failure to successfully introduce new or +enhanced products and develop new markets could have a material adverse effect on our business and prospects. +If We Lose +Our Key Personnel or Are Unable to Attract and Retain Qualified Personnel as Necessary, Our Business Could be Harmed. +Our +success depends to a large extent upon the contributions of our executive officers, management and sales, marketing, operations and scientific staff. We may not be able to attract or retain a sufficient number of qualified employees in the future +due to the intense competition for qualified personnel among medical products and other life science businesses. We generally do not enter into employment agreements requiring our employees to work for us for any specified period. +22 +Table of Contents +If we are not able to attract and retain the necessary personnel to accomplish our business +objectives, we may experience constraints that will adversely affect our ability to effectively manufacture, sell and market our products, to meet the demands of our strategic partners in a timely fashion, or to support research, development and +clinical programs. Although we believe we will be successful in attracting and retaining qualified personnel, competition for experienced scientists and other personnel from numerous companies and academic and other research institutions may limit +our ability to do so on acceptable terms. +Future Acquisitions or Investments Could Disrupt Our Ongoing Business, Distract +Our Management, Increase Our Expenses and Adversely Affect Our Business. +We may consider strategic acquisitions or +investments as a way to expand our business in the future. These activities, and their impact on our business, are subject to many risk factors, including the following: +• +Suitable acquisitions or investments may not be found or consummated on terms or schedules that are satisfactory to us or consistent with our +objectives; +• +We may be unable to successfully integrate an acquired company’s personnel, assets, management systems, products and/or technology into our +business; +• +Acquisitions may require substantial expense and management time and could disrupt our business; +• +An acquisition and subsequent integration activities may require greater capital and other resources than originally anticipated at the time of +acquisition; +• +An acquisition may result in the incurrence of unexpected expenses, the dilution of our earnings or our existing stockholders’ percentage +ownership, or potential losses from undiscovered liabilities not covered by an indemnification from the seller(s) of the acquired business; +• +An acquisition may result in the loss of our or the acquired company’s key personnel, customers, distributors or suppliers; +• +The benefits expected to be derived from an acquisition may not materialize and could be affected by numerous factors, such as regulatory developments, +general economic conditions, increased competition and our ability to complete the acquisition and integrate the acquired entity’s operations and business; and +• +An acquisition of a foreign business may involve additional risks, including, but not limited to, foreign currency exposure, liability or restrictions +under foreign laws or regulations, and our inability to successfully assimilate differences in foreign business practices or overcome language or cultural barriers. +The occurrence of one or more of the above or other factors may prevent us from achieving all or a significant part of the benefits expected +from an acquisition or investment. This may adversely affect our financial condition, results of operations and ability to grow our business or otherwise achieve our financial and strategic objectives. +Our Revenues Could be Affected by Third-Party Reimbursement Policies and Potential Cost Constraints. +The end-users of our products are expected to increasingly include hospitals, physicians and other healthcare providers. Use of our products +could be adversely impacted if end-users do not receive adequate reimbursement for the cost of our products from their patients’ healthcare insurers or payors. Our net sales could also be adversely affected by changes in reimbursement policies +of governmental or private healthcare payors, including in particular the level of reimbursement for our products. +In the +United States, healthcare providers such as hospitals and physicians who purchase diagnostic products generally rely on third-party payors, principally private health insurance plans, Medicare and Medicaid, to +23 +Table of Contents +reimburse all or part of the cost of the product and procedure. We believe that the overall escalating cost of medical products and services has led to, and will continue to lead to, increased +pressures on the healthcare industry, both foreign and domestic, to reduce the cost of products and services. Given the efforts to control and reduce healthcare costs in the United States in recent years, currently available levels of reimbursement +may not continue to be available in the future for our existing products or products under development. Third-party reimbursement and coverage may not be available or adequate in either the United States or foreign markets, current reimbursement +amounts may be decreased in the future and future legislation, and regulation or reimbursement policies of third-party payors, may reduce the demand for our products or our ability to sell our products on a profitable basis. +Changes in Healthcare Regulation Could Affect Our Revenues, Costs and Financial Condition. +In recent years, there have been numerous initiatives on the federal and state levels for comprehensive reforms affecting the payment for, +the availability of and reimbursement for healthcare services in the United States. These initiatives have ranged from proposals to fundamentally change federal and state healthcare reimbursement programs, including providing comprehensive +healthcare coverage to the public under governmental funded programs, to minor modifications to existing programs. Similar reforms may occur internationally. +Legislative and regulatory bodies are likely to continue to pursue healthcare reform initiatives and may continue to reduce the funding of the Medicare and Medicaid programs, including Medicare Advantage, +in an effort to reduce overall federal healthcare spending. In addition, some of the proposed reform legislation in the U.S. contains taxes on medical device manufacturers as a way to help pay for the costs of reform. +The ultimate content or timing of any future healthcare reform legislation, and its impact on us, is impossible to predict. If significant +reforms are made to the healthcare system in the United States, or in other jurisdictions, those reforms may increase our costs or otherwise have an adverse effect on our financial condition and results of operations. +Increases in Demand for Our Products Could Require Us to Expend Considerable Resources or Harm Our Customer Relationships if We are +Unable to Meet That Demand. +If we experience significant or unexpected increases in the demand for our products, we and +our suppliers may not be able to meet that demand without expending additional capital resources. These capital resources could involve the cost of new machinery or even the cost of new manufacturing facilities. This would increase our capital +costs, which could adversely affect our earnings. Our suppliers may be unable or unwilling to expend the necessary capital resources or otherwise expand their capacity. In addition, new manufacturing equipment or facilities may require FDA approval +before they can be used to manufacture our products. To the extent we are unable to obtain or are delayed in obtaining such approvals, our ability to meet the demand for our products could be adversely affected. +If we or our suppliers are unable to develop necessary manufacturing capabilities in a timely manner, our sales could be adversely affected. +If we fail to increase production volumes cost effectively or if we experience lower than anticipated yields or production problems as a result of changes that we or our suppliers make in our manufacturing processes to meet increased demand, we +could experience shipment delays or interruptions and increased manufacturing costs, which could also have a material adverse effect on our revenues and profitability. +Unexpected increases in demand for our products may require us to obtain additional raw materials in order to manufacture products to meet the demand. Some raw materials require significant ordering lead +time and some are currently obtained from a sole supplier or a limited group of suppliers. We have long-term supply agreements with many of these suppliers, but these long-term agreements involve risks for us, such as our potential inability to +obtain an adequate supply of raw materials and components and our reduced control over pricing, quality and +24 +Table of Contents +timely delivery. It is also possible that one or more of these suppliers may become unwilling or unable to deliver materials to us. Any shortfall in our supply of raw materials and components, or +our inability to quickly and cost-effectively obtain alternative sources for this supply, could have a material adverse effect on our total revenues or cost of sales and related profits. +Our inability to meet customer demand for our products could also harm our customer relationships and impair our reputation within the +industry. This, in turn, could have a material adverse effect on our business and prospects. +Risks Relating to +Collaborators +The Use of Sole Supply Sources or Third Party Suppliers For Critical Components of Our Products Could +Adversely Affect Our Business. +We currently purchase certain critical components of our products from +sole supply sources or other third party suppliers. For example, all of the HIV antigen and nitrocellulose required to make our OraQuick ADVANCE ® rapid HIV-1/2 antibody test is currently purchased from sole source suppliers. In addition, the conjugates used in our MICROPLATE oral fluid drugs of abuse assays are +obtained from third party suppliers. +If these suppliers are unable or unwilling to supply the required component or if they +make changes in the component or do not supply materials meeting our specifications, we may need to find another source and perform additional development work. We may also need to obtain FDA or other regulatory approvals for the use of the +alternative component for our products. Completing that development and obtaining such approvals could require significant time and may not occur at all. The availability of critical components from sole supply sources or other third parties could +also reduce our control over pricing, quality and timely delivery. These events could either disrupt our ability to manufacture and sell certain of our products, or completely prevent us from doing so or increase our costs. Any such event could have +a material adverse effect on our results of operations, cash flow and business. +Our Failure to Maintain Existing +Distribution Channels, or Develop New Distribution Channels, May Result in Lower Revenues. +We have marketed many of our +products by collaborating with laboratories, diagnostic companies and distributors. Our sales depend to a substantial degree on our ability to sell products to these customers and on the marketing and distribution abilities of the companies with +which we collaborate. +Relying on distributors or others to market and sell our products could harm our business for various +reasons, including: +• +Our distributors or other customers may not fulfill their contractual obligations to us or otherwise market and distribute our products in the manner +or at the levels we expect; +• +Agreements with distributors may terminate prematurely due to disagreements or may result in litigation between the parties; +• +We may not be able to renew existing distribution agreements on acceptable terms or at all; +• +Our distributors may not designate sufficient resources or priority to the sale of our products; +• +Our existing distributor relationships or contracts may preclude or limit us from entering into additional future arrangements with other distributors; +and +• +We may not be able to negotiate future distribution agreements on acceptable terms or at all. +Although we will try to maintain and expand our business with distributors and customers and require that they fulfill their contractual +obligations, there can be no assurance that such companies will do so or that new distribution channels will be available on satisfactory terms. As a result, our revenues and business could be adversely affected. +25 +Table of Contents +Some of our distributors have also consolidated and such consolidation has had, and may +continue to have, an adverse impact on the level of orders for our products. In addition, some distributors have experienced, and may continue to experience, pressure from their customers to reduce the price of their products and testing services. +This may cause customers to stop using our products or to purchase or manufacture lower cost alternatives. +The Unavailability of an FDA-Approved HIV-1 EIA Screening Test Distributed by a Third Party Could Adversely Affect Sales of Our OraSure ® Oral Fluid Collection Device. +In testing an oral fluid sample collected with an OraSure ® device +for HIV-1 in the United States, our customers must use an HIV-1 EIA screening test approved by the FDA for use with our OraSure ® collection device. Historically, BMX manufactured and sold the only oral fluid HIV-1 EIA screening test approved by the FDA for use in detecting HIV-1 in an oral +fluid specimen collected with our OraSure ® collection device. However, BMX discontinued manufacturing the HIV-1 +EIA screening test in 2007. +During 2009, Avioq, Inc., a company that had acquired a license to produce a +new HIV-1 EIA test originally developed by BMX, obtained FDA approval of the new product for use with our OraSure ® device. The Avioq HIV-1 EIA is now the only such screening test approved for use with the OraSure ® device. +If at some +point in the future our customers cannot purchase the Avioq HIV-1 EIA or otherwise obtain an HIV-1 EIA screening test that has been approved by the FDA for use with our OraSure ® collection device, sales of our OraSure ® device could be negatively affected. +We +May Need Strategic Partners to Assist in Developing and Commercializing Some of Our Diagnostic Products. +Although we +intend to pursue some product opportunities independently, opportunities that require a significant level of investment for development and commercialization or a distribution network beyond our existing sales force may necessitate involving one or +more strategic partners. Our strategy for development and commercialization of products may entail entering into arrangements with distributors or other corporate partners, universities, research laboratories, licensees and others. Relying on +collaborative relationships could be risky to our business for a number of reasons, including: +• +We may be required to transfer material rights to such strategic partners, licensees and others; +• +Our collaborators may not devote sufficient resources to the success of our collaboration; +• +Our collaborators may not obtain regulatory approvals necessary to continue the collaborations in a timely manner; +• +Our collaborators may be acquired by another company and decide to terminate our collaborative arrangement or become insolvent; +• +Our collaborators may develop technologies or components competitive with our products; +• +Disagreements with collaborators could result in the termination of the relationship or litigation; +• +Collaborators may not have sufficient capital resources; and +• +We may not be able to negotiate future collaborative arrangements, or renewals of existing collaborative agreements, on acceptable terms. +While we expect that our current and future collaborative partners have and will have an economic +motivation to succeed in performing their contractual responsibilities, there is no assurance that they will do so and the amount and timing of resources to be devoted to these activities will be controlled by others. Consequently, there can be no +assurance that any revenues or profits will be derived from such arrangements. +26 +Table of Contents +We may need to collaborate with one or more third parties or find new +product distribution channels in order to commercialize our OraQuick ® HIV-1/2 test in the United States OTC +market should we receive approval from the FDA. In order to successfully commercialize an OraQuick ® HIV OTC +test, we and/or our distributors may need to invest significantly in advertising and promotion in order to sell this product. If we are unable to collaborate with a third party having sufficient resources to assist in these efforts or find +alternative distribution channels to access the OTC market, we may need to incur significant costs for advertising and promotion, and our ability to maximize our future revenues and profits from this opportunity could be adversely affected. +Risks Relating to Intellectual Property +Our Success Depends on Our Ability to Protect Our Proprietary Technology. +The diagnostics industry places considerable importance on obtaining patent, trademark and trade secret protection, as well as other intellectual property rights, for new technologies, products and processes. Our success depends, in part, +on our ability to develop and maintain a strong intellectual property portfolio or obtain licenses to patents for products and technologies both in the United States and in other countries. +As appropriate, we intend to file patent applications and obtain patent protection for our proprietary technology. These patent applications +and patents will cover, as applicable, compositions of matter for our products, methods of making those products, methods of using those products and apparatus relating to the use or manufacture of those products. +We will also rely on trade secrets, know-how and continuing technological advancements to protect our proprietary technology. We have +entered, and will continue to enter, into confidentiality agreements with our employees, consultants, advisors and collaborators. Our employees and third party consultants also sign agreements requiring that they assign to us interests in inventions +and original expressions and any patents or copyrights arising from their work. However, these parties may not honor these agreements. +We cannot guarantee that the process of filing patents, the laws governing trade secrets and proprietary information, or any agreements we enter into with employees, consultants, advisors or collaborators will provide adequate protection of +our intellectual property rights. Moreover, issued patents remain in effect for a fixed period and after expiration will not provide protection of the inventions they cover. We may also not be able to successfully protect our rights to unpatented +trade secrets and know-how. Others may independently develop substantially equivalent proprietary information and techniques or otherwise gain access to our trade secrets and know-how. +Some of our employees, including scientific and management personnel, were previously employed by competing companies. Although we encourage +and expect all of our employees to abide by any confidentiality agreement with a prior employer, competing companies may allege trade secret violations and similar claims against us. +We may collaborate with universities and governmental research organizations which, as a result, may acquire part of the rights to any +inventions or technical information derived from our collaboration with them. +To facilitate development and commercialization +of a proprietary technology base, we may need to obtain licenses to patents or other proprietary rights from other parties. Obtaining and maintaining such licenses may require the payment of substantial amounts. In addition, if we are unable to +obtain these types of licenses, our product development and commercialization efforts may be delayed or precluded. +We may +incur substantial costs and be required to expend substantial resources in asserting or protecting our intellectual property rights, or in defending suits against us related to intellectual property rights. Disputes regarding intellectual property +rights could substantially delay product development or commercialization +27 +Table of Contents +activities. Disputes regarding intellectual property rights might include state, federal or foreign court litigation, as well as patent interference, patent reexamination, patent reissue, or +trademark opposition proceedings in the United States Patent and Trademark Office. Opposition or revocation proceedings could be instituted in a foreign patent office. An adverse decision in any proceeding regarding intellectual property rights +could result in the loss or limitation of our rights to a patent, an invention or trademark. +We May Become Involved in +Intellectual Property Infringement Disputes, Which Could Increase our Costs and Limit or Eliminate Our Ability to Sell Our Products or Use Certain of Our Technologies in the Future. +From time to time, we may seek to enforce our patents or other intellectual property rights through litigation. In addition, there are a +large number of patents and patent applications in our product areas, and additional patents may be issued to third parties relating to our product areas. We or our customers may be sued for infringement of patents or misappropriation of other +intellectual property rights with respect to one or more of our products. Litigation in our industry regarding patent and other intellectual property rights is prevalent and is expected to continue. +Our industry is characterized by a large number of patents, claims of which appear to overlap in many cases. As a result, there is a +significant amount of uncertainty regarding the extent of patent protection and infringement. Companies may have pending patent applications, which are typically confidential for the first eighteen months following filing, that cover technologies we +incorporate in our products. Accordingly, we may be subjected to substantial damages for past infringement or be required to modify our products or stop selling them if it is ultimately determined that our products infringe a third party’s +proprietary rights. In addition, governmental agencies could commence investigations or criminal proceedings against our employees or us relating to claims of misuse or misappropriation of another party’s proprietary rights. +Our involvement in litigation or other legal proceedings with respect to patents or other intellectual property and proprietary technology, +either as a plaintiff or defendant, could adversely affect our revenues, market share, results of operations and business because: +• +As is common with major litigation, it could consume a substantial portion of managerial and financial resources; +• +Its outcome would be uncertain and a court may find that our patents are invalid or unenforceable in response to claims by another party or that the +third-party patent claims are valid and infringed by our products; +• +An adverse outcome could subject us to the loss of the protection of our patents or to liability in the form of past royalty payments, penalties, +special and punitive damages, or future royalty payments significantly affecting our future earnings; +• +Failure to obtain a necessary license upon an adverse outcome could prevent us from selling our current products or other products we may develop or +acquire; +• +The pendency of any litigation may in and of itself cause our distributors and customers to reduce purchases of our products; and +• +A court could award a preliminary and/or permanent injunction, which would prevent us from selling our current or future products. +In addition to the foregoing, we may also indemnify some customers and strategic partners under our +agreements with such parties if our products or activities have actually or allegedly infringed upon, misappropriated or misused another party’s proprietary rights. Further, our products may contain technology provided to us by other parties, +such as contractors, suppliers or customers, and we may have little or no ability to determine in advance whether such technology infringes the intellectual property rights of a third party. These other parties may also not be required or +financially able to indemnify us in the event that an infringement or misappropriation claim is asserted against us. +28 +Table of Contents +The Sales Potential for Our OraQuick ® Products Could be Affected by Our Ability to Obtain Certain Licenses and by Future Litigation. +Our OraQuick ® test platform is a lateral flow assay that tests for specific antibodies or other substances. The term “lateral flow” generally refers to a test strip +through which a sample flows and which provides a test result on a portion of the strip downstream from where the sample is applied. There are numerous patents in the United States and other countries which claim lateral flow assay methods and +devices. There are also patents that cover the type of analyte (i.e., HIV-1, HIV-2, HCV, etc.) which our OraQuick ® test is designed to detect. Some of these patents may broadly cover the aspects of our OraQuick ® test and are in force in the United States and other countries. We may not be able to make or sell the OraQuick ® test in the United States or other countries where these patents are in force. +We have obtained licenses under several lateral flow patents, and assays directed at specific analytes, which we believe +should be sufficient to permit the manufacturing and sale of the OraQuick ® device as currently contemplated. +However, licenses under additional patents may be required and it is possible that a third party could seek to enforce one or more lateral flow patents against us. +If we are unable to successfully defend against or resolve patent infringement litigation or it is determined that a +license is required and it is not possible to negotiate or otherwise obtain a license agreement on reasonable terms under a necessary patent, our ability to manufacture and sell OraQuick ® devices and develop and commercialize new applications using the same technology could be limited and we may incur increased costs or damages. In such case, we may be +able to modify the OraQuick ® test to avoid the claim of infringement or the need for a license. However, this +alternative could delay or limit our ability to sell the OraQuick ® test in the United States and other markets, +which would adversely affect our results of operations, cash flow and business. +Risks Relating to Products, Marketing and +Sales +A Market for Our Products May Not Develop. +Our future success will depend, in part, on the market acceptance, and the timing of such acceptance, of new products +such as an OraQuick ® HIV OTC test, an OraQuick ® HCV test, and other new products or technologies that may be developed or acquired. To achieve market acceptance, we and/or our distributors will likely be required +to undertake substantial marketing efforts and spend significant funds to inform potential customers and the public of the perceived benefits of these products. In addition, governmental funding for the purchase of our products may be needed to help +create market acceptance and expand the use of our products. +There may be limited evidence on which to +evaluate the market reaction to products that may be developed and our marketing efforts for new products may not be successful. It is also possible that governmental funding may not be available for new products, such as an OraQuick ® HCV test. As such, there can be no assurance that any products will obtain market acceptance and fill the market +need that is perceived to exist. +If Acceptance and Adoption of Our Oral Fluid Testing Does Not Continue, Our Future +Results May Suffer. +We have made significant progress in gaining acceptance of oral fluid testing for HIV in the public +health, hospital, insurance and other markets. We have also made significant progress in gaining acceptance of oral fluid testing for drugs of abuse in the workplace and criminal justice testing markets. However, the ultimate degree of acceptance in +these markets is uncertain, and other markets may resist the adoption of oral fluid testing as a replacement for other testing methods in use today. In addition, certain state laws prohibit or restrict the use of oral fluid testing for drugs of +abuse in certain markets or the rapid, point-of-care testing for HIV. As a result, there can be no assurance that we will be able to expand the use of our oral fluid testing products in these or other markets. +29 +Table of Contents +Our Customers May Resist Adoption of Rapid Point-of-Care Diagnostic Testing. +We expect sales of our rapid point-of-care diagnostic products, such as our OraQuick +ADVANCE ® HIV-1/2 and OraQuick ® HCV tests, to become an increasingly important part of our business. Hospitals, clinical reference laboratories, physicians and other customers may resist the +adoption of rapid point-of-care tests and instead may choose to use or continue to use competing laboratory tests. Our failure to achieve initial or additional market acceptance of our rapid point-of-care diagnostic tests with customers would have a +negative effect on our future sales growth. +Our Inability to Carry Out Certain of Our Marketing and Sales Plans May Make +it Difficult for Us to Grow or Maintain Our Business. +We have implemented in the past, and we intend to implement in the +future, an aggressive sales and marketing plan to expand sales of our products. Specifically, we will continue to expand the reach of our direct field sales force, use third party distributors and implement other sales and marketing programs. If we +are unable to successfully implement these programs, we may be unable to grow and our business could suffer. +Our Sales +Cycles Can be Lengthy and May Depend on Public Funding, Which Can Cause Variability and Unpredictability in Our Operating Results. +The sales cycles for certain of our products can be lengthy and unpredictable, which makes it more difficult to accurately forecast revenues in a given period and may cause revenues and operating results +to vary from period to period. Sales of our products often involve purchasing decisions by large public and private institutions, may require many levels of approval and may be dependent on economic or political conditions and the availability of +grants or other funding from governmental or public health agencies which can vary from period to period in both amount and timing. For example, in past years our OraQuick ADVANCE ® HIV-1/2 test has been purchased through bulk procurement or other funding provided by governmental agencies. There can be no assurance that purchases or funding from +these agencies will continue at the same or higher levels or at all, especially if current negative economic conditions continue or intensify. As a result, we may expend considerable resources on unsuccessful sales efforts or we may not be able to +complete transactions at all or on a schedule and in an amount consistent with our objectives. +We May be Sued for Product +Liabilities for Injuries Resulting From the Use of Our Products. +We may be held liable if any of our products, or any +product which is made with the use or incorporation of any of our technologies, causes injury of any type or is found otherwise unsuitable during product testing, manufacturing, marketing, sale or usage. There is no assurance that we would be +successful in defending any product liability lawsuits brought against us. Regardless of merit or eventual outcome, product liability claims could result in: +• +Decreased demand for our products; +• +Lost revenues; +• +Damage to our image or reputation; +• +Costs related to litigation; and +• +Incurrence of damages payable to plaintiffs. +We are selling cryosurgical wart removal products in the consumer or OTC market in the U.S. and certain other countries. +We expect to expand the OTC sales of these products to other countries and to eventually distribute other types of products in the domestic and international OTC markets, such as our OraQuick ® HIV-1/2 test. We believe the sale of products in the OTC market increases the risk of potential product liability exposure. +30 +Table of Contents +The Insurance We Purchase to Cover Our Potential Business Risks May be Inadequate. +Although we believe that our present product liability and other insurance coverage is sufficient to cover our current +estimated exposures, we cannot be sure that we will not incur liabilities in excess of our policy limits. In addition, although we believe that we will be able to continue to obtain adequate coverage in the future, there is no assurance that we will +be able to do so at acceptable costs. +We Could Suffer Monetary Damages, Incur Substantial Costs or be Prevented From Using +Technologies Important to Our Products as a Result of Legal Proceedings. +We have been and in the future may become +involved in various legal proceedings arising out of our businesses. These may include commercial disputes, negligence claims or various other lawsuits arising in the ordinary course of our business, including employment matters. Such lawsuits can +seek damages, sometimes in substantial amounts, for commercial or personal injuries allegedly suffered and can include claims for punitive or other special damages. An adverse ruling or rulings in one or more such lawsuits could, individually or in +the aggregate, result in the termination or modification of a material contract or otherwise have a material adverse effect on our sales, operations or financial performance. +Performance of Our Products May Affect Our Revenues, Stock Price and Reputation. +Our products are generally sold with labeling that contains performance claims approved or cleared by the FDA or other regulators. If our +products fail to perform in accordance with the applicable label claims or otherwise in accordance with the expectations or needs of our customers, customers may switch to a competing product or otherwise stop using our products, and our revenues +could be adversely affected. In addition, poor performance by one or more of our products and publicity surrounding such performance could have an adverse effect on our reputation, our continuing ability to sell products and the prevailing market +price of our Common Stock. +Our International Presence May Increase Our Risks and Expose Our Business to Regulatory, +Cultural or Other Restraints. +We intend to increase revenue derived from international sales of our products. Our +international sales accounted for $14.8 million or 19% of total revenues for 2009, $13.7 million or 19% of total revenues for 2008 and $18.1 million or 22% of total revenues for 2007. +A number of factors can slow or prevent international sales, or substantially increase the cost of international sales, including those set +forth below: +• +Regulatory requirements (including compliance with applicable customs regulations) and the need for reimbursement approvals may slow, limit, or prevent +the offering of products in foreign countries; +• +The unavailability of licenses to certain patents in force in a foreign country which cover our products may restrict our ability to sell into that +country; +• +Reduced protection for, or enforcement of, our patents and other intellectual property rights in foreign countries could lower our sales; +• +The inability to obtain or maintain ISO certification for our or our suppliers’ manufacturing facilities could preclude, interrupt or delay our +ability to manufacture products for sale in Europe or other international territories; +• +Our inability to obtain or maintain the CE mark on our products or other country-specific registrations may preclude or delay our ability to sell +products in the European Union; +• +The uncertainty of foreign laws and the inconsistent imposition of legal and regulatory requirements may make it more difficult to sell our products +internationally; +31 +Table of Contents +• +Our inability to identify international distributors and negotiate acceptable terms for distribution agreements may delay or reduce our sales; +• +Cultural and political differences may favor local competitors or make it difficult to effectively market, sell and gain acceptance of products in +foreign countries; +• +Inexperience in international markets and difficulties in staffing and managing foreign operations may slow or limit our ability to sell products in +foreign countries; +• +Exchange rates, currency fluctuations, tariffs and other barriers, extended payment terms and dependence on and difficulties in finding and managing +international distributors or representatives may affect our revenues even when product shipments occur; +• +The creditworthiness of foreign distributors and customers may be less certain and foreign accounts receivable collection may be more difficult; +• +It may be more difficult to enforce contractual obligations or recover damages under foreign legal systems; +• +Economic conditions, political instability, the absence of available funding sources, terrorism, civil unrest, war and natural disasters may slow or +limit our ability to sell our products in foreign countries; +• +Our exposure to liability under the Foreign Corrupt Practices Act and various other laws, rules and/or regulations applicable to us as a result of our +international sales may affect our ability to sell into international markets; +• +International markets often have long sales cycles, especially for sales to foreign governments, quasi-governmental agencies and international public +health agencies, thereby delaying or limiting our ability to sell our products; and +• +We may be at a disadvantage if competitors in foreign countries sell competing products at prices at or below such competitors’ or our cost. +Currently, most of our international sales are negotiated for and paid in U.S. dollars. Nevertheless, these +sales are subject to currency risks since the changes in the values of foreign currencies relative to the value of the U.S. dollar can render our products comparatively more expensive. These exchange rate fluctuations could negatively impact +international sales of our products, as could changes in the general economic conditions in those markets. +In addition, we have entered into a contract for the manufacture and supply of our OraQuick ® HIV-1/2 +test in Thailand, and the Histofreezer ® cryosurgical product is currently manufactured in The Netherlands. We +may enter into agreements to manufacture other products in foreign countries as well. However, economic, cultural and political conditions and foreign regulatory requirements may slow or prevent the manufacture of our products in countries other +than the United States. Interruption of the supply of our products could reduce revenues or cause us to incur significant additional expenses in finding an alternative source of supply. Foreign currency fluctuations and economic conditions in +foreign countries could also increase the costs of manufacturing our products in foreign countries. +Risks Relating to the +Economy, Our Financial Results, Investments, Stock Price, Credit Facilities and Need for Financing +Continued Economic +Volatility and Disruption Could Adversely Affect Our Results of Operations, Cash Flow and Financial Condition or Those of Our Customers and Suppliers. +Capital and credit markets have been experiencing a period of unprecedented turmoil and upheaval, characterized by the bankruptcy, failure, collapse or sale of various financial institutions and +substantial +32 +Table of Contents +intervention by the U.S. government. These conditions could adversely affect the demand for our products and services and, therefore, reduce purchases by our customers, which would negatively +affect our revenues and profitability. In addition, interest rate fluctuations, financial market volatility or credit market disruptions may limit our access to capital, and may also negatively affect our customers’ and our suppliers’ +ability to obtain credit to finance their businesses on acceptable terms. As a result, our customers’ needs and ability to purchase our products or services may decrease, and our suppliers may increase their prices, reduce their output or +change their terms of sale. If our customers’ or suppliers’ operating and financial performance deteriorates, or if they are unable to make scheduled payments or obtain credit, our customers may not be able to pay, or may delay payment of, +accounts receivable owed to us, and our suppliers may restrict credit or impose different payment terms. Any inability of customers to pay us for our products and services, or any demands by suppliers for different payment terms, may adversely +affect our earnings and cash flow. +Additionally, both state and federal government sponsored payers, as a result of budget +deficits or reductions, may seek to reduce their health care expenditures by reducing their purchases of our products or renegotiating their contracts with us. Any reduction in payments by such government sponsored payers may adversely affect our +earnings and cash flow. +The current economic circumstances could adversely affect our access to liquidity needed to conduct +or expand our business or conduct acquisitions and make other discretionary investments. Declining economic conditions may also increase our costs. If the economic conditions do not improve or continue to deteriorate, our results of operations or +financial condition could be adversely affected. +We Have a History of Losses and May Not Be Able to Achieve Sustained +Profitability. +Although we achieved profitability in 2005, 2006 and 2007, we experienced net losses in 2008 and 2009. In +addition, as of December 31, 2009, the Company had an accumulated deficit of $135.1 million. Even though we achieved profitability in the past, there can be no assurance that we will be able to achieve or sustain profitability in the future. +Our ability to achieve and sustain profitability in the future will be dependent upon a number of factors including, without +limitation, the following: +• +Creating market acceptance for and selling increasing volumes of our OraQuick ADVANCE ® rapid HIV-1/2 antibody test in the United States and internationally; +• +The level of expenditures we are required to make in order to develop and obtain regulatory approvals for our new products, including our OraQuick ® HIV-1/2 test for use in the OTC market and an OraQuick ® HCV test for professional use; +• +Our ability to successfully launch new products after receipt of required regulatory approvals including our OraQuick ® rapid HCV test; +• +The degree to which certain of our new products may replace sales of our existing products and the financial impact of that change, including the +degree to which our OraQuick ADVANCE ® test will replace our OraSure ® collection device for HIV-1 testing or sales of our cryosurgical wart removal products in the OTC market will +replace sales of our Histofreezer ® product to physicians’ offices or other professional markets; +• +The degree to which our major distributors comply with their contractual obligations, including minimum purchase commitments; +• +Whether we are successful in obtaining and maintaining required regulatory approvals and registrations for our new products; +• +Changes in the level of competition, such as would occur if larger and financially stronger competitors introduced new or lower priced products to +compete with our products; +33 +Table of Contents +• +Changes in economic conditions in domestic or international markets, such as economic downturns, reduced demand, inflation and currency fluctuations; +• +Failure to achieve our targets for growth in revenues; +• +Changes in distributor buying patterns or a buildup of significant quantities in our distributors’ inventories or distribution channels; and +• +The costs and results of patent infringement and other litigation or claims asserted against us. +We May Experience Fluctuations in Our Financial Results or Fail to Meet Our Financial Projections. +Our operating results can fluctuate from quarter to quarter and year to year, which could cause our growth or financial performance to fall +below the expectations of investors and securities analysts. Our financial projections for future periods are based on a number of assumptions, including estimated demand for our products. However, sales to our distributors and other customers may +fall short of expectations because of less than estimated customer demand or other factors, including continued volatility and disruption in economic conditions and other circumstances described elsewhere in this Annual Report. Infrequent, unusual +or unexpected revenues or costs could also contribute to the variability of our financial results. In addition, our products provide different contributions to our gross margin and our operating results could also fluctuate and be affected depending +on the mix of products sold and the relative prices and gross margin contribution of those products. Failure to achieve operating results consistent with the expectations of investors and securities analysts could adversely affect our reputation and +the price of our Common Stock. +Our Portfolio Investments May Be Subject to Volatility and Uncertainty in the Financial +Markets and Other Risks. +At December 31, 2009, we had $79.7 million in cash, cash equivalents and short-term +investments. We invest our cash in a variety of financial instruments, consisting principally of investments in certificates of deposit, commercial paper, U.S. government and agency obligations, and U.S. corporate bonds. These investments are +denominated in U.S. dollars. +All of the cash equivalents and marketable securities are treated as +“available-for-sale.” Investments in both fixed rate and floating rate interest earning instruments carry a degree of interest rate risk. Fixed rate debt securities may have their market value adversely impacted due to a rise in interest +rates, while floating rate securities may produce less income than expected if interest rates fall. The market value of our investments could also be reduced as a result of market and other conditions or events, such as the recent U.S. sub-prime +mortgage defaults and resulting credit and liquidity issues. Due in part to these factors, our future investment income may fall short of expectations. We may also suffer losses in principal if we are forced to sell securities that decline in market +value due to changes in interest rates or other factors. However, because any debt securities we hold are classified as “available-for-sale,” no gains or losses are recognized unless such securities are sold prior to maturity. +Our Estimates or Judgments Relating to Critical Accounting Policies Are Based on Assumptions That Can Change or Prove to be Incorrect. +Our discussion and analysis of financial condition and results of operations is based on our financial statements, which +have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and +assumptions that affect the amounts reported in the financial statements and accompanying notes. On an ongoing basis, we evaluate significant estimates used in preparing our financial statements, including those related to: +• +Revenue recognition; +• +Allowance for uncollectible accounts receivable; +34 +Table of Contents +• +Reserve for inventory write-downs; +• +Stock-based compensation; +• +Potential impairment of long-lived and intangible assets; +• +Clinical trial accruals; and +• +Contingencies. +We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances, as provided in our discussion and analysis of financial condition and results of operations, the +results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these and other estimates if our assumptions change or if +actual circumstances differ from those in our assumptions, which could cause our operating results to fall below the expectations of securities analysts and investors, resulting in a decline in our stock price. +Our Credit Facilities Contain Certain Financial Covenants Which, if Not Satisfied, Could Result in the Acceleration of the Amounts Due +Under These Facilities and Limit Our Ability to Borrow in the Future. +Our credit facility with Comerica Bank contains +various financial and other covenants with which we must comply on an ongoing or periodic basis. Although we do not expect to violate these covenants and obligations, if such a violation were to occur, the outstanding debt under our credit facility +could become immediately due and payable, our lender could proceed against any collateral securing such indebtedness and our ability to borrow additional funds in the future may be adversely affected. +We May Require Future Additional Capital. +Our future liquidity and ability to meet our future capital requirements will depend on numerous factors, including, but not limited to, the following: +• +The time, cost and degree of success of conducting clinical trials and obtaining regulatory approvals; +• +The costs and timing of expansion of sales and marketing activities; +• +The timing of the commercial launch of new products; +• +The extent to which existing and new or enhanced products gain market acceptance; +• +The costs and timing of the expansion of our manufacturing capacity; +• +The success of our research and product development efforts; +• +The magnitude of capital expenditures; +• +Changes in existing and potential relationships with distributors and other business partners; +• +The costs involved in obtaining and enforcing patents, proprietary rights and necessary licenses; +• +The costs and liability associated with patent infringement or other types of litigation; +• +Competing technological and market developments; and +• +The scope and timing of strategic acquisitions. +If additional financing is needed, we may seek to raise funds through the sale of equity or other securities or through bank borrowings. There can be no assurance that financing through the sale of +securities, bank borrowings or otherwise, will be available to us on satisfactory terms, or at all. +35 +Table of Contents +Terrorist Attacks or National Disasters May Adversely Affect Our Business. +Terrorist attacks or natural disasters, and subsequent governmental responses to these events, could cause economic +instability. These actions could adversely affect economic conditions both within and outside the United States and reduce demand for our products. These events could disrupt the operations of our customers and suppliers and eliminate, reduce or +delay our customers’ ability to purchase and use our products and our suppliers’ ability to provide raw materials and finished products. +Our manufacturing facilities are located in Bethlehem, Pennsylvania. Although we have business interruption insurance, our facilities and some pieces of manufacturing equipment are difficult to replace +and could require substantial replacement lead-time. Various types of disasters, including earthquakes, fires, floods and acts of terrorism, may affect our manufacturing facilities. In the event our existing manufacturing facilities or equipment is +affected by man-made or natural disasters, we may be unable to manufacture products for sale or meet customer demands or sales projections. If our manufacturing operations were curtailed or ceased, it would seriously harm our business. +Risks Relating to Our Common Stock +Our Stock Price Could Continue to be Volatile. +Our stock price has been +volatile, has fluctuated substantially in the past and may be volatile in the future and could experience substantial declines. The following factors, among others, could have a significant impact on the market for our Common Stock: +• +Future announcements concerning us, our products, our competitors or our industry; +• +Clinical results with respect to our products in development or those of our competitors; +• +Status of clinical studies and pending submissions for required regulatory approvals; +• +The gain or loss of significant contracts; +• +Delays in the development or commercialization of new or enhanced products; +• +Legislative developments; +• +Disputes or developments with key customers, distributors or suppliers; +• +Developments in patent or other proprietary rights; +• +Litigation or threatened litigation; +• +Public concern as to the performance or safety of products that we or others have developed or sold; +• +Failure to achieve, or changes in, financial estimates by securities analysts and comments or opinions about us by securities analysts or major +stockholders; +• +Governmental regulation; +• +Changes in the level of competition; +• +Loss of or declines in sales to major distributors or customers or changes in the mix of products sold; +• +The relatively low trading volume for our Common Stock; +• +Period to period fluctuations in our operating results; +• +Additions or departures of key personnel; +• +General market and economic conditions; and +• +Terrorist attacks, civil unrest, war and national disasters. +36 +Table of Contents +In addition, the stock market in general has experienced extreme price and volume +fluctuations that have affected the market price of our Common Stock, as well as the stock of many companies in the diagnostics and life sciences industries. Often, price fluctuations are unrelated to operating performance of the specific companies +whose stock is affected. +In the past, following periods of volatility in the market price of a company’s stock, +securities class action litigation has occurred against the issuing company. If we were subject to this type of litigation in the future, we could incur substantial costs and a diversion of our management’s attention and resources, each of +which could have a material adverse effect on our revenue and earnings. Any adverse determination in this type of litigation could also subject us to significant liabilities. +Future Sales of Our Common Stock by Existing Stockholders, Executive Officers or Directors Could Depress the Market Price of Our Common +Stock and Make It More Difficult For Us to Sell Stock in the Future. +Sales of our Common Stock in the public market, or +the perception that such sales could occur, could negatively impact the market price of our Common Stock. We are unable to estimate the number of shares of our Common Stock that may actually be resold in the public market since this will depend on +the market price for our Common Stock, the individual circumstances of the sellers and other factors. +We have a number of +institutional stockholders that own significant blocks of our Common Stock. If one or more of these stockholders sell large portions of their holdings in a relatively short time, for liquidity or other reasons, the prevailing market price of our +Common Stock could be negatively affected. In addition, it is possible that one or more of our executive officers or non-employee members of our Board of Directors could sell shares of our Common Stock during an open trading window under our Insider +Trading Policy. These transactions and the perceived reasons for these transactions could have a negative effect on the prevailing market price of our Common Stock. +Investor Confidence and Share Value May be Adversely Impacted if We and/or Our Independent Registered Public Accounting Firm Conclude That Our Internal Control Over Financial Reporting is Not +Effective. +As directed by Section 404 of the Sarbanes-Oxley Act of 2002, the SEC adopted rules requiring us, as a +public company, to include a report in our Annual Reports on Form 10-K that contains an assessment by management of the effectiveness of our internal control over financial reporting. In addition, our independent registered public accounting firm +must report on the effectiveness of these internal controls. +We expect that our internal controls will continue to evolve as +our business activities change. Although we seek to diligently and vigorously review our internal control over financial reporting in an effort to ensure compliance with the Section 404 requirements, any control system, regardless of how well +designed, operated and evaluated, can provide only reasonable, not absolute, assurance that its objectives will be met. If, during any year, our independent registered public accounting firm is not satisfied with our internal control over financial +reporting or the level at which our controls are documented, designed, operated, tested or assessed, or if the independent registered public accounting firm interprets the requirements, rules or regulations differently than we do, then it may issue +a report that is qualified. We also could conclude that our internal control over financial reporting is not effective. These events could result in an adverse reaction in the financial marketplace due to a loss of investor confidence in the +reliability of our financial statements and effectiveness of our internal controls, which ultimately could negatively impact the market price of our Common Stock. +Because We Do Not Intend to Pay Cash Dividends on Our Common Stock, an Investor in Our Common Stock Will Benefit Only if it Appreciates in Value. +We currently intend to retain our current earnings and future earnings, if any, to finance the expansion of our business and do not expect to +pay any cash dividends on our Common Stock in the foreseeable future. As a +37 +Table of Contents +result, the success of an investment in our Common Stock will depend entirely upon any future appreciation. There is no guarantee that our Common Stock will appreciate in value or even maintain +the price at which investors purchased their shares. +Anti-Takeover Provisions in Our Certificate of Incorporation, Bylaws +and Stockholder Rights Plan and Under Delaware Law Could Make a Third Party Acquisition of Us Difficult. +Our Certificate +of Incorporation, Bylaws and Stockholder Rights Plan contain provisions that could make it more difficult for a third party to acquire us, even if doing so would be beneficial to our stockholders. We are also subject to certain provisions of +Delaware law that could delay, deter or prevent a change in control of us. These provisions could limit the price investors might be willing to pay in the future for shares of our Common Stock. +Future Sales of Shares of Our Common Stock or the Issuance of Securities Senior to Our Common Stock Could Adversely Affect the Trading +Price of Our Common Stock and Our Ability to Raise Funds in New Equity Offerings. +Future sales of a substantial number of +our shares of Common Stock or equity-related securities in the public market or privately, or the perception that such sales may occur, could adversely affect prevailing trading prices of our Common Stock, and could impair our ability to raise +capital through future offerings of equity or equity-related securities. No prediction can be made as to the effect, if any, that future sales of shares of Common Stock or the availability of shares of Common Stock for future sale will have on the +trading price of our Common Stock. +ITEM 1B. +Unresolved Staff Comments. +Not Applicable. +ITEM 2. Properties. +We own a 48,000 square +foot facility which is our primary corporate office and manufacturing facility, a 31,700 square foot facility that houses our sales and marketing and research and development offices, and a 33,500 square foot facility which is used for manufacturing +activities. Each of these facilities is located in Bethlehem, Pennsylvania, and is subject to a mortgage in favor of Comerica Bank. We also rent additional warehouse space on an as-needed basis. +We believe that the facilities described above are adequate for our current requirements. +ITEM 3. Legal +Proceedings. +Lateral +Flow Patent Infringement Litigation +On April 22, 2008, a complaint was filed against us in the +United States District Court for the District of New Jersey by Inverness Medical Innovations, Inc., Inverness Medical Switzerland GmbH and Church & Dwight Co., Inc., alleging that we infringed U.S. Patent No. 6,485,982. The complaint +specifically referred to our OraQuick ADVANCE ® Rapid HIV-1/2 Antibody Test. The complaint sought +injunctive relief, damages and an award of attorneys’ fees. We aggressively defended against this lawsuit and asserted various defenses and counterclaims. +In November 2009, the parties entered into several agreements to settle this lawsuit, pursuant to which we paid Inverness $3 million, Inverness granted us non-exclusive, worldwide licenses to certain +lateral flow patents, we and Inverness granted certain product distribution rights to each other, and we granted a limited right of first +38 +Table of Contents +negotiation for the worldwide rights to market and distribute our OraQuick ® HIV OTC test to the consumer diagnostics joint venture between Inverness and Proctor & Gamble. As a result of the settlement, the lawsuit and the claims of +each party were dismissed by the Court with prejudice. +Cryosurgical Patent Infringement Litigation +In December 2009, we filed legal proceedings in the Patents Court of the High Court of England and Wales against D.D.D. Limited, DioMed +Developments Limited and Sixtem Life Srl, alleging that the import and/or sale of the Bazuka Sub-Zero OTC cryosurgical product by the defendants in the United Kingdom infringes our European Patent (UK) 0 608 954. We are seeking injunctive relief and +damages, among other remedies, in this matter. The defendants have filed a response denying infringement and alleging that our patent is invalid. +ITEM 4. (Removed +and Reserved). +39 +Table of Contents +PART II +ITEM 5. +Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities. +Market Information +Our +Common Stock is listed for trading on the Global Select Market tier of The Nasdaq Stock Market LLC (“NASDAQ”) under the symbol OSUR. High and low sales prices reported by NASDAQ during the periods indicated are shown below. +Year ended December 31, +2009 +2008 +High +Low +High +Low +First Quarter +$ +3.82 +$ +2.16 +$ +9.23 +$ +6.37 +Second Quarter +4.09 +2.41 +7.81 +3.74 +Third Quarter +3.55 +2.35 +6.25 +3.69 +Fourth Quarter +5.25 +2.80 +4.96 +2.18 +On March 9, 2010, +there were 551 holders of record and approximately 11,300 holders in street name of our Common Stock, and the closing price of our Common Stock was $5.35 per share. +Dividends +We have never paid any cash dividends and our Board of Directors +does not anticipate paying cash dividends in the foreseeable future. We are generally not permitted to pay dividends or make other distributions to our stockholders under the terms of our credit facilities with Comerica Bank, without first obtaining +Comerica’s consent. We intend to retain any future earnings to provide funds for the operation and expansion of our business. +Share +Repurchases and Retirements +Pursuant to our 2000 Stock Award Plan and in connection with the vesting of restricted shares, +we retired 2,825 shares to satisfy minimum tax withholding obligations during the three months ended December 31, 2009. No shares were repurchased under our $25.0 million share repurchase program during this same period. +40 +Table of Contents +Performance Graph +The performance graph set forth below shall not be deemed “soliciting material” or “filed” for purposes of Section 18 of the Securities Exchange Act of 1934, as amended (the +“Exchange Act”), or otherwise subject to liability under that Section. This graph will not be deemed “incorporated by reference” into any filing under the Securities Act of 1933, as amended, or the Exchange Act, whether such +filing occurs before or after the date hereof, regardless of any general incorporation language in such filing. +The +following graph compares the cumulative total returns to investors in the Company’s Common Stock, the NASDAQ Composite Index and the NASDAQ Biotechnology Index for the period from December 31, 2004 through December 31, 2009. The graph +assumes that $100 was invested on December 31, 2004 in the Company’s Common Stock and in each of the above-mentioned indices, and that all dividends, if any, were reinvested. +The NASDAQ Composite Index was chosen because it is a broad index of companies whose equity securities are traded on the NASDAQ Stock +Market. The NASDAQ Biotechnology Index was chosen because it includes a number of our competitors. Stockholders are cautioned that the graph shows the returns to investors only as of the dates noted and may not be representative of the returns for +any other past or future period. +* +$100 invested on 12/31/04 in stock or index, including reinvestment of dividends. Fiscal year ended December 31. +12/04 +12/05 +12/06 +12/07 +12/08 +12/09 +OraSure Technologies, Inc. +100.00 +131.25 +122.92 +132.29 +54.76 +75.60 +NASDAQ Composite +100.00 +101.33 +114.01 +123.71 +73.11 +105.61 +NASDAQ Biotechnology +100.00 +117.54 +117.37 +121.37 +113.41 +124.58 +41 +Table of Contents +ITEM 6. +Selected Financial Data +The following table sets forth selected financial data of the Company. This information should be read in conjunction with the Financial Statements and notes thereto included in Item 15 and the information set forth in Item 7, +“Management’s Discussion and Analysis of Financial Condition and Results of Operations.” +Selected Financial +Data +(In thousands, except per share data) +Year ended December 31, +2009 +2008 +2007 +2006 +2005 +Operating Results: +Revenues +$ +77,026 +$ +71,104 +$ +82,686 +$ +68,155 +$ +69,366 +Costs and expenses +85,819 +82,551 +83,905 +62,692 +61,793 +Operating income (loss) +(8,793 +) +(11,447 +) +(1,219 +) +5,463 +7,573 +Other income, net +357 +2,699 +5,513 +3,599 +2,146 +Income tax provision (benefit) +(622 +) +22,527 +1 +1,821 +3,794 +(17,729 +) 2 +Net income (loss) +(7,813 +) +(31,275 +) 1 +2,472 +5,268 +27,448 +2 +Earnings (loss) per share +Basic +$ +(0.17 +) +$ +(0.67 +) +$ +0.05 +$ +0.11 +$ +0.61 +Diluted +$ +(0.17 +) +$ +(0.67 +) +$ +0.05 +$ +0.11 +$ +0.59 +Shares used in computing earnings (loss) per share +Basic +45,878 +46,550 +46,325 +45,910 +45,110 +Diluted +45,878 +46,550 +46,878 +46,580 +46,147 +Cash Flow: +Cash flows provided by (used in) operating activities +$ +(293 +) +$ +(2,460 +) +$ +11,584 +$ +16,886 +$ +10,392 +December 31, +2009 +2008 +2007 +2006 +2005 +Financial Position: +Cash, cash equivalents, and short-term investments +$ +79,670 +$ +82,523 +$ +95,566 +$ +91,001 +$ +77,620 +Working capital +89,435 +90,936 +105,620 +95,979 +90,670 +Deferred tax assets +— +— +22,327 +23,522 +26,708 +Total assets +126,991 +131,918 +167,353 +156,565 +130,747 +Long-term debt, excluding current portion +7,792 +8,301 +8,818 +10,031 +884 +Accumulated deficit +(135,088 +) +(127,275 +) +(96,000 +) +(98,414 +) +(103,682 +) +Stockholders’ equity +103,807 +108,325 +140,055 +129,504 +118,919 +1 +Includes an income +tax provision of $25,978 resulting from the establishment of a full valuation allowance on our net deferred tax assets (see Note 9 to the financial statements). +2 +Includes an income tax benefit of $18,165 resulting from the elimination of a significant portion of the valuation allowance on our net deferred tax +assets. +42 +Table of Contents +ITEM 7. Management’s Discussion and Analysis of +Financial Condition and Results of Operations. +Statements below regarding future events or performance are +“forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995. Our actual results could be quite different from those expressed or implied by the forward-looking statements. Factors that could +affect results are discussed more fully under the Item 1A, entitled “Risk Factors,” and elsewhere in this Annual Report. Although forward-looking statements help to provide complete information about us, readers should keep in mind +that forward-looking statements may not be reliable. Readers are cautioned not to place undue reliance on the forward-looking statements. We undertake no duty to update any forward-looking statements made herein after the date of this Annual Report. +The following discussion should be read in conjunction with the financial statements contained herein and the notes +thereto, along with the Section entitled “Critical Accounting Policies and Estimates,” set forth below. +Overview +We operate primarily in the in vitro diagnostic business. Our business principally involves the development, manufacture, marketing +and sale of oral fluid diagnostic products and specimen collection devices using our proprietary oral fluid technologies, as well as other diagnostic products including immunoassays and other in vitro diagnostic tests that are used on other +specimen types, and other medical devices used for the removal of benign skin lesions by cryosurgery, or freezing. Our diagnostic products include tests which are performed on a rapid basis at the point of care and tests which are processed in a +laboratory. These products are sold in the United States and internationally to various clinical laboratories, hospitals, clinics, community-based organizations and other public health organizations, distributors, government agencies, +physicians’ offices, and commercial and industrial entities. One of our products is sold in the OTC or consumer retail market in North America, Europe, Central and South America, and Australia. +In vitro diagnostic testing is the process of analyzing oral fluid, blood, urine and other bodily fluids or tissue for the presence +of specific substances or markers for infectious diseases, drugs of abuse or other conditions. However, we have targeted the use of oral fluid in our products as a differentiating factor and believe that it provides a significant competitive +advantage over blood and urine. Our oral fluid tests have sensitivity and specificity comparable to blood and/or urine tests. When combined with their ease of use, non-invasive and dignified nature, and cost effectiveness, our oral fluid tests +represent a very competitive alternative to the more traditional testing methods in the diagnostic marketplace. +We rely heavily on distributors to purchase and resell many of our products. For example, Genomma Labs has exclusive rights to our wart removal product in the OTC market in Mexico, Argentina, Brazil, and various other Central and South +American countries and SSL has similar rights to our wart removal product in the OTC footcare market in Europe, Australia and New Zealand. We have contracted with several distributors to sell our OraQuick ADVANCE ® HIV-1/2 test to the U.S. physician office market and our Intercept ® and OraSure ® +product lines are sold by several laboratory distributors. We also use distributors to sell our Histofreezer ® +product into the domestic and international physician office markets. We expect to enter into additional distribution agreements for existing and future products in the U.S. and internationally. If our distributors are unable or unwilling to meet +the minimum purchase commitments set forth in their agreements or otherwise substantially reduce the volume of their purchases, our revenues and results of operations could be adversely affected. +Because of the regulatory approvals needed for most of our products, we often are required to rely on sole source +providers for critical components and materials and on related products supplied by third parties. This is particularly true for our OraQuick ADVANCE ® HIV-1/2 test, our OraSure ® +oral fluid collection device and our oral fluid Western blot HIV-1 confirmatory product. If we are unable to obtain necessary components or materials from these sole sources or if the related products supplied by third parties become unavailable, +the time required to develop replacements and obtain the required FDA approvals could disrupt our ability to sell the affected products. +43 +Table of Contents +Competitive and Economic Outlook +Competition in the market for HIV testing is intense and is expected to increase. We believe that our principal competition will come from +existing point-of-care rapid blood tests, laboratory-based blood tests, and urine assays or other oral fluid-based tests that may be developed. Our competitors include medical diagnostic companies and specialized biotechnology firms, as well as +pharmaceutical companies with biotechnology divisions. +The current economic downturn, including disruptions in the capital +and credit markets, may continue for the foreseeable future and intensify, and could adversely affect our financial performance and condition or those of our customers and suppliers. These circumstances could adversely affect our access to liquidity +needed to conduct or expand our business or conduct acquisitions or make other discretionary investments. These circumstances may also adversely impact the capital or funding available to our customers and suppliers, which, in turn, could adversely +affect their ability to purchase our products or supply us with necessary equipment, raw materials or components. In addition, demand for our products by consumers may also be adversely affected by the economic downturn. +Current Financial Results +During the year ended December 31, 2009, our total revenues were $77.0 million, which represents an 8% increase from the same period in 2008. Our net loss for the year ended December 31, 2009 was $7.8 million or $0.17 per share, +compared to a net loss of $31.3 million or $0.67 per share for the year ended December 31, 2008. Our net loss in 2009 included a $3.0 million pre-tax charge for the impairment of patents and product rights and a $1.5 million pre-tax charge for +the settlement of a patent infringement lawsuit. Our net loss in 2008 included a $4.9 million pre-tax payment received in connection with the settlement of a patent infringement lawsuit and an income tax charge of $26.0 million recorded to establish +a full valuation allowance against our net deferred tax asset. +Cash flow used in operating activities for the year ended +December 31, 2009 was $293,000, an improvement of $2.2 million compared to the $2.5 million used in operating activities for the year ended December 31, 2008. As of December 31, 2009, we had $79.7 million in cash, cash equivalents and +short-term investments, compared to $82.5 million at December 31, 2008. +2009 and More Recent Developments +OraQuick ® HCV Test +During the +fourth quarter of 2009, we received approval to affix the CE mark to our OraQuick ® rapid HCV test. CE mark +approval is the first step required in order to allow us to sell our HCV test in the 27 countries that make up the European Union. Our HCV test is the first and only rapid HCV test bearing a CE mark that can be used with oral fluid. We are currently +pursuing certain additional registrations in specific European countries where required. +During the +fourth quarter of 2008, we filed a PMA with the FDA for our OraQuick ® HCV test for use in the U.S. professional +market. The application sought approval for use of the product with multiple specimen types, including venous whole blood, fingerstick whole blood and oral fluid. The clinical study data submitted in the PMA showed a high degree of correlation to a +comparator assay conducted at a central laboratory. +During its review of the PMA, the FDA indicated that our clinical data +could potentially have been affected by bias because the same operators performed the test and interpreted the results on multiple specimen types derived from the same patient. The FDA had previously reviewed and concurred with our original clinical +trial protocol. As a result, in the second quarter of 2009, the FDA concluded that additional clinical testing would be required to obtain approval of the PMA for a venous whole blood claim, and that a new clinical study would be required for +approval of claims for oral fluid and other sample types. Although we believe the clinical data +44 +Table of Contents +originally submitted to the FDA is sufficient to support approval of our PMA, we agreed to conduct the additional clinical testing and study mandated by the FDA in order to obtain approved claims +for oral fluid, venous whole blood, and fingerstick whole blood. +In December 2009, we filed a PMA amendment with the FDA +which contains the additional clinical data requested for use of the test in detecting HCV antibodies in venous whole blood samples. We continue to work on the additional clinical study required to obtain approval of the HCV test for use with oral +fluid and fingerstick whole blood. We expect this clinical study to be completed during the first half of 2010. +OraQuick ® HIV OTC Test +In August 2008, we submitted the results of our observed use study to the FDA as part of our efforts to obtain approval +for an OraQuick ® rapid HIV OTC test. The observed use study was designed to assess an individual’s ability +to interact with the product packaging, comprehend the instructions for use, take the test and interpret the results while a trained professional observed those activities. The observed use study was stopped after testing was completed for the first +1,000 subjects, because data from the study met the success criteria initially established in the study protocol for this phase of the trials. +During the second quarter of 2009, the FDA reviewed the data from the observed use study at a meeting of its senior management. Following this meeting, the FDA contacted us and indicated that both the +results of the observed use study and our remaining clinical activities should also be reviewed and approved by the Blood Products Advisory Committee (“BPAC”), an advisory committee to the FDA, before proceeding. In November 2009, we +attended a BPAC meeting in which we reviewed the results of our ongoing clinical studies related to our HIV OTC test. We received feedback from the BPAC which will be used to continue our efforts to seek FDA approval of our HIV OTC test. +OraQuick ® HIV Manufacturing +During the second quarter of 2009, we experienced difficulty manufacturing a component for our OraQuick ® rapid HIV-1/2 antibody test in accordance with our internal quality requirements. A multi-functional team was organized and worked aggressively with the assistance of +outside consultants to resolve this manufacturing issue. As the second quarter progressed, this manufacturing issue remained unresolved and our inventory levels became depleted. As a result, we were required to allocate available product across our +customer base and this resulted in a $2.2 million order backlog at June 30, 2009. We provided some customers with free OraSure ® oral fluid collection devices in order to help them meet their HIV testing needs during this period. +Early in the third quarter of 2009, we identified the root cause of the manufacturing issue and implemented corrective +action. We resumed full-scale production of our OraQuick ® rapid HIV-1/2 antibody test, fulfilled the $2.2 +million backlog, and replenished our finished goods inventories for this product. +Availability of HIV-1 Antigen and Screening Tests +In past years, bioMérieux, Inc. (“BMX”) manufactured and sold the only oral fluid HIV-1 +enzyme immunoassay screening test (“EIA”) that had received FDA approval for use in detecting HIV-1 in an oral fluid specimen collected with our OraSure ® collection device. BMX also supplied the HIV-1 antigen used to manufacture our oral fluid Western blot HIV-1 confirmatory test and was the exclusive world-wide +distributor of that product. BMX discontinued manufacturing their HIV-1 EIA screening test during 2007 and our agreement with BMX for the supply of HIV-1 antigen terminated on December 31, 2007. As a result, we purchased a two-year supply of +the antigen from BMX as permitted under the agreement. +During the third quarter of 2009, we made arrangements to purchase +additional HIV-1 antigen from a third party subcontractor that historically had been used by BMX to manufacture this product for resale to us by BMX. We believe this subcontractor can supply our future requirements for the HIV-1 antigen. +45 +Table of Contents +As previously disclosed, we had initially planned to conduct clinical +trials and seek FDA approval of an alternate HIV-1 EIA for use in testing oral fluid samples collected with our OraSure ® collection device. However, in mid-2009 we learned that, Avioq Inc., who had acquired a license from BMX to produce a new HIV-1 EIA test originally developed by BMX, +obtained FDA approval of this product for use with our OraSure ® device. As a result, we no longer intend to +conduct our own clinical trials or seek FDA approval for an alternate HIV-1 EIA, as originally planned. +Substance Abuse Testing +In January 2010, we signed an agreement with Roche Diagnostics for the worldwide commercialization of +homogeneous, fully-automated oral fluid drugs of abuse assays with our Intercept ® oral specimen collection +device. The oral fluid assays are being jointly developed under a development agreement previously executed with Roche. The oral fluid assays are designed to run on various clinical chemistry automated analyzers, which is intended to allow oral +fluid samples to be processed with the same efficiency currently provided by fully-automated, urine-based drug tests. The commercialization agreement is structured to take advantage of each party’s respective distribution strengths, including +our established market presence with oral fluid testing and Roche’s established base of analyzers and broad marketing capabilities. +Settlement of Patent Infringement Lawsuit +In November 2009, we settled a patent +infringement lawsuit filed against us by Inverness Medical and Church & Dwight that primarily targeted our OraQuick ADVANCE ® HIV test. Pursuant to the terms of the settlement, we paid Inverness $3.0 million. We recorded $1.5 million of the $3.0 million payment as litigation settlement +expense in our statement of operations. The remaining $1.5 million was recorded as prepaid royalties and will be expensed to cost of goods sold based on OraQuick ® revenues through December 31, 2012. For additional information regarding the terms of this settlement, please see the Section entitled, “Legal +Proceedings,” in this Annual Report. +Termination of Royalty Agreement +In July 2009, we entered into a termination and release agreement with the third party from whom we had previously purchased certain patents, +trademarks, copyrights and technology related to our cryosurgical systems product line. Pursuant to this agreement, we made a one-time payment of $643,050 in full consideration of the termination of the original asset purchase agreement we executed +with this third party in June 1998, and its related royalty obligations, which would have extended until December 2011. We recorded this payment, net of the royalties previously accrued, as prepaid royalties, which will be expensed in relation to +cryosurgical revenues through December 31, 2011. +Termination of License and Supply Agreement +In January 2010, we entered into an agreement with the supplier of certain HIV peptides used in the manufacture of our +OraQuick HIV 1/2 test. This agreement was executed in connection with the supplier’s bankruptcy and terminated our obligation to exclusively purchase peptides from the supplier and pay royalties on worldwide sales of our OraQuick ® HIV tests. Pursuant to this agreement, we made a one-time payment of $2.1 million to the supplier in full +consideration of the termination of the original agreement with this supplier and satisfaction of our royalty and purchase obligations. We also received a fully paid-up worldwide, non-exclusive license to the supplier’s patent rights related to +the peptides. We recorded the payment, net of royalties previously accrued, as prepaid royalties, which will be expensed in relation to OraQuick ® sales through June 30, 2011. +46 +Table of Contents +Results of Operations +Year Ended December 31, 2009 Compared to December 31, 2008 +Total +revenues increased 8% to $77.0 million in 2009 from $71.1 million in 2008. Increased sales in the infectious disease, cryosurgical systems and insurance risk assessment markets were partially offset by declines in sales of our substance abuse +testing products and a reduction in licensing and product development revenues. Revenues derived from products sold to customers outside the United States were $14.8 million and $13.7 million or 19% of total revenues for the years ended +December 31, 2009 and 2008, respectively. The majority of our international sales are denominated in U.S. dollars. As such, the impact of foreign currencies was not material to our operating results. +The table below shows the amount of our total revenues (in thousands, except %) generated in each of our principal markets and by licensing +and product development activities. +Year Ended December 31, +Dollars +% +Change +Percentage of Total +Revenues +Market +2009 +2008 +2009 +2008 +Infectious disease testing +$ +46,098 +$ +38,096 +21 +% +60 +% +54 +% +Substance abuse testing +12,026 +14,006 +(14 +) +16 +20 +Cryosurgical systems +10,888 +10,655 +2 +14 +15 +Insurance risk assessment +6,157 +6,085 +1 +8 +8 +Product revenues +75,169 +68,842 +9 +98 +97 +Licensing and product development +1,857 +2,262 +(18 +) +2 +3 +Total revenues +$ +77,026 +$ +71,104 +8 +% +100 +% +100 +% +Infectious Disease Testing Market +Sales to the infectious disease testing market increased 21% to $46.1 million in 2009, primarily as a result of our +switch to a direct sales model for the U.S. hospital market which allowed us to realize a higher average selling price for these customers. Higher volumes in the U.S. public health market and higher international sales also contributed to the +increase. OraQuick ® and OraSure ® sales during 2009 totaled $43.8 million and $2.3 million, respectively, as compared to $35.3 million and $2.8 million in 2008, respectively. +The table below shows a breakdown of our total OraQuick ® revenues (in thousands, except %) during 2009 and 2008. +Year ended December 31, +Customers +2009 +2008 +% +Change +Direct to U.S. Public Health +$ +28,308 +$ +25,450 +11 +% +Hospital Market +10,998 +6,625 +66 +International +4,511 +3,234 +39 +Total OraQuick ® revenues +$ +43,817 +$ +35,309 +24 +% +During 2009, OraQuick ® sales to the U.S. public health market increased by 11% as compared to 2008. This increase was caused by higher purchase volumes due in part to the fact that a number +of our hospital customers are procuring OraQuick ® product through public health channels in lieu of purchasing +the test directly from us. We believe this pattern is the result of increased public health support of testing initiatives by hospitals across the country. As a result, sales to the hospital market are being redirected to the U.S. public health +market, thereby increasing revenues within that customer category. We expect this trend to continue in 2010. +47 +Table of Contents +Sales into the hospital market increased 66% to $11.0 million during 2009, compared to $6.6 +million in 2008. In January 2009, we switched to a direct sales model for U.S. hospitals as a result of the termination of our distribution agreement with Abbott Laboratories at the end of 2008. The increase in revenues in the hospital market is +primarily due to a higher average selling price realized under our direct sales model. +International +sales of our OraQuick ® test increased to $4.5 million in 2009 from $3.2 million in 2008. This 39% increase +reflects higher sales into Latin America, Europe and Asia. Sales into Africa remained flat at $2.3 million in both 2009 and 2008. +We continue to see evidence that sales of our OraQuick ADVANCE ® +HIV test are negatively impacting sales of our OraSure ® oral fluid collection device in the infectious +disease testing market in the U.S. During 2009, sales of OraSure ® declined $506,000 from $2.8 million in 2008 to +$2.3 million in 2009. Some customers who have purchased our OraSure ® device for laboratory HIV-1 testing in the +past are electing to purchase our OraQuick ADVANCE ® test. We believe this is the result of customers +recognizing the benefits of rapid HIV testing, especially with oral fluid, and the CDC’s efforts to increase rapid HIV testing in healthcare settings. While it is not possible at this time to estimate the ultimate impact of such ongoing change +in purchasing patterns, we believe OraSure ® sales will continue to decrease in 2010. +Substance Abuse Testing Market +Sales to the substance abuse testing market decreased 14% in 2009 primarily as a result of lower sales of our Intercept ® collection devices and oral fluid assays. The table below shows a breakdown of our total Intercept ® revenues (in thousands, except %) generated in each market during 2009 and 2008. +Year ended +December 31, +% +Change +Market +2009 +2008 +Workplace testing +$ +3,895 +$ +4,750 +(18 +)% +Criminal justice +2,593 +2,663 +(3 +) +International +2,003 +2,168 +(8 +) +Direct +917 +1,204 +(24 +) +Total Intercept ® revenues +$ +9,408 +$ +10,785 +(13 +)% +Our workplace testing business decreased 18% from $4.8 million in 2008 to $3.9 million in 2009. +Pre-employment drug screening represents over 50% of our workplace testing business and the current recession in the domestic economy and high unemployment levels have had a significant negative impact on this part of our business, as well as on our +direct sales to small and mid-size companies. Revenues in our workplace testing business are not expected to increase until employment rates begin to improve. +Sales to the criminal justice market decreased 3% from $2.7 million in 2008 to $2.6 million in 2009, primarily as a +result of the availability of competing lower priced drug testing products. International sales of Intercept ® +devices and assays decreased 8% to $2.0 million in 2009 from $2.2 million in 2008, also as a result of competition from lower priced drug testing products outside of the U.S. +We do not expect renewed growth in Intercept ® sales until employment conditions in the U.S. recover and overall economic conditions improve. In addition, the microplate oral fluid drug assays, which are sold for +use with the Intercept ® collection device, have come under increasing competitive pressure from +“home-brew” assays developed internally by our laboratory customers and compete with urine-based homogeneous assays that are run on fully-automated, random access analyzers. We believe our competitors are developing oral fluid tests +suitable for use on these fully automated homogeneous assay systems and these assays, if and when they are developed and commercialized, could represent a significant competitive threat to our oral fluid microplate business. Pursuant to a +development agreement with Roche Diagnostics, homogenous fully-automated oral fluid +48 +Table of Contents +drugs of abuse assays are being developed for use with our Intercept ® collection device. The assays use Roche’s technology and will run on various automated analyzers to allow oral fluid samples to be processed with the same +efficiency currently achieved with urine-based drug tests. We have also entered into a commercialization agreement with Roche pursuant to which a drug testing system comprised of our Intercept ® device and the newly developed homogenous assays will be marketed and sold on a worldwide basis. +Cryosurgical Systems Market +Sales of our products in +the cryosurgical systems market (which includes both the physicians’ office and OTC markets) increased 2% to $10.9 million in 2009 from $10.7 million in 2008. This increase was primarily caused by higher sales to our Latin American OTC +distributor, Genomma, partially offset by lower sales to our European OTC distributor, SSL, and decreased Histofreezer ® +sales in international professional markets. +The table below shows a breakdown of our total cryosurgery revenues (in +thousands, except %) generated in each market during 2009 and 2008. +Year ended +December 31, +% +Change +Market +2009 +2008 +Professional domestic +$ +3,902 +$ +3,911 +0 +% +Professional international +1,919 +2,529 +(24 +) +OTC domestic +144 +— +N/A +OTC international +4,923 +4,215 +17 +Total cryosurgical systems revenues +$ +10,888 +$ +10,655 +2 +% +Sales to Genomma for the year ended December 31, 2009 increased to $2.3 million, compared to +$401,000 during the year ended December 31, 2008. During 2008, Genomma reduced its purchases in response to an increase in product returns from retailers in Mexico who overstocked during the winter months of 2007. Throughout 2008 and early in +2009, Genomma worked through its excess inventory levels and resumed purchasing product during the second quarter of 2009. In addition, Genomma launched our cryosurgical wart removal product in Brazil and we completed our first shipment to Brazil in +September 2009. We expect sales to Genomma to increase during 2010. +The increased sales to Latin America were partially +offset by a decrease in sales to SSL. Sales to SSL were $2.6 million and $3.8 million in 2009 and 2008, respectively. The decrease in revenues from SSL resulted from a reduction in the transfer price paid by SSL and a decrease in units purchased as +a result of increased competition in the wart removal market in Europe. We expect this increased competition to continue and sales to SSL to decline in 2010. +During the first quarter of 2009, we reentered the U.S. OTC cryosurgery marketplace through the launch of our own cryosurgical wart removal product under our new national brand, Freeze ‘n Clear Skin +Clinic™. Commencing in February 2009, we shipped product to one major retailer and we plan to expand distribution to other retailers in the future. During the year ended December 31, 2009, we recorded $1.2 million in revenues from Freeze +‘n Clear Skin Clinic™. However, these revenues were offset by $1.0 million in promotional rebates, advertising, slotting and return allowances provided to the retail trade, which we netted against the revenues in accordance with U.S. +generally accepted accounting principles. We believe our participation in these promotional and advertising programs, which were executed and controlled by the retail trade, was necessary in order to increase initial awareness and implement the +launch of our product within the OTC market. It is not possible to predict at this time how successful our new brand will perform in the domestic OTC marketplace or whether we will need to participate in future retail promotional and advertising +programs at comparable levels. +49 +Table of Contents +Sales of our Histofreezer ® product to physicians’ offices in the United States were $3.9 million in both 2009 and 2008. Sales of Histofreezer ® in the professional international market decreased 24% to $1.9 million in 2009, as compared to $2.5 million in 2008. +The selling prices for our Histofreezer ® product are lower in some foreign countries due to differences in the +healthcare systems in those countries. During 2008 and early 2009, some distributors in these countries purchased English-labeled Histofreezer ® product and resold it into the domestic distribution network to distributors who employ alternate sourcing programs. Although we tried to aggressively address this +diversion issue, we believe it negatively impacted sales in the domestic physicians’ office market during 2009 and may continue to do so until the supply of diverted product is exhausted. The decline in Histofreezer ® revenues in the professional international market in 2009 is largely due to a reduction of sales to distributors +that we believe were diverting product to the U.S. market. +In early 2010, we signed agreements with two +manufacturer’s sales representative organizations to support sales of our Histofreezer ® product in the U.S. +Under these arrangements, over 40 additional sale representatives will be working with our physicians’ office distributors throughout the United States. The addition of these sale representatives is expected to contribute to domestic +Histofreezer ® sales growth in 2010. +We see evidence that sales of OTC cryosurgical products may reduce the number of individuals that will seek to obtain +treatment of their warts by a physician, which in turn could negatively affect sales of our Histofreezer ® +product in the domestic professional market. Furthermore, in the European professional marketplace, there is increasing pressure to change or exclude healthcare reimbursement for certain treatment types, including treatments for common warts. The +reduction in or elimination of reimbursement for wart treatments could negatively affect international sales of our Histofreezer ® product. However, it is not possible at this time to estimate the likelihood or financial impact of these changes. +Insurance Risk Assessment Market +Sales to the insurance risk assessment market increased 1% from $6.1 million in 2008 to $6.2 million in 2009, due to variations in laboratory ordering patterns and an increase in purchases of lower face value insurance policies for which +insurers use our oral fluid screening device. Overall, we expect our 2010 revenues in this market will remain at levels comparable to those attained in 2009. +Licensing and Product Development +Licensing and +product development revenues decreased to $1.9 million in 2009, from $2.3 million in 2008. In January 2008, we entered into a license and settlement agreement with Merck & Co. Inc. (“Merck”, formerly called Schering-Plough) in +which Merck agreed to pay us royalties on U.S. sales of their Freeze Away TM OTC cryosurgical wart removal product. Licensing revenues represent these royalties from Merck in 2009 and 2008. +We expect licensing and product development revenues to increase in 2010, primarily due to the anticipated achievement of certain regulatory milestones under our international collaboration agreement with +Merck for the development and promotion of a rapid HCV oral fluid test. Payments received from Merck upon reaching the defined milestones will be recorded as licensing and product development revenues. +Gross Margin +The Company’s gross margin was 61% in 2009, compared to 58% in 2008. Gross margin was favorably impacted during 2009 primarily by our switch in January 2009 to a direct sales model for our OraQuick ADVANCE ® HIV-1/2 test in the U.S. hospital market. Also contributing to the increase was an improvement in manufacturing +efficiency in 2009. +50 +Table of Contents +Operating Expenses +Research and development expenses decreased 34% to $13.4 million in 2009, from $20.3 million in 2008, primarily as a +result of decreased clinical trial spending for our OraQuick ® HIV OTC test and OraQuick ® HCV test. The majority of the initial product development and clinical costs associated with the OraQuick ® HCV device and related PMA submission was incurred during 2008. A decrease in staffing costs resulting from +organizational changes made during the fourth quarter of 2008 also contributed to the current period decrease. Expenses in 2008 also included a $1.0 million patent license milestone payment required as a result of our filing of a PMA submission with +the FDA for our OraQuick ® HCV device, while 2009 expenses did not include any such payment. We expect our +research and development costs will increase in 2010 as we continue clinical trials for the HIV OTC test and OraQuick ® +HCV product and develop other new products. +Sales and marketing expenses increased 1% to $21.2 million in 2009 from +$20.9 million in 2008. Staffing costs increased in 2009 as a result of hiring a new sales force in support of our direct sales model for the U.S. hospital market, as well as hiring, compensation, and relocation costs associated with new senior-level +sales and marketing personnel. Market research and consulting expenses related to our cryosurgical products also increased during 2009. +These increases were offset by a decrease in reimbursement of distributor advertising expenses. We expect 2010 sales and marketing expenses to increase from 2009 levels as we incur full-year staffing +expenses for the new senior-level sales and marketing personnel hired in 2009 and we launch our OraQuick ® HCV +test in the European market. +General and administrative expenses increased 3% to $16.9 million in 2009 +from $16.3 million in 2008. This increase was primarily attributable to increased staffing costs as well as legal expenses associated with the patent infringement lawsuit related to our OraQuick ADVANCE ® HIV test filed against us by Inverness Medical and Church & Dwight, which was settled in the fourth quarter +of 2009 . We expect 2010 general and administrative expenses to remain at approximately 2009 levels as decreases in legal expenses are expected to be largely offset by increased consulting costs. +In November 2009, we settled the patent infringement lawsuit filed by Inverness and Church & Dwight. Pursuant +to the settlement we paid Inverness $3.0 million. We recorded $1.5 million of the $3.0 million payment as litigation settlement expense in our Statement of Operations. The remaining $1.5 million was recorded as prepaid royalties and will be expensed +in cost of goods sold in relation to OraQuick ® revenues generated through December 31, 2012. +In the first quarter of 2008, we received a payment of $4.9 million as a result of the settlement of patent infringement litigation we had +previously filed against Merck. In response to a comment letter received from the SEC dated August 31, 2009, we reclassified our patent litigation settlement of $4.9 million received in January 2008 from other income in our Statement of +Operations to a reduction of operating expenses. +During the second quarter of 2009, we recorded an impairment charge of $3.0 +million related to license payments for certain HCV patents, which we previously capitalized. Management’s intent in capitalizing these payments was to utilize this license in certain developing countries for the marketing and sale of an +existing rapid HCV test supplied by a third party manufacturer. However, we were unable to penetrate this international marketplace with the third-party’s rapid HCV test. Furthermore, given the impact of the current global recession and the +deteriorating status of certain third-world economies, we no longer believed that we would be successful in selling a third-party’s rapid HCV test in the foreseeable future. Accordingly, we recorded a non-cash impairment charge for the +remaining unamortized book value of the patent and product rights in the second quarter of 2009. +51 +Table of Contents +Other Income/Expense +Interest expense increased to $361,000 in 2009 from $346,000 in 2008. Interest income decreased to $738,000 in 2009 from $3.1 million in 2008 primarily as a result of lower yields earned on our investment +portfolio, lower investment balances, and an overall conservative, shorter-term investment approach. +Income Taxes +In November 2009, The Worker, Homeownership, and Business Assistance Act of 2009 was enacted. This new law extends the carryback +period for a net operating loss (“NOL”) from two years up to a maximum of five years. The carryback of the NOL can be applied to both regular tax NOLs and alternative minimum tax (“AMT”) NOLs. The new law also eliminates the 90% +limitation on the use of any AMT NOLs. As a result of the elimination of the 90% limitations, we have elected to carryback our 2008 AMT NOL to our 2007, 2006, and 2005 tax years and apply for a refund of the AMT taxes paid for those years. As such, +in the fourth quarter of 2009, we recorded a $632,000 federal tax benefit associated with this AMT NOL carryback. Offsetting this benefit was a nominal amount of state income taxes. +During 2008, we evaluated whether or not we would realize the benefits associated with our total net deferred tax asset in the future. Given +the uncertainty surrounding the magnitude and length of the current economic recession, our loss in 2008, and our projection of a loss in 2009, which would result in a net cumulative three-year loss, we determined that it was more likely than not +that we would not realize the benefits associated with our net deferred tax assets in the immediate future. Accordingly, in accordance with Financial Accounting Standards Board (“FASB”) guidance, we recorded an income tax charge of $26.0 +million in the fourth quarter of 2008 in order to establish a full valuation allowance against our net deferred tax asset. +Year Ended +December 31, 2008 Compared to December 31, 2007 +Total revenues decreased 14% to $71.1 million in 2008 from $82.7 +million in 2007. Increased sales in both the infectious disease and insurance risk assessment markets, together with an increase in licensing and product development revenues, were more than offset by declines in sales of our cryosurgical wart +removal and substance abuse testing products. Revenues derived from products sold to customers outside the United States were $13.7 million and $18.1 million or 19% and 22% of total revenues for the years ended December 31, 2008 and 2007, +respectively. The majority of our international sales are transactions in U.S. dollars. As such, the impact of foreign currencies was not material to our operating results. +The table below shows the amount of our total revenues (in thousands, except %) generated in each of our principal markets and by licensing +and product development activities. +Year Ended December 31, +Dollars +% +Change +Percentage of +Total Revenues +Market +2008 +2007 +2008 +2007 +Infectious disease testing +$ +38,096 +$ +35,791 +6 +% +54 +% +43 +% +Substance abuse testing +14,006 +15,789 +(11 +) +20 +19 +Cryosurgical systems +10,655 +23,533 +(55 +) +15 +28 +Insurance risk assessment +6,085 +5,464 +11 +8 +7 +Product revenues +68,842 +80,577 +(15 +) +97 +97 +Licensing and product development +2,262 +2,109 +7 +3 +3 +Total revenues +$ +71,104 +$ +82,686 +(14 +)% +100 +% +100 +% +52 +Table of Contents +Infectious Disease Testing Market +Sales to the infectious disease testing market increased 6% to $38.1 million in 2008, primarily as a result of the +continued strong performance of our OraQuick ADVANCE ® rapid HIV-1/2 antibody test in an increasingly +competitive environment. OraQuick ® and OraSure ® sales during 2008 totaled $35.3 million and $2.8 million, respectively, as compared to $32.7 million and $3.1 million in 2007, respectively. +The table below shows a breakdown of our total OraQuick ® revenues (in thousands, except %) during 2008 and 2007. +Year ended December 31, +Customers +2008 +2007 +% +Change +Direct to U.S. Public Health +$ +25,438 +$ +19,799 +28 +% +Abbott +6,625 +8,102 +(18 +) +International +3,234 +3,291 +(2 +) +SAMHSA / CDC +12 +1,464 +(99 +) +Total OraQuick ® revenues +$ +35,309 +$ +32,656 +8 +% +During 2008, OraQuick ® revenue derived from direct sales to the U.S. public health market increased by 28% as compared to 2007. This increase is the result of continued growth in our base +business and from incremental sales driven by the CDC’s efforts to increase HIV testing. In September 2007, the CDC awarded incremental funding to expand HIV testing and prevention programs in populations disproportionately affected by HIV, +primarily African Americans. These funds were allocated to targeted state and public health agencies, for utilization during 2008. +For the year ended December 31, 2008, sales to our former hospital distributor, Abbott, decreased 18% to $6.6 million, as compared to $8.1 million in 2007. This decrease was largely the result of Abbott’s ordering patterns, the +impact of negotiations to end our distribution agreement at the end of 2008, and increased competition in the hospital market. +Revenues derived from the CDC and SAMHSA declined significantly in 2008 when compared to 2007. In 2007, the CDC and SAMHSA placed bulk purchase orders directly with the Company for OraQuick +ADVANCE ® devices and related testing materials, for further distribution to various public health +entities. However, both the CDC and SAMHSA did not place new bulk orders in 2008 and are not currently engaging in bulk procurement and distribution activities. +International sales of our OraQuick ® test remained relatively flat at $3.2 million in both 2008 and 2007, with sales in Africa contributing $2.4 and $2.5 million of those revenues in 2008 and 2007, +respectively. +During 2008, sales of our OraSure ® collection device declined $348,000 from $3.1 million in 2007 to $2.8 million in 2008. +53 +Table of Contents +Substance Abuse Testing Market +Sales to the substance abuse testing market decreased 11% in 2008 as the use of our Intercept ® device for workplace testing was impacted by the continuing adverse economic conditions. The table below shows a +breakdown of our total Intercept ® revenues (in thousands, except %) generated in each market during 2008 and +2007. +Year ended December 31, +Market +2008 +2007 +% +Change +Workplace testing +$ +4,750 +$ +6,650 +(29 +)% +Criminal justice +2,663 +2,570 +4 +International +2,168 +2,188 +(1 +) +Direct +1,204 +1,003 +20 +Total Intercept ® revenues +$ +10,785 +$ +12,411 +(13 +)% +Cryosurgical Systems Market +Sales to the cryosurgical systems market (which includes both the physicians’ office and OTC markets) decreased 55% to $10.7 million in 2008 from $23.5 million in 2007. This decrease was primarily +the result of a significant decline in sales of our domestic and international OTC cryosurgical products when compared to 2007. +The table below shows a breakdown of our total cryosurgery revenues (in thousands, except %) generated in each market during 2008 and 2007. +Year ended December 31, +Market +2008 +2007 +% +Change +Professional domestic +$ +3,911 +$ +5,247 +(25 +)% +Professional international +2,529 +2,349 +8 +OTC domestic +— +6,237 +(100 +) +OTC international +4,215 +9,700 +(57 +) +Total cryosurgical systems revenues +$ +10,655 +$ +23,533 +(55 +)% +Our domestic OTC cryosurgical product was previously distributed in the United +States and Canada by Prestige Brands, owner of the Compound W ® line of wart removal products. Our distribution +agreement with Prestige terminated on December 31, 2007, and as a result, no sales were made to Prestige in 2008 or will be made in the future to this distributor. Sales to Prestige were $6.2 million in 2007. +We have an agreement with SSL under which we manufacture and supply, and SSL distributes on an exclusive basis, our cryosurgical wart +removal product in the OTC footcare market in Europe, Australia and New Zealand. The product is manufactured and sold under SSL’s Scholl and Dr. Scholl trademarks. Sales to SSL were $3.8 million and $5.3 million in 2008 and 2007, +respectively. The $1.5 million sales decline in 2008 was due to lower than expected outsales by SSL in key markets outside the United Kingdom, primarily resulting from intense competition from an already existing brand and new market entrants. +We have granted Genomma Labs exclusive distribution rights to our cryosurgical wart removal product in the OTC markets in +Mexico, Argentina, Brazil, and various other Central and South American countries. Sales to Genomma Labs were approximately $400,000 in 2008 and $4.4 million in 2007. During 2008, Genomma Labs reduced its purchases from us, in response to an +increase in product returns from retailers in Mexico who overstocked during the winter months of 2007. Throughout 2008, Genomma worked to reduce its excess inventory position, and accordingly did not purchase additional product from us. +54 +Table of Contents +Sales of our Histofreezer ® product to physicians’ offices in the United States decreased 25% to $3.9 million in 2008, as compared to $5.2 million in 2007. Sales of +Histofreezer ® in the international market increased 8% to $2.5 million from $2.3 million in 2007. On a combined +basis, however, cryosurgical sales in the professional market declined in 2008, as this business was affected by the diversion of some lower-priced Histofreezer ® product from international sources into the U.S. professional market. The selling prices for our Histofreezer ® product are lower in some foreign countries due to differences in the healthcare systems in those countries. During 2008, some distributors in these countries +purchased English-labeled Histofreezer ® product and resold it into the domestic distribution network to +distributors who employ alternate sourcing programs. We aggressively addressed this diversion issue by increasing our international pricing, changing product labeling and packaging, and enforcing contractual rights against certain international +distributors. +Insurance Risk Assessment Market +Sales to the insurance risk assessment market increased 11% from $5.5 million in 2007 to $6.1 million in 2008, primarily as a result of an increase in revenues associated with our oral fluid Western blot +HIV-1 confirmatory test. At the end of 2007, BMX discontinued the distribution of our Western blot HIV-1 confirmatory test and, as a result, in 2008 we began and are now selling this product directly to our laboratory customers. +Licensing and Product Development +Licensing and product development revenues increased to $2.3 million in 2008, from $2.1 million in 2007. In January 2008, we entered into a license and settlement agreement with Merck (formerly, +Schering-Plough) in which Merck agreed to pay us royalties on U.S. sales of its Freeze Away TM OTC cryosurgical wart removal product. Pursuant to the terms of that agreement, during 2008, we recorded $2.3 million in royalty payments from Merck. +In December 2006, we entered into a collaboration agreement with Merck for the development and promotion of a rapid oral fluid test for the +detection of antibodies to HCV. During 2007, we recognized $2.0 million in revenues associated with funded research and development under this agreement. +Gross Margin +The Company’s gross margin was 58% +in 2008, compared to 61% in 2007. Our 2008 gross margin was negatively impacted by the significant decline in higher-margin cryosurgical sales and by increases in manufacturing scrap and spoilage expense. Scrap expense increased from $1.3 million in +2007 to $2.0 million in 2008. Although scrap and spoilage expense exceeded 2007 levels, OraQuick ® scrap and +spoilage was down sequentially in each quarter of 2008, as we identified its root cause and made the appropriate adjustments. +Operating +Expenses +Research and development expenses increased 43% to $20.3 million in 2008, from $14.1 million +in 2007, primarily as a result of increased product and clinical development costs for our OraQuick ® HCV test, +costs associated with our continued efforts to obtain FDA approval to sell our OraQuick ® HIV test over the +counter, and costs to develop our homogeneous fully-automated drugs of abuse assays for use with our Intercept ® +oral fluid collection device in collaboration with Roche Diagnostics. Also included in our 2008 expense is a $1.0 million patent license milestone payment required as a result of our filing of a premarket approval application with the FDA for +our OraQuick ® HCV device. +Sales and marketing expenses increased 4% to $20.9 million in 2008 from $20.1 million in 2007. This increase was primarily the result of incremental salaries, benefits, and recruiting and relocation +expenses related to hiring additional direct sales personnel for the hospital market, as we prepared to assume control of this distribution channel from Abbott in 2009. These increases were partially offset by a decrease in distributor advertising +and promotional costs. +55 +Table of Contents +General and administrative expenses decreased 6% to $16.3 million in 2008 from $17.3 million +in 2007. This decrease was primarily attributable to lower cash and stock compensation costs, bank charges, consulting fees and legal expenses. +As a result of the license and settlement agreement we entered into with Merck to resolve our patent infringement litigation, we received a payment of $4.9 million during the first quarter of 2008. +Other Income/Expense +Interest expense decreased to $346,000 in 2008 from $520,000 in 2007, as a result of lower outstanding debt balances and our election to fix the interest rate on our primary facilities advance at 4.15% until its maturity in June 2011. +Interest income decreased to $3.1 million in 2008 from $4.7 million in 2007 primarily as a result of lower yields earned on our investment portfolio, usage of some previously-invested cash to fund inventory purchases, capital expenditures, and the +stock repurchase program initiated during 2008, and an overall conservative, shorter-term investment approach. +In January +2007, we sold our ownership interest in a privately-held nonaffiliated company and recorded a $1.4 million pre-tax gain on the sale of this investment. +We purchase some of our cryosurgical products from, or utilize the services of, vendors located in The Netherlands. Although the majority of our international sales are denominated in United States +dollars, as a result of the weakness of the dollar in relation to the euro, we recorded a net loss on foreign currency transactions in the amount of $36,000 and $105,000 for the years ended December 31, 2008 and 2007, respectively. +Income Taxes +During +2008, we evaluated whether or not we would realize the benefits associated with our total net deferred tax asset in the future. Given the uncertainty surrounding the magnitude and length of the current economic recession, our loss in 2008, and our +projection of a loss in 2009, which would result in a net cumulative three-year loss, we determined that it was more likely than not that we would not realize the benefits associated with our net deferred tax assets in the immediate future. +Accordingly, in accordance with FASB accounting guidance, we recorded an income tax charge of $26.0 million in the fourth quarter of 2008 in order to establish a full valuation allowance against our net deferred tax asset. +During 2007, we recorded provisions for federal and state income taxes of $1.8 million, which reflect a 42% effective tax rate. Our +effective rate reflects the impact of permanent differences, generated by items which are not deductible on our income tax returns. In addition, during the fourth quarter of 2007, we recorded an income tax benefit of $289,000 related to the +inclusion of a federal research and development tax credit. +Liquidity and Capital Resources +December 31, +2009 +2008 +(In thousands) +Cash and cash equivalents +$ +74,934 +$ +39,565 +Short-term investments +4,737 +42,957 +Working capital +89,435 +90,936 +Our cash, cash +equivalents and short-term investments decreased $2.8 million at December 31, 2008 to $79.7 million at December 31, 2009, primarily as a result of using $293,000 to fund operations, $1.2 million for +56 +Table of Contents +property and equipment purchases, $558,000 for debt repayments, $309,000 to buy back shares under our stock repurchase plan and $392,000 for the retirement of common stock to pay minimum tax +withholding obligations on the vesting of restricted shares. +Net cash used in operating activities was $293,000 in 2009, +resulting from our net loss of $7.8 million and a reduced provision for scrap and spoilage of $228,000 for the year, partially offset by non-cash charges of $3.0 million associated with the impairment of the HCV patent rights, stock-based +compensation expense of $4.0 million and depreciation and amortization of $3.0 million. Also contributing to net cash used in operations were increases in accounts receivable and prepaid expenses of $2.1 million and $2.4 million, respectively. +Accounts receivable increased primarily due to the change in 2009 to a direct sales model in the U.S. hospital market and an increase in hospital sales in the fourth quarter of 2009 when compared to 2008. Prepaid expenses include $1.5 million and +$643,000 in prepaid royalties associated with payments made pursuant to our Inverness settlement and the termination and release agreement related to our cryosurgical product line, respectively. Other current assets increased as a result of the +$632,000 in refundable AMT taxes recorded at the end of 2009. An additional use of cash during 2009 was related to a decrease in accounts payable of $501,000. Offsetting these uses of cash during the year was a $2.1 million decrease in inventory +related to the utilization of a significant amount of cryosurgical raw material inventory for the Latin America OTC market and an increase in accrued expenses of $707,000, primarily related to increases in our year end management incentive bonus +accrual and our royalty obligations. +Net cash provided by investing activities during 2009 was $36.9 million. Payments of +$1.2 million for additions to property and equipment, were offset by $38.1 million of net proceeds from maturities and redemptions of short-term investments. +During the year ending December 31, 2010, we expect to invest approximately $6.0 million in capital expenditures, primarily to purchase additional equipment, upgrade certain older equipment and make +improvements to our facilities. +Net cash used in financing activities was $1.2 million for the year ended December 31, +2009 primarily as a result of $558,000 in loan principal repayments and $392,000 used for the withholding and retirement of common stock. During the year, we also used $309,000 to purchase 108,293 shares of common stock under our stock repurchase +plan and we received $25,000 in cash proceeds from the exercise of stock options. +At December 31, 2009, we had in place +a $10,000,000 credit advance with Comerica Bank (“Comerica”). Pursuant to the terms of the advance, principal, and interest fixed at 4.15%, are payable monthly through June 2011, at which time the remaining unpaid principal balance is +payable. As of December 31, 2009, we had $8.3 million in outstanding borrowings under this advance. +On +June 29, 2009, our $4,000,000 working capital line of credit with Comerica expired. We elected not to renew this working capital line of credit, since our facility advance matures in June 2011 and we had in excess of $79.0 million of cash, cash +equivalents and short-term investments available as of June 30, 2009 to fund our ongoing operations and capital needs. +All borrowings from Comerica are collateralized by a first priority security interest in all of our assets, including present and future accounts receivable, chattel paper, contracts and contract rights, equipment and accessories, general +intangibles, investments, instruments, inventories, and a mortgage on our three facilities in Bethlehem, Pennsylvania. The Comerica agreement contains certain covenants that set forth minimum requirements for our quick ratio, liquidity, and tangible +net worth. We were in full compliance with all covenants at December 31, 2009. The agreement also restricts our ability to pay dividends, to make certain investments, to incur additional indebtedness, to sell or otherwise dispose of a +substantial portion of assets, and to merge or consolidate operations with an unaffiliated entity, without the consent of Comerica. +57 +Table of Contents +At December 31, 2009, we had NOL carryforwards of $54.1 million for federal income tax +purposes. During the fourth quarter of 2005, the Company retained independent tax specialists to perform an ownership change study and analysis to determine the annual limitation amount applicable to utilization of the NOL carryforwards due to past +ownership changes, as defined in Section 382 of the Internal Revenue Code. We continue to review ownership changes on an annual basis. We do not believe that ownership change limitations would impair our ability to utilize our NOLs against +taxable income that we may generate in the future. In the fourth quarter of 2008, we recorded a full valuation allowance against the deferred tax asset generated by these NOLs. Establishment of this valuation allowance does not change our view of +the Company’s long-term financial outlook or the expected utilization of our NOL carryforwards. +The combination of our +current cash, cash equivalents and short-term investments is expected to be more than sufficient to fund our operating and capital needs through at least the end of 2010. Our cash requirements, however, may vary materially from those now planned due +to many factors, including, but not limited to, the scope and timing of strategic acquisitions, the cost and timing of the expansion of our manufacturing capacity, the progress of our research and development programs, the scope and results of +clinical testing, the cost of any future litigation, the magnitude of capital expenditures, changes in existing and potential relationships with business partners, the time and cost of obtaining regulatory approvals, the costs involved in obtaining +and enforcing patents, proprietary rights and any necessary licenses, the cost and timing of expansion of sales and marketing activities, the timing of market launch of new products, market acceptance of new products, competing technological and +market developments, the impact of the ongoing economic downturn and other factors. +Contractual Obligations and Commercial Commitments +The following sets forth our approximate aggregate obligations at December 31, 2009 for future payments under +contracts and other contingent commitments, for the year 2010 and beyond: +Payments due by December 31, +Contractual Obligations +Total +2010 +2011 +2012 +2013 +2014 +Thereafter +Long-term debt 1 +$ +8,301,440 +$ +509,761 +$ +7,791,679 +$ +— +$ +— +$ +— +$ +— +Operating leases 2 +136,340 +136,340 +— +— +— +— +— +Employment contracts 3 +1,788,500 +1,526,000 +262,500 +— +— +— +— +Purchase obligations 4 +3,578,021 +2,223,346 +1,354,675 +— +— +— +— +Minimum commitments under contracts 5 +4,291,667 +500,000 +500,000 +500,000 +500,000 +500,000 +1,791,667 +Total contractual obligations +$ +18,095,968 +$ +4,895,447 +$ +9,908,854 +$ +500,000 +$ +500,000 +$ +500,000 +$ +1,791,667 +1 +Represents principal repayments required under notes payable to our lenders. See Note 8 to the financial statements included herein. +2 +Represents payments required under our operating leases. +3 +Represents salary payments payable under the terms of employment agreements executed by us with certain executives. See Note 11 to the financial statements included +herein. +4 +Represents payments required by non-cancellable purchase orders related to inventory, capital expenditures and other goods or services. See Note 11 to the financial +statements included herein. +5 +Represents payments required pursuant to certain, licensing agreements executed by the Company. These agreements are cancellable within a specified number of days after +communication by the Company of its intent to terminate. See Note 11 to the financial statements included herein. Additional payments of up to $4,500,000 may be required pursuant to one of these licensing agreements for the achievement of specific +development and/or commercial milestones. +Off-Balance Sheet Arrangements . We do +not have any off-balance sheet arrangements, as defined in Item 303(a) (4) (ii) of Regulation S-K under the Securities Exchange Act of 1934, as amended. +58 +Table of Contents +Critical Accounting Policies and Estimates +This Management’s Discussion and Analysis of Financial Condition and Results of Operations discusses our financial statements, which +have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires that we make estimates and assumptions that affect the reported amounts of assets +and liabilities, the disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenues and expenses during the reporting period. On an on-going basis, we evaluate our judgments and +estimates, including those related to bad debts, inventories, investments, intangible assets, income taxes, revenue recognition, clinical trial accruals, contingencies and litigation. We base our judgments and estimates on historical experience and +on various other factors that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying value of assets and liabilities that are not readily apparent from other sources. Actual +results may differ from these estimates under different assumptions or conditions. +Our significant accounting policies are +described in Note 2 to the financial statements included in Item 15 of this Annual Report. We consider the following accounting estimates, which have been discussed with our Audit Committee, to be most critical in understanding the more complex +judgments that are involved in preparing our financial statements and the uncertainties that could impact our results of operations, financial condition and cash flows. +Revenue Recognition . We recognize product revenues when there is persuasive evidence that an arrangement exists, the price is fixed or determinable, title has passed and +collection is reasonably assured. Product revenues are net of allowances for any discounts or rebates. We do not grant price protection or product return rights to our customers except for warranty returns and return rights granted to retail +customers for our domestic cryosurgical wart removal product. Historically, returns arising from warranty issues have been infrequent and immaterial. Accordingly, we expense warranty returns as incurred. For our cryosurgical product sold in the +retail market, a provision for estimated product returns is recorded as a reduction of revenue in the same period in which the revenue is recognized. In addition, revenue from retail sales is also recorded net of promotional, advertising, and +slotting allowances granted to the retail trade. +Royalty income from the grant of license rights is recognized during the +period in which the revenue is earned and the amount is determinable from the licensee. +Up-front licensing fees are deferred +and recognized ratably over the related license period. Product development revenues are recognized over the period in which the related product development efforts are performed. Amounts received prior to the performance of product development +efforts are recorded as deferred revenues. Grant revenue is recognized as the related work is performed and costs are incurred. We record shipping and handling charges billed to our customers as product revenue and the related expense as cost of +products sold. Taxes assessed by governmental authorities, such as sales or value-added taxes, are excluded from product revenues. +Allowance for Uncollectible Accounts Receivable . Accounts receivable are reduced by an estimated allowance for amounts that may become uncollectible in the future. On an ongoing basis, we perform credit +evaluations of our customers and adjust credit limits based upon the customer’s payment history and creditworthiness, as determined by a review of their current credit information. We also continuously monitor collections and payments from our +customers. +Based upon historical experience and any specific customer collection issues that are identified, we use our +judgment to establish and evaluate the adequacy of our allowance for estimated credit losses, which was approximately $257,000 at December 31, 2009. While credit losses have been within our expectations and the allowance provided, these losses +can vary from period to period. Furthermore, there is no assurance that we will experience credit losses at the same rates as we have in the past. The current economic downturn, including disruptions in the capital and credit markets, may continue +indefinitely and intensify, and could adversely affect +59 +Table of Contents +the operations, cash flows and financial condition of our customers. These circumstances may adversely impact the liquidity or financial position of our customers and could have a material impact +on the collectability of our accounts receivable and future operating results. +Inventories . Our +inventories are valued at the lower of cost or market, determined on a first-in, first-out basis, and include the cost of raw materials, labor and overhead. The majority of our inventories are subject to expiration dating. We continually evaluate +the carrying value of our inventories and when, in the opinion of management, factors indicate that impairment has occurred, either a reserve is established against the inventories’ carrying value or the inventories are completely written off. +We base these decisions on the level of inventories on hand in relation to our estimated forecast of product demand, production requirements over the next twelve months and the expiration dates of raw materials and finished goods. During 2009, 2008 +and 2007, we wrote-off inventory which had a cost of $1.2 million, $1.6 million and $922,000, respectively, as a result of quality, scrap and product expiration issues. Although we make every effort to ensure the accuracy of our forecasts of future +product demand, any significant unanticipated changes in demand could have a significant impact on the carrying value of our inventories and reported operating results. +Stock-based Compensation . We recognize the fair value of equity-based awards as compensation expense in our statement of operations. The fair value of our stock option awards +was estimated using a Black-Scholes option valuation model. This valuation model’s computations incorporate highly subjective assumptions, such as the expected stock price volatility and the estimated life of each award. The fair value of +awards, after considering the effect of expected forfeitures, is then amortized, generally on a straight-line basis, over the related vesting period of the award. +Long-lived and Intangible Assets . Our long-lived assets are comprised of property and equipment and our intangible assets primarily consist of patents and product rights. +Together, these assets had a net book value of $20.8 million, or 16% of our total assets, at December 31, 2009. Property and equipment and patents and product rights are depreciated or amortized on a straight-line basis over their estimated +useful lives, which we determine based upon our estimate of the period of time over which each asset will generate revenues. An impairment of long-lived or intangible assets could occur whenever events or changes in circumstances indicate that the +net book value of our assets may not be recoverable. Events which could trigger asset impairment include significant underperformance relative to historical or projected future operating results, significant changes in the manner of our use of an +asset or in our overall business strategy, significant negative industry or economic trends, and shortening of product life-cycles or changes in technology. If we believe impairment of an asset has occurred, we measure the amount of such impairment +by comparing the net book value of the affected assets to the fair value of these assets, which is generally determined based upon the present value of the expected cash flows associated with the use of these assets. If the net book value exceeds +the fair value of the impaired assets, we would incur an impairment expense equal to this difference. During the second quarter of 2009, we recorded an impairment charge of $3.0 million related to license payments for certain HCV patents, which were +previously capitalized. Management’s intent in capitalizing these payments was to utilize this license in certain developing countries for the marketing and sale of an existing rapid HCV test supplied by a third party manufacturer. However, we +were unable to penetrate this international marketplace with the third-party’s rapid HCV test. Furthermore, given the impact of the current global recession and the deteriorating status of certain third-world economies, we no longer believed +that we would be successful in selling a third-party’s rapid HCV test in the foreseeable future. We currently believe the future cash flows to be received from all remaining long-lived and intangible assets at December 31, 2009 will exceed +their book value. We did not recognize any impairment losses for the years ended December 31, 2008 and 2007. Any unanticipated significant impairment in the future, however, could have a material adverse impact to our balance sheet and future +operating results. +Deferred Tax Assets . At December 31, 2009, we had federal NOL +carryforwards of $54.1 million. The deferred tax assets, before a full valuation allowance, associated with these NOLs and other temporary differences was $27.5 million at December 31, 2009. In assessing the realizability of net deferred tax +assets, we consider whether it is more likely than not that some portion or all of the deferred tax assets will not be realized. +60 +Table of Contents +The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income during the period in which those temporary differences become deductible or the NOLs and +credit carryforwards can be utilized. We consider the scheduled reversal of deferred tax liabilities, projected future taxable income and tax planning strategies in making this assessment. +During the fourth quarter of 2008, we evaluated our ability to realize our net deferred tax asset, in order to determine if a valuation +allowance should be recorded against it pursuant to FASB accounting guidance. A cumulative loss in recent years is a significant piece of negative evidence to be considered when evaluating the need for a valuation allowance and this evidence is +difficult to overcome. Given the uncertainty surrounding the magnitude and length of the current economic recession, our loss in 2008, and our projection of a loss in 2009, which would result in a net cumulative three-year loss, we determined that +it was more likely than not that we would not realize the benefits associated with our net deferred tax asset in the immediate future. Accordingly, we recorded an income tax charge of $26.0 million in the fourth quarter of 2008 to establish a full +valuation allowance against our net deferred tax asset. +Our ability to use our NOL carryforwards to offset future federal +income tax obligations could be limited by changes in the ownership of our stock. Internal Revenue Code (“IRC”) Section 382 contains provisions that limit the amount of federal NOL carryforwards that can be used in any given year in +the event of specified occurrences, including significant ownership changes. During the fourth quarter of 2005, the Company completed an analysis, with the assistance of independent tax specialists, to determine if any IRC Section 382 ownership +changes had occurred that would limit the amount of NOLs that could be utilized to offset future taxable income. As a result of this analysis, the Company concluded that prior period ownership changes may impose a limitation on the amount of NOLs +that can be utilized in a given year. The Company does not believe, however, that this limitation will impair our future ability to utilize NOLs to offset our future taxable income. The Company continues to review ownership changes on an annual +basis. +Clinical Trial Accruals . Some of our research and development is conducted by third +parties, including contract research and development service providers. All such costs are charged to research and development expense systematically as incurred, which may be measured by patient enrollment or the passage of time. At the end of each +quarter, we compare the payments made to each service provider to the estimated progress toward completion of the research or development objectives. Such estimates are subject to change as additional information becomes available. Depending on the +timing of payments to the service providers and the estimated service provided, we record net prepaid or accrued expense relating to these costs. +Contingencies . In the ordinary course of business, we have entered into various contractual relationships with strategic corporate partners, customers, distributors, research +laboratories and universities, licensors, licensees, suppliers, vendors and other parties. As such, we could be subject to litigation, claims or assessments arising from any or all of these relationships. We record an estimated loss contingency when +information available prior to issuance of our financial statements indicates that it is probable that an asset has been impaired or a liability has been incurred at the date of the financial statements and the amount of the loss can be reasonably +estimated. Accounting for contingencies arising from contractual or legal proceedings requires that we use our best judgment when estimating an accrual related to such contingencies. As additional information becomes known, our accrual for a loss +contingency could fluctuate, thereby creating variability in our results of operations from period to period. Likewise, an actual loss arising from a loss contingency which significantly exceeds the amount accrued for in our financial statements +could have a material adverse impact on our operating results for the period in which such actual loss becomes known. +ITEM 7A. +Quantitative and Qualitative Disclosures About Market Risk. +We do not hold any amounts of derivative financial instruments or derivative commodity instruments and, accordingly, we have no material derivative risk to report under this Item. +61 +Table of Contents +The majority of our assets is comprised of cash and cash equivalents and as a result we have +little exposure to market risks associated with available-for-sale securities. +In January 2008, we elected to fix the +interest rate on our long-term debt at 4.15% until the debt’s maturity in June 2011. As a result, we have no exposure to interest rate changes. +As of December 31, 2009, we did not have any foreign currency exchange contracts or purchase currency options to hedge local currency cash flows. We have operations in Europe and Africa, which are +subject to foreign currency fluctuations. As currency rates change, translation of revenues and expenses for these operations from foreign currencies to U.S. dollars affects year-to-year comparability of operating results. Sales denominated in a +foreign currency were minimal compared to our total revenues for the year ended December 31, 2009. We do not expect the risk of foreign currency fluctuations to be material to us in the near future. +ITEM 8. +Financial Statements and Supplementary Data. +Information with respect to this Item is contained in our Financial Statements included in Item 15 of this Annual Report on Form 10-K. +ITEM 9. +Changes in and Disagreements with Accountants on Accounting and Financial Disclosure. +Not applicable. +ITEM 9A. +Controls and Procedures. +(a) Evaluation of Disclosure Controls and Procedures. +The Company’s management, with the participation of +the Company’s Chief Executive Officer and Chief Financial Officer, has evaluated the effectiveness of the Company’s disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) of the Securities Exchange Act of 1934) as +of December 31, 2009. Based on that evaluation, the Company’s management, including such officers, concluded that as of December 31, 2009 the Company’s disclosure controls and procedures were adequate and effective to ensure that +information required to be disclosed by the Company in the reports that we file or submit under the Securities Exchange Act of 1934 is accumulated and communicated to the Company’s management, including the Chief Executive Officer and Chief +Financial Officer, to allow timely decisions regarding required disclosure and is recorded, processed, summarized, and reported within the time periods specified in the rules and forms of the Securities and Exchange Commission. +(b) Management’s Report on Internal Control Over Financial Reporting. +The Company’s management is responsible for establishing and maintaining adequate internal control over financial reporting, as such +term is defined in Rule 13a-15(f) and 15d-15(f) under the Securities Exchange Act of 1934. Under the supervision and with the participation of the Company’s management, including our principal executive officer and principal financial officer, +we conducted an evaluation of the effectiveness of our internal control over financial reporting based on the framework in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway +Commission. Based on our evaluation under the framework, our management concluded that our internal control over financial reporting was effective to provide reasonable assurance regarding the reliability of financial reporting and the preparation +of financial statements for external purposes in accordance with generally accepted accounting principles as of December 31, 2009. +The effectiveness of our internal control over financial reporting as of December 31, 2009 has been audited by KPMG LLP, an independent registered public accounting firm, as stated in their report, +which is included below. +62 +Table of Contents +Because of its inherent limitations, internal control over financial reporting may not +prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies +or procedures may deteriorate. +(c) Changes in Internal Control Over Financial Reporting. +There was no change in the Company’s internal control over financial reporting during the three months ended December 31, 2009 that +was identified in connection with the evaluation referred to in paragraph (b) above that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting. +(d) Report of Independent Registered Public Accounting Firm +The Board of Directors and Stockholders +OraSure Technologies, Inc.: +We have audited OraSure Technologies, Inc.’s internal control over financial reporting as of December 31, 2009, based on criteria +established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). OraSure Technologies, Inc.’s management is responsible for maintaining effective internal +control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Management’s Report on Internal Control Over Financial Reporting. Our responsibility is to +express an opinion on the Company’s internal control over financial reporting based on our audit. +We conducted our audit +in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial +reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating +effectiveness of internal control based on the assessed risk. Our audit also included performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion. +A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding +the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies +and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are +recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management +and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial +statements. +Because of its inherent limitations, internal control over financial reporting may not prevent or detect +misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may +deteriorate. +In our opinion, OraSure Technologies, Inc. maintained, in all material respects, effective internal control over +financial reporting as of December 31, 2009, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). +63 +Table of Contents +We also have audited, in accordance with the standards of the Public Company Accounting +Oversight Board (United States), the balance sheets of OraSure Technologies, Inc. as of December 31, 2009 and 2008, and the related statements of operations, stockholders’ equity and comprehensive income (loss), and cash flows for each of +the years in the three-year period ended December 31, 2009, and our report dated March 15, 2010 expressed an unqualified opinion on those financial statements. +/s/ KPMG LLP +Philadelphia, Pennsylvania +March 15, 2010 +ITEM 9B. +Other Information. +Not +applicable. +64 +Table of Contents +PART III +We have omitted from Part III the information that will appear in our Definitive Proxy Statement for our 2010 Annual Meeting of Stockholders +(the “Proxy Statement”), which will be filed within 120 days after the end of our fiscal year pursuant to Regulation 14A. +ITEM 10. Directors, Executive Officers and Corporate Governance. +Certain information +required by this Item is incorporated by reference to the information under the captions, “Corporate Governance—Committees of the Board—Audit Committee,” “Election of Directors,” “Executive Officers,” and +“Section 16(a) Beneficial Ownership Reporting Compliance,” in the Proxy Statement. +Our Board of Directors has +adopted a Code of Business Conduct and Ethics that applies to our principal executive officer, principal financial officer and principal accounting officer, as well as to the members of our Board of Directors and our other officers and employees. +This Code of Business Conduct and Ethics is available on our website at www.orasure.com . We intend to satisfy the amendment and waiver disclosure requirements under applicable securities regulations by posting any amendments of, or waivers +to, the Code of Business Conduct and Ethics on our website. +ITEM 11. Executive +Compensation. +The information required by this Item is incorporated by reference to the information under the caption, +“Executive Compensation,” in the Proxy Statement. +ITEM 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters. +The information required by this Item with respect to the securities ownership of certain beneficial owners and management, and equity +compensation plan information, is incorporated by reference to the information under the captions, “Principal Stockholders” and “Equity Compensation Plan Information,” in the Proxy Statement. +ITEM 13. Certain Relationships and Related Transactions, and Director Independence. +The information required by this Item is incorporated by reference to the information under the captions, “Transactions with Related +Persons” and “Corporate Governance—Director Independence,” in the Proxy Statement. +ITEM 14. Principal Accountant Fees and Services. +The +information required by this Item is incorporated by reference to the information under the caption, “Audit Fees; Audit-Related Fees; Tax Fees; All Other Fees,” in the Proxy Statement. +65 +Table of Contents +PART IV +ITEM 15. Exhibits and Financial Statement Schedules. +(a)(1) and (a)(2). Financial Statements and Schedules . For a list of the Financial Statements filed herewith, see the Index to Financial Statements following the signature +page to this Annual Report. No schedules are included with the Financial Statements because the required information is inapplicable or is presented in the Financial Statements or related notes thereto. +(a)(3). Exhibits . See Index to Exhibits following the Financial Statements in this Annual Report. +66 +Table of Contents +SIGNATURES +Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this +report to be signed on its behalf by the undersigned, thereunto duly authorized, on March 15, 2010. +ORASURE TECHNOLOGIES, INC. +By: +/s/ D OUGLAS A. M ICHELS +Douglas A. Michels +President and Chief Executive Officer +Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed on March 15, 2010, by the following persons on behalf of the Registrant and in the capacities +indicated. +SIGNATURE +TITLE +/s/ D OUGLAS A. M ICHELS +Douglas A. Michels +President, Chief Executive Officer and Director +(Principal Executive Officer) +/s/ R ONALD H. S PAIR +Ronald H. Spair +Chief Operating Officer, Chief Financial Officer and +Director (Principal Financial Officer) +/s/ M ARK L. K UNA +Mark L. Kuna +Senior Vice President, Finance and Controller +(Principal Accounting Officer) +*M ICHAEL C ELANO +Michael Celano +Director +*J ACK G OLDSTEIN , P H .D. +Jack Goldstein, Ph.D. +Director +*R ONNY B. L ANCASTER +Ronny B. Lancaster +Director +*C HARLES W. P ATRICK +Charles W. Patrick +Director +*R OGER L. P RINGLE +Roger L. Pringle +Director +*D OUGLAS G. W ATSON +Douglas G. Watson +Director +*By: +/s/ J ACK E. J ERRETT +Jack E. Jerrett +(Attorney-in-Fact) +67 +Table of Contents +INDEX TO FINANCIAL STATEMENTS +Page +Report of Independent Registered Public Accounting Firm +F-2 +Balance Sheets +F-3 +Statements of Operations +F-4 +Statements of Stockholders’ Equity and Comprehensive Income (Loss) +F-5 +Statements of Cash Flows +F-6 +Notes to the Financial Statements +F-7 +F-1 +Table of Contents +REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM +The Board of Directors and Stockholders +OraSure Technologies, Inc.: +We have audited the accompanying balance sheets of OraSure Technologies, Inc. as of December 31, +2009 and 2008, and the related statements of operations, stockholders’ equity and comprehensive income (loss), and cash flows for each of the years in the three-year period ended December 31, 2009. These financial statements are the +responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits. +We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial +statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant +estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. +In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of OraSure Technologies, Inc. as of December 31, 2009 and 2008, and the +results of its operations and its cash flows for each of the years in the three-year period ended December 31, 2009, in conformity with U.S. generally accepted accounting principles. +We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), OraSure Technologies, Inc.’s +internal control over financial reporting as of December 31, 2009, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), and our +report dated March 15, 2010 expressed an unqualified opinion on the effectiveness of the Company’s internal control over financial reporting. +/s/ KPMG LLP +Philadelphia, Pennsylvania +March 15, 2010 +F-2 +Table of Contents +ORASURE TECHNOLOGIES, INC. +BALANCE SHEETS +December 31, +2009 +2008 +ASSETS +CURRENT ASSETS: +Cash and cash equivalents +$ +74,933,630 +$ +39,565,218 +Short-term investments +4,736,730 +42,957,467 +Accounts receivable, net of allowance for doubtful accounts of $256,572 and $163,100 +13,693,340 +11,571,048 +Inventories +8,844,492 +10,704,088 +Prepaid expenses and other +2,609,518 +1,418,171 +Total current assets +104,817,710 +106,215,992 +PROPERTY AND EQUIPMENT, net +20,014,466 +21,235,367 +PATENTS AND PRODUCT RIGHTS, net +809,252 +4,380,540 +OTHER ASSETS +1,349,319 +86,290 +$ +126,990,747 +$ +131,918,189 +LIABILITIES AND STOCKHOLDERS’ EQUITY +CURRENT LIABILITIES: +Current portion of long-term debt +$ +509,761 +$ +557,897 +Accounts payable +3,370,604 +3,925,662 +Accrued expenses and other +11,502,802 +10,795,955 +Total current liabilities +15,383,167 +15,279,514 +LONG-TERM DEBT +7,791,679 +8,301,440 +OTHER LIABILITIES +8,911 +11,985 +COMMITMENTS AND CONTINGENCIES (Note 11) +STOCKHOLDERS’ EQUITY: +Preferred stock, par value $.000001, 25,000,000 shares authorized, none issued +— +— +Common stock, par value $.000001, 120,000,000 shares authorized, 45,929,511 and 45,769,221 shares issued and +outstanding +46 +46 +Additional paid-in capital +239,126,422 +235,862,999 +Accumulated other comprehensive loss +(230,992 +) +(262,442 +) +Accumulated deficit +(135,088,486 +) +(127,275,353 +) +Total stockholders’ equity +103,806,990 +108,325,250 +$ +126,990,747 +$ +131,918,189 +The accompanying notes are an integral part of these statements. +F-3 +Table of Contents +ORASURE TECHNOLOGIES, INC. +STATEMENTS OF OPERATIONS +For the year ended December 31, +2009 +2008 +2007 +REVENUES: +Product +$ +75,168,959 +$ +68,842,755 +$ +80,576,622 +Licensing and product development +1,857,267 +2,261,712 +2,109,254 +77,026,226 +71,104,467 +82,685,876 +COST OF PRODUCTS SOLD +29,895,832 +29,976,120 +32,402,794 +Gross profit +47,130,394 +41,128,347 +50,283,082 +OPERATING EXPENSES: +Research and development +13,371,358 +20,255,451 +14,136,019 +Sales and marketing +21,224,125 +20,916,718 +20,061,685 +General and administrative +16,847,920 +16,286,907 +17,304,615 +Litigation settlement (recovery) +1,451,183 +(4,883,714 +) +— +Impairment of patent and product rights +3,028,375 +— +— +55,922,961 +52,575,362 +51,502,319 +Operating loss +(8,792,567 +) +(11,447,015 +) +(1,219,237 +) +INTEREST EXPENSE +(361,188 +) +(345,767 +) +(520,002 +) +INTEREST INCOME +737,892 +3,080,950 +4,709,771 +OTHER INCOME +— +— +1,428,691 +FOREIGN CURRENCY LOSS +(19,554 +) +(36,136 +) +(105,448 +) +Income (loss) before income taxes +(8,435,417 +) +(8,747,968 +) +4,293,775 +INCOME TAX PROVISION (BENEFIT) +(622,284 +) +22,527,334 +1,821,336 +NET INCOME (LOSS) +$ +(7,813,133 +) +$ +(31,275,302 +) +$ +2,472,439 +EARNINGS (LOSS) PER SHARE: +BASIC +$ +(0.17 +) +$ +(0.67 +) +$ +0.05 +DILUTED +$ +(0.17 +) +$ +(0.67 +) +$ +0.05 +SHARES USED IN COMPUTING EARNINGS (LOSS) PER SHARE: +BASIC +45,877,843 +46,549,739 +46,325,338 +DILUTED +45,877,843 +46,549,739 +46,878,143 +The accompanying notes are an integral part of these statements. +F-4 +Table of Contents +ORASURE TECHNOLOGIES, INC. +STATEMENTS OF STOCKHOLDERS’ EQUITY AND COMPREHENSIVE INCOME (LOSS) +For the years ended December 31, 2009, 2008 and 2007 +Common Stock +Additional +Paid-in +Capital +Accumulated +Other +Comprehensive +Loss +Accumulated +Deficit +Shares +Amount +Total +Balance at January 1, 2007 +45,994,752 +$ +46 +$ +228,069,433 +$ +(151,197 +) +$ +(98,414,307 +) +$ +129,503,975 +Adoption of FIN 48 +— +— +— +— +(58,183 +) +(58,183 +) +Reclassification of liability-classified awards +— +— +51,550 +— +— +51,550 +Common stock issued upon exercise of options +481,647 +1 +3,100,036 +— +— +3,100,037 +Vesting of restricted stock +258,093 +— +— +— +— +— +Purchase and retirement of treasury shares +(90,446 +) +— +(785,908 +) +— +— +(785,908 +) +Compensation cost for restricted stock +— +— +2,877,463 +— +— +2,877,463 +Compensation cost for stock option grants +— +— +2,980,915 +— +— +2,980,915 +Comprehensive income: +Net income +— +— +— +— +2,472,439 +2,472,439 +Currency translation adjustment +— +— +— +1,650 +— +1,650 +Unrealized loss on marketable securities, net of tax benefit of $52,287 +— +— +— +(89,349 +) +— +(89,349 +) +Total comprehensive income +2,384,740 +Balance at December 31, 2007 +46,644,046 +47 +236,293,489 +(238,896 +) +(96,000,051 +) +140,054,589 +Common stock issued upon exercise of options +14,786 +— +92,517 +— +— +92,517 +Vesting of restricted stock +393,551 +— +— +— +— +— +Purchase and retirement of treasury shares +(135,432 +) +— +(995,367 +) +— +— +(995,367 +) +Shares purchased and retired pursuant to the stock repurchase plan +(1,147,730 +) +(1 +) +(5,121,107 +) +— +(5,121,108 +) +Compensation cost for restricted stock +— +— +3,352,876 +— +— +3,352,876 +Compensation cost for stock option grants +— +— +2,240,591 +— +— +2,240,591 +Comprehensive loss: +Net loss +— +— +— +— +(31,275,302 +) +(31,275,302 +) +Currency translation adjustment +— +— +— +(36,201 +) +— +(36,201 +) +Unrealized gain on marketable securities +— +— +— +12,655 +— +12,655 +Total comprehensive loss +(31,298,848 +) +Balance at December 31, 2008 +45,769,221 +46 +235,862,999 +(262,442 +) +(127,275,353 +) +108,325,250 +Common stock issued upon exercise of options +30,911 +— +24,807 +— +— +24,807 +Vesting of restricted stock +370,457 +— +— +— +— +— +Purchase and retirement of treasury shares +(132,785 +) +— +(391,590 +) +— +— +(391,590 +) +Shares purchased and retired pursuant to the stock repurchase plan +(108,293 +) +— +(308,605 +) +— +— +(308,605 +) +Compensation cost for restricted stock +— +— +2,621,723 +— +— +2,621,723 +Compensation cost for stock option grants +— +— +1,317,088 +— +— +1,317,088 +Comprehensive loss: +Net loss +— +— +— +— +(7,813,133 +) +(7,813,133 +) +Currency translation adjustment +— +— +— +34,513 +— +34,513 +Unrealized loss on marketable securities +— +— +— +(3,063 +) +— +(3,063 +) +Total comprehensive loss +(7,781,683 +) +Balance at December 31, 2009 +45,929,511 +$ +46 +$ +239,126,422 +$ +(230,992 +) +$ +(135,088,486 +) +$ +103,806,990 +The accompanying notes are an integral part of these statements. +F-5 +Table of Contents +ORASURE TECHNOLOGIES, INC. +STATEMENTS OF CASH FLOWS +For the year ended December 31, +2009 +2008 +2007 +OPERATING ACTIVITIES: +Net income (loss) +$ +(7,813,133 +) +$ +(31,275,302 +) +$ +2,472,439 +Adjustments to reconcile net income (loss) to net cash provided by (used in) operating activities: +Gain on sale of investment in nonaffiliated company +— +— +(1,428,691 +) +Impairment of patent and product rights +3,028,375 +— +— +Deferred income taxes +— +22,305,250 +1,313,839 +Stock-based compensation +3,935,737 +5,456,135 +5,830,770 +Depreciation and amortization +3,049,962 +3,386,670 +2,735,999 +Acquired in-process technology +— +1,000,000 +— +Reserve for excess and obsolete inventories +(228,417 +) +(919,925 +) +922,433 +Changes in assets and liabilities: +Accounts receivable +(2,116,410 +) +(274,284 +) +(937,622 +) +Inventories +2,088,013 +(374,420 +) +(4,797,609 +) +Prepaid expenses and other +(2,442,562 +) +1,070,168 +(463,674 +) +Accounts payable +(501,177 +) +(1,686,143 +) +2,584,439 +Accrued expenses and other liabilities +706,847 +(1,148,491 +) +3,351,556 +Net cash provided by (used in) operating activities +(292,765 +) +(2,460,342 +) +11,583,879 +INVESTING ACTIVITIES: +Purchase of property and equipment +(1,199,551 +) +(2,643,270 +) +(5,503,770 +) +Proceeds from sale of investment in nonaffiliated company +— +— +1,765,943 +Purchase of patents, product rights, or acquired in-process technology +— +(1,200,000 +) +(4,200,000 +) +Purchase of short-term investments +(5,986,000 +) +(67,125,962 +) +(93,953,103 +) +Proceeds from maturities and redemptions of short-term investments +44,090,000 +87,315,645 +101,526,541 +Net cash provided by (used in) investing activities +36,904,449 +16,346,413 +(364,389 +) +FINANCING ACTIVITIES: +Repayments of long-term debt +(557,897 +) +(515,083 +) +(1,264,716 +) +Proceeds from issuance of common stock +24,807 +92,517 +3,100,037 +Purchase and retirement of common stock +(308,605 +) +(5,121,108 +) +— +Withholding and retirement of common stock +(391,590 +) +(995,367 +) +(785,908 +) +Net cash provided by (used in) financing activities +(1,233,285 +) +(6,539,041 +) +1,049,413 +EFFECT OF FOREIGN EXCHANGE RATE CHANGES ON CASH +(9,987 +) +(11,509 +) +10,973 +NET INCREASE IN CASH AND CASH EQUIVALENTS +35,368,412 +7,335,521 +12,279,876 +CASH AND CASH EQUIVALENTS, BEGINNING OF YEAR +39,565,218 +32,229,697 +19,949,821 +CASH AND CASH EQUIVALENTS, END OF YEAR +$ +74,933,630 +$ +39,565,218 +$ +32,229,697 +The accompanying notes are an integral part of these statements. +F-6 +Table of Contents +ORASURE TECHNOLOGIES, INC. +NOTES TO THE FINANCIAL STATEMENTS +1. +THE COMPANY: +We develop, +manufacture and market oral fluid diagnostic products and specimen collection devices using our proprietary oral fluid technologies, as well as other diagnostic products, including in vitro diagnostic tests that are used on other specimen +types, and other medical devices used for the removal of warts and other benign skin lesions by cryosurgery, or freezing. Our diagnostic products include tests which are performed on a rapid basis at the point of care and tests which are processed +in a laboratory. These products are sold in the United States and internationally to various clinical laboratories, hospitals, clinics, community-based organizations and other public health organizations, distributors, government agencies, +physicians’ offices, and commercial and industrial entities. One of our products has been sold in the over-the-counter or consumer retail markets in the United States, Canada, Europe, Mexico and Australia. +The current economic downturn, including disruptions in the capital and credit markets, may continue indefinitely and intensify, and could +adversely affect our results of operations, cash flows and financial condition or those of our customers and suppliers. These circumstances could adversely affect our access to liquidity needed to conduct or expand our business or conduct +acquisitions or make other discretionary investments. They may also adversely impact the capital needs of our customers and suppliers, which, in turn, could adversely affect their ability to purchase our products or supply us with necessary +equipment, raw materials or components. This could adversely affect our results of operations, cash flows and financial condition. The current weak business climate could cause longer sales cycles and slower growth, and could expose us to increased +business or credit risk in dealing with customers or suppliers adversely affected by economic conditions. Our ability to collect accounts receivable may be delayed or precluded if our customers are unable to pay their obligations. +2. +SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES: +Use of Estimates +The preparation of financial statements in conformity +with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions about future events. These estimates and underlying assumptions affect the amounts of assets and liabilities +reported, disclosures about contingent assets and liabilities, and reported amounts of revenues and expenses. Such estimates include the valuation of accounts receivable, inventories and intangible assets, as well as calculations related to +contingencies, accruals and indemnifications, among others. These estimates and assumptions are based on management’s best estimates and judgment. Management evaluates its estimates and assumptions on an ongoing basis, using historical +experience and other factors, which management believes to be reasonable under the circumstances, including the current economic environment. We adjust such estimates and assumptions when facts and circumstances dictate. Illiquid credit markets, +volatile equity, foreign currency, and energy markets, and declines in consumer spending have combined to increase the uncertainty inherent in such estimates and assumptions. As future events and their effects cannot be determined with precision, +actual results could differ significantly from these estimates. Changes in those estimates resulting from continuing changes in the economic environment will be reflected in the financial statements in those future periods. +Cash and Cash Equivalents +We consider all highly liquid investments with a purchased maturity of ninety days or less to be cash equivalents. As of December 31, 2009 and 2008, cash equivalents consisted of money market +accounts, commercial paper and U.S. government agency obligations. +Short-term Investments +We consider all short-term investments to be available-for-sale securities. These securities are comprised of certificates of deposits, +commercial paper, U.S. government and agency obligations, and corporate bonds, all +F-7 +Table of Contents +with purchased maturities greater than ninety days. Available-for-sale securities are carried at fair value, based upon quoted market prices, with unrealized gains and losses reported in +stockholders’ equity as a component of accumulated other comprehensive income (loss). There were no securities held as of December 31, 2009 in a continuous unrealized loss position for twelve or more months. +The following is a summary of our available-for-sale securities at December 31, 2009 and 2008: +Amortized +Cost +Gross +Unrealized +Gains +Gross +Unrealized +Losses +Fair Value +December 31, 2009 +Certificates of deposit +$ +3,986,000 +$ +— +$ +— +$ +3,986,000 +Commercial paper +— +— +— +— +Government and agency bonds +— +— +— +— +Corporate bonds +750,278 +452 +— +750,730 +Total available-for-sale securities +$ +4,736,278 +$ +452 +$ +— +$ +4,736,730 +December 31, 2008 +Certificates of deposit +$ +6,098,000 +$ +8,401 +$ +— +$ +6,106,401 +Commercial paper +2,894,609 +4,425 +— +2,899,034 +Government and agency bonds +11,229,287 +106,173 +— +11,335,460 +Corporate bonds +22,730,229 +8,639 +(122,296 +) +22,616,572 +Total available-for-sale securities +$ +42,952,125 +$ +127,638 +$ +(122,296 +) +$ +42,957,467 +At December 31, 2009, maturities of our available-for-sale securities were as follows: +Less than one year +$ +2,741,278 +$ +452 +$ +— +$ +2,741,730 +One to two years +1,995,000 +— +— +1,995,000 +Total available-for-sale securities +$ +4,736,278 +$ +452 +$ +— +$ +4,736,730 +Supplemental Cash Flow Information +In 2009, 2008 and 2007, we paid interest of $361,121, $409,902, and $663,127, respectively. In 2008 and 2007, we capitalized interest of +$47,463 and $131,738, respectively. +In 2009, 2008 and 2007, we paid federal and state income taxes of $16,461, $381,950, and +$500,529, respectively. +In 2009, 2008 and 2007, we recorded through the statement of operations an increase in our allowance +for doubtful accounts of $93,472, $78,044 and $27,288, respectively. We had write-offs of $101,412 and $40,914 against the allowance for doubtful accounts in 2008 and 2007, respectively. We had no write-offs against the allowance for doubtful +accounts in 2009. +In 2008 and 2007, we recorded accruals for purchases of property and equipment of $25,250 and $66,053, +respectively. We had no accruals for purchases of property and equipment in 2009. +Accounts Receivable +Accounts receivable have been reduced by an allowance for amounts that may become uncollectible in the future. This estimated allowance is +based primarily on management’s evaluation of specific balances as the balances become past due, the financial condition of our customers and our historical experience related to write- offs. If not reserved or exempted through these specific +examination procedures, our policy is to reserve 100% of accounts receivable in aging categories greater than 120 days. +F-8 +Table of Contents +Inventories +Inventories are stated at the lower of cost or market determined on a first-in, first-out basis, and include the cost of raw materials, labor +and overhead. The majority of our inventories are subject to expiration dating. We continually evaluate quantities on hand and the carrying value of our inventories to determine the need for reserves for excess and obsolete inventories, based +primarily on the estimated forecast of product sales. When factors indicate that impairment has occurred, either a reserve is established against the inventories’ carrying value or the inventories are completely written off, as in the case of +lapsing expiration dates. In addition to reserving for these items identified through specific identification procedures, we also reserve for unidentified scrap or spoilage under a fixed-formula methodology. We currently buy a portion of our +cryosurgical product line from a foreign vendor and pay for such purchases in euros. Changes in the exchange rate of the euro will impact our product cost. +Property and Equipment +Property and equipment are stated at cost. +Additions or improvements are capitalized, while repairs and maintenance are charged to expense. Depreciation and amortization are provided using the straight-line method over the estimated useful lives of the related assets. Buildings are +depreciated over twenty to forty years, while computer equipment, machinery and equipment, and furniture and fixtures are depreciated over three to ten years. Building improvements are amortized over their estimated useful lives. When assets are +sold or otherwise disposed of, the related property amounts are relieved from the accounts, and any gain or loss is recorded in the statement of operations. +Patents and Product Rights +Patents and product rights consist of costs +associated with the acquisition of patents, licenses and product distribution rights. Patents and product rights are amortized using the straight-line method over their estimated useful lives of three to ten years. +Impairment of Long-Lived Assets +If indicators of impairment exist, we assess the recoverability of the affected long-lived assets, which include property and equipment and patents and product rights, by determining whether the carrying +value of such assets can be recovered through the sum of the undiscounted future cash flows from the use and eventual disposition of the asset. If impairment is indicated, we measure the amount of such impairment by comparing the carrying value of +the assets to the fair value of these assets, which is generally determined based on the present value of the expected future cash flows associated with the use of the asset. +Revenue Recognition +We recognize product revenues when there is persuasive evidence that an arrangement exists, the price is fixed or determinable, title has passed and collection is reasonably assured. Product revenues are recorded net of allowances for any +discounts or rebates. We do not grant price protection or product return rights to our customers, except for warranty returns and return rights granted to retail customers for our domestic cryosurgical wart removal product. +Historically, returns arising from warranty issues have been infrequent and immaterial. Accordingly, we expense warranty returns as +incurred. For our cryosurgical product sold in the retail market, a provision for estimated product returns is recorded as a reduction of revenue in the same period in which the revenue is recognized. In addition, revenue from retail sales is also +recorded net of promotional, advertising, and slotting allowances granted to the retail trade. +Royalty income from the grant +of license rights is recognized during the period in which the revenue is earned and the amount is determinable from the licensee. +F-9 +Table of Contents +Up-front licensing fees are deferred and recognized ratably over the related license period. +Product development revenues are recognized over the period in which the related product development efforts are performed. Amounts received prior to the performance of product development efforts are recorded as deferred revenues. Grant revenue is +recognized as the related work is performed and costs are incurred. We record shipping and handling charges billed to our customers as product revenue and the related expense as cost of products sold. Taxes assessed by governmental authorities, such +as sales or value-added taxes, are excluded from product revenues. +Significant Customer Concentration +We had the following significant concentrations in revenue and accounts receivable: +Percentage of Total Revenues +For the years ended December 31, +Customer +2009 +2008 +2007 +Quest Diagnostics, Incorporated +9 +% +10 +% +11 +% +Abbott Laboratories +— +10 +10 +Percentage of +Accounts Receivable +at December 31, +2009 +2008 +SSL International plc +3 +% +10 +% +National Aids Control Program +11 +15 +Our distribution agreement with Abbott Laboratories terminated at the end of +2008. Effective January 1, 2009, we began selling the OraQuick ADVANCE ® rapid HIV-1/2 test directly +to U.S. hospitals and other customers previously served by Abbott. As a result, we had no sales to Abbott during the year ended December 31, 2009. +Research and Development +Research and development expenses consist of +costs incurred in performing research and development activities including salaries and benefits, facilities expenses, overhead expenses, clinical trial and related clinical manufacturing expenses, contract services and other outside expenses. +Research and development costs are charged to expense as incurred. Clinical trial expenses include expenses associated with contract research organizations, or CROs. The invoicing from CROs can precede the services provided or can lag the service +period by several months. Invoices paid prior to service being provided are recorded as a prepaid expense and then expensed appropriately as services are provided. We accrue the cost of services rendered but unbilled by CROs based on purchase order +estimates provided by the CROs. Differences between actual and estimated clinical trial expenses recorded are generally not material and would be adjusted for in the period in which they become known. +Advertising Expenses +Advertising costs are charged to expense as incurred. During 2009, 2008, and 2007, we incurred $165,394, $893,279, and $1,261,356, respectively, in advertising expenses. Included in advertising expenses +for 2008 and 2007 were $687,308 and $1,164,294, respectively, in reimbursement for marketing expenses incurred for our OTC cryosurgical products. +Stock-Based Compensation +We account for stock-based compensation to +employees and directors using the fair value method. We have elected to recognize compensation expense for stock option awards issued to employees and directors on a +F-10 +Table of Contents +straight-line basis over the requisite service period of the award. To satisfy the exercise of options or to issue new restricted stock, we normally issue new shares rather than purchase shares +on the open market. +Income Taxes +We follow the asset and liability method for accounting for income taxes. Under this method, deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences +between the financial statement carrying amounts of existing assets and liabilities and the respective tax basis of assets and liabilities, and operating loss and credit carryforwards. Deferred tax assets and liabilities are measured using enacted +tax rates that are expected to apply to taxable income in the years in which those temporary differences and operating loss and credit carryforwards are expected to be recovered, settled or utilized. The effect on deferred tax assets and liabilities +of a change in tax rates is recognized in income in the period that includes the enactment date. +We assess the realizability +of our net deferred tax assets on a quarterly basis. If, after considering all relevant positive and negative evidence, it is more likely than not that some portion or all of the net deferred tax assets will not be realized we reduce our net +deferred tax assets by a valuation allowance. The realization of the net deferred tax assets is dependent on several factors, including the generation of sufficient taxable income prior to the expiration of the net operating loss carryforwards. +Foreign Currency Translation +The assets and liabilities of our foreign operations are translated from euros into U.S. dollars at current exchange rates as of the balance sheet date, and revenues and expenses are translated at average +exchange rates for the period. Resulting translation adjustments are reflected in accumulated other comprehensive loss, which is a separate component of stockholders’ equity. +Earnings (Loss) Per Share +Basic earnings (loss) per share is computed by dividing net income (loss) by the weighted-average number of shares of common stock outstanding during the period. Diluted earnings per share is computed in +a manner similar to basic earnings per share except that the weighted average number of shares outstanding is increased to include incremental shares from the assumed vesting or exercise of dilutive securities, such as common stock options, warrants +and unvested restricted stock. The number of incremental shares is calculated by assuming that outstanding stock options and warrants were exercised and unvested restricted shares were vested, and the proceeds from such exercises or vesting were +used to acquire shares of common stock at the average market prices during the reporting period. +The computations of basic +and diluted earnings (loss) per share are as follows: +Year ended December 31, +2009 +2008 +2007 +Net income (loss) +$ +(7,813,133 +) +$ +(31,275,302 +) +$ +2,472,439 +Weighted average shares of common stock outstanding: +Basic +45,877,843 +46,549,739 +46,325,338 +Dilutive effect of stock options, warrants and restricted stock +— +— +552,805 +Diluted +45,877,843 +46,549,739 +46,878,143 +Earnings (loss) per share: +Basic +$ +(0.17 +) +$ +(0.67 +) +$ +0.05 +Diluted +$ +(0.17 +) +$ +(0.67 +) +$ +0.05 +F-11 +Table of Contents +For the years ended December 31, 2009, 2008, and 2007, outstanding common stock options +and unvested restricted stock representing 6,033,966, 5,403,228, and 2,751,325 shares, respectively, were excluded from the computation of diluted earnings per share as their inclusion would have been anti-dilutive. +Other Comprehensive Income (Loss) +We classify items of other comprehensive income (loss) by their nature and disclosure of the accumulated balance of other comprehensive income (loss), separately from accumulated deficit and additional +paid-in capital, in the stockholders’ equity section of our balance sheet. +Fair Value of Financial Instruments +As of December 31, 2009, the carrying values of cash and cash equivalents, short-term investments, accounts receivable, +accounts payable and accrued expenses approximate their respective fair values based on their short-term nature. In addition, we believe the carrying value of our debt instruments, which do not have readily ascertainable market values, approximate +their fair values, given that the interest rates on outstanding borrowings approximate market rates. +Fair value measurements +of all financial assets and liabilities that are being measured and reported on a fair value basis are required to be classified and disclosed in one of the following three categories: +Level 1: +Unadjusted quoted prices in active markets that are accessible at the measurement date for identical, unrestricted assets or liabilities; +Level 2: +Quoted prices in markets that are not active, or inputs which are observable, either directly or indirectly, for substantially the full term of the asset or liability; +and +Level 3: +Prices or valuation techniques that require inputs that are both significant to the fair value measurement and unobservable (i.e., supported by little or no market activity). +All our available for sale securities were classified and measured as Level 1 instruments. +Reclassification +In response to a comment letter received from the SEC dated August 31, 2009, we reclassified our patent litigation settlement of $4.9 million received in January 2008 from Other Income in the Statement of Operations to a reduction of +operating expenses. +Recent Accounting Pronouncements +In April 2009, the FASB added additional disclosures requirements under FASB ASC 825-10-65 “Financial Instruments,” to require +disclosures about fair value of financial instruments in interim financial statements as well as in annual financial statements, effective for interim reporting periods ending after June 15, 2009. FASB ASC 825-10-65 also requires those +disclosures in summarized financial information in interim financial statements. These additional disclosure requirements did not have a material impact on our financial statements. +F-12 +Table of Contents +3. +INVENTORIES: +December 31, +2009 +2008 +Raw materials +$ +4,911,570 +$ +6,721,102 +Work in process +334,452 +390,259 +Finished goods +3,598,470 +3,592,727 +$ +8,844,492 +$ +10,704,088 +4. +PROPERTY AND EQUIPMENT: +December 31, +2009 +2008 +Land +$ +1,117,788 +$ +1,117,788 +Buildings and improvements +15,730,546 +15,571,279 +Machinery and equipment +14,705,102 +14,383,479 +Computer equipment and software +3,982,769 +3,791,012 +Furniture and fixtures +1,469,785 +1,455,965 +Construction in progress +772,840 +682,955 +37,778,830 +37,002,478 +Less accumulated depreciation +(17,764,364 +) +(15,767,111 +) +$ +20,014,466 +$ +21,235,367 +Depreciation expense was $2,395,202, $2,278,257, and $1,687,126 for 2009, 2008, and 2007, respectively. +5. +PATENTS, PRODUCT RIGHTS AND ACQUIRED IN-PROCESS TECHNOLOGY: +Patents product rights and licenses were as follows: +December 31, +2009 +2008 +HIV-related +$ +1,900,000 +$ +1,900,000 +HCV-related +— +4,500,000 +Lateral flow-related +1,500,000 +1,500,000 +Cryosurgery-related +2,548,620 +2,548,620 +5,948,620 +10,448,620 +Less accumulated amortization +(5,139,368 +) +(6,068,080 +) +$ +809,252 +$ +4,380,540 +Amortization expense for 2009, 2008, and 2007 was $542,913, $898,931, and $1,048,873, respectively. +Amortization expense for each of the three succeeding fiscal years is estimated as $294,000 in both 2010 and 2011 and +$221,252 in 2012. +In June 1998, we acquired the patents and exclusive worldwide distribution rights to our cryosurgical +product line. The purchase price of $2,548,620, including transaction costs, has been recorded as patents and product rights and is being amortized using the straight-line method over an estimated useful life of ten years. +F-13 +Table of Contents +In June 2004, we entered into a sublicense agreement with a third party, +pursuant to which we have been granted a limited, worldwide, non-exclusive sublicense to certain HIV-2 patents held by such party. The agreement required us to pay the third party a one-time non-refundable license fee of $900,000, which was recorded +as patent and product rights on our balance sheet and is being amortized through June 30, 2014. This agreement also contained an option to expand the application of this sublicense to other immunoassay platforms, in addition to our +OraQuick ® platform. In June 2006, we exercised this option, which required us to pay the third party a +non-refundable license fee of $600,000, in $200,000 increments in July of 2008, 2007, and 2006. We recognized this $600,000 license fee as acquired in-process technology, which was included in research and development expense in our 2006 statement +of operations, because other immunoassay platforms for the detection of HIV-2 will require additional research and development efforts and subsequent regulatory approvals. +In August 2005, we entered into a license agreement with third parties, pursuant to which we have been granted a +limited, personal, non-transferable, non-exclusive license related to certain Hepatitis C Virus (“HCV”) patents held by such parties. The agreement required us to pay the third parties a one-time non-refundable license fee of $1,500,000, +which was paid in August 2005. In December 2006, the first milestone was achieved and $3,000,000 was paid in 2007. In November 2008, we achieved a second milestone upon filing our OraQuick ® HCV pre-market approval application with the FDA and paid a $1,000,000 license fee. This fee was recognized as acquired in-process technology and included in research +and development expense in our 2008 statement of operations as additional research and development efforts and regulatory approval is required in order to commercialize this product in the U.S. domestic market. Under the terms of the license +agreement, we may also be required to pay additional license fees of up to $4,500,000, upon the achievement of specific development and/or commercial milestones. +Management’s intent in executing the HCV license agreement was to provide for various alternatives of the licensed patents, one of which was the marketing and sale of an existing rapid HCV test +supplied by a third party manufacturer in certain developing countries. Based on management’s estimate of the cash flows to be received from future product sales in these international markets, we capitalized both the $1,500,000 and $3,000,000 +payments. We were amortizing these amounts to cost of products sold on a straight-line basis over ten years, which represented management’s estimate of the remaining useful life of the licensed patents. +However, we have been unable to penetrate the international marketplace with this third-party’s rapid HCV test. In addition, given the +impact of the current global recession and the deteriorating status of certain third-world economies, we no longer believe that we will be successful in selling a third-party’s rapid HCV test in the foreseeable future. As a result, during the +second quarter of 2009, we recorded an impairment charge of $3,028,375 which represented the remaining net book value of the HCV license, patents and product rights. +In December 2006, we amended a license agreement with third parties, pursuant to which we have been granted a limited, non-exclusive license to certain lateral flow technology patents held by such +parties. The amendment provided for the renewal of our license to certain lateral flow patents held by these parties, the expansion of these patents to future product applications to be developed by us, and the settlement of prior royalty +obligations arising prior to the amendment date. It required us to pay the third parties a one-time non-refundable fee of $1,750,000 which was allocated based upon the relative fair values of the items contained in the agreement. Accordingly, at +December 31, 2006, we capitalized $1,000,000 as patent and product rights and are amortizing this amount to cost of products sold through December 2011. +6. +PREPAID EXPENSES AND OTHER NONCURRENT ASSETS: +In July 2009, we entered into a termination and release agreement with the third party from whom we purchased certain patents, trademarks, copyrights and technology related to our Histofreezer ® product line. Pursuant to this termination and release agreement, we made a one-time payment of $643,050 to this +third party in full consideration of the termination of the original asset purchase agreement we executed with this third party in June 1998, and its related royalty obligations, which extended until December 2011. We recorded this +F-14 +Table of Contents +payment, net of the royalties previously accrued, as prepaid royalties, which will be expensed in relation to Histofreezer ® revenues through December 31, 2011. +In August 2008, a complaint was filed against the Company in the US District Court for the District of New Jersey by Inverness Medical Innovations, Inc., and Inverness Medical Switzerland GmbH +(collectively, “Inverness”) and Church & Dwight Co. Inc., alleging that the Company’s OraQuick ADVANCE ® Rapid HIV-1/2 Antibody Test infringed US Patent No. 6,485,982 (the “’982 Patent”). In November 2009, the Company entered into a settlement +agreement with Inverness and Church & Dwight and the litigation was dismissed with prejudice. Under the settlement agreement, the Company made a $3,000,000 payment to Inverness. Inverness granted the Company nonexclusive, worldwide, +royalty-bearing, non-transferable and nonsublicensable (sub)licenses to certain patent rights, including the ’982 Patent. In addition, each party received limited supply and distribution rights to certain other products developed by the other +party. We allocated the $3,000,000 payment based upon the relative fair values of the litigation settlement, of which, $1,451,183 was immediately expensed in our statement of operations and $1,548,817 was recorded as prepaid royalties and will be +expensed to cost of goods sold, based on future OraQuick ® revenues through December 31, 2012. As of +December 31, 2009, $1,055,049 of prepaid royalties were included in other assets on the accompanying balance sheet with the balance in prepaid expenses. +7. +ACCRUED EXPENSES AND OTHER: +December 31, +2009 +2008 +Payroll and related benefits +$ +4,867,716 +$ +3,513,124 +Royalties +3,394,991 +2,481,466 +Deferred revenue +1,618,798 +1,951,921 +Professional fees +290,208 +472,969 +Advertising +— +365,313 +Clinical research obligations +658,605 +348,459 +Other +672,484 +1,662,703 +$ +11,502,802 +$ +10,795,955 +Deferred revenue includes customer prepayments of +$1,501,598 and $1,824,721 at December 31, 2009 and 2008, respectively. +8. +LONG-TERM DEBT: +December 31, +2009 +2008 +Note payable to bank, interest payable monthly at 4.15% through June 2011, at which time the remaining unpaid principal balance +is payable, secured by a first priority security interest in all of our assets. +$ +8,291,679 +$ +8,791,679 +Note payable to Pennsylvania Industrial Development Authority, interest at 2% monthly installments of principal and interest of +$4,893 through March 2010, secured by a second lien on one of our buildings. +9,761 +67,658 +8,301,440 +8,859,337 +Less current portion +(509,761 +) +(557,897 +) +$ +7,791,679 +$ +8,301,440 +F-15 +Table of Contents +At December 31, 2009, we had in place a $10,000,000 facility advance (the “Credit +Facility”) with Comerica Bank (“Comerica”). Pursuant to the terms of the facility advance, principal, and interest fixed at 4.15%, are payable monthly through June 2011, at which time the remaining unpaid principal balance is payable. +As of December 31, 2009, we had $8,291,679 in outstanding borrowings under this facility advance. +On June 29, 2009, +our $4,000,000 working capital line of credit with Comerica expired. We elected not to renew this working capital line of credit, since our Credit Facility matures in June 2011 and we had in excess of $79.0 million of cash, cash equivalents and +short-term investments available as of June 30, 2009 to fund our ongoing operation and capital needs. +All borrowings +under the Credit Facility are collateralized by a first priority security interest in all of our assets, including present and future accounts receivable, chattel paper, contracts and contract rights, equipment and accessories, general intangibles, +investments, instruments, inventories, and a mortgage on our three facilities in Bethlehem, Pennsylvania. The Credit Facility contains certain covenants that set forth minimum requirements for our quick ratio, liquidity, and tangible net worth. We +were in full compliance with all covenants at December 31, 2009. The Credit Facility also restricts our ability to pay dividends, to make certain investments, to incur additional indebtedness, to sell or otherwise dispose of a substantial +portion of assets, and to merge or consolidate operations with an unaffiliated entity, without the consent of Comerica. +The +maturities of our long-term debt as of December 31, 2009 are $509,761 in 2010 and $7,791,679 in 2011. +9. +INCOME TAXES: +The +components of the income tax provision (benefit) for the years ended December 31, 2009, 2008 and 2007 are as follows: +2009 +2008 +2007 +Current +Federal +$ +(631,688 +) +$ +9,590 +$ +137,520 +State +9,404 +212,494 +369,977 +(622,284 +) +222,084 +507,497 +Deferred +Federal +(2,115,338 +) +(3,200,853 +) +1,417,925 +State +(35,591 +) +(472,064 +) +(104,086 +) +(2,150,929 +) +(3,672,917 +) +1,313,839 +Change in valuation allowance +2,150,929 +25,978,167 +— +— +22,305,250 +1,313,839 +Total income tax provision (benefit) +$ +(622,284 +) +$ +22,527,334 +$ +1,821,336 +In November 2009, The Worker, Homeownership, and Business Assistance Act of 2009 was enacted. This new law +extended the carryback period for a net operating loss (“NOL”) from two years up to a maximum of five years. The carryback of the NOL can be applied to both regular tax NOLs and alternative minimum tax NOLs (“AMT NOL”). The new +law also eliminates the 90% limitation on the use of any AMT NOLs. As a result of the elimination of the 90% limitations, we have elected to carryback our 2008 AMT NOL to our 2007, 2006, and 2005 tax years and apply for a refund of the AMT taxes +paid for those years. As such, in the fourth quarter of 2009, we recorded a $632,000 federal and benefit associated with the AMT NOL carryback. +F-16 +Table of Contents +A reconciliation of the statutory United States federal income tax rate to our effective tax +rate for each of the years ended December 31, 2009, 2008, and 2007 is as follows: +2009 +2008 +2007 +Statutory U.S. federal income tax rate +34.0 +% +34.0 +% +34.0 +% +State income taxes, net of federal benefit +0.2 +2.8 +4.1 +Nondeductible expenses and other +(3.1 +) +(3.4 +) +11.0 +Research and development credits +1.8 +6.1 +(6.7 +) +Change in valuation allowance, federal and state +(25.5 +) +(297.0 +) +— +Effective tax rate +7.4 +% +(257.5 +)% +42.4 +% +Deferred income taxes reflect the tax effects of temporary differences between the basis of assets and +liabilities recognized for financial reporting purposes and tax purposes, and net operating loss and tax credit carryforwards. Significant components of our total deferred tax asset as of December 31, 2009 and 2008 are as follows: +2009 +2008 +Deferred tax assets (liabilities): +Net operating loss carryforwards +$ +18,740,789 +$ +17,006,767 +Inventory +1,047,607 +1,424,523 +Capitalized research and development costs +1,179,422 +1,445,495 +Accruals and reserves currently not deductible +1,185,360 +657,761 +Patent costs +2,078,303 +1,193,265 +Depreciation and amortization +(1,077,860 +) +(451,061 +) +Stock-based compensation +3,361,386 +3,240,047 +Research and development tax credit carryforward +980,410 +827,689 +Alternative minimum tax credit carryforwards +— +633,681 +Net deferred tax asset +27,495,417 +25,978,167 +Valuation allowance +(27,495,417 +) +(25,978,167 +) +Net deferred tax asset +$ +— +$ +— +In assessing the realizability of our net deferred tax asset, we consider all relevant positive and negative +evidence in determining whether it is more likely than not that some portion or all of the deferred income tax assets will not be realized. The realization of the gross deferred tax assets is dependent on several factors, including the generation of +sufficient taxable income prior to the expiration of the net operating loss (“NOL”) carryforwards. +Pursuant to FASB +accounting guidance, a cumulative loss in recent years is a significant piece of negative evidence to be considered when evaluating the need for a valuation allowance and this evidence is difficult to overcome. Based upon our pre-tax loss in 2008, +and our projection of a pre-tax loss in 2009, which would result in a net cumulative three-year loss and the volatility and uncertainty in the global economy, we determined that it was more likely than not that our net deferred tax assets would not +be realized in the immediate future. Accordingly, we recorded an income tax charge of $25,978,167 in the fourth quarter of 2008 to establish a full valuation allowance against our net deferred tax asset. During 2009 we continued to reevaluate our +valuation allowance position and believe that it is more likely than not that our deferred income tax asset will not be realized in the immediate future. As such, we maintained a full valuation allowance against our net deferred tax assets as of +December 31, 2009. +F-17 +Table of Contents +Our federal NOL carryforwards expire as follows: +Year of Expiration +NOLs +2011 +$ +5,765,731 +2017-2021 +30,428,371 +2022-2029 +17,925,009 +$ +54,119,111 +The Tax Reform Act of 1986 contains provisions that +limit the annual amount of NOLs available to be used in any given year in the event of a significant change in ownership. On September 29, 2000, two separate companies, STC Technologies, Inc. and Epitope, Inc., merged to form our Company. A +significant change in ownership, as defined by Section 382 of the Internal Revenue Code, occurred in connection with this merger. As such, the utilization of NOLs generated prior to September 29, 2000 is limited to approximately +$13,700,000 per year. We do not believe that this limitation will have a material adverse impact on the utilization of our NOL carryforwards in future years. +In July 2006, the FASB issued FASB Interpretation (“FIN”) No. 48, “Accounting for Uncertainty in Income Taxes—an Interpretation of FASB Statement No. 109,” which +clarifies what criteria must be met prior to recognition of the financial statement benefit of a position taken in a tax return. FIN No. 48 also provides guidance on derecognition of tax benefits, classification on the balance sheet, interest +and penalties, accounting in interim periods, disclosure and transition. We adopted FIN No. 48 effective January 1, 2007, and pursuant to its provisions, decided to classify interest and penalties as a component of tax expense. As a result +of the implementation of FIN No. 48, we recognized a $58,183 net increase in our liability for unrecognized tax benefits, which was accounted for as a reduction to the January 1, 2007 balance of retained earnings. +We had gross unrecognized tax benefits of $2,044,929 and $2,184,370 as of December 31, 2009 and 2008, respectively, which if +recognized, $2,019,203 and $2,151,345, respectively, would result in a reduction to our effective tax rate. Interest and penalties were immaterial at December 31, 2009 and 2008. As a result of our net operating loss carryforward position, we +are subject to audit by the Internal Revenue Service since our inception, as well as by several state jurisdictions for the years ended December 31, 2000 through 2009. +A reconciliation of the beginning and ending amount of unrecognized tax benefits is as follows: +2009 +2008 +2007 +Balance at January 1 +$ +2,184,370 +$ +2,370,526 +$ +2,370,300 +Additions based on tax positions related to the current period +10,121 +46,836 +40,000 +Additions for tax positions of prior periods +— +28,021 +60,226 +Reductions for tax positions of prior periods +(149,562 +) +(105,729 +) +(100,000 +) +Settlements +— +(155,284 +) +— +Balance at December 31 +$ +2,044,929 +$ +2,184,370 +$ +2,370,526 +10. +STOCKHOLDERS’ EQUITY: +Stock-Based Awards +We grant stock-based awards under the OraSure Technologies, Inc. 2000 Stock Award Plan, as +amended and restated (the “2000 Plan”). The 2000 Plan permits stock-based awards to employees, outside directors and consultants or other third-party advisors. Awards which may be granted under the 2000 Plan include qualified incentive +stock options, nonqualified stock options, stock appreciation rights, restricted awards, performance awards and other stock-based awards. We recognize compensation expense for stock option awards issued to +F-18 +Table of Contents +employees and directors on a straight-line basis over the requisite service period of the award. To satisfy the exercise of options or to issue new restricted stock, we normally issue new shares +rather than purchase shares on the open market. +Under the terms of the 2000 Plan, qualified incentive stock options for +shares of our common stock may be granted to eligible employees, including our officers. To date, options generally have been granted with ten-year exercise periods and an exercise price not less than the fair market value on the date of grant. +Options generally vest over four years, with one quarter of the options vesting one year after grant and the remainder vesting on a monthly basis over the next three years. The 2000 Plan also provides that nonqualified options may be granted at a +price not less than 75 percent of the fair market value of a share of common stock on the date of grant. The option term and vesting schedule of such awards may be either unlimited or have a specified period in which to vest and be exercised. +As of December 31, 2009, 3,031,540 shares were available for future grants under the 2000 Plan. +The fair value of each stock option was estimated on the date of the grant using the Black-Scholes option-pricing model using the following +weighted-average assumptions: +Year Ended +December 31, +Black-Scholes Option Valuation Assumptions +2009 +2008 +2007 +Risk-free interest rate (1) +1.50 +% +2.50 +% +4.79 +% +Expected dividend yield +— +— +— +Expected stock price volatility (2) +53 +% +46 +% +49 +% +Expected life of stock options (in years) (3) +4 +4 +4 +(1) +Based on the constant maturity interest rate of U.S. Treasury securities whose term is consistent with the expected life of our stock options. +(2) +Expected stock price volatility is based upon historical experience. +(3) +Expected life of stock options is based upon historical experience. +The weighted-average grant date fair value of stock options granted during the years ended December 31, 2009, 2008 and 2007 was $1.22, +$2.84 and $3.62, respectively. +Amounts recognized in the financial statements related to stock options were as follows: +Year Ended December 31, +2009 +2008 +2007 +Total compensation cost during the year +$ +1,314,014 +$ +2,103,259 +$ +2,953,307 +Amounts capitalized into inventory during the year +(55,381 +) +(142,965 +) +(303,472 +) +Amounts recognized in cost of products sold for amounts previously capitalized +128,805 +229,860 +280,283 +Amounts charged against income, before income tax benefit +$ +1,387,438 +$ +2,190,154 +$ +2,930,118 +Amount of related income tax benefit +$ +— +$ +— +$ +802,300 +The aggregate intrinsic value of options (the amount by which the market price of the stock on the date of +exercise exceeded the exercise price) exercised during the years ended December 31, 2009, 2008 and 2007 was $79,884, $31,037, and $1,284,319, respectively. +F-19 +Table of Contents +The following table summarizes the stock option activity under the 2000 Plan: +Options +Weighted-Average +Exercise Price +Per +Share +Weighted-Average +Remaining +Contractual Term +(in years) +Aggregate +Intrinsic +Value +Outstanding on January 1, 2007 +4,788,418 +$ +7.44 +Granted +519,566 +8.37 +Exercised +(481,647 +) +6.43 +Forfeited +(99,796 +) +8.22 +Outstanding on December 31, 2007 +4,726,541 +7.63 +Granted +604,049 +7.27 +Exercised +(14,786 +) +6.26 +Forfeited +(185,097 +) +7.86 +Outstanding on December 31, 2008 +5,130,707 +7.58 +Granted +681,708 +2.89 +Exercised +(30,911 +) +0.80 +Forfeited +(349,839 +) +6.61 +Balance, December 31, 2009 +5,431,665 +$ +7.09 +5.68 +$ +1,716,663 +Vested or expected to vest as of +December 31, 2009 +5,336,288 +$ +7.09 +5.68 +$ +1,686,519 +Exercisable on December 31, 2009 +4,484,524 +$ +7.64 +5.03 +$ +261,421 +As of December 31, 2009, there was $1,645,902 of +unrecognized compensation expense related to unvested option awards that is expected to be recognized over a weighted-average period of 1.8 years. +Net cash proceeds from the exercise of stock options were $24,807, $92,517 and $3,100,037 for the years ended December 31, 2009, 2008 and 2007, respectively. As a result of our net operating loss +carryforward position, no actual income tax benefit was realized from stock option exercises for these periods. +The following +table summarizes information about stock options outstanding at December 31, 2009: +Options outstanding +Options exercisable +Range of exercise prices +Number +Outstanding +Weighted- +average +remaining +life, in years +Weighted- +average +exercise +price +Number +exercisable +Weighted- +average +exercise +price +$2.55–$3.31 +554,790 +9.13 +$ +2.82 +— +$ +— +$3.34–$5.60 +817,871 +9.09 +4.86 +685,692 +5.03 +$5.76–$6.96 +837,280 +2.70 +6.50 +836,577 +6.50 +$6.98–$7.77 +672,965 +3.53 +7.52 +671,298 +7.52 +$7.90–$8.18 +477,692 +7.47 +8.05 +334,275 +8.05 +$8.20 +586,736 +4.04 +8.20 +586,736 +8.20 +$8.28–$8.97 +589,659 +6.25 +8.48 +518,063 +8.51 +$9.04–$9.56 +551,712 +5.86 +9.40 +509,341 +9.42 +$9.78–$10.99 +337,960 +2.51 +10.57 +337,542 +10.57 +$12.69 +5,000 +1.68 +12.69 +5,000 +12.69 +5,431,665 +5.68 +$ +7.09 +4,484,524 +$ +7.64 +F-20 +Table of Contents +The 2000 Plan also permits us to grant restricted shares of our common stock to eligible +employees, including officers, and our outside directors. Generally, these shares are nontransferable until vested and are subject to vesting requirements and/or forfeiture, as determined by the Compensation Committee of our Board of Directors. The +market value of these shares at the date of grant is recognized on a straight-line basis over the period during which the restrictions lapse. Compensation cost of $2,621,723, $3,352,876 and $2,877,463 related to restricted shares was recognized +during the years ended December 31, 2009, 2008 and 2007, respectively. +The following table summarizes restricted stock +award activity under the 2000 Plan: +Shares +Weighted-Average +Grant Date Fair +Value +Issued and unvested, January 1, 2007 +807,054 +$ +8.13 +Granted +348,655 +8.29 +Vested +(258,093 +) +7.91 +Forfeited +(14,655 +) +8.10 +Issued and unvested, December 31, 2007 +882,961 +8.24 +Granted +418,565 +7.83 +Vested +(393,551 +) +8.08 +Forfeited +(76,487 +) +8.31 +Issued and unvested, December 31, 2008 +831,488 +8.11 +Granted +429,870 +2.82 +Vested +(370,457 +) +8.39 +Forfeited +(71,024 +) +5.38 +Issued and unvested, December 31, 2009 +819,877 +$ +5.44 +Issued and expected to vest, December 31, 2009 +819,877 +$ +5.44 +As of December 31, 2009, there was $2,531,778 of +unrecognized compensation expense related to unvested restricted stock awards that is expected to be recognized over a weighted average period of 2.6 years. +In connection with the vesting of restricted shares during the years ended December 31, 2009, 2008 and 2007, we purchased and immediately retired 132,785, 135,432 and 90,446 shares with aggregate +values of $391,590, $995,367 and $785,908, respectively, in satisfaction of minimum tax withholding obligations. +Certain of +our share-based payment arrangements are vested stock options held by certain nonemployee consultants and are accounted for as liability-classified awards. The fair value of these awards is remeasured at each financial reporting date until the +awards are settled or expire. During 2007, $51,500 was reclassified from a liability to equity upon the settlement of 20,000 options. No options held by nonemployees were settled in 2009 or 2008. As of December 31, 2009 and 2008, $8,911 and +$11,985, respectively, was included in other liabilities for stock options to acquire 58,000 and 63,000 shares, respectively, of common stock which remain unexercised. For the years ended December 31, 2009, 2008 and 2007, the mark-to-market +adjustment recorded as a reduction of compensation costs in the statements of operations was $3,074, $137,332 and $27,608, respectively. +Share Repurchase Program +On August 5, 2008, our Board of Directors +approved a share repurchase program pursuant to which we are permitted to acquire up to $25,000,000 of our outstanding common shares. During the year ended December 31, 2009, we purchased and retired 108,293 shares of common stock at an average +price of $2.85 per share. During the year ended December 31, 2008, we purchased and retired 1,147,730 shares of common stock at an average price of $4.46 per share. +F-21 +Table of Contents +11. +COMMITMENTS AND CONTINGENCIES: +Sublicense Agreement +In June 2004, we entered into a sublicense agreement with a third party, pursuant to +which we have been granted a limited, worldwide, non-exclusive sublicense to certain HIV-2 patents held by such party. Under the terms of this sublicense agreement, we are obligated to pay royalties based on a percentage of our net sales of certain +products, which incorporate the technology covered by the licensed patents. Future minimum payments under this agreement are as follows: +2010 +$ +500,000 +2011 +500,000 +2012 +500,000 +2013 +500,000 +2014 +500,000 +Thereafter +1,791,667 +$ +4,291,667 +Royalties from our commercial sale of products covered +by the sublicense can be credited against these minimum royalty obligations. +License Agreement +In August 2005, we entered into a license agreement with third parties, pursuant to which we have been granted a limited, personal, +non-transferable, non-exclusive license related to certain HCV patents held by such parties. Under the terms of the HCV license agreement, we are also obligated to pay royalties based on our net sales of certain products which incorporate the +technology covered by the licensed patents. Royalties under the license agreement vary based upon the geographical territory where the product is sold. No minimum payments were required under this agreement in 2009 or are required thereafter. We +may, however, be required to pay additional license fees of up to $4,500,000, upon the achievement of specific development and/or commercial milestones. +Leases +We lease office and warehouse facilities under operating lease +agreements. Future payments required under these non-cancelable leases are $136,340 for 2010. +Rent expense for 2009, 2008 and +2007 was $181,124, $184,128, and $186,714, respectively. +Purchase Commitments +As of December 31, 2009, we had outstanding non-cancelable purchase commitments in the amount of $3,578,021 related to inventory, +capital expenditures, and other goods or services. +Employment Agreements +Under terms of employment agreements with certain executive officers, extending through 2011, we are required to pay each individual a base +salary for continuing employment with us. The agreements require payments of $1,526,000 and $262,500 in 2010 and 2011, respectively. +Litigation +From time-to-time, we are involved in certain legal actions arising in the ordinary course of +business. In management’s opinion, based upon the advice of counsel, the outcome of such actions are not expected to have a material adverse effect on our future financial position or results of operations. +F-22 +Table of Contents +12. +RETIREMENT PLANS: +Substantially all of our employees are eligible to participate in the OraSure Technologies, Inc. 401(k) Plan (the “401(k) Plan”). The 401(k) Plan permits voluntary employee contributions to be excluded from an employee’s +current taxable income under provisions of Internal Revenue Code Section 401(k) and the regulations thereunder. The 401(k) Plan also provides for us to match employee contributions up to $4,000 per year. Contributions to the 401(k) Plan, net of +forfeitures, were $563,017, $579,592, and $477,390 in 2009, 2008, and 2007, respectively. +13. +OTHER INCOME: +In January +2008, we entered into a settlement and license agreement with Merck to resolve our patent infringement litigation against Merck. Under the terms of the agreement, Merck was required to make a payment of $4,883,714 to us. This payment was received +during the first quarter of 2008 and recorded as a reduction of operating expenses. +In January 2007, we sold our shares in a +privately-held nonaffiliated company that had a carrying value of $337,252 and we received $1,765,943 for our ownership interest. Accordingly, in 2007, we recorded a $1,428,691 pre-tax gain on the sale of this investment in other income. +14. +GEOGRAPHIC INFORMATION: +We believe we operate within one reportable segment. Our products are sold principally in the United States and Europe. Segmentation of operating income and identifiable assets is not applicable since our revenues outside the United States +are export sales, and we do not have significant operating assets outside the United States. +The following table represents +total revenues by geographic area, based on the location of the customer (amounts in thousands): +2009 +2008 +2007 +United States +$ +62,209 +$ +57,391 +$ +64,587 +Europe +6,592 +7,746 +9,618 +Other regions +8,225 +5,967 +8,481 +$ +77,026 +$ +71,104 +$ +82,686 +F-23 +Table of Contents +15. +QUARTERLY DATA (Unaudited): +The following tables summarize the quarterly results of operations for each of the quarters in 2009 and 2008. These quarterly results are unaudited, but in the opinion of management, have been prepared on the same basis as our audited +financial information and include all adjustments (consisting only of normal recurring adjustments) necessary for a fair presentation of the information set forth herein (all amounts in thousands, except per share amounts). +2009 Results +Three months ended +Year ended +December 31, +2009 +March 31, +2009 +June 30, +2009 +September 30, +2009 +December 31, +2009 +Revenues +$ +17,256 +$ +17,274 +$ +21,609 +$ +20,887 +$ +77,026 +Costs and expenses +19,116 +22,579 +19,834 +24,289 +85,818 +Operating income (loss) +(1,860 +) +(5,305 +) +1,775 +(3,402 +) +(8,792 +) +Other income (expense), net +242 +145 +24 +(54 +) +357 +Income (loss) before income taxes +(1,618 +) +(5,160 +) +1,799 +(3,456 +) +(8,435 +) +Income tax benefit +— +— +— +(622 +) +(622 +) +Net income (loss) +$ +(1,618 +) +$ +(5,160 +) +$ +1,799 +$ +(2,834 +) +$ +(7,813 +) +Earnings (loss) per share +Basic +$ +(0.04 +) +$ +(0.11 +) +$ +0.04 +$ +(0.06 +) +$ +(0.17 +) +Diluted +$ +(0.04 +) +$ +(0.11 +) +$ +0.04 +$ +(0.06 +) +$ +(0.17 +) +2008 Results +Three months ended +Year ended +December 31, +2008 +March 31, +2008 +June 30, +2008 +September 30, +2008 +December 31, +2008 +Revenues +$ +18,089 +$ +18,946 +$ +16,860 +$ +17,209 +$ +71,104 +Costs and expenses +16,216 +22,754 +20,200 +23,381 +82,551 +Operating income (loss) +1,873 +(3,808 +) +(3,340 +) +(6,172 +) +(11,447 +) +Other income, net +861 +744 +587 +507 +2,699 +Income (loss) before income taxes +2,734 +(3,064 +) +(2,753 +) +(5,665 +) +(8,748 +) +Income tax provision (benefit) +732 +(820 +) +(991 +) +23,606 +22,527 +Net income (loss) +$ +2,002 +$ +(2,244 +) +$ +(1,762 +) +$ +(29,271 +) +$ +(31,275 +) +Earnings (loss) per share (1) +Basic +$ +0.04 +$ +(0.05 +) +$ +(0.04 +) +$ +(0.64 +) +$ +(0.67 +) +Diluted +$ +0.04 +$ +(0.05 +) +$ +(0.04 +) +$ +(0.64 +) +$ +(0.67 +) +(1) +The summation of the quarterly amounts may not equal the year-end amounts due to the use of weighted-average shares for each period. +16. +SUBSEQUENT EVENTS: +In January 2010, we entered into an agreement with the supplier of HIV peptides used in the manufacture of our OraQuick HIV 1/2 test. This agreement was executed in connection with the supplier’s bankruptcy and terminated our +obligation to exclusively purchase peptides from the supplier and pay royalties on worldwide sales of our OraQuick ® +tests. Pursuant to this agreement, we made a one-time payment of $2.1 million to the supplier in full consideration of the termination of the original agreement with this supplier and satisfaction of our royalty and purchase obligations. We +also received a fully paid-up worldwide, non-exclusive license to the supplier’s patent rights related to the peptides. We recorded the payment, net of royalties previously accrued, as prepaid royalties, which will be expensed in relation to +OraQuick ® sales through June 30, 2011. +F-24 +Table of Contents +INDEX TO EXHIBITS +Exhibit +Number +Exhibit +3.1.1 +Certificate of Incorporation of OraSure Technologies, Inc. is incorporated by reference to Exhibit 3.1 to the Company’s Registration Statement on Form S-4 (No. 333-39210), +filed June 14, 2000. +3.1.2 +Certificate of Amendment to Certificate of Incorporation dated May 23, 2000 is incorporated by reference to Exhibit 3.1.1 to the Company’s Registration Statement on Form S-4 +(No. 333-39210), filed June 14, 2000. +3.1.3 +Certificate of Designation of Series A Preferred Stock of OraSure Technologies (filed as Exhibit A to the Rights Agreement referred to in Exhibit 4.1). +3.2 +Bylaws of OraSure Technologies, amended and restated as of August 18, 2008, are incorporated by reference to Exhibit 3 to the Company’s Current Report on Form 8-K filed August +22, 2008. +4.1 +Rights Agreement, dated as of May 6, 2000, between OraSure Technologies, Inc. and ChaseMellon Shareholder Service, L.L.C. (now called BNY Mellon Shareowner Services), as Rights +Agent, is incorporated by reference to Exhibit 4.2 to Amendment No. 1 to the Company’s Registration Statement on Form S-4 (No. 333-39210), filed August 8, 2000. +10.1 +Form of Indemnification Agreement (and list of parties to such agreement) is incorporated by reference to Exhibit 10.1 to Amendment No. 3 to the Company’s Registration +Statement on Form S-4 (No. 333-39210), filed August 30, 2000.* +10.2 +Employment Agreement, dated as of June 22, 2004, between OraSure Technologies, Inc. and Douglas A. Michels, is incorporated by reference to Exhibit 10.3 to the Company’s +Quarterly Report on Form 10-Q for the quarter ended June 30, 2004.* +10.3 +Amendment No. 1 to Employment Agreement, dated as of December 16, 2008, between the Company and Douglas A. Michels, is incorporated by reference to Exhibit 10.2 to the +Company’s Current Report on Form 8-K filed December 19, 2008.* +10.4 +Employment Agreement, dated as of July 1, 2004, between OraSure Technologies, Inc. and Ronald H. Spair, is incorporated by reference to Exhibit 10.4 to the Company’s Quarterly +Report on Form 10-Q for the quarter ended June 30, 2004.* +10.5 +Amendment No. 1 to Employment Agreement, dated as of December 16, 2008, between the Company and Ronald H. Spair, is incorporated by reference to Exhibit 10.3 to the Company’s +Current Report on Form 8-K filed December 19, 2008.* +10.6 +Employment Agreement, dated September 23, 2005, between OraSure Technologies, Inc. and Stephen R. Lee, Ph.D., is incorporated herein by reference to Exhibit 99 to the Company’s +Current Report on Form 8-K filed September 28, 2005.* +10.7 +Amendment No. 1 to Employment Agreement, dated as of December 16, 2008, between the Company and Stephen R. Lee, Ph.D., is incorporated by reference to Exhibit 10.5 to the +Company’s Current Report on Form 8-K filed December 19, 2008.* +10.8 +Employment Agreement, dated as of July 1, 2004, between OraSure Technologies, Inc. and P. Michael Formica, is incorporated by reference to Exhibit 10.5 to the Company’s +Quarterly Report on Form 10-Q for the quarter ended June 30, 2004.* +10.9 +Amendment No. 1 to Employment Agreement, dated as of December 16, 2008, between the Company and P. Michael Formica, is incorporated by reference to Exhibit 10.4 to the +Company’s Current Report on Form 8-K filed December 19, 2008.* +10.10 +Employment Agreement, dated as of July 1, 2004, between OraSure Technologies, Inc. and Jack E. Jerrett, is incorporated by reference to Exhibit 10.7 to the Company’s +Quarterly Report on Form 10-Q for the quarter ended June 30, 2004.* +Table of Contents +Exhibit +Number +Exhibit +10.11 +Amendment No. 1 to Employment Agreement, dated as of December 16, 2008, between the Company and Jack E. Jerrett, is incorporated by reference to Exhibit 10.6 to the +Company’s Current Report on Form 8-K filed December 19, 2008.* +10.12 +Employment Agreement, dated as of October 2, 2006, between Mark L. Kuna and OraSure Technologies, Inc., is incorporated by reference to Exhibit 99.1 to the Company’s Current +Report on Form 8-K filed October 5, 2006.* +10.13 +Amendment No. 1 to Employment Agreement, dated as of December 16, 2008, between the Company and Mark L. Kuna, is incorporated by reference to Exhibit 10.7 to the Company’s +Current Report on Form 8-K filed December 19, 2008.* +10.14 +Description of Non-employee Director Compensation Policy, as amended as of February 1, 2007, is incorporated by reference to Exhibit 10.9 to the Company’s Annual Report on Form +10-K for the year ended December 31, 2007.* +10.15 +Description of Non-employee Director Compensation Policy, as amended as of February 15, 2010.* +10.16 +Amended and Restated Epitope, Inc. 1991 Stock Award Plan is incorporated by reference to Exhibit 10.9 to the Company’s Annual Report on Form 10-K for the year ended December +31, 2002.* +10.17 +OraSure Technologies, Inc. Employee Incentive and Non-Qualified Stock Option Plan, as amended and restated effective September 29, 2000, is incorporated by reference to Exhibit +10.12 to the Company’s Annual Report on Form 10-K for the year ended December 31, 2000.* +10.18 +OraSure Technologies, Inc. 2000 Stock Award Plan, as amended and restated effective as of May 13, 2008, is incorporated by reference to Exhibit 10 to the Company’s Current +Report on Form 8-K filed May 19, 2008.* +10.19 +Form of Restricted Share Grant Agreement (Officers and Employees) is incorporated by reference to Exhibit 10.2.1 to the Company’s Quarterly Report on Form 10-Q for the quarter +ended June 30, 2004.* +10.20 +Form of Restricted Share Grant Agreement (Non-Employee Directors) is incorporated by reference to Exhibit 10.19 to the Company’s Annual Report on Form 10-K for the year ended +December 31, 2008.* +10.21 +Incentive Stock Option General Terms and Conditions (Officers and Employees) is incorporated by reference to Exhibit 10.12 to the Company’s Annual Report on Form 10-K for the +year ended December 31, 2004.* +10.22 +Nonqualified Stock Option Award General Terms and Conditions (Officers and Employees) is incorporated by reference to Exhibit 10.13 to the Company’s Annual Report on Form 10-K +for the year ended December 31, 2004.* +10.23 +Nonqualified Stock Option Award General Terms and Conditions (Non-Employee Directors) is incorporated by reference to Exhibit 10.14 to the Company’s Annual Report on Form 10-K +for the year ended December 31, 2004.* +10.24 +Description of the OraSure Technologies, Inc. 2010 Management Incentive Plan is incorporated by reference to Item 5.02 to the Company’s Current Report on Form 8-K filed +February 19 2010.* +10.25 +Description of the OraSure Technologies, Inc. 2009 Self-Funding Management Incentive Plan is incorporated by reference to Item 5.02 to the Company’s Current Report on Form 8-K +filed February 24, 2009.* +10.26 +Description of the OraSure Technologies, Inc. 2010 Stock Award Guidelines is incorporated by reference to Item 5.02 to the Company’s Current Report on Form 8-K filed +February 19, 2010.* +Table of Contents +Exhibit +Number +Exhibit +10.27 +Description of the OraSure Technologies, Inc. 2009 Stock Award Guidelines is incorporated by reference to Item 5.02 to the Company’s Current Report on Form 8-K filed February +24, 2009.* +10.28 +Loan and Security Agreement, dated as of September 10, 2002, between Comerica Bank—California and OraSure Technologies, Inc., is incorporated by reference to Exhibit 10.1 to +the Company’s Quarterly Report on Form 10-Q for the quarter ended September 30, 2002. +10.29 +First Amendment to Loan and Security Agreement, dated as of May 23, 2003, between OraSure Technologies, Inc. and Comerica Bank—California, is incorporated by reference to +Exhibit 10.24 to the Company’s Annual Report on Form 10-K for the year ended December 31, 2003. +10.30 +Second Amendment to Loan and Security Agreement, dated as of September 12, 2003, between OraSure Technologies, Inc. and Comerica Bank, is incorporated by reference to Exhibit 99.1 +to the Company’s Current Report on Form 8-K, dated September 17, 2003. +10.31 +Third Amendment to Loan and Security Agreement, dated as of April 21, 2005, between OraSure Technologies, Inc. and Comerica Bank, is incorporated by reference to Exhibit 10 to the +Company’s Current Report on Form 8-K filed April 27, 2005. +10.32 +Fourth Amendment to Loan and Security Agreement, dated as of June 27, 2006, between OraSure Technologies, Inc. and Comerica Bank, is incorporated by reference to Exhibit 10 to the +Company’s Current Report on Form 8-K filed June 30, 2006. +10.33 +Fifth Amendment to Loan and Security Agreement, dated as of June 28, 2007, between OraSure Technologies, Inc. and Comerica Bank, is incorporated by reference to Exhibit 10 to the +Company’s Current Report on Form 8-K filed July 5, 2007. +10.34 +Settlement Agreement, effective as of November 17, 2009, by and among Inverness Medical Innovations, Inc., Inverness Medical Switzerland GmbH and OraSure Technologies, +Inc. +10.35 +License Agreement, effective as of November 17, 2009, by and among Inverness Medical Innovations, Inc., Inverness Medical Switzerland GmbH and OraSure Technologies, +Inc.** +23 +Consent of KPMG LLP, Independent Registered Public Accounting Firm. +24 +Powers of Attorney. +31.1 +Certification of Douglas A. Michels required by Rule 13a-14(a) or Rule 15d-14(a) under the Securities Exchange Act of 1934, as amended. +31.2 +Certification of Ronald H. Spair required by Rule 13a-14(a) or Rule 15d-14(a) under the Securities Exchange Act of 1934, as amended. +32.1 +Certification of Douglas A. Michels required by Rule 13a-14(b) or Rule 15a-14(b) under the Securities Exchange Act of 1934, as amended, and 18 U.S.C. Section 1350, as Adopted +Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. +32.2 +Certification of Ronald H. Spair required by Rule 13a-14(b) or Rule 15a-14(b) under the Securities Exchange Act of 1934, as amended, and 18 U.S.C. Section 1350, as Adopted Pursuant +to Section 906 of the Sarbanes-Oxley Act of 2002. +* +Management contract or compensatory plan or arrangement. +** +Portions of this exhibit were omitted pursuant to an application for confidential treatment and filed separately with the Securities and Exchange Commission. \ No newline at end of file diff --git a/raw/filings/0001116463/2009/0001193125-10-057039/filing_metadata.csv b/raw/filings/0001116463/2009/0001193125-10-057039/filing_metadata.csv new file mode 100644 index 0000000000000000000000000000000000000000..a80fcac49fca0075c22c940ec720f3199ff2c4a9 --- /dev/null +++ b/raw/filings/0001116463/2009/0001193125-10-057039/filing_metadata.csv @@ -0,0 +1,2 @@ +cik,ticker,company_name,form,filing_date,report_date,acceptance_datetime,accession_number,primary_document,primary_doc_description,size,is_xbrl,is_inline_xbrl,document_url,filing_index_url,year,fiscal_year,is_primary_filing +0001116463,OSUR,ORASURE TECHNOLOGIES INC,10-K,2010-03-15,2009-12-31,2010-03-15T20:19:00.000Z,0001193125-10-057039,d10k.htm,FORM 10-K,1574057,0,0,https://www.sec.gov/Archives/edgar/data/1116463/000119312510057039/d10k.htm,https://www.sec.gov/Archives/edgar/data/1116463/000119312510057039/,2009,2009,1 diff --git a/raw/filings/0001116463/2009/0001193125-10-057039/item1.txt b/raw/filings/0001116463/2009/0001193125-10-057039/item1.txt new file mode 100644 index 0000000000000000000000000000000000000000..e25d5e256d8778520aa676ef10fdac4dfef848db --- /dev/null +++ b/raw/filings/0001116463/2009/0001193125-10-057039/item1.txt @@ -0,0 +1,554 @@ +ITEM 1. Business. +Our business principally involves the development, manufacture, marketing and sale of oral fluid diagnostic products and +specimen collection devices using our proprietary oral fluid technologies, as well as other diagnostic products including immunoassays and other in vitro diagnostic tests that are used on other specimen types, and other medical devices used +for the removal of benign skin lesions by cryosurgery or freezing. Our diagnostic products include tests which are performed on a rapid basis at the point of care and tests which are processed in a laboratory. These products are sold in the United +States and internationally to various clinical laboratories, hospitals, clinics, community-based organizations and other public health organizations, distributors, government agencies, physicians’ offices, and commercial and industrial +entities. One of our products is sold in the over-the-counter (“OTC”) or consumer retail markets in North America, Europe, Central and South America, and Australia. +In vitro diagnostic testing is the process of analyzing oral fluid, blood, urine and other bodily fluids or tissue for the presence +of specific substances or markers for infectious diseases, drugs of abuse or other conditions. We have targeted the use of oral fluid in our products as a differentiating factor and believe that it provides a significant competitive advantage over +blood and urine. Our oral fluid tests have sensitivity and specificity comparable to blood and/or urine tests. When combined with their ease of use, non-invasive nature, and cost effectiveness, our oral fluid tests represent a very competitive +alternative to the more traditional testing methods in the diagnostic space. +Our Company was formed in May 2000 under +Delaware law solely for the purposes of combining two companies, STC Technologies, Inc. (“STC Technologies”) and Epitope, Inc. (“Epitope”), and changing the state of incorporation of Epitope from Oregon to Delaware. STC +Technologies and Epitope were merged into our Company on September 29, 2000. Our principal offices are located at 220 East First Street, Bethlehem, Pennsylvania 18015, and our telephone number is (610) 882-1820. +Additional information about us can be found on our website. Our website address is www.orasure.com . We make available free of charge +through a link provided at such website our Annual Reports on Form 10-K, our Quarterly Reports on Form 10-Q, our Current Reports on Form 8-K and our other filings with the Securities and Exchange Commission (“SEC”), as well as any +amendments to those Reports and filings. These Reports and filings are made available as soon as reasonably practicable after they are filed or furnished to the SEC. Our Internet website and the information contained in or connected to that website +are not intended to be incorporated by reference into this Annual Report. +1 +Table of Contents +Products +The following is a summary of our principal products and their regulatory and commercial status: +Product +Description +Regulatory Status +Commercial Status +OraQuick +ADVANCE ® +HIV-1/2 +A rapid, point-of-care test for antibodies to the Human Immunodeficiency Virus Type 1 (“HIV-1”) and Type 2 (“HIV-2” and together with HIV-1, “HIV-1/2”) +that can be visually read at the point of care in approximately 20 minutes. +Premarket approval (“PMA”) by the U.S. Food and Drug Administration (“FDA”) for use with oral fluid, finger-stick +and venous whole blood, and plasma. +CLIA (Clinical Laboratory Improvement Amendments of 1988) waived for use with oral fluid, finger-stick and +venous whole blood. Twelve-month shelf life approved in December 2008. +Marketed +CE mark (European Union) approved. Also registered in various countries. +Marketed +OraQuick ® HIV-1/2 OTC +A rapid, point-of-care oral fluid HIV-1/2 test intended to be sold in various OTC markets. +Clinical trials are in process. Data from observed user study submitted to FDA. +Not Marketed +OraQuick ® HCV +A rapid, point-of-care test for antibodies to the hepatitis C virus (“HCV”). +CE mark (European Union) approved. Individual country registrations in process. +Marketed +PMA submitted to FDA. Additional clinical studies are in process. +Not Marketed +OraSure ® +Oral fluid collection device for the detection of antibodies to HIV-1 in an oral fluid sample in a laboratory setting. +PMA approved by FDA. +Marketed +FDA 510(k) cleared for use in detecting cocaine and cotinine (an indicator of nicotine) in oral fluid. +Marketed +CE marked and registered in various countries. +Marketed +Intercept ® +Oral fluid collection device, along with nine related immunoassays, for oral fluid drugs of abuse (“DOA”) testing in a laboratory setting. +Collection device—FDA 510(k) cleared. +Marketed +MICRO-PLATE DOA Assays +Used to detect the following drugs in an oral fluid sample: marijuana, cocaine, opiates, amphetamines, methamphetamines, PCP, benzodiazepines, barbiturates and +methadone. +Nine drug assays—FDA 510(k) cleared. +Marketed +Intercept ® device and various assays CE marked and +registered in certain countries. +Marketed +Homogeneous DOA Assays +Homogeneous fully-automated oral fluid DOA assays jointly developed with Roche Diagnostics for use with Intercept ® collection device. +510(k) applications submitted to FDA for opiates, amphetamines, methamphetamines and PCP. +Not Marketed +2 +Table of Contents +Product +Description +Regulatory Status +Commercial Status +Cryosurgical Systems—Professional +Cryosurgical (freezing) system for the removal of warts and other benign skin lesions, marketed under the Histofreezer ® tradename primarily to the physicians’ office market. +Nine indications—FDA 510(k) cleared. +Marketed +CE marked and registered in certain countries. +Marketed +Cryosurgical Systems—OTC +Cryosurgical system for the removal of common and plantar warts, sold in various OTC markets. +FDA 510(k) cleared. Sold under Freeze ‘n Clear Skin Clinic ™ brand. +Marketed +Registered in Canada. +Marketed +CE marked and registered in certain countries under Scholl Freeze Spray ® and POINTTS ® names. +Marketed +In addition to the above products, we also sell certain immunoassay tests and reagents for insurance risk assessment, substance abuse testing and forensic toxicology applications; an oral fluid Western blot HIV-1 confirmatory test for +confirming positive HIV-1 test results obtained from the use of our OraSure ® collection device; and the FDA +510(k) cleared Q.E.D. ® rapid point-of-care saliva alcohol test. +OraQuick ® Rapid HIV Test +OraQuick ® is our rapid test platform designed to test oral fluid, whole blood (i.e., both finger-stick +and venous), plasma and serum samples for the presence of various antibodies or analytes. The device uses a porous flat pad to collect an oral fluid specimen. After collection, the pad is inserted into a vial containing a pre-measured amount of +developer solution and allowed to develop. When whole blood or plasma is to be tested, a loop collection device is used to collect a drop of blood or plasma and mix it in the developer solution, after which the collection pad is inserted into the +solution and allowed to develop. In all cases, the specimen and developer solution then flow through the testing device where test results are observable in approximately 20 minutes. The OraQuick ® device is a screening test and generally requires a confirmation test where an initial positive result is obtained. +We have commercialized this technology in the form of our OraQuick ADVANCE ® rapid HIV-1/2 antibody test. This is a rapid, point-of-care test which has received FDA approval for the detection +of antibodies to both HIV-1 and HIV-2 in oral fluid, finger-stick whole blood, venous whole blood and plasma. This test is available for use by laboratories located in the United States certified under the Clinical Laboratory Improvements Amendment +of 1988 (“CLIA”) to perform moderately complex tests. We have also received a CLIA waiver for use of the OraQuick ADVANCE ® test with oral fluid and finger-stick and venous whole blood. As a result, the test can be used by numerous additional sites in the United States not certified under +CLIA to perform moderately complex tests, such as outreach clinics, community-based organizations and physicians’ offices. +On the international front, we have obtained a CE mark for our OraQuick ADVANCE ® test so that we can sell this product in Europe and other countries accepting the CE mark for commercialization. We have distributors in place for certain countries +and are seeking to expand our distribution network for this product throughout the world. +In late 2008, +the FDA approved our request to increase the shelf life for OraQuick ADVANCE ® to twelve months from the +date of manufacture. This approval was based on enhancements we made to the manufacturing process and product packaging for this product and represented a substantial increase in shelf life from the six months approved for the OraQuick +ADVANCE ® test then on the market. OraQuick ® product with twelve month dating became available in the U.S. market in February 2009. In June 2008, we began to sell OraQuick ® tests with twelve month dating in certain international markets and received approval for the new dating in Europe. +Additional real-time stability testing is being performed for this product, and we expect to seek future approval for shelf life extensions beyond 12 months in both the U.S. and international markets. +3 +Table of Contents +We believe that the OraQuick ADVANCE ® device, because it is approved for detecting antibodies to both HIV-1 and HIV-2 in finger-stick and venous whole +blood, oral fluid and plasma samples, provides a significant competitive advantage in the market for rapid HIV testing in the United States and elsewhere around the world. We also believe the twelve month shelf life approved by the FDA further +strengthens the competitiveness of this product. +OraSure ® /Intercept ® +Collection Devices +Our OraSure ® oral fluid collection device is used in conjunction with screening and confirmatory tests for HIV-1 antibodies and other analytes. This device consists of a small, +treated cotton-fiber pad on a handle that is placed in a person’s mouth for two to five minutes. The device collects oral mucosal transudate (“OMT”), a serum-derived fluid that contains higher concentrations of certain antibodies and +analytes than saliva. As a result, OMT testing is a highly accurate method for detecting HIV-1 infection and other analytes. +We believe that oral fluid testing has several significant advantages over blood or urine-based systems for infectious disease testing, for both health care professionals and the individuals being tested. These advantages include +eliminating the risk of needle-stick accidents, providing a non-invasive collection technique, requiring minimal training to administer, providing rapid and efficient collection in almost any setting, and reducing the cost of administration by a +trained health care professional. +HIV-1 antibody detection using the OraSure ® collection device involves three steps: +• +Collection of an oral fluid specimen using the OraSure ® device; +• +Screening of the specimen for HIV-1 antibodies at a laboratory with an enzyme immunoassay (“EIA”) screening test approved by the FDA for use +with the OraSure ® device; and +• +Laboratory confirmation of any positive screening test results with our oral fluid Western blot HIV-1 confirmatory test (described below). +A trained health care professional then conveys test results and provides appropriate counseling to the individual who was +tested. +In past years, the HIV-1 EIA test approved by the FDA for use with our OraSure ® device was manufactured and sold by bioMerieux, Inc. (“BMX”). In 2007, however, BMX discontinued this +product. During 2009, Avioq, Inc., a company that had acquired a license from BMX to manufacture and sell a new HIV-1 EIA test originally developed by BMX, obtained FDA approval of this new product for use with the OraSure ® test. This new HIV-1 EIA is now commercially available to our OraSure ® customers. +A collection device that is substantially similar to the OraSure ® device is sold by us under the name +Intercept ® , and is used to collect OMT for oral fluid drug testing. We have received FDA 510(k) clearance to use +the Intercept ® collection device with laboratory-based EIAs to test for drugs of abuse commonly identified by +the National Institute for Drug Abuse (“NIDA”) as the NIDA-5 (i.e., cannabinoids (marijuana), cocaine, opiates, amphetamines/methamphetamines and phencyclidine (“PCP”)), and for barbiturates, methadone and benzodiazepines. Each +of these EIAs is also FDA 510(k) cleared for use with the Intercept ® device. +We have received a CE mark for the Intercept ® and OraSure ® devices and our +oral fluid assays, all of which are distributed in Canada, the United Kingdom and Mexico. The OraSure ® device +and our oral fluid drugs of abuse assays are also sold in several other foreign countries. +We believe +that the Intercept ® device has several advantages over competing urine and other drugs-of-abuse testing +products, including its lower total testing cost, its non-invasive nature, mobility and accuracy, the ease of maintaining a chain-of-custody, the treatment of test subjects with greater dignity, no requirement for specially-prepared collection +facilities and difficulty of sample adulteration. The availability of an oral fluid test is intended to allow our customers to test for drug impairment, eliminate scheduling costs and inconvenience, and thereby streamline the testing process. +4 +Table of Contents +Cryosurgical Systems (Skin Lesion Removal Products) +The Histofreezer ® cryosurgical removal system is a low-cost alternative to liquid nitrogen and other methods for removal of warts and other benign skin lesions by physicians. The +Histofreezer ® product mixes three environmentally friendly cryogenic gases in a small aerosol canister. When +released, these gases are delivered to a specially designed foam bud, cooling the bud to a maximum of –50°C to –55°C. The frozen bud is then applied to the wart or lesion for 15 to 40 seconds (depending on the type of lesion) +creating localized destruction of the target area by freezing. We have received 510(k) clearance for use of the Histofreezer ® product to remove common warts and eight other types of benign skin lesions, and this product has been CE marked and registered for distribution in Canada, throughout +Europe and in certain other foreign countries. +We have also received FDA 510(k) clearance to market and +sell a cryosurgical product similar to the Histofreezer ® product in the OTC or retail market for the removal of +common and plantar warts only. This product was initially sold in the United States and Canadian OTC markets by a third party distributor under that party’s trade name. As a result of the termination of our agreement with this party on +December 31, 2007, we re-launched our OTC cryosurgical wart product in the U.S. in 2009 under our own new national brand called Freeze ‘n Clear Skin Clinic™. +Internationally, we distribute an OTC cryosurgical product through our distributor Genomma Labs, under the POINTTS tradename, in Mexico and +a number of South and Central American countries. We also distribute a CE marked cryosurgical wart removal product into the OTC footcare market in Europe, Australia and New Zealand through our distributor, SSL International plc (“SSL”), +under the Scholl and Dr. Scholl trademarks. SSL is the owner of the Scholl and Dr. Scholl trademarks in countries outside North and South America. +Immunoassay Tests and Reagents +We develop and sell +immunoassay tests in two formats, known as MICRO-PLATE and AUTO-LYTE ® , to meet the specific needs of our +customers. +In a MICRO-PLATE kit, the sample to be tested is placed into a small plastic receptacle, +called a microwell, along with the reagents. The result of the test is determined by the color of the microwell upon completion of the reaction. Controlling the reaction involves the use of reagents by laboratory personnel. Test results are analyzed +by any of a variety of commercially available laboratory instruments, which we may also provide to our laboratory customers. MICRO-PLATE tests can be performed on commonly used instruments and can detect drugs in urine, serum and sweat specimens. +MICRO-PLATE tests are also used as part of the Intercept ® product line to detect drugs of abuse in oral fluid +specimens. +AUTO-LYTE ® tests are sold in the form of bottles of liquid reagents. These reagents are run on commercially available laboratory-based automated analytical instruments, which +are manufactured by a variety of third parties. AUTO-LYTE ® is typically used in high volume, automated, +commercial reference insurance laboratories to detect certain drugs or chemicals in urine. Test results are produced quickly, allowing for high throughput. Our AUTO-LYTE ® tests continue to face strong competition from cheaper “home-brew” tests developed internally by our laboratory customers. As a result, we expect to +eventually stop selling our AUTO-LYTE ® tests. +Western blot HIV-1 Confirmatory Test +We sell an oral fluid Western blot HIV-1 confirmatory test that received premarket approval from the FDA in 1996. This +test uses the original specimen collected with the OraSure ® oral fluid collection device to confirm positive +results of initial oral fluid HIV-1 EIA screening tests. Our oral fluid Western blot HIV-1 confirmatory test was previously marketed under an exclusive arrangement with BMX. +At the end of 2007, BMX terminated the agreement under which it supplied the HIV-1 antigen used to manufacture our oral fluid Western blot +HIV-1 confirmatory test and the agreement under which it distributed +5 +Table of Contents +that product on an exclusive, world-wide basis. As a result, we are now supplying this test directly to our laboratory customers. Pursuant to the terms of our antigen supply agreement with BMX, +we purchased an additional two-year supply of the antigen from BMX so that we could continue to manufacture and sell our oral fluid Western blot test. The antigen was historically manufactured by a subcontractor to BMX and we expect that this party +will be able to meet our future needs for HIV-1 antigen. +Q.E.D. ® Saliva Alcohol Test +Our Q.E.D. ® saliva alcohol test is a point-of-care test device that is a cost-effective alternative to breath or blood alcohol testing. The test is a quantitative, saliva-based +method for the detection of ethanol, has been cleared for sale by the FDA and has received a CLIA waiver. The U.S. Department of Transportation (“DOT”) has also approved the test for purchase. +Each Q.E.D. ® test kit contains a collection stick that is used to collect a sample of saliva and a disposable detection device that displays results in a format similar to a +thermometer. The Q.E.D. ® device is easy to operate and instrumentation is not required to read the result. The +product has a testing range of 0 to 0.145% blood alcohol and produces results in approximately two minutes. +Products Under Development +OraQuick ® Platform +We believe +that OraQuick ® has significant potential as a point-of-care testing platform for clinics and other public health +entities, hospitals, physicians’ offices and other markets. Because the OraQuick ® platform is simple to use +and can operate in a non-invasive manner with oral fluid, we believe it will be suitable for use by consumers without the assistance of a doctor or other medical professional. We also believe that OraQuick ® provides a platform technology that can be modified for detection of a variety of infectious diseases in addition to HIV, such as viral hepatitis and +certain sexually transmitted diseases. +We are currently devoting significant resources to obtaining FDA +approval to sell our OraQuick ® HIV-1/2 test in the United States OTC market. We have completed an observed user +study and submitted our data to the FDA. We have also developed an information and referral system and product packaging and labeling suitable for the OTC market. We expect to conduct additional clinical work in 2010 and 2011, and we intend to +submit an application for FDA approval after our clinical studies are completed. +We have developed a +rapid test on the OraQuick ® platform which can detect antibodies to the Hepatitis C virus, or HCV, in oral fluid +and other sample types. A PMA application for this test was originally submitted to the FDA in October 2008. In response to comments on our submission received from the FDA, we have provided additional clinical data to the FDA in support of a whole +blood claim for this product. We are also conducting an additional clinical study requested by the FDA in support of oral fluid and finger-stick whole blood claims. In late 2009, we received authorization to affix a CE mark to this product for all +sample types, and this product is now available for sale in Europe. +We have entered into agreements with +Merck & Co. Inc. (“Merck,” formerly Schering-Plough) to collaborate on the development and promotion of our OraQuick ® HCV test for use with oral fluid. Under the terms of these agreements, we have been and may be reimbursed by Merck for a portion of our costs to develop the test and +obtain regulatory approvals, and Merck will provide detailing and other promotional support for the test in the physicians’ office market in the United States and internationally. +OraSure ® /Intercept ® Applications +Oral mucosal transudate, or OMT, contains many constituents found in blood and serum, although in lower +concentrations. We believe the OraSure ® and Intercept ® devices are a platform technology with a wide variety of +6 +Table of Contents +potential applications, where laboratory testing is available. For example, the OraSure ® device may be useful for the collection of a variety of antibodies or markers for infectious diseases or conditions in addition to HIV-1, such as antibodies to viral +hepatitis. +In 2004, the Substance Abuse and Mental Health Services Administration (“SAMHSA”) +issued proposed regulations for oral fluid drug testing for federal workers. These proposed regulations have since been withdrawn. If and when reissued in final form, these regulations may require certain modifications to our Intercept ® product in order to permit its use by federal workers. As a result, we are developing modifications to the +Intercept ® collection device that we anticipate will be required by these regulations or are otherwise likely to +be desired by our customers. +We are also currently collaborating on the development of additional drugs +of abuse assays for use with our Intercept ® collection device. Pursuant to a development agreement with Roche +Diagnostics, homogeneous fully-automated oral fluid drugs of abuse assays are being developed for use with our Intercept ® collection device. The assays use Roche’s KIMs (kinetic interaction of micro-particles in solution) technology and will run on various automated analyzers to +allow oral fluid samples to be processed with the same efficiency currently achieved with urine-based drug tests. Applications for 510(k) clearance of assays to detect opiates, methamphetamine, amphetamine and PCP in oral samples collected with our +Intercept ® device have been submitted to the FDA, and we expect that submissions for assays detecting cocaine +and cannabinoids (marijuana) will be filed in 2010. We have also entered into a commercialization agreement with Roche pursuant to which a drug testing system comprised of our Intercept ® device and the newly developed homogeneous assays will be marketed and sold on a worldwide basis. +Research and Development +In 2009, our research and +development activities focused primarily on clinical and regulatory activities related to obtaining PMA and CE approval for our OraQuick ® HCV test, discussions and planning to obtain FDA approval for use of an OraQuick ® HIV test in the United States OTC market, and development of certain improvements to existing products in the OraQuick ® and Intercept ® +product lines. +From time to time, we have contracted with third parties to conduct research and development activities and we +may do so in the future. +Research and development expenses were $13.4 million in 2009, $20.3 million in 2008 and $14.1 +million in 2007. These expenses include our costs associated with research and development, regulatory affairs, clinical trials and product support. +Sales and Marketing +We attempt to reach our major target markets through a combination of direct sales, +strategic collaborations and independent distributors. Our marketing strategy is to create or raise awareness through a full array of marketing activities, which include trade shows, print advertising, special programs and distributor promotions, in +order to stimulate sales in each target market. +We market our products in the United States and internationally. Revenues +attributable to customers in the United States were $62.2 million, $57.4 million and $64.6 million in 2009, 2008 and 2007, respectively. Revenues attributable to international customers amounted to $14.8 million, $13.7 million and $18.1 million, or +19%, 19% and 22% of our total revenues, in 2009, 2008 and 2007, respectively. +7 +Table of Contents +Infectious Disease Testing +We market the OraQuick ADVANCE ® rapid HIV-1/2 antibody test directly to customers in the public health market for HIV testing. This market consists of a broad range of clinics and laboratories and +includes states, counties, and other governmental agencies, family planning clinics, colleges and universities, correctional facilities and the military. There are also a number of organizations in the public health market, such as AIDS service +organizations and various community-based organizations set up primarily for the purpose of encouraging and enabling HIV testing. +As a result of the termination of our agreement with Abbott Laboratories (“Abbott”) at the end of 2008 for the distribution of the OraQuick ADVANCE ® HIV test primarily in U.S. hospitals, we are now selling OraQuick ADVANCE ® directly to this market. In anticipation of the transition of this business, we increased the size of our hospital +sales force and added additional inside sales, customer service and sales support resources. In addition to selling OraQuick ADVANCE ® to hospitals, we expect our hospital sales force to eventually sell new products to this market, including our OraQuick ® HCV test once FDA approval is obtained. We also sell OraQuick ® to the U.S. physician market primarily through distributors. +We currently distribute our OraQuick ® test in several foreign +countries. During 2007, we obtained a CE mark for this product and have since launched sales in several European countries. We expect to increase the number of countries where this product is sold as we find new distributors and complete +registrations in additional countries. +We market the OraSure ® oral fluid collection device for HIV-1 testing, on its own and as a kit in combination with laboratory testing services. To better serve our public +health customers, we have contracted with two commercial laboratories to provide prepackaged OraSure ® test kits, +with prepaid laboratory testing and specimen shipping costs included. We also sell the OraSure ® device in the +international public health market. +A PMA application is pending for FDA approval of our OraQuick ® HCV test, and we plan to apply for CLIA waiver for this product. In late 2009, we received approval to affix the CE +mark to this test and intend to sell this product on a worldwide basis. We previously entered into agreements with Merck to collaborate on the development and promotion of our OraQuick ® HCV test for use with oral fluid. Under the terms of these agreements, we have been and may be reimbursed by Merck for a portion of our costs to develop the test and +obtain regulatory approvals, and Merck will provide detailing and other promotional support for the test in the physicians’ office market in the United States and internationally. +Substance Abuse Testing +Our substance abuse testing products are marketed to laboratories serving the workplace testing, forensic toxicology, criminal justice and drug rehabilitation markets. +We have entered into agreements for the distribution of Intercept ® collection devices and associated MICRO-PLATE assays for drugs-of-abuse testing in the workplace testing market in the United States and Canada through several +laboratory distributors, including Quest Diagnostics (“Quest”) and Clinical Reference Laboratory (“CRL”), and internationally for workplace, criminal justice and forensic toxicology testing through other distributors. In some +cases, we assist our laboratory customers in customizing their testing services by selling them equipment required to test oral fluid specimens collected with the Intercept ® device. +We also market +the Intercept ® collection device on its own and as a kit in combination with laboratory testing services. To +better serve our workplace customers, we have contracted with two commercial laboratories to provide prepackaged Intercept ® test kits, with prepaid laboratory testing and specimen shipping costs included. +The criminal justice market in the United States for our substance abuse testing products consists of a wide variety of entities in the criminal justice system that require drug screening, such as +pre-trial services, parole and +8 +Table of Contents +probation officials, police forces, drug courts, prisons, drug treatment programs and community/family service programs. The forensic toxicology market consists of several hundred laboratories +including federal, state and county crime laboratories, medical examiner laboratories and reference laboratories. +We also distribute our Q.E.D. ® saliva alcohol test primarily through various distributors in the United +States and internationally. The markets for alcohol testing are relatively small and fragmented with a broad range of legal and procedural barriers to entry. Markets range from law enforcement testing to workplace testing of employees in safety +sensitive occupations. Typical usage situations include pre-employment, random, post-accident, reasonable-cause and return-to-duty testing. +Cryosurgical Systems +Most of our Histofreezer ® sales occur in the United States to distributors that, in turn, resell the product to primary care physicians and +podiatrists in the United States. Our major U.S. distributors include Cardinal Healthcare, McKesson HBOC, Physicians Sales & Service, AmerisourceBergen Corporation, and Henry Schein. We recently entered into agreements with two +manufacturers’ representative organizations under which a contract sales force will be provided to help our U.S. distributors promote and sell Histofreezer ® . Internationally, we sell the Histofreezer ® product through a network of distributors in more than 20 countries worldwide. +We distribute cryosurgical wart removal products in the OTC footcare market in Europe, Australia and New Zealand through our distributor, SSL, under its Scholl and Dr. Scholl tradenames, and in the +OTC markets in Mexico and several Central and South American countries under the POINTTS tradename through our distributor, Genomma Labs. In early 2009, we re-launched our OTC cryosurgical wart product in the U.S. under our own proprietary national +brand called Freeze ‘n Clear Skin Clinic™. This launch started with one major retailer, and we are beginning to expand to other retail outlets. +Insurance Risk Assessment +We currently market the +OraSure ® oral fluid collection device for use in screening life insurance applicants in the United States and +internationally to test for three of the most important underwriting risk factors: HIV-1, cocaine and cotinine (a metabolite of nicotine). Devices are sold to insurance testing laboratories, including Quest, Heritage Labs and CRL. These laboratories +in turn provide the devices to insurance companies, usually in combination with testing services. +We also +promote use of the OraSure ® device directly to insurance companies for life insurance risk assessment. Insurance +companies then make their own decision regarding which laboratory to use to supply their collection devices and testing services. We sell our OraSure ® Western blot confirmatory test directly to insurance testing laboratories for use in confirming oral fluid specimens collected with our OraSure ® device that initially test positive for HIV-1. +There exists a wide range of policy limits where our OraSure ® product is being used. In general, most of our insurance company customers use the OraSure ® device in connection with life insurance policies having face amounts of up to $250,000, with some customers using the device for policies of up to $500,000 in +amount. Some insurance companies have chosen to extend their testing to lower policy limits where they did not test at all before, while others have used OraSure ® to replace some of their blood and urine-based testing. +We also sell our AUTO-LYTE ® assays and reagents in the insurance +testing market directly to laboratories, including Heritage Labs and CRL. +9 +Table of Contents +International Markets +We sell most of our products into international markets primarily through distributors with knowledge of their local markets. Principal +markets include foreign governments, physicians’ offices, insurance risk assessment, substance abuse, public health and laboratory testing. +We assist our international distributors in registering the products and obtaining required regulatory approvals in each country, and we provide training and support materials. +Significant Products and Customers +Several different products have contributed significantly to our financial performance, accounting for 10% or more of our total revenues during the past three years. The OraQuick ® rapid HIV testing products, the cryosurgical systems products, and the OraSure ® and Intercept ® oral fluid collection devices accounted for total revenues of $43.8 million, $10.9 million and $11.7 million in 2009, $35.3 million, $10.7 million and $13.6 million +in 2008 and $32.7 million, $23.5 million and $15.5 million in 2007, respectively. +We had one customer, Quest, which accounted +for 9% of our total revenues during 2009. The loss of Quest, or a significant decrease in the volume of products purchased by this customer, could have a material adverse effect on our financial results. +Revenue by Segment +We +operate our business within one reportable segment and all of our revenues are generated from this one segment. Our revenue is generated by our product sales and licensing and product development activities. For more information about our revenues +from external customers, income and total assets, please see the sections entitled “Selected Financial Data” and “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and Note 14 to the +financial statements, included elsewhere in this Annual Report. +Supply and Manufacturing +We manufacture the OraQuick ADVANCE ® HIV test in our Bethlehem, Pennsylvania facility. In addition, we have contracted with a third party in Thailand for the assembly of the OraQuick ® HIV device, in order to supply certain international markets. This supply agreement had an initial term of one year, +and automatically renews for additional annual periods unless either party provides a timely notice of termination prior to the end of an annual period. We believe that other firms would be able to manufacture the OraQuick ® test on terms no less favorable than those set forth in the agreement if the Thailand contractor would be unable or +unwilling to continue manufacturing this product. +We can purchase the HIV antigen and the nitrocellulose +required for the OraQuick ® test only from a limited number of sources. For the past ten years, we purchased the +antigen from a single contract supplier under an exclusive long-term agreement. We recently negotiated a buy-out of our obligations under this agreement, including the right to purchase the antigen from other third parties. We are now purchasing the +antigen from a subcontractor historically used by the original supplier, and we expect to enter into a long-term supply agreement with this subcontractor in the near future. We also purchase the nitrocellulose used in the test from a single vendor, +under a supply agreement which was recently renewed through 2014. If for any reason these suppliers are unwilling or no longer able to supply our antigen or nitrocellulose needs, we believe that alternative supplies could be obtained at a +competitive cost. However, a change in the antigen or nitrocellulose would require FDA approval and some additional development work. This in turn could require significant time to complete and could disrupt our ability to manufacture and sell the +OraQuick ® device. +The OraQuick ® HCV test that is available for sale in Europe is manufactured in our Bethlehem, Pennsylvania facility. +10 +Table of Contents +We manufacture both the OraSure ® and Intercept ® +collection devices and our assays in our Bethlehem, Pennsylvania facility, and we expect to continue to do so for the foreseeable future. +The oral fluid Western blot HIV-1 confirmatory test is currently manufactured in our Bethlehem, Pennsylvania facility. The HIV antigen needed to manufacture the Western blot test is currently available +from only a limited number of sources. For many years, we purchased the antigen for this product from BMX on an exclusive basis. Our agreement with BMX for the supply of HIV-1 antigen terminated on December 31, 2007. As a result, we purchased +an additional two-year supply of the antigen from BMX as permitted under the agreement. The antigen was historically manufactured by a subcontractor to BMX. We have continued to purchase antigen directly from this subcontractor and we expect that +this party will be able to meet our future needs for this product. +Histofreezer ® is assembled in The Netherlands by Koninklijke, Utermöhlen, N.V. (“Utermöhlen”), the company +from which we acquired the product in 1998. We purchase the product pursuant to an exclusive production agreement. The cryosurgical wart removal products distributed in OTC markets are supplied by vendors located in the United States. We believe +that additional suppliers of all of our cryosurgical products are available on terms no less favorable than the terms of our existing supply agreements in the event that our current suppliers would be unable or unwilling to continue manufacturing +these products. +Our AUTO-LYTE ® and MICRO-PLATE assays are manufactured in our Bethlehem, Pennsylvania facility. These tests require the production of highly specific and sensitive antibodies +corresponding to the antigen of interest. Substantially all our antibody requirements are provided by contract suppliers. We believe that we have adequate reserves of antibody supplies and that we have access to sufficient raw materials for these +products. +The Q.E.D. ® saliva alcohol test is manufactured and packaged for shipment in our Bethlehem, Pennsylvania facility. +Employees +As of December 31, 2009, we had 280 full-time employees, +including 82 in sales, marketing and client services; 19 in research and development; 130 in operations, manufacturing, quality control, information systems, purchasing and shipping; 22 in regulatory affairs; and 27 in administration and finance. +This compares to 287 employees as of December 31, 2008. Our employees are not currently represented by a collective bargaining agreement. +Competition +The diagnostic industry is a multi-billion dollar international industry and is intensely +competitive. Many of our competitors are substantially larger than we are, and they have greater financial, research, manufacturing and marketing resources. +Important competitive factors for our products include product quality, performance, price, ease of use, customer service and reputation. Industry competition is based on the following: +• +Scientific and technological capability; +• +Proprietary know-how; +• +The ability to develop and market products and processes; +• +The ability to obtain FDA or other regulatory approvals; +• +The ability to manufacture products that meet applicable FDA requirements (i.e., good manufacturing practices); +• +Commercial execution and strength of distribution; +• +Access to adequate capital; +11 +Table of Contents +• +The ability to attract and retain qualified personnel; and +• +The availability of patent protection. +A few large corporations produce a wide variety of diagnostic tests and other medical devices and equipment. A larger number of mid-size companies generally compete only in the diagnostic industry and a +significant number of small companies produce only a few diagnostic products. As a result, the diagnostic test industry is highly fragmented and segmented. +The future market for diagnostic tests is expected to be characterized by consolidation, greater cost consciousness and tighter reimbursement policies. The purchasers of diagnostic products are expected +to place increased emphasis on lowering costs, reducing inventory levels, automation, service and volume discounts. The increased complexity of the market is expected to force many competitors to enter into joint ventures or license certain products +or technologies. +We expect competition to intensify as technological advances are made and become more widely known, and as +new products reach the market. Furthermore, new testing methodologies could be developed in the future that render our products impractical, uneconomical or obsolete. There can be no assurance that our competitors will not succeed in developing or +marketing technologies and products that are more effective than those we develop or that would render our technologies and products obsolete or otherwise commercially unattractive. In addition, there can be no assurance that our competitors will +not succeed in obtaining regulatory approval for these products, or introduce or commercialize them, before we can do so. These developments could have a material adverse effect on our business, financial condition and results of operations. +Several companies market or have announced plans to market oral specimen collection devices and tests +both within and outside the United States. We expect the number of devices competing with our Intercept ® , +OraQuick ® and OraSure ® devices to increase as the benefits of oral fluid-based testing become more widely accepted. +Competition in the HIV testing market is intense and is expected to increase. We believe that the principal competition will come from +existing laboratory-based blood tests, point-of-care rapid blood tests, laboratory-based urine assays or other oral fluid-based tests that may be developed. Our competitors include specialized biotechnology firms, as well as pharmaceutical companies +with biotechnology divisions and medical diagnostic companies. +Significant competitors for our OraQuick +ADVANCE ® rapid HIV-1/2 test, such as the Ortho Diagnostics division of Johnson & Johnson, +Bio-Rad Laboratories and Abbott, sell laboratory-based HIV-1/2 EIAs, and Maxim Biomedical (formerly Calypte, Inc.) sells an HIV-1 screening test for urine, in the United States. MedMira and Trinity Biotech each sell competing rapid HIV-1 blood +tests, and Bio-Rad Laboratories and Inverness Medical/Chembio sell competing rapid HIV-1/2 blood tests in the United States. These tests compete with our OraQuick ADVANCE ® test in hospitals and other laboratory settings. In addition, Trinity Biotech and Inverness Medical/Chembio have received CLIA waivers for their rapid HIV tests, and +these tests compete with our OraQuick ADVANCE ® test in the markets outside of the traditional hospital +and laboratory settings. These companies, or others, may continue to expand the bodily fluids with which a rapid HIV test may be performed, or develop and commercialize new rapid HIV tests, which would provide further competition for our OraQuick +ADVANCE ® test. We believe other companies may also seek FDA approval to sell competing rapid HIV tests in +the future. +Internationally, our OraQuick ADVANCE ® HIV test competes against rapid HIV tests sold by a number of other entities, and often these competing tests are sold at prices substantially below the +prices we charge for our OraQuick ADVANCE ® test. Inverness Medical and Trinity Biotech sell rapid HIV-1/2 +blood tests outside the United States and Calypte has developed a rapid oral fluid HIV test which is now being sold in certain foreign countries. Lower priced rapid HIV blood tests are also sold internationally by various third parties. +12 +Table of Contents +The OraQuick ® HCV test that is now available in Europe is expected to compete primarily against laboratory-based HCV blood tests. Major suppliers of these competing tests are +Abbott Labs, Seimens, Ortho-Clinical Diagnostics, Roche and Bio-Rad. In non-U.S. countries outside of Europe, we expect that our OraQuick ® HCV test will compete against other rapid HCV blood tests in addition to the laboratory-based tests. +The Intercept ® drug testing system competes with laboratory-based drug testing products and services using testing matrices such as urine, hair, sweat and oral fluid. Major +competitors include Ansys Technologies, Inc., Dade Behring, Psychemedics and Immunalysis. +Our MICRO-PLATE +oral fluid drug assays, which are sold for use with the Intercept ® and OraSure ® collection devices, continue to come under increasing competitive pressure from “home-brew” assays +developed internally by our laboratory customers. Our oral fluid MICRO-PLATE assays also compete with urine-based homogeneous assays that are run on fully-automated, random access analyzers. These tests provide strong competitive pressure because +they provide the benefits of automation, including lower costs and short turn-around times. In addition, we believe our competitors are developing oral fluid tests suitable for use on these fully automated homogeneous assay systems and these assays, +if and when they are developed and commercialized, will represent a significant competitive threat to our oral fluid MICRO-PLATE business. In order to meet this competition, we are developing and intend to commercialize fully-automated homogeneous +oral fluid drugs of abuse assays with Roche Diagnostics for use with our Intercept ® device. +Our MICRO-PLATE drugs-of-abuse reagents sold in the forensic toxicology market are targeted to forensic testing laboratories where +sensitivity, automation and “system solutions” are important. In the past, these laboratories have typically had to rely on radioimmunoassay test methods to provide an adequate level of sensitivity. Radioimmunoassays require radioactive +materials, which have a short shelf-life and disposal problems. Our MICRO-PLATE tests meet the laboratories’ sensitivity needs, run on automated equipment, are not radioimmunoassays, and are offered to the laboratory as a complete system +solution of reagents, instrumentation and software to meet the specific needs of each customer. We compete with both homogeneous and heterogeneous tests manufactured by many companies. Significant competitors in the market for these assays include +Microgenics, Inc., Roche Diagnostics and Immunalysis. +Sales of our AUTO-LYTE ® urine assays have declined substantially during the past several years, primarily due to competition from +“home-brew” assays developed internally by our laboratory customers, which can be produced at a cost lower than the price typically paid for our products. Many of our customers no longer purchase our AUTO-LYTE ® assays, and we eventually expect to stop selling this product line. +The Histofreezer ® product’s delivery system and operating temperature, which is warmer than liquid nitrogen, provide us with the opportunity to target sales to primary care +physicians, such as family practitioners, pediatricians and podiatrists. We do not generally target sales to dermatologists because they have the volume of patients required to support the capital costs associated with a liquid nitrogen delivery +system, which is also used to remove warts and other benign skin lesions. Major competitors for the Histofreezer ® product include Cryosurgery, Inc. in the United States and Wartner in Europe. +Competition in the United States and Canadian OTC markets comes primarily from cryosurgical products sold by Merck under +the Dr. Scholl’s ® brand and by Prestige Brands under the Compound W ® and Wartner ® tradenames. Salicylic acid wart removal products also compete against our OTC cryosurgical product. Internationally, our OTC products compete against cryosurgical +products sold by Wartner and several other firms. +Q.E.D. ® has two primary competitors, Ansys Technologies, Inc. and Chematics. These companies offer semi-quantitative saliva-based alcohol tests and have +received DOT approval. Indirect competitors who offer breath testing equipment include Intoximeters, Dräger and CMI. Although there are lower priced tests on the market that use oral fluid or breath as a test medium, these tests are qualitative +tests that are believed to be substantially lower in quality and provide fewer benefits than our Q.E.D. ® test. +13 +Table of Contents +Patents and Proprietary Information +We seek patents and other intellectual property rights to protect and preserve our proprietary technology and our right to capitalize on the +results of our research and development activities. We also rely on trade secrets, know-how, continuing technological innovations and licensing opportunities to provide competitive advantages for our products in our markets and to accelerate new +product introductions. We regularly search for third-party patents in fields related to our business to shape our own patent and product commercialization strategies as effectively as possible and to identify licensing opportunities. United States +patents generally have a maximum term of 20 years from the date an application is filed. +We have nine +United States patents and numerous foreign patents for the OraSure ® and Intercept ® collection devices and technology relating to oral fluid collection, containers for oral fluids, methods to test +oral fluid, formulations for the manufacture of synthetic oral fluid, and methods to control the volume of oral fluid collected and dispersed. The patents expire from January 2013 to March 2018. We have also applied for additional patents, in both +the United States and certain foreign countries, on such products and technology. +We have three United +States patents for our OraQuick ® platform, and we have several related patent applications pending in the United +States and internationally. These patents expire from March to April 2019. We have obtained licenses to certain lateral flow patents and to certain HIV-1 and HIV-2 patents held by other parties. We also have obtained a license to certain HCV patents +which we use to manufacture and sell a rapid HCV test on the OraQuick ® or other technology platforms. We +obtained these licenses through the payment of certain upfront fees and an agreement to pay ongoing royalties. We believe these fees and royalties are comparable to those generally paid by other companies under similar arrangements. +We may need to obtain licenses or other rights under, or enter into distribution or other business arrangements in +connection with, certain other intellectual property patents in order to manufacture and sell the OraQuick ADVANCE ® HIV test or other tests that use the same or similar technology platform. See Section 1A, entitled “Risk Factors,” for a further discussion of these +issues. +We have three United States patents and numerous foreign patents issued for apparatuses and methods for the topical +removal of skin lesions relating to our cryosurgical wart removal products, and we have pending patent applications related to these products in the United States and in certain foreign countries. These patents expire from July 2012 to August 2013. +We have also licensed another patent relating to apparatuses and methods for the topical removal of skin lesions relating to our cryosurgical wart removal products. +We require our employees, consultants, outside collaborators and other advisors to execute confidentiality agreements upon the commencement of employment or consulting relationships with us. These +agreements provide that all confidential information developed by or made known to the individual during the course of the individual’s relationship with us is to be kept confidential and not disclosed to third parties except in specific +circumstances. In the case of employees, the agreements provide that all inventions conceived by the individual during his or her tenure with us will be our exclusive property. +We own rights to trademarks and service marks that we believe are necessary to conduct our business as currently +operated. In the United States, we own a number of trademarks, including the OraSure ® , Intercept ® , OraQuick ® , OraQuick ADVANCE ® , +Histofreezer ® , Freeze ‘n Clear Skin Clinic™, Q.E.D. ® and AUTO-LYTE ® +trademarks. We also own many of these marks and others in several foreign countries. With respect to our international OTC cryosurgical products, the Scholl and Dr. Scholl tradenames are owned by SSL in Europe, Australia, New Zealand and other +countries outside North and South America, and the POINTTS tradename is owned by Genomma Labs. +Although important, the +issuance of a patent or existence of trademark or trade secret protection does not in itself ensure the success of our business. Competitors may be able to produce products competing with our patented products without infringing our patent rights. +Issuance of a patent in one country generally does not +14 +Table of Contents +prevent manufacture or sale of the patented product in other countries. The issuance of a patent is not conclusive as to validity or as to the enforceable scope of the patent. The validity or +enforceability of a patent can be challenged by litigation after its issuance. If the outcome of such litigation is adverse to the owner of the patent, the owner’s rights could be diminished or withdrawn. Trade secret protection does not +prevent independent discovery and exploitation of the secret product or technique. +Government Regulation +General +Most of our products are regulated by the FDA, certain state and local agencies and comparable regulatory bodies in other countries. This regulated environment governs almost all aspects of development, production and marketing, including +product testing, authorizations to market, labeling, promotion, manufacturing and recordkeeping. +All of our FDA-regulated +products require some form of action by the FDA before they can be marketed in the United States. After approval or clearance by the FDA, we must continue to comply with other FDA requirements applicable to marketed products. Both before and after +approval or clearance, failure to comply with the FDA’s requirements can lead to significant penalties or could disrupt our ability to manufacture and sell these products. In addition, the FDA could refuse permission to obtain certificates +needed to export our products if the agency determines that we are not in compliance. +Domestic Regulation +Most of our products are regulated in the United States as medical devices. +There are two mechanisms by which regulated medical devices can be placed on the market in the United States. Some products may qualify for +clearance under Section 510(k) of the Federal Food, Drug and Cosmetic Act. To obtain this clearance from the FDA, the manufacturer must provide a premarket notification that it intends to begin marketing the product, and show that the product +is substantially equivalent to another legally marketed product (i.e., that it has the same intended use and is as safe and effective as a legally marketed device and does not raise different questions of safety and effectiveness). In some cases, +the submission must include data from human clinical studies. Marketing may only commence when the FDA issues a clearance letter finding substantial equivalence. An applicant must submit a 510(k) application at least 90 days before marketing of the +affected product commences. Although FDA clearance may be granted within that 90-day period, in some cases as much as a year or more may be required before clearance is obtained, if at all. +If the medical device does not qualify for the 510(k) procedure (either because it is not substantially equivalent to a legally marketed +device or because it is required by statute and the FDA’s regulations to have an approved premarket application, or PMA), the FDA must approve a PMA before marketing can begin. PMAs must demonstrate, among other matters, that the medical device +provides a reasonable assurance of safety and effectiveness. A PMA is typically a complex submission, including the results of preclinical and clinical studies. Preparing a PMA is a detailed and time-consuming process. Once a PMA has been submitted, +the FDA is required to review the submission within 180 days. However, the FDA’s review may, and often is, much longer, often requiring one year or more, and may include requests for additional data and facility inspections before approval is +granted, if at all. +Some of our products are used for non-medical purposes and many of our drugs-of-abuse products sold to +state crime laboratories are for forensic use. The FDA does not currently regulate products used for these purposes. +Every +company that manufactures medical devices distributed in the United States must comply with the FDA’s Quality System Regulations (“QSRs”). These regulations govern the manufacturing process, including +15 +Table of Contents +design, manufacture, testing, release, packaging, distribution, documentation and purchasing. In complying with the QSRs, manufacturers must continue to expend time, money and effort in the area +of production and quality to ensure full technical compliance. Companies are also subject to other post-market and general requirements, including restrictions imposed on marketed products, promotional standards and requirements for recordkeeping +and reporting of certain adverse reactions. If there are any modifications made to our marketed devices, a premarket notification or PMA may be required to be submitted to, and cleared or approved by, the FDA, before the modified device may be +marketed. The FDA regularly inspects companies to determine compliance with the QSRs and other post-market requirements. Failure to comply with statutory requirements and the FDA’s regulations can result in warning letters, monetary penalties, +suspension or withdrawal of regulatory approvals, operating restrictions, total or partial suspension of production, injunctions, product recalls, seizure of products and criminal prosecution. +The Clinical Laboratory Improvements Amendments of 1988, or CLIA, prohibit any facility that does laboratory testing on +specimens derived from humans from providing information for the diagnosis, prevention or treatment of any disease or impairment of, or the assessment of, the health of human beings, unless there is in effect for such facility a certificate issued +by the U.S. Department of Health and Human Services applicable to the category of examination or procedure performed. Tests may be waived from this regulatory oversight if they meet certain requirements established under CLIA. We consider the +applicability of the requirements of CLIA in the design and development of our products. We have obtained a waiver of the CLIA requirements for both our OraQuick ADVANCE ® rapid HIV-1/2 antibody test and our Q.E.D. ® alcohol saliva test and may seek similar waivers for certain other products. A CLIA waiver allows certain customers to use the waived products that may not have been +able to use them without complying with applicable quality control and other requirements. +Certain of our products may also +be affected by state regulations in the United States. For example, there are several states that restrict or do not currently permit oral fluid drug testing in the workplace or other markets. In addition, several states prohibit or limit the use of +rapid, point-of-care HIV testing. We are presently working with legislators or regulators in certain of these states in an effort to modify or remove any restrictions affecting our ability to sell products. +International +We are also subject to regulations in foreign countries governing products, human clinical trials and marketing, and may need to obtain approval from international public health agencies, such as the World Health Organization, in order to +sell products in certain countries. Approval processes vary from country to country, and the length of time required for approval or to obtain other clearances may in some cases be longer than that required for U.S. governmental approvals. We +generally pursue approval only in those countries that we believe have a significant market opportunity. +The International +Organization for Standardization (“ISO”) is a worldwide federation of national standards bodies from some 130 countries, established in 1947. The mission of the ISO is to promote the development of standardization and related activities in +the world with a view to facilitating the international exchange of goods and services. ISO certification is a pre-requisite to use of the CE mark and indicates that our quality system complies with standards applicable to activities ranging from +initial product design and development through production and distribution. The CE mark is a European Union (“EU”) requirement to sell products that fall under the scope of the Medical Devices Directive (“MDD”) and the In Vitro +Diagnostic Directive (“IVDD”). The CE mark is evidence that the manufacturer and the product meet the requirements of all applicable directives, including the MDD and IVDD. +We received authorization to use the CE mark for the OraQuick ADVANCE ® rapid HIV-1/2 test, the OraQuick ® rapid HCV test, the OraSure ® +and Intercept ® collection devices and our Histofreezer ® product line, and SSL has obtained authorization to use the CE mark for our cryosurgical wart removal product in the OTC European footcare market. +16 +Table of Contents +We must also comply with certain registration requirements as dictated by Health Canada, +prior to commencing sales in Canada. We have completed this process for several of our current products and may do so with respect to other products in the future. In addition, Canadian law requires manufacturers of medical devices to have a quality +management system that meets various ISO requirements in order to obtain a license to sell their devices in Canada. +Anti-Kickback and Other Fraud and Abuse Laws +The Federal Anti-Kickback Statute prohibits the knowing and +willful offer, payment, solicitation, or receipt of any form of remuneration in return for, or to induce: +• +The referral of a person; +• +The furnishing or arranging for the furnishing of items or services reimbursable under Medicare, Medicaid or other governmental programs; or +• +The purchase, lease, or order of, or the arrangement or recommendation of the purchasing, leasing, or ordering of any item or service reimbursable +under Medicare, Medicaid, or other governmental programs. +Our products are or may be purchased by customers +that will seek or receive reimbursement under Medicare, Medicaid or other governmental programs. Noncompliance with the federal anti-kickback legislation can result in exclusion from Medicare, Medicaid or other governmental programs, and/or +restrictions on our ability to operate in certain jurisdictions, as well as civil and criminal penalties, any of which could have an adverse effect on our business and results of operations. +The Federal Civil Monetary Penalties Law prohibits the offering or transferring of remuneration to a Medicare or Medicaid beneficiary that +the person knows or should know is likely to influence the beneficiary’s selection of a particular supplier of Medicare or Medicaid payable items or services. Noncompliance can result in civil money penalties of up to $10,000 for each wrongful +act, assessment of three times the amount claimed for each item or service and exclusion from the Federal healthcare programs. +Many states have also adopted some form of anti-kickback laws. A determination of liability under such laws could result in fines and penalties and restrictions on our ability to operate in these jurisdictions. +We are also subject to other federal and state laws targeting fraud and abuse in the healthcare industry, including false claims laws and +marketing conduct laws and laws constraining the sales, marketing and other promotional activities of manufacturers of medical devices by limiting the kinds of financial arrangements, including sales programs, with physicians, hospitals, +laboratories and other potential purchasers of medical devices. Violations of these laws may be punishable by criminal or civil sanctions, including substantial fines, imprisonment and exclusion from participation in government healthcare programs +such as Medicare and Medicaid. These laws and regulations are wide ranging and subject to changing interpretation and application. In recent years, there has been greater scrutiny of marketing practices in the medical device industry which has +resulted in several government investigations by various government authorities and the introduction and/or passage of federal and state legislation regulating interactions between medical device manufacturers and healthcare professionals and +providers and requiring the disclosure by medical device manufacturers of gifts or other payments to healthcare professionals and providers. To be in compliance with such disclosure laws, we have implemented necessary systems for accurately tracking +gifts and other payments. +We are in the process of adopting a written Policy on Interactions with Health Care Professionals +and will train our personnel on this policy, which is based on the Code of Conduct for Interactions with Health Care Professionals promulgated by the Advanced Medical Technology Association, or AdvaMed, a leading trade association representing +medical device manufacturers. The Policy is intended to comply with applicable state and federal laws, regulations and government guidance. The Policy addresses interactions related to sales and +17 +Table of Contents +marketing practices, research and development, product training and education, grants and charitable contributions, support of third-party educational conferences, and consulting arrangements. +Foreign Corrupt Practices Act +The U.S. Foreign Corrupt Practices Act (“FCPA”) prohibits corporations and individuals from engaging in certain activities to obtain or retain business or to influence a person working in an +official capacity. It is illegal to pay, offer to pay or authorize the payment of anything of value to any foreign government official, government staff member, political party or political candidate in an attempt to obtain or retain business or to +otherwise influence a person working in an official capacity. Our present and future business has and will continue to be subject to the FCPA and various other laws, rules and/or regulations applicable to us as a result of our international sales. +Environmental Regulation +Because of the nature of our current and proposed research, development, and manufacturing processes, we are subject to stringent federal, state and local laws, rules, regulations and policies governing +the use, generation, manufacture, storage, air emission, effluent discharge and handling and disposal of materials and wastes. +The foregoing discussion of our business should be read in conjunction with the Financial Statements and accompanying notes included in Item 15 of this Annual Report. \ No newline at end of file diff --git a/raw/filings/0001116463/2009/0001193125-10-057039/item13.txt b/raw/filings/0001116463/2009/0001193125-10-057039/item13.txt new file mode 100644 index 0000000000000000000000000000000000000000..aac7b7ac5689d0ab1b870d828257bf2836982a7b --- /dev/null +++ b/raw/filings/0001116463/2009/0001193125-10-057039/item13.txt @@ -0,0 +1,3 @@ +ITEM 13. Certain Relationships and Related Transactions, and Director Independence. +The information required by this Item is incorporated by reference to the information under the captions, “Transactions with Related +Persons” and “Corporate Governance—Director Independence,” in the Proxy Statement. \ No newline at end of file diff --git a/raw/filings/0001116463/2009/0001193125-10-057039/item9a.txt b/raw/filings/0001116463/2009/0001193125-10-057039/item9a.txt new file mode 100644 index 0000000000000000000000000000000000000000..7f52ac53c71bcdd725b62d60e7dc1ffb3409b3fa --- /dev/null +++ b/raw/filings/0001116463/2009/0001193125-10-057039/item9a.txt @@ -0,0 +1,54 @@ +ITEM 9A. +Controls and Procedures. +(a) Evaluation of Disclosure Controls and Procedures. +The Company’s management, with the participation of +the Company’s Chief Executive Officer and Chief Financial Officer, has evaluated the effectiveness of the Company’s disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) of the Securities Exchange Act of 1934) as +of December 31, 2009. Based on that evaluation, the Company’s management, including such officers, concluded that as of December 31, 2009 the Company’s disclosure controls and procedures were adequate and effective to ensure that +information required to be disclosed by the Company in the reports that we file or submit under the Securities Exchange Act of 1934 is accumulated and communicated to the Company’s management, including the Chief Executive Officer and Chief +Financial Officer, to allow timely decisions regarding required disclosure and is recorded, processed, summarized, and reported within the time periods specified in the rules and forms of the Securities and Exchange Commission. +(b) Management’s Report on Internal Control Over Financial Reporting. +The Company’s management is responsible for establishing and maintaining adequate internal control over financial reporting, as such +term is defined in Rule 13a-15(f) and 15d-15(f) under the Securities Exchange Act of 1934. Under the supervision and with the participation of the Company’s management, including our principal executive officer and principal financial officer, +we conducted an evaluation of the effectiveness of our internal control over financial reporting based on the framework in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway +Commission. Based on our evaluation under the framework, our management concluded that our internal control over financial reporting was effective to provide reasonable assurance regarding the reliability of financial reporting and the preparation +of financial statements for external purposes in accordance with generally accepted accounting principles as of December 31, 2009. +The effectiveness of our internal control over financial reporting as of December 31, 2009 has been audited by KPMG LLP, an independent registered public accounting firm, as stated in their report, +which is included below. +62 +Table of Contents +Because of its inherent limitations, internal control over financial reporting may not +prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies +or procedures may deteriorate. +(c) Changes in Internal Control Over Financial Reporting. +There was no change in the Company’s internal control over financial reporting during the three months ended December 31, 2009 that +was identified in connection with the evaluation referred to in paragraph (b) above that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting. +(d) Report of Independent Registered Public Accounting Firm +The Board of Directors and Stockholders +OraSure Technologies, Inc.: +We have audited OraSure Technologies, Inc.’s internal control over financial reporting as of December 31, 2009, based on criteria +established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). OraSure Technologies, Inc.’s management is responsible for maintaining effective internal +control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Management’s Report on Internal Control Over Financial Reporting. Our responsibility is to +express an opinion on the Company’s internal control over financial reporting based on our audit. +We conducted our audit +in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial +reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating +effectiveness of internal control based on the assessed risk. Our audit also included performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion. +A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding +the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies +and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are +recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management +and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial +statements. +Because of its inherent limitations, internal control over financial reporting may not prevent or detect +misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may +deteriorate. +In our opinion, OraSure Technologies, Inc. maintained, in all material respects, effective internal control over +financial reporting as of December 31, 2009, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). +63 +Table of Contents +We also have audited, in accordance with the standards of the Public Company Accounting +Oversight Board (United States), the balance sheets of OraSure Technologies, Inc. as of December 31, 2009 and 2008, and the related statements of operations, stockholders’ equity and comprehensive income (loss), and cash flows for each of +the years in the three-year period ended December 31, 2009, and our report dated March 15, 2010 expressed an unqualified opinion on those financial statements. +/s/ KPMG LLP +Philadelphia, Pennsylvania +March 15, 2010 \ No newline at end of file diff --git a/raw/filings/0001116463/2009/0001193125-10-057039/rp_note.txt b/raw/filings/0001116463/2009/0001193125-10-057039/rp_note.txt new file mode 100644 index 0000000000000000000000000000000000000000..e69de29bb2d1d6434b8b29ae775ad8c2e48c5391 diff --git a/raw/filings/0001116463/2009/0001193125-10-057039/rpt_disclosure.txt b/raw/filings/0001116463/2009/0001193125-10-057039/rpt_disclosure.txt new file mode 100644 index 0000000000000000000000000000000000000000..7b79e8172e95790f321ff1999f943f0e95820348 --- /dev/null +++ b/raw/filings/0001116463/2009/0001193125-10-057039/rpt_disclosure.txt @@ -0,0 +1,9 @@ +Transactions With Related Persons +Since January 1, 2009, there have been no transactions with related persons which would require disclosure in this Proxy Statement. The +Audit Committee is required to review and approve in advance all transactions with related persons involving the Company. The Audit Committee may approve a related party transaction if the transaction is on terms comparable to those that could be +obtained in arms’ length dealings with an unrelated third party. The Audit Committee also reviews any public disclosures of a related party transaction contained in our SEC filings. These responsibilities are described in the Audit +Committee’s charter, a copy of which is available on our website at www.orasure.com . +Information regarding +employment and severance agreements between our executive officers and the Company is set forth in the Section entitled, “Employment Agreements and Potential Payments Upon Termination or Change in Control,” in this Proxy Statement. +12 +Table of Contents \ No newline at end of file diff --git a/raw/filings/0001116463/2010/0001193125-11-062311/filing.txt b/raw/filings/0001116463/2010/0001193125-11-062311/filing.txt new file mode 100644 index 0000000000000000000000000000000000000000..4db5d0fa2b5b81b08de1fc15063d95464e2264ac --- /dev/null +++ b/raw/filings/0001116463/2010/0001193125-11-062311/filing.txt @@ -0,0 +1,4779 @@ +10-K +1 +d10k.htm +FORM 10-K +Form 10-K +UNITED STATES +SECURITIES AND EXCHANGE COMMISSION +Washington, D.C. 20549 +FORM 10-K +ANNUAL REPORT PURSUANT +TO SECTION 13 OR 15(d) OF THE +SECURITIES EXCHANGE ACT OF 1934 +(Mark One) +x +ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 +For the fiscal year ended December 31, 2010 +OR +¨ +TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 +For the transition period from +to +Commission File No. 001-16537 +ORASURE +TECHNOLOGIES, INC. +(Exact Name of Registrant as Specified in Its Charter) +Delaware +36-4370966 +(State or Other Jurisdiction of +Incorporation or Organization) +(I.R.S. Employer Identification No.) +220 East First Street +Bethlehem, Pennsylvania +18015 +(Address of Principal Executive Offices) +(Zip Code) +(610) +882-1820 +(Registrant’s Telephone Number, Including Area Code) +Securities registered pursuant to Section 12(b) of the Act: +Title of Each Class +Name of Each Exchange on Which Registered +Common Stock $0.000001 par value per share +The NASDAQ Stock Market LLC +Securities registered pursuant to Section 12(g) of the Act: None +Indicate by check mark if the Registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes ¨ No x +Indicate by check mark if the Registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Exchange +Act. Yes ¨ No x +Indicate by check mark whether the Registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for +such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No ¨ +Indicate by check mark whether the Registrant has submitted electronically and +posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405) during the preceding 12 months (or for such shorter period that the Registrant was +required to submit and post such files). Yes ¨ No ¨ +Indicate by check mark if disclosure of delinquent filers pursuant to +Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of Registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to +this Form 10-K. x +Indicate by check mark whether the Registrant is a large +accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of +the Exchange Act. +Large accelerated filer ¨ +Accelerated filer x +Non-accelerated filer ¨ +Smaller reporting company ¨ +(Do not check if a smaller reporting company) +Indicate by check mark whether the Registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ¨ No x +State the aggregate market value of the voting and non-voting common equity held +by nonaffiliates, computed by reference to the price at which the common equity was last sold, or the average bid and asked price of such common equity, as of the last business day of the Registrant’s most recently completed second fiscal +quarter (June 30, 2010): $209,793,347 +Indicate the number of shares outstanding of each of the Registrant’s classes of +common stock, as of March 7, 2011: 46,626,324 shares. +Documents Incorporated by Reference: +Portions of the Registrant’s Definitive Proxy Statement for the 2011 Annual Meeting of Stockholders are incorporated by reference +into Part III of this Report. +Table of Contents +Page +PART I +ITEM 1. +Business +1 +ITEM 1A. +Risk Factors +19 +ITEM 1B. +Unresolved Staff Comments +39 +ITEM 2. +Properties +39 +ITEM 3. +Legal Proceedings +39 +ITEM 4. +[Removed and Reserved] +39 +PART II +ITEM 5. +Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities +40 +ITEM 6. +Selected Financial Data +42 +ITEM 7. +Management’s Discussion and Analysis of Financial Condition and Results of +Operations +43 +ITEM 7A. +Quantitative and Qualitative Disclosures About Market Risk +60 +ITEM 8. +Financial Statements and Supplementary Data +60 +ITEM 9. +Changes in and Disagreements with Accountants on Accounting and Financial +Disclosure +60 +ITEM 9A. +Controls and Procedures +60 +ITEM 9B. +Other Information +62 +PART III +ITEM 10. +Directors, Executive Officers and Corporate Governance +63 +ITEM 11. +Executive Compensation +63 +ITEM 12. +Security Ownership of Certain Beneficial Owners and Management and Related Stockholder +Matters +63 +ITEM 13. +Certain Relationships and Related Transactions, and Director Independence +63 +ITEM 14. +Principal Accountant Fees and Services +63 +PART IV +ITEM 15. +Exhibits and Financial Statement Schedules +64 +This Report contains certain “forward-looking statements,” within the meaning +of the Federal securities laws. These may include statements about our expected revenues, earnings, expenses or other financial performance, future product performance or development, expected regulatory filings and approvals, planned business +transactions, expected manufacturing performance, views of future industry, competitive or market conditions, and other factors that could affect our future operations, results of operations or financial position. These statements often include +words, such as “believes,” “expects,” “anticipates,” “intends,” “plans,” “estimates,” “may,” “will,” “should,” “could,” or similar expressions. +Forward-looking statements are not guarantees of future performance or results. Known and unknown factors could cause +actual performance or results to be materially different from those expressed or implied in these statements. Factors that could affect our results are discussed more fully under Item 1A., entitled “Risk Factors,” and elsewhere in +this Annual Report. Although forward-looking statements help to provide complete information about us, readers should keep in mind that forward-looking statements may not be reliable. Readers are cautioned not to place undue reliance on the +forward-looking statements. The forward-looking statements are made as of the date of this Annual Report and we undertake no duty to update these statements. +PART I +ITEM 1. +Business. +Our business +principally involves the development, manufacture, marketing and sale of oral fluid diagnostic products and specimen collection devices using our proprietary oral fluid technologies, as well as other diagnostic products including immunoassays and +other in vitro diagnostic tests that are used on other specimen types. We also manufacture and sell other medical devices used for the removal of benign skin lesions by cryosurgery or freezing. Our diagnostic products include tests which are +performed on a rapid basis at the point of care and tests which are processed in a laboratory. These products are sold in the United States and internationally to various clinical laboratories, hospitals, clinics, community-based organizations and +other public health organizations, distributors, government agencies, physicians’ offices, and commercial and industrial entities. One of our products is sold in the over-the-counter (“OTC”) or consumer retail markets in North +America, Europe, Central and South America, and Australia. +In vitro diagnostic testing is the process of analyzing +oral fluid, blood, urine and other bodily fluids or tissue for the presence of specific substances or markers for infectious diseases, drugs of abuse or other conditions. We have targeted the use of oral fluid in our products as a differentiating +factor and believe that it provides a significant competitive advantage over blood and urine. Our oral fluid tests have sensitivity and specificity comparable to blood and/or urine tests. When combined with their ease of use, non-invasive nature, +and cost effectiveness, our oral fluid tests represent a very competitive alternative to the more traditional testing methods in the diagnostic space. +Our Company was formed in May 2000 under Delaware law solely for the purposes of combining two companies, STC Technologies, Inc. (“STC Technologies”) and Epitope, Inc. (“Epitope”), and +changing the state of incorporation of Epitope from Oregon to Delaware. STC Technologies and Epitope were merged into our Company on September 29, 2000. Our principal offices are located at 220 East First Street, Bethlehem, Pennsylvania 18015, +and our telephone number is (610) 882-1820. +Additional information about us can be found on our website. Our website +address is www.orasure.com . We make available free of charge through a link provided at such website our Annual Reports on Form 10-K, our Quarterly Reports on Form 10-Q, our Current Reports on Form 8-K and our other filings with the +Securities and Exchange Commission (“SEC”), as well as any amendments to those Reports and filings. These Reports and filings are made available as soon as reasonably practicable after they are filed or furnished to the SEC. Our Internet +website and the information contained in or connected to that website are not intended to be incorporated by reference into this Annual Report. +1 +Products +The following is a summary of our principal products and their regulatory and commercial status: +Product +Description +Regulatory Status +Commercial Status +OraQuick +ADVANCE ® HIV-1/2 +A rapid, point-of-care qualitative test for antibodies to the Human Immunodeficiency Virus Type 1 (“HIV-1”) and Type 2 (“HIV-2” and together with HIV-1, +“HIV-1/2”) that can be visually read in approximately 20 minutes. +Premarket approval (“PMA”) by the U.S. Food and Drug Administration (“FDA”) for use with oral fluid, finger-stick +and venous whole blood, and plasma. +CLIA (Clinical Laboratory Improvement +Amendments of 1988) waived for use with oral fluid, finger-stick and venous whole blood. +Marketed +Marketed +CE mark (European Union) approved. Also registered in various other countries. +Marketed +OraQuick ® HIV-1/2 OTC +A rapid, point-of-care qualitative oral fluid HIV-1/2 test intended to be sold in various OTC markets. +FDA granted an IDE (Investigation Device Exemption) allowing final clinical phase to begin. +Not Marketed +OraQuick ® HCV +A rapid, point-of-care qualitative test for antibodies to the hepatitis C virus (“HCV”) that can be visually read in approximately 20 minutes. +PMA approved by FDA for use with venous whole blood and finger-stick whole blood specimens. +Clinical program for oral fluid claim remains pending. +Marketed +Not Marketed +CE mark (European Union) approved for use with oral fluid, finger-stick and venous whole blood, serum and plasma. Also registered in various other countries. +Marketed +OraSure QuickFlu™ Rapid Flu A&B Test +A rapid, point-of-care qualitative test for antibodies to influenza (flu) Types A and B, including H1N1 infections, with results available in 10 minutes. +FDA 510(k) cleared for use with nasal swab, nasopharyngeal swab and nasal aspirate/wash. +CLIA waiver application pending with FDA. +Marketed +Not Marketed +OraSure ® +Oral fluid collection device for the detection of antibodies to HIV-1 in an oral fluid sample in a laboratory setting. +PMA approved by FDA for use in detecting antibodies to HIV-1. +Marketed +FDA 510(k) cleared for use in detecting cocaine and cotinine (an indicator of nicotine) in oral fluid. +Marketed +CE marked and registered in various countries. +Marketed +Intercept ® +Oral fluid collection device for oral fluid drugs of abuse (“DOA”) testing in a laboratory setting. +Collection device—FDA 510(k) cleared. +Marketed +2 +Product +Description +Regulatory Status +Commercial Status +MICRO-PLATE DOA Assays +Used to detect the following drugs in an oral fluid sample collected with Intercept ® device: tetrahydrocannabinol (“THC” or marijuana), cocaine, opiates, amphetamines, methamphetamines, phencyclidine (“PCP”), benzodiazepines, +barbiturates and methadone. +Nine drug assays—FDA 510(k) cleared. +Intercept ® device +and various assays CE marked and registered in certain countries. +Marketed +Marketed +Homogeneous DOA Assays +Homogeneous fully-automated oral fluid DOA assays jointly developed with Roche Diagnostics for use on oral fluid samples collected with Intercept ® device. +FDA 510(k) cleared for PCP, opiates, cocaine and methamphetamines. 510(k) application for amphetamines is pending with FDA. Clinical studies for marijuana and barbiturates +underway. +Not Marketed +Cryosurgical Systems—Professional +Cryosurgical (freezing) system for the removal of warts and other benign skin lesions, marketed under the Histofreezer ® tradename primarily to the physicians’ office market. +Nine indications—FDA 510(k) cleared. +CE marked and registered in certain countries. +Marketed +Marketed +Cryosurgical Systems—OTC +Cryosurgical system for the removal of common and plantar warts, sold in various OTC markets. +FDA 510(k) cleared for common and plantar warts. +Registered in Canada for warts and skin tags. +Marketed +Not Marketed +CE marked and registered for warts in certain countries under Scholl Freeze Spray ® and POINTTS ® +names. +Marketed +CE marked for skin tags. +Not Marketed +In addition to the above products, we also sell certain immunoassay tests and reagents for insurance risk assessment, substance abuse testing and forensic toxicology applications; an oral fluid Western +blot HIV-1 confirmatory test for confirming positive HIV-1 test results obtained from the use of our OraSure ® +collection device; and the FDA 510(k) cleared Q.E.D. ® rapid point-of-care saliva alcohol test. +OraQuick ® Rapid HIV Test +OraQuick ® is our rapid test platform designed to test oral fluid, whole blood (i.e., both finger-stick and venous), plasma and serum samples for the presence of various +antibodies or analytes. The device uses a porous flat pad to collect an oral fluid specimen. After collection, the pad is inserted into a vial containing a pre-measured amount of developer solution and allowed to develop. When blood, plasma or serum +is to be tested, a loop collection device is used to collect a drop of the specimen and mix it in the developer solution, after which the collection pad is inserted into the solution and allowed to develop. In all cases, the specimen and developer +solution then flow through the testing device where test results are observable in approximately 20 minutes. The +OraQuick ® device is a screening test and generally requires a confirmation test where an initial positive result +is obtained. +3 +We initially commercialized this technology in the form of our OraQuick ® rapid HIV-1/2 antibody test. This is a rapid, point-of-care test which has received FDA approval for the detection +of antibodies to both HIV-1 and HIV-2 in oral fluid, finger-stick whole blood, venous whole blood and plasma. This test is available for use by laboratories located in the United States certified under the Clinical Laboratory Improvements Amendment +of 1988, or CLIA, to perform moderately complex tests. We have also received a CLIA waiver for use of the OraQuick +ADVANCE ® test with oral fluid and finger-stick and venous whole blood. As a result, the test can be used +by numerous additional sites in the United States not certified under CLIA to perform moderately complex tests, such as outreach clinics, community-based organizations and physicians’ offices. +On the international front, we have obtained a CE mark for our OraQuick ADVANCE ® test so that we can sell this product in Europe and other countries accepting the CE mark for commercialization. We +have distributors in place for certain countries and are seeking to increase awareness and expand our distribution network for this product throughout the world. +We believe that the OraQuick ADVANCE ® device, because it is approved for detecting antibodies to both HIV-1 and HIV-2 in finger-stick and venous whole blood, oral fluid and plasma samples, provides a +significant competitive advantage in the market for rapid HIV testing in the United States and elsewhere. +OraQuick ® HCV Rapid Antibody Test +Another test available on the OraQuick ® platform is the OraQuick ® HCV rapid antibody test. Like the OraQuick ® HIV test, this product is a qualitative test that can detect antibodies to the Hepatitis C virus, or HCV, in oral fluid and other sample types. The OraQuick ® HCV test operates in substantially the same manner as the +OraQuick ® HIV test. +We have received FDA approval for use of the test in detecting HCV antibodies in venous whole blood and finger-stick +whole blood specimens, making it the first rapid HCV test approved by the FDA for use in the United States. We intend to apply for a CLIA waiver for this product in the near future. Our clinical program for an oral fluid claim for this product is +still underway, although our FDA filing has been delayed pending the completion of additional testing and further discussions with the agency. The OraQuick ® HCV test has received a CE mark for use with oral fluid, venous whole blood, finger-stick whole blood, plasma and serum and was made available for sale in Europe in +2010. +We have entered into agreements with Merck & Co. Inc. (“Merck,” formerly +Schering-Plough) to collaborate on the development and promotion of our OraQuick ® HCV test. Under the terms of +these agreements, we have been and may in the future be reimbursed by Merck for a portion of our costs to develop the test and obtain regulatory approvals. In addition, Merck will provide detailing and other promotional support for the test in the +physicians’ office market in the United States and internationally. +OraSure QuickFlu™ Rapid Flu A&B Test +The OraSure QuickFlu™ rapid flu A&B test is an FDA 510(k) cleared rapid qualitative test for the detection of +influenza (flu) Types A and B, including H1N1 viral infections. The test utilizes specimen collected with a nasal swab, nasopharyngeal swab or nasal aspirate/wash. A reagent is first inserted into a test cartridge, the specimen is added and the test +is allowed to flow. Results are available in as little as ten minutes. +The OraSure QuickFlu™ test is intended to be used +as an aid in the rapid differential diagnosis of influenza and covers a broad range of influenza subtypes, including 2009 H1N1, with proven clinical detection spanning three flu seasons from 2007 through 2009. The test is highly accurate across all +specimen types based on standard culture confirmation with demonstrated sensitivity for influenza Type A at 90% or greater. Additionally, in clinical studies a significant number of culture negative samples that were tested positive with the OraSure +QuickFlu™ product were determined to be true positives by PCR (polymerase chain reaction) testing. +4 +This product is manufactured for us under an agreement with Princeton BioMeditech +Corporation. An application for a CLIA waiver for this test is pending with the FDA. The OraSure QuickFlu™ test is currently available for sale in the U.S. +OraSure ® Collection Device +Our OraSure ® oral fluid collection device is used in conjunction with screening and confirmatory tests for HIV-1 antibodies and other analytes. This device consists of a small, +treated cotton-fiber pad on a handle that is placed in a person’s mouth for two to five minutes. The device collects oral mucosal transudate (“OMT”), a serum-derived fluid that contains higher concentrations of certain antibodies and +analytes than saliva. As a result, OMT testing is a highly accurate method for detecting HIV-1 infection and other analytes. +The OraSure ® collection device is FDA approved for use in the +detection of HIV-1 antibodies and 510(k) cleared for the detection of cocaine and cotinine in oral fluid specimens. In addition, we have received a CE mark for the OraSure ® device and our cocaine and cotinine assays, all of which are sold through distributors in Canada, the United Kingdom, Mexico and certain other foreign countries. +HIV-1 antibody detection using the OraSure ® collection device involves three steps: +• +Collection of an oral fluid specimen using the OraSure ® device; +• +Screening of the specimen for HIV-1 antibodies at a laboratory with an enzyme immunoassay (“EIA”) screening test approved by the FDA for use +with the OraSure ® device; and +• +Laboratory confirmation of any positive screening test results with our oral fluid Western blot HIV-1 confirmatory test (described below). +A trained health care professional then conveys test results and provides appropriate counseling to the individual who was +tested. +We believe that oral fluid testing has several significant advantages over blood or urine-based systems for +infectious disease testing, for both health care professionals and the individuals being tested. These advantages include eliminating the risk of needle-stick accidents, providing a non-invasive collection technique, requiring minimal training to +administer, providing rapid and efficient collection in almost any setting, and reducing the cost of administration by a trained health care professional. +Intercept ® Drug Testing System +A collection device that is substantially similar to the OraSure ® device is sold by us under the name +Intercept ® , and is used to collect OMT for oral fluid drug testing. We have received FDA 510(k) clearance to use +the Intercept ® collection device with laboratory-based EIAs to test for drugs of abuse commonly identified by +the National Institute for Drug Abuse (“NIDA”) as the NIDA-5 (i.e., tetrahydrocannabinol (“THC” or marijuana), cocaine, opiates, amphetamines/methamphetamines and phencyclidine (“PCP”)), and for barbiturates, methadone +and benzodiazepines. Each of these EIAs is also FDA 510(k) cleared for use with the Intercept ® device. Our +Intercept ® device and oral fluid assays are sold in the U.S. primarily through laboratory distributors. +We have received a CE mark for the Intercept ® device and our oral fluid assays and distribute these products in Canada, the United Kingdom and Mexico. +We believe that the Intercept ® device has several advantages over competing urine and other drugs-of-abuse testing products, including its lower total testing cost, its non-invasive nature, +mobility and accuracy, the ease of maintaining a chain-of-custody, the treatment of test subjects with greater dignity, no requirement for specially-prepared collection facilities and difficulty of sample adulteration. The availability of an oral +fluid test is intended to allow our customers to test for drug impairment and eliminate scheduling costs and inconvenience, thereby streamlining the testing process. +5 +In an effort to expand our Intercept ® product line and meet the needs of our laboratory customers, we have jointly developed with Roche Diagnostics a +series of homogeneous fully-automated oral fluid drugs of abuse assays. These assays use Roche’s KIMs (kinetic interaction of micro-particles in solution) technology and will run on various automated analyzers to allow oral fluid samples to be +processed with the same efficiency currently achieved by our laboratory customers with urine-based drug tests. FDA 510(k) clearance has been received for assays to detect PCP, opiates, cocaine and methamphetamines and a 510(k) application for +amphetamines is currently pending before the FDA. Clinical studies for THC and barbiturate assays are in process, and the parties are continuing to develop several other assays pursuant to their joint development agreement. +The high-throughput assays will be distributed in the U.S. and internationally by OraSure and Roche pursuant to a commercialization +agreement between the parties. We expect the initial U.S. commercial launch of the assays to occur later in 2011. +Cryosurgical Systems (Skin Lesion Removal Products) +The Histofreezer ® cryosurgical removal system is a low-cost alternative to liquid nitrogen and other methods for removal of warts and other benign skin lesions by physicians. The +Histofreezer ® product mixes three environmentally friendly cryogenic gases in a small aerosol canister. When +released, these gases are delivered to a specially designed foam bud, cooling the bud to a maximum of –50°C to –55°C. The frozen bud is then applied to the wart or lesion for 15 to 40 seconds (depending on the type of lesion) +creating localized destruction of the target area by freezing. We have received 510(k) clearance for use of the +Histofreezer ® product to remove common warts and eight other types of benign skin lesions, and this product has +been CE marked and registered for distribution in Canada, throughout Europe and in certain other foreign countries. +We have also received FDA 510(k) clearance to market and sell a cryosurgical product similar to the Histofreezer ® product in the OTC or retail market for the removal of common and plantar warts only. In 2009, we began directly selling our cryosurgical wart product in the U.S. OTC +market under a new national brand called Freeze ‘n Clear Skin Clinic™. However, due to the limited revenues derived from this product, competing priorities and limited corporate funding, we decided to stop selling this product in the U.S. +at the end of 2010. +Internationally, we distribute an OTC cryosurgical product through our distributor Genomma Labs, under +the POINTTS tradename, in Mexico and a number of South and Central American countries. We also distribute a CE marked cryosurgical wart removal product into the OTC footcare market in Europe, Australia and New Zealand through our distributor, +Reckitt Benckiser (successor to SSL International) (“Reckitt”), under the Scholl and Dr. Scholl trademarks. Reckitt is the owner of the Scholl and Dr. Scholl trademarks in countries outside North and South America. We intend to +sell OTC cryosurgical products for the treatment of both warts and skin tags to retailers in Canada on a private label basis beginning in 2011. +Immunoassay Tests and Reagents +We develop and sell +immunoassay tests in two formats, known as MICRO-PLATE and AUTO-LYTE ® , to meet the specific needs of our +customers. +In a MICRO-PLATE kit, the sample to be tested is placed into a small plastic receptacle, +called a microwell, along with the reagents. The result of the test is determined by the color of the microwell upon completion of the reaction. Controlling the reaction involves the use of reagents by laboratory personnel. Test results are analyzed +by any of a variety of commercially available laboratory instruments, which we may also provide to our laboratory customers. MICRO-PLATE tests can be performed on commonly used instruments and can detect drugs in urine, serum and sweat specimens. +MICRO-PLATE tests are also used as part of the Intercept ® product line to detect drugs of abuse in oral fluid +specimens. +AUTO-LYTE ® tests are sold in the form of bottles of liquid reagents. These reagents are run on commercially available laboratory-based automated analytical instruments, which +are manufactured by a variety +6 +of third parties. AUTO-LYTE ® is typically used in high +volume, automated, commercial reference insurance laboratories to detect certain drugs or chemicals in urine. Test results are produced quickly, allowing for high throughput. Our AUTO-LYTE ® tests continue to face strong competition from cheaper “home-brew” tests developed internally by our laboratory customers. As a result, we may eventually +stop selling our AUTO-LYTE ® tests. +Western blot HIV-1 Confirmatory Test +We sell an oral +fluid Western blot HIV-1 confirmatory test that received premarket approval from the FDA in 1996. This test uses the original specimen collected with the OraSure ® oral fluid collection device to confirm positive results of initial oral fluid HIV-1 EIA screening tests. +Q.E.D. ® Saliva Alcohol Test +Our Q.E.D. ® saliva alcohol test is a point-of-care test device that is a cost-effective alternative to breath or blood alcohol testing. The test is a quantitative, saliva-based +method for the detection of ethanol, has been cleared for sale by the FDA and has received a CLIA waiver. The U.S. Department of Transportation (“DOT”) has also approved the test. +Each Q.E.D. ® test kit contains a collection stick that is used to collect a sample of saliva and a disposable detection device that displays results in a format similar to a +thermometer. The Q.E.D. ® device is easy to operate and instrumentation is not required to read the result. The +product has a testing range of 0 to 0.145% blood alcohol and produces results in approximately two minutes. +Products Under Development +OraQuick ® Platform +We believe +that OraQuick ® has significant potential as a point-of-care testing platform for clinics and other public health +entities, hospitals, physicians’ offices and other markets. Because the OraQuick ® platform is simple to use +and can operate in a non-invasive manner with oral fluid, we believe it will be suitable for use by consumers without the assistance of a doctor or other medical professional. We also believe that OraQuick ® provides a platform technology that can be modified for detection of a variety of infectious diseases in addition to +HIV, such as viral hepatitis and certain sexually transmitted diseases. +We are currently devoting +significant resources to obtaining FDA approval to sell our OraQuick ® HIV-1/2 test in the United States OTC +market. We have developed an information and referral system and product packaging and labeling suitable for the OTC market. In late 2010, we received an investigational device exemption (“IDE”) from the FDA which allowed us to commence +the final phase of clinical testing for this product. This final phase consists of an unobserved user study that is designed to assess an individual’s ability to conduct self-testing of an oral fluid sample collected with the investigational +OTC version of the test in an unsupervised setting. We expect this clinical phase to continue during 2011, and we intend to submit an application for FDA approval after the study is completed. +Several other new products using the OraQuick ® technology platform are in varying stages of development. These include a second generation OraQuick ® HIV-1/2 antibody test, which we believe will provide improved performance compared to our current product, along with assays for certain other infectious diseases. +OraSure ® /Intercept ® Applications +Oral mucosal transudate, or OMT, contains many constituents found in blood and serum, although in +lower concentrations. We believe the OraSure ® and Intercept ® devices are a platform technology with a wide variety of potential applications, where laboratory testing is available. For example, the OraSure ® device may be useful for the collection of a variety of antibodies or markers for infectious diseases or conditions +in addition to HIV-1, such as antibodies to viral hepatitis. +7 +In 2004, the Substance Abuse and Mental Health Services Administration +(“SAMHSA”) issued proposed regulations for oral fluid drug testing for federal workers. Although these proposed regulations were withdrawn, we believe that SAMHSA, through its Drug Testing Advisory Board, may attempt to promulgate new +regulations that will include oral fluid as an approved testing matrix for federally-regulated workers. If and when issued in final form, these regulations may require certain modifications to our Intercept ® product in order to permit its use by federal workers. As a result, we are developing modifications to the Intercept ® collection device that we anticipate will be required by these regulations or otherwise desired by our customers. +This new version of our Intercept ® device is also expected eventually to be used with the high-throughput drug +assays jointly developed with Roche Diagnostics. +Research and Development +In 2010, our research and development activities focused primarily on clinical and regulatory activities related to +obtaining PMA approval for our OraQuick ® HCV test, planning and implementation of the final phase of clinical +testing for FDA approval of an OraQuick ® HIV OTC test, development of next generation versions of our OraQuick ® HIV and Intercept ® products and assessing initial feasibility of certain other products. +From time to time, we have contracted with third parties to conduct research and development activities and we may do so in the future. +Research and development expenses were $13.2 million in 2010, $13.4 million in 2009 and $20.3 million in 2008. These expenses include our +costs associated with research and development, regulatory affairs, clinical trials and product support. +Sales and Marketing +We attempt to reach our major target markets through a combination of direct sales, strategic collaborations and +independent distributors. Our marketing strategy is to create or raise awareness through a full array of marketing activities, which include trade shows, print advertising, special programs and distributor promotions, in order to stimulate sales in +each target market. +We market our products in the United States and internationally. Revenues attributable to customers in +the United States were $63.5 million, $62.2 million and $57.4 million in 2010, 2009 and 2008, respectively. Revenues attributable to international customers amounted to $11.5 million, $14.8 million and $13.7 million, or 15%, 19% and 19% of our total +revenues, in 2010, 2009 and 2008, respectively. +Infectious Disease Testing +We market the OraQuick ADVANCE ® rapid HIV-1/2 antibody test directly to customers in the public health market for HIV testing. This market consists of a broad range of clinics and laboratories and +includes states, counties, and other governmental agencies, family planning clinics, colleges and universities, correctional facilities and the military. There are also a number of organizations in the public health market, such as AIDS service +organizations and various community-based organizations, that are set up primarily for the purpose of encouraging and enabling HIV testing. We also sell our OraQuick ADVANCE ® test directly to hospitals in the U.S. and through distributors into the U.S. physician market. Beginning in 2011, we have engaged two manufacturers’ +representative organizations to assist in sales to U.S. physicians. +Internationally, we distribute our +OraQuick ® HIV test in Europe and other foreign countries. We expect to increase the number of countries where +this product is sold as we find new distributors and complete registrations in additional countries. +We +market the OraSure ® oral fluid collection device for HIV-1 testing, on its own and as a kit in combination with +laboratory testing services. To better serve our public health customers, we have contracted +8 +with two commercial laboratories to provide prepackaged +OraSure ® test kits, with prepaid laboratory testing and specimen shipping costs included. We also sell the +OraSure ® device in the international public health market. +In June 2010, we received FDA approval of our OraQuick ® HCV test for use with venous whole blood specimens, and in February 2011 we received FDA approval of a finger-stick whole blood claim for this product. We intend to +apply for a CLIA waiver for this product in the near future. Based on the FDA approvals received to date, our +OraQuick ® HCV test is currently sold primarily in the U.S. hospital market. Receipt of a CLIA waiver will enable +us to expand sales of this product into the U.S. public health and physician office markets. In late 2009, we received CE mark approval for this test for use with oral fluid, finger-stick whole blood, venous whole blood, serum and plasma samples and +began selling this product in 2010 through distributors in Europe and other countries. +We previously +entered into agreements with Merck to collaborate on the development and promotion of our OraQuick ® HCV test. +Under the terms of these agreements, we have been and in the future may be reimbursed by Merck for a portion of our costs to develop the test and obtain regulatory approvals. Merck will also provide detailing and other promotional support for the +test in the physicians’ office market in the United States and internationally. +In January 2011, we obtained +distribution rights to an FDA 510(k) cleared rapid flu A&B test. This product is being supplied to us by Princeton BioMeditech Corporation and will be sold under our proprietary OraSure QuickFlu™ tradename. Under our agreement with +Princeton BioMeditech, we will sell this product into the U.S. hospital and public health markets. An application for a CLIA waiver for this test is currently pending with the FDA. +Substance Abuse Testing +Our substance abuse testing products are marketed to laboratories serving the workplace testing, forensic toxicology, criminal justice and drug rehabilitation markets. +We have entered into agreements for the distribution of Intercept ® collection devices and associated MICRO-PLATE assays for drugs-of-abuse testing in the workplace testing market in the United States and Canada through several +laboratory distributors, including Quest Diagnostics (“Quest”) and Clinical Reference Laboratory (“CRL”), and internationally for workplace, criminal justice and forensic toxicology testing through other distributors. In some +cases, we assist our laboratory customers in customizing their testing services by selling them equipment required to test oral fluid specimens collected with the Intercept ® device. +We also market +the Intercept ® collection device on its own and as a kit in combination with laboratory testing services. To +better serve our workplace customers, we have contracted with two commercial laboratories to provide prepackaged +Intercept ® test kits, with prepaid laboratory testing and specimen shipping costs included. +The criminal justice market in the United States for our substance abuse testing products consists of a wide variety of entities in the +criminal justice system that require drug screening, such as pre-trial services, parole and probation officers, police forces, drug courts, prisons, drug treatment programs and community/family service programs. The forensic toxicology market +consists of several hundred laboratories including federal, state and county crime laboratories, medical examiner laboratories and reference laboratories. +As discussed above, the FDA has issued 510(k) clearances for the use of fully-automated high-throughput oral fluid assays for the detection of PCP, opiates, cocaine and methamphetamines with oral fluid +samples collected with our Intercept ® device. An application for 510(k) clearance of an assay for detection of +amphetamines is pending before the FDA, and the clinical studies for marijuana and barbiturates are underway. We expect to begin selling the cleared assays as part of our Intercept ® drug testing system into the workplace, criminal justice, hospital and government markets in collaboration with Roche Diagnostics later in 2011. +9 +We distribute our +Q.E.D. ® saliva alcohol test primarily through various distributors in the United States and internationally. The +markets for alcohol testing are relatively small and fragmented with a broad range of legal and procedural barriers to entry. Markets range from law enforcement testing to workplace testing of employees in safety sensitive occupations. Typical usage +situations include pre-employment, random, post-accident, reasonable-cause and return-to-duty testing. +Cryosurgical +Systems +Most of our Histofreezer ® sales occur in the United States to distributors that, in turn, resell the product to primary care physicians and podiatrists in the United States. Our major U.S. +distributors include Cardinal Healthcare, McKesson HBOC, Physicians Sales & Service, AmerisourceBergen Corporation, and Henry Schein. We have entered into agreements with two manufacturers’ representative organizations under which a +contract salesforce is helping our U.S. distributors promote and sell Histofreezer ® . Internationally, we sell +the Histofreezer ® product through a network of distributors in more than 20 countries worldwide. +We distribute cryosurgical wart removal products in the OTC footcare market in Europe, Australia and New Zealand through our distributor, +Reckitt, under its Scholl and Dr. Scholl tradenames, and in the OTC markets in Mexico and several Central and South American countries under the POINTTS tradename through our distributor, Genomma Labs. In early 2009, we re-launched our OTC +cryosurgical wart product in the U.S. under our own proprietary national brand called Freeze ‘n Clear Skin Clinic™. However, due to limited revenues derived from this product, competing priorities and limited corporate funding, we decided +to stop selling our OTC product in the U.S. at the end of 2010. Beginning in 2011, we intend to begin selling OTC cryosurgical products for the removal of warts and skin tags under private label arrangements with retailers in Canada. +Insurance Risk Assessment +We currently market the OraSure ® oral fluid collection device for +use in screening life insurance applicants in the United States and internationally to test for three of the most important underwriting risk factors: HIV-1, cocaine and cotinine (a metabolite of nicotine). Devices are sold to insurance testing +laboratories, including Quest, Heritage Labs and CRL. These laboratories in turn provide the devices to insurance companies, usually in combination with testing services. +We also promote use of the OraSure ® device directly to insurance companies for life insurance risk assessment. Insurance companies then make their own decision regarding which laboratory to use to +supply their collection devices and testing services. We sell our OraSure ® Western blot confirmatory test +directly to insurance testing laboratories for use in confirming oral fluid specimens collected with our +OraSure ® device that initially test positive for HIV-1. +There exists a wide range of policy limits where our OraSure ® product is being used. In general, most of our insurance company customers use the OraSure ® device in connection with life insurance policies having face amounts of up to $250,000, with some customers using the device for policies of up to $500,000 in +amount. Some insurance companies have chosen to extend their testing to lower policy limits where they did not test at all before, while others have used OraSure ® to replace some of their blood and urine-based testing. +We also sell our AUTO-LYTE ® assays and reagents in the insurance +testing market directly to laboratories, including Heritage Labs and CRL. +International Markets +We sell most of our products into international markets primarily through distributors with knowledge of their local markets. Principal +markets include foreign governments, physicians’ offices, insurance risk assessment, substance abuse, public health and laboratory testing. +10 +We assist our international distributors in registering the products and obtaining required +regulatory approvals in each country, and we provide training and support materials. +Significant Products and Customers +Several different products have contributed significantly to our financial performance, accounting for 10% or more of +our total revenues during the past three years. The OraQuick ® rapid HIV testing products, the cryosurgical +systems products, and the OraSure ® and Intercept ® oral fluid collection devices accounted for total revenues of $40.1 million, $11.9 million and $11.2 million in 2010, $43.8 million, $10.9 million and $12.5 million +in 2009 and $35.3 million, $10.7 million and $13.4 million in 2008, respectively. +We had no individual customers who +accounted for more than 10% of our total revenues in 2010. +Revenue by Segment +We operate our business within one reportable segment and all of our revenues are generated from this one segment. Our revenue is +generated by our product sales and licensing and product development activities. For more information about our revenues from external customers, income and total assets, please see the sections entitled “Selected Financial Data” and +“Management’s Discussion and Analysis of Financial Condition and Results of Operations” and Note 14 to the financial statements, included elsewhere in this Annual Report. +Supply and Manufacturing +Our OraQuick ADVANCE ® HIV test, OraQuick ® HCV test, OraSure ® and +Intercept ® collection devices, Western blot HIV-1 confirmatory test, AUTOLYTE and MICRO-PLATE assays and QED ® saliva alcohol test are all manufactured in our Bethlehem, Pennsylvania facility. We expect to continue to +manufacture these products at this location for the foreseeable future. +We have contracted with a third +party in Thailand for the assembly of the OraQuick ® HIV device, in order to supply certain international +markets. This supply agreement had an initial term of one year, and automatically renews for additional annual periods unless either party provides a timely notice of termination prior to the end of an annual period. We believe that other firms +would be able to manufacture the OraQuick ® test on terms no less favorable than those set forth in the agreement +if the Thailand contractor would be unable or unwilling to continue manufacturing this product. +We can +purchase the HIV antigen and the nitrocellulose used in the OraQuick ® test, the HCV antigen used in the OraQuick ® HCV test and the antigen used in the Western blot HIV-1 confirmatory test only from a limited number of sources. If +for any reason these suppliers are unwilling or no longer able to supply our antigen or nitrocellulose needs, we believe that alternative supplies could be obtained at a competitive cost. However, a change in any of the antigens or nitrocellulose +used in our products would require FDA approval and some additional development work. This in turn could require significant time to complete and could disrupt our ability to manufacture and sell the affected products. +Our MICROPLATE and AUTO-LYTE assays require the production of highly specific and sensitive antibodies corresponding to the antigen of +interest. Substantially all our antibody requirements are provided by contract suppliers. We believe that we have adequate reserves of antibody supplies and that we have access to sufficient raw materials for these products. +Our OraSure QuickFlu™ test is manufactured and supplied by a third party, Princeton BioMeditech. +The Histofreezer ® product sold in the U.S. is assembled by U.S. vendors and the Histofreezer ® product sold internationally is assembled in The Netherlands by Koninklijke, Utermöhlen, N.V. (“Utermöhlen”), the company +11 +from which we acquired the product in 1998. The cryosurgical wart removal products distributed in OTC markets are also assembled by vendors located in the United States. We believe that +additional suppliers of all of our cryosurgical products are available on terms no less favorable than the terms of our existing supply agreements in the event that our current suppliers would be unable or unwilling to continue manufacturing these +products. +Employees +As of December 31, 2010, we had 231 full-time employees, including 65 in sales, marketing and client services; 17 in research and development; 107 in operations, manufacturing, quality control, +information systems, purchasing and shipping; 19 in regulatory affairs; and 23 in administration and finance. This compares to 280 employees as of December 31, 2009. Our employees are not currently represented by a collective bargaining +agreement. +Competition +The diagnostic industry is a multi-billion dollar international industry and is intensely competitive. Many of our competitors are substantially larger than we are, and they have greater financial, +research, manufacturing and marketing resources. +Important competitive factors for our products include product quality, +performance, price, ease of use, customer service and reputation. Industry competition is based on the following: +• +Scientific and technological capability; +• +Proprietary know-how; +• +The ability to develop and market products and processes; +• +The ability to obtain FDA or other regulatory approvals; +• +The ability to manufacture products that meet applicable FDA requirements (i.e., good manufacturing practices); +• +Commercial execution and strength of distribution; +• +Access to adequate capital; +• +The ability to attract and retain qualified personnel; and +• +The availability of patent protection. +A few large corporations produce a wide variety of diagnostic tests and other medical devices and equipment. A larger number of mid-size companies generally compete only in the diagnostic industry and a +significant number of small companies produce only a few diagnostic products. As a result, the diagnostic test industry is highly fragmented and segmented. +The future market for diagnostic tests is expected to be characterized by consolidation, greater cost consciousness and tighter reimbursement policies. The purchasers of diagnostic products are expected +to place increased emphasis on lowering costs, reducing inventory levels, automation, service and volume discounts. The increased complexity of the market is expected to force many competitors to enter into joint ventures or license certain products +or technologies. +We expect competition to intensify as technological advances are made and become more widely known, and as +new products reach the market. Furthermore, new testing methodologies could be developed in the future that render our products impractical, uneconomical or obsolete. There can be no assurance that our competitors will not succeed in developing or +marketing technologies and products that are more effective than those we develop or that would render our technologies and products obsolete or otherwise commercially unattractive. In +12 +addition, there can be no assurance that our competitors will not succeed in obtaining regulatory approval for these products, or introduce or commercialize them, before we can do so. These +developments could have a material adverse effect on our business, financial condition and results of operations. +Several companies market or have announced plans to market oral specimen collection devices and tests both within and outside the United States. We expect the number of devices competing with our +Intercept ® , OraQuick ® and OraSure ® devices to +increase as the benefits of oral fluid-based testing become more widely accepted. +Competition in the HIV +testing market is intense and is expected to increase. We believe that the principal competition will continue to come from existing laboratory-based blood tests, point-of-care rapid blood tests, laboratory-based urine assays or other oral +fluid-based tests that may be developed. Our competitors include specialized biotechnology firms, as well as pharmaceutical companies with biotechnology divisions and medical diagnostic companies. Significant competitors for our OraQuick +ADVANCE ® rapid HIV-1/2 test, such as the Ortho Diagnostics division of Johnson & Johnson, +Bio-Rad Laboratories and Abbott, sell laboratory-based HIV-1/2 EIAs, and Maxim Biomedical (formerly Calypte, Inc.) sells an HIV-1 screening test for urine, in the United States. MedMira and Trinity Biotech each sell competing rapid HIV-1 blood +tests, and Bio-Rad Laboratories and Alere (formerly Inverness Medical) sell competing rapid HIV-1/2 blood tests in the United States. These tests compete with our OraQuick ADVANCE ® test in hospitals and other laboratory settings. In addition, Trinity Biotech and Alere have received CLIA waivers for their rapid HIV tests, and these tests compete +with our OraQuick ADVANCE ® test in the markets outside of the traditional hospital and laboratory +settings. These companies, or others, may continue to expand the bodily fluids with which a rapid HIV test may be performed, or develop and commercialize new rapid HIV tests, which would provide further competition for our OraQuick ADVANCE ® test. We believe other companies may also seek FDA approval to sell competing rapid HIV tests in the future. +Internationally, our OraQuick ADVANCE ® HIV test competes against rapid HIV tests sold by a number of other entities, and often these competing tests are sold at prices substantially below the prices we +charge for our OraQuick ADVANCE ® test. Alere and Trinity Biotech sell rapid HIV-1/2 blood tests outside +the United States and Calypte has developed a rapid oral fluid HIV test which is now being sold in certain foreign countries. Lower priced rapid HIV blood tests are also sold internationally by various third parties. +The OraQuick ® HCV test competes primarily against laboratory-based HCV blood tests. Major suppliers of these competing tests are Abbott Labs, Seimens, Ortho-Clinical Diagnostics, +Roche and Bio-Rad. In non-U.S. countries outside of Europe, we expect that our OraQuick ® HCV test will compete +against other rapid HCV blood tests in addition to the laboratory-based tests. +The OraSure QuickFlu™ test will compete +primarily against other rapid flu tests sold by various third parties into the U.S. hospital and public health markets. The principal suppliers of these competing tests include Quidel and Alere. +The Intercept ® drug testing system competes with laboratory-based drug testing products and services using testing matrices such as urine, hair, sweat and oral fluid. Major +competitors include Ansys Technologies, Dade Behring, Psychemedics and Immunalysis. +Our MICRO-PLATE oral +fluid drug assays, which are sold for use with the Intercept ® and OraSure ® collection devices, continue to come under increasing competitive pressure from “home-brew” assays +developed internally by our laboratory customers. Our oral fluid MICRO-PLATE assays also compete with urine-based homogeneous assays that are run on fully-automated, random access analyzers. These tests provide strong competitive pressure because +they provide the benefits of automation, including lower costs and short turn-around times. In addition, we believe our competitors are developing oral fluid tests suitable for use on these fully automated homogeneous assay systems and these assays, +if and when they are developed and +13 +commercialized, will represent a significant competitive threat to our oral fluid MICRO-PLATE business. In order to meet this competition, we are developing and intend to commercialize +fully-automated homogeneous oral fluid drugs of abuse assays with Roche Diagnostics for use with our Intercept ® +device. +Our MICRO-PLATE drugs-of-abuse reagents sold in the forensic toxicology market are targeted to forensic testing +laboratories where sensitivity, automation and “system solutions” are important. In the past, these laboratories have typically had to rely on radioimmunoassay test methods to provide an adequate level of sensitivity. Radioimmunoassays +require radioactive materials, which have a short shelf-life and disposal problems. Our MICRO-PLATE tests meet the laboratories’ sensitivity needs, run on automated equipment, are not radioimmunoassays, and are offered to the laboratory as a +complete system solution of reagents, instrumentation and software to meet the specific needs of each customer. We compete with both homogeneous and heterogeneous tests manufactured by many companies. Significant competitors in the market for these +assays include Thermo Scientific (formerly Microgenics, Inc.), Roche Diagnostics and Immunalysis. +Sales +of our AUTO-LYTE ® urine assays have declined substantially during the past several years, primarily due to +competition from “home-brew” assays developed internally by our laboratory customers, which can be produced at a cost lower than the price typically paid for our products. Many of our customers no longer purchase our AUTO-LYTE ® assays, and we may eventually stop selling this product line. +The Histofreezer ® product’s delivery system and operating temperature, which is warmer than liquid nitrogen, provide us with the opportunity to target sales to primary care +physicians, such as family practitioners, pediatricians and podiatrists. We do not generally target sales to dermatologists because they have the volume of patients required to support the capital costs associated with a liquid nitrogen delivery +system, which is also used to remove warts and other benign skin lesions. Major competitors for the +Histofreezer ® product include Cryosurgery, Inc. in the United States and Wartner in Europe. Competition in the +international OTC markets comes primarily from cryosurgical products sold by Wartner and several other firms. +Q.E.D. ® has two primary competitors, Ansys Technologies and +Chematics. These companies offer semi-quantitative saliva-based alcohol tests and have received DOT approval. Indirect competitors who offer breath testing equipment include Intoximeters, Dräger and CMI. Although there are lower priced tests on +the market that use oral fluid or breath as a test medium, these tests are qualitative tests that are believed to be substantially lower in quality and provide fewer benefits than our Q.E.D. ® test. +Patents and Proprietary Information +We seek patents and other intellectual property rights to protect and preserve our proprietary technology and our right to +capitalize on the results of our research and development activities. We also rely on trade secrets, know-how, continuing technological innovations and licensing opportunities to provide competitive advantages for our products in our markets and to +accelerate new product introductions. We regularly search for third-party patents in fields related to our business to shape our own patent and product commercialization strategies as effectively as possible and to identify licensing opportunities. +United States patents generally have a maximum term of 20 years from the date an application is filed. +We +have ten United States patents and numerous foreign patents for the OraSure ® and Intercept ® collection devices and technology relating to oral fluid collection, containers for oral fluids, methods to test +oral fluid, formulations for the manufacture of synthetic oral fluid, and methods to control the volume of oral fluid collected and dispersed. The patents expire from January 2013 to September 2022. We have also applied for additional patents, in +both the United States and certain foreign countries, on such products and technology. +We have four +United States patents for our OraQuick ® platform, and we have several related patent applications pending in +the United States and internationally. Three of these patents expire from March to April 2019 and the fourth in August 2027. We have obtained licenses to certain lateral flow patents and to certain +14 +HIV-1 and HIV-2 patents held by other parties. We also have obtained a license to certain HCV patents which we use to manufacture and sell a rapid HCV test on the OraQuick ® or other technology platforms. We obtained these licenses through the payment of certain upfront fees and an +agreement to pay ongoing royalties. We believe these fees and royalties are comparable to those generally paid by other companies under similar arrangements. +We may need to obtain licenses or other rights under, or enter into distribution or other business arrangements in +connection with, certain other intellectual property patents in order to manufacture and sell the OraQuick +ADVANCE ® HIV test or other tests that use the same or similar technology platform. See Section 1A, +entitled “Risk Factors,” for a further discussion of these issues. +We have four United States patents and numerous +foreign patents issued for apparatuses and methods for the topical removal of skin lesions relating to our cryosurgical wart removal products, and we have pending patent applications related to these products in the United States and in certain +foreign countries. These patents expire from July 2012 to January 2014. We have also licensed another patent relating to apparatuses and methods for the topical removal of skin lesions relating to our cryosurgical wart removal products. +We require our employees, consultants, outside collaborators and other advisors to execute confidentiality agreements upon the +commencement of employment or consulting relationships with us. These agreements provide that all confidential information developed by or made known to the individual during the course of the individual’s relationship with us is to be kept +confidential and not disclosed to third parties except in specific circumstances. In the case of employees, the agreements provide that all inventions conceived by the individual during his or her tenure with us will be our exclusive property. +We own rights to trademarks and service marks that we believe are necessary to conduct our business as +currently operated. In the United States, we own a number of trademarks, including the OraSure ® , Intercept ® , OraQuick ® , OraQuick ADVANCE ® , +Histofreezer ® , OraSure QuickFlu™, Q.E.D. ® and AUTO-LYTE ® trademarks. We +also own many of these marks and others in several foreign countries. With respect to our international OTC cryosurgical products, the Scholl and Dr. Scholl tradenames are owned by Reckitt in Europe, Australia, New Zealand and other countries +outside North and South America, and the POINTTS tradename is owned by Genomma Labs. +Although important, the issuance of a +patent or existence of trademark or trade secret protection does not in itself ensure the success of our business. Competitors may be able to produce products competing with our patented products without infringing our patent rights. Issuance of a +patent in one country generally does not prevent manufacture or sale of the patented product in other countries. The issuance of a patent is not conclusive as to validity or as to the enforceable scope of the patent. The validity or enforceability +of a patent can be challenged by litigation after its issuance. If the outcome of such litigation is adverse to the owner of the patent, the owner’s rights could be diminished or withdrawn. Trade secret protection does not prevent independent +discovery and exploitation of the secret product or technique. +Government Regulation +General +Most of our products are regulated by the FDA, certain state and local agencies and comparable regulatory bodies in other countries. This +regulated environment governs almost all aspects of development, production and marketing, including product testing, authorizations to market, labeling, promotion, manufacturing and recordkeeping. +All of our FDA-regulated products require some form of action by the FDA before they can be marketed in the United States. After approval +or clearance by the FDA, we must continue to comply with other FDA requirements applicable to marketed products. Both before and after approval or clearance, failure to comply +15 +with the FDA’s requirements can lead to significant penalties or could disrupt our ability to manufacture and sell these products. In addition, the FDA could refuse permission to obtain +certificates needed to export our products if the agency determines that we are not in compliance. +Domestic Regulation +Most of our products are regulated in the United States as medical devices. +There are two mechanisms by which regulated medical devices can be placed on the market in the United States. Some products may qualify +for clearance under Section 510(k) of the Federal Food, Drug and Cosmetic Act. To obtain this clearance from the FDA, the manufacturer must provide a premarket notification that it intends to begin marketing the product, and show that the +product is substantially equivalent to another legally marketed product (i.e., that it has the same intended use and is as safe and effective as a legally marketed device and does not raise different questions of safety and effectiveness). In some +cases, the submission must include data from human clinical studies. Marketing may only commence when the FDA issues a clearance letter finding substantial equivalence. An applicant must submit a 510(k) application at least 90 days before marketing +of the affected product commences. Although FDA clearance may be granted within that 90-day period, in some cases as much as a year or more may be required before clearance is obtained, if at all. +If the medical device does not qualify for the 510(k) procedure (either because it is not substantially equivalent to a legally marketed +device or because it is required by statute and the FDA’s regulations to have an approved premarket application, or PMA), the FDA must approve a PMA before marketing can begin. PMAs must demonstrate, among other matters, that the medical device +provides a reasonable assurance of safety and effectiveness. A PMA is typically a complex submission, including the results of preclinical and clinical studies. Preparing a PMA is a detailed and time-consuming process. Once a PMA has been submitted, +the FDA is required to review the submission within 180 days. However, the FDA’s review may be, and often is, much longer, often requiring one year or more, and may include requests for additional data and facility inspections before approval +is granted, if at all. +Some of our products are used for non-medical purposes and many of our drugs-of-abuse products sold to +state crime laboratories are for forensic use. The FDA does not currently regulate products used for these purposes. +Every +company that manufactures medical devices distributed in the United States must comply with the FDA’s Quality System Regulations (“QSRs”). These regulations govern the manufacturing process, including design, manufacture, testing, +release, packaging, distribution, documentation and purchasing. In complying with the QSRs, manufacturers must continue to expend time, money and effort in the area of production and quality to ensure full technical compliance. Companies are also +subject to other post-market and general requirements, including restrictions imposed on marketed products, promotional standards and requirements for recordkeeping and reporting of certain adverse reactions. If there are any modifications made to +our marketed devices, a premarket notification or PMA may be required to be submitted to, and cleared or approved by, the FDA, before the modified device may be marketed. The FDA regularly inspects companies to determine compliance with the QSRs and +other post-market requirements. Failure to comply with statutory requirements and the FDA’s regulations can result in warning letters, monetary penalties, suspension or withdrawal of regulatory approvals, operating restrictions, total or +partial suspension of production, injunctions, product recalls, seizure of products and criminal prosecution. +The Clinical +Laboratory Improvements Amendments of 1988, or CLIA, prohibit any facility that does laboratory testing on specimens derived from humans from providing information for the diagnosis, prevention or treatment of any disease or impairment of, or the +assessment of, the health of human beings, unless there is in effect for such facility a certificate issued by the U.S. Department of Health and Human Services applicable to the category of examination or procedure performed. Tests may be waived +from this regulatory oversight if they +16 +meet certain requirements established under CLIA. We consider the applicability of the requirements of CLIA in the design and development of our products. We have obtained a waiver of the CLIA +requirements for both our OraQuick ADVANCE ® rapid HIV-1/2 antibody test and our Q.E.D. ® alcohol saliva test and may seek similar waivers for certain other products. A CLIA waiver allows certain customers +to use the waived products that may not have been able to use them without complying with applicable quality control and other requirements. +Certain of our products may also be affected by state regulations in the United States. We are presently working with legislators or regulators in certain of these states in an effort to modify or remove +any restrictions affecting our ability to sell products. +International +We are also subject to regulations in foreign countries governing products, human clinical trials and marketing, and may need to obtain +approval from international public health agencies, such as the World Health Organization, in order to sell products in certain countries. Approval processes vary from country to country, and the length of time required for approval or to obtain +other clearances may in some cases be longer than that required for U.S. governmental approvals. We generally pursue approval only in those countries that we believe have a significant market opportunity. +The International Organization for Standardization (“ISO”) is a worldwide federation of national standards bodies from some 130 +countries, established in 1947. The mission of the ISO is to promote the development of standardization and related activities in the world with a view to facilitating the international exchange of goods and services. ISO certification is a +pre-requisite to use of the CE mark and indicates that our quality system complies with standards applicable to activities ranging from initial product design and development through production and distribution. The CE mark is a European Union +(“EU”) requirement to sell products that fall under the scope of the Medical Devices Directive (“MDD”) and the In Vitro Diagnostic Directive (“IVDD”). The CE mark is evidence that the manufacturer and the product meet +the requirements of all applicable directives, including the MDD and IVDD. +We received authorization to +use the CE mark for the OraQuick ADVANCE ® HIV-1/2 test, the OraQuick ® HCV test, the OraSure ® and Intercept ® collection +devices, our Histofreezer ® product line, and our OTC cryosurgical removal product. +We must also comply with certain registration requirements as dictated by Health Canada, prior to commencing sales in Canada. We have +completed this process for several of our current products and may do so with respect to other products in the future. In addition, Canadian law requires manufacturers of medical devices to have a quality management system that meets various ISO +requirements in order to obtain a license to sell their devices in Canada. +Anti-Kickback and Other Fraud and Abuse Laws +The Federal Anti-Kickback Statute prohibits the knowing and willful offer, payment, solicitation, or receipt of any form +of remuneration in return for, or to induce: +• +The referral of a person; +• +The furnishing or arranging for the furnishing of items or services reimbursable under Medicare, Medicaid or other governmental programs; or +• +The purchase, lease, or order of, or the arrangement or recommendation of the purchasing, leasing, or ordering of any item or service reimbursable +under Medicare, Medicaid, or other governmental programs. +17 +Our products are or may be purchased by customers that will seek or receive reimbursement +under Medicare, Medicaid or other governmental programs. Noncompliance with the federal anti-kickback legislation can result in exclusion from Medicare, Medicaid or other governmental programs, and/or restrictions on our ability to operate in +certain jurisdictions, as well as civil and criminal penalties, any of which could have an adverse effect on our business and results of operations. +The Federal Civil Monetary Penalties Law prohibits the offering or transferring of remuneration to a Medicare or Medicaid beneficiary that the person knows or should know is likely to influence the +beneficiary’s selection of a particular supplier of Medicare or Medicaid payable items or services. Noncompliance can result in civil monetary penalties for each wrongful act, assessment of three times the amount claimed for each item or +service and exclusion from the Federal healthcare programs. +Many states have also adopted some form of anti-kickback laws. A +determination of liability under such laws could result in fines and penalties and restrictions on our ability to operate in these jurisdictions. +We are also subject to other federal and state laws targeting fraud and abuse in the healthcare industry, including false claims laws and marketing conduct laws and laws constraining the sales, marketing +and other promotional activities of manufacturers of medical devices by limiting the kinds of financial arrangements, including sales programs, with physicians, hospitals, laboratories and other potential purchasers of medical devices. Violations of +these laws may be punishable by criminal or civil sanctions, including substantial fines, imprisonment and exclusion from participation in government healthcare programs such as Medicare and Medicaid. These laws and regulations are wide ranging and +subject to changing interpretation and application. In recent years, there has been greater scrutiny of marketing practices in the medical device industry which has resulted in several government investigations by various government authorities and +the introduction and/or passage of federal and state legislation regulating interactions between medical device manufacturers and healthcare professionals and providers and requiring the disclosure by medical device manufacturers of gifts or other +payments to healthcare professionals and providers. To be in compliance with such disclosure laws, we have implemented necessary systems for accurately tracking gifts and other payments. +We have implemented a written Policy on Interactions with Health Care Professionals, which is based on the Code of Conduct for +Interactions with Health Care Professionals promulgated by the Advanced Medical Technology Association, or AdvaMed, a leading trade association representing medical device manufacturers. The Policy applies to all employees and is intended to comply +with applicable state and federal laws, regulations and government guidance. The Policy addresses interactions related to sales and marketing practices, research and development, product training and education, grants and charitable contributions, +support of third-party educational conferences, and consulting arrangements. +Foreign Corrupt Practices Act +The U.S. Foreign Corrupt Practices Act (“FCPA”) prohibits corporations and individuals from engaging in certain activities to +obtain or retain business or to influence a person working in an official capacity. It is illegal to pay, offer to pay or authorize the payment of anything of value to any foreign government official, government staff member, political party or +political candidate in an attempt to obtain or retain business or to otherwise influence a person working in an official capacity. Our present and future business has and will continue to be subject to the FCPA and various other laws, rules and/or +regulations applicable to us as a result of our international sales. +Environmental Regulation +Because of the nature of our current and proposed research, development, and manufacturing processes, we are subject to stringent federal, +state and local laws, rules, regulations and policies governing the use, generation, manufacture, storage, air emission, effluent discharge and handling and disposal of materials and wastes. +18 +The foregoing discussion of our business should be read in conjunction with the Financial +Statements and accompanying notes included in Item 15 of this Annual Report. +ITEM 1A. +Risk Factors +You +should carefully consider the risks and uncertainties described below, together with all of the other information included in this Annual Report and our other SEC filings, in considering our business and prospects. The risks and uncertainties +described below are not the only ones facing us. Additional risks and uncertainties not disclosed or not presently known to us or that we currently deem immaterial also may impair our business operations. The occurrence of any of the following risks +could harm our business, financial condition or results of operations. +Regulatory Risks +The Need to Obtain Regulatory Approvals Could Increase Our Costs and Adversely Affect Our Financial Performance. +Many of our proposed and existing products are subject to regulation by the FDA and other governmental or public health agencies. In +particular, we are subject to strict governmental controls on the development, manufacture, labeling, distribution and marketing of our products. In addition, we are often required to obtain approval or registration with foreign governments or +regulatory bodies before we can import and sell our products in foreign countries. +The process of obtaining required +approvals or registrations from governmental or public health agencies can involve lengthy and detailed laboratory testing, human clinical trials, sampling activities and other costly, time-consuming procedures. These approvals and registrations can +require the submission of a large amount of clinical data which can be expensive and may require significant time to obtain. It is also possible that a product will not perform at a level needed to generate the clinical data required to obtain +approval or registration. The submission of an application to the FDA or other international regulatory authority does not guarantee that an approval or registration to market the product will be received. A regulatory authority may impose its own +requirements as a condition to granting an approval or registration, may include significant restrictions or limitations as part of any approval or clearance it grants and may delay or refuse to grant approval or registration, even though a product +has been approved without restrictions or limitations in another country or by another agency. +The process required for +approval or registration of our new products can be lengthy and may increase the costs associated with developing those products, as well as the risk that we will not succeed in introducing or selling them in the United States or other countries. +Our future performance depends on, among other things, our estimates as to when and at what cost we will receive regulatory approvals and registrations for new products. +We are conducting the final phase of clinical studies to support an application for FDA approval of our OraQuick ® HIV-1/2 test for sale in the United States OTC market. Since a rapid HIV test has never before been approved by the +FDA for OTC use, its approval will depend on our further discussions with the FDA and its advisory committees and our ability to successfully complete the remaining clinical work. In addition, we recently received FDA approval of our OraQuick ® HCV test for use with venous whole blood and finger-stick blood specimens, and we plan to seek FDA approval for an +oral fluid claim and a CLIA waiver for this product. There can be no assurance that our clinical trials will support FDA approval of an OraQuick ® HIV OTC test or that we will obtain any future approvals for our OraQuick ® HCV test. Failure to obtain or any delay in obtaining these approvals for either product could significantly reduce future revenues, increase our costs and adversely +affect our financial performance and prospects. +19 +In addition, all in vitro diagnostic products that are to be sold in the EU must bear +the CE mark indicating conformance with the essential requirements of the IVDD. We are not permitted to sell our products in the EU without a CE mark. We have obtained the CE mark for several of our existing products. We also intend to obtain CE +mark for certain of our future products and are not aware of any material reason why we will be unable to do so. However, there can be no assurance that compliance with all provisions of the IVDD will be demonstrated and the CE mark will be obtained +or maintained for all products that we desire to sell in the EU. The failure to obtain or maintain the CE mark for one or more of our products could lead to the termination of strategic alliances and agreements for sales of those products in the EU. +Our Ability to Respond to Changes in Regulatory Requirements Could Adversely Affect Our Business. +Newly promulgated regulations could require changes to our products, necessitate additional clinical trials or procedures, or could make +it impractical or impossible for us to market our products for certain uses, in certain markets, or at all. In addition, the FDA and other regulatory authorities have the ability to change the requirements for obtaining product approval and/or +impose new or additional requirements as part of the approval process. These changes or new or additional requirements may occur after the completion of substantial clinical work and other costly development activities. The implementation of such +changes or new or additional requirements may result in additional clinical trials and substantial additional costs and can delay or make it more difficult or complicated to obtain product approvals. +Failure to Comply With FDA or Other Regulatory Requirements May Require Us to Suspend Production of Our Products or Institute a Recall +Which Could Result in Higher Costs and a Loss of Revenues. +Our businesses are extensively regulated by the FDA and other +federal, state and foreign regulatory agencies. Our suppliers and distributors often are subject to similar regulation. These regulations impact many aspects of our operations, and the operations of our suppliers and distributors, including +manufacturing, labeling, packaging, adverse event reporting, storage, advertising, promotion and record keeping. For example, our manufacturing facilities and those of our suppliers and distributors are, or can be, subject to periodic regulatory +inspections. The FDA and foreign regulatory agencies may require post-marketing testing and surveillance to monitor the performance of approved products or place conditions on any product approvals that could restrict the commercial applications of +those products. In addition, the subsequent discovery of previously unknown problems with a product may result in restrictions on the product, including withdrawal of the product from the market. We are also subject to routine inspection by the FDA +and certain state agencies for compliance with Quality System Requirement and Medical Device Reporting requirements in the United States and other applicable regulations worldwide, including but not limited to ISO regulations. +Although we believe that we have adequate processes in place to ensure compliance with these requirements, the FDA or other regulatory +bodies could force us to stop manufacturing, selling or exporting our products if it concludes that we are out of compliance with applicable regulations. The ability of our suppliers to supply critical components or materials and of our distributors +to sell our products could be adversely affected if their operations are determined to be out of compliance. The FDA and other regulatory bodies could also require us to recall products if we fail to comply with applicable regulations, which could +force us to stop manufacturing and selling such products. Such actions by the FDA and other regulatory bodies could adversely affect our revenues, costs and results of operations. +In the ordinary course of business, we must frequently make subjective judgments with respect to compliance with applicable laws and +regulations. If regulators subsequently disagree with the manner in which we have sought to comply with these regulations, we could be subjected to substantial civil and criminal penalties, as well as product recall, seizure or injunction with +respect to the sale of our products. The assessment of any civil and criminal penalties against us could severely impair our reputation within the industry and any limitation on our ability to manufacture and market our products could have a +material adverse effect on our business. +20 +Our Inability to Manufacture Products in Accordance With Applicable Specifications, +Performance Standards or Quality Requirements Could Adversely Affect Our Business. +The materials and processes used to +manufacture our products must meet detailed specifications, performance standards and quality requirements to ensure our products will perform in accordance with their label claims, our customers’ expectations and applicable regulatory +requirements. As a result, our products and the materials used in their manufacture or assembly undergo regular inspections and quality testing. Factors such as defective materials or processes, mechanical failures, human errors, environmental +conditions, changes in materials or production methods by our vendors, and other events or conditions could cause our products or the materials used to produce or assemble our products to fail inspections and quality testing. +Any failure or delay in our ability to meet the applicable specifications, performance standards or quality requirements could adversely +affect our ability to manufacture and sell our products or comply with regulatory requirements. These events could, in turn, adversely affect our revenues and results of operations. +We Are Subject to Numerous Government Regulations in Addition to FDA Requirements, Which Could Increase Our Costs or Affect Our +Operations. +In addition to the FDA and other regulations described previously, regulations in some states may restrict our +ability to sell products in those states. While we intend to work with state legislators and regulators to remove or modify any applicable restrictions, there is no guarantee we will be successful in these efforts. +We must also comply with numerous laws relating to such matters as safe working conditions, manufacturing practices, environmental +protection, fire hazard control, disposal of hazardous substances and labor or employment practices. Compliance with these laws or any new or changed laws regulating our business could result in substantial costs. Because of the number and extent of +the laws and regulations affecting our industry, and the number of governmental agencies whose actions could affect our operations, it is impossible to reliably predict the full nature and impact of these requirements. To the extent the costs and +procedures associated with complying with these laws and requirements are substantial or it is determined that we do not comply, our business and results of operations could be adversely affected. +Compliance With Regulations Governing Public Company Corporate Governance and Reporting is Complex and Expensive. +Many laws and regulations impose obligations on public companies, which have increased the scope, complexity and cost of corporate +governance, reporting and disclosure practices. Examples include the Sarbanes-Oxley Act of 2002, the requirements of the NASDAQ Global Market, The Dodd-Frank Wall Street Reform and Consumer Protection Act, the SEC’s requirements for public +companies to provide financial statements in interactive data format using the eXtensible Business Reporting Language, or XBRL, and the International Financial Reporting Standards conversion requirements. Our implementation of certain aspects of +these laws and regulations has required and will continue to require substantial management time and oversight and may require us to incur significant additional accounting and legal costs. We continually evaluate and monitor developments with +respect to new and proposed rules and cannot predict or estimate the ultimate amount of additional costs we may incur or the timing of such costs. These laws and regulations are subject to varying interpretations, in many cases due to their lack of +specificity, and as a result, their application in practice may evolve over a time as new guidance is provided by regulatory and governing bodies. This could result in continuing uncertainty regarding compliance matters and higher costs necessitated +by ongoing revisions to disclosure and governance practices. Although we are committed to maintaining high standards of corporate governance and public disclosure, if we fail to comply with any of these requirements, legal proceedings may be +initiated against us and we may be harmed. +21 +Federal and State Laws Pertaining to Healthcare Fraud and Abuse Could Materially +Adversely Affect Our Business, Financial Condition and Results of Operations. +We are subject to various federal and state +laws targeting fraud and abuse in the healthcare industry, including anti-kickback laws, false claims laws and marketing conduct laws, including laws constraining the sales, marketing and other promotional activities of manufacturers of medical +devices by limiting the kinds of financial arrangements, including sales programs, with physicians, hospitals, laboratories and other potential purchasers of medical devices. Violations of these laws are punishable by criminal or civil sanctions, +including substantial fines, imprisonment and exclusion from participation in government healthcare programs such as Medicare and Medicaid. Many of the existing requirements are new and have not been definitively interpreted by state authorities or +courts, and available guidance is limited. Unless and until we are in full compliance with these laws, we could face enforcement action and fines and other penalties, and could receive adverse publicity, all of which could materially harm our +business. In addition, changes in these laws, regulations, or administrative or judicial interpretations, may require us to change our business practices or subject our existing business practices to legal challenges, which could have a material +adverse effect on our business, financial condition and results of operations. +Risks Relating to Our Industry, Business and +Strategy +Our Ability to Sell Products Could be Adversely Affected by Competition From New and Existing Diagnostic +Products. +The diagnostics industry is focused on the testing of biological specimens in a laboratory or at the point of +care and is highly competitive and rapidly changing. Many of our principal competitors have considerably greater financial, technical and marketing resources. As new products enter the market, our products may become obsolete or a competitor’s +products may be more effective or more effectively marketed and sold than ours. If we fail to maintain and enhance our competitive position, our customers may decide to use products developed by competitors which could result in a loss of revenues. +We also face competition from products which are sold at a lower price. Where this occurs, customers may choose to buy lower +cost products from third parties or we may be forced to sell our products at a lower price, both of which could result in a loss of revenues or a lower gross margin contribution from the sale of our products. We may also be required to increase our +marketing efforts in order to compete effectively, which would increase our costs. +Our Research, Development and +Commercialization Efforts May Not Succeed and Our Competitors May Develop and Commercialize More Effective or Successful Diagnostic Products. +In order to remain competitive, we must regularly commit substantial resources to research and development and the commercialization of new or enhanced products. The research and development process +generally takes a significant amount of time from product inception to commercial launch. This process is conducted in various stages. During each stage there is a substantial risk that we will not achieve our goals on a timely basis, or at all, and +we may have to abandon a new or enhanced product in which we have invested substantial time and money. +During 2010, 2009 and +2008, we incurred $13.2 million, $13.4 million and $20.3 million, respectively, in research and development expenses. We expect to continue to incur significant costs related to our research and development activities. +Successful products require significant development and investment, including testing, to demonstrate their cost-effectiveness or other +benefits prior to commercialization. In addition, regulatory approval must be obtained before most products may be sold. Additional development efforts on these products can be required before any +22 +regulatory authority will review them. As noted above, regulatory authorities may not approve these products for commercial sale or can substantially delay approval. In addition, even if a +product is developed and all applicable regulatory approvals are obtained, there may be little or no market for the product. Accordingly, if we fail to develop and gain commercial acceptance for our products, or if competitors develop more effective +products or a greater number of successful new products, customers may decide to use products developed by our competitors. This would result in a loss of revenues and adversely affect our results of operations, cash flow and business. +Failure to Achieve Our Financial and Strategic Objectives Could Have a Material Adverse Impact on Our Business Prospects. +As a result of any number of risk factors identified in this Annual Report, no assurance can be given +that we will be successful in implementing our financial and strategic objectives, including our clinical development programs for a rapid HIV OTC test and/or a rapid HCV test using the OraQuick ® technology platform. In addition, the funds for the foregoing projects have in the past come primarily from our business operations. If our business slows and we have +less money available to fund research and development and clinical programs, we will have to decide at that time which programs to cut, and by how much. Similarly, if adequate financial, personnel, equipment or other resources are not available, we +may be required to delay or scale back our strategic efforts. Our operations will be adversely affected if our total revenue and gross profits do not correspondingly increase or if our technology, product, clinical and market development efforts are +unsuccessful or delayed. Furthermore, our failure to successfully introduce new or enhanced products and develop new markets could have a material adverse effect on our business and prospects. +If We Lose Our Key Personnel or Are Unable to Attract and Retain Qualified Personnel as Necessary, Our Business Could be Harmed. +Our success depends to a large extent upon the contributions of our executive officers, management and sales, marketing, +operations and scientific staff. We may not be able to attract or retain a sufficient number of qualified employees in the future due to the intense competition for qualified personnel among medical products and other life science businesses. We +generally do not enter into employment agreements requiring our employees to work for us for any specified period. +If we are +not able to attract and retain the necessary personnel to accomplish our business objectives, we may experience constraints that will adversely affect our ability to effectively manufacture, sell and market our products, to meet the demands of our +strategic partners in a timely fashion, or to support research, development and clinical programs. Although we believe we will be successful in attracting and retaining qualified personnel, competition for experienced scientists and other personnel +from numerous companies and academic and other research institutions may limit our ability to do so on acceptable terms. +Future Acquisitions or Investments Could Disrupt Our Ongoing Business, Distract Our Management, Increase Our Expenses and Adversely +Affect Our Business. +We may consider strategic acquisitions or investments as a way to expand our business in the future. +These activities, and their impact on our business, are subject to many risk factors, including the following: +• +Suitable acquisitions or investments may not be found or consummated on terms or schedules that are satisfactory to us or consistent with our +objectives; +• +We may be unable to successfully integrate an acquired company’s personnel, assets, management systems, products and/or technology into our +business; +• +Acquisitions may require substantial expense and management time and could disrupt our business; +• +An acquisition and subsequent integration activities may require greater capital and other resources than originally anticipated at the time of +acquisition; +23 +• +An acquisition may result in the incurrence of unexpected expenses, the dilution of our earnings or our existing stockholders’ percentage +ownership, or potential losses from undiscovered liabilities not covered by an indemnification from the seller(s) of the acquired business; +• +An acquisition may result in the loss of our or the acquired company’s key personnel, customers, distributors or suppliers; +• +The benefits expected to be derived from an acquisition may not materialize and could be affected by numerous factors, such as regulatory developments, +general economic conditions, increased competition and our ability to complete the acquisition and integrate the acquired entity’s operations and business; and +• +An acquisition of a foreign business may involve additional risks, including, but not limited to, foreign currency exposure, liability or restrictions +under foreign laws or regulations, and our inability to successfully assimilate differences in foreign business practices or overcome language or cultural barriers. +The occurrence of one or more of the above or other factors may prevent us from achieving all or a significant part of the benefits +expected from an acquisition or investment. This may adversely affect our financial condition, results of operations and ability to grow our business or otherwise achieve our financial and strategic objectives. +Our Revenues Could be Affected by Third-Party Reimbursement Policies and Potential Cost Constraints. +The end-users of our products include hospitals, physicians and other healthcare providers. Use of our products could be adversely +impacted if end-users do not receive adequate reimbursement for the cost of our products from their patients’ healthcare insurers or payors. Our net sales could also be adversely affected by changes in reimbursement policies of governmental or +private healthcare payors, including in particular the level of reimbursement for our products. +In the United States, +healthcare providers such as hospitals and physicians who purchase diagnostic products generally rely on third-party payors, such as private health insurance plans, Medicare and Medicaid, to reimburse all or part of the cost of the product and +procedure. The overall escalating cost of medical products and services has led to, and will continue to lead to, increased pressures on the healthcare industry, both foreign and domestic, to reduce the cost of products and services. Given the +efforts to control and reduce healthcare costs in the United States in recent years, currently available levels of reimbursement may not continue to be available in the future for our existing products or products under development. Third-party +reimbursement and coverage may not be available or adequate in either the United States or foreign markets, current reimbursement amounts may be decreased in the future and future legislation, and regulation or reimbursement policies of third-party +payors, may reduce the demand for our products or our ability to sell our products on a profitable basis. +Changes in +Healthcare Regulation Could Affect Our Revenues, Costs and Financial Condition. +In recent years, there have been numerous +initiatives on the federal and state levels for comprehensive reforms affecting the payment for, the availability of and reimbursement for healthcare services in the United States. These initiatives have ranged from proposals to fundamentally change +federal and state healthcare reimbursement programs, including providing comprehensive healthcare coverage to the public under governmental funded programs, to minor modifications to existing programs. One example is the Patient Protection and +Affordable Care Act, the Federal healthcare reform law enacted in 2010 (“Affordable Care Act”). Similar reforms may occur internationally. +Legislative and regulatory bodies are likely to continue to pursue healthcare reform initiatives and may continue to reduce the funding of the Medicare and Medicaid programs, including Medicare Advantage, +in an +24 +effort to reduce overall federal healthcare spending. In addition, the new Affordable Care Act is expected to impose a 2.3% excise tax on certain transactions, including U.S. sales of many +medical devices, which we expect will include domestic sales of our products. This new tax is scheduled to take effect in 2013. +The ultimate content or timing of any future healthcare reform legislation, and its impact on us, is impossible to predict. If +significant reforms are made to the healthcare system in the United States, or in other jurisdictions, those reforms may increase our costs or otherwise have an adverse effect on our financial condition and results of operations. +Increases in Demand for Our Products Could Require Us to Expend Considerable Resources or Harm Our Customer Relationships if We are +Unable to Meet That Demand. +If we experience significant or unexpected increases in the demand for our products, we and +our suppliers may not be able to meet that demand without expending additional capital resources. These capital resources could involve the cost of new machinery or even the cost of new manufacturing facilities. This would increase our capital +costs, which could adversely affect our earnings. Our suppliers may be unable or unwilling to expend the necessary capital resources or otherwise expand their capacity. In addition, new manufacturing equipment or facilities may require FDA approval +before they can be used to manufacture our products. To the extent we are unable to obtain or are delayed in obtaining such approvals, our ability to meet the demand for our products could be adversely affected. +If we or our suppliers are unable to develop necessary manufacturing capabilities in a timely manner, our sales could be adversely +affected. If we fail to increase production volumes in a cost effective manner or if we experience lower than anticipated yields or production problems as a result of changes that we or our suppliers make in our manufacturing processes to meet +increased demand, we could experience shipment delays or interruptions and increased manufacturing costs, which could also have a material adverse effect on our revenues and profitability. +Unexpected increases in demand for our products may require us to obtain additional raw materials in order to manufacture products to +meet the demand. Some raw materials require significant ordering lead time and some are currently obtained from a sole supplier or a limited group of suppliers. We have long-term supply agreements with many of these suppliers, but these long-term +agreements involve risks for us, such as our potential inability to obtain an adequate supply of raw materials and components and our reduced control over pricing, quality and timely delivery. It is also possible that one or more of these suppliers +may become unwilling or unable to deliver materials to us. Any shortfall in our supply of raw materials and components, or our inability to quickly and cost-effectively obtain alternative sources for this supply, could have a material adverse effect +on our total revenues or cost of sales and related profits. +Our inability to meet customer demand for our products could also +harm our customer relationships and impair our reputation within the industry. This, in turn, could have a material adverse effect on our business and prospects. +Risks Relating to Collaborators +The Use of Sole Supply Sources or +Third Party Suppliers For Critical Components of Our Products Could Adversely Affect Our Business. +We +currently purchase certain critical components of our products from sole supply sources or other third party suppliers. For example, all of the HIV antigen and nitrocellulose required to make our OraQuick ADVANCE ® HIV-1/2 test and OraQuick ® HCV test is currently purchased from sole source suppliers. Our OraSure QuickFlu™ test is obtained from a sole source supplier. In addition, the conjugates used +in our MICROPLATE oral fluid drugs of abuse assays are obtained from third party suppliers. +25 +If these suppliers are unable or unwilling to supply the required component or product or if +they make changes in the component or product or do not supply materials meeting our specifications, we may need to find another source and perform additional development work. We may also need to obtain FDA or other regulatory approvals for the use +of the alternative component for our products. Completing that development and obtaining such approvals could require significant time and may not occur at all. The availability of critical components and products from sole supply sources or other +third parties could also reduce our control over pricing, quality and timely delivery. These events could either disrupt our ability to manufacture and sell certain of our products, or completely prevent us from doing so or increase our costs. Any +such event could have a material adverse effect on our results of operations, cash flow and business. +Our Failure to +Maintain Existing Distribution Channels, or Develop New Distribution Channels, May Result in Lower Revenues. +We have +marketed many of our products by collaborating with laboratories, diagnostic companies and distributors. Our sales depend to a substantial degree on our ability to sell products to these customers and on the marketing and distribution abilities of +the companies with which we collaborate. +Relying on distributors or others to market and sell our products could harm our +business for various reasons, including: +• +Our distributors or other customers may not fulfill their contractual obligations to us or otherwise market and distribute our products in the manner +or at the levels we expect; +• +Agreements with distributors may terminate prematurely due to disagreements or may result in litigation between the parties; +• +We may not be able to renew existing distribution agreements on acceptable terms or at all; +• +Our distributors may not devote sufficient resources or priority to the sale of our products; +• +Our existing distributor relationships or contracts may preclude or limit us from entering into additional future arrangements with other distributors; +and +• +We may not be able to negotiate future distribution agreements on acceptable terms or at all. +Although we will try to maintain and expand our business with distributors and customers and require that they fulfill their contractual +obligations, there can be no assurance that such companies will do so or that new distribution channels will be available on satisfactory terms. As a result, our revenues and business could be adversely affected. +Some of our distributors have also consolidated and such consolidation has had, and may continue to have, an adverse impact on the level +of orders for our products. In addition, some distributors have experienced, and may continue to experience, pressure from their customers to reduce the price of their products and testing services. This may cause customers to stop using our +products or to purchase or manufacture lower cost alternatives. +The Unavailability of an FDA-Approved +HIV-1 EIA Screening Test Distributed by a Third Party Could Adversely Affect Sales of Our OraSure ® Oral Fluid +Collection Device. +In testing an oral fluid sample collected with an OraSure ® device for HIV-1 in the United States, our customers must use an HIV-1 EIA screening test approved by the FDA for +use with our OraSure ® collection device. There is currently only one company, Avioq, Inc., that manufactures and +sells such an FDA-approved screening test. If at some point in the future our customers cannot purchase the Avioq HIV-1 EIA or otherwise obtain an HIV-1 EIA screening test that has been approved by the FDA for use with our OraSure ® collection device, sales of our OraSure ® device could be negatively affected. +26 +We May Need Strategic Partners to Assist in Developing and Commercializing Some of Our +Diagnostic Products. +Although we intend to pursue some product opportunities independently, opportunities that require a +significant level of investment for development and commercialization or a distribution network beyond our existing sales force may necessitate involving one or more strategic partners. Our strategy for development and commercialization of products +may entail entering into arrangements with distributors or other corporate partners, universities, research laboratories, licensees and others. Relying on collaborative relationships could be risky to our business for a number of reasons, including: +• +We may be required to transfer material rights to such strategic partners, licensees and others; +• +Our collaborators may not devote sufficient resources or attach a sufficiently high priority to the success of our collaboration; +• +Our collaborators may not obtain regulatory approvals necessary to continue the collaborations in a timely manner; +• +Our collaborators may be acquired by another company and decide to terminate our collaborative arrangement or become insolvent; +• +Our collaborators may develop technologies or components competitive with our products; +• +Disagreements with collaborators could result in the termination of the relationship or litigation; +• +Collaborators may not have sufficient capital resources; and +• +We may not be able to negotiate future collaborative arrangements, or renewals of existing collaborative agreements, on acceptable terms or at all. +While we expect that our current and future collaborative partners have and will have an economic +motivation to succeed in performing their contractual responsibilities, there is no assurance that they will do so and the amount and timing of resources to be devoted to these activities will be controlled by others. Consequently, there can be no +assurance that any revenues or profits will be derived from such arrangements. +We may need to collaborate +with one or more third parties or find new product distribution channels in order to commercialize our OraQuick ® +HIV-1/2 test in the United States OTC market should we receive approval from the FDA. In order to successfully commercialize an OraQuick ® HIV OTC test, we and/or our distributors may need to invest significantly in advertising and promotion in order to sell this product. If we are unable to collaborate +with a third party having sufficient resources to assist in these efforts or find alternative distribution channels to access the OTC market, we may need to incur significant costs for advertising and promotion, and our ability to maximize our +future revenues and profits from this opportunity could be adversely affected. +Actions of a Third Party Inventory +Management and Logistics Provider Could Adversely Affect Our Ability to Supply Products to our Customers. +In order to +improve efficiencies, beginning in 2011 we will be using a third party logistics provider to store and manage our finished goods inventory and ship finished product to our customers. We have selected a highly reputable provider with extensive +experience in the logistics field and have negotiated a long-term service agreement for these services. However, in the event our provider loses or damages our product, experiences a casualty or catastrophic event at its warehouse or otherwise fails +to meet the requirements of our agreement for the safe storage and timely handling and delivery of our products, we could incur additional costs, experience difficulty in supplying our products to our customers or suffer damage to our reputation in +the industry. These events could, in turn, reduce our revenues and adversely affect our results of operations. +27 +Risks Relating to Intellectual Property +Our Success Depends on Our Ability to Protect Our Proprietary Technology. +The diagnostics industry places considerable importance on obtaining patent, trademark and trade secret protection, as well as other +intellectual property rights, for new technologies, products and processes. Our success depends, in part, on our ability to develop and maintain a strong intellectual property portfolio or obtain licenses to patents and technologies both in the +United States and in other countries. If we cannot continue to develop, obtain and protect intellectual property rights, our revenue and gross profits could be adversely affected. Moreover, our current and future licenses or other rights to patents +and other technologies may not be adequate for the operation of our business. +As appropriate, we intend to file patent +applications and obtain patent protection for our proprietary technology. These patent applications and patents will cover, as applicable, compositions of matter for our products, methods of making those products, methods of using those products and +apparatus relating to the use or manufacture of those products. +We will also rely on trade secrets, know-how and continuing +technological advancements to protect our proprietary technology. We have entered, and will continue to enter, into confidentiality agreements with our employees, consultants, advisors and collaborators. Our employees and third party consultants +also sign agreements requiring that they assign to us interests in inventions and original expressions and any patents or copyrights arising from their work. However, these parties may not honor these agreements. +We cannot guarantee that the process of filing patents, the laws governing trade secrets and proprietary information, or any agreements +we enter into with employees, consultants, advisors or collaborators will provide adequate protection of our intellectual property rights. Moreover, issued patents remain in effect for a fixed period and after expiration will not provide protection +of the inventions they cover. We may also not be able to successfully protect our rights to unpatented trade secrets and know-how. Others may independently develop substantially equivalent proprietary information and techniques or otherwise gain +access to our trade secrets and know-how. +Some of our employees, including scientific and management personnel, were +previously employed by competing companies. Although we encourage and expect all of our employees to abide by any confidentiality agreement with a prior employer, competing companies may allege trade secret violations and similar claims against us. +We may collaborate with universities and governmental research organizations which, as a result, may acquire part of the +rights to any inventions or technical information derived from our collaboration with them. +To facilitate development and +commercialization of a proprietary technology base, we may need to obtain licenses to patents or other proprietary rights from other parties. Obtaining and maintaining such licenses may require the payment of substantial amounts. In addition, if we +are unable to obtain these types of licenses, our product development and commercialization efforts may be delayed or precluded. +We May Become Involved in Intellectual Property Disputes, Which Could Increase our Costs and Limit or Eliminate Our Ability to Sell Our Products or Use Certain of Our Technologies in the Future. +From time to time, we may seek to enforce our patents or other intellectual property rights through litigation. In +addition, there are a large number of patents and patent applications in our product areas, and additional patents may be issued to third parties relating to our product areas. We or our customers may be sued for infringement of patents or +misappropriation of other intellectual property rights with respect to one or more of our products. Litigation in our industry regarding patent and other intellectual property rights is prevalent and is expected to continue. +28 +Our industry is characterized by a large number of patents, claims of which appear to +overlap in many cases. As a result, there is a significant amount of uncertainty regarding the extent of patent protection and infringement. Companies may have pending patent applications, which are typically confidential for the first eighteen +months following filing, that cover technologies we incorporate in our products. Accordingly, we may be subjected to substantial damages for past infringement or be required to modify our products or stop selling them if it is ultimately determined +that our products infringe a third party’s proprietary rights. In addition, governmental agencies could commence investigations or criminal proceedings against our employees or us relating to claims of misuse or misappropriation of another +party’s proprietary rights. +Our involvement in litigation or other legal proceedings with respect to patents or other +intellectual property and proprietary technology, either as a plaintiff or defendant, could adversely affect our revenues, market share, results of operations and business because: +• +As is common with major litigation, it could consume a substantial portion of managerial and financial resources; +• +Its outcome would be uncertain and a court may find that our patents are invalid or unenforceable in response to claims by another party or that the +third-party patent claims are valid and infringed by our products; +• +An adverse outcome could subject us to the loss of the protection of our patents or to liability in the form of past royalty payments, penalties, +special and punitive damages, or future royalty payments significantly affecting our future earnings; +• +Failure to obtain a necessary license upon an adverse outcome could prevent us from selling our current products or other products we may develop or +acquire; +• +The pendency of any litigation may in and of itself cause our distributors and customers to reduce purchases of our products; and +• +A court could award a preliminary and/or permanent injunction, which would prevent us from selling our current or future products. +We may indemnify some customers and strategic partners under our agreements with such parties if our +products or activities have actually or allegedly infringed upon, misappropriated or misused another party’s proprietary rights. Further, our products may contain technology provided to us by other parties, such as contractors, suppliers or +customers, and we may have little or no ability to determine in advance whether such technology infringes the intellectual property rights of a third party. These other parties may also not be required or financially able to indemnify us in the +event that an infringement or misappropriation claim is asserted against us. +We may also become involved in other types of +disputes regarding intellectual property rights, including state, federal or foreign court litigation, and patent interference, patent reexamination, patent reissue, or trademark opposition proceedings in the United States Patent and Trademark +Office. Opposition or revocation proceedings could be instituted in a foreign patent office. An adverse decision in any proceeding regarding intellectual property rights could result in the loss or limitation of our rights to a patent, an invention +or trademark. +The Sales Potential for Our OraQuick ® Products Could be Affected by Our Ability to Obtain Certain Licenses and by Future Litigation. +Our OraQuick ® test platform is a lateral flow assay that tests for specific antibodies or other substances. The term “lateral flow” generally refers to a test strip +through which a sample flows and which provides a test result on a portion of the strip downstream from where the sample is applied. There are numerous patents in the United States and other countries which claim lateral flow assay methods and +devices. There are also patents that cover +29 +the type of analyte (i.e., HIV-1, HIV-2, HCV, etc.) which our +OraQuick ® test is designed to detect. Some of these patents may broadly cover the aspects of our OraQuick ® test and are in force in the United States and other countries. We may not be able to make or sell the OraQuick ® test in the United States or other countries where these patents are in force. +We have obtained licenses under several lateral flow patents, and assays directed at specific analytes, which we +believe are sufficient to permit the manufacturing and sale of the OraQuick ® device as currently contemplated. +However, licenses under additional patents may be required and it is possible that a third party could seek to enforce one or more patents against us. +If we are unable to successfully defend against or resolve patent infringement litigation or it is determined that a license is required and it is not possible to negotiate or otherwise obtain a license +agreement on reasonable terms under a necessary patent, our ability to manufacture and sell OraQuick ® devices +and develop and commercialize new applications using the same technology could be limited and we may incur increased costs or damages. In such case, we may be able to modify the OraQuick ® test to avoid the claim of infringement or the need for a license. However, this alternative could delay or limit our ability to sell the OraQuick ® test in the United States and other markets, which would adversely affect our results of operations, cash flow and +business. +Risks Relating to Products, Marketing and Sales +A Market for Our Products May Not Develop. +Our future success will depend, in part, on the market acceptance, and the timing of such acceptance, of new products +such as our OraQuick ® HCV test, our OraSure QuickFlu™ test, an OraQuick ® HIV OTC test, and other new products or technologies that may be developed or acquired. To achieve market +acceptance, we and/or our distributors will likely be required to undertake substantial marketing efforts and spend significant funds to inform potential customers and the public of the perceived benefits of these products. In addition, governmental +funding for the purchase of our products may be needed to help create market acceptance and expand the use of our products. +There may be limited evidence on which to evaluate the market reaction to products that may be developed and our marketing efforts for new products may not be successful. It is also possible that +governmental funding may not be available for new products, such as an OraQuick ® HCV test. As such, there can be +no assurance that any products will obtain market acceptance and fill the market need that is perceived to exist. +If +Acceptance and Adoption of Our Oral Fluid Testing Does Not Continue, Our Future Results May Suffer. +We have made +significant progress in gaining acceptance of oral fluid testing for HIV in the public health, hospital, insurance and other markets. We have also made significant progress in gaining acceptance of oral fluid testing for drugs of abuse in the +workplace and criminal justice testing markets. However, the ultimate degree of acceptance in these markets is uncertain, and other markets may resist the adoption of oral fluid testing as a replacement for other testing methods in use today. As a +result, there can be no assurance that we will be able to expand the use of our oral fluid testing products in these or other markets. +Our Customers May Resist Adoption of Rapid Point-of-Care Diagnostic Testing. +We expect sales of our rapid point-of-care diagnostic products, such as our OraQuick ADVANCE ® HIV-1/2 and OraQuick ® HCV +tests, to become an increasingly important part of our business. Rapid point-of-care tests are beneficial to healthcare providers because, among other things, they can be administered by providers in their own facilities without sending samples to +central laboratories. However, clinical reference laboratories and +30 +hospital-based laboratories currently provide the majority of diagnostic tests used by physicians and other healthcare providers in the U.S. Our future sales will depend, in part, on our ability +to expand market acceptance of rapid point-of-care testing by physicians and other healthcare providers. We expect that clinical reference and other hospital-based laboratories will continue to compete vigorously against our rapid point-of-care +products. Even if we can demonstrate that our products are more cost effective, save time, or have better performance, physicians and other healthcare providers may resist changing to rapid point-of-care tests and instead may choose to use competing +laboratory tests. Our failure to achieve initial or additional market acceptance of our rapid point-of-care diagnostic tests with customers would have a negative effect on our future sales growth. +We Expect to Face Intense Competition From Other Providers of Rapid Point-of- Care Diagnostic Tests. +Our rapid point-of-care tests compete with similar point-of-care products made by our competitors. This competition is +particularly evident with respect to our OraQuick ADVANCE ® HIV-1/2 test. There are a number of +competitors making investments in competing technologies and products, and a number of our competitors may have a competitive advantage because of their greater financial, technical, research and other resources. Moreover, some competitors offer +broader product lines, aggressively discount prices for their products and may have greater name recognition than we have. If our competitors’ products are more effective than ours or take market share from our products through more effective +marketing or competitive pricing, our revenues, margins and operating results could be adversely affected. +Sales of our +OraSure QuickFlu™ Test May be Affected by Factors Beyond our Control. +In 2011, we expect to begin selling a new rapid +flu test under the tradename OraSure QuickFlu™, primarily in the U.S. hospital and public health markets. A number of factors that are beyond our control could affect sales of this product, including: +• +Variability in the timing of the onset, length and severity of the flu season, which typically occurs from November of one year to May of the following +year; +• +Competition from other rapid flu tests in the markets we serve; +• +The failure of our supplier for this product to obtain a CLIA waiver, which we believe is important to expand sales, particularly in the public health +market; +• +The inability of our supplier to provide quantities of the product sufficient to meet the demands of our customers; +• +Changes in the types or strains of influenza during a particular flu season; +• +Lower than expected market penetration of the OraSure QuickFlu™ test; and +• +Our inexperience in selling a rapid flu test. +Our Inability to Carry Out Certain of Our Marketing and Sales Plans May Make it Difficult for Us to Grow or Maintain Our Business. +We have implemented in the past, and we intend to implement in the future, an aggressive sales and marketing plan to expand sales of our +products. Specifically, we will continue to expand the impact of our direct field sales force, use third party distributors and manufacturers’ sales representatives, and implement other sales and marketing programs. If we are unable to +successfully implement these programs, we may be unable to grow and our business could suffer. +Our Sales Cycles Can be +Lengthy and May Depend on Public Funding, Which Can Cause Variability and Unpredictability in Our Operating Results. +The +sales cycles for certain of our products can be lengthy and unpredictable, which makes it more difficult to accurately forecast revenues in a given period and may cause revenues and operating results to vary from +31 +period to period. Sales of our products often involve purchasing decisions by large public and private institutions, may require many levels of approval and may be dependent on economic or +political conditions and the availability of grants or funding from governmental or public health agencies which can vary from period to period in both amount and timing. For example, in past years our OraQuick ADVANCE ® HIV-1/2 test has been purchased through bulk procurement or other funding provided by governmental agencies. There +can be no assurance that purchases or funding from these agencies will continue at the same or higher levels or at all, especially if current negative economic conditions continue or intensify. As a result, we may expend considerable resources on +unsuccessful sales efforts or we may not be able to complete transactions at all or on a schedule and in an amount consistent with our objectives. +We May be Sued for Product Liabilities for Injuries Resulting From the Use of Our Products. +We may be held liable if any of our products, or any product which is made with the use or incorporation of any of our technologies, causes injury of any type or is found otherwise unsuitable during +product testing, manufacturing, marketing, sale or usage. There is no assurance that we would be successful in defending any product liability lawsuits brought against us. Regardless of merit or eventual outcome, product liability claims could +result in: +• +Decreased demand for our products; +• +Lost revenues; +• +Damage to our image or reputation; +• +Costs related to litigation; +• +Diversion of management time and attention; and +• +Incurrence of damages payable to plaintiffs. +We are selling cryosurgical products in the consumer or OTC market in certain countries. We may expand the OTC sales +of these products to other countries and eventually distribute other types of products in the domestic and international OTC markets, such as our OraQuick ® HIV-1/2 test. We believe the sale of products in the OTC market increases the risk of potential product liability exposure. +The Insurance We Purchase to Cover Our Potential Business Risks May be Inadequate. +Although we believe that our present product liability and other insurance coverage is sufficient to cover our current estimated +exposures, we cannot be sure that we will not incur liabilities in excess of our policy limits. In addition, although we believe that we will be able to continue to obtain adequate coverage in the future, there is no assurance that we will be able +to do so at acceptable costs. +We Could Suffer Monetary Damages, Incur Substantial Costs or be Prevented From Using +Technologies Important to Our Products as a Result of Legal Proceedings. +We have been and in the future may become +involved in various legal proceedings arising out of our businesses. These may include commercial disputes, negligence claims or various other lawsuits arising in the ordinary course of our business, including employment matters. Such lawsuits can +seek damages, sometimes in substantial amounts, for commercial or personal injuries allegedly suffered and can include claims for punitive or other special damages. An adverse ruling or rulings in one or more such lawsuits could, individually or in +the aggregate, result in the termination or modification of a material contract or otherwise have a material adverse effect on our sales, operations or financial performance. +Performance of Our Products May Affect Our Revenues, Stock Price and Reputation. +Our products are generally sold with labeling that contains performance claims approved or cleared by the FDA or other regulators. However, our products may not perform as expected. For example, a defect +in one of +32 +our diagnostic products or a failure by a customer to follow proper testing procedures, may cause the product to report inaccurate information such as a false positive result or a false negative +result. If our products fail to perform in accordance with the applicable label claims or otherwise in accordance with the expectations or needs of our customers, customers may switch to a competing product or otherwise stop using our products, and +our revenues could be adversely affected. In addition, poor performance by one or more of our products and publicity surrounding such performance could have an adverse effect on our reputation, our continuing ability to sell products and the +prevailing market price of our Common Stock. +Our International Presence May Increase Our Risks and Expose Our Business to +Regulatory, Cultural or Other Restraints. +We intend to increase revenue derived from international sales of our products. +Our international sales accounted for $11.5 million or 15% of total revenues in 2010, $14.8 million or 19% of total revenues in 2009 and $13.7 million or 19% of total revenues in 2008. +A number of factors can slow or prevent international sales, or substantially increase the cost of sales in Europe or other countries, +including those set forth below: +• +Regulatory requirements (including compliance with applicable customs regulations) and the need for reimbursement approvals; +• +The inability to obtain or maintain ISO certification for our or our suppliers’ manufacturing facilities; +• +Our inability to obtain or maintain the CE mark on our products or other country-specific registrations; +• +The uncertainty of foreign laws and the inconsistent imposition of legal and regulatory requirements; +• +Our inability to identify international distributors and negotiate acceptable terms for distribution agreements; +• +The loss of one or more distributors and difficulties or delays in obtaining new or transferred product registrations or approvals for use by a +replacement distributor; +• +Cultural and political differences that favor local competitors or make it difficult to effectively market, sell and gain acceptance of our products; +• +Inexperience in international markets and difficulties in staffing and managing foreign operations; +• +Exchange rates, currency fluctuations, tariffs and other barriers, extended payment terms and dependence on and difficulties in finding and managing +international distributors or representatives; +• +The creditworthiness of foreign distributors and customers and difficulty in collecting foreign accounts receivable; +• +Difficulty of enforcing contractual obligations or recovering damages under foreign legal systems; +• +Economic conditions, political instability, the absence of available funding sources, terrorism, civil unrest, war and natural disasters in foreign +countries; +• +Our exposure to liability under the Foreign Corrupt Practices Act and various other laws, rules and/or regulations applicable to us as a result of our +international sales; +• +Long sales cycles in international markets, especially for sales to foreign governments, quasi-governmental agencies and international public health +agencies; +• +The sale of competing products by foreign competitors at prices at or below such competitors’ or our costs; +• +The unavailability of licenses to certain patents in force in a foreign country which cover our products; and +• +Reduced protection for, or enforcement of, our patents and other intellectual property rights in foreign countries. +33 +In addition, we have entered into a contract for the manufacture and +supply of our OraQuick ® HIV-1/2 test in Thailand, and the Histofreezer ® cryosurgical product sold in international markets is currently manufactured by a third party in The Netherlands. We +may enter into agreements to manufacture these or other products in additional foreign countries as well. However, economic, cultural and political conditions and foreign regulatory requirements may slow or prevent the manufacture of our products in +countries other than the United States. Interruption of the supply of our products could reduce revenues or cause us to incur significant additional expenses in finding an alternative source of supply. Foreign currency fluctuations and economic +conditions in foreign countries could also increase the costs of manufacturing our products in foreign countries. +Risks +Relating to the Economy, Our Financial Results, Investments, Credit Facilities and Need for Financing +Continued +Economic Volatility and Disruption Could Adversely Affect Our Results of Operations, Cash Flow and Financial Condition or Those of Our Customers and Suppliers. +Capital and credit markets have recently experienced a period of unprecedented turmoil and upheaval, characterized by the bankruptcy, failure, collapse or sale of various financial institutions and +substantial intervention by the U.S. government. These conditions could adversely affect the demand for our products and services and, therefore, reduce purchases by our customers, which would negatively affect our revenues and profitability. In +addition, interest rate fluctuations, financial market volatility or credit market disruptions may limit our access to capital, and may also negatively affect our customers’ and our suppliers’ ability to obtain credit to finance their +businesses on acceptable terms. Some of our customers rely on public funding provided by state and local governments, and this funding has been and may continue to be reduced or deferred as a result of current economic conditions. As a result, our +customers’ needs and ability to purchase our products or services may decrease, and our suppliers may increase their prices, reduce their output or change their terms of sale. If our customers’ or suppliers’ operating and financial +performance deteriorates, or if they are unable to make scheduled payments or obtain credit, our customers may not be able to pay, or may delay payment of, accounts receivable owed to us, and our suppliers may restrict credit or impose different +payment terms. Any inability of customers to pay us for our products and services, or any demands by suppliers for different payment terms, may adversely affect our earnings and cash flow. +Additionally, both state and federal governments, as a result of budget deficits or reductions, have reduced and may seek to continue to +reduce their expenditures by reducing their purchases of our products or renegotiating their contracts with us. Any reduction in payments by such governments may adversely affect our earnings and cash flow. +The current economic circumstances could adversely affect our access to liquidity needed to conduct or expand our business or conduct +acquisitions and make other discretionary investments. Declining economic conditions may also increase our costs. If the economic conditions do not improve or continue to deteriorate, our results of operations or financial condition could be +adversely affected. +We Have a History of Losses and May Not Be Able to Achieve Sustained Profitability. +We have experienced net losses in 2008, 2009 and 2010. In addition, as of December 31, 2010, the Company had an accumulated deficit +of $138.6 million. Even though we have achieved profitability in the past, there can be no assurance that we will be able to achieve or sustain profitability in the future. +Our ability to achieve and sustain profitability in the future will be dependent upon a number of factors including, without limitation, the following: +• +Creating market acceptance for and selling increasing volumes of our OraQuick ADVANCE ® HIV-1/2 test and our +OraQuick ® HCV test in the United States and internationally; +34 +• +The level of expenditures we are required to make in order to develop and obtain regulatory approvals for our new products, including our OraQuick ® HIV-1/2 test for use in the OTC market and our OraQuick ® HCV test for professional use; +• +Our ability to successfully launch new products after receipt of required regulatory approvals or the acquisition of rights to those products; +• +The degree to which certain of our new products may replace sales of our existing products and the financial impact of that change, including the +degree to which our OraQuick ADVANCE ® HIV-1/2 test will replace our OraSure ® collection device for HIV-1 testing or sales of our cryosurgical wart removal products in OTC markets will replace +sales of our Histofreezer ® product to physicians’ offices or other professional markets; +• +The degree to which our major distributors comply with their contractual obligations, including minimum purchase commitments; +• +Whether we are successful in obtaining and maintaining required regulatory approvals and registrations for our new products; +• +Changes in the level of competition, such as would occur if larger and financially stronger competitors introduced new or lower priced products to +compete with our products; +• +Changes in economic conditions in domestic or international markets, such as economic downturns, reduced demand, inflation and currency fluctuations; +• +Failure to achieve our targets for growth in revenues; +• +Changes in distributor buying patterns or a buildup of significant quantities in our distributors’ inventories or distribution channels; and +• +The costs and results of patent infringement and other litigation or claims asserted against us. +We May Experience Fluctuations in Our Financial Results or Fail to Meet Our Financial Projections. +Our operating results can fluctuate from quarter to quarter and year to year, which could cause our growth or financial performance to +fall below the expectations of investors and securities analysts. Our financial projections for future periods are based on a number of assumptions, including estimated demand for our products. However, sales to our distributors and other customers +may fall short of expectations because of less than estimated customer demand or other factors, including continued volatility and disruption in economic conditions, reduced governmental funding and other circumstances described elsewhere in this +Annual Report. Infrequent, unusual or unexpected changes in revenues or costs could also contribute to the variability of our financial results. In addition, our products provide different contributions to our gross margin and our operating results +could also fluctuate and be affected by the mix of products sold and the relative prices and gross margin contribution of those products. Failure to achieve operating results consistent with the expectations of investors and securities analysts +could adversely affect our reputation and the price of our Common Stock. +Our Estimates or Judgments Relating to Critical +Accounting Policies Are Based on Assumptions That Can Change or Prove to be Incorrect. +Our discussion and analysis of +financial condition and results of operations is based on our financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of financial statements in conformity with +generally accepted accounting principles requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. On an ongoing basis, we evaluate significant estimates used in +preparing our financial statements, including those related to: +• +Revenue recognition; +• +Allowance for uncollectible accounts receivable; +35 +• +Reserve for inventory write-downs; +• +Stock-based compensation; +• +Potential impairment of long-lived and intangible assets; +• +Clinical trial accruals; and +• +Contingencies. +We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances, as provided in our discussion and analysis of financial condition +and results of operations, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these and other estimates if our +assumptions change or if actual circumstances differ from those in our assumptions, which could cause our operating results to fall below the expectations of securities analysts and investors, resulting in a decline in our stock price. +Our Credit Facilities Contain Certain Financial Covenants Which, if Not Satisfied, Could Result in the Acceleration of the Amounts Due +Under These Facilities and Limit Our Ability to Borrow in the Future. +Our credit facility with Comerica Bank contains +various financial and other covenants with which we must comply on an ongoing or periodic basis. If we enter into new or additional credit facilities or loan agreements, we would expect those arrangements would contain similar types of covenants. +Although we do not expect to violate these covenants and obligations, if such a violation were to occur, the outstanding debt under our credit facility or other arrangement could become immediately due and payable, our lender could proceed against +any collateral securing such indebtedness and our ability to borrow additional funds in the future may be adversely affected. +We May Require Future Additional Capital. +Our future liquidity and ability to meet our future capital requirements will depend on numerous factors, including, but not limited to, the following: +• +The time, cost and degree of success of conducting clinical trials and obtaining regulatory approvals; +• +The costs and timing of expansion of sales and marketing activities; +• +The timing and success of the commercial launch of new products; +• +The extent to which we gain or expand market acceptance for existing, new or enhanced products; +• +The costs and timing of the expansion of our manufacturing capacity; +• +The success of our research and product development efforts; +• +The magnitude of capital expenditures; +• +Changes in existing and potential relationships with distributors and other business partners; +• +The costs involved in obtaining and enforcing patents, proprietary rights and necessary licenses; +• +The costs and liability associated with patent infringement or other types of litigation; +• +Competing technological and market developments; and +• +The scope and timing of strategic acquisitions. +If additional financing is needed, we may seek to raise funds through the sale of equity or other securities or through bank borrowings. There can be no assurance that financing through the sale of +securities, bank borrowings or otherwise, will be available to us on satisfactory terms, or at all. +36 +Terrorist Attacks or National Disasters May Adversely Affect Our Business. +Terrorist attacks or natural disasters, and subsequent governmental responses to these events, could cause economic +instability. These actions could adversely affect economic conditions both within and outside the United States and reduce demand for our products. These events could disrupt the operations of our customers and suppliers and eliminate, reduce or +delay our customers’ ability to purchase and use our products and our suppliers’ ability to provide raw materials and finished products. +Our manufacturing facilities are located in Bethlehem, Pennsylvania. Although we have business interruption insurance, our facilities, including some pieces of manufacturing equipment and our computer +systems, may be difficult to replace and could require substantial replacement lead-time. Various types of disasters, including earthquakes, fires, floods and acts of terrorism, may affect our manufacturing facilities and computer systems. In the +event our existing manufacturing facilities or computer systems are affected by man-made or natural disasters, we may have difficulty operating our business and may be unable to manufacture products for sale or meet customer demands or sales +projections. If our manufacturing operations were curtailed or ceased, it would seriously harm our business. +Risks Relating +to Our Common Stock +Our Stock Price Could Continue to be Volatile. +Our stock price has been volatile, has fluctuated substantially in the past, may be volatile in the future and could experience +substantial declines. The following factors, among others, could have a significant impact on the market for our Common Stock: +• +Future announcements concerning us, our products, our competitors or our industry; +• +Clinical results with respect to our products or those of our competitors; +• +Status of clinical studies and pending submissions for required regulatory approvals; +• +The gain or loss of significant contracts and availability of funding for the purchase of our products; +• +Delays in the development, regulatory approval or commercialization of new or enhanced products; +• +Legislative developments; +• +Disputes or developments with key customers, distributors or suppliers; +• +Developments in patent or other proprietary rights; +• +Litigation or threatened litigation; +• +Public concern as to the performance or safety of products that we or others have developed or sold; +• +Failure to achieve, or changes in, financial estimates by securities analysts and comments or opinions about us by securities analysts or major +stockholders; +• +Governmental regulation; +• +Changes in the level of competition; +• +Loss of or declines in sales to major distributors or customers or changes in the mix of products sold; +• +The relatively low trading volume for our Common Stock; +• +Period to period fluctuations in our operating results; +• +Additions or departures of key personnel; +• +General market and economic conditions; and +• +Terrorist attacks, civil unrest, war and national disasters. +37 +In addition, the stock market in general has experienced extreme price and volume +fluctuations that have affected the market price of our Common Stock, as well as the stock of many companies in the diagnostics and life sciences industries. Often, price fluctuations are unrelated to operating performance of the specific companies +whose stock is affected. +In the past, following periods of volatility in the market price of a company’s stock, +securities class action litigation has occurred against the issuing company. If we were subject to this type of litigation in the future, we could incur substantial costs and a diversion of our management’s attention and resources, each of +which could have a material adverse effect on our revenue and earnings. Any adverse determination in this type of litigation could also subject us to significant liabilities. +Future Sales of Our Common Stock by Existing Stockholders, Executive Officers or Directors Could Depress the Market Price of Our Common Stock and Make It More Difficult For Us to Sell Stock in the +Future. +Sales of our Common Stock in the public market, or the perception that such sales may occur, could negatively +impact the market price of our Common Stock. We are unable to estimate the number of shares of our Common Stock that may actually be resold in the public market since this will depend on the market price for our Common Stock, the individual +circumstances of the sellers and other factors. +We have a number of institutional stockholders that own significant blocks of +our Common Stock. If one or more of these stockholders sell large portions of their holdings in a relatively short time, for liquidity or other reasons, the prevailing market price of our Common Stock could be negatively affected. In addition, it is +possible that one or more of our executive officers or non-employee members of our Board of Directors could sell shares of our Common Stock during an open trading window under our Insider Trading Policy. These transactions and the perceived reasons +for these transactions could have a negative effect on the prevailing market price of our Common Stock. +Investor +Confidence and Share Value May be Adversely Impacted if We and/or Our Independent Registered Public Accounting Firm Conclude That Our Internal Control Over Financial Reporting is Not Effective. +As directed by Section 404 of the Sarbanes-Oxley Act of 2002, the SEC adopted rules requiring us, as a public company, to include a +report in our Annual Reports on Form 10-K that contains an assessment by management of the effectiveness of our internal control over financial reporting. In addition, our independent registered public accounting firm must report on the +effectiveness of these internal controls. +We expect that our internal controls will continue to evolve as our business +activities change. Although we seek to diligently and vigorously review our internal control over financial reporting in an effort to ensure compliance with the Section 404 requirements, any control system, regardless of how well designed, +operated and evaluated, can provide only reasonable, not absolute, assurance that its objectives will be met. If, during any year, our independent registered public accounting firm is not satisfied with our internal control over financial reporting +or the level at which our controls are documented, designed, operated, tested or assessed, or if the independent registered public accounting firm interprets the requirements, rules or regulations differently than we do, then it may issue a report +that is qualified. We also could conclude that our internal control over financial reporting is not effective. These events could result in an adverse reaction in the financial marketplace due to a loss of investor confidence in the reliability of +our financial statements and effectiveness of our internal controls, which ultimately could negatively impact the market price of our Common Stock. +Because We Do Not Intend to Pay Cash Dividends on Our Common Stock, an Investor in Our Common Stock Will Benefit Only if it Appreciates in Value. +We currently intend to retain our current earnings and future earnings, if any, to finance the expansion of our business and do not expect +to pay any cash dividends on our Common Stock in the foreseeable future. As a +38 +result, the success of an investment in our Common Stock will depend entirely upon any future appreciation. There is no guarantee that our Common Stock will appreciate in value or even maintain +the price at which investors purchased their shares. +Certain Provisions in Our Certificate of Incorporation and Bylaws and +Under Delaware Law Could Make a Third Party Acquisition of Us Difficult. +Our Certificate of Incorporation and Bylaws +contain provisions that could make it more difficult for a third party to acquire us, even if doing so would be beneficial to our stockholders. We are also subject to certain provisions of Delaware law that could delay, deter or prevent a change in +control of us. These provisions could limit the price investors might be willing to pay in the future for shares of our Common Stock. +Future Sales of Shares of Our Common Stock or the Issuance of Securities Senior to Our Common Stock Could Adversely Affect the Trading Price of Our Common Stock and Our Ability to Raise Funds in New +Equity Offerings. +Future sales of a substantial number of our shares of Common Stock or equity-related securities in the +public market or privately, or the perception that such sales may occur, could adversely affect prevailing trading prices of our Common Stock, and could impair our ability to raise capital through future offerings of equity or equity-related +securities. No prediction can be made as to the effect, if any, that future sales of shares of Common Stock or the availability of shares of Common Stock for future sale will have on the trading price of our Common Stock. +ITEM 1B. +Unresolved Staff Comments. +Not Applicable. +ITEM 2. +Properties. +We own a +48,000 square foot facility which is our primary corporate office and manufacturing facility, a 31,700 square foot facility that houses our sales and marketing and research and development offices, and a 33,500 square foot facility which is used for +manufacturing activities. Each of these facilities is located in Bethlehem, Pennsylvania, and is subject to a mortgage in favor of Comerica Bank. We also rent additional warehouse space on an as-needed basis. +We believe that the facilities described above are adequate for our current requirements. +ITEM 3. +Legal Proceedings. +Cryosurgical Patent Infringement Litigation +In December 2009, we filed legal proceedings in the Patents Court of the High Court of England and Wales against D.D.D. Limited, DioMed Developments Limited and Sixtem Life Srl, alleging that the import +and/or sale of the Bazuka Sub-Zero OTC cryosurgical product by the defendants in the United Kingdom infringes our European Patent (UK) 0 608 954. We are seeking injunctive relief and damages, among other remedies, in this matter. The defendants have +filed a response denying infringement and alleging that our patent is invalid. +Since the filing of these proceedings, the +parties have engaged in limited discovery and participated in mediation. A trial in this matter is expected to occur in late April 2012. +ITEM 4. +[Removed and Reserved]. +39 +PART II +ITEM 5. +Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities. +Market Information +Our +Common Stock is listed for trading on the Global Select Market tier of The Nasdaq Stock Market LLC (“NASDAQ”) under the symbol OSUR. High and low sales prices reported by NASDAQ during the periods indicated are shown below. +Year ended December 31, +2010 +2009 +High +Low +High +Low +First Quarter +$ +6.09 +$ +4.75 +$ +3.82 +$ +2.16 +Second Quarter +6.80 +4.15 +4.09 +2.41 +Third Quarter +5.09 +3.18 +3.55 +2.35 +Fourth Quarter +6.15 +3.79 +5.25 +2.80 +On March 2, +2011, there were 528 holders of record and approximately 10,600 holders in street name of our Common Stock, and the closing price of our Common Stock was $6.76 per share. +Dividends +We have never paid any cash dividends and our Board of Directors +does not anticipate paying cash dividends in the foreseeable future. We are generally not permitted to pay dividends or make other distributions to our stockholders under the terms of our credit facilities with Comerica Bank, without first obtaining +Comerica’s consent. We intend to retain any future earnings to provide funds for the operation and expansion of our business. +Share +Repurchases and Retirements +Pursuant to our 2000 Stock Award Plan and in connection with the vesting of restricted shares, +we retired 2,697 shares to satisfy minimum tax withholding obligations during the three months ended December 31, 2010. No shares were repurchased under our $25.0 million share repurchase program during this same period. +40 +Performance Graph +The performance graph set forth below shall not be deemed “soliciting material” or “filed” for purposes of Section 18 of the Securities Exchange Act of 1934, as amended (the +“Exchange Act”), or otherwise subject to liability under that Section. This graph will not be deemed “incorporated by reference” into any filing under the Securities Act of 1933, as amended, or the Exchange Act, whether such +filing occurs before or after the date hereof, regardless of any general incorporation language in such filing. +The +following graph compares the cumulative total returns to investors in the Company’s Common Stock, the NASDAQ Composite Index and the NASDAQ Biotechnology Index for the period from December 31, 2005 through December 31, 2010. The graph +assumes that $100 was invested on December 31, 2005 in the Company’s Common Stock and in each of the above-mentioned indices, and that all dividends, if any, were reinvested. +The NASDAQ Composite Index was chosen because it is a broad index of companies whose equity securities are traded on the NASDAQ Stock +Market. The NASDAQ Biotechnology Index was chosen because it includes a number of our competitors. Stockholders are cautioned that the graph shows the returns to investors only as of the dates noted and may not be representative of the returns for +any other past or future period. +12/05 +12/06 +12/07 +12/08 +12/09 +12/10 +OraSure Technologies, Inc. +100.00 +93.65 +100.79 +41.72 +57.60 +65.19 +NASDAQ Composite +100.00 +111.74 +124.67 +73.77 +107.12 +125.93 +NASDAQ Biotechnology +100.00 +99.71 +103.09 +96.34 +106.49 +114.80 +41 +ITEM 6. +Selected Financial Data +The following table sets forth selected financial data of the Company. This information should be read in conjunction with the Financial +Statements and notes thereto included in Item 15 and the information set forth in Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations.” +Selected Financial Data +(In thousands, except per share data) +Year ended December 31, +2010 +2009 +2008 +2007 +2006 +Operating Results: +Revenues +$ +75,015 +$ +77,026 +$ +71,104 +$ +82,686 +$ +68,155 +Costs and expenses +78,369 +85,819 +82,551 +83,905 +62,692 +Operating income (loss) +(3,354 +) +(8,793 +) +(11,447 +) +(1,219 +) +5,463 +Other income (expense), net +(143 +) +357 +2,699 +5,513 +3,599 +Income tax provision (benefit) +— +(622 +) +22,527 +1 +1,821 +3,794 +Net income (loss) +(3,497 +) +(7,813 +) +(31,275 +) 1 +2,472 +5,268 +Earnings (loss) per share +Basic and Diluted +$ +(0.08 +) +$ +(0.17 +) +$ +(0.67 +) +$ +0.05 +$ +0.11 +Shares used in computing earnings (loss) per share +Basic +46,187 +45,878 +46,550 +46,325 +45,910 +Diluted +46,187 +45,878 +46,550 +46,878 +46,580 +Cash Flow: +Cash flows provided by (used in) operating activities +$ +3,887 +$ +(293 +) +$ +(2,460 +) +$ +11,584 +$ +16,886 +December 31, +2010 +2009 +2008 +2007 +2006 +Financial Position: +Cash, cash equivalents, and short-term investments +$ +75,738 +$ +79,670 +$ +82,523 +$ +95,566 +$ +91,001 +Working capital +77,808 +89,435 +90,936 +105,620 +95,979 +Deferred tax assets +— +— +— +22,327 +23,522 +Total assets +122,520 +126,991 +131,918 +167,353 +156,565 +Long-term debt, excluding current portion +— +7,792 +8,301 +8,818 +10,031 +Accumulated deficit +(138,585 +) +(135,088 +) +(127,275 +) +(96,000 +) +(98,414 +) +Stockholders’ equity +102,843 +103,807 +108,325 +140,055 +129,504 +¹ +Includes an income tax provision of $25,978 resulting from the establishment of a full valuation allowance on our net deferred tax assets (see Note 9 of the Notes to +the financial statements). +42 +ITEM 7. +Management’s Discussion and Analysis of Financial Condition and Results of Operations. +Statements below regarding future events or performance are “forward-looking statements” within the meaning of the Private +Securities Litigation Reform Act of 1995. Our actual results could be quite different from those expressed or implied by the forward-looking statements. Factors that could affect results are discussed more fully under the Item 1A, entitled +“Risk Factors,” and elsewhere in this Annual Report. Although forward-looking statements help to provide complete information about us, readers should keep in mind that forward-looking statements may not be reliable. Readers are cautioned +not to place undue reliance on the forward-looking statements. We undertake no duty to update any forward-looking statements made herein after the date of this Annual Report. +The following discussion should be read in conjunction with the financial statements contained herein and the notes thereto, along with +the Section entitled “Critical Accounting Policies and Estimates,” set forth below. +Overview +We operate primarily in the in vitro diagnostic business. Our business principally involves the development, manufacture, marketing +and sale of oral fluid diagnostic products and specimen collection devices using our proprietary oral fluid technologies, as well as other diagnostic products including immunoassays and other in vitro diagnostic tests that are used on other +specimen types. We also manufacture and sell other medical devices used for the removal of benign skin lesions by cryosurgery, or freezing. Our diagnostic products include tests which are performed on a rapid basis at the point of care and tests +which are processed in a laboratory. These products are sold in the United States and internationally to various clinical laboratories, hospitals, clinics, community-based organizations and other public health organizations, distributors, government +agencies, physicians’ offices, and commercial and industrial entities. One of our products is sold in the OTC or consumer retail market in North America, Europe, Central and South America, and Australia. +In vitro diagnostic testing is the process of analyzing oral fluid, blood, urine and other bodily fluids or tissue for the +presence of specific substances or markers for infectious diseases, drugs of abuse or other conditions. We have targeted the use of oral fluid in our products as a differentiating factor and believe that it provides a significant competitive +advantage over blood and urine. Our oral fluid tests have sensitivity and specificity comparable to blood and/or urine tests. When combined with their ease of use, non-invasive nature, and cost effectiveness, our oral fluid tests represent a very +competitive alternative to the more traditional testing methods in the diagnostic space. +We rely heavily +on distributors to purchase and resell many of our products. For example, Genomma Labs has exclusive rights to our wart removal product in the OTC market in Mexico, Argentina, Brazil, and various other Central and South American countries and +Reckitt Benckiser has similar rights to our wart removal product in the OTC footcare market in Europe, Australia and New Zealand. We have contracted with several distributors to sell our OraQuick ADVANCE ® HIV-1/2 test to the U.S. physician office market and our +Intercept ® and OraSure ® product lines are sold by several laboratory distributors. We use distributors to sell our Histofreezer ® product into the domestic and international physician office markets. We expect to enter into additional distribution agreements for existing and future products in +the U.S. and internationally. If our distributors are unable or unwilling to meet the minimum purchase commitments set forth in their agreements or otherwise substantially reduce the volume of their purchases, our revenues and results of operations +could be adversely affected. +Because of the regulatory approvals needed for most of our products, we +often are required to rely on sole source providers for critical components and materials and on related products supplied by third parties. This is particularly true for our OraQuick ADVANCE ® HIV-1/2 test, our OraQuick ® +HCV test, our OraSure ® oral fluid collection device and our oral fluid Western blot HIV-1 confirmatory product. +If we are unable to obtain necessary components or materials from these sole sources, the time required to develop replacements and obtain the required FDA approvals could disrupt our ability to sell the affected products. +43 +Competitive and Economic Outlook +Competition in the market for HIV testing is intense and is expected to increase. We believe that our principal +competition will come from existing point-of-care rapid blood tests, laboratory-based blood tests, and urine assays or other oral fluid-based tests that may be developed. Our competitors include medical diagnostic companies and specialized +biotechnology firms, as well as pharmaceutical companies with biotechnology divisions. Competing rapid blood tests are often sold at a lower price than we charge for our OraQuick ® HIV test. This competition can result in lost sales and degradation of the price (and therefore the profit margin) we can charge for our product. +Our OraQuick ® HCV test is now available in Europe and is expected to compete against laboratory-based HCV blood tests. In non-U.S. countries outside of Europe, we expect this +product to compete against other rapid HCV blood tests and laboratory-based tests. We have received FDA approval for use of the OraQuick ® HCV test with venous whole blood specimens and fingerstick whole blood, and we expect this test to compete against laboratory-based HCV blood tests in the U.S. +The recent economic downturn, including disruptions in the capital and credit markets, may continue for the foreseeable +future and intensify. These conditions have adversely affected and could continue to adversely affect our financial performance and condition or those of our customers and suppliers. These circumstances could also adversely affect our access to +liquidity needed to conduct or expand our business or conduct acquisitions or make other discretionary investments. Some of our customers rely on public funding provided by state and local governments, and this funding has been and may continue to +be reduced or deferred as a result of current economic conditions. These circumstances may also adversely impact our customers and suppliers, which, in turn, could adversely affect their ability to purchase our products or supply us with necessary +equipment, raw materials or components. In addition, demand for our products may also be adversely affected by the economic downturn. +Current Financial Results +During the year ended December 31, 2010, our total revenues were $75.0 million, which represents a 3% decrease from 2009. Our net +loss for the year ended December 31, 2010 was $3.5 million, or $0.08 per share, compared to a net loss of $7.8 million, or $0.17 per share, for the year ended December 31, 2009. Our net loss in 2009 included a $3.0 million pre-tax charge +for the impairment of patents and product rights and a $1.5 million pre-tax charge for the settlement of a patent infringement lawsuit. +Cash flow provided by operating activities for the year ended December 31, 2010 was $3.9 million, an improvement when compared to the $293,000 used in operating activities for the year ended +December 31, 2009. As of December 31, 2010, we had $75.7 million in cash, cash equivalents and short-term investments, compared to $79.7 million at December 31, 2009. +2010 and More Recent Developments +OraQuick ® HCV Test +In April 2010, we commercially launched our OraQuick ® rapid HCV +antibody test in Europe at a meeting of the European Association for the Study of the Liver. We have now begun selling the +OraQuick ® HCV test internationally, and we are currently pursuing additional registrations in a number of +foreign countries. Our current focus is on finding distributors and building awareness of and acceptance for this product. +In June 2010, our OraQuick ® HCV test received FDA approval for use +in venous whole blood specimens, making it the first rapid HCV test approved by the FDA. We launched this product domestically at the annual meeting of the American Association of Clinical Chemistry in July 2010 and we are actively selling this +product to customers in the U.S. +44 +During 2010, we continued our efforts to obtain FDA approval of +additional applications for our OraQuick ® HCV test. A separate PMA supplement was filed with the FDA for +fingerstick whole blood in July 2010 and was approved in February 2011, making it the second application to be approved by the FDA. We intend to pursue approval of an oral fluid claim for our +OraQuick ® HCV test. However, the filing of a PMA supplement for oral fluid has been delayed pending the +completion of additional testing and further discussions with the FDA. +Our protocols for a CLIA waiver have been reviewed and +approved by the FDA and our CLIA studies have been completed. We intend to submit the results of our studies and request a CLIA waiver for our fingerstick whole blood and venous whole blood claims in the near future. +OraQuick ® +HIV Test +During the second quarter of 2010, the FDA approved a dating extension for our +OraQuick ADVANCE ® HIV-1/2 test from 12 to 18 months. We also received approval from our notified body to +extend dating to 18 months in Europe. In November 2010, we received approval from the FDA and in Europe for an additional dating extension from 18 to 24 months. Real time stability studies are still in process for this product and, assuming the +product continues to meet our stability criteria, we expect to seek approval of further shelf life extensions in the future. +Also during the second quarter of 2010, the automated manufacturing equipment we installed in our Bethlehem, Pennsylvania facility was validated and approved by the FDA for use in the manufacture of our +OraQuick ADVANCE ® HIV test. During the third quarter of 2010, we commenced manufacturing our OraQuick +ADVANCE ® test with this equipment and we have begun to produce larger quantities of this product at a +lower overall cost. +OraQuick ® HIV OTC Test +In the +fourth quarter of 2010, we completed our studies to validate the labeling for our OraQuick ® HIV OTC test, and in +October 2010 we submitted to the FDA our final label validation data and a request for an investigational device exemption (“IDE”) for the final phase of clinical studies. We were granted the IDE in November 2010 and have begun the final +phase of clinical testing, which consists of a study in which individuals will conduct unsupervised self-testing using the investigational OTC version of the OraQuick ® HIV test with an oral fluid collection. +Substance Abuse +Testing +In January 2010, we signed an agreement with Roche Diagnostics for the worldwide +commercialization of homogeneous, fully-automated oral fluid drugs of abuse assays with our Intercept ® oral +specimen collection device. The oral fluid assays are being jointly developed under a development agreement previously executed with Roche. The oral fluid assays are designed to run on various clinical chemistry automated analyzers, which is +intended to allow oral fluid samples to be processed with the same efficiency currently provided by fully-automated, urine-based drug tests. The commercialization agreement is structured to take advantage of each party’s respective distribution +strengths, including our established market presence with oral fluid testing and Roche’s established base of analyzers and broad marketing capabilities. +In the first quarter of 2011, the FDA issued 510(k) clearances for use of high throughput oral fluid assays for PCP, +opiates, cocaine and methamphetamines with our Intercept ® device. These are the first such clearances resulting +from our collaboration with Roche Diagnostics. The FDA is in the final stages of review for one other assay for amphetamines and we expect the FDA to issue an additional 510(k) clearance for this product in the near future. +45 +OraSure QuickFlu™ Test +In the first quarter of 2011, we added a new infectious disease testing product to our product portfolio. The OraSure QuickFlu™ Rapid Flu A+B is an FDA-cleared in vitro rapid qualitative test +for the detection of influenza type A and type B, including H1N1 viral infections. We expect to sell this product directly into the U.S. hospital and public health markets. An application for CLIA waiver has also been submitted to the FDA for this +product. OraSure QuickFlu™ is manufactured and supplied to us under our agreement with Princeton BioMeditech Corporation. +Results of +Operations +Year Ended December 31, 2010 Compared to December 31, 2009 +Total revenues decreased 3% to $75.0 million in 2010 from $77.0 million in 2009. Decreased sales in the infectious disease testing, +substance abuse testing, and insurance risk assessment markets were partially offset by an increase in sales of our cryosurgical systems products and higher licensing and product development revenues. Revenues derived from products sold to customers +outside the United States were $11.5 million and $14.8 million or 15% and 19% of total revenues for the years ended December 31, 2010 and 2009, respectively. The majority of our international sales are denominated in U.S. dollars. As such, the +impact of foreign currencies was not material to our operating results. +The table below shows the amount of our total +revenues (in thousands) generated in each of our principal markets and by licensing and product development activities. +Twelve Months Ended December 31, +Dollars +% +Change +Percentage of +Total Revenues +Market +2010 +2009 +2010 +2009 +Infectious disease testing +$ +41,738 +$ +46,098 +(9 +)% +55 +% +60 +% +Substance abuse testing +11,671 +12,026 +(3 +) +16 +16 +Cryosurgical systems +11,965 +10,888 +10 +16 +14 +Insurance risk assessment +5,825 +6,157 +(5 +) +8 +8 +Product revenues +71,199 +75,169 +(5 +) +95 +98 +Licensing and product development +3,816 +1,857 +105 +5 +2 +Total revenues +$ +75,015 +$ +77,026 +(3 +)% +100 +% +100 +% +Infectious Disease Testing Market +As previously disclosed, an increasing number of our public health customers are supplying hospitals with OraQuick +ADVANCE ® HIV tests purchased from us. This is a positive development as it indicates increased support of +hospital testing initiatives by public health agencies. However, this overlap is making it more difficult to separately track OraQuick ® sales into these markets. Since this trend is likely to continue, we are now reporting public health and hospitals sales of our OraQuick ADVANCE ® HIV-1/2 test in the U.S. as a combined domestic market. Prior year amounts have been reclassified to conform to the +current presentation. +Sales to the infectious disease testing market decreased 9% to $41.7 million in +2010. OraQuick ® sales totaled $40.1 million and $43.8 million for the years ended December 31, 2010 and +2009, respectively. Sales of our OraSure ® oral fluid collection device totaled $1.6 million and $2.3 million in +2010 and 2009, respectively. +46 +The table below shows a breakdown of our total OraQuick ® revenues (in thousands) during 2010 and 2009. +Twelve Months Ended December 31, +Market +2010 +2009 +% +Change +Domestic +$ +38,218 +$ +39,306 +(3 +)% +International +1,919 +4,511 +(57 +) +Total OraQuick ® revenues +$ +40,137 +$ +43,817 +(8 +)% +During 2010, sales of the OraQuick ADVANCE ® HIV test in the U.S. market decreased 3% or $1.1 million, when compared to the same period in 2009. This decrease in +revenue reflects lower sales volumes resulting from changes in ordering patterns of one of our larger public health customers and reduced public health funding by state and local governments, as well as a lower average selling price. +International sales of our OraQuick ® HIV test decreased 57% to $1.9 million for the year ended December 31, 2010 from $4.5 million for the year ended December 31, 2009. This decrease resulted +from customer losses due to price competition, changes in the use of our test within government testing algorithms, and a decrease or elimination of funding for HIV testing initiatives. +Sales of our OraSure ® oral fluid collection device decreased 30% from $2.3 million in the 2009 to $1.6 million in 2010 due to reduced public health funding by state and local governments. +In addition, some customers who have purchased our OraSure ® device for laboratory HIV-1 testing in the past are +now electing to purchase our OraQuick ADVANCE ® test. We believe this is the result of customers +recognizing the benefits of rapid HIV testing, especially with oral fluid. +Substance Abuse Testing Market +As a result of declining economic conditions and consolidations in the laboratory industry, several of our laboratory +customers are performing substance abuse testing for both the criminal justice and workplace testing markets. As such, it is becoming increasingly difficult to track Intercept ® revenues separately in these markets. We expect this trend to continue and, accordingly, we are now reporting Intercept ® sales to the U.S. criminal justice and workplace testing markets on a combined basis. Prior year amounts have been +reclassified to conform to the current presentation. +Sales to the substance abuse testing market +decreased 3% in 2010 primarily as a result of lower sales of our Intercept ® drug testing system and a decrease +in laboratory equipment sales. The table below shows a breakdown of our total Intercept ® revenues (in thousands) +generated in each market during 2010 and 2009. +Twelve Months Ended December 31, +Market +2010 +2009 +% +Change +Domestic +$ +7,274 +$ +7,405 +(2 +)% +International +1,976 +2,003 +(1 +) +Total Intercept ® revenues +$ +9,250 +$ +9,408 +(2 +)% +Domestic Intercept ® revenues decreased 2% and international revenues remained relatively flat for 2010 when compared to the prior year. +We do not expect renewed growth in Intercept ® sales until employment conditions in the U.S. recover and overall economic conditions improve. In addition, the microplate oral fluid drug assays, which are sold for +use with the Intercept ® collection device, have come under increasing competitive pressure from +“home-brew” +47 +assays developed internally by our laboratory customers and compete with urine-based homogeneous assays that are run on fully-automated, random access analyzers. We believe our competitors are +developing oral fluid tests suitable for use on these fully automated homogeneous assay systems and these assays, if and when they are developed and commercialized, could represent a significant competitive threat to our oral fluid microplate +business. As discussed above, pursuant to a development agreement with Roche Diagnostics, homogenous fully-automated oral fluid drugs of abuse assays are being developed for use with our Intercept ® collection device. The FDA has issued 510(k) clearances on the high throughput assays for PCP, opiates, cocaine and methamphetamines and an application for 510(k) +clearance of an amphetamines assay for use with the Intercept ® device is currently pending before the FDA. The +assays use Roche’s KIMs (kinetic interaction of micro-particles in solution) technology and will run on various automated analyzers to allow oral fluid samples to be processed with the same efficiency currently achieved with urine-based drug +tests. We have also entered into a commercialization agreement with Roche pursuant to which a drug testing system comprised of our Intercept ® device and the newly developed homogenous assays will be marketed and sold on a worldwide basis. +Cryosurgical Systems Market +Sales of our products in the cryosurgical +systems market (which includes both the physicians’ office and OTC markets) increased 10% to $12.0 million in 2010 from $10.9 million in 2009. +The table below shows a breakdown of our total cryosurgical revenues (in thousands) generated in each market during 2010 and 2009. +Twelve Months Ended December 31, +Market +2010 +2009 +% +Change +Professional domestic +$ +5,967 +$ +3,902 +53 +% +Professional international +1,385 +1,919 +(28 +) +Over-the-counter +4,613 +5,067 +(9 +) +Total cryosurgical systems revenues +$ +11,965 +$ +10,888 +10 +% +Sales of our Histofreezer ® product to physicians’ offices in the United States increased 53% to $6.0 million in 2010, compared to $3.9 million in 2009, largely due to the elimination of +the diversion of less expensive international Histofreezer ® product into the domestic market. In addition, in +early 2010, we signed agreements with two manufacturers’ sales representative organizations to support sales of our Histofreezer ® product in the U.S. Under these arrangements, over 40 additional sales representatives have been working with our physicians’ office distributors throughout the +United States, resulting in additional domestic Histofreezer ® sales growth during this year. +Sales of Histofreezer ® in the international market decreased 28% in 2010, compared to 2009. This decline was largely due to a discontinuance of sales to certain foreign distributors that we +believe were diverting product to the U.S. market. The selling prices for our Histofreezer ® product are lower in +some foreign countries due to differences in the healthcare systems in those countries. During 2008 and early 2009, some distributors in these countries purchased English-labeled Histofreezer ® product and resold it into the domestic distribution network to distributors who employ alternate sourcing programs. +We also experienced a decline in Histofreezer ® sales in the European market as a result of the negative impact of changing European health regulations. In the European professional marketplace, healthcare +reimbursement has been or may be reduced or eliminated for certain treatment types, including treatments for common warts. The reduction in or elimination of reimbursement for wart treatments has affected international sales of our Histofreezer ® product and will continue to do so. +During the year ended December 31, 2010, our OTC cryosurgical sales decreased 9% primarily due to decreased sales to our Latin American OTC distributor, Genomma. During 2009, Genomma increased its +48 +purchases to support the launch of our OTC cryosurgical wart removal product in Brazil. We did not have this similar pipeline fill in 2010, resulting in a decrease in sales to Genomma of +approximately $314,000. +In July 2010, SSL International (“SSL”), our European OTC distributor, was acquired by +Reckitt Benckiser Group PLC. Our distribution contract with Reckitt was subject to an annual renewal at the end of 2010 and was extended through March 31, 2011. We expect that an additional short-term renewal will occur to permit the parties to +negotiate a new distribution contract. Sales to Reckitt for distribution in the European OTC market were $2.6 million in 2010 and 2009, respectively. +During the first quarter of 2009, we launched our own wart removal product under the Freeze ‘n Clear Skin Clinic TM tradename into the U.S. OTC cryosurgical marketplace. This venture resulted in limited revenues. As a result of the +product’s limited success, competing priorities and limited corporate funding, management decided to end its participation in the U.S. OTC cryosurgical marketplace at the end of 2010. +Insurance Risk Assessment Market +Sales to the insurance risk assessment +market decreased 5% from $6.2 million in 2009 to $5.8 million in 2010, as some insurance companies abandoned pre-screening for lower face value insurance policies. We expect this trend to continue in 2011. +Licensing and Product Development +Licensing and product development revenues increased to $3.8 million during 2010 from $1.9 million during 2009. This increase was primarily due to $2.0 million in milestone payments received as a result +of our achievement of certain regulatory and commercial objectives pursuant to a collaboration agreement with Merck for the development and promotion of our OraQuick ® rapid HCV test in international markets. The remaining licensing revenues for both 2010 and 2009 represent royalties received on domestic outsales of Merck’s OTC +cryosurgical wart removal product, pursuant to our license and settlement agreement executed in January 2008. +Gross Margin +The Company’s gross margin was 63% in 2010, compared to 61% in 2009. The increase in gross margin in 2010 was primarily the result of +the higher licensing and product development revenues. +Operating Expenses +Research and development expenses decreased 1% from $13.4 million in 2009 to $13.2 million in 2010, as a result of +lower validation and clinical trial costs related to the development of our OraQuick ® HCV test. These decreases +were partially offset by higher laboratory supplies expense related to the development of new infectious disease products and higher clinical trial costs related to the development of our OraQuick ® HIV OTC test. We expect our research and development costs will increase in 2011 as we continue clinical trials for our HIV OTC test and OraQuick ® HCV product and develop other new products. +Sales and marketing expenses decreased 2% to $20.7 million in 2010 from $21.2 million in 2009. This decrease was primarily the result of +lower relocation expenses. We expect 2011 sales and marketing expenses to decrease from 2010 levels as a result of lower staffing costs. +General and administrative expenses remained relatively unchanged at $16.8 million in 2010 and 2009. Lower legal expenses in 2010 were offset by an increase in consulting costs. We expect 2011 general and +administrative expenses to decrease slightly from 2010 levels as a result of expected reductions in staffing and consulting costs. +49 +In November 2009, we settled the patent infringement lawsuit filed by +Inverness Medical and Church & Dwight. Pursuant to the settlement we paid Inverness $3.0 million. We recorded $1.5 million of the $3.0 million payment as litigation settlement expense in our Statement of Operations for 2009. The remaining +$1.5 million was recorded as prepaid royalties and is being expensed in cost of goods sold in relation to estimated OraQuick ADVANCE ® HIV revenues to be generated through December 31, 2012. +During the second quarter of 2009, we recorded an impairment charge of $3.0 million related to license payments for certain HCV patents, which we previously capitalized. Management’s intent in +capitalizing these payments was to utilize this license in certain developing countries for the marketing and sale of an existing rapid HCV test supplied by a third party manufacturer. However, we were unable to penetrate this international +marketplace with this third-party’s rapid HCV test. Furthermore, given the impact of the current global recession and the deteriorating status of certain third-world economies, we no longer believed that we would be successful in selling this +third-party’s rapid HCV test in the foreseeable future. Accordingly, we recorded a non-cash impairment charge for the remaining unamortized book value of the patent and product rights in the quarter ended June 30, 2009. +Other Income/Expense +Interest expense decreased to $316,000 in 2010 from $361,000 in 2009. Interest income also decreased to $152,000 in 2010 from $738,000 in +2009, primarily as a result of lower yields earned on our investment portfolio, lower investment balances, and an overall more conservative, shorter-term investment approach. +Income Taxes +In 2008, we established a full valuation allowance against +our total net deferred tax asset. Management has continued to evaluate whether the full valuation is still appropriate. At December 31, 2010, we concluded that the full valuation allowance remained appropriate as the facts and circumstances +since the establishment of the allowance had not changed. As a result, no income tax benefit was recorded in 2010. +In +November 2009, The Worker, Homeownership, and Business Assistance Act of 2009 was enacted. This new law extended the carryback period for a net operating loss (“NOL”) from two years up to a maximum of five years. The carryback of +the NOL can be applied to both regular tax NOLs and alternative minimum tax (“AMT”) NOLs. The new law also eliminates the 90% limitation on the use of any AMT NOLs. As a result of the elimination of the 90% limitations, we elected to +carryback our 2008 AMT NOL to our 2007, 2006, and 2005 tax years and apply for a refund of the AMT taxes paid for those years. As such, in the fourth quarter of 2009, we recorded a $632,000 federal tax benefit associated with this AMT NOL carryback. +Offsetting this benefit was a nominal amount of state income taxes. +Year Ended December 31, 2009 Compared to December 31, 2008 +Total revenues increased 8% to $77.0 million in 2009 from $71.1 million in 2008. Revenues derived from products sold to +customers outside the United States were $14.8 million and $13.7 million or 19% of total revenues for the years ended December 31, 2009 and 2008, respectively. The majority of our international sales are denominated in U.S. dollars. As such, +the impact of foreign currencies was not material to our operating results. +50 +The table below shows the amount of our total revenues (in thousands) generated in each of +our principal markets and by licensing and product development activities. +Year Ended December 31, +Dollars +% +Change +Percentage of +Total Revenues +Market +2009 +2008 +2009 +2008 +Infectious disease testing +$ +46,098 +$ +38,096 +21 +% +60 +% +54 +% +Substance abuse testing +12,026 +14,006 +(14 +) +16 +20 +Cryosurgical systems +10,888 +10,655 +2 +14 +15 +Insurance risk assessment +6,157 +6,085 +1 +8 +8 +Product revenues +75,169 +68,842 +9 +98 +97 +Licensing and product development +1,857 +2,262 +(18 +) +2 +3 +Total revenues +$ +77,026 +$ +71,104 +8 +% +100 +% +100 +% +Infectious Disease Testing Market +Sales to the infectious disease testing market increased 21% to $46.1 million in 2009, primarily as a result of our +switch to a direct sales model for the U.S. hospital market which allowed us to realize a higher average selling price for these customers. Higher volumes in the U.S. public health market and higher international sales also contributed to the +increase. OraQuick ® and OraSure ® sales during 2009 totaled $43.8 million and $2.3 million, respectively, as compared to $35.3 million and $2.8 million in 2008, respectively. +The table below shows a breakdown of our total OraQuick ® revenues (in thousands) during 2009 and 2008. +Year ended December 31, +Customers +2009 +2008 +% Change +Direct to U.S. Public Health +$ +28,308 +$ +25,450 +11 +% +Hospital Market +10,998 +6,625 +66 +International +4,511 +3,234 +39 +Total OraQuick ® revenues +$ +43,817 +$ +35,309 +24 +% +During 2009, OraQuick ® sales to the U.S. public health market increased by 11% as compared to 2008. This increase was caused by higher purchase volumes due in part to the fact that a number +of our hospital customers were procuring OraQuick ® product through public health channels in lieu of purchasing +the test directly from us. We believed this pattern was the result of increased public health support of testing initiatives by hospitals across the country. As a result, sales to the hospital market were being redirected to the U.S. public health +market, thereby increasing revenues within that customer category. +Sales into the hospital market increased 66% to $11.0 +million during 2009, compared to $6.6 million in 2008. In January 2009, we switched to a direct sales model for U.S. hospitals as a result of the termination of our distribution agreement with Abbott Laboratories at the end of 2008. The increase in +revenues in the hospital market was primarily due to a higher average selling price realized under our direct sales model. +International sales of our OraQuick ® test increased to $4.5 million +in 2009 from $3.2 million in 2008. This 39% increase reflected higher sales into Latin America, Europe and Asia. Sales into Africa remained flat at $2.3 million in both 2009 and 2008. +During 2009, sales of OraSure ® declined $506,000 from $2.8 million in 2008 to $2.3 million in 2009. Some customers who had purchased our OraSure ® device for laboratory HIV-1 testing in the past are electing to purchase our OraQuick ADVANCE ® test. +51 +Substance Abuse Testing Market +Sales to the substance abuse testing market decreased 14% in 2009 primarily as a result of lower sales of our +Intercept ® collection devices and oral fluid assays. The table below shows a breakdown of our total Intercept ® revenues (in thousands) generated in each market during 2009 and 2008. +Year ended December 31, +Market +2009 +2008 +% Change +Workplace testing +$ +3,895 +$ +4,750 +(18 +)% +Criminal justice +2,593 +2,663 +(3 +) +International +2,003 +2,168 +(8 +) +Direct +917 +1,204 +(24 +) +Total Intercept ® revenues +$ +9,408 +$ +10,785 +(13 +)% +Our workplace testing business decreased 18% from $4.8 million in 2008 to $3.9 million in 2009. +Pre-employment drug screening represented over 50% of our workplace testing business and the downturn in the domestic economy and high unemployment levels had a significant negative impact on this part of our business, as well as on our direct sales +to small and mid-size companies. +Sales to the criminal justice market decreased 3% from $2.7 million in +2008 to $2.6 million in 2009, primarily as a result of the availability of competing lower priced drug testing products. International sales of Intercept ® devices and assays decreased 8% to $2.0 million in 2009 from $2.2 million in 2008, also as a result of competition from lower priced drug testing products outside of +the U.S. +Cryosurgical Systems Market +Sales of our products in the cryosurgical systems market (which includes both the physicians’ office and OTC markets) increased 2% to $10.9 million in 2009 from $10.7 million in 2008. This increase +was primarily caused by higher sales to our Latin American OTC distributor, Genomma, partially offset by lower sales to our European OTC distributor, SSL, and decreased Histofreezer ® sales in international professional markets. +The table below shows a breakdown of our total cryosurgery revenues (in thousands) generated in each market during 2009 and 2008. +Year ended December 31, +Market +2009 +2008 +% Change +Professional domestic +$ +3,902 +$ +3,911 +0 +% +Professional international +1,919 +2,529 +(24 +) +OTC domestic +144 +— +N/A +OTC international +4,923 +4,215 +17 +Total cryosurgical systems revenues +$ +10,888 +$ +10,655 +2 +% +Sales to Genomma for the year ended December 31, 2009 increased to $2.3 million, compared to +$401,000 during the year ended December 31, 2008. During 2008, Genomma reduced its purchases in response to an increase in product returns from retailers in Mexico who overstocked during the winter months of 2007. Throughout 2008 and early in +2009, Genomma worked through its excess inventory levels and resumed purchasing product during the second quarter of 2009. In addition, Genomma launched our cryosurgical wart removal product in Brazil and we completed our first shipment to Brazil in +September 2009. +The increased sales to Latin America were partially offset by a decrease in sales to SSL. Sales to SSL were +$2.6 million and $3.8 million in 2009 and 2008, respectively. The decrease in revenues from SSL resulted from a +52 +reduction in the transfer price paid by SSL and a decrease in units purchased as a result of increased competition in the OTC wart removal market in Europe. +During the first quarter of 2009, we reentered the U.S. OTC cryosurgery marketplace through the launch of our own cryosurgical wart +removal product under our new national brand, Freeze ‘n Clear Skin Clinic™. During the year ended December 31, 2009, we recorded $1.2 million in revenues from Freeze ‘n Clear Skin Clinic™. However, these revenues were offset +by $1.0 million in promotional rebates, advertising, slotting and return allowances provided to the retail trade, which we netted against the revenues in accordance with U.S. generally accepted accounting principles. +Sales of our Histofreezer ® product to physicians’ offices in the United States were $3.9 million in both 2009 and 2008. Sales of Histofreezer ® in the professional international market decreased 24% to $1.9 million in 2009, as compared to $2.5 million in 2008. +The selling prices for our Histofreezer ® product are lower in some foreign countries due to differences in the +healthcare systems in those countries. During 2008 and early 2009, some distributors in these countries purchased English-labeled Histofreezer ® product and resold it into the domestic distribution network to distributors who employ alternate sourcing programs. Although we tried to aggressively address this +diversion issue, we believe it negatively impacted sales in the domestic physicians’ office market during 2009. The decline in Histofreezer ® revenues in the professional international market in 2009 was largely due to a reduction of sales to distributors that we believe were diverting product to the U.S. +market. +Insurance Risk Assessment Market +Sales to the insurance risk assessment market increased 1% from $6.1 million in 2008 to $6.2 million in 2009, due to variations in laboratory ordering patterns and an increase in purchases of lower face +value insurance policies for which insurers use our oral fluid screening device. +Licensing and Product Development +Licensing and product development revenues decreased to $1.9 million in 2009, from $2.3 million in 2008. In January +2008, we entered into a license and settlement agreement with Merck & Co. Inc. (“Merck”, successor to Schering-Plough) in which Merck agreed to pay us royalties on U.S. sales of their Freeze Away TM OTC cryosurgical wart removal product. Licensing revenues represent +these royalties from Merck in 2009 and 2008. +Gross Margin +The Company’s gross margin was 61% in 2009, compared to 58% in 2008. Gross margin was favorably impacted during +2009 primarily by our switch in January 2009 to a direct sales model for our OraQuick ADVANCE ® HIV-1/2 +test in the U.S. hospital market. Also contributing to the increase was an improvement in manufacturing efficiency in 2009. +Operating +Expenses +Research and development expenses decreased 34% to $13.4 million in 2009, from $20.3 million +in 2008, primarily as a result of decreased clinical trial spending for our OraQuick ® HIV OTC test and OraQuick ® HCV test. The majority of the initial product development and clinical costs associated with the OraQuick ® HCV device and related PMA submission was incurred during 2008. A decrease in staffing costs resulting from +organizational changes made during the fourth quarter of 2008 also contributed to the current period decrease. In addition, expenses in 2008 included a $1.0 million patent license milestone payment required as a result of our filing of a PMA +submission with the FDA for our OraQuick ® HCV device, while 2009 expenses did not include any such payment. +Sales and marketing expenses increased 1% to $21.2 million in 2009 from $20.9 million in 2008. Staffing costs increased in +2009 as a result of hiring a new sales force in support of our direct sales model for the U.S. +53 +hospital market, as well as hiring, compensation, and relocation costs associated with new senior-level sales and marketing personnel. Market research and consulting expenses related to our +cryosurgical products also increased during 2009. These increases were offset by a decrease in reimbursement of distributor advertising expenses. +General and administrative expenses increased 3% to $16.9 million in 2009 from $16.3 million in 2008. This increase was primarily attributable to higher staffing costs as well as legal expenses associated +with the patent infringement lawsuit related to our OraQuick ADVANCE ® HIV test filed against us by +Inverness Medical and Church & Dwight. +In November 2009, we settled the patent infringement +lawsuit filed by Inverness and Church & Dwight. Pursuant to the settlement we paid Inverness $3.0 million. We recorded $1.5 million of the $3.0 million payment as litigation settlement expense in our Statement of Operations for 2009. The +remaining $1.5 million was recorded as prepaid royalties and will be expensed in cost of goods sold in relation to +OraQuick ® ADVANCE ® HIV revenues generated through December 31, 2012. +In the first quarter of 2008, we received a payment of $4.9 million as a result of the settlement of patent infringement litigation we had previously filed against Merck. +During the second quarter of 2009, we recorded an impairment charge of $3.0 million related to license payments for certain HCV patents, +which we previously capitalized. Management’s intent in capitalizing these payments was to utilize this license in certain developing countries for the marketing and sale of an existing rapid HCV test supplied by a third party manufacturer. +However, we were unable to penetrate this international marketplace with this third-party’s rapid HCV test. Furthermore, given the impact of the global recession and the deteriorating status of certain third-world economies, we no longer +believed that we would be successful in selling a third-party’s rapid HCV test in the foreseeable future. Accordingly, we recorded a non-cash impairment charge for the remaining unamortized book value of the patent and product rights in the +second quarter of 2009. +Other Income/Expense +Interest expense increased to $361,000 in 2009 from $346,000 in 2008. Interest income decreased to $738,000 in 2009 from $3.1 million in 2008 primarily as a result of lower yields earned on our investment +portfolio, lower investment balances, and an overall conservative, shorter-term investment approach. +Income Taxes +In November 2009, The Worker, Homeownership, and Business Assistance Act of 2009 was enacted. This new law extended the carryback +period for NOLs from two years up to a maximum of five years. The carryback of the NOL can be applied to both regular tax NOLs and AMT NOLs. The new law also eliminates the 90% limitation on the use of any AMT NOLs. As a result of the elimination of +the 90% limitations, we elected to carryback our 2008 AMT NOL to our 2007, 2006, and 2005 tax years and apply for a refund of the AMT taxes paid for those years. As such, in the fourth quarter of 2009, we recorded a $632,000 federal tax benefit +associated with this AMT NOL carryback. Offsetting this benefit was a nominal amount of state income taxes. +During 2008, we +evaluated whether or not we would realize the benefits associated with our total net deferred tax asset in the future. Given the uncertainty surrounding the magnitude and length of the current economic recession, our loss in 2008, and our projection +of a loss in 2009, which would result in a net cumulative three-year loss, we determined that it was more likely than not that we would not realize the benefits associated with our net deferred tax assets in the immediate future. Accordingly, in +accordance with Financial Accounting Standards Board (“FASB”) guidance, we recorded an income tax charge of $26.0 million in the fourth quarter of 2008 in order to establish a full valuation allowance against our net deferred tax asset. +54 +Liquidity and Capital Resources +December 31, +2010 +2009 +(In thousands) +Cash and cash equivalents +$ +73,843 +$ +74,934 +Short-term investments +1,895 +4,737 +Working capital +77,808 +89,435 +Our cash, cash +equivalents and short-term investments decreased $4.0 million from $79.7 million as of December 31, 2009 to $75.7 million as of December 31, 2010, primarily as a result of $3.9 million of cash flows from operations offset by $4.5 million +in payments for patents and product rights, $2.1 million in property and equipment purchases, $709,000 associated with the retirement of common stock to pay minimum tax withholding obligations on the vesting of restricted shares, and $510,000 for +debt repayments. Our working capital declined primarily as a result of the classification of the remaining unpaid principal balance of our debt obligation to a current liability as a result of its June 2011 maturity date. +During 2010, operating activities provided cash of $3.9 million. Cash provided by operating activities resulted +primarily from the offset of our $3.5 million net loss by non-cash stock-based compensation expense of $3.2 million and depreciation and amortization of $3.0 million. Also contributing to the cash provided by operating activities was a $1.2 million +decrease in accounts receivable resulting from the decrease in sales and the timely collection of amounts due, a $1.4 million decrease in inventories largely as a result of managing our OraQuick ® inventory to lower levels, and a $1.4 million decrease in prepaid expenses largely due to the collection of a federal tax refund of $597,000 and the routine +amortization of prepaid royalties. Offsetting these cash contributions was a decrease in accounts payable of $472,000 and a $2.5 million decrease in accrued expenses and other liabilities associated with payment of our 2009 royalty obligations, +management incentive bonuses and a decrease in deferred revenues. +Net cash used in investing activities during 2010 was $3.8 +million. Proceeds of $2.8 million from maturities and redemptions of short-term investments were offset by $2.1 million in purchases of property and equipment and $4.5 million in payments for patents and licenses related to the achievement of +milestones pursuant to our HCV patent license agreement. +During the year ended December 31, 2011, we expect to invest +approximately $2.8 million in capital expenditures, primarily to purchase additional equipment, upgrade certain older equipment and make improvements to our facilities. +Net cash used in financing activities was $1.2 million in 2010, primarily as a result of $510,000 in loan principal repayments and $709,000 used for the withholding and retirement of common stock related +to the vesting of restricted shares. +As of December 31, 2010, we had in place a $10,000,000 credit facility with +Comerica Bank (“Comerica”). Pursuant to the terms of the facility, principal, and interest fixed at 4.15% per annum, are payable monthly through June 2011, at which time the remaining unpaid principal balance is payable and the +facility will expire. Accordingly, beginning on June 30, 2010, our remaining unpaid principal balance was classified as a current liability as it will be payable within the ensuing twelve months. As of December 31, 2010, we had no +available borrowings under this credit facility. We are evaluating possible options to address the upcoming expiration of the facility, including refinancing with a new credit facility or other borrowings. +All borrowings from Comerica are collateralized by a first priority security interest in all of our assets, including present and future +accounts receivable, chattel paper, contracts and contract rights, equipment and accessories, general intangibles, investments, instruments, inventories, and a mortgage on our three facilities in +55 +Bethlehem, Pennsylvania. The Comerica agreement contains certain covenants that set forth minimum requirements for our quick ratio, liquidity, and tangible net worth. We were in full compliance +with all covenants as of December 31, 2010. The agreement also restricts our ability to pay dividends, to make certain investments, to incur additional indebtedness, to sell or otherwise dispose of a substantial portion of assets, and to merge +or consolidate operations with an unaffiliated entity, without the consent of Comerica. +As of December 31, 2010, we had +net operating loss (“NOL”) carryforwards of approximately $50.4 million for federal income tax purposes. In the fourth quarter of 2008, we recorded a full valuation allowance against the deferred tax asset generated by these NOLs. +The combination of our current cash, cash equivalents and short-term investments is expected to be more than sufficient to +fund our operating and capital needs through at least the next twelve months. Our cash requirements, however, may vary materially from those now planned due to many factors, including, but not limited to, the scope and timing of strategic +acquisitions, the cost and timing of the expansion of our manufacturing capacity, the progress of our research and development programs, the scope and results of clinical testing, the cost of any future litigation, the magnitude of capital +expenditures, changes in existing and potential relationships with business partners, the time and cost of obtaining regulatory approvals, the costs involved in obtaining and enforcing patents, proprietary rights and any necessary licenses, the cost +and timing of expansion of sales and marketing activities, the timing of market launch of new products, market acceptance of new products, competing technological and market developments, the impact of the ongoing economic downturn and other +factors. +Contractual Obligations and Commercial Commitments +The following sets forth our approximate aggregate obligations as of December 31, 2010 for future payments under contracts and other contingent commitments, for the year 2011 and beyond: +Total +Payments due by December 31, +Contractual Obligations +2011 +2012 +2013 +2014 +2015 +Thereafter +Long-term debt 1 +$ +7,791,680 +$ +7,791,680 +$ +— +$ +— +$ +— +$ +— +$ +— +Operating leases 2 +62,442 +62,442 +— +— +— +— +— +Employment contracts 3 +3,666,500 +2,245,500 +1,171,000 +250,000 +— +— +— +Purchase obligations 4 +2,634,454 +2,634,454 +— +— +— +— +— +Minimum commitments under contracts 5 +3,791,667 +500,000 +500,000 +500,000 +500,000 +500,000 +1,291,667 +Total contractual obligations +$ +17,946,743 +$ +13,234,076 +$ +1,671,000 +$ +750,000 +$ +500,000 +$ +500,000 +$ +1,291,667 +1 +Represents principal repayments required under notes payable to our lenders. See Note 8 of the Notes to the financial statements included herein. +2 +Represents payments required under our operating leases. +3 +Represents salary payments payable under the terms of employment agreements executed by us with certain executives. See Note 11 of the Notes to the financial statements +included herein. +4 +Represents payments required by non-cancellable purchase orders related to inventory, capital expenditures and other goods or services. See Note 11 of the Notes to the +financial statements included herein. +5 +Represents payments required pursuant to certain, licensing agreements executed by the Company. These agreements are cancellable within a specified number of days after +communication by the Company of its intent to terminate. See Note 11 of the Notes to the financial statements included herein. +Off-Balance Sheet Arrangements . We do not have any off-balance sheet arrangements, as defined in Item 303(a)(4) (ii) of Regulation S-K under the Securities Exchange +Act of 1934, as amended. +56 +Critical Accounting Policies and Estimates +This Management’s Discussion and Analysis of Financial Condition and Results of Operations discusses our financial statements, which +have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires that we make estimates and assumptions that affect the reported amounts of assets +and liabilities, the disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenues and expenses during the reporting period. On an on-going basis, we evaluate our judgments and +estimates, including those related to bad debts, inventories, investments, intangible assets, income taxes, revenue recognition, clinical trial accruals, contingencies and litigation. We base our judgments and estimates on historical experience and +on various other factors that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying value of assets and liabilities that are not readily apparent from other sources. Actual +results may differ from these estimates under different assumptions or conditions. +Our significant accounting policies are +described in Note 2 of the Notes to the financial statements included in Item 15 of this Annual Report. We consider the following accounting estimates, which have been discussed with our Audit Committee, to be most critical in understanding the +more complex judgments that are involved in preparing our financial statements and the uncertainties that could impact our results of operations, financial condition and cash flows. +Revenue Recognition . We recognize product revenues when there is persuasive evidence that an arrangement +exists, the price is fixed or determinable, title has passed and collection is reasonably assured. Product revenues are recorded net of allowances for any discounts or rebates. We do not grant price protection or product return rights to our +customers except for warranty returns and return rights granted to retail customers for our domestic cryosurgical wart removal product. +Historically, returns arising from warranty issues have been infrequent and immaterial. Accordingly, we expense warranty returns as incurred. For our cryosurgical product sold in the domestic retail +market, a provision for estimated product returns is recorded as a reduction of revenue in the same period in which the revenue is recognized. In addition, revenue from domestic retail sales is also recorded net of promotional, advertising, and +slotting allowances granted to the retail trade. +Royalty income from the grant of license rights is recognized during the +period in which the revenue is earned and the amount is determinable from the licensee. +Product development revenues are +recognized over the period in which the related product development efforts are performed. Amounts received prior to the performance of product development efforts are recorded as deferred revenues. Grant revenue is recognized as the related work is +performed and costs are incurred. We record shipping and handling charges billed to our customers as product revenue and the related expense as cost of products sold. Taxes assessed by governmental authorities, such as sales or value-added taxes, +are excluded from product revenues. +Allowance for Uncollectible Accounts Receivable . Accounts +receivable are reduced by an estimated allowance for amounts that may become uncollectible in the future. On an ongoing basis, we perform credit evaluations of our customers and adjust credit limits based upon the customer’s payment history and +creditworthiness, as determined by a review of their current credit information. We also continuously monitor collections and payments from our customers. +Based upon historical experience and any specific customer collection issues that are identified, we use our judgment to establish and evaluate the adequacy of our allowance for estimated credit losses, +which was $106,000 as of December 31, 2010. While credit losses have been within our expectations and the allowance provided, these losses can vary from period to period. Furthermore, there is no assurance that we will experience +57 +credit losses at the same rates as we have in the past. The current economic downturn, including disruptions in the capital and credit markets, may continue indefinitely and intensify, and could +adversely affect the operations, cash flows and financial condition of our customers. These circumstances may adversely impact the liquidity or financial position of our customers and could have a material impact on the collectability of our +accounts receivable and future operating results. +Inventories . Our inventories are valued at +the lower of cost or market, determined on a first-in, first-out basis, and include the cost of raw materials, labor and overhead. The majority of our inventories are subject to expiration dating. We continually evaluate quantities on hand and the +carrying value of our inventories to determine the need for reserves for excess and obsolete inventories based primarily on the estimated forecast of product sales. When, in the opinion of management, factors indicate that impairment has occurred, +either a reserve is established against the inventories’ carrying value or the inventories are completely written off, as in the case of lapsing expiration dates. During 2010, 2009 and 2008, we wrote-off inventory which had a cost of $919,000, +$1.5 million and $2.0 million, respectively, as a result of quality, scrap and product expiration issues. Although we make every effort to ensure the accuracy of our forecasts of future product demand, any significant unanticipated changes in demand +could have a significant impact on the carrying value of our inventories and reported operating results. +Stock-based +Compensation . We recognize the fair value of equity-based awards as compensation expense in our statement of operations. The fair value of our stock option awards was estimated using a Black-Scholes option valuation model. +This valuation model’s computations incorporate highly subjective assumptions, such as the expected stock price volatility and the estimated life of each award. The fair value of the options, after considering the effect of expected +forfeitures, is then amortized, generally on a straight-line basis, over the related vesting period of the option. The fair value of our restricted shares is based on the market value of the shares at the date of grant and is recognized on a +straight-line basis over the related vesting period of the award. +Long-lived and Intangible +Assets . Our long-lived assets are comprised of property and equipment and our intangible assets primarily consist of patents and product rights. Together, these assets had a net book value of $24.4 million, or 20% of our +total assets, as of December 31, 2010. Property and equipment and patents and product rights are depreciated or amortized on a straight-line basis over their estimated useful lives, which we determine based upon our estimate of the period of +time over which each asset will generate revenues. An impairment of long-lived or intangible assets could occur whenever events or changes in circumstances indicate that the net book value of our assets may not be recoverable. Events which could +trigger asset impairment include significant underperformance relative to historical or projected future operating results, significant changes in the manner of our use of an asset or in our overall business strategy, significant negative industry +or economic trends, and shortening of product life-cycles or changes in technology. If we believe impairment of an asset has occurred, we measure the amount of such impairment by comparing the net book value of the affected assets to the fair value +of these assets, which is generally determined based upon the present value of the expected cash flows associated with the use of these assets. If the net book value exceeds the fair value of the impaired assets, we would incur an impairment expense +equal to this difference. +During the second quarter of 2009, we recorded an impairment charge of $3.0 million related to +license payments for certain HCV patents, which were previously capitalized. Management’s intent in capitalizing these payments was to utilize this license in certain developing countries for the marketing and sale of an existing rapid HCV test +supplied by a third party manufacturer. However, we were unable to penetrate this international marketplace with this third-party’s rapid HCV test. Furthermore, given the impact of the recent global recession and the deteriorating status of +certain third-world economies at that time, we no longer believed that we would be successful in selling a third-party’s rapid HCV test in the foreseeable future. We currently believe the future cash flows to be received from all remaining +long-lived and intangible assets as of December 31, 2010 will exceed their book value. We did not recognize any impairment losses for the years ended December 31, 2010 or 2008. Any unanticipated significant impairment in the future, +however, could have a material adverse impact to our balance sheet and future operating results. +58 +Deferred Tax Assets. At December 31, 2010, we had federal +NOL carryforwards of $50.4 million. The deferred tax assets, before a full valuation allowance, associated with these NOLs and other temporary differences was $28.8 million at December 31, 2010. In assessing the realizability of net deferred +tax assets, we consider whether it is more likely than not that some portion or all of the deferred tax assets will not be realized. The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income during the +period in which those temporary differences become deductible or the NOLs and credit carryforwards can be utilized. We consider the scheduled reversal of deferred tax liabilities, projected future taxable income and tax planning strategies in making +this assessment. +During the fourth quarter of 2008, we evaluated our ability to realize our net deferred tax asset, in order +to determine if a valuation allowance should be recorded against it pursuant to FASB accounting guidance. A cumulative loss in recent years is a significant piece of negative evidence to be considered when evaluating the need for a valuation +allowance and this evidence is difficult to overcome. Given the uncertainty surrounding the magnitude and length of the economic recession at that time, our loss in 2008, and our projection of a loss in 2009, which would result in a net cumulative +three-year loss, we determined that it was more likely than not that we would not realize the benefits associated with our net deferred tax asset in the immediate future. Accordingly, we recorded an income tax charge of $26.0 million in the fourth +quarter of 2008 to establish a full valuation allowance against our net deferred tax asset. During 2010 and 2009, we continued to reevaluate our valuation allowance position and believe that it is more likely than not that our deferred income tax +asset will not be realized in the immediate future. As such, we maintain a full valuation allowance against our net deferred tax assets as of December 31, 2010 and 2009. +Our ability to use our NOL carryforwards to offset future federal income tax obligations could be limited by changes in the ownership of our stock. Internal Revenue Code (“IRC”) Section 382 +contains provisions that limit the amount of federal NOL carryforwards that can be used in any given year in the event of specified occurrences, including significant ownership changes. During the fourth quarter of 2005, the Company completed an +analysis, with the assistance of independent tax specialists, to determine if any IRC Section 382 ownership changes had occurred that would limit the amount of NOLs that could be utilized to offset future taxable income. As a result of this +analysis, the Company concluded that prior period ownership changes may impose a limitation on the amount of NOLs that can be utilized in a given year. The Company does not believe, however, that this limitation will impair our future ability to +utilize NOLs to offset our future taxable income. The Company continues to review ownership changes on an annual basis and we have not had an ownership change that would impact the NOLs. +Clinical Trial Accruals . Some of our research and development is conducted by third parties, including +contract research and development service providers. All such costs are charged to research and development expense systematically as incurred, which may be measured by patient enrollment or the passage of time. At the end of each quarter, we +compare the payments made to each service provider to the estimated progress toward completion of the research or development objectives. Such estimates are subject to change as additional information becomes available. Depending on the timing of +payments to the service providers and the estimated service provided, we record net prepaid or accrued expense relating to these costs. +Contingencies. In the ordinary course of business, we have entered into various contractual relationships with strategic corporate partners, customers, distributors, research laboratories and +universities, licensors, licensees, suppliers, vendors and other parties. As such, we could be subject to litigation, claims or assessments arising from any or all of these relationships. We record an estimated loss contingency when information +available prior to issuance of our financial statements indicates that it is probable that an asset has been impaired or a liability has been incurred at the date of the financial statements and the amount of the loss can be reasonably estimated. +Accounting for contingencies arising from contractual or legal proceedings requires that we use our best judgment when estimating an accrual related to such contingencies. As additional information becomes known, our accrual for a loss contingency +could fluctuate, thereby creating variability in our results of operations from period to period. Likewise, an actual loss arising from a loss contingency which significantly +59 +exceeds the amount accrued for in our financial statements could have a material adverse impact on our operating results for the period in which such actual loss becomes known. +ITEM 7A. +Quantitative and Qualitative Disclosures About Market Risk. +We do not hold any amounts of derivative financial instruments or derivative commodity instruments and, accordingly, we have no material derivative risk to report under this Item. +The majority of our assets is comprised of cash and cash equivalents and as a result we have little exposure to market risks associated +with available-for-sale securities. +In January 2008, we elected to fix the interest rate on our long-term debt at 4.15% until +the debt’s maturity in June 2011. As a result, we have no exposure to interest rate changes. +As of December 31, +2010, we did not have any foreign currency exchange contracts or purchase currency options to hedge local currency cash flows. We have operations in Europe and Africa, which are subject to foreign currency fluctuations. As currency rates change, +translation of revenues and expenses for these operations from foreign currencies to U.S. dollars affects year-to-year comparability of operating results. Sales denominated in a foreign currency were minimal compared to our total revenues for the +year ended December 31, 2010. We do not expect the risk of foreign currency fluctuations to be material to us in the near future. +ITEM 8. +Financial Statements and Supplementary Data. +Information with respect to this Item is contained in our Financial Statements included in Item 15 of this Annual Report on Form 10-K. +ITEM 9. +Changes in and Disagreements with Accountants on Accounting and Financial Disclosure. +Not applicable. +ITEM 9A. +Controls and Procedures. +(a) Evaluation of Disclosure Controls and Procedures. +The Company’s management, with the participation of the Company’s Chief Executive Officer and Chief Financial Officer, has evaluated the effectiveness of the Company’s disclosure controls +and procedures (as defined in Rules 13a-15(e) and 15d-15(e) of the Securities Exchange Act of 1934) as of December 31, 2010. Based on that evaluation, the Company’s management, including such officers, concluded that as of +December 31, 2010 the Company’s disclosure controls and procedures were adequate and effective to ensure that information required to be disclosed by the Company in the reports that we file or submit under the Securities Exchange Act of +1934 is accumulated and communicated to the Company’s management, including the Chief Executive Officer and Chief Financial Officer, to allow timely decisions regarding required disclosure and is recorded, processed, summarized, and reported +within the time periods specified in the rules and forms of the Securities and Exchange Commission. +(b) Management’s +Report on Internal Control Over Financial Reporting. +The Company’s management is responsible for establishing and +maintaining adequate internal control over financial reporting, as such term is defined in Rule 13a-15(f) and 15d-15(f) under the Securities Exchange Act of 1934. Under the supervision and with the participation of the Company’s management, +including our principal executive officer and principal financial officer, we conducted an evaluation of the effectiveness of our internal control over financial reporting based on the framework in Internal Control—Integrated Framework +issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on our evaluation under the framework, our management concluded that our internal control over financial reporting was effective to provide reasonable +assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles as of December 31, 2010. +60 +The effectiveness of our internal control over financial reporting as of December 31, +2010 has been audited by KPMG LLP, an independent registered public accounting firm, as stated in their report, which is included below. +Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject +to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. +(c) Changes in Internal Control Over Financial Reporting. +There was no +change in the Company’s internal control over financial reporting during the three months ended December 31, 2010 that was identified in connection with the evaluation referred to in paragraph (b) above that has materially affected, +or is reasonably likely to materially affect, the Company’s internal control over financial reporting. +(d) Report of +Independent Registered Public Accounting Firm +The Board of Directors and Stockholders +OraSure Technologies, Inc.: +We +have audited OraSure Technologies, Inc.’s internal control over financial reporting as of December 31, 2010, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring +Organizations of the Treadway Commission (COSO). OraSure Technologies, Inc.’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over +financial reporting, included in the accompanying Management’s Report on Internal Control Over Financial Reporting. Our responsibility is to express an opinion on the Company’s internal control over financial reporting based on our audit. +We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). +Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of +internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audit also included performing such +other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion. +A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial +statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, +in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in +accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance +regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements. +Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections +of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. +61 +In our opinion, OraSure Technologies, Inc. maintained, in all material respects, effective +internal control over financial reporting as of December 31, 2010, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). +We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the +balance sheets of OraSure Technologies, Inc. as of December 31, 2010 and 2009, and the related statements of operations, stockholders’ equity and comprehensive loss, and cash flows for each of the years in the three-year period ended +December 31, 2010, and our report dated March 10, 2011 expressed an unqualified opinion on those financial statements. +/s/ KPMG LLP +Philadelphia, Pennsylvania +March 10, 2011 +ITEM 9B. +Other Information. +Not +applicable. +62 +PART III +We have omitted from Part III the information that will appear in our Definitive Proxy Statement for our 2011 Annual Meeting of +Stockholders (the “Proxy Statement”), which will be filed within 120 days after the end of our fiscal year pursuant to Regulation 14A. +ITEM 10. +Directors, Executive Officers and Corporate Governance. +Certain information required by this Item is incorporated by reference to the information under the captions, “Corporate Governance—Committees of the Board—Audit Committee,” “Item +1—Election of Directors,” “Executive Officers,” and “Section 16(a) Beneficial Ownership Reporting Compliance,” in the Proxy Statement. +Our Board of Directors has adopted a Code of Business Conduct and Ethics that applies to our principal executive officer, principal financial officer and principal accounting officer, as well as to the +members of our Board of Directors and our other officers and employees. This Code of Business Conduct and Ethics is available on our website at www.orasure.com . We intend to satisfy the amendment and waiver disclosure requirements under +applicable securities regulations by posting any amendments of, or waivers to, the Code of Business Conduct and Ethics on our website. +ITEM 11. +Executive Compensation. +The information required by this Item is incorporated by reference to the information under the caption, “Executive +Compensation,” in the Proxy Statement. +ITEM 12. +Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters. +The information required by this Item with respect to the securities ownership of certain beneficial owners and management, and equity +compensation plan information, is incorporated by reference to the information under the captions, “Principal Stockholders” and “Executive Compensation—Equity Compensation Plan Information,” in the Proxy Statement. +ITEM 13. +Certain Relationships and Related Transactions, and Director Independence. +The information required by this Item is incorporated by reference to the information under the captions, “Transactions with Related Persons” and “Corporate Governance—Director +Independence,” in the Proxy Statement. +ITEM 14. +Principal Accountant Fees and Services. +The information required by this Item is incorporated by reference to the information under the caption, “Item 2—Ratification of Appointment of Independent Registered Public Accounting +Firm.” +63 +PART IV +ITEM 15. +Exhibits and Financial Statement Schedules. +(a)(1) and (a)(2). Financial Statements and Schedules . For a list of the Financial Statements filed herewith, see the Index to Financial Statements following the signature page to this Annual +Report. No schedules are included with the Financial Statements because the required information is inapplicable or is presented in the Financial Statements or related notes thereto. +(a)(3). Exhibits . See Index to Exhibits following the Financial Statements in this Annual Report. +64 +SIGNATURES +Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly +authorized, on March 10, 2011. +ORASURE TECHNOLOGIES, INC. +By: +/s/ D OUGLAS A. M ICHELS +Douglas A. Michels +President and Chief Executive Officer +Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed on March 10, 2011, by the following persons on behalf of the Registrant and in the capacities +indicated. +SIGNATURE +TITLE +/s/ D OUGLAS A. M ICHELS +Douglas A. Michels +President, Chief Executive Officer and Director +(Principal Executive Officer) +/s/ R ONALD H. S PAIR +Ronald H. Spair +Chief Operating Officer, Chief Financial Officer and +Director (Principal Financial Officer) +/s/ M ARK L. K UNA +Mark L. Kuna +Senior Vice President, Finance and Controller +(Principal Accounting Officer) +*M ICHAEL C ELANO +Michael Celano +Director +*J ACK G OLDSTEIN , P H .D. +Jack Goldstein, Ph.D. +Director +*R ONNY B. L ANCASTER +Ronny B. Lancaster +Director +*C HARLES W. P ATRICK +Charles W. Patrick +Director +*R OGER L. P RINGLE +Roger L. Pringle +Director +*D OUGLAS G. W ATSON +Douglas G. Watson +Director +*By: +/s/ J ACK E. J ERRETT +Jack E. Jerrett +(Attorney-in-Fact) +65 +INDEX TO FINANCIAL STATEMENTS +Page +Report of Independent Registered Public Accounting Firm +F-2 +Balance Sheets +F-3 +Statements of Operations +F-4 +Statements of Stockholders’ Equity and Comprehensive Income (Loss) +F-5 +Statements of Cash Flows +F-6 +Notes to the Financial Statements +F-7 +F-1 +REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM +The Board of Directors and Stockholders +OraSure Technologies, Inc.: +We have audited the accompanying balance sheets of OraSure +Technologies, Inc. as of December 31, 2010 and 2009, and the related statements of operations, stockholders’ equity and comprehensive loss, and cash flows for each of the years in the three-year period ended December 31, 2010. These +financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits. +We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable +assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the +accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. +In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of OraSure Technologies, Inc. +as of December 31, 2010 and 2009, and the results of its operations and its cash flows for each of the years in the three-year period ended December 31, 2010, in conformity with U.S. generally accepted accounting principles. +We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), OraSure Technologies, +Inc.’s internal control over financial reporting as of December 31, 2010, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission +(COSO), and our report dated March 10, 2011 expressed an unqualified opinion on the effectiveness of the Company’s internal control over financial reporting. +/s/ KPMG LLP +Philadelphia, Pennsylvania +March 10, 2011 +F-2 +ORASURE TECHNOLOGIES, INC. +BALANCE SHEETS +December 31, +2010 +2009 +ASSETS +CURRENT ASSETS: +Cash and cash equivalents +$ +73,843,402 +$ +74,933,630 +Short-term investments +1,895,000 +4,736,730 +Accounts receivable, net of allowance for doubtful accounts of $105,954 and $256,572 +12,471,249 +13,693,340 +Inventories +7,345,594 +8,844,492 +Prepaid expenses +1,930,108 +2,609,518 +Total current assets +97,485,353 +104,817,710 +PROPERTY AND EQUIPMENT, net +19,610,583 +20,014,466 +PATENTS AND PRODUCT RIGHTS, net +4,806,919 +809,252 +OTHER ASSETS +617,238 +1,349,319 +$ +122,520,093 +$ +126,990,747 +LIABILITIES AND STOCKHOLDERS’ EQUITY +CURRENT LIABILITIES: +Current portion of long-term debt +$ +7,791,680 +$ +509,761 +Accounts payable +2,898,846 +3,370,604 +Accrued expenses and other +8,986,879 +11,502,802 +Total current liabilities +19,677,405 +15,383,167 +LONG-TERM DEBT +— +7,791,679 +OTHER LIABILITIES +— +8,911 +COMMITMENTS AND CONTINGENCIES (Note 11) +STOCKHOLDERS’ EQUITY: +Preferred stock, par value $.000001, 25,000,000 shares authorized, none issued +— +— +Common stock, par value $.000001, 120,000,000 shares authorized, 46,225,622 and 45,929,511 shares issued and +outstanding +46 +46 +Additional paid-in capital +241,663,337 +239,126,422 +Accumulated other comprehensive loss +(235,264 +) +(230,992 +) +Accumulated deficit +(138,585,431 +) +(135,088,486 +) +Total stockholders’ equity +102,842,688 +103,806,990 +$ +122,520,093 +$ +126,990,747 +See accompanying notes to the financial statements. +F-3 +ORASURE TECHNOLOGIES, INC. +STATEMENTS OF OPERATIONS +For the years ended December 31, +2010 +2009 +2008 +REVENUES: +Product +$ +71,198,520 +$ +75,168,959 +$ +68,842,755 +Licensing and product development +3,816,316 +1,857,267 +2,261,712 +75,014,836 +77,026,226 +71,104,467 +COST OF PRODUCTS SOLD +27,655,507 +29,895,832 +29,976,120 +Gross profit +47,359,329 +47,130,394 +41,128,347 +OPERATING EXPENSES: +Research and development +13,191,917 +13,371,358 +20,255,451 +Sales and marketing +20,727,667 +21,224,125 +20,916,718 +General and administrative +16,793,852 +16,847,920 +16,286,907 +Litigation settlement (recovery) +— +1,451,183 +(4,883,714 +) +Impairment of patent and product rights +— +3,028,375 +— +50,713,436 +55,922,961 +52,575,362 +Operating loss +(3,354,107 +) +(8,792,567 +) +(11,447,015 +) +INTEREST EXPENSE +(316,185 +) +(361,188 +) +(345,767 +) +INTEREST INCOME +151,757 +737,892 +3,080,950 +OTHER INCOME +16,350 +1,788 +— +FOREIGN CURRENCY GAIN (LOSS) +5,240 +(21,342 +) +(36,136 +) +Loss before income taxes +(3,496,945 +) +(8,435,417 +) +(8,747,968 +) +INCOME TAX PROVISION (BENEFIT) +— +(622,284 +) +22,527,334 +NET LOSS +$ +(3,496,945 +) +$ +(7,813,133 +) +$ +(31,275,302 +) +LOSS PER SHARE: +BASIC AND DILUTED +$ +(0.08 +) +$ +(0.17 +) +$ +(0.67 +) +SHARES USED IN COMPUTING LOSS PER SHARE: +BASIC AND DILUTED +46,187,332 +45,877,843 +46,549,739 +See accompanying notes to the financial statements. +F-4 +ORASURE TECHNOLOGIES, INC. +STATEMENTS OF STOCKHOLDERS’ EQUITY AND COMPREHENSIVE LOSS +For the years ended December 31, 2010, 2009 and 2008 +Common Stock +Additional +Paid-in +Capital +Accumulated +Other +Comprehensive +Loss +Accumulated +Deficit +Total +Shares +Amount +Balance at January 1, 2008 +46,644,046 +$ +47 +$ +236,293,489 +$ +(238,896 +) +$ +(96,000,051 +) +$ +140,054,589 +Common stock issued upon exercise of options +14,786 +— +92,517 +— +— +92,517 +Vesting of restricted stock +393,551 +— +— +— +— +— +Purchase and retirement of treasury shares +(135,432 +) +— +(995,367 +) +— +— +(995,367 +) +Shares purchased and retired pursuant to the stock repurchase plan +(1,147,730 +) +(1 +) +(5,121,107 +) +— +— +(5,121,108 +) +Compensation cost for restricted stock +— +— +3,352,876 +— +— +3,352,876 +Compensation cost for stock option grants +— +— +2,240,591 +— +— +2,240,591 +Comprehensive loss: +Net loss +— +— +— +— +(31,275,302 +) +(31,275,302 +) +Currency translation adjustment +— +— +— +(36,201 +) +— +(36,201 +) +Unrealized gain on marketable securities +— +— +— +12,655 +— +12,655 +Total comprehensive loss +(31,298,848 +) +Balance at December 31, 2008 +45,769,221 +46 +235,862,999 +(262,442 +) +(127,275,353 +) +108,325,250 +Common stock issued upon exercise of options +30,911 +— +24,807 +— +— +24,807 +Vesting of restricted stock +370,457 +— +— +— +— +— +Purchase and retirement of treasury shares +(132,785 +) +— +(391,590 +) +— +— +(391,590 +) +Shares purchased and retired pursuant to the stock repurchase plan +(108,293 +) +— +(308,605 +) +— +(308,605 +) +Compensation cost for restricted stock +— +— +2,621,723 +— +— +2,621,723 +Compensation cost for stock option grants +— +— +1,317,088 +— +— +1,317,088 +Comprehensive loss: +Net loss +— +— +— +— +(7,813,133 +) +(7,813,133 +) +Currency translation adjustment +— +— +— +34,513 +— +34,513 +Unrealized loss on marketable securities +— +— +— +(3,063 +) +— +(3,063 +) +Total comprehensive loss +(7,781,683 +) +Balance at December 31, 2009 +45,929,511 +46 +239,126,422 +(230,992 +) +(135,088,486 +) +103,806,990 +Common stock issued upon exercise of options +2,844 +— +7,977 +— +— +7,977 +Vesting of restricted stock +429,309 +— +— +— +— +— +Purchase and retirement of treasury shares +(136,042 +) +— +(708,785 +) +— +— +(708,785 +) +Compensation cost for restricted stock +— +— +2,354,109 +— +— +2,354,109 +Compensation cost for stock option grants +— +— +883,614 +— +— +883,614 +Comprehensive loss: +Net loss +— +— +— +— +(3,496,945 +) +(3,496,945 +) +Currency translation adjustment +— +— +— +(3,985 +) +— +(3,985 +) +Unrealized loss on marketable securities +— +— +— +(287 +) +— +(287 +) +Total comprehensive loss +(3,501,217 +) +Balance at December 31, 2010 +46,225,622 +$ +46 +$ +241,663,337 +$ +(235,264 +) +$ +(138,585,431 +) +$ +102,842,688 +See accompanying notes to the financial statements. +F-5 +ORASURE TECHNOLOGIES, INC. +STATEMENTS OF CASH FLOWS +For the years ended December 31, +2010 +2009 +2008 +OPERATING ACTIVITIES: +Net loss +$ +(3,496,945 +) +$ +(7,813,133 +) +$ +(31,275,302 +) +Adjustments to reconcile net loss to net cash provided by (used in) operating activities: +Impairment of patent and product rights +— +3,028,375 +— +Deferred income taxes +— +— +22,305,250 +Stock-based compensation +3,228,812 +3,935,737 +5,456,135 +Depreciation and amortization +3,012,270 +3,049,962 +3,386,670 +Acquired in-process technology +— +— +1,000,000 +Reserve for excess and obsolete inventories +58,259 +(228,417 +) +(919,925 +) +Changes in assets and liabilities: +Accounts receivable +1,218,808 +(2,116,410 +) +(274,284 +) +Inventories +1,440,639 +2,088,013 +(374,420 +) +Prepaid expenses and other +1,413,708 +(2,442,562 +) +1,070,168 +Accounts payable +(472,461 +) +(501,177 +) +(1,686,143 +) +Accrued expenses and other liabilities +(2,515,923 +) +706,847 +(1,148,491 +) +Net cash provided by (used in ) operating activities +3,887,167 +(292,765 +) +(2,460,342 +) +INVESTING ACTIVITIES: +Purchase of property and equipment +(2,105,775 +) +(1,199,551 +) +(2,643,270 +) +Purchase of patents, product rights, or acquired in-process technology +(4,500,000 +) +— +(1,200,000 +) +Purchase of short-term investments +— +(5,986,000 +) +(67,125,962 +) +Proceeds from maturities and redemptions of short-term investments +2,841,000 +44,090,000 +87,315,645 +Net cash (used in) provided by investing activities +(3,764,775 +) +36,904,449 +16,346,413 +FINANCING ACTIVITIES: +Repayments of long-term debt +(509,760 +) +(557,897 +) +(515,083 +) +Proceeds from issuance of common stock +7,977 +24,807 +92,517 +Purchase and retirement of common stock +— +(308,605 +) +(5,121,108 +) +Withholding and retirement of common stock +(708,785 +) +(391,590 +) +(995,367 +) +Net cash used in financing activities +(1,210,568 +) +(1,233,285 +) +(6,539,041 +) +EFFECT OF FOREIGN EXCHANGE RATE CHANGES ON CASH +(2,052 +) +(9,987 +) +(11,509 +) +NET (DECREASE) INCREASE IN CASH AND CASH EQUIVALENTS +(1,090,228 +) +35,368,412 +7,335,521 +CASH AND CASH EQUIVALENTS, BEGINNING OF YEAR +74,933,630 +39,565,218 +32,229,697 +CASH AND CASH EQUIVALENTS, END OF YEAR +$ +73,843,402 +$ +74,933,630 +$ +39,565,218 +See accompanying notes to the financial statements. +F-6 +ORASURE TECHNOLOGIES, INC. +NOTES TO THE FINANCIAL STATEMENTS +1. +THE COMPANY: +We develop, +manufacture, market and sell oral fluid diagnostic products and specimen collection devices using our proprietary oral fluid technologies, as well as other diagnostic products, including immunoassays and other in vitro diagnostic tests that +are used on other specimen types. We also manufacture and sell other medical devices used for the removal of benign skin lesions by cryosurgery, or freezing. Our diagnostic products include tests which are performed on a rapid basis at the point of +care and tests which are processed in a laboratory. These products are sold in the United States and internationally to various clinical laboratories, hospitals, clinics, community-based organizations and other public health organizations, +distributors, government agencies, physicians’ offices, and commercial and industrial entities. One of our products is sold in the over-the-counter or consumer retail markets in North America, Europe, Central and South America and Australia. +The recent economic downturn, including disruptions in the capital and credit markets, may continue indefinitely and +intensify, and could adversely affect our results of operations, cash flows and financial condition or those of our customers and suppliers. These circumstances could adversely affect our access to liquidity needed to conduct or expand our business +or conduct acquisitions or make other discretionary investments. They may also adversely impact the capital needs of our customers and suppliers, which, in turn, could adversely affect their ability to purchase our products or supply us with +necessary equipment, raw materials or components. This could adversely affect our results of operations, cash flows and financial condition. The recent weak business climate could cause longer sales cycles and slower growth, and could expose us to +increased business or credit risk in dealing with customers or suppliers adversely affected by economic conditions. Our ability to collect accounts receivable may be delayed or precluded if our customers are unable to pay their obligations. +2. +SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES: +Use of Estimates +The preparation of financial statements in conformity +with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions about future events. These estimates and underlying assumptions affect the amounts of assets and liabilities +reported, disclosures about contingent assets and liabilities, and reported amounts of revenues and expenses. Such estimates include the valuation of accounts receivable, inventories and intangible assets, as well as calculations related to +contingencies, accruals and indemnifications, among others. These estimates and assumptions are based on management’s best estimates and judgment. Management evaluates its estimates and assumptions on an ongoing basis, using historical +experience and other factors, which management believes to be reasonable under the circumstances, including the current economic environment. We adjust such estimates and assumptions when facts and circumstances dictate. Illiquid credit markets, +volatile equity, foreign currency and energy markets, and declines in consumer spending have combined to increase the uncertainty inherent in such estimates and assumptions. As future events and their effects cannot be determined with precision, +actual results could differ significantly from these estimates. Changes in those estimates resulting from continuing changes in the economic environment will be reflected in the financial statements in those future periods. +Cash and Cash Equivalents +We consider all highly liquid investments with a purchased maturity of ninety days or less to be cash equivalents. As of December 31, 2010 and 2009, cash equivalents consisted of money market +accounts and commercial paper. +Short-term Investments +We consider all short-term investments to be available-for-sale securities. These securities are comprised of certificates of deposits and +corporate bonds, all with purchased maturities greater than ninety days. Available- +F-7 +for-sale securities are carried at fair value, based upon quoted market prices, with unrealized gains and losses reported in stockholders’ equity as a component of accumulated other +comprehensive loss. There were no securities held as of December 31, 2010 in a continuous unrealized loss position for twelve or more months. +The following is a summary of our available-for-sale securities as of December 31, 2010 and 2009: +Amortized +Cost +Gross +Unrealized +Gains +Gross +Unrealized +Losses +Fair Value +December 31, 2010 +Certificates of deposit +$ +1,895,000 +$ +— +$ +— +$ +1,895,000 +Total available-for-sale securities +$ +1,895,000 +$ +— +$ +— +$ +1,895,000 +December 31, 2009 +Certificates of deposit +$ +3,986,000 +$ +— +$ +— +$ +3,986,000 +Corporate bonds +750,278 +452 +— +750,730 +Total available-for-sale securities +$ +4,736,278 +$ +452 +$ +— +$ +4,736,730 +At December 31, 2010, all of our available-for-sale securities mature within less than one year. +Supplemental Cash Flow Information +In 2010, 2009 and 2008, we paid interest of $339,281, $361,121, and $409,902, respectively. In 2010 and 2008, we capitalized interest of $20,238 and $47,463, respectively. No interest was capitalized in +2009. +In 2010, we received a federal income tax refund of $597,393 related to refundable alternative minimum taxes paid in +previous years, and paid state income taxes of $11,500. In 2009 and 2008, we paid federal and state income taxes of $16,461 and $381,950, respectively. +In 2010, we recorded through the Statement of Operations a decrease in our allowance for doubtful accounts of $114,716. In 2009 and 2008, we recorded through the Statement of Operations an increase in our +allowance for doubtful accounts of $93,472 and $78,044, respectively. We had write-offs of $35,902 and $101,412 against the allowance for doubtful accounts in 2010 and 2008, respectively. We had no write-offs against the allowance for doubtful +accounts in 2009. +In 2008, we recorded accruals for purchases of property and equipment of $25,250. We had no accruals for +purchases of property and equipment in 2010 and 2009. +Accounts Receivable +Accounts receivable have been reduced by an estimated allowance for amounts that may become uncollectible in the future. This estimated +allowance is based primarily on management’s evaluation of specific balances as they become past due, the financial condition of our customers and our historical experience related to write-offs. If not reserved or exempted through these +specific examination procedures, our policy is to reserve 100% of accounts receivable in aging categories greater than 120 days. +Inventories +Inventories are stated at the lower of cost or market +determined on a first-in, first-out basis, and include the cost of raw materials, labor and overhead. The majority of our inventories are subject to expiration dating. We continually evaluate quantities on hand and the carrying value of our +inventories to determine the need for reserves for excess and obsolete inventories, based primarily on the estimated forecast of product sales. When +F-8 +factors indicate that impairment has occurred, either a reserve is established against the inventories’ carrying value or the inventories are completely written off, as in the case of +lapsing expiration dates. In addition to reserving for these items identified through specific identification procedures, we also reserve for unidentified scrap or spoilage under a fixed-formula methodology. We currently buy a portion of our +cryosurgical product line from a foreign vendor and pay for such purchases in euros. +Property and Equipment +Property and equipment are stated at cost. Additions or improvements are capitalized, while repairs and maintenance are +charged to expense. Depreciation and amortization are provided using the straight-line method over the estimated useful lives of the related assets. Buildings are depreciated over twenty to forty years, while computer equipment, machinery and +equipment, and furniture and fixtures are depreciated over three to ten years. Building improvements are amortized over their estimated useful lives. When assets are sold or otherwise disposed of, the related property amounts are relieved from the +accounts, and any gain or loss is recorded in the statement of operations. +Patents and Product Rights +Patents and product rights consist of costs associated with the acquisition of patents, licenses and product distribution rights. Patents +and product rights are amortized using the straight-line method over their estimated useful lives of three to ten years. +Impairment of Long-Lived Assets +If indicators of impairment exist, we assess the recoverability of the affected long-lived assets, which include property and equipment and patents and product rights, by determining whether the carrying +value of such assets can be recovered through the sum of the undiscounted future cash flows from the use and eventual disposition of the asset. If impairment is indicated, we measure the amount of such impairment by comparing the carrying value of +the assets to the fair value of these assets, which is generally determined based on the present value of the expected future cash flows associated with the use of the asset. +Revenue Recognition +We recognize product revenues when there is persuasive +evidence that an arrangement exists, the price is fixed or determinable, title has passed and collection is reasonably assured. Product revenues are recorded net of allowances for any discounts or rebates. We do not grant price protection or product +return rights to our customers, except for warranty returns and return rights granted to retail customers for our domestic cryosurgical wart removal product. +Historically, returns arising from warranty issues have been infrequent and immaterial. Accordingly, we expense warranty returns as incurred. For our cryosurgical product sold in the domestic retail +market, a provision for estimated product returns is recorded as a reduction of revenue in the same period in which the revenue is recognized. In addition, revenue from domestic retail sales is also recorded net of promotional, advertising, and +slotting allowances granted to the retail trade. +Royalty income from the grant of license rights is recognized during the +period in which the revenue is earned and the amount is determinable from the licensee. +Product development revenues are +recognized over the period in which the related product development efforts are performed. Amounts received prior to the performance of product development efforts are recorded as deferred revenues. Grant revenue is recognized as the related work is +performed and costs are incurred. We record shipping and handling charges billed to our customers as product revenue and the related expense as cost of products sold. Taxes assessed by governmental authorities, such as sales or value-added taxes, +are excluded from product revenues. +F-9 +Significant Customer Concentration +We had the following significant concentrations in revenues and accounts receivable: +Percentage of Total Revenues +For the years ended December 31, +Customer +2010 +2009 +2008 +Quest Diagnostics, Incorporated +8 +% +9 +% +10 +% +Abbott Laboratories +— +— +10 +Percentage of +Accounts +Receivable +at December 31, +2010 +2009 +Quest Diagnostics, Incorporated +10 +% +7 +% +National Aids Control Program +2 +11 +Our distribution agreement with Abbott Laboratories terminated at the end of +2008. Effective January 1, 2009, we began selling the OraQuick ADVANCE ® rapid HIV-1/2 test directly +to U.S. hospitals and other customers previously served by Abbott. As a result, we had no sales to Abbott during the years ended December 31, 2010 and 2009. +Research and Development +Research and development expenses consist of +costs incurred in performing research and development activities including salaries and benefits, facilities expenses, overhead expenses, clinical trial and related clinical manufacturing expenses, contract services and other outside expenses. +Research and development costs are charged to expense as incurred. Clinical trial expenses include expenses associated with contract research organizations, or CROs. The invoicing from CROs can precede the services provided or can lag the service +period by several months. Invoices paid prior to service being provided are recorded as a prepaid expense and then expensed appropriately as services are provided. We accrue the cost of services rendered but unbilled by CROs based on purchase order +estimates provided by the CROs. Differences between actual and estimated clinical trial expenses recorded are generally not material and would be adjusted for in the period in which they become known. +Advertising Expenses +Advertising costs are charged to expense as incurred. During 2010, 2009, and 2008, we incurred $209,621, $165,394, and $893,279, respectively, in advertising expenses. Included in advertising expenses for +2008 was $687,308 in reimbursement for marketing expenses incurred for our OTC cryosurgical products. +Stock-Based +Compensation +We account for stock-based compensation to employees and directors using the fair value method. We have +elected to recognize compensation expense for stock option awards issued to employees and directors on a straight-line basis over the requisite service period of the award. To satisfy the exercise of options or to issue new restricted stock, we +normally issue new shares rather than purchase shares on the open market. +Income Taxes +We follow the asset and liability method for accounting for income taxes. Under this method, deferred tax assets and liabilities are +recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and the respective tax basis of assets and liabilities, and operating loss and credit +carryforwards. Deferred tax assets and liabilities are measured using enacted tax rates that are expected to apply to taxable income in the years in which those temporary differences +F-10 +and operating loss and credit carryforwards are expected to be recovered, settled or utilized. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income +in the period that includes the enactment date. +We assess the realizability of our net deferred tax assets on a quarterly +basis. If, after considering all relevant positive and negative evidence, it is more likely than not that some portion or all of the net deferred tax assets will not be realized we reduce our net deferred tax assets by a valuation allowance. The +realization of the net deferred tax assets is dependent on several factors, including the generation of sufficient taxable income prior to the expiration of the net operating loss carryforwards. +Foreign Currency Translation +The assets and liabilities of our foreign operations are translated from euros into U.S. dollars at current exchange rates as of the balance sheet date, and revenues and expenses are translated at average +exchange rates for the period. Resulting translation adjustments are reflected in accumulated other comprehensive loss, which is a separate component of stockholders’ equity. +Loss Per Share +Basic and diluted loss per share is computed by dividing net loss by the weighted-average number of shares of common stock outstanding during the period. Diluted loss per share is generally computed +assuming the exercise or vesting of all dilutive securities such as common stock options and unvested restricted stock. As a result of our net losses for the years ended December 31, 2010, 2009 and 2008, outstanding common stock options and +unvested restricted stock representing 5,577,771, 6,033,966, and 5,403,228 shares, respectively, were excluded from the computation of diluted loss per share, as their inclusion would have been anti-dilutive. +Other Comprehensive Income (Loss) +We classify items of other comprehensive income (loss) by their nature and disclosure of the accumulated balance of other comprehensive income (loss), separately from accumulated deficit and additional +paid-in capital, in the stockholders’ equity section of our balance sheet. +Fair Value of Financial Instruments +As of December 31, 2010, the carrying values of cash and cash equivalents, short-term investments, accounts +receivable, accounts payable and accrued expenses approximate their respective fair values based on their short-term nature. In addition, we believe the carrying value of our debt instruments, which do not have readily ascertainable market values, +approximate their fair values, given that the interest rates on outstanding borrowings approximate market rates. +Fair value +measurements of all financial assets and liabilities that are being measured and reported on a fair value basis are required to be classified and disclosed in one of the following three categories: +Level 1: +Unadjusted quoted prices in active markets that are accessible at the measurement date for identical, unrestricted assets or liabilities; +Level 2: +Quoted prices in markets that are not active, or inputs which are observable, either directly or indirectly, for substantially the full term of the asset or liability; +and +Level 3: +Prices or valuation techniques that require inputs that are both significant to the fair value measurement and unobservable (i.e., supported by little or no market +activity). +All our available for sale securities were classified and measured as Level 1 instruments. +F-11 +Recent Accounting Pronouncements +In April 2010, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) 2010-17, +“Revenue Recognition – Milestone Method,” which amended guidance on the criteria that should be met for determining whether the milestone method of revenue recognition is appropriate. A vendor can recognize consideration that is +contingent upon achievement of a milestone in its entirety as revenue in the period in which the milestone is achieved only if the milestone meets all criteria to be considered substantive. The amendments in this ASU are effective on a prospective +basis for milestones achieved in fiscal years, and interim periods within those years, beginning on or after June 15, 2010. Adoption of this ASU is not expected to have a material impact on our financial statements. +3. +INVENTORIES: +December 31, +2010 +2009 +Raw materials +$ +4,453,560 +$ +4,911,570 +Work in process +258,335 +334,452 +Finished goods +2,633,699 +3,598,470 +$ +7,345,594 +$ +8,844,492 +4. +PROPERTY AND EQUIPMENT: +December 31, +2010 +2009 +Land +$ +1,117,788 +$ +1,117,788 +Buildings and improvements +16,211,986 +15,730,546 +Machinery and equipment +16,375,791 +14,705,102 +Computer equipment and software +4,312,488 +3,982,769 +Furniture and fixtures +1,517,647 +1,469,785 +Construction in progress +279,200 +772,840 +39,814,900 +37,778,830 +Less accumulated depreciation +(20,204,317 +) +(17,764,364 +) +$ +19,610,583 +$ +20,014,466 +Depreciation expense was $2,509,658, $2,395,202, and $2,278,257 for 2010, 2009, and 2008, respectively. +5. +PATENTS, PRODUCT RIGHTS AND ACQUIRED IN-PROCESS TECHNOLOGY: +Patents and product rights were as follows: +December 31, +2010 +2009 +HIV-related +$ +1,900,000 +$ +1,900,000 +HCV-related +4,500,000 +— +Lateral flow-related +1,500,000 +1,500,000 +Cryosurgery-related +2,548,620 +2,548,620 +10,448,620 +5,948,620 +Less accumulated amortization +(5,641,701 +) +(5,139,368 +) +$ +4,806,919 +$ +809,252 +F-12 +Amortization expense for 2010, 2009, and 2008 was $502,333, $542,913, and $898,931, +respectively. +Amortization expense for each of the five succeeding fiscal years is estimated as follows: +2011 +$ +744,000 +2012 +540,000 +2013 +540,000 +2014 +491,250 +2015 +450,000 +Beyond +2,041,669 +In June 1998, we +acquired the patents and exclusive worldwide distribution rights to our cryosurgical product line. The purchase price of $2,548,620, including transaction costs, was recorded as patents and product rights and is fully amortized. +In June 2004, we entered into a sublicense agreement with a third party, pursuant to which we have been granted a limited, worldwide, +non-exclusive sublicense to certain HIV-2 patents held by such party. The agreement required us to pay the third party a one-time non-refundable license fee of $900,000, which was recorded as patents and product rights and is being amortized through +June 30, 2014. +In August 2005, we entered into a license agreement with third parties, pursuant to +which we have been granted a limited, personal, non-transferable, non-exclusive license related to certain Hepatitis C Virus (“HCV”) patents held by such parties. The agreement required us to pay the third parties a one-time non-refundable +license fee of $1,500,000, which was paid in August 2005. In December 2006, the first milestone was achieved and $3,000,000 was paid in 2007. In November 2008, we achieved a second milestone upon filing our OraQuick ® HCV pre-market approval application with the FDA and paid a $1,000,000 license fee. This fee was recognized as +acquired in-process technology and included in research and development expense in our 2008 Statement of Operations as additional research and development efforts and regulatory approval was required in order to commercialize this product in the +U.S. domestic market. +Management’s intent in executing the HCV license agreement was to provide for various alternatives +of the licensed patents, one of which was the marketing and sale of an existing rapid HCV test supplied by a third party manufacturer in certain developing countries. Based on management’s estimate of the cash flows to be received from future +product sales in these international markets, we capitalized both the $1,500,000 and $3,000,000 payments. We were amortizing these amounts to cost of products sold on a straight-line basis over ten years, which represented management’s estimate +of the remaining useful life of the licensed patents. +However, we were unable to penetrate the international marketplace with +this third-party’s rapid HCV test. In addition, given the impact of the global recession and the deteriorating status of certain third-world economies at that time, we no longer believed that we would be successful in selling a +third-party’s rapid HCV test for the foreseeable future. As a result, during the second quarter of 2009, we recorded an impairment charge of $3,028,375 which represented the remaining net book value of the HCV license, patents and product +rights. +During 2010, upon achievement of three additional domestic development and commercial milestones, we paid a total of +$4,500,000 in license fees pursuant to the terms of this HCV license agreement. Based on our estimate of the cash flows to be received from future product sales in the domestic market that utilize this HCV technology, we capitalized these fees as +patent and product rights. We are amortizing the amounts to cost of products sold on a straight-line basis over ten years, which represents the expected life of the product. No additional payments are require under this agreement. +In December 2006, we amended a license agreement with third parties, pursuant to which we have been granted a limited, non-exclusive +license to certain lateral flow technology patents held by such parties. The amendment provided for the renewal of our license to certain lateral flow patents held by these parties, the +F-13 +expansion of these patents to future product applications to be developed by us, and the settlement of prior royalty obligations arising prior to the amendment date. It required us to pay the +third parties a one-time non-refundable fee of $1,750,000 which was allocated based upon the relative fair values of the items contained in the agreement. Accordingly, in December 2006, we capitalized $1,000,000 as patent and product rights and are +amortizing this amount to cost of products sold through December 2011. +6. +PREPAID EXPENSES: +In January 2010, we entered into an agreement with the supplier of HIV peptides used in the manufacture of our OraQuick HIV test. This agreement was executed in connection with the supplier’s +bankruptcy and terminated our obligations to exclusively purchase peptides from this supplier and to pay royalties on worldwide sales of our OraQuick ® tests. Pursuant to this agreement, we made a one-time payment of $2.1 million to this supplier in full consideration of the termination of the original agreement and +satisfaction of all obligations, including our royalty obligations, to this supplier. We also received a fully paid-up worldwide, non-exclusive, non-transferable license to this supplier’s patent rights related to the peptides, which expires on +July 8, 2011. We recorded the payment, net of the $1,379,732 in royalties previously accrued, as prepaid royalties, which is being expensed in connection with sales of our OraQuick ADVANCE ® HIV test through June 30, 2011. +In July 2009, we entered into a termination and release agreement with the third party from whom we purchased certain patents, trademarks, copyrights and technology related to our Histofreezer ® product line. Pursuant to this termination and release agreement, we made a one-time payment of $643,050 to this +third party in full consideration of the termination of the original asset purchase agreement we executed with this third party in June 1998, and its related royalty obligations, which extended until December 2011. We recorded this payment, net of +the royalties previously accrued, as prepaid royalties, and it was and will be expensed in relation to +Histofreezer ® revenues through December 31, 2011. +In August 2008, a complaint was filed against the Company in the US District Court for the District of New Jersey by +Inverness Medical Innovations, Inc., and Inverness Medical Switzerland GmbH (collectively, “Inverness”) and Church & Dwight Co. Inc., alleging that the Company’s OraQuick ADVANCE ® Rapid HIV-1/2 Antibody Test infringed US Patent No. 6,485,982 (the “’982 Patent”). In November +2009, the Company entered into a settlement agreement with Inverness and Church & Dwight and the litigation was dismissed with prejudice. Under the settlement agreement, the Company made a $3,000,000 payment to Inverness. Inverness granted +the Company nonexclusive, worldwide, royalty-bearing, non-transferable and nonsublicensable (sub)licenses to certain patent rights, including the ’982 Patent. In addition, each party received limited supply and distribution rights to certain +other products developed by the other party. We allocated the $3,000,000 payment based upon the relative fair values of the litigation settlement, of which, $1,451,183 was immediately expensed in our 2009 Statement of Operations and $1,548,817 was +recorded as prepaid royalties and it was and will be expensed to cost of goods sold, based on future OraQuick +ADVANCE ® HIV revenues through December 31, 2012. +7. +ACCRUED EXPENSES AND OTHER: +December 31, +2010 +2009 +Payroll and related benefits +$ +4,343,350 +$ +4,867,716 +Royalties +1,985,799 +3,394,991 +Deferred revenue +896,531 +1,618,798 +Clinical research obligations +400,860 +658,605 +Professional fees +213,308 +290,208 +Other +1,147,031 +672,484 +$ +8,986,879 +$ +11,502,802 +F-14 +Deferred revenue includes customer prepayments of $851,031 and $1,501,598 at +December 31, 2010 and 2009, respectively. +8. +LONG-TERM DEBT: +December 31, +2010 +2009 +Credit Facility +$ +7,791,680 +$ +8,291,679 +Note payable to Pennsylvania Industrial Development Authority, interest at 2% +— +9,761 +7,791,680 +8,301,440 +Less current portion +(7,791,680 +) +(509,761 +) +$ +— +$ +7,791,679 +As of December 31, 2010 and 2009, we had in place a $10,000,000 credit facility (the “Credit +Facility”) with Comerica Bank (“Comerica”). Pursuant to the terms of the Credit Facility, principal and interest fixed at 4.15% per annum, are payable monthly through June 2011, at which time the remaining unpaid principal +balance is payable. Accordingly, beginning on June 30, 2010, our remaining unpaid principal balance was classified as a current liability as it will be payable within the ensuing twelve months. As of December 31, 2010, we had no available +borrowings under this Credit Facility. We are evaluating possible options to address the upcoming expiration of the Credit Facility, including refinancing with a new credit facility or other borrowings. +All borrowings under the Credit Facility are collateralized by a first priority security interest in all of our assets, including present +and future accounts receivable, chattel paper, contracts and contract rights, equipment and accessories, general intangibles, investments, instruments, inventories, and a mortgage on our three facilities in Bethlehem, Pennsylvania. The Credit +Facility contains certain covenants that set forth minimum requirements for our quick ratio, liquidity, and tangible net worth. We were in full compliance with all covenants as of December 31, 2010. The Credit Facility also restricts our +ability to pay dividends, to make certain investments, to incur additional indebtedness, to sell or otherwise dispose of a substantial portion of assets, and to merge or consolidate operations with an unaffiliated entity, without the consent of +Comerica. +9. +INCOME TAXES: +The +components of the income tax provision (benefit) for the years ended December 31, 2010, 2009 and 2008 are as follows: +2010 +2009 +2008 +Current +Federal +$ +— +$ +(631,688 +) +$ +9,590 +State +— +9,404 +212,494 +— +(622,284 +) +222,084 +Deferred +Federal +(1,214,773 +) +(2,115,338 +) +(3,200,853 +) +State +(91,805 +) +(35,591 +) +(472,064 +) +(1,306,578 +) +(2,150,929 +) +(3,672,917 +) +Change in valuation allowance +1,306,578 +2,150,929 +25,978,167 +— +— +22,305,250 +Total income tax provision (benefit) +$ +— +$ +(622,284 +) +$ +22,527,334 +F-15 +In November 2009, The Worker, Homeownership, and Business Assistance Act of 2009 was +enacted. This new law extended the carryback period for a net operating loss (“NOL”) from two years up to a maximum of five years. The carryback of the NOL can be applied to both regular tax NOLs and alternative minimum tax NOLs (“AMT +NOL”). The new law also eliminates the 90% limitation on the use of any AMT NOLs. As a result of the elimination of the 90% limitations, in 2009 we elected to carryback our 2008 AMT NOL to our 2007, 2006, and 2005 tax years and applied for a +refund of the AMT taxes paid for those years. As such, in the fourth quarter of 2009, we recorded a $632,000 federal benefit associated with the AMT NOL carryback. +A reconciliation of the statutory United States federal income tax rate to our effective tax rate for each of the years ended December 31, 2010, 2009, and 2008 is as follows: +2010 +2009 +2008 +Statutory U.S. federal income tax rate +(34.0 +)% +(34.0 +)% +(34.0 +)% +State income taxes, net of federal benefit +(0.9 +) +(0.2 +) +(2.8 +) +Nondeductible expenses and other +6.8 +3.1 +3.4 +Research and development credits +(9.7 +) +(1.8 +) +(6.1 +) +Change in valuation allowance, federal and state +37.8 +25.5 +297.0 +Effective tax rate +— +% +(7.4 +)% +257.5 +% +Deferred income taxes reflect the tax effects of temporary differences between the basis of assets and +liabilities recognized for financial reporting purposes and tax purposes, and net operating loss and tax credit carryforwards. Significant components of our total deferred tax asset as of December 31, 2010 and 2009 are as follows: +2010 +2009 +Deferred tax assets (liabilities): +Net operating loss carryforwards +$ +17,258,574 +$ +18,740,789 +Inventory +1,001,425 +1,047,607 +Capitalized research and development costs +3,639,949 +1,179,422 +Accruals and reserves currently not deductible +1,228,788 +1,185,360 +Patent costs +1,814,528 +2,078,303 +Depreciation and amortization +(1,129,974 +) +(1,077,860 +) +Stock-based compensation +3,672,184 +3,361,386 +Research and development tax credit carryforward +1,316,804 +980,410 +Net deferred tax asset +28,802,278 +27,495,417 +Valuation allowance +(28,802,278 +) +(27,495,417 +) +Net deferred tax asset +$ +— +$ +— +In assessing the realizability of our net deferred tax asset, we consider all relevant positive and negative +evidence in determining whether it is more likely than not that some portion or all of the deferred income tax assets will not be realized. The realization of the gross deferred tax assets is dependent on several factors, including the generation of +sufficient taxable income prior to the expiration of the NOL carryforwards. +Pursuant to FASB accounting guidance, a +cumulative loss in recent years is a significant piece of negative evidence to be considered when evaluating the need for a valuation allowance and this evidence is difficult to overcome. Based upon our pre-tax loss in 2008, and our projection of a +pre-tax loss in 2009, which would result in a net cumulative three-year loss and the volatility and uncertainty in the global economy, we determined that it was more likely than not that our net deferred tax assets would not be realized in the +immediate future. Accordingly, we recorded an income tax charge of $25,978,167 in the fourth quarter of 2008 to establish a full valuation allowance against our net deferred tax asset. During 2010 and 2009 we continued to reevaluate our +F-16 +valuation allowance position and believe that it is more likely than not that our deferred income tax asset will not be realized in the immediate future. As such, we maintained a full valuation +allowance against our net deferred tax assets as of December 31, 2010 and 2009. +Our federal NOL carryforwards expire as +follows: +Year of Expiration +NOLs +2011 +$ +1,215,525 +2017-2018 +7,563,004 +2019 +12,807,326 +2020-2024 +16,397,737 +2025-2030 +12,420,404 +$ +50,403,996 +The Tax Reform Act of 1986 contains provisions that limit the annual amount of NOLs available to be used in +any given year in the event of a significant change in ownership. On September 29, 2000, two separate companies, STC Technologies, Inc. and Epitope, Inc., merged to form our Company. A significant change in ownership, as defined by +Section 382 of the Internal Revenue Code, occurred in connection with this merger. As such, the utilization of NOLs generated prior to September 29, 2000 is limited to approximately $13,700,000 per year. We do not believe that this +limitation will have a material adverse impact on the utilization of our NOL carryforwards in future years. +As of +December 31, 2010, our gross unrecognized tax benefits totaled $2,089,801 of which, if recognized, $2,064,643 would result in a reduction to our effective tax rate. We record interest and penalties related to unrecognized tax benefits as a +component of income tax expense. Interest and penalties were immaterial in 2010, 2009 and 2008. As a result of our net operating loss carryforward position, we are subject to audit by the Internal Revenue Service since our inception, as well as by +several state jurisdictions for the years ended December 31, 2000 through 2010. +A reconciliation of the beginning and +ending amount of unrecognized tax benefits is as follows: +2010 +2009 +2008 +Balance as of January 1 +$ +2,044,929 +$ +2,184,370 +$ +2,370,526 +Additions based on tax positions related to the current period +51,793 +10,121 +46,836 +Additions for tax positions of prior periods +— +— +28,021 +Reductions for tax positions of prior periods +(6,921 +) +(149,562 +) +(105,729 +) +Settlements +— +— +(155,284 +) +Balance as of December 31 +$ +2,089,801 +$ +2,044,929 +$ +2,184,370 +10. +STOCKHOLDERS’ EQUITY: +Stock-Based Awards +We grant stock-based awards under the OraSure Technologies, Inc. 2000 Stock Award Plan, as amended and restated (the “2000 Plan”). The 2000 Plan permits stock-based awards to employees, outside +directors and consultants or other third-party advisors. Awards which may be granted under the 2000 Plan include qualified incentive stock options, nonqualified stock options, stock appreciation rights, restricted awards, performance awards and +other stock-based awards. We recognize compensation expense for stock option awards issued to employees and directors on a straight-line basis over the requisite service period of the award. To satisfy the exercise of options or to issue new +restricted stock, we normally issue new shares rather than purchase shares on the open market. +F-17 +Under the terms of the 2000 Plan, nonqualified options may be granted to eligible employees, +including our officers at a price not less than 75 percent of the fair market value of a share of common stock on the date of grant. The option term and vesting schedule of such awards may be either unlimited or have a specified period in which to +vest and be exercised. To date, options generally have been granted with ten-year exercise periods and an exercise price not less than the fair market value on the date of grant. Options generally vest over four years, with one quarter of the +options vesting one year after grant and the remainder vesting on a monthly basis over the next three years. +As of +December 31, 2010, 2,555,240 shares were available for future grants under the 2000 Plan. +The fair value of each stock +option was estimated on the date of the grant using the Black-Scholes option-pricing model using the following weighted-average assumptions: +Years Ended +December 31, +Black-Scholes Option Valuation Assumptions +2010 +2009 +2008 +Risk-free interest rate (1) +1.89 +% +1.50 +% +2.50 +% +Expected dividend yield +— +— +— +Expected stock price volatility (2) +54 +% +53 +% +46 +% +Expected life of stock options (in years) (3) +4 +4 +4 +(1) +Based on the constant maturity interest rate of U.S. Treasury securities whose term is consistent with the expected life of our stock options. +(2) +Expected stock price volatility is based upon historical experience. +(3) +Expected life of stock options is based upon historical experience. +The weighted-average grant date fair value of stock options granted during the years ended December 31, 2010, 2009 and 2008 was +$2.24, $1.22 and $2.84, respectively. +Amounts recognized in the financial statements related to stock options were as +follows: +Years Ended December 31, +2010 +2009 +2008 +Total compensation cost during the year +$ +876,918 +$ +1,314,014 +$ +2,103,259 +Amounts capitalized into inventory during the year +(40,332 +) +(55,381 +) +(142,965 +) +Amounts recognized in cost of products sold for amounts previously capitalized +63,001 +128,805 +229,860 +Amounts charged against income +$ +899,587 +$ +1,387,438 +$ +2,190,154 +The aggregate intrinsic value of options (the amount by which the market price of the stock on the date of +exercise exceeded the exercise price) exercised during the years ended December 31, 2010, 2009 and 2008 was $9,024, $79,884, and $31,037, respectively. +F-18 +The following table summarizes the stock option activity under the 2000 Plan: +Options +Weighted-Average +Exercise Price Per +Share +Weighted-Average +Remaining +Contractual Term +(in years) +Aggregate +Intrinsic +Value +Outstanding on January 1, 2008 +4,726,541 +$ +7.63 +Granted +604,049 +7.27 +Exercised +(14,786 +) +6.26 +Forfeited +(185,097 +) +7.86 +Outstanding on December 31, 2008 +5,130,707 +7.58 +Granted +681,708 +2.89 +Exercised +(30,911 +) +0.80 +Forfeited +(349,839 +) +6.61 +Outstanding on December 31, 2009 +5,431,665 +7.09 +Granted +709,230 +5.15 +Exercised +(2,844 +) +2.81 +Forfeited +(634,518 +) +7.19 +Balance, December 31, 2010 +5,503,533 +$ +6.83 +5.43 +$ +2,677,316 +Vested or expected to vest as of December 31, 2010 +5,443,457 +$ +6.86 +5.39 +$ +2,601,134 +Exercisable on December 31, 2010 +4,461,755 +$ +7.32 +4.68 +$ +1,329,831 +As of December 31, 2010, there was $2,146,338 of unrecognized compensation expense related to unvested +option awards that is expected to be recognized over a weighted-average period of 2.0 years. +Net cash proceeds from the +exercise of stock options were $7,977, $24,807 and $92,517 for the years ended December 31, 2010, 2009 and 2008, respectively. As a result of our net operating loss carryforward position, no actual income tax benefit was realized from stock +option exercises for these periods. +The following table summarizes information about stock options outstanding as of +December 31, 2010: +Options outstanding +Options exercisable +Range of exercise prices +Number +Outstanding +Weighted- +average +remaining +life, in +years +Weighted- +average +exercise +price +Number +exercisable +Weighted- +average +exercise +price +$2.55–$3.63 +567,319 +8.19 +$ +2.90 +256,696 +$ +2.87 +$3.71–$5.19 +926,822 +10.37 +4.87 +305,822 +4.31 +$5.28–$5.87 +718,927 +2.86 +5.71 +703,927 +5.72 +$6.37–$6.98 +565,628 +2.20 +6.90 +555,237 +6.91 +$7.48–$8.06 +805,957 +5.22 +7.90 +738,701 +7.89 +$8.18 +30,000 +5.75 +8.18 +30,000 +8.18 +$8.20 +583,575 +3.04 +8.20 +583,575 +8.20 +$8.28–$8.97 +564,509 +5.33 +8.49 +553,252 +8.49 +$9.04–$10.25 +553,796 +5.18 +9.44 +547,545 +9.44 +$10.29–$12.69 +187,000 +1.47 +10.78 +187,000 +10.78 +5,503,533 +5.43 +$ +6.83 +4,461,755 +$ +7.32 +F-19 +The 2000 Plan also permits us to grant restricted shares of our common stock to eligible +employees, including officers, and our outside directors. Generally, these shares are nontransferable until vested and are subject to vesting requirements and/or forfeiture, as determined by the Compensation Committee of our Board of Directors. The +market value of these shares at the date of grant is recognized on a straight-line basis over the period during which the restrictions lapse. Compensation cost of $2,354,109, $2,621,723 and $3,352,876 related to restricted shares was recognized +during the years ended December 31, 2010, 2009 and 2008, respectively. +The following table summarizes restricted stock +award activity under the 2000 Plan: +Shares +Weighted-Average +Grant Date Fair +Value +Issued and unvested, January 1, 2008 +882,961 +$ +8.24 +Granted +418,565 +7.83 +Vested +(393,551 +) +8.08 +Forfeited +(76,487 +) +8.31 +Issued and unvested, December 31, 2008 +831,488 +8.11 +Granted +429,870 +2.82 +Vested +(370,457 +) +8.39 +Forfeited +(71,024 +) +5.38 +Issued and unvested, December 31, 2009 +819,877 +5.44 +Granted +454,715 +5.19 +Vested +(429,309 +) +5.51 +Forfeited +(53,127 +) +5.15 +Issued and unvested, December 31, 2010 +792,156 +$ +5.28 +Issued and expected to vest, December 31, 2010 +792,156 +$ +5.28 +As of December 31, 2010, there was $2,264,291 of unrecognized compensation expense related to unvested +restricted stock awards that is expected to be recognized over a weighted average period of 2.3 years. +In connection with the +vesting of restricted shares during the years ended December 31, 2010, 2009 and 2008, we purchased and immediately retired 136,042, 132,785 and 135,432 shares with aggregate values of $708,785, $391,590 and $995,367, respectively, in +satisfaction of minimum tax withholding obligations. +Certain of our share-based payment arrangements are vested stock options +held by certain nonemployee consultants and are accounted for as liability-classified awards. The fair value of these awards is remeasured at each financial reporting date until the awards are settled or expire. As of December 31, 2010 and +2009, $2,217 and $8,911, respectively, was included in accrued expenses and other liabilities, respectively, for stock options to acquire 8,000 and 58,000 shares, respectively, of common stock, which remain unexercised. For the years ended +December 31, 2010, 2009 and 2008, the mark-to-market adjustment recorded as a reduction of compensation costs in the Statements of Operations was $6,695, $3,074 and $137,332, respectively. +Share Repurchase Program +On August 5, 2008, our Board of Directors approved a share repurchase program pursuant to which we are permitted to acquire up to $25,000,000 of our outstanding common shares. No shares were +purchased and retired in 2010. During the year ended December 31, 2009, we purchased and retired 108,293 shares of common stock at an average price of $2.85 per share. During the year ended December 31, 2008, we purchased and retired +1,147,730 shares of common stock at an average price of $4.46 per share. +F-20 +11. +COMMITMENTS AND CONTINGENCIES: +Sublicense Agreement +In June 2004, we entered into a sublicense agreement +with a third party, pursuant to which we have been granted a limited, worldwide, non-exclusive sublicense to certain HIV-2 patents held by such party. Under the terms of this sublicense agreement, we are obligated to pay royalties based on a +percentage of our net sales of certain products, which incorporate the technology covered by the licensed patents. Future minimum payments under this agreement are as follows: +2011 +$ +500,000 +2012 +500,000 +2013 +500,000 +2014 +500,000 +2015 +500,000 +Thereafter +1,291,667 +$ +3,791,667 +Royalties from our commercial sale of products covered by the sublicense can be credited against these +minimum royalty obligations. +Leases +We lease warehouse facilities under operating lease agreements. Future payments required under these non-cancelable leases are $62,442 for 2011. +Rent expense for 2010, 2009 and 2008 was $162,584, $181,124, and $184,128, respectively. +Purchase Commitments +As of December 31, 2010, we had outstanding non-cancelable purchase commitments in the amount of $2,634,454 related to inventory, capital expenditures, and other goods or services. +Employment Agreements +Under terms of employment agreements with certain executive officers, extending through 2013, we are required to pay each individual a base salary for continuing employment with us. The agreements require +payments of $2,245,500, $1,171,000 and $250,000 in 2011, 2012, and 2013, respectively. +Litigation +From time-to-time, we are involved in certain legal actions arising in the ordinary course of business. In management’s opinion, +based upon the advice of counsel, the outcomes of such actions are not expected to have a material adverse effect on our future financial position or results of operations. +12. +RETIREMENT PLANS: +Substantially all of our employees are eligible to participate in the OraSure Technologies, Inc. 401(k) Plan (the “401(k) +Plan”). The 401(k) Plan permits voluntary employee contributions to be excluded from an employee’s current taxable income under provisions of Internal Revenue Code Section 401(k) and the regulations thereunder. The 401(k) Plan also +provides for us to match employee contributions up to $4,000 per year. Contributions to the 401(k) Plan, net of forfeitures, were $597,285, $563,017, and $579,592 in 2010, 2009, and 2008, respectively. +F-21 +13. +OTHER INCOME: +In January +2008, we entered into a settlement and license agreement with Merck to resolve our patent infringement litigation against Merck. Under the terms of the agreement, Merck was required to make a payment of $4,883,714 to us. This payment was received +during the first quarter of 2008 and recorded as a reduction of operating expenses. +14. +GEOGRAPHIC INFORMATION: +We believe we operate within one reportable segment. Our products are sold principally in the United States and Europe. Segmentation of +operating income and identifiable assets is not applicable since our revenues outside the United States are export sales, and we do not have significant operating assets outside the United States. +The following table represents total revenues by geographic area, based on the location of the customer (amounts in thousands): +For the Years Ended December 31, +2010 +2009 +2008 +United States +$ +63,520 +$ +62,209 +$ +57,391 +Europe +6,493 +6,592 +7,746 +Other regions +5,002 +8,225 +5,967 +$ +75,015 +$ +77,026 +$ +71,104 +15. +QUARTERLY DATA (Unaudited): +The following tables summarize the quarterly results of operations for each of the quarters in 2010 and 2009. These quarterly results are unaudited, but in the opinion of management, have been prepared on +the same basis as our audited financial information and include all adjustments (consisting only of normal recurring adjustments) necessary for a fair presentation of the information set forth herein (all amounts in thousands, except per share +amounts). +2010 Results +Three months ended +March 31, +2010 +June 30, +2010 +September 30, +2010 +December 31, +2010 +Revenues +$ +17,945 +$ +19,218 +$ +19,034 +$ +18,818 +Costs and expenses +20,121 +19,753 +18,745 +19,750 +Operating income (loss) +(2,176 +) +(535 +) +289 +(932 +) +Other income (expense), net +(19 +) +(18 +) +(15 +) +(91 +) +Income (loss) before income taxes +(2,195 +) +(553 +) +274 +(1,023 +) +Income tax benefit +— +— +— +— +Net income (loss) +$ +(2,195 +) +$ +(553 +) +$ +274 +$ +(1,023 +) +Earnings (loss) per share (1) +Basic and Diluted +$ +(0.05 +) +$ +(0.01 +) +$ +0.01 +$ +(0.02 +) +F-22 +2009 Results +Three months ended +March 31, +2009 +June 30, +2009 +September 30, +2009 +December 31, +2009 +Revenues +$ +17,256 +$ +17,274 +$ +21,609 +$ +20,887 +Costs and expenses +19,116 +22,579 +(2) +19,834 +24,289 +(3) +Operating income (loss) +(1,860 +) +(5,305 +) +1,775 +(3,402 +) +Other income, net +242 +145 +24 +(54 +) +Income (loss) before income taxes +(1,618 +) +(5,160 +) +1,799 +(3,456 +) +Income tax provision (benefit) +— +— +— +(622 +) +Net income (loss) +$ +(1,618 +) +$ +(5,160 +) +$ +1,799 +$ +(2,834 +) +Earnings (loss) per share +Basic and Diluted +$ +(0.04 +) +$ +(0.11 +) +$ +0.04 +$ +(0.06 +) +(1) +The summation of the quarterly amounts may not equal the year-end amounts as included in the financial statements due to the use of weighted-average +shares for each period. +(2) +During the second +quarter of 2009, we recorded an impairment charge of $3.0 million related to license payment for certain HCV patents, which were previously capitalized. See further discussion in Note 5. +(3) +During the fourth quarter of 2009, we settled a patent infringement lawsuit and recorded a litigation expense of $1.5 million. +F-23 +INDEX TO EXHIBITS +Exhibit +Number +Exhibit +3.1.1 +Certificate of Incorporation of OraSure Technologies, Inc. is incorporated by reference to Exhibit 3.1 to the Company’s Registration Statement on Form S-4 (No. 333-39210), +filed June 14, 2000. +3.1.2 +Certificate of Amendment to Certificate of Incorporation dated May 23, 2000 is incorporated by reference to Exhibit 3.1.1 to the Company’s Registration Statement on Form S-4 +(No. 333-39210), filed June 14, 2000. +3.2 +Bylaws of OraSure Technologies, amended and restated as of August 18, 2008, are incorporated by reference to Exhibit 3 to the Company’s Current Report on Form 8-K filed August +22, 2008. +10.1 +Form of Indemnification Agreement (and list of parties to such agreement) is incorporated by reference to Exhibit 10.1 to Amendment No. 3 to the Company’s Registration +Statement on Form S-4 (No. 333-39210), filed August 30, 2000.* +10.2 +Employment Agreement, dated as of June 22, 2004, between OraSure Technologies, Inc. and Douglas A. Michels, is incorporated by reference to Exhibit 10.3 to the Company’s +Quarterly Report on Form 10-Q for the quarter ended June 30, 2004.* +10.3 +Amendment No. 1 to Employment Agreement, dated as of December 16, 2008, between the Company and Douglas A. Michels, is incorporated by reference to Exhibit 10.2 to the +Company’s Current Report on Form 8-K filed December 19, 2008.* +10.4 +Amendment No. 2 to Employment Agreement, dated as of December 15, 2010, between the Company and Douglas A. Michels.* +10.5 +Employment Agreement, dated as of July 1, 2004, between OraSure Technologies, Inc. and Ronald H. Spair, is incorporated by reference to Exhibit 10.4 to the Company’s Quarterly +Report on Form 10-Q for the quarter ended June 30, 2004.* +10.6 +Amendment No. 1 to Employment Agreement, dated as of December 16, 2008, between the Company and Ronald H. Spair, is incorporated by reference to Exhibit 10.3 to the Company’s +Current Report on Form 8-K filed December 19, 2008.* +10.7 +Amendment No. 2 to the Employment Agreement, dated as of December 15, 2010, between the Company and Ronald H. Spair.* +10.8 +Employment Agreement, dated September 23, 2005, between OraSure Technologies, Inc. and Stephen R. Lee, Ph.D., is incorporated herein by reference to Exhibit 99 to the Company’s +Current Report on Form 8-K filed September 28, 2005.* +10.9 +Amendment No. 1 to Employment Agreement, dated as of December 16, 2008, between the Company and Stephen R. Lee, Ph.D., is incorporated by reference to Exhibit 10.5 to the +Company’s Current Report on Form 8-K filed December 19, 2008.* +10.10 +Amendment No. 2 to the Employment Agreement, dated as of December 15, 2010, between the Company and Stephen R. Lee, Ph.D.* +10.11 +Employment Agreement, dated as of July 1, 2004, between OraSure Technologies, Inc. and Jack E. Jerrett, is incorporated by reference to Exhibit 10.7 to the Company’s +Quarterly Report on Form 10-Q for the quarter ended June 30, 2004.* +10.12 +Amendment No. 1 to Employment Agreement, dated as of December 16, 2008, between the Company and Jack E. Jerrett, is incorporated by reference to Exhibit 10.6 to the Company’s +Current Report on Form 8-K filed December 19, 2008.* +Exhibit +Number +Exhibit +10.13 +Amendment No. 2 to the Employment Agreement, dated as of December 15, 2010, between the Company and Jack E. Jerrett.* +10.14 +Employment Agreement, dated as of October 2, 2006, between Mark L. Kuna and OraSure Technologies, Inc., is incorporated by reference to Exhibit 99.1 to the Company’s Current +Report on Form 8-K filed October 5, 2006.* +10.15 +Amendment No. 1 to Employment Agreement, dated as of December 16, 2008, between the Company and Mark L. Kuna, is incorporated by reference to Exhibit 10.7 to the Company’s +Current Report on Form 8-K filed December 19, 2008.* +10.16 +Amendment No. 2 to the Employment Agreement, dated as of December 15, 2010, between the Company and Mark L. Kuna.* +10.17 +Employment Agreement, dated as of January 3, 2011, between the Company and Anthony Zezzo II.* +10.18 +Description of Non-employee Director Compensation Policy, as amended as of February 15, 2010, is incorporated by reference to Exhibit 10.15 to the Company’s Annual Report on +Form 10-K for the year ended December 31, 2009.* +10.19 +Amended and Restated Epitope, Inc. 1991 Stock Award Plan is incorporated by reference to Exhibit 10.9 to the Company’s Annual Report on Form 10-K for the year ended +December 31, 2002.* +10.20 +OraSure Technologies, Inc. Employee Incentive and Non-Qualified Stock Option Plan, as amended and restated effective September 29, 2000, is incorporated by reference to Exhibit +10.12 to the Company’s Annual Report on Form 10-K for the year ended December 31, 2000.* +10.21 +OraSure Technologies, Inc. 2000 Stock Award Plan, as amended and restated effective as of May 13, 2008, is incorporated by reference to Exhibit 10 to the Company’s Current +Report on Form 8-K filed May 19, 2008.* +10.22 +Form of Restricted Share Grant Agreement (Officers and Employees) is incorporated by reference to Exhibit 10.2.1 to the Company’s Quarterly Report on Form 10-Q for the quarter +ended June 30, 2004.* +10.23 +Form of Restricted Share Grant Agreement (Non-Employee Directors) is incorporated by reference to Exhibit 10.19 to the Company’s Annual Report on Form 10-K for the year ended +December 31, 2008.* +10.24 +Incentive Stock Option General Terms and Conditions (Officers and Employees) is incorporated by reference to Exhibit 10.12 to the Company’s Annual Report on Form 10-K for the +year ended December 31, 2004.* +10.25 +Nonqualified Stock Option Award General Terms and Conditions (Officers and Employees) is incorporated by reference to Exhibit 10.13 to the Company’s Annual Report on Form 10-K +for the year ended December 31, 2004.* +10.26 +Nonqualified Stock Option Award General Terms and Conditions (Non-Employee Directors) is incorporated by reference to Exhibit 10.14 to the Company’s Annual Report on Form 10-K +for the year ended December 31, 2004.* +10.27 +Description of the OraSure Technologies, Inc. 2011 Management Incentive Plan is incorporated by reference to Item 5.02 to the Company’s Current Report on Form 8-K filed +February 23, 2011.* +10.28 +Description of the OraSure Technologies, Inc. 2010 Management Incentive Plan is incorporated by reference to Item 5.02 to the Company’s Current Report on Form 8-K filed +February 19 2010.* +10.29 +Description of the OraSure Technologies, Inc. Long Term Incentive Plan is incorporated by reference to Item 5.02 to the Company’s Current Report on Form 8-K filed February 23, +2011.* +Exhibit +Number +Exhibit +10.30 +Description of the OraSure Technologies, Inc. 2010 Stock Award Guidelines is incorporated by reference to Item 5.02 to the Company’s Current Report on Form 8-K filed February +19, 2010.* +10.31 +Loan and Security Agreement, dated as of September 10, 2002, between Comerica Bank – California and OraSure Technologies, Inc., is incorporated by reference to Exhibit 10.1 to +the Company’s Quarterly Report on Form 10-Q for the quarter ended September 30, 2002. +10.32 +First Amendment to Loan and Security Agreement, dated as of May 23, 2003, between OraSure Technologies, Inc. and Comerica Bank – California, is incorporated by reference to +Exhibit 10.24 to the Company’s Annual Report on Form 10-K for the year ended December 31, 2003. +10.33 +Second Amendment to Loan and Security Agreement, dated as of September 12, 2003, between OraSure Technologies, Inc. and Comerica Bank, is incorporated by reference to Exhibit 99.1 +to the Company’s Current Report on Form 8-K, dated September 17, 2003. +10.34 +Third Amendment to Loan and Security Agreement, dated as of April 21, 2005, between OraSure Technologies, Inc. and Comerica Bank, is incorporated by reference to Exhibit 10 to the +Company’s Current Report on Form 8-K filed April 27, 2005. +10.35 +Fourth Amendment to Loan and Security Agreement, dated as of June 27, 2006, between OraSure Technologies, Inc. and Comerica Bank, is incorporated by reference to Exhibit 10 to the +Company’s Current Report on Form 8-K filed June 30, 2006. +10.36 +Fifth Amendment to Loan and Security Agreement, dated as of June 28, 2007, between OraSure Technologies, Inc. and Comerica Bank, is incorporated by reference to Exhibit 10 to the +Company’s Current Report on Form 8-K filed July 5, 2007. +10.37 +Settlement Agreement, effective as of November 17, 2009, by and among Inverness Medical Innovations, Inc., Inverness Medical Switzerland GmbH and OraSure Technologies, Inc., is +incorporated by reference to Exhibit 10.34 to the Company’s Annual Report on Form 10-K for the year ended December 31, 2009. +10.38 +License Agreement, effective as of November 17, 2009, by and among Inverness Medical Innovations, Inc., Inverness Medical Switzerland GmbH and OraSure Technologies, Inc., is +incorporated by reference to Exhibit 10.35 to the Company’s Annual Report on Form 10-K for the year ended December 31, 2009. +23 +Consent of KPMG LLP, Independent Registered Public Accounting Firm. +24 +Powers of Attorney. +31.1 +Certification of Douglas A. Michels required by Rule 13a-14(a) or Rule 15d-14(a) under the Securities Exchange Act of 1934, as amended. +31.2 +Certification of Ronald H. Spair required by Rule 13a-14(a) or Rule 15d-14(a) under the Securities Exchange Act of 1934, as amended. +32.1 +Certification of Douglas A. Michels required by Rule 13a-14(b) or Rule 15a-14(b) under the Securities Exchange Act of 1934, as amended, and 18 U.S.C. Section 1350, as Adopted +Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. +32.2 +Certification of Ronald H. Spair required by Rule 13a-14(b) or Rule 15a-14(b) under the Securities Exchange Act of 1934, as amended, and 18 U.S.C. Section 1350, as Adopted Pursuant +to Section 906 of the Sarbanes-Oxley Act of 2002. +* +Management contract or compensatory plan or arrangement. \ No newline at end of file diff --git a/raw/filings/0001116463/2010/0001193125-11-062311/filing_metadata.csv b/raw/filings/0001116463/2010/0001193125-11-062311/filing_metadata.csv new file mode 100644 index 0000000000000000000000000000000000000000..c4ad7f4b06b46c0d3f0106de9f4296ed911640fb --- /dev/null +++ b/raw/filings/0001116463/2010/0001193125-11-062311/filing_metadata.csv @@ -0,0 +1,2 @@ +cik,ticker,company_name,form,filing_date,report_date,acceptance_datetime,accession_number,primary_document,primary_doc_description,size,is_xbrl,is_inline_xbrl,document_url,filing_index_url,year,fiscal_year,is_primary_filing +0001116463,OSUR,ORASURE TECHNOLOGIES INC,10-K,2011-03-10,2010-12-31,2011-03-10T21:14:19.000Z,0001193125-11-062311,d10k.htm,FORM 10-K,1513628,0,0,https://www.sec.gov/Archives/edgar/data/1116463/000119312511062311/d10k.htm,https://www.sec.gov/Archives/edgar/data/1116463/000119312511062311/,2010,2010,1 diff --git a/raw/filings/0001116463/2010/0001193125-11-062311/item1.txt b/raw/filings/0001116463/2010/0001193125-11-062311/item1.txt new file mode 100644 index 0000000000000000000000000000000000000000..a782b1eb2ab706845f05b80732da2ca0de3be8c2 --- /dev/null +++ b/raw/filings/0001116463/2010/0001193125-11-062311/item1.txt @@ -0,0 +1,578 @@ +ITEM 1. +Business. +Our business +principally involves the development, manufacture, marketing and sale of oral fluid diagnostic products and specimen collection devices using our proprietary oral fluid technologies, as well as other diagnostic products including immunoassays and +other in vitro diagnostic tests that are used on other specimen types. We also manufacture and sell other medical devices used for the removal of benign skin lesions by cryosurgery or freezing. Our diagnostic products include tests which are +performed on a rapid basis at the point of care and tests which are processed in a laboratory. These products are sold in the United States and internationally to various clinical laboratories, hospitals, clinics, community-based organizations and +other public health organizations, distributors, government agencies, physicians’ offices, and commercial and industrial entities. One of our products is sold in the over-the-counter (“OTC”) or consumer retail markets in North +America, Europe, Central and South America, and Australia. +In vitro diagnostic testing is the process of analyzing +oral fluid, blood, urine and other bodily fluids or tissue for the presence of specific substances or markers for infectious diseases, drugs of abuse or other conditions. We have targeted the use of oral fluid in our products as a differentiating +factor and believe that it provides a significant competitive advantage over blood and urine. Our oral fluid tests have sensitivity and specificity comparable to blood and/or urine tests. When combined with their ease of use, non-invasive nature, +and cost effectiveness, our oral fluid tests represent a very competitive alternative to the more traditional testing methods in the diagnostic space. +Our Company was formed in May 2000 under Delaware law solely for the purposes of combining two companies, STC Technologies, Inc. (“STC Technologies”) and Epitope, Inc. (“Epitope”), and +changing the state of incorporation of Epitope from Oregon to Delaware. STC Technologies and Epitope were merged into our Company on September 29, 2000. Our principal offices are located at 220 East First Street, Bethlehem, Pennsylvania 18015, +and our telephone number is (610) 882-1820. +Additional information about us can be found on our website. Our website +address is www.orasure.com . We make available free of charge through a link provided at such website our Annual Reports on Form 10-K, our Quarterly Reports on Form 10-Q, our Current Reports on Form 8-K and our other filings with the +Securities and Exchange Commission (“SEC”), as well as any amendments to those Reports and filings. These Reports and filings are made available as soon as reasonably practicable after they are filed or furnished to the SEC. Our Internet +website and the information contained in or connected to that website are not intended to be incorporated by reference into this Annual Report. +1 +Products +The following is a summary of our principal products and their regulatory and commercial status: +Product +Description +Regulatory Status +Commercial Status +OraQuick +ADVANCE ® HIV-1/2 +A rapid, point-of-care qualitative test for antibodies to the Human Immunodeficiency Virus Type 1 (“HIV-1”) and Type 2 (“HIV-2” and together with HIV-1, +“HIV-1/2”) that can be visually read in approximately 20 minutes. +Premarket approval (“PMA”) by the U.S. Food and Drug Administration (“FDA”) for use with oral fluid, finger-stick +and venous whole blood, and plasma. +CLIA (Clinical Laboratory Improvement +Amendments of 1988) waived for use with oral fluid, finger-stick and venous whole blood. +Marketed +Marketed +CE mark (European Union) approved. Also registered in various other countries. +Marketed +OraQuick ® HIV-1/2 OTC +A rapid, point-of-care qualitative oral fluid HIV-1/2 test intended to be sold in various OTC markets. +FDA granted an IDE (Investigation Device Exemption) allowing final clinical phase to begin. +Not Marketed +OraQuick ® HCV +A rapid, point-of-care qualitative test for antibodies to the hepatitis C virus (“HCV”) that can be visually read in approximately 20 minutes. +PMA approved by FDA for use with venous whole blood and finger-stick whole blood specimens. +Clinical program for oral fluid claim remains pending. +Marketed +Not Marketed +CE mark (European Union) approved for use with oral fluid, finger-stick and venous whole blood, serum and plasma. Also registered in various other countries. +Marketed +OraSure QuickFlu™ Rapid Flu A&B Test +A rapid, point-of-care qualitative test for antibodies to influenza (flu) Types A and B, including H1N1 infections, with results available in 10 minutes. +FDA 510(k) cleared for use with nasal swab, nasopharyngeal swab and nasal aspirate/wash. +CLIA waiver application pending with FDA. +Marketed +Not Marketed +OraSure ® +Oral fluid collection device for the detection of antibodies to HIV-1 in an oral fluid sample in a laboratory setting. +PMA approved by FDA for use in detecting antibodies to HIV-1. +Marketed +FDA 510(k) cleared for use in detecting cocaine and cotinine (an indicator of nicotine) in oral fluid. +Marketed +CE marked and registered in various countries. +Marketed +Intercept ® +Oral fluid collection device for oral fluid drugs of abuse (“DOA”) testing in a laboratory setting. +Collection device—FDA 510(k) cleared. +Marketed +2 +Product +Description +Regulatory Status +Commercial Status +MICRO-PLATE DOA Assays +Used to detect the following drugs in an oral fluid sample collected with Intercept ® device: tetrahydrocannabinol (“THC” or marijuana), cocaine, opiates, amphetamines, methamphetamines, phencyclidine (“PCP”), benzodiazepines, +barbiturates and methadone. +Nine drug assays—FDA 510(k) cleared. +Intercept ® device +and various assays CE marked and registered in certain countries. +Marketed +Marketed +Homogeneous DOA Assays +Homogeneous fully-automated oral fluid DOA assays jointly developed with Roche Diagnostics for use on oral fluid samples collected with Intercept ® device. +FDA 510(k) cleared for PCP, opiates, cocaine and methamphetamines. 510(k) application for amphetamines is pending with FDA. Clinical studies for marijuana and barbiturates +underway. +Not Marketed +Cryosurgical Systems—Professional +Cryosurgical (freezing) system for the removal of warts and other benign skin lesions, marketed under the Histofreezer ® tradename primarily to the physicians’ office market. +Nine indications—FDA 510(k) cleared. +CE marked and registered in certain countries. +Marketed +Marketed +Cryosurgical Systems—OTC +Cryosurgical system for the removal of common and plantar warts, sold in various OTC markets. +FDA 510(k) cleared for common and plantar warts. +Registered in Canada for warts and skin tags. +Marketed +Not Marketed +CE marked and registered for warts in certain countries under Scholl Freeze Spray ® and POINTTS ® +names. +Marketed +CE marked for skin tags. +Not Marketed +In addition to the above products, we also sell certain immunoassay tests and reagents for insurance risk assessment, substance abuse testing and forensic toxicology applications; an oral fluid Western +blot HIV-1 confirmatory test for confirming positive HIV-1 test results obtained from the use of our OraSure ® +collection device; and the FDA 510(k) cleared Q.E.D. ® rapid point-of-care saliva alcohol test. +OraQuick ® Rapid HIV Test +OraQuick ® is our rapid test platform designed to test oral fluid, whole blood (i.e., both finger-stick and venous), plasma and serum samples for the presence of various +antibodies or analytes. The device uses a porous flat pad to collect an oral fluid specimen. After collection, the pad is inserted into a vial containing a pre-measured amount of developer solution and allowed to develop. When blood, plasma or serum +is to be tested, a loop collection device is used to collect a drop of the specimen and mix it in the developer solution, after which the collection pad is inserted into the solution and allowed to develop. In all cases, the specimen and developer +solution then flow through the testing device where test results are observable in approximately 20 minutes. The +OraQuick ® device is a screening test and generally requires a confirmation test where an initial positive result +is obtained. +3 +We initially commercialized this technology in the form of our OraQuick ® rapid HIV-1/2 antibody test. This is a rapid, point-of-care test which has received FDA approval for the detection +of antibodies to both HIV-1 and HIV-2 in oral fluid, finger-stick whole blood, venous whole blood and plasma. This test is available for use by laboratories located in the United States certified under the Clinical Laboratory Improvements Amendment +of 1988, or CLIA, to perform moderately complex tests. We have also received a CLIA waiver for use of the OraQuick +ADVANCE ® test with oral fluid and finger-stick and venous whole blood. As a result, the test can be used +by numerous additional sites in the United States not certified under CLIA to perform moderately complex tests, such as outreach clinics, community-based organizations and physicians’ offices. +On the international front, we have obtained a CE mark for our OraQuick ADVANCE ® test so that we can sell this product in Europe and other countries accepting the CE mark for commercialization. We +have distributors in place for certain countries and are seeking to increase awareness and expand our distribution network for this product throughout the world. +We believe that the OraQuick ADVANCE ® device, because it is approved for detecting antibodies to both HIV-1 and HIV-2 in finger-stick and venous whole blood, oral fluid and plasma samples, provides a +significant competitive advantage in the market for rapid HIV testing in the United States and elsewhere. +OraQuick ® HCV Rapid Antibody Test +Another test available on the OraQuick ® platform is the OraQuick ® HCV rapid antibody test. Like the OraQuick ® HIV test, this product is a qualitative test that can detect antibodies to the Hepatitis C virus, or HCV, in oral fluid and other sample types. The OraQuick ® HCV test operates in substantially the same manner as the +OraQuick ® HIV test. +We have received FDA approval for use of the test in detecting HCV antibodies in venous whole blood and finger-stick +whole blood specimens, making it the first rapid HCV test approved by the FDA for use in the United States. We intend to apply for a CLIA waiver for this product in the near future. Our clinical program for an oral fluid claim for this product is +still underway, although our FDA filing has been delayed pending the completion of additional testing and further discussions with the agency. The OraQuick ® HCV test has received a CE mark for use with oral fluid, venous whole blood, finger-stick whole blood, plasma and serum and was made available for sale in Europe in +2010. +We have entered into agreements with Merck & Co. Inc. (“Merck,” formerly +Schering-Plough) to collaborate on the development and promotion of our OraQuick ® HCV test. Under the terms of +these agreements, we have been and may in the future be reimbursed by Merck for a portion of our costs to develop the test and obtain regulatory approvals. In addition, Merck will provide detailing and other promotional support for the test in the +physicians’ office market in the United States and internationally. +OraSure QuickFlu™ Rapid Flu A&B Test +The OraSure QuickFlu™ rapid flu A&B test is an FDA 510(k) cleared rapid qualitative test for the detection of +influenza (flu) Types A and B, including H1N1 viral infections. The test utilizes specimen collected with a nasal swab, nasopharyngeal swab or nasal aspirate/wash. A reagent is first inserted into a test cartridge, the specimen is added and the test +is allowed to flow. Results are available in as little as ten minutes. +The OraSure QuickFlu™ test is intended to be used +as an aid in the rapid differential diagnosis of influenza and covers a broad range of influenza subtypes, including 2009 H1N1, with proven clinical detection spanning three flu seasons from 2007 through 2009. The test is highly accurate across all +specimen types based on standard culture confirmation with demonstrated sensitivity for influenza Type A at 90% or greater. Additionally, in clinical studies a significant number of culture negative samples that were tested positive with the OraSure +QuickFlu™ product were determined to be true positives by PCR (polymerase chain reaction) testing. +4 +This product is manufactured for us under an agreement with Princeton BioMeditech +Corporation. An application for a CLIA waiver for this test is pending with the FDA. The OraSure QuickFlu™ test is currently available for sale in the U.S. +OraSure ® Collection Device +Our OraSure ® oral fluid collection device is used in conjunction with screening and confirmatory tests for HIV-1 antibodies and other analytes. This device consists of a small, +treated cotton-fiber pad on a handle that is placed in a person’s mouth for two to five minutes. The device collects oral mucosal transudate (“OMT”), a serum-derived fluid that contains higher concentrations of certain antibodies and +analytes than saliva. As a result, OMT testing is a highly accurate method for detecting HIV-1 infection and other analytes. +The OraSure ® collection device is FDA approved for use in the +detection of HIV-1 antibodies and 510(k) cleared for the detection of cocaine and cotinine in oral fluid specimens. In addition, we have received a CE mark for the OraSure ® device and our cocaine and cotinine assays, all of which are sold through distributors in Canada, the United Kingdom, Mexico and certain other foreign countries. +HIV-1 antibody detection using the OraSure ® collection device involves three steps: +• +Collection of an oral fluid specimen using the OraSure ® device; +• +Screening of the specimen for HIV-1 antibodies at a laboratory with an enzyme immunoassay (“EIA”) screening test approved by the FDA for use +with the OraSure ® device; and +• +Laboratory confirmation of any positive screening test results with our oral fluid Western blot HIV-1 confirmatory test (described below). +A trained health care professional then conveys test results and provides appropriate counseling to the individual who was +tested. +We believe that oral fluid testing has several significant advantages over blood or urine-based systems for +infectious disease testing, for both health care professionals and the individuals being tested. These advantages include eliminating the risk of needle-stick accidents, providing a non-invasive collection technique, requiring minimal training to +administer, providing rapid and efficient collection in almost any setting, and reducing the cost of administration by a trained health care professional. +Intercept ® Drug Testing System +A collection device that is substantially similar to the OraSure ® device is sold by us under the name +Intercept ® , and is used to collect OMT for oral fluid drug testing. We have received FDA 510(k) clearance to use +the Intercept ® collection device with laboratory-based EIAs to test for drugs of abuse commonly identified by +the National Institute for Drug Abuse (“NIDA”) as the NIDA-5 (i.e., tetrahydrocannabinol (“THC” or marijuana), cocaine, opiates, amphetamines/methamphetamines and phencyclidine (“PCP”)), and for barbiturates, methadone +and benzodiazepines. Each of these EIAs is also FDA 510(k) cleared for use with the Intercept ® device. Our +Intercept ® device and oral fluid assays are sold in the U.S. primarily through laboratory distributors. +We have received a CE mark for the Intercept ® device and our oral fluid assays and distribute these products in Canada, the United Kingdom and Mexico. +We believe that the Intercept ® device has several advantages over competing urine and other drugs-of-abuse testing products, including its lower total testing cost, its non-invasive nature, +mobility and accuracy, the ease of maintaining a chain-of-custody, the treatment of test subjects with greater dignity, no requirement for specially-prepared collection facilities and difficulty of sample adulteration. The availability of an oral +fluid test is intended to allow our customers to test for drug impairment and eliminate scheduling costs and inconvenience, thereby streamlining the testing process. +5 +In an effort to expand our Intercept ® product line and meet the needs of our laboratory customers, we have jointly developed with Roche Diagnostics a +series of homogeneous fully-automated oral fluid drugs of abuse assays. These assays use Roche’s KIMs (kinetic interaction of micro-particles in solution) technology and will run on various automated analyzers to allow oral fluid samples to be +processed with the same efficiency currently achieved by our laboratory customers with urine-based drug tests. FDA 510(k) clearance has been received for assays to detect PCP, opiates, cocaine and methamphetamines and a 510(k) application for +amphetamines is currently pending before the FDA. Clinical studies for THC and barbiturate assays are in process, and the parties are continuing to develop several other assays pursuant to their joint development agreement. +The high-throughput assays will be distributed in the U.S. and internationally by OraSure and Roche pursuant to a commercialization +agreement between the parties. We expect the initial U.S. commercial launch of the assays to occur later in 2011. +Cryosurgical Systems (Skin Lesion Removal Products) +The Histofreezer ® cryosurgical removal system is a low-cost alternative to liquid nitrogen and other methods for removal of warts and other benign skin lesions by physicians. The +Histofreezer ® product mixes three environmentally friendly cryogenic gases in a small aerosol canister. When +released, these gases are delivered to a specially designed foam bud, cooling the bud to a maximum of –50°C to –55°C. The frozen bud is then applied to the wart or lesion for 15 to 40 seconds (depending on the type of lesion) +creating localized destruction of the target area by freezing. We have received 510(k) clearance for use of the +Histofreezer ® product to remove common warts and eight other types of benign skin lesions, and this product has +been CE marked and registered for distribution in Canada, throughout Europe and in certain other foreign countries. +We have also received FDA 510(k) clearance to market and sell a cryosurgical product similar to the Histofreezer ® product in the OTC or retail market for the removal of common and plantar warts only. In 2009, we began directly selling our cryosurgical wart product in the U.S. OTC +market under a new national brand called Freeze ‘n Clear Skin Clinic™. However, due to the limited revenues derived from this product, competing priorities and limited corporate funding, we decided to stop selling this product in the U.S. +at the end of 2010. +Internationally, we distribute an OTC cryosurgical product through our distributor Genomma Labs, under +the POINTTS tradename, in Mexico and a number of South and Central American countries. We also distribute a CE marked cryosurgical wart removal product into the OTC footcare market in Europe, Australia and New Zealand through our distributor, +Reckitt Benckiser (successor to SSL International) (“Reckitt”), under the Scholl and Dr. Scholl trademarks. Reckitt is the owner of the Scholl and Dr. Scholl trademarks in countries outside North and South America. We intend to +sell OTC cryosurgical products for the treatment of both warts and skin tags to retailers in Canada on a private label basis beginning in 2011. +Immunoassay Tests and Reagents +We develop and sell +immunoassay tests in two formats, known as MICRO-PLATE and AUTO-LYTE ® , to meet the specific needs of our +customers. +In a MICRO-PLATE kit, the sample to be tested is placed into a small plastic receptacle, +called a microwell, along with the reagents. The result of the test is determined by the color of the microwell upon completion of the reaction. Controlling the reaction involves the use of reagents by laboratory personnel. Test results are analyzed +by any of a variety of commercially available laboratory instruments, which we may also provide to our laboratory customers. MICRO-PLATE tests can be performed on commonly used instruments and can detect drugs in urine, serum and sweat specimens. +MICRO-PLATE tests are also used as part of the Intercept ® product line to detect drugs of abuse in oral fluid +specimens. +AUTO-LYTE ® tests are sold in the form of bottles of liquid reagents. These reagents are run on commercially available laboratory-based automated analytical instruments, which +are manufactured by a variety +6 +of third parties. AUTO-LYTE ® is typically used in high +volume, automated, commercial reference insurance laboratories to detect certain drugs or chemicals in urine. Test results are produced quickly, allowing for high throughput. Our AUTO-LYTE ® tests continue to face strong competition from cheaper “home-brew” tests developed internally by our laboratory customers. As a result, we may eventually +stop selling our AUTO-LYTE ® tests. +Western blot HIV-1 Confirmatory Test +We sell an oral +fluid Western blot HIV-1 confirmatory test that received premarket approval from the FDA in 1996. This test uses the original specimen collected with the OraSure ® oral fluid collection device to confirm positive results of initial oral fluid HIV-1 EIA screening tests. +Q.E.D. ® Saliva Alcohol Test +Our Q.E.D. ® saliva alcohol test is a point-of-care test device that is a cost-effective alternative to breath or blood alcohol testing. The test is a quantitative, saliva-based +method for the detection of ethanol, has been cleared for sale by the FDA and has received a CLIA waiver. The U.S. Department of Transportation (“DOT”) has also approved the test. +Each Q.E.D. ® test kit contains a collection stick that is used to collect a sample of saliva and a disposable detection device that displays results in a format similar to a +thermometer. The Q.E.D. ® device is easy to operate and instrumentation is not required to read the result. The +product has a testing range of 0 to 0.145% blood alcohol and produces results in approximately two minutes. +Products Under Development +OraQuick ® Platform +We believe +that OraQuick ® has significant potential as a point-of-care testing platform for clinics and other public health +entities, hospitals, physicians’ offices and other markets. Because the OraQuick ® platform is simple to use +and can operate in a non-invasive manner with oral fluid, we believe it will be suitable for use by consumers without the assistance of a doctor or other medical professional. We also believe that OraQuick ® provides a platform technology that can be modified for detection of a variety of infectious diseases in addition to +HIV, such as viral hepatitis and certain sexually transmitted diseases. +We are currently devoting +significant resources to obtaining FDA approval to sell our OraQuick ® HIV-1/2 test in the United States OTC +market. We have developed an information and referral system and product packaging and labeling suitable for the OTC market. In late 2010, we received an investigational device exemption (“IDE”) from the FDA which allowed us to commence +the final phase of clinical testing for this product. This final phase consists of an unobserved user study that is designed to assess an individual’s ability to conduct self-testing of an oral fluid sample collected with the investigational +OTC version of the test in an unsupervised setting. We expect this clinical phase to continue during 2011, and we intend to submit an application for FDA approval after the study is completed. +Several other new products using the OraQuick ® technology platform are in varying stages of development. These include a second generation OraQuick ® HIV-1/2 antibody test, which we believe will provide improved performance compared to our current product, along with assays for certain other infectious diseases. +OraSure ® /Intercept ® Applications +Oral mucosal transudate, or OMT, contains many constituents found in blood and serum, although in +lower concentrations. We believe the OraSure ® and Intercept ® devices are a platform technology with a wide variety of potential applications, where laboratory testing is available. For example, the OraSure ® device may be useful for the collection of a variety of antibodies or markers for infectious diseases or conditions +in addition to HIV-1, such as antibodies to viral hepatitis. +7 +In 2004, the Substance Abuse and Mental Health Services Administration +(“SAMHSA”) issued proposed regulations for oral fluid drug testing for federal workers. Although these proposed regulations were withdrawn, we believe that SAMHSA, through its Drug Testing Advisory Board, may attempt to promulgate new +regulations that will include oral fluid as an approved testing matrix for federally-regulated workers. If and when issued in final form, these regulations may require certain modifications to our Intercept ® product in order to permit its use by federal workers. As a result, we are developing modifications to the Intercept ® collection device that we anticipate will be required by these regulations or otherwise desired by our customers. +This new version of our Intercept ® device is also expected eventually to be used with the high-throughput drug +assays jointly developed with Roche Diagnostics. +Research and Development +In 2010, our research and development activities focused primarily on clinical and regulatory activities related to +obtaining PMA approval for our OraQuick ® HCV test, planning and implementation of the final phase of clinical +testing for FDA approval of an OraQuick ® HIV OTC test, development of next generation versions of our OraQuick ® HIV and Intercept ® products and assessing initial feasibility of certain other products. +From time to time, we have contracted with third parties to conduct research and development activities and we may do so in the future. +Research and development expenses were $13.2 million in 2010, $13.4 million in 2009 and $20.3 million in 2008. These expenses include our +costs associated with research and development, regulatory affairs, clinical trials and product support. +Sales and Marketing +We attempt to reach our major target markets through a combination of direct sales, strategic collaborations and +independent distributors. Our marketing strategy is to create or raise awareness through a full array of marketing activities, which include trade shows, print advertising, special programs and distributor promotions, in order to stimulate sales in +each target market. +We market our products in the United States and internationally. Revenues attributable to customers in +the United States were $63.5 million, $62.2 million and $57.4 million in 2010, 2009 and 2008, respectively. Revenues attributable to international customers amounted to $11.5 million, $14.8 million and $13.7 million, or 15%, 19% and 19% of our total +revenues, in 2010, 2009 and 2008, respectively. +Infectious Disease Testing +We market the OraQuick ADVANCE ® rapid HIV-1/2 antibody test directly to customers in the public health market for HIV testing. This market consists of a broad range of clinics and laboratories and +includes states, counties, and other governmental agencies, family planning clinics, colleges and universities, correctional facilities and the military. There are also a number of organizations in the public health market, such as AIDS service +organizations and various community-based organizations, that are set up primarily for the purpose of encouraging and enabling HIV testing. We also sell our OraQuick ADVANCE ® test directly to hospitals in the U.S. and through distributors into the U.S. physician market. Beginning in 2011, we have engaged two manufacturers’ +representative organizations to assist in sales to U.S. physicians. +Internationally, we distribute our +OraQuick ® HIV test in Europe and other foreign countries. We expect to increase the number of countries where +this product is sold as we find new distributors and complete registrations in additional countries. +We +market the OraSure ® oral fluid collection device for HIV-1 testing, on its own and as a kit in combination with +laboratory testing services. To better serve our public health customers, we have contracted +8 +with two commercial laboratories to provide prepackaged +OraSure ® test kits, with prepaid laboratory testing and specimen shipping costs included. We also sell the +OraSure ® device in the international public health market. +In June 2010, we received FDA approval of our OraQuick ® HCV test for use with venous whole blood specimens, and in February 2011 we received FDA approval of a finger-stick whole blood claim for this product. We intend to +apply for a CLIA waiver for this product in the near future. Based on the FDA approvals received to date, our +OraQuick ® HCV test is currently sold primarily in the U.S. hospital market. Receipt of a CLIA waiver will enable +us to expand sales of this product into the U.S. public health and physician office markets. In late 2009, we received CE mark approval for this test for use with oral fluid, finger-stick whole blood, venous whole blood, serum and plasma samples and +began selling this product in 2010 through distributors in Europe and other countries. +We previously +entered into agreements with Merck to collaborate on the development and promotion of our OraQuick ® HCV test. +Under the terms of these agreements, we have been and in the future may be reimbursed by Merck for a portion of our costs to develop the test and obtain regulatory approvals. Merck will also provide detailing and other promotional support for the +test in the physicians’ office market in the United States and internationally. +In January 2011, we obtained +distribution rights to an FDA 510(k) cleared rapid flu A&B test. This product is being supplied to us by Princeton BioMeditech Corporation and will be sold under our proprietary OraSure QuickFlu™ tradename. Under our agreement with +Princeton BioMeditech, we will sell this product into the U.S. hospital and public health markets. An application for a CLIA waiver for this test is currently pending with the FDA. +Substance Abuse Testing +Our substance abuse testing products are marketed to laboratories serving the workplace testing, forensic toxicology, criminal justice and drug rehabilitation markets. +We have entered into agreements for the distribution of Intercept ® collection devices and associated MICRO-PLATE assays for drugs-of-abuse testing in the workplace testing market in the United States and Canada through several +laboratory distributors, including Quest Diagnostics (“Quest”) and Clinical Reference Laboratory (“CRL”), and internationally for workplace, criminal justice and forensic toxicology testing through other distributors. In some +cases, we assist our laboratory customers in customizing their testing services by selling them equipment required to test oral fluid specimens collected with the Intercept ® device. +We also market +the Intercept ® collection device on its own and as a kit in combination with laboratory testing services. To +better serve our workplace customers, we have contracted with two commercial laboratories to provide prepackaged +Intercept ® test kits, with prepaid laboratory testing and specimen shipping costs included. +The criminal justice market in the United States for our substance abuse testing products consists of a wide variety of entities in the +criminal justice system that require drug screening, such as pre-trial services, parole and probation officers, police forces, drug courts, prisons, drug treatment programs and community/family service programs. The forensic toxicology market +consists of several hundred laboratories including federal, state and county crime laboratories, medical examiner laboratories and reference laboratories. +As discussed above, the FDA has issued 510(k) clearances for the use of fully-automated high-throughput oral fluid assays for the detection of PCP, opiates, cocaine and methamphetamines with oral fluid +samples collected with our Intercept ® device. An application for 510(k) clearance of an assay for detection of +amphetamines is pending before the FDA, and the clinical studies for marijuana and barbiturates are underway. We expect to begin selling the cleared assays as part of our Intercept ® drug testing system into the workplace, criminal justice, hospital and government markets in collaboration with Roche Diagnostics later in 2011. +9 +We distribute our +Q.E.D. ® saliva alcohol test primarily through various distributors in the United States and internationally. The +markets for alcohol testing are relatively small and fragmented with a broad range of legal and procedural barriers to entry. Markets range from law enforcement testing to workplace testing of employees in safety sensitive occupations. Typical usage +situations include pre-employment, random, post-accident, reasonable-cause and return-to-duty testing. +Cryosurgical +Systems +Most of our Histofreezer ® sales occur in the United States to distributors that, in turn, resell the product to primary care physicians and podiatrists in the United States. Our major U.S. +distributors include Cardinal Healthcare, McKesson HBOC, Physicians Sales & Service, AmerisourceBergen Corporation, and Henry Schein. We have entered into agreements with two manufacturers’ representative organizations under which a +contract salesforce is helping our U.S. distributors promote and sell Histofreezer ® . Internationally, we sell +the Histofreezer ® product through a network of distributors in more than 20 countries worldwide. +We distribute cryosurgical wart removal products in the OTC footcare market in Europe, Australia and New Zealand through our distributor, +Reckitt, under its Scholl and Dr. Scholl tradenames, and in the OTC markets in Mexico and several Central and South American countries under the POINTTS tradename through our distributor, Genomma Labs. In early 2009, we re-launched our OTC +cryosurgical wart product in the U.S. under our own proprietary national brand called Freeze ‘n Clear Skin Clinic™. However, due to limited revenues derived from this product, competing priorities and limited corporate funding, we decided +to stop selling our OTC product in the U.S. at the end of 2010. Beginning in 2011, we intend to begin selling OTC cryosurgical products for the removal of warts and skin tags under private label arrangements with retailers in Canada. +Insurance Risk Assessment +We currently market the OraSure ® oral fluid collection device for +use in screening life insurance applicants in the United States and internationally to test for three of the most important underwriting risk factors: HIV-1, cocaine and cotinine (a metabolite of nicotine). Devices are sold to insurance testing +laboratories, including Quest, Heritage Labs and CRL. These laboratories in turn provide the devices to insurance companies, usually in combination with testing services. +We also promote use of the OraSure ® device directly to insurance companies for life insurance risk assessment. Insurance companies then make their own decision regarding which laboratory to use to +supply their collection devices and testing services. We sell our OraSure ® Western blot confirmatory test +directly to insurance testing laboratories for use in confirming oral fluid specimens collected with our +OraSure ® device that initially test positive for HIV-1. +There exists a wide range of policy limits where our OraSure ® product is being used. In general, most of our insurance company customers use the OraSure ® device in connection with life insurance policies having face amounts of up to $250,000, with some customers using the device for policies of up to $500,000 in +amount. Some insurance companies have chosen to extend their testing to lower policy limits where they did not test at all before, while others have used OraSure ® to replace some of their blood and urine-based testing. +We also sell our AUTO-LYTE ® assays and reagents in the insurance +testing market directly to laboratories, including Heritage Labs and CRL. +International Markets +We sell most of our products into international markets primarily through distributors with knowledge of their local markets. Principal +markets include foreign governments, physicians’ offices, insurance risk assessment, substance abuse, public health and laboratory testing. +10 +We assist our international distributors in registering the products and obtaining required +regulatory approvals in each country, and we provide training and support materials. +Significant Products and Customers +Several different products have contributed significantly to our financial performance, accounting for 10% or more of +our total revenues during the past three years. The OraQuick ® rapid HIV testing products, the cryosurgical +systems products, and the OraSure ® and Intercept ® oral fluid collection devices accounted for total revenues of $40.1 million, $11.9 million and $11.2 million in 2010, $43.8 million, $10.9 million and $12.5 million +in 2009 and $35.3 million, $10.7 million and $13.4 million in 2008, respectively. +We had no individual customers who +accounted for more than 10% of our total revenues in 2010. +Revenue by Segment +We operate our business within one reportable segment and all of our revenues are generated from this one segment. Our revenue is +generated by our product sales and licensing and product development activities. For more information about our revenues from external customers, income and total assets, please see the sections entitled “Selected Financial Data” and +“Management’s Discussion and Analysis of Financial Condition and Results of Operations” and Note 14 to the financial statements, included elsewhere in this Annual Report. +Supply and Manufacturing +Our OraQuick ADVANCE ® HIV test, OraQuick ® HCV test, OraSure ® and +Intercept ® collection devices, Western blot HIV-1 confirmatory test, AUTOLYTE and MICRO-PLATE assays and QED ® saliva alcohol test are all manufactured in our Bethlehem, Pennsylvania facility. We expect to continue to +manufacture these products at this location for the foreseeable future. +We have contracted with a third +party in Thailand for the assembly of the OraQuick ® HIV device, in order to supply certain international +markets. This supply agreement had an initial term of one year, and automatically renews for additional annual periods unless either party provides a timely notice of termination prior to the end of an annual period. We believe that other firms +would be able to manufacture the OraQuick ® test on terms no less favorable than those set forth in the agreement +if the Thailand contractor would be unable or unwilling to continue manufacturing this product. +We can +purchase the HIV antigen and the nitrocellulose used in the OraQuick ® test, the HCV antigen used in the OraQuick ® HCV test and the antigen used in the Western blot HIV-1 confirmatory test only from a limited number of sources. If +for any reason these suppliers are unwilling or no longer able to supply our antigen or nitrocellulose needs, we believe that alternative supplies could be obtained at a competitive cost. However, a change in any of the antigens or nitrocellulose +used in our products would require FDA approval and some additional development work. This in turn could require significant time to complete and could disrupt our ability to manufacture and sell the affected products. +Our MICROPLATE and AUTO-LYTE assays require the production of highly specific and sensitive antibodies corresponding to the antigen of +interest. Substantially all our antibody requirements are provided by contract suppliers. We believe that we have adequate reserves of antibody supplies and that we have access to sufficient raw materials for these products. +Our OraSure QuickFlu™ test is manufactured and supplied by a third party, Princeton BioMeditech. +The Histofreezer ® product sold in the U.S. is assembled by U.S. vendors and the Histofreezer ® product sold internationally is assembled in The Netherlands by Koninklijke, Utermöhlen, N.V. (“Utermöhlen”), the company +11 +from which we acquired the product in 1998. The cryosurgical wart removal products distributed in OTC markets are also assembled by vendors located in the United States. We believe that +additional suppliers of all of our cryosurgical products are available on terms no less favorable than the terms of our existing supply agreements in the event that our current suppliers would be unable or unwilling to continue manufacturing these +products. +Employees +As of December 31, 2010, we had 231 full-time employees, including 65 in sales, marketing and client services; 17 in research and development; 107 in operations, manufacturing, quality control, +information systems, purchasing and shipping; 19 in regulatory affairs; and 23 in administration and finance. This compares to 280 employees as of December 31, 2009. Our employees are not currently represented by a collective bargaining +agreement. +Competition +The diagnostic industry is a multi-billion dollar international industry and is intensely competitive. Many of our competitors are substantially larger than we are, and they have greater financial, +research, manufacturing and marketing resources. +Important competitive factors for our products include product quality, +performance, price, ease of use, customer service and reputation. Industry competition is based on the following: +• +Scientific and technological capability; +• +Proprietary know-how; +• +The ability to develop and market products and processes; +• +The ability to obtain FDA or other regulatory approvals; +• +The ability to manufacture products that meet applicable FDA requirements (i.e., good manufacturing practices); +• +Commercial execution and strength of distribution; +• +Access to adequate capital; +• +The ability to attract and retain qualified personnel; and +• +The availability of patent protection. +A few large corporations produce a wide variety of diagnostic tests and other medical devices and equipment. A larger number of mid-size companies generally compete only in the diagnostic industry and a +significant number of small companies produce only a few diagnostic products. As a result, the diagnostic test industry is highly fragmented and segmented. +The future market for diagnostic tests is expected to be characterized by consolidation, greater cost consciousness and tighter reimbursement policies. The purchasers of diagnostic products are expected +to place increased emphasis on lowering costs, reducing inventory levels, automation, service and volume discounts. The increased complexity of the market is expected to force many competitors to enter into joint ventures or license certain products +or technologies. +We expect competition to intensify as technological advances are made and become more widely known, and as +new products reach the market. Furthermore, new testing methodologies could be developed in the future that render our products impractical, uneconomical or obsolete. There can be no assurance that our competitors will not succeed in developing or +marketing technologies and products that are more effective than those we develop or that would render our technologies and products obsolete or otherwise commercially unattractive. In +12 +addition, there can be no assurance that our competitors will not succeed in obtaining regulatory approval for these products, or introduce or commercialize them, before we can do so. These +developments could have a material adverse effect on our business, financial condition and results of operations. +Several companies market or have announced plans to market oral specimen collection devices and tests both within and outside the United States. We expect the number of devices competing with our +Intercept ® , OraQuick ® and OraSure ® devices to +increase as the benefits of oral fluid-based testing become more widely accepted. +Competition in the HIV +testing market is intense and is expected to increase. We believe that the principal competition will continue to come from existing laboratory-based blood tests, point-of-care rapid blood tests, laboratory-based urine assays or other oral +fluid-based tests that may be developed. Our competitors include specialized biotechnology firms, as well as pharmaceutical companies with biotechnology divisions and medical diagnostic companies. Significant competitors for our OraQuick +ADVANCE ® rapid HIV-1/2 test, such as the Ortho Diagnostics division of Johnson & Johnson, +Bio-Rad Laboratories and Abbott, sell laboratory-based HIV-1/2 EIAs, and Maxim Biomedical (formerly Calypte, Inc.) sells an HIV-1 screening test for urine, in the United States. MedMira and Trinity Biotech each sell competing rapid HIV-1 blood +tests, and Bio-Rad Laboratories and Alere (formerly Inverness Medical) sell competing rapid HIV-1/2 blood tests in the United States. These tests compete with our OraQuick ADVANCE ® test in hospitals and other laboratory settings. In addition, Trinity Biotech and Alere have received CLIA waivers for their rapid HIV tests, and these tests compete +with our OraQuick ADVANCE ® test in the markets outside of the traditional hospital and laboratory +settings. These companies, or others, may continue to expand the bodily fluids with which a rapid HIV test may be performed, or develop and commercialize new rapid HIV tests, which would provide further competition for our OraQuick ADVANCE ® test. We believe other companies may also seek FDA approval to sell competing rapid HIV tests in the future. +Internationally, our OraQuick ADVANCE ® HIV test competes against rapid HIV tests sold by a number of other entities, and often these competing tests are sold at prices substantially below the prices we +charge for our OraQuick ADVANCE ® test. Alere and Trinity Biotech sell rapid HIV-1/2 blood tests outside +the United States and Calypte has developed a rapid oral fluid HIV test which is now being sold in certain foreign countries. Lower priced rapid HIV blood tests are also sold internationally by various third parties. +The OraQuick ® HCV test competes primarily against laboratory-based HCV blood tests. Major suppliers of these competing tests are Abbott Labs, Seimens, Ortho-Clinical Diagnostics, +Roche and Bio-Rad. In non-U.S. countries outside of Europe, we expect that our OraQuick ® HCV test will compete +against other rapid HCV blood tests in addition to the laboratory-based tests. +The OraSure QuickFlu™ test will compete +primarily against other rapid flu tests sold by various third parties into the U.S. hospital and public health markets. The principal suppliers of these competing tests include Quidel and Alere. +The Intercept ® drug testing system competes with laboratory-based drug testing products and services using testing matrices such as urine, hair, sweat and oral fluid. Major +competitors include Ansys Technologies, Dade Behring, Psychemedics and Immunalysis. +Our MICRO-PLATE oral +fluid drug assays, which are sold for use with the Intercept ® and OraSure ® collection devices, continue to come under increasing competitive pressure from “home-brew” assays +developed internally by our laboratory customers. Our oral fluid MICRO-PLATE assays also compete with urine-based homogeneous assays that are run on fully-automated, random access analyzers. These tests provide strong competitive pressure because +they provide the benefits of automation, including lower costs and short turn-around times. In addition, we believe our competitors are developing oral fluid tests suitable for use on these fully automated homogeneous assay systems and these assays, +if and when they are developed and +13 +commercialized, will represent a significant competitive threat to our oral fluid MICRO-PLATE business. In order to meet this competition, we are developing and intend to commercialize +fully-automated homogeneous oral fluid drugs of abuse assays with Roche Diagnostics for use with our Intercept ® +device. +Our MICRO-PLATE drugs-of-abuse reagents sold in the forensic toxicology market are targeted to forensic testing +laboratories where sensitivity, automation and “system solutions” are important. In the past, these laboratories have typically had to rely on radioimmunoassay test methods to provide an adequate level of sensitivity. Radioimmunoassays +require radioactive materials, which have a short shelf-life and disposal problems. Our MICRO-PLATE tests meet the laboratories’ sensitivity needs, run on automated equipment, are not radioimmunoassays, and are offered to the laboratory as a +complete system solution of reagents, instrumentation and software to meet the specific needs of each customer. We compete with both homogeneous and heterogeneous tests manufactured by many companies. Significant competitors in the market for these +assays include Thermo Scientific (formerly Microgenics, Inc.), Roche Diagnostics and Immunalysis. +Sales +of our AUTO-LYTE ® urine assays have declined substantially during the past several years, primarily due to +competition from “home-brew” assays developed internally by our laboratory customers, which can be produced at a cost lower than the price typically paid for our products. Many of our customers no longer purchase our AUTO-LYTE ® assays, and we may eventually stop selling this product line. +The Histofreezer ® product’s delivery system and operating temperature, which is warmer than liquid nitrogen, provide us with the opportunity to target sales to primary care +physicians, such as family practitioners, pediatricians and podiatrists. We do not generally target sales to dermatologists because they have the volume of patients required to support the capital costs associated with a liquid nitrogen delivery +system, which is also used to remove warts and other benign skin lesions. Major competitors for the +Histofreezer ® product include Cryosurgery, Inc. in the United States and Wartner in Europe. Competition in the +international OTC markets comes primarily from cryosurgical products sold by Wartner and several other firms. +Q.E.D. ® has two primary competitors, Ansys Technologies and +Chematics. These companies offer semi-quantitative saliva-based alcohol tests and have received DOT approval. Indirect competitors who offer breath testing equipment include Intoximeters, Dräger and CMI. Although there are lower priced tests on +the market that use oral fluid or breath as a test medium, these tests are qualitative tests that are believed to be substantially lower in quality and provide fewer benefits than our Q.E.D. ® test. +Patents and Proprietary Information +We seek patents and other intellectual property rights to protect and preserve our proprietary technology and our right to +capitalize on the results of our research and development activities. We also rely on trade secrets, know-how, continuing technological innovations and licensing opportunities to provide competitive advantages for our products in our markets and to +accelerate new product introductions. We regularly search for third-party patents in fields related to our business to shape our own patent and product commercialization strategies as effectively as possible and to identify licensing opportunities. +United States patents generally have a maximum term of 20 years from the date an application is filed. +We +have ten United States patents and numerous foreign patents for the OraSure ® and Intercept ® collection devices and technology relating to oral fluid collection, containers for oral fluids, methods to test +oral fluid, formulations for the manufacture of synthetic oral fluid, and methods to control the volume of oral fluid collected and dispersed. The patents expire from January 2013 to September 2022. We have also applied for additional patents, in +both the United States and certain foreign countries, on such products and technology. +We have four +United States patents for our OraQuick ® platform, and we have several related patent applications pending in +the United States and internationally. Three of these patents expire from March to April 2019 and the fourth in August 2027. We have obtained licenses to certain lateral flow patents and to certain +14 +HIV-1 and HIV-2 patents held by other parties. We also have obtained a license to certain HCV patents which we use to manufacture and sell a rapid HCV test on the OraQuick ® or other technology platforms. We obtained these licenses through the payment of certain upfront fees and an +agreement to pay ongoing royalties. We believe these fees and royalties are comparable to those generally paid by other companies under similar arrangements. +We may need to obtain licenses or other rights under, or enter into distribution or other business arrangements in +connection with, certain other intellectual property patents in order to manufacture and sell the OraQuick +ADVANCE ® HIV test or other tests that use the same or similar technology platform. See Section 1A, +entitled “Risk Factors,” for a further discussion of these issues. +We have four United States patents and numerous +foreign patents issued for apparatuses and methods for the topical removal of skin lesions relating to our cryosurgical wart removal products, and we have pending patent applications related to these products in the United States and in certain +foreign countries. These patents expire from July 2012 to January 2014. We have also licensed another patent relating to apparatuses and methods for the topical removal of skin lesions relating to our cryosurgical wart removal products. +We require our employees, consultants, outside collaborators and other advisors to execute confidentiality agreements upon the +commencement of employment or consulting relationships with us. These agreements provide that all confidential information developed by or made known to the individual during the course of the individual’s relationship with us is to be kept +confidential and not disclosed to third parties except in specific circumstances. In the case of employees, the agreements provide that all inventions conceived by the individual during his or her tenure with us will be our exclusive property. +We own rights to trademarks and service marks that we believe are necessary to conduct our business as +currently operated. In the United States, we own a number of trademarks, including the OraSure ® , Intercept ® , OraQuick ® , OraQuick ADVANCE ® , +Histofreezer ® , OraSure QuickFlu™, Q.E.D. ® and AUTO-LYTE ® trademarks. We +also own many of these marks and others in several foreign countries. With respect to our international OTC cryosurgical products, the Scholl and Dr. Scholl tradenames are owned by Reckitt in Europe, Australia, New Zealand and other countries +outside North and South America, and the POINTTS tradename is owned by Genomma Labs. +Although important, the issuance of a +patent or existence of trademark or trade secret protection does not in itself ensure the success of our business. Competitors may be able to produce products competing with our patented products without infringing our patent rights. Issuance of a +patent in one country generally does not prevent manufacture or sale of the patented product in other countries. The issuance of a patent is not conclusive as to validity or as to the enforceable scope of the patent. The validity or enforceability +of a patent can be challenged by litigation after its issuance. If the outcome of such litigation is adverse to the owner of the patent, the owner’s rights could be diminished or withdrawn. Trade secret protection does not prevent independent +discovery and exploitation of the secret product or technique. +Government Regulation +General +Most of our products are regulated by the FDA, certain state and local agencies and comparable regulatory bodies in other countries. This +regulated environment governs almost all aspects of development, production and marketing, including product testing, authorizations to market, labeling, promotion, manufacturing and recordkeeping. +All of our FDA-regulated products require some form of action by the FDA before they can be marketed in the United States. After approval +or clearance by the FDA, we must continue to comply with other FDA requirements applicable to marketed products. Both before and after approval or clearance, failure to comply +15 +with the FDA’s requirements can lead to significant penalties or could disrupt our ability to manufacture and sell these products. In addition, the FDA could refuse permission to obtain +certificates needed to export our products if the agency determines that we are not in compliance. +Domestic Regulation +Most of our products are regulated in the United States as medical devices. +There are two mechanisms by which regulated medical devices can be placed on the market in the United States. Some products may qualify +for clearance under Section 510(k) of the Federal Food, Drug and Cosmetic Act. To obtain this clearance from the FDA, the manufacturer must provide a premarket notification that it intends to begin marketing the product, and show that the +product is substantially equivalent to another legally marketed product (i.e., that it has the same intended use and is as safe and effective as a legally marketed device and does not raise different questions of safety and effectiveness). In some +cases, the submission must include data from human clinical studies. Marketing may only commence when the FDA issues a clearance letter finding substantial equivalence. An applicant must submit a 510(k) application at least 90 days before marketing +of the affected product commences. Although FDA clearance may be granted within that 90-day period, in some cases as much as a year or more may be required before clearance is obtained, if at all. +If the medical device does not qualify for the 510(k) procedure (either because it is not substantially equivalent to a legally marketed +device or because it is required by statute and the FDA’s regulations to have an approved premarket application, or PMA), the FDA must approve a PMA before marketing can begin. PMAs must demonstrate, among other matters, that the medical device +provides a reasonable assurance of safety and effectiveness. A PMA is typically a complex submission, including the results of preclinical and clinical studies. Preparing a PMA is a detailed and time-consuming process. Once a PMA has been submitted, +the FDA is required to review the submission within 180 days. However, the FDA’s review may be, and often is, much longer, often requiring one year or more, and may include requests for additional data and facility inspections before approval +is granted, if at all. +Some of our products are used for non-medical purposes and many of our drugs-of-abuse products sold to +state crime laboratories are for forensic use. The FDA does not currently regulate products used for these purposes. +Every +company that manufactures medical devices distributed in the United States must comply with the FDA’s Quality System Regulations (“QSRs”). These regulations govern the manufacturing process, including design, manufacture, testing, +release, packaging, distribution, documentation and purchasing. In complying with the QSRs, manufacturers must continue to expend time, money and effort in the area of production and quality to ensure full technical compliance. Companies are also +subject to other post-market and general requirements, including restrictions imposed on marketed products, promotional standards and requirements for recordkeeping and reporting of certain adverse reactions. If there are any modifications made to +our marketed devices, a premarket notification or PMA may be required to be submitted to, and cleared or approved by, the FDA, before the modified device may be marketed. The FDA regularly inspects companies to determine compliance with the QSRs and +other post-market requirements. Failure to comply with statutory requirements and the FDA’s regulations can result in warning letters, monetary penalties, suspension or withdrawal of regulatory approvals, operating restrictions, total or +partial suspension of production, injunctions, product recalls, seizure of products and criminal prosecution. +The Clinical +Laboratory Improvements Amendments of 1988, or CLIA, prohibit any facility that does laboratory testing on specimens derived from humans from providing information for the diagnosis, prevention or treatment of any disease or impairment of, or the +assessment of, the health of human beings, unless there is in effect for such facility a certificate issued by the U.S. Department of Health and Human Services applicable to the category of examination or procedure performed. Tests may be waived +from this regulatory oversight if they +16 +meet certain requirements established under CLIA. We consider the applicability of the requirements of CLIA in the design and development of our products. We have obtained a waiver of the CLIA +requirements for both our OraQuick ADVANCE ® rapid HIV-1/2 antibody test and our Q.E.D. ® alcohol saliva test and may seek similar waivers for certain other products. A CLIA waiver allows certain customers +to use the waived products that may not have been able to use them without complying with applicable quality control and other requirements. +Certain of our products may also be affected by state regulations in the United States. We are presently working with legislators or regulators in certain of these states in an effort to modify or remove +any restrictions affecting our ability to sell products. +International +We are also subject to regulations in foreign countries governing products, human clinical trials and marketing, and may need to obtain +approval from international public health agencies, such as the World Health Organization, in order to sell products in certain countries. Approval processes vary from country to country, and the length of time required for approval or to obtain +other clearances may in some cases be longer than that required for U.S. governmental approvals. We generally pursue approval only in those countries that we believe have a significant market opportunity. +The International Organization for Standardization (“ISO”) is a worldwide federation of national standards bodies from some 130 +countries, established in 1947. The mission of the ISO is to promote the development of standardization and related activities in the world with a view to facilitating the international exchange of goods and services. ISO certification is a +pre-requisite to use of the CE mark and indicates that our quality system complies with standards applicable to activities ranging from initial product design and development through production and distribution. The CE mark is a European Union +(“EU”) requirement to sell products that fall under the scope of the Medical Devices Directive (“MDD”) and the In Vitro Diagnostic Directive (“IVDD”). The CE mark is evidence that the manufacturer and the product meet +the requirements of all applicable directives, including the MDD and IVDD. +We received authorization to +use the CE mark for the OraQuick ADVANCE ® HIV-1/2 test, the OraQuick ® HCV test, the OraSure ® and Intercept ® collection +devices, our Histofreezer ® product line, and our OTC cryosurgical removal product. +We must also comply with certain registration requirements as dictated by Health Canada, prior to commencing sales in Canada. We have +completed this process for several of our current products and may do so with respect to other products in the future. In addition, Canadian law requires manufacturers of medical devices to have a quality management system that meets various ISO +requirements in order to obtain a license to sell their devices in Canada. +Anti-Kickback and Other Fraud and Abuse Laws +The Federal Anti-Kickback Statute prohibits the knowing and willful offer, payment, solicitation, or receipt of any form +of remuneration in return for, or to induce: +• +The referral of a person; +• +The furnishing or arranging for the furnishing of items or services reimbursable under Medicare, Medicaid or other governmental programs; or +• +The purchase, lease, or order of, or the arrangement or recommendation of the purchasing, leasing, or ordering of any item or service reimbursable +under Medicare, Medicaid, or other governmental programs. +17 +Our products are or may be purchased by customers that will seek or receive reimbursement +under Medicare, Medicaid or other governmental programs. Noncompliance with the federal anti-kickback legislation can result in exclusion from Medicare, Medicaid or other governmental programs, and/or restrictions on our ability to operate in +certain jurisdictions, as well as civil and criminal penalties, any of which could have an adverse effect on our business and results of operations. +The Federal Civil Monetary Penalties Law prohibits the offering or transferring of remuneration to a Medicare or Medicaid beneficiary that the person knows or should know is likely to influence the +beneficiary’s selection of a particular supplier of Medicare or Medicaid payable items or services. Noncompliance can result in civil monetary penalties for each wrongful act, assessment of three times the amount claimed for each item or +service and exclusion from the Federal healthcare programs. +Many states have also adopted some form of anti-kickback laws. A +determination of liability under such laws could result in fines and penalties and restrictions on our ability to operate in these jurisdictions. +We are also subject to other federal and state laws targeting fraud and abuse in the healthcare industry, including false claims laws and marketing conduct laws and laws constraining the sales, marketing +and other promotional activities of manufacturers of medical devices by limiting the kinds of financial arrangements, including sales programs, with physicians, hospitals, laboratories and other potential purchasers of medical devices. Violations of +these laws may be punishable by criminal or civil sanctions, including substantial fines, imprisonment and exclusion from participation in government healthcare programs such as Medicare and Medicaid. These laws and regulations are wide ranging and +subject to changing interpretation and application. In recent years, there has been greater scrutiny of marketing practices in the medical device industry which has resulted in several government investigations by various government authorities and +the introduction and/or passage of federal and state legislation regulating interactions between medical device manufacturers and healthcare professionals and providers and requiring the disclosure by medical device manufacturers of gifts or other +payments to healthcare professionals and providers. To be in compliance with such disclosure laws, we have implemented necessary systems for accurately tracking gifts and other payments. +We have implemented a written Policy on Interactions with Health Care Professionals, which is based on the Code of Conduct for +Interactions with Health Care Professionals promulgated by the Advanced Medical Technology Association, or AdvaMed, a leading trade association representing medical device manufacturers. The Policy applies to all employees and is intended to comply +with applicable state and federal laws, regulations and government guidance. The Policy addresses interactions related to sales and marketing practices, research and development, product training and education, grants and charitable contributions, +support of third-party educational conferences, and consulting arrangements. +Foreign Corrupt Practices Act +The U.S. Foreign Corrupt Practices Act (“FCPA”) prohibits corporations and individuals from engaging in certain activities to +obtain or retain business or to influence a person working in an official capacity. It is illegal to pay, offer to pay or authorize the payment of anything of value to any foreign government official, government staff member, political party or +political candidate in an attempt to obtain or retain business or to otherwise influence a person working in an official capacity. Our present and future business has and will continue to be subject to the FCPA and various other laws, rules and/or +regulations applicable to us as a result of our international sales. +Environmental Regulation +Because of the nature of our current and proposed research, development, and manufacturing processes, we are subject to stringent federal, +state and local laws, rules, regulations and policies governing the use, generation, manufacture, storage, air emission, effluent discharge and handling and disposal of materials and wastes. +18 +The foregoing discussion of our business should be read in conjunction with the Financial +Statements and accompanying notes included in Item 15 of this Annual Report. \ No newline at end of file diff --git a/raw/filings/0001116463/2010/0001193125-11-062311/item13.txt b/raw/filings/0001116463/2010/0001193125-11-062311/item13.txt new file mode 100644 index 0000000000000000000000000000000000000000..1d9d765f602391bad11824e4d821d50ba62ab2e6 --- /dev/null +++ b/raw/filings/0001116463/2010/0001193125-11-062311/item13.txt @@ -0,0 +1,4 @@ +ITEM 13. +Certain Relationships and Related Transactions, and Director Independence. +The information required by this Item is incorporated by reference to the information under the captions, “Transactions with Related Persons” and “Corporate Governance—Director +Independence,” in the Proxy Statement. \ No newline at end of file diff --git a/raw/filings/0001116463/2010/0001193125-11-062311/item9a.txt b/raw/filings/0001116463/2010/0001193125-11-062311/item9a.txt new file mode 100644 index 0000000000000000000000000000000000000000..884829136acbd79a62ffc7abac407f3b0405962a --- /dev/null +++ b/raw/filings/0001116463/2010/0001193125-11-062311/item9a.txt @@ -0,0 +1,52 @@ +ITEM 9A. +Controls and Procedures. +(a) Evaluation of Disclosure Controls and Procedures. +The Company’s management, with the participation of the Company’s Chief Executive Officer and Chief Financial Officer, has evaluated the effectiveness of the Company’s disclosure controls +and procedures (as defined in Rules 13a-15(e) and 15d-15(e) of the Securities Exchange Act of 1934) as of December 31, 2010. Based on that evaluation, the Company’s management, including such officers, concluded that as of +December 31, 2010 the Company’s disclosure controls and procedures were adequate and effective to ensure that information required to be disclosed by the Company in the reports that we file or submit under the Securities Exchange Act of +1934 is accumulated and communicated to the Company’s management, including the Chief Executive Officer and Chief Financial Officer, to allow timely decisions regarding required disclosure and is recorded, processed, summarized, and reported +within the time periods specified in the rules and forms of the Securities and Exchange Commission. +(b) Management’s +Report on Internal Control Over Financial Reporting. +The Company’s management is responsible for establishing and +maintaining adequate internal control over financial reporting, as such term is defined in Rule 13a-15(f) and 15d-15(f) under the Securities Exchange Act of 1934. Under the supervision and with the participation of the Company’s management, +including our principal executive officer and principal financial officer, we conducted an evaluation of the effectiveness of our internal control over financial reporting based on the framework in Internal Control—Integrated Framework +issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on our evaluation under the framework, our management concluded that our internal control over financial reporting was effective to provide reasonable +assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles as of December 31, 2010. +60 +The effectiveness of our internal control over financial reporting as of December 31, +2010 has been audited by KPMG LLP, an independent registered public accounting firm, as stated in their report, which is included below. +Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject +to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. +(c) Changes in Internal Control Over Financial Reporting. +There was no +change in the Company’s internal control over financial reporting during the three months ended December 31, 2010 that was identified in connection with the evaluation referred to in paragraph (b) above that has materially affected, +or is reasonably likely to materially affect, the Company’s internal control over financial reporting. +(d) Report of +Independent Registered Public Accounting Firm +The Board of Directors and Stockholders +OraSure Technologies, Inc.: +We +have audited OraSure Technologies, Inc.’s internal control over financial reporting as of December 31, 2010, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring +Organizations of the Treadway Commission (COSO). OraSure Technologies, Inc.’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over +financial reporting, included in the accompanying Management’s Report on Internal Control Over Financial Reporting. Our responsibility is to express an opinion on the Company’s internal control over financial reporting based on our audit. +We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). +Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of +internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audit also included performing such +other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion. +A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial +statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, +in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in +accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance +regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements. +Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections +of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. +61 +In our opinion, OraSure Technologies, Inc. maintained, in all material respects, effective +internal control over financial reporting as of December 31, 2010, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). +We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the +balance sheets of OraSure Technologies, Inc. as of December 31, 2010 and 2009, and the related statements of operations, stockholders’ equity and comprehensive loss, and cash flows for each of the years in the three-year period ended +December 31, 2010, and our report dated March 10, 2011 expressed an unqualified opinion on those financial statements. +/s/ KPMG LLP +Philadelphia, Pennsylvania +March 10, 2011 \ No newline at end of file diff --git a/raw/filings/0001116463/2010/0001193125-11-062311/rp_note.txt b/raw/filings/0001116463/2010/0001193125-11-062311/rp_note.txt new file mode 100644 index 0000000000000000000000000000000000000000..e69de29bb2d1d6434b8b29ae775ad8c2e48c5391 diff --git a/raw/filings/0001116463/2010/0001193125-11-062311/rpt_disclosure.txt b/raw/filings/0001116463/2010/0001193125-11-062311/rpt_disclosure.txt new file mode 100644 index 0000000000000000000000000000000000000000..09e17151b6fc3a210735249bc3ab85eafd559dbb --- /dev/null +++ b/raw/filings/0001116463/2010/0001193125-11-062311/rpt_disclosure.txt @@ -0,0 +1,7 @@ +Transactions With Related Persons +Since January 1, 2010, there have been no transactions with related persons +which would require disclosure in this Proxy Statement. The Audit Committee is required to review and approve in advance all transactions with related persons involving the Company. The Audit Committee may approve a related party transaction if the +transaction is on terms comparable to those that could be obtained in arms’ length dealings with an unrelated third party. The Audit Committee also reviews any public disclosures of a related party transaction contained in our SEC filings. +These responsibilities are described in the Audit Committee’s charter, a copy of which is available on our website at www.orasure.com . +Information regarding employment and severance agreements between our executive officers and the Company is set forth in the Section entitled, “Employment Agreements and Potential Payments Upon +Termination or Change in Control,” in this Proxy Statement. \ No newline at end of file diff --git a/raw/filings/0001116463/2011/0001193125-12-114853/filing.txt b/raw/filings/0001116463/2011/0001193125-12-114853/filing.txt new file mode 100644 index 0000000000000000000000000000000000000000..4688473769ddbeb5207502315f091e50ed9eaeed --- /dev/null +++ b/raw/filings/0001116463/2011/0001193125-12-114853/filing.txt @@ -0,0 +1,5356 @@ +10-K +1 +d279006d10k.htm +FORM 10-K +Form 10-K +Table of Contents +UNITED STATES +SECURITIES AND EXCHANGE COMMISSION +Washington, D.C. 20549 +FORM 10-K +ANNUAL REPORT PURSUANT +TO SECTION 13 OR 15(d) OF THE +SECURITIES EXCHANGE ACT OF 1934 +(Mark One) +x +ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 +For the fiscal year ended December 31, 2011 +OR +¨ +TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 +For the transition period from +to +Commission File No. 001-16537 +ORASURE TECHNOLOGIES, INC. +(Exact Name of Registrant as Specified in Its Charter) +Delaware +36-4370966 +(State or Other Jurisdiction of +Incorporation or Organization) +(I.R.S. Employer Identification No.) +220 East First Street +Bethlehem, Pennsylvania +18015 +(Address of Principal Executive Offices) +(Zip Code) +(610) 882-1820 +(Registrant’s Telephone Number, Including Area Code) +Securities +registered pursuant to Section 12(b) of the Act: +Title of Each Class +Name of Each Exchange on Which Registered +Common Stock $0.000001 par value per share +The NASDAQ Stock Market LLC +Securities registered pursuant to Section 12(g) of the Act: None +Indicate by check mark if the Registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes ¨ No x +Indicate by check mark if the Registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Exchange +Act. Yes ¨ No x +Indicate by check mark whether the Registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for +such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No ¨ +Indicate by check mark whether the Registrant has submitted electronically and +posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405) during the preceding 12 months (or for such shorter period that the Registrant was +required to submit and post such files). Yes x No ¨ +Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of Registrant’s knowledge, in +definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. x +Indicate by check mark whether the Registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller +reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. +Large accelerated filer ¨ +Accelerated filer x +Non-accelerated filer ¨ +Smaller reporting company ¨ +(Do not check if a smaller reporting company) +Indicate by check mark whether the Registrant is a shell company (as defined in Rule 12b-2 of the Exchange +Act). Yes ¨ No x +State the aggregate market value of the voting and non-voting common equity held by nonaffiliates, computed by reference to the price at which the common equity was last sold, or the average bid and asked +price of such common equity, as of the last business day of the Registrant’s most recently completed second fiscal quarter (June 30, 2011): $391,263,048 +Indicate the number of shares outstanding of each of the Registrant’s classes of common stock, as of March 7, 2012: 48,175,889 shares. +Documents Incorporated by Reference: +Portions of the Registrant’s Definitive Proxy Statement for the 2012 Annual Meeting of Stockholders are incorporated by reference into Part III of this Annual Report. +Table of Contents +Table of Contents +Page +PART I +ITEM 1. +Business +1 +ITEM 1A. +Risk Factors +21 +ITEM 1B. +Unresolved Staff Comments +43 +ITEM 2. +Properties +43 +ITEM 3. +Legal Proceedings +43 +ITEM 4. +Mine Safety Disclosures +44 +PART II +ITEM 5. +Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities +45 +ITEM 6. +Selected Consolidated Financial Data +47 +ITEM 7. +Management’s Discussion and Analysis of Financial Condition and Results of +Operations +48 +ITEM 7A. +Quantitative and Qualitative Disclosures About Market Risk +65 +ITEM 8. +Consolidated Financial Statements and Supplementary Data +66 +ITEM 9. +Changes in and Disagreements with Accountants on Accounting and Financial +Disclosure +66 +ITEM 9A. +Controls and Procedures +66 +ITEM 9B. +Other Information +68 +PART III +ITEM 10. +Directors, Executive Officers and Corporate Governance +69 +ITEM 11. +Executive Compensation +69 +ITEM 12. +Security Ownership of Certain Beneficial Owners and Management and Related Stockholder +Matters +69 +ITEM 13. +Certain Relationships and Related Transactions, and Director Independence +69 +ITEM 14. +Principal Accountant Fees and Services +69 +PART IV +ITEM 15. +Exhibits and Consolidated Financial Statement Schedules +70 +Table of Contents +This Report contains certain “forward-looking statements,” within the meaning +of the Federal securities laws. These may include statements about our expected revenues, earnings, expenses or other financial performance, future product performance or development, expected regulatory filings and approvals, planned business +transactions, expected manufacturing performance, views of future industry, competitive or market conditions, and other factors that could affect our future operations, results of operations or financial position. These statements often include +words, such as “believes,” “expects,” “anticipates,” “intends,” “plans,” “estimates,” “may,” “will,” “should,” “could,” or similar expressions. +Forward-looking statements are not guarantees of future performance or results. Known and unknown factors could cause +actual performance or results to be materially different from those expressed or implied in these statements. Factors that could affect our results are discussed more fully under Item 1A., entitled “Risk Factors,” and elsewhere in +this Annual Report. Although forward-looking statements help to provide complete information about us, readers should keep in mind that forward-looking statements may not be reliable. Readers are cautioned not to place undue reliance on the +forward-looking statements. The forward-looking statements are made as of the date of this Annual Report and we undertake no duty to update these statements. +References in this Annual Report to “OraSure” mean OraSure Technologies, Inc. References in this Annual Report to “we,” “us,” “our,” or the “Company” +mean OraSure and its consolidated subsidiaries, unless otherwise indicated. +PART I +ITEM 1. +Business. +Our business +principally involves the development, manufacture, marketing and sale of oral fluid diagnostic products and specimen collection devices using our proprietary oral fluid technologies, as well as other diagnostic products including immunoassays and +other in vitro diagnostic tests that are used on other specimen types. We also manufacture and sell medical devices used for the removal of benign skin lesions by cryosurgery or freezing. Our diagnostic products include tests that are +performed on a rapid basis at the point of care and tests that are processed in a laboratory. These products are sold in the United States and internationally to various clinical laboratories, hospitals, clinics, community-based organizations and +other public health organizations, distributors, government agencies, physicians’ offices, and commercial and industrial entities. One of our products has been sold in the over-the-counter (“OTC”) or consumer retail markets in North +America, Europe, Central and South America, and Australia. +In vitro diagnostic testing is the process of analyzing +oral fluid, blood, urine and other bodily fluids or tissue for the presence of specific substances or markers. We have targeted the use of oral fluid in our products as a differentiating factor and believe that it provides a significant competitive +advantage over blood and urine. Our oral fluid tests have sensitivity and specificity comparable to blood and/or urine tests. When combined with their ease of use, non-invasive nature, and cost effectiveness, our oral fluid tests represent a very +competitive alternative to the more traditional testing methods in the diagnostic space. +In August 2011, +we completed the acquisition of DNA Genotek Inc. (“DNAG”), a company based in Ottawa, Canada. DNAG manufactures and sells oral fluid collection kits that are used to collect samples of genetic material (DNA and RNA) for molecular testing +in the academic research, clinical, pharmacogenomics, personalized medicine, animal and livestock genetics markets. DNAG’s lead product, the Oragene ® sample collection kit, provides an all-in-one system for the collection, stabilization, transportation and storage of DNA from saliva. DNAG serves customers in many +countries worldwide, including many leading research universities and hospitals in the world. +1 +Table of Contents +OraSure was formed in May 2000 under Delaware law solely for the purposes of combining two +companies, STC Technologies, Inc. (“STC Technologies”) and Epitope, Inc. (“Epitope”), and changing the state of incorporation of Epitope from Oregon to Delaware. STC Technologies and Epitope were merged into OraSure on +September 29, 2000. Our principal offices are located at 220 East First Street, Bethlehem, Pennsylvania 18015, and our telephone number is (610) 882-1820. +Additional information about us can be found on our website. Our website address is www.orasure.com . We make available free of charge through a link provided at such website our Annual Reports on +Form 10-K, our Quarterly Reports on Form 10-Q, our Current Reports on Form 8-K and our other filings with the Securities and Exchange Commission (“SEC”), as well as any amendments to those Reports and filings. These Reports and filings are +made available as soon as reasonably practicable after they are filed or furnished to the SEC. Our Internet website and the information contained in or connected to that website are not intended to be incorporated by reference into this Annual +Report. +Products +The following is a summary of our principal products and their regulatory and commercial status: +Product +Description +Regulatory Status +Commercial Status +OraQuick +ADVANCE ® HIV-1/2 +A rapid, point-of-care +qualitative test for antibodies to the Human Immunodeficiency Virus Type 1 (“HIV-1”) and Type 2 (“HIV-2” and together with HIV-1, +“HIV-1/2”) that can be visually read in approximately 20 minutes. +Premarket approval (“PMA”) by the U.S. Food and Drug Administration (“FDA”) for use with oral fluid, finger-stick +and venous whole blood, and plasma. +CLIA (Clinical Laboratory Improvement +Amendments of 1988) waived for use with oral fluid, finger-stick and venous whole blood. +CE mark (European Union) approved for use with oral fluid, finger-stick and venous whole blood, serum and plasma. Also registered in various other countries. +Marketed +Marketed +Marketed +OraQuick ® HIV-1/2 OTC +A rapid, point-of-care qualitative oral fluid HIV-1/2 test intended to be sold in various OTC markets. +PMA application for OTC use is pending with FDA. +Not Marketed +OraQuick ® HCV +A rapid, point-of-care qualitative test for antibodies to the hepatitis C virus (“HCV”) that can be visually read in approximately 20 minutes. +PMA approved and CLIA waived for use with venous whole blood and finger-stick whole blood specimens. +Clinical program for oral fluid claim remains pending. +CE mark (European Union) approved for use with oral fluid, finger-stick and venous +whole blood, serum and plasma. Also registered in various other countries. +Marketed +Not Marketed +Marketed +2 +Table of Contents +Product +Description +Regulatory Status +Commercial Status +OraSure QuickFlu™ +Rapid +Flu +A&B Test +A rapid, point-of-care qualitative test for antibodies to influenza (flu) Types A and B, including H1N1 infections, with results available in 10 minutes. +FDA 510(k) cleared for use with nasal swab, nasopharyngeal swab and nasal aspirate/wash. +Marketed +OraSure ® +Oral fluid collection device for the detection of antibodies to HIV-1 and for detection of cocaine and cotinine in an oral fluid sample in a laboratory setting. +PMA approved by FDA for use in detecting antibodies to HIV-1. +FDA 510(k) cleared for use in detecting cocaine and cotinine (an indicator of +nicotine) in oral fluid. +CE marked and registered in various +countries. +Marketed +Marketed +Marketed +Intercept ® +Oral fluid collection device for oral fluid drugs of abuse (“DOA”) testing in a laboratory setting. +FDA 510(k) cleared for use with MICRO-PLATE DOA assays. +CE marked and registered in certain countries. +Marketed +Marketed +MICRO-PLATE DOA Assays +Used to detect the following drugs in an oral fluid sample collected with Intercept ® device: tetrahydrocannabinol (“THC” or marijuana), cocaine, opiates, amphetamines, methamphetamines, phencyclidine (“PCP”), benzodiazepines, +barbiturates and methadone. +Nine drug assays—FDA 510(k) cleared. +Assays CE marked and registered in certain countries. +Marketed +Marketed +Homogeneous DOA Assays +Homogeneous fully-automated oral fluid DOA assays jointly developed with Roche Diagnostics for use on oral fluid samples collected with Intercept ® device. +FDA 510(k) cleared for use of PCP, opiates, cocaine, methamphetamines and amphetamines assays with Intercept ® collection device. Clinical studies for marijuana and barbiturates underway. +Marketed +Cryosurgical Systems—Professional +Cryosurgical (freezing) system for the removal of warts and other benign skin lesions, marketed under the Histofreezer ® tradename primarily to the physicians’ office market. +Nine indications—FDA 510(k) cleared. +CE marked and registered in certain countries. +Marketed +Marketed +Cryosurgical Systems—OTC +Cryosurgical system for the removal of common and plantar warts, sold in various OTC markets. +FDA 510(k) cleared for common and plantar warts. +Registered in Canada for warts and skin tags. +CE marked and registered for warts in certain countries under Scholl Freeze Spray ® and POINTTS ® +names. +CE marked for skin tags. +Marketed +Marketed +Marketed +Not +Marketed +3 +Table of Contents +Product +Description +Regulatory Status +Commercial Status +Oragene ® ·DX +Non-invasive all-in-one system for the collection, stabilization, transportation and storage of human DNA from saliva. +FDA 510(k) cleared for in vitro diagnostic use with FDA-cleared molecular tests. +Marketed +Oragene ® ·DNA +Non-invasive all-in-one system for the collection, stabilization, transportation, and storage of human DNA from saliva. +CE mark and registered as Class 1 Medical Device in Canada. +Registered in various other countries. +Marketed +Oragene ® ·DISCOVER +Non-invasive all-in-one system for the collection, stabilization, transportation, and storage of human DNA from saliva. +Research use only product. +Marketed +Oragene ® ·RNA +Non-invasive all-in-one system for the collection, stabilization and transportation of RNA from human saliva. +Research use only product. +Marketed +ORAcollect™ +All-in-one system for the collection, stabilization, transportation, and storage of human DNA from saliva. +CE marked and registered as Class 1 Medical Device in the U.S. and Canada. +Registered in various other countries. +Marketed +OMNIgene™·DISCOVER +Non-invasive all-in-one system for the collection, stabilization, transportation, and storage of microbial DNA from saliva. +Research use only product. +Marketed +Performagene™· +LIVESTOCK and +Oragene ® ·ANIMAL +All-in-one systems for the collection, stabilization, transportation, and storage of livestock DNA from nasal samples. +Animal research use only +Marketed +In addition to the above products, we also sell certain immunoassay tests and +reagents for insurance risk assessment, substance abuse testing and forensic toxicology applications; an oral fluid Western blot HIV-1 confirmatory test for confirming positive HIV-1 test results obtained from the use of our OraSure ® collection device; and the FDA 510(k) cleared Q.E.D. ® rapid point-of-care saliva alcohol test. +OraQuick ® Rapid HIV Test +OraQuick ® is our rapid point-of-care test platform designed to test oral fluid, whole blood (i.e., both finger-stick and venous), plasma and serum samples for the presence of +various antibodies or analytes. The device uses a porous flat pad to collect an oral fluid specimen. After collection, the pad is inserted into a vial containing a pre-measured amount of developer solution and allowed to develop. When blood, plasma +or serum is to be tested, a loop collection device is used to collect a drop of the specimen and mix it in the developer solution, after which the collection pad is inserted into the solution and allowed to develop. In all cases, the specimen and +developer solution then flow through the testing device where test results are observable in approximately 20 minutes. The +OraQuick ® device is a screening test and generally requires a confirmation test where an initial positive result +is obtained. +4 +Table of Contents +This product is sold under the OraQuick ADVANCE ® name in North America, Europe and certain other countries and under the OraQuick ® name in other developing countries. The test has received PMA approval from the FDA for the detection of antibodies +to both HIV-1 and HIV-2 in oral fluid, finger-stick whole blood, venous whole blood and plasma. This test is available for use by laboratories located in the United States certified under the Clinical Laboratory Improvements Amendment of 1988, or +CLIA, to perform moderately complex tests. We have also received a CLIA waiver for use of the test with oral fluid and finger-stick and venous whole blood. As a result, the test can be used by numerous additional sites in the United States not +certified under CLIA to perform moderately complex tests, such as outreach clinics, community-based organizations and physicians’ offices. +On the international front, we have obtained a CE mark for our OraQuick +ADVANCE ® test so that we can sell this product in Europe and other countries accepting the CE mark for +commercialization and this product is registered in other countries. We have distributors in place for several countries and are seeking to increase awareness and expand our distribution network for this product throughout the world. +We believe that the OraQuick ADVANCE ® device, because it is approved for detecting antibodies to both HIV-1 and HIV-2 in finger-stick and venous whole blood, oral fluid and plasma samples, provides a +significant competitive advantage in the market for rapid HIV testing in the United States and elsewhere. +OraQuick ® HCV Rapid Antibody Test +Another test available on the OraQuick ® platform is the OraQuick ® HCV rapid antibody test. Like the OraQuick ® HIV test, this product is a qualitative test that can detect antibodies to the Hepatitis C virus, or HCV, in a variety of sample types. The OraQuick ® HCV test operates in substantially the same manner as the +OraQuick ® HIV test. +We have received FDA approval for use of the test in detecting HCV antibodies in venous whole blood and finger-stick +whole blood specimens, making it the first rapid HCV test approved by the FDA for use in the United States. In November 2011, we also received a CLIA waiver for use of this product in the same specimen types. Our clinical program for approval of an +oral fluid claim for this product is on hold pending further discussions with the FDA. The OraQuick ® HCV test +has received a CE mark for use with oral fluid, venous whole blood, finger-stick whole blood, plasma and serum and is sold in Europe and other foreign countries. +OraSure QuickFlu™ Rapid Flu A&B Test +The OraSure QuickFlu™ +rapid flu A&B test is an FDA 510(k) cleared rapid qualitative test for the detection of influenza (flu) Types A and B, including H1N1 viral infections. The test utilizes specimen collected with a nasal swab, nasopharyngeal swab or nasal +aspirate/wash. A reagent is first inserted into a test cartridge, the specimen is added and the test is allowed to flow. Results are available in as little as ten minutes. +The OraSure QuickFlu™ test is intended to be used as an aid in the rapid differential diagnosis of influenza and covers a broad range of influenza subtypes, including 2009 H1N1, with proven clinical +detection spanning three flu seasons from 2007 through 2009. The test is highly accurate across all specimen types based on standard culture confirmation with demonstrated sensitivity for influenza Type A at 90% or greater. Additionally, in clinical +studies a significant number of culture negative samples that were tested positive with the OraSure QuickFlu™ product were determined to be true positives by PCR (polymerase chain reaction) testing. +This product is manufactured for us under an agreement with Princeton BioMeditech Corporation. The OraSure QuickFlu™ test is +currently available for sale in certain U.S. markets. +5 +Table of Contents +OraSure ® Collection Device +Our OraSure ® oral fluid collection device is used in conjunction with screening and confirmatory tests for HIV-1 antibodies and other analytes. This device consists of a small, +treated cotton-fiber pad on a handle that is placed in a person’s mouth for two to five minutes. The device collects oral mucosal transudate (“OMT”), a serum-derived fluid that contains higher concentrations of certain antibodies and +analytes than saliva. As a result, OMT testing is a highly accurate method for detecting HIV-1 infection and other analytes. +The OraSure ® collection device is FDA approved for use in the +detection of HIV-1 antibodies and 510(k) cleared for the detection of cocaine and cotinine in oral fluid specimens. In addition, we have received a CE mark for the OraSure ® device and our cocaine and cotinine assays, all of which are sold through distributors in Canada, the United Kingdom, Mexico and certain other foreign countries. +HIV-1 antibody detection using the OraSure ® collection device involves three steps: +• +Collection of an oral fluid specimen using the OraSure ® device; +• +Screening of the specimen for HIV-1 antibodies at a laboratory with an enzyme immunoassay (“EIA”) screening test approved by the FDA for use +with the OraSure ® device; and +• +Laboratory confirmation of any positive screening test results with our oral fluid Western blot HIV-1 confirmatory test (described below). +A trained health care professional then conveys test results and provides appropriate counseling to the +individual who was tested. +We believe that oral fluid testing has several significant advantages over blood or urine-based +systems for infectious disease testing, for both health care professionals and the individuals being tested. These advantages include eliminating the risk of needle-stick accidents, providing a non-invasive collection technique, requiring minimal +training to administer, providing rapid and efficient collection in almost any setting, and reducing the cost of administration by a trained health care professional. +Intercept ® Drug Testing System +A collection device that is substantially similar to the OraSure ® device is sold by us under the name +Intercept ® , and is used to collect OMT for oral fluid drug testing. We have received FDA 510(k) clearance to use +the Intercept ® collection device with laboratory-based EIAs to test for drugs of abuse commonly identified by +the National Institute for Drug Abuse (“NIDA”) as the NIDA-5 (i.e., tetrahydrocannabinol (“THC” or marijuana), cocaine, opiates, amphetamines/methamphetamines and phencyclidine (“PCP”)), and for barbiturates, methadone +and benzodiazepines. Each of these EIAs is also FDA 510(k) cleared for use with the Intercept ® device. Our +Intercept ® device and oral fluid assays are sold in the U.S. primarily through laboratory distributors. +We have received a CE mark for the Intercept ® device and our oral fluid assays and distribute these products in Canada, the United Kingdom and Mexico. +We believe that the Intercept ® device has several advantages over competing urine and other drugs-of-abuse testing products, including its lower total testing cost, its non-invasive nature, +mobility and accuracy, the ease of maintaining a chain-of-custody, the treatment of test subjects with greater dignity, no requirement for specially-prepared collection facilities and difficulty of sample adulteration. The availability of an oral +fluid test is intended to allow our customers to test for drug impairment and eliminate scheduling costs and inconvenience, thereby streamlining the testing process. +In an effort to expand our Intercept ® product line and meet the needs of our laboratory customers, we have jointly developed with Roche Diagnostics a series of homogeneous fully-automated oral fluid drugs +of abuse +6 +Table of Contents +assays. These assays use Roche’s KIMs (kinetic interaction of micro-particles in solution) technology and will run on various automated analyzers to allow oral fluid samples to be processed +with the same efficiency currently achieved by our laboratory customers with urine-based drug tests. FDA 510(k) clearance has been received for assays to detect PCP, opiates, cocaine, methamphetamines and amphetamines. Clinical studies for THC and +barbiturate assays are in process. +The high-throughput assays will be distributed in the U.S. and internationally by OraSure +and Roche pursuant to a commercialization agreement between the parties. Sales of the assays in the U.S. are expected to begin in 2012. +Cryosurgical Systems (Skin Lesion Removal Products) +The Histofreezer ® cryosurgical removal system is a low-cost alternative to liquid nitrogen and other methods for removal of warts and other benign skin lesions by physicians. The +Histofreezer ® product mixes three cryogenic gases in a small aerosol canister. When released, these gases are +delivered to a specially designed foam bud, cooling the bud to a maximum of –50°C to –55°C. The frozen bud is then applied to the wart or lesion for 15 to 40 seconds (depending on the type of lesion) creating localized destruction +of the target area by freezing. We have received 510(k) clearance for use of the Histofreezer ® product to remove +common warts and eight other types of benign skin lesions, and this product has been CE marked and registered for distribution in Canada, throughout Europe and in certain other foreign countries. +Internationally, we sell an OTC cryosurgical product through our distributor Genomma Labs, under the POINTTS tradename, in Mexico and a +number of South and Central American countries. We also sell a CE marked cryosurgical wart removal product into the OTC footcare market in Europe, Australia and New Zealand through our distributor, Reckitt Benckiser (“Reckitt”), under the +Scholl and Dr. Scholl trademarks. Reckitt is the owner of the Scholl and Dr. Scholl trademarks in countries outside North and South America. In 2011, we began selling OTC cryosurgical products for the treatment of both warts and skin tags +to retailers in Canada on a private label basis. +Molecular Collection Systems +Our wholly-owned subsidiary, DNAG, sells a number of products that provide all-in-one systems for the collection, +stabilization, transportation, and storage of DNA and/or RNA from human and animal biologic samples. DNAG’s lead product is sold under the Oragene ® name and is used to collect DNA from human saliva. DNAG products are currently sold to thousands of academic and research customers in many countries worldwide. +DNAG products are available in several different configurations and contain proprietary chemical +solutions that are optimized for the specific application each product is designed for. Product physical design is focused on providing easy-to-use and reliable products for self or assisted collection of samples. For example, several of the Oragene ® products require users to simply hold the product close to their mouth and spit into the collection device. When the +container is closed the reagents stored in the lid of the container are mixed with the captured saliva and immediately protect the nucleic acids in the sample. This non-invasive collection method yields nucleic acid that remains stable at ambient +temperature for extended periods. The stabilizing technology results in high quality and high quantity nucleic acids that are required for most genetic testing and analysis methods. +We believe these products provide significant advantages over competing DNA and RNA collection methods such as blood collection or buccal +swabs, particularly in human genetic applications. Benefits include the reliable collection of high quality genetic samples, use of simple non-invasive collection methods, the ability to store and transport collected samples for extended periods at +ambient temperatures and compatibility with fully-automated laboratory testing systems. +7 +Table of Contents +DNAG products historically have been sold primarily as Class I medical +devices for use by research and academic institutions. In late 2011, DNAG received FDA 510(k) clearance for the +Oragene ® — Dx product and began marketing this product to +clinical diagnostics and personalized medicine customers in the U.S. in the first quarter of 2012. This clearance will enable the Oragene ® — Dx product to be used with other FDA-cleared molecular diagnostic applications. +Immunoassay Tests and Reagents +We develop and sell immunoassay tests in two formats, known as MICRO-PLATE and AUTO-LYTE ® , to meet the specific needs of our customers. +In a MICRO-PLATE kit, the sample to be tested is placed into a small plastic receptacle, called a microwell, along with the reagents. The result of the test is determined by the color of the microwell +upon completion of the reaction. Controlling the reaction involves the use of reagents by laboratory personnel. Test results are analyzed by any of a variety of commercially available laboratory instruments, which we may also provide to our +laboratory customers. MICRO-PLATE tests can be performed on commonly used instruments and can detect drugs in urine, serum and sweat specimens. MICRO-PLATE tests are also used as part of the +Intercept ® product line to detect drugs of abuse in oral fluid specimens. +AUTO-LYTE ® tests are sold in the form of bottles of liquid reagents. These reagents are run on commercially available laboratory-based automated analytical instruments, which +are manufactured by a variety of third parties. AUTO-LYTE ® is typically used in high volume, automated, +commercial reference insurance laboratories to detect certain drugs or chemicals in urine. Test results are produced quickly, allowing for high throughput. Our AUTO-LYTE ® tests continue to face strong competition from cheaper “home-brew” tests developed internally by our laboratory customers. As a result, we may eventually +stop selling our AUTO-LYTE ® tests. +Western blot HIV-1 Confirmatory Test +We sell an oral +fluid Western blot HIV-1 confirmatory test that received premarket approval from the FDA in 1996. This test uses the original specimen collected with the OraSure ® oral fluid collection device to confirm positive results of initial oral fluid HIV-1 EIA screening tests. +Q.E.D. ® Saliva Alcohol Test +Our Q.E.D. ® saliva alcohol test is a point-of-care test device that is a cost-effective alternative to breath or blood alcohol testing. The test is a quantitative, saliva-based +method for the detection of ethanol, has been cleared for sale by the FDA and has received a CLIA waiver. The U.S. Department of Transportation (“DOT”) has also approved the test. +Each Q.E.D. ® test kit contains a collection stick that is used to collect a sample of saliva and a disposable detection device that displays results in a format similar to a +thermometer. The Q.E.D. ® device is easy to operate and instrumentation is not required to read the result. The +product has a testing range of 0 to 0.145% blood alcohol and produces results in approximately two minutes. +Products Under Development +OraQuick ® Platform +We believe +that OraQuick ® has significant potential as a point-of-care testing platform for clinics and other public health +entities, hospitals, physicians’ offices and other markets. Because the OraQuick ® platform is simple to use +and can operate in a non-invasive manner with oral fluid, we believe it will be suitable for use by +8 +Table of Contents +consumers without the assistance of a doctor or other medical professional. We also believe that OraQuick ® provides a platform technology that can be modified for detection of a variety of infectious diseases in addition to HIV, such as viral hepatitis and certain sexually +transmitted diseases. +We are currently devoting significant resources to obtaining FDA approval to sell +our OraQuick ® HIV-1/2 test in the United States OTC market. We have developed an information and referral system +and product packaging and labeling suitable for the OTC market. In 2011, we completed the final phase of clinical testing for this product and submitted the final of three modules to our pre-market approval, or PMA, application to the FDA. +Several other new products based on the OraQuick ® technology platform are in varying stages of development. A second generation rapid HIV-1/2 antibody test, which we believe will provide improved performance compared +to our current product, is being developed and the feasibility of several assays for certain other infectious diseases is being evaluated. +OraSure ® /Intercept ® Applications +Oral mucosal transudate, or OMT, contains many constituents found in blood and serum, although in lower concentrations. We believe the OraSure ® and Intercept ® devices are a +platform technology with a wide variety of potential applications, where laboratory testing is available. For example, the +OraSure ® device may be useful for the collection of a variety of antibodies or markers for infectious diseases +or conditions in addition to HIV-1, such as antibodies to viral hepatitis. +Since January 2011, the Drug +Testing Advisory Board (“DTAB”) has been evaluating oral fluid as a potential alternative specimen to be permitted under the Mandatory Guidelines for Federal Workplace Drug Testing Programs (the “Guidelines”). The Guidelines +govern workplace drug testing of federally-regulated workers. Based on its evaluation, DTAB has recommended that oral fluid be included as an alternative specimen in the Guidelines, and the Substance Abuse and Mental Health Services Administration +has approved this recommendation. If and when issued in final form, these regulations will likely require certain modifications to our Intercept ® product in order to permit its use by federal workers. As a result, we are developing modifications to the +Intercept ® collection device that we anticipate will be required by these regulations or otherwise desired by +our customers. This new version of our Intercept ® device is also expected eventually to be used with the +high-throughput drug assays jointly developed with Roche Diagnostics. +Molecular Collection Systems +Molecular testing in both the research and clinical diagnostics markets continues to evolve at a rapid pace. As a result, we expect to +continue development activities designed to modify the capabilities and fit of the DNAG products to meet the evolving needs of existing and potential molecular testing market applications. To address unique customer needs, we will continue to +develop new chemical and/or physical platforms as needed by our customers. DNAG has a number of development projects underway to expand its product offerings in three primary market segments—human genetics, infectious disease testing and animal +testing. +Research and Development +In 2011, our research and development activities focused primarily on clinical and regulatory activities related to obtaining a CLIA waiver for our +OraQuick ® HCV test, completing the final phase of clinical testing and preparing and filing a PMA application +for FDA approval of an OraQuick ® HIV OTC test, development of next generation versions of our OraQuick ® HIV and Intercept ® products and assessing initial feasibility of certain other products. +From time to time, we have contracted with third parties to conduct research and development activities and we may do so in the future. +9 +Table of Contents +Research and development expenses were $18.4 million in 2011 (including $1.0 million of DNAG +expenses since the August 2011 acquisition), $13.2 million in 2010 and $13.4 million in 2009. These expenses include our costs associated with research and development, regulatory affairs, clinical trials and product support. +Sales and Marketing +We +attempt to reach our major target markets through a combination of direct sales, strategic collaborations and independent distributors. Our marketing strategy is to create or raise awareness through a full array of marketing activities, which +include trade shows, print advertising, special programs and distributor promotions, in order to stimulate sales in each target market. +We market our products in the United States and internationally. Revenues attributable to customers in the United States were $67.6 million, $63.5 million and $62.2 million in 2011, 2010 and 2009, +respectively. Revenues attributable to international customers amounted to $14.2 million, $11.5 million and $14.8 million, or 17%, 15% and 19% of our total revenues, in 2011, 2010 and 2009, respectively. For more information about our revenues and +long-lived assets attributable to U.S. and international customers, please see Note 12 to our consolidated financial statements included elsewhere in this Annual Report. +Infectious Disease Testing +We market the OraQuick +ADVANCE ® rapid HIV-1/2 antibody test directly to customers in the public health market for HIV testing. +This market consists of a broad range of clinics and laboratories and includes states, counties, and other governmental agencies, family planning clinics, colleges and universities, correctional facilities and the military. There are also a number +of organizations in the public health market, such as AIDS service organizations and various community-based organizations, that are set up primarily for the purpose of encouraging and enabling HIV testing. We also sell our OraQuick ADVANCE ® test directly to hospitals in the U.S. and through distributors into the U.S. physician market. In 2010, we engaged +two manufacturers’ representative organizations to assist with sales to U.S. physicians. +Internationally, we distribute our OraQuick ® HIV test in Europe and other foreign countries. We expect to increase the number of countries where this product is sold as we find new distributors and complete +registrations in additional countries. +We market the OraSure ® oral fluid collection device for HIV-1 testing, on its own and as a kit in combination with laboratory testing +services. To better serve our public health customers, we have contracted a commercial laboratory to provide prepackaged +OraSure ® test kits, with prepaid laboratory testing and specimen shipping costs included. We also sell the +OraSure ® device in the international public health market. +Based on the FDA approvals in place during most of 2011, our +OraQuick ® HCV test has been sold primarily to customers operating CLIA-certified laboratories. In late 2011, we +received a CLIA waiver for this product, which will enable us to expand sales to non-CLIA certified settings, primarily in the U.S. public health and physician office markets. We also sell this test in Europe and other countries through +distributors. +We previously entered into agreements with Merck & Co. Inc. (“Merck”) to +collaborate on the development and promotion of our OraQuick ® HCV test. Under the terms of these agreements, we +have been and in the future may be reimbursed by Merck for a portion of our costs to develop the test and obtain regulatory approvals. Merck will also provide detailing and other promotional support for the test in the physicians’ office market +in the United States and internationally. +We have distribution rights to an FDA 510(k) cleared rapid flu A&B test, which +we market under our proprietary OraSure QuickFlu™ tradename. Under our agreement with the supplier of this product, we are permitted to sell this product into the U.S. hospital and public health markets. +10 +Table of Contents +Substance Abuse Testing +Our substance abuse testing products are marketed to laboratories serving the workplace testing, forensic toxicology, criminal justice and +drug rehabilitation markets in the U.S. and in certain international markets. +We have entered into +agreements for the distribution of Intercept ® collection devices and associated MICRO-PLATE assays for +drugs-of-abuse testing in the workplace testing market in the United States and Canada through several laboratory distributors and internationally for workplace, criminal justice and forensic toxicology testing through other distributors. In some +cases, we assist our laboratory customers in customizing their testing services by selling them equipment required to test oral fluid specimens collected with the Intercept ® device. +We also market +the Intercept ® collection device on its own and as a kit in combination with laboratory testing services. To +better serve our workplace customers, we have contracted with commercial laboratories to provide prepackaged +Intercept ® test kits, with prepaid laboratory testing and specimen shipping costs included. +The criminal justice market in the United States for our substance abuse testing products consists of a wide variety of entities in the +criminal justice system that require drug screening, such as pre-trial services, parole and probation offices, police forces, drug courts, prisons, drug treatment programs and community/family service programs. The forensic toxicology market +consists of several hundred laboratories including federal, state and county crime laboratories, medical examiner laboratories and reference laboratories. +As discussed above, the FDA has issued 510(k) clearances for the use of fully-automated high-throughput oral fluid assays for the detection of PCP, opiates, cocaine, methamphetamines and amphetamines with +oral fluid samples collected with our Intercept ® device. In 2012, we expect to begin selling the cleared assays +as part of our Intercept ® drug testing system into the workplace, criminal justice, hospital and government +markets in collaboration with Roche Diagnostics. +We distribute our Q.E.D. ® saliva alcohol test primarily through various distributors in the United States and internationally. The markets for +alcohol testing are relatively small and fragmented with a broad range of legal and procedural barriers to entry. Markets range from law enforcement testing to workplace testing of employees in safety sensitive occupations. Typical usage situations +include pre-employment, random, post-accident, reasonable-cause and return-to-duty testing. +Cryosurgical Systems +Most of our Histofreezer ® sales occur in the United States to distributors that, in turn, resell the product to primary care physicians and podiatrists in the United States. Our major U.S. +distributors include Cardinal Healthcare, McKesson HBOC, Physicians Sales & Service, AmerisourceBergen Corporation, and Henry Schein. We have also engaged two manufacturers’ representative organizations to help our U.S. distributors +promote and sell Histofreezer ® . Internationally, we sell the Histofreezer ® product through a network of distributors in more than 20 countries worldwide. +We distribute cryosurgical wart removal products in the OTC footcare market in Europe, Australia and New Zealand through our distributor, +Reckitt Benckiser, under its Scholl and Dr. Scholl tradenames, and in the OTC markets in Mexico and several Central and South American countries under the POINTTS tradename through our distributor, Genomma Labs. In 2011, we began selling OTC +cryosurgical products for the removal of warts and skin tags under private label arrangements with retailers in Canada. +11 +Table of Contents +Insurance Risk Assessment +We currently market the OraSure ® oral fluid collection device for use in screening life insurance applicants in the United States and internationally to test for three of the most important +underwriting risk factors: HIV-1, cocaine and cotinine (a metabolite of nicotine). Devices are sold to insurance testing laboratories, which in turn sell the devices to insurance companies, usually in combination with testing services. +We also promote use of the OraSure ® device directly to insurance companies for life insurance risk assessment. Insurance companies then make their own decision regarding which laboratory to use to +supply their collection devices and testing services. We sell our OraSure ® Western blot confirmatory test +directly to insurance testing laboratories for use in confirming oral fluid specimens collected with our +OraSure ® device that initially test positive for HIV-1. +There exists a wide range of policy limits where our OraSure ® product is being used. In general, many (but not all) of our insurance company customers use the OraSure ® device in connection with life insurance policies having face amounts of up to $250,000, with some customers using the device for policies of up to $500,000 in +amount. Some insurance companies have chosen to extend their testing to lower policy limits where they did not test at all before, while others have used OraSure ® to replace some of their blood and urine-based testing. More recently, some insurance customers have adopted a “Simplified Issues” policy, where lab testing +is no longer required and instead the applicant completes a questionnaire about personal behaviors. +We +also sell our AUTO-LYTE ® assays and reagents in the insurance testing market directly to certain laboratories. +Molecular Collection Systems +DNAG primarily sells its products directly to its customers through its own global sales force. In some countries distributors are used, particularly in the Asia-Pacific region. Over half of DNAG’s +employees work in the areas of sales, marketing, business development or product management. The significant majority of employees who deal directly with customers have molecular science backgrounds, which we believe is useful in selling and +marketing molecular collection products, and more importantly, in identifying and evaluating new market and business opportunities. +Historically, most of DNAG revenues have been derived from product sales into the academic and research markets. A significant portion of DNAG’s sales is derived from repeat customers. The clinical +diagnostic market for human genetics is still in its early stages with only a few diagnostic customers currently using DNAG’s products. DNAG has a number of established global customers in the livestock market, including breed associations and +research institutions. Finally, a molecular collection product focused on the infectious disease testing market was launched by DNAG in mid-2011. +Significant Products and Customers +Several different +products have contributed significantly to our financial performance, accounting for 10% or more of our total revenues during the past three years. The OraQuick ® rapid HIV testing products, the cryosurgical systems products, and the OraSure ® and Intercept ® oral fluid +collection devices accounted for total revenues of $41.7 million, $12.0 million and $10.7 million in 2011, $40.0 million, $11.9 million and $11.2 million in 2010, and $43.8 million, $10.9 million and $12.5 million in 2009, respectively. +We had no individual customers who accounted for more than 10% of our total revenues in 2011, 2010, or 2009. +12 +Table of Contents +Financial Information by Segment +We operate our business within two reportable segments. The first is our core “OraSure” business, which consists of the +development, manufacture and sale of oral fluid diagnostic products and specimen collection devices and the manufacture and sale of medical devices used for the removal of benign skin lesions by cryosurgery. The second segment is the business of our +newly acquired subsidiary, DNAG, which is based in Ottawa, Canada and manufactures and sells oral fluid collection devices that are used to collect samples of genetic material for molecular testing. +OraSure revenues consist primarily of product sold into the United States and internationally to various clinical laboratories, hospital, +clinics, community-based organizations and other public health organizations, distributors, government agencies, physicians’ offices, and commercial and industrial entities. OraSure also derives revenues from licensing and production +development activities. DNAG revenues consist of product sold into the Unites States and internationally in the academic research, clinical genetic testing, pharmacogenomics, personalized medicine, animal and livestock genetics markets. For more +information about our revenues from external customers, income and total assets, please see the sections entitled “Selected Consolidated Financial Data” and “Management’s Discussion and Analysis of Financial Condition and Results +of Operations” and Note 12 to the consolidated financial statements, included elsewhere in this Annual Report. +Supply and +Manufacturing +Our OraQuick ADVANCE ® HIV test, OraQuick ® HCV test, +OraSure ® and Intercept ® collection devices, Western blot HIV-1 confirmatory test, AUTOLYTE and MICRO-PLATE assays and QED ® saliva alcohol test are all manufactured in our Bethlehem, Pennsylvania facilities. We expect to continue to manufacture these products at this location for the +foreseeable future. +We have contracted with a third party in Thailand for the assembly of the OraQuick ® HIV device, in order to supply certain international markets. This supply agreement had an initial term of one year, +and automatically renews for additional annual periods unless either party provides a timely notice of termination prior to the end of an annual period. We believe that other firms would be able to manufacture the OraQuick ® test on terms no less favorable than those set forth in the agreement if the Thailand contractor would be unable or +unwilling to continue manufacturing this product. +We can purchase the HIV antigens and the nitrocellulose +used in the OraQuick ® test, the HCV antigens used in the OraQuick ® HCV test and the antigen used in the Western blot HIV-1 confirmatory test only from a limited number of sources. If +for any reason these suppliers are unwilling or no longer able to supply our antigen or nitrocellulose needs, we believe that alternative supplies could be obtained at a competitive cost. However, a change in any of the antigens or nitrocellulose +used in our products would require FDA approval and some additional development work. This in turn could require significant time to complete and could disrupt our ability to manufacture and sell the affected products. +Our MICROPLATE and AUTO-LYTE assays require the production of highly specific and sensitive antibodies corresponding to the antigen of +interest. Substantially all our antibody requirements are provided by contract suppliers. We believe that we have adequate reserves of antibody supplies and that we have access to sufficient raw materials for these products. +Our OraSure QuickFlu™ test is manufactured and supplied by a third party, Princeton BioMeditech. +The Histofreezer ® product sold in the U.S. is assembled by U.S. vendors and the Histofreezer ® product sold internationally is assembled in the Netherlands by Koninklijke, Utermöhlen, N.V., the company from which we acquired the product in 1998. The +cryosurgical wart removal products distributed in OTC markets are also assembled by vendors located in the United States. We believe that additional suppliers of all of our cryosurgical products are available on terms no less favorable than the +terms of our existing supply agreements in the event that our current suppliers would be unable or unwilling to continue manufacturing these products. +13 +Table of Contents +DNAG has engaged two third-party manufacturers to supply virtually all +of its products, including the Oragene ® product line. Many of the raw materials and components used in these +products are also purchased from third parties, including one critical component that is purchased from a sole source supplier. We believe there are other suppliers that can manufacture and supply the raw materials and components for the DNAG +products. +Employees +As of December 31, 2011, we had 308 full-time employees (including 77 employees at our subsidiary, DNAG), including 105 in sales, marketing and client services; 35 in research and development; 116 in +operations, manufacturing, quality control, information systems, purchasing and shipping; 21 in regulatory affairs; and 31 in administration and finance. This compares to 231 employees as of December 31, 2010. Our employees are not currently +represented by a collective bargaining agreement. +Competition +The diagnostic industry is a multi-billion dollar international industry and is intensely competitive. Many of our competitors are substantially larger than we are, and they have greater financial, +research, manufacturing and marketing resources. +Important competitive factors for our products include product quality, +performance, price, ease of use, customer service and reputation. Industry competition is based on the following: +• +Scientific and technological capability; +• +Proprietary know-how; +• +The ability to develop and market products and processes; +• +The ability to obtain FDA or other regulatory approvals; +• +The ability to manufacture products that meet applicable FDA requirements (i.e., good manufacturing practices); +• +Commercial execution and strength of distribution; +• +Access to adequate capital; +• +The ability to attract and retain qualified personnel; and +• +The availability of patent protection. +A few large corporations produce a wide variety of diagnostic tests and other medical devices and equipment. A larger number of mid-size companies generally compete only in the diagnostic industry and a +significant number of small companies produce only a few diagnostic products. As a result, the diagnostic test industry is highly fragmented and segmented. +The future market for diagnostic tests is expected to be characterized by consolidation, greater cost consciousness and tighter reimbursement policies. The purchasers of diagnostic products are expected +to place increased emphasis on lowering costs, reducing inventory levels, automation, service and volume discounts. The increased complexity of the market is expected to force many competitors to enter into joint ventures or license certain products +or technologies. +We expect competition to intensify as technological advances are made and become more widely known, and as +new products reach the market. Furthermore, new testing methodologies could be developed in the future that render our products impractical, uneconomical or obsolete. There can be no assurance that our competitors +14 +Table of Contents +will not succeed in developing or marketing technologies and products that are more effective than those we develop or that would render our technologies and products obsolete or otherwise +commercially unattractive. In addition, there can be no assurance that our competitors will not succeed in obtaining regulatory approval for these products, or introduce or commercialize them, before we can do so. These developments could have a +material adverse effect on our business, financial condition and results of operations. +Several companies +market or have announced plans to market oral specimen collection devices and tests both within and outside the United States. We expect the number of devices competing with our OraQuick ® , OraSure ® and Intercept ® devices to increase as the benefits of oral fluid-based testing become more widely accepted. +Competition in the HIV testing market is intense and is expected to increase. We believe that the principal +competition will continue to come from existing laboratory-based blood tests, point-of-care rapid blood tests, laboratory-based urine assays or other oral fluid-based tests that may be developed. Our competitors include specialized biotechnology +firms, as well as pharmaceutical companies with biotechnology divisions and medical diagnostic companies. Significant competitors for our OraQuick ADVANCE ® rapid HIV-1/2 test, such as the Ortho Diagnostics division of Johnson & Johnson, Bio-Rad Laboratories and Abbott, sell laboratory-based HIV-1/2 EIAs, and +Maxim Biomedical (formerly Calypte, Inc.) sells an HIV-1 screening test for urine, in the United States. MedMira and Trinity Biotech each sell competing rapid HIV-1 blood tests, and Bio-Rad Laboratories and Alere (formerly Inverness Medical) sell +competing rapid HIV-1/2 blood tests in the United States. These tests compete with our OraQuick ADVANCE ® +test in hospitals and other laboratory settings. In addition, Trinity Biotech and Alere have received CLIA waivers for their rapid HIV tests, and these tests compete with our OraQuick ADVANCE ® test in the markets outside of the traditional hospital and laboratory settings. These companies, or others, may continue to expand the bodily fluids with which a +rapid HIV test may be performed, or develop and commercialize new rapid HIV tests, which would provide further competition for our OraQuick ADVANCE ® test. We believe other companies may also seek FDA approval to sell competing rapid HIV tests in the future. +Internationally, our OraQuick ADVANCE ® HIV test competes against rapid HIV tests sold by a number of other entities, and often these competing tests are sold at prices substantially below the prices we +charge for our OraQuick ADVANCE ® test. Alere and Trinity Biotech sell rapid HIV-1/2 blood tests outside +the United States and Calypte has developed a rapid oral fluid HIV test which is now being sold in certain foreign countries. Lower priced rapid HIV blood tests are also sold internationally by various third parties. +The OraQuick ® HCV test competes against laboratory-based HCV blood tests in the U.S. Major suppliers of these competing tests are Abbott Labs, Siemens, Ortho-Clinical Diagnostics, +Roche and Bio-Rad. In non-U.S. countries, our OraQuick ® HCV test competes against other rapid HCV blood tests in +addition to the laboratory-based tests. +The OraSure QuickFlu™ test competes primarily against other rapid flu tests sold +by various third parties into the U.S. hospital and public health markets. The principal suppliers of these competing tests include Quidel and Alere. +The Intercept ® drug testing system competes with laboratory-based +drug testing products and services using testing matrices such as urine, hair, sweat and oral fluid. Major competitors include Ansys Technologies, Dade Behring, Psychemedics and Immunalysis. +Our MICRO-PLATE oral fluid drug assays, which are sold for use with the Intercept ® and OraSure ® collection devices, continue to come under increasing competitive pressure from “home-brew” assays developed internally by our laboratory customers. Our +oral fluid MICRO-PLATE assays also compete with urine-based homogeneous assays that are run on fully-automated, random access analyzers. These tests provide strong competitive pressure because they provide the benefits of automation, including lower +costs and short +15 +Table of Contents +turn-around times. In addition, we believe our competitors are developing oral fluid tests suitable for use on these fully automated homogeneous assay systems and these assays, if and when they +are developed and commercialized, will represent a significant competitive threat to our oral fluid MICRO-PLATE business. +The fully-automated homogeneous oral fluid drugs of abuse assays, which were jointly developed with Roche Diagnostics for use with our Intercept ® device, compete against both homogeneous urine assays, which have dominated the drug testing market for many years, and other homogeneous oral fluid assays that have +come on the market more recently. Competing homogeneous urine assays are sold by a number of competitors. Competing oral fluid homogeneous assays are sold by Thermo Fisher and Immunologics. +Our MICRO-PLATE drugs-of-abuse reagents sold in the forensic toxicology market are targeted to forensic testing laboratories where +sensitivity, automation and “system solutions” are important. In the past, these laboratories have typically had to rely on radioimmunoassay test methods to provide an adequate level of sensitivity. Radioimmunoassays require radioactive +materials, which have a short shelf-life and disposal problems. Our MICRO-PLATE tests meet the laboratories’ sensitivity needs, run on automated equipment, are not radioimmunoassays, and are offered to the laboratory as a complete system +solution of reagents, instrumentation and software to meet the specific needs of each customer. We compete with both homogeneous and heterogeneous tests manufactured by many companies. Significant competitors in the market for these assays include +Thermo Scientific (formerly Microgenics, Inc.), Roche Diagnostics and Immunalysis. +Sales of our AUTO-LYTE ® urine assays have declined substantially during the past several years, primarily due to competition from +“home-brew” assays developed internally by our laboratory customers, which can be produced at a cost lower than the price typically paid for our products. Many of our customers no longer purchase our AUTO-LYTE ® assays, and we may eventually stop selling this product line. +The Histofreezer ® product’s delivery system and operating temperature, which is warmer than liquid nitrogen, provide us with the opportunity to target sales to primary care +physicians, such as family practitioners, pediatricians and podiatrists. We do not generally target sales to dermatologists because they have the volume of patients required to support the capital costs associated with a liquid nitrogen delivery +system, which is also used to remove warts and other benign skin lesions. Major competitors for the +Histofreezer ® product include Cryosurgery, Inc. in the United States and Wartner in Europe. Competition in the +international OTC markets comes primarily from cryosurgical products sold by Wartner and several other firms. +Q.E.D. ® has two primary competitors, Ansys Technologies and +Chematics. These companies offer semi-quantitative saliva-based alcohol tests and have received U.S. Department of Transportation approval. Indirect competitors who offer breath testing equipment include Intoximeters, Dräger and CMI. Although +there are lower priced tests on the market that use oral fluid or breath as a test medium, these tests are qualitative tests that are believed to be substantially lower in quality and provide fewer benefits than our Q.E.D. ® test. +Finally, DNAG’s Oragene ® product line competes against other +types of collection devices used for molecular testing, such as blood collection devices and buccal swabs. These competing products are offered by a number of companies and are often sold for prices lower than the prices charged for the Oragene ® products. +Patents and Proprietary Information +We seek patents and other intellectual property rights to protect and preserve our proprietary technology and our right to capitalize on the results of our research and development activities. We also +rely on trade secrets, know-how, continuing technological innovations and licensing opportunities to provide competitive advantages for our products in our markets and to accelerate new product introductions. We regularly search for third-party +patents in fields related to our business to shape our own patent and product commercialization strategies as effectively as possible and to identify licensing opportunities. United States patents generally have a maximum term of 20 years from the +date an application is filed. +16 +Table of Contents +We have ten United States patents and numerous foreign patents for the +OraSure ® and Intercept ® collection devices and technology relating to oral fluid collection, containers for oral fluids, methods to test oral fluid, formulations for the manufacture of +synthetic oral fluid, and methods to control the volume of oral fluid collected and dispersed. The patents expire from January 2013 to September 2022. We have also applied for additional patents, in both the United States and certain foreign +countries, on such products and technology. +We have four United States patents for our OraQuick ® platform, and we have several related patent applications pending in the United States and internationally. Three of +these patents expire from March to July 2019 and the fourth in August 2027. We have obtained licenses to certain lateral flow patents and to certain HIV-1 and HIV-2 patents held by other parties. We also have obtained a license to certain HCV +patents which we use to manufacture and sell a rapid HCV test on the OraQuick ® technology platform. We obtained +these licenses through the payment of certain upfront fees and an agreement to pay ongoing royalties. We believe these fees and royalties are comparable to those generally paid by other companies under similar arrangements. +One of the lateral flow patent licenses was obtained as part of a patent infringement litigation settlement with +Alere (formerly Inverness Medical) in 2009. Under that license, royalties on net sales of our OraQuick ® HIV +products begin in 2013 and royalties on net sales of our OraQuick ® HCV test begin in 2012. +We may need to obtain licenses or other rights under, or enter into distribution or other business arrangements in +connection with, certain other intellectual property patents in order to manufacture and sell the OraQuick +ADVANCE ® HIV test or other tests that use the same or similar technology platform. See Section 1A, +entitled “Risk Factors,” for a further discussion of these issues. +We have five United States patents and numerous +foreign patents issued for apparatuses and methods for the topical removal of skin lesions relating to our cryosurgical wart removal products, and we have pending patent applications related to these products in the United States and in certain +foreign countries. These patents expire from July 2012 to September 2025. We have also licensed another patent relating to apparatuses and methods for the topical removal of skin lesions relating to our cryosurgical wart removal products. +We hold, through our subsidiary, DNAG, six United States patents and numerous foreign patents issued for compositions, +methods and apparatus for the collection, stabilization, transportation and storage of nucleic acids (DNA and RNA) from oral fluid and other bodily fluids and tissues. These patents expire from June 2023 through May 2030. +We require our employees, consultants, outside collaborators and other advisors to execute confidentiality agreements upon the +commencement of employment or consulting relationships with us. These agreements provide that all confidential information developed by or made known to the individual during the course of the individual’s relationship with us is to be kept +confidential and not disclosed to third parties except in specific circumstances. In the case of employees, the agreements provide that all inventions conceived by the individual during his or her tenure with us will be our exclusive property. +We own rights to trademarks and service marks that we believe are necessary to conduct our business as +currently operated. In the United States, we own a number of trademarks, including the OraSure ® , Intercept ® , OraQuick ® , OraQuick ADVANCE ® , +Histofreezer ® , OraSure QuickFlu™, Q.E.D. ® , Oragene ® , ORAcollect™, +OMNIgene™, Performagene™ and AUTO-LYTE ® trademarks. We also own many of these marks and others in +several foreign countries. With respect to our international OTC cryosurgical products, the Scholl and Dr. Scholl tradenames are owned by Reckitt Benckiser in Europe, Australia, New Zealand and other countries outside North and South America, +and the POINTTS tradename is owned by Genomma Labs. +Although important, the issuance of a patent or existence of trademark or +trade secret protection does not in itself ensure the success of our business. Competitors may be able to produce products competing with our patented products without infringing our patent rights. Issuance of a patent in one country generally does +not prevent manufacture or sale of the patented product in other countries. The issuance of a patent is not conclusive +17 +Table of Contents +as to validity or as to the enforceable scope of the patent. The validity or enforceability of a patent can be challenged by litigation after its issuance. If the outcome of such litigation is +adverse to the owner of the patent, the owner’s rights could be diminished or withdrawn. Trade secret protection does not prevent independent discovery and exploitation of the secret product or technique. +Government Regulation +General +Most of our products are regulated by the FDA, certain state and local agencies and comparable regulatory bodies in other countries. This +regulated environment governs almost all aspects of development, production and marketing, including product testing, authorizations to market, labeling, promotion, manufacturing and recordkeeping. +All of our FDA-regulated products require some form of action by the FDA before they can be marketed in the United States. After approval +or clearance by the FDA, we must continue to comply with other FDA requirements applicable to marketed products. Both before and after approval or clearance, failure to comply with the FDA’s requirements can lead to significant penalties or +could disrupt our ability to manufacture and sell these products. In addition, the FDA could refuse permission to obtain certificates needed to export our products if the agency determines that we are not in compliance. +Domestic Regulation +Most of our products are regulated in the United States as medical devices. +There are two mechanisms by which regulated medical devices can be placed on the market in the United States. Some products may qualify +for clearance under Section 510(k) of the Federal Food, Drug and Cosmetic Act. To obtain this clearance from the FDA, the manufacturer must provide a premarket notification that it intends to begin marketing the product, and show that the +product is substantially equivalent to another legally marketed product (i.e., that it has the same intended use and is as safe and effective as a legally marketed device and does not raise different questions of safety and effectiveness). In some +cases, the submission must include data from human clinical studies. Marketing may only commence when the FDA issues a clearance letter finding substantial equivalence. An applicant must submit a 510(k) application at least 90 days before marketing +of the affected product commences. Although FDA clearance may be granted within that 90-day period, in some cases as much as a year or more may be required before clearance is obtained, if at all. +If the medical device does not qualify for the 510(k) procedure (either because it is not substantially equivalent to a legally marketed +device or because it is required by statute and the FDA’s regulations to have an approved premarket application, “PMA”), the FDA must approve a PMA before marketing can begin. PMAs must demonstrate, among other matters, that the +medical device provides a reasonable assurance of safety and effectiveness. A PMA is typically a complex submission, including the results of preclinical and clinical studies. Preparing a PMA is a detailed and time-consuming process. Once a PMA has +been submitted, the FDA is required to review the submission within 180 days. However, the FDA’s review may be, and often is, much longer, often requiring one year or more, and may include requests for additional data and facility inspections +before approval is granted, if at all. +Some of our products are used for research only or other non-medical purposes and many +of our drugs-of-abuse products sold to state crime laboratories are for forensic use. The FDA does not currently regulate products used for these purposes. +Every company that manufactures medical devices distributed in the United States must comply with the FDA’s Quality System Regulations (“QSRs”). These regulations govern the manufacturing +process, including design, manufacture, testing, release, packaging, distribution, documentation and purchasing. In complying with the QSRs, manufacturers must continue to expend time, money and effort in the area of production and quality to +18 +Table of Contents +ensure full technical compliance. Companies are also subject to other post-market and general requirements, including restrictions imposed on marketed products, promotional standards and +requirements for recordkeeping and reporting of certain adverse reactions. If there are any modifications made to our marketed devices, a premarket notification or PMA may be required to be submitted to, and cleared or approved by, the FDA, before +the modified device may be marketed. The FDA regularly inspects companies to determine compliance with the QSRs and other post-market requirements. Failure to comply with statutory requirements and the FDA’s regulations can result in warning +letters, monetary penalties, suspension or withdrawal of regulatory approvals, operating restrictions, total or partial suspension of production, injunctions, product recalls, seizure of products and criminal prosecution. +The Clinical Laboratory Improvement Amendments of 1988, or CLIA, prohibit any facility that does laboratory testing +on specimens derived from humans from providing information for the diagnosis, prevention or treatment of any disease or impairment of, or the assessment of, the health of human beings, unless there is in effect for such facility a certificate +issued by the U.S. Department of Health and Human Services applicable to the category of examination or procedure performed. Tests may be waived from this regulatory oversight if they meet certain requirements established under CLIA. We consider the +applicability of the requirements of CLIA in the design and development of our products. We have obtained a waiver of the CLIA requirements for our OraQuick ADVANCE ® rapid HIV-1/2 antibody test, our +OraQuick ® HCV rapid antibody test and our Q.E.D. ® alcohol saliva test and may seek similar waivers for certain other products. A CLIA waiver allows certain customers to use the waived products that may not have been +able to use them without complying with applicable quality control and other requirements. +Certain of our products may also +be affected by state regulations in the United States. We are presently working with legislators or regulators in certain of these states in an effort to modify or remove any restrictions affecting our ability to sell products. +International +We are also subject to regulations in foreign countries governing products, human clinical trials and marketing, and may need to obtain approval from international public health agencies, such as the +World Health Organization, in order to sell products in certain countries. Approval processes vary from country to country, and the length of time required for approval or to obtain other clearances may in some cases be longer than that required for +U.S. governmental approvals. We generally pursue approval only in those countries that we believe have a significant market opportunity. +The International Organization for Standardization (“ISO”) is a worldwide federation of national standards bodies from some 130 countries, established in 1947. The mission of the ISO is to +promote the development of standardization and related activities in the world with a view to facilitating the international exchange of goods and services. ISO certification is a pre-requisite to use of the CE mark and indicates that our quality +system complies with standards applicable to activities ranging from initial product design and development through production and distribution. The CE mark is a European Union (“EU”) requirement to sell products that fall under the scope +of the Medical Devices Directive (“MDD”) and the In Vitro Diagnostic Directive (“IVDD”). The CE mark is evidence that the manufacturer and the product meet the requirements of all applicable directives, including the MDD and +IVDD. +We received authorization to use the CE mark for the OraQuick ADVANCE ® HIV-1/2 test, the OraQuick ® HCV test, the OraSure ® and +Intercept ® collection devices, our Histofreezer ® product line, our OTC cryosurgical removal product and certain of the Oragene ® collection kits sold by DNA Genotek. +We +must also comply with certain registration and licensing requirements as dictated by Health Canada, prior to commencing sales in Canada. We have completed this process for several of our current products and may do so with respect to other products +in the future. In addition, Canadian law requires manufacturers of medical devices to have a quality management system that meets various ISO requirements in order to obtain a license to sell their devices in Canada. +19 +Table of Contents +Anti-Kickback and Other Fraud and Abuse Laws +The Federal Anti-Kickback Statute prohibits the knowing and willful offer, payment, solicitation, or receipt of any form of remuneration +in return for, or to induce: +• +The referral of a person; +• +The furnishing or arranging for the furnishing of items or services reimbursable under Medicare, Medicaid or other governmental programs; or +• +The purchase, lease, or order of, or the arrangement or recommendation of the purchasing, leasing, or ordering of any item or service reimbursable +under Medicare, Medicaid, or other governmental programs. +Our products are or may be purchased by customers +that will seek or receive reimbursement under Medicare, Medicaid or other governmental programs. Noncompliance with the federal anti-kickback legislation can result in exclusion from Medicare, Medicaid or other governmental programs, and/or +restrictions on our ability to operate in certain jurisdictions, as well as civil and criminal penalties, any of which could have an adverse effect on our business and results of operations. +The Federal Civil Monetary Penalties Law prohibits the offering or transferring of remuneration to a Medicare or Medicaid beneficiary +that the person knows or should know is likely to influence the beneficiary’s selection of a particular supplier of Medicare or Medicaid payable items or services. Noncompliance can result in civil monetary penalties for each wrongful act, +assessment of three times the amount claimed for each item or service and exclusion from the Federal healthcare programs. +Many states have also adopted some form of anti-kickback laws. A determination of liability under such laws could result in fines and +penalties and restrictions on our ability to operate in these jurisdictions. +We are also subject to other federal and state +laws targeting fraud and abuse in the healthcare industry, including false claims laws and marketing conduct laws and laws constraining the sales, marketing and other promotional activities of manufacturers of medical devices by limiting the kinds +of financial arrangements, including sales programs, with physicians, hospitals, laboratories and other potential purchasers of medical devices. Violations of these laws may be punishable by criminal or civil sanctions, including substantial fines, +imprisonment and exclusion from participation in government healthcare programs such as Medicare and Medicaid. These laws and regulations are wide ranging and subject to changing interpretation and application. In recent years, there has been +greater scrutiny of marketing practices in the medical device industry which has resulted in several government investigations by various government authorities and the introduction and/or passage of federal and state legislation regulating +interactions between medical device manufacturers and healthcare professionals and providers and requiring the disclosure by medical device manufacturers of gifts or other payments to healthcare professionals and providers. To be in compliance with +such disclosure laws, we have implemented necessary systems for accurately tracking gifts and other payments. +We have +implemented a written Policy on Interactions with Health Care Professionals, which is based on the Code of Conduct for Interactions with Health Care Professionals promulgated by the Advanced Medical Technology Association, or AdvaMed, a leading +trade association representing medical device manufacturers. The Policy applies to all employees and is intended to comply with applicable state and federal laws, regulations and government guidance. The Policy addresses interactions related to +sales and marketing practices, research and development, product training and education, grants and charitable contributions, support of third-party educational conferences, and consulting arrangements. +Foreign Corrupt Practices Act +The U.S. Foreign Corrupt Practices Act (“FCPA”) prohibits corporations and individuals from engaging in certain activities to obtain or retain business or to influence a person working in an +official capacity. It is illegal to pay, offer to pay or authorize the payment of anything of value to any foreign government official, government +20 +Table of Contents +staff member, political party or political candidate in an attempt to obtain or retain business or to otherwise influence a person working in an official capacity. Our present and future business +has and will continue to be subject to the FCPA and various other laws, rules and/or regulations applicable to us as a result of our international sales. +Environmental Regulation +Because of the nature of our current and proposed +research, development, and manufacturing processes, we are subject to stringent federal, state and local laws, rules, regulations and policies governing the use, generation, manufacture, storage, air emission, effluent discharge and handling and +disposal of materials and wastes. +The foregoing discussion of our business should be read in conjunction with the +consolidated financial statements and accompanying notes included in Item 15 of this Annual Report. +ITEM 1A. +Risk Factors +You +should carefully consider the risks and uncertainties described below, together with all of the other information included in this Annual Report and our other SEC filings, in considering our business and prospects. The risks and uncertainties +described below are not the only ones facing us. Additional risks and uncertainties not disclosed or not presently known to us or that we currently deem immaterial also may impair our business operations. The occurrence of any of the following risks +could harm our business, financial condition or results of operations. +Regulatory Risks +The Need to Obtain Regulatory Approvals Could Increase Our Costs and Adversely Affect Our Financial Performance. +Many of our proposed and existing products are subject to regulation by the FDA and other governmental or public health agencies. In +particular, we are subject to strict governmental controls on the development, manufacture, labeling, distribution and marketing of our products. In addition, we are often required to obtain approval or registration with foreign governments or +regulatory bodies before we can import and sell our products in foreign countries. +The process of obtaining required +approvals or registrations from governmental or public health agencies can involve lengthy and detailed laboratory testing, human clinical trials, sampling activities and other costly, time-consuming procedures. These approvals and registrations can +require the submission of a large amount of clinical data which can be expensive and may require significant time to obtain. It is also possible that a product will not perform at a level needed to generate the clinical data required to obtain +approval or registration. The submission of an application to the FDA or other international regulatory authority does not guarantee that an approval or registration to market the product will be received. A regulatory authority may impose +requirements as a condition to granting an approval or registration, may include significant restrictions or limitations as part of any approval or clearance it grants and may delay or refuse to grant approval or registration, even though a product +has been approved without restrictions or limitations in another country or by another agency. +In 2011, +we completed the final phase of clinical studies for FDA approval of our OraQuick ® HIV-1/2 test for sale in the +United States OTC market, and we filed all three modules to our PMA application for this product. Since a rapid HIV test has never before been approved by the FDA for OTC use, its approval will depend on the FDA’s evaluation of our PMA +application and our further discussions with the agency and its advisory committees. There can be no assurance that the FDA will approve an OraQuick ® HIV OTC test based on our clinical trials. Failure to obtain or any delay in obtaining this approval could result in significantly lower future revenues or increased +costs and may adversely affect our financial performance and prospects. +21 +Table of Contents +In addition, all in vitro diagnostic products that are to be sold in the EU must bear +the CE mark indicating conformance with the essential requirements of the IVDD. We are not permitted to sell our products in the EU without a CE mark. We have obtained the CE mark for several of our existing products. We also intend to apply for CE +marks for certain of our future products and are not aware of any material reason why we would be unable to obtain those marks. However, there can be no assurance that compliance with all provisions of the IVDD will be demonstrated and the CE mark +will be obtained or maintained for all products that we desire to sell in the EU. The failure to obtain or maintain the CE mark for one or more of our products could lead to the termination of strategic alliances and agreements for sales of those +products in the EU. +Our Ability to Respond to Changes in Regulatory Requirements Could Adversely Affect Our Business. +Newly promulgated regulations could require changes to our products, necessitate additional clinical trials or procedures, +or could make it impractical or impossible for us to market our products for certain uses, in certain markets, or at all. In addition, the FDA and other regulatory authorities have the ability to change the requirements for obtaining product +approval and/or impose new or additional requirements as part of the approval process. These changes or new or additional requirements may occur after the completion of substantial clinical work and other costly development activities. The +implementation of such changes or new or additional requirements may result in additional clinical trials and substantial additional costs and can delay or make it more difficult or complicated to obtain product approvals. +Failure to Comply With FDA or Other Regulatory Requirements May Require Us to Suspend Production of Our Products or Institute a Recall +Which Could Result in Higher Costs and a Loss of Revenues. +Our businesses are extensively regulated by the FDA and other +federal, state and foreign regulatory agencies. Our suppliers and distributors often are subject to similar regulation. These regulations impact many aspects of our operations, and the operations of our suppliers and distributors, including +manufacturing, labeling, packaging, adverse event reporting, storage, advertising, promotion and record keeping. For example, our manufacturing facilities and those of our suppliers and distributors are, or can be, subject to periodic regulatory +inspections. The FDA and foreign regulatory agencies may require post-marketing testing and surveillance to monitor the performance of approved products or place conditions on any product approvals that could restrict the commercial applications of +those products. In addition, the subsequent discovery of previously unknown problems with a product may result in restrictions on the product, including withdrawal of the product from the market. We are also subject to routine inspection by the FDA +and certain state agencies for compliance with Quality System Requirement and Medical Device Reporting requirements in the United States and other applicable regulations worldwide, including but not limited to ISO regulations. +Although we believe that we have adequate processes in place to ensure compliance with these requirements, the FDA or other regulatory +bodies could force us to stop manufacturing, selling or exporting our products if it concludes that we are out of compliance with applicable regulations. The ability of our suppliers to supply critical components or materials and of our distributors +to sell our products could be adversely affected if their operations are determined to be out of compliance. The FDA and other regulatory bodies could also require us to recall products if we fail to comply with applicable regulations, which could +force us to stop manufacturing and selling such products. Such actions by the FDA and other regulatory bodies could adversely affect our revenues, costs and results of operations. +In the ordinary course of business, we must frequently make subjective judgments with respect to compliance with applicable laws and +regulations. If regulators subsequently disagree with the manner in which we have sought to comply with these regulations, we could be subjected to substantial civil and criminal penalties, as well as product recall, seizure or injunction with +respect to the sale of our products. The assessment of any civil and criminal penalties against us could severely impair our reputation within the industry and any limitation on our ability to manufacture and market our products could have a +material adverse effect on our business. +22 +Table of Contents +Our Inability to Manufacture Products in Accordance With Applicable Specifications, +Performance Standards or Quality Requirements Could Adversely Affect Our Business. +The materials and processes used to +manufacture our products must meet detailed specifications, performance standards and quality requirements to ensure our products will perform in accordance with their label claims, our customers’ expectations and applicable regulatory +requirements. As a result, our products and the materials used in their manufacture or assembly undergo regular inspections and quality testing. Factors such as defective materials or processes, mechanical failures, human errors, environmental +conditions, changes in materials or production methods by our vendors, and other events or conditions could cause our products or the materials used to produce or assemble our products to fail inspections and quality testing. +Any failure or delay in our ability to meet the applicable specifications, performance standards or quality requirements could adversely +affect our ability to manufacture and sell our products or comply with regulatory requirements. These events could, in turn, adversely affect our revenues and results of operations. +We Are Subject to Numerous Government Regulations in Addition to FDA Requirements, Which Could Increase Our Costs and Affect Our +Operations. +In addition to the FDA and other regulations described previously, laws and regulations in some states may +restrict our ability to sell products in those states. While we intend to work with state legislators and regulators to remove or modify any applicable restrictions, there is no guarantee we will be successful in these efforts. +We must also comply with numerous laws relating to such matters as safe working conditions, manufacturing practices, environmental +protection, fire hazard control, disposal of hazardous substances and labor or employment practices. Compliance with these laws or any new or changed laws regulating our business could result in substantial costs. Because of the number and extent of +the laws and regulations affecting our industry, and the number of governmental agencies whose actions could affect our operations, it is impossible to reliably predict the full nature and impact of these requirements. To the extent the costs and +procedures associated with complying with these laws and requirements are substantial or it is determined that we do not comply, our business and results of operations could be adversely affected. +Compliance With Regulations Governing Public Company Corporate Governance and Reporting is Complex and Expensive. +Many laws and regulations impose obligations on public companies, which have increased the scope, complexity and cost of corporate +governance, reporting and disclosure practices. Examples include the Sarbanes-Oxley Act of 2002, the requirements of the NASDAQ Global Market, The Dodd-Frank Wall Street Reform and Consumer Protection Act, the SEC’s requirements for public +companies to provide financial statements in interactive data format using the eXtensible Business Reporting Language, or XBRL, and the International Financial Reporting Standards conversion requirements. Our implementation of certain aspects of +these laws and regulations has required and will continue to require substantial management time and oversight and may require us to incur significant additional accounting and legal costs. We continually evaluate and monitor developments with +respect to new and proposed rules and cannot predict or estimate the ultimate amount of additional costs we may incur or the timing of such costs. These laws and regulations are also subject to varying interpretations, in many cases due to their +lack of specificity, and as a result, their application in practice may evolve over time as new guidance is provided by regulatory and governing bodies. This could result in continuing uncertainty regarding compliance matters and higher costs +necessitated by ongoing revisions to disclosure and governance practices. Although we are committed to maintaining high standards of corporate governance and public disclosure, if we fail to comply with any of these requirements, legal proceedings +may be initiated against us and we may be harmed. +23 +Table of Contents +Federal and State Laws Pertaining to Healthcare Fraud and Abuse Could Materially +Adversely Affect Our Business, Financial Condition and Results of Operations. +We are subject to various federal and state +laws targeting fraud and abuse in the healthcare industry, including anti-kickback laws, false claims laws, and laws constraining the sales, marketing and other promotional activities of manufacturers of medical devices by limiting the kinds of +financial arrangements with physicians, hospitals, laboratories and other potential purchasers of medical devices. Violations of these laws are punishable by criminal or civil sanctions, including substantial fines, imprisonment and exclusion from +participation in government healthcare programs such as Medicare and Medicaid. Many of the existing requirements are new and have not been definitively interpreted by state authorities or courts, and available guidance is limited. Unless and until +we are in full compliance with these laws, we could face enforcement action and fines and other penalties, and could receive adverse publicity, all of which could materially harm our business. In addition, changes in or evolving interpretations of +these laws, regulations, or administrative or judicial interpretations, may require us to change our business practices or subject our existing business practices to legal challenges, which could have a material adverse effect on our business, +financial condition and results of operations. +Risks Relating to Our Industry, Business and Strategy +Our Ability to Sell Products Could be Adversely Affected by Competition From New and Existing Diagnostic Products. +The diagnostics industry is focused on the testing of biological specimens in a laboratory or at the point of care and is highly +competitive and rapidly changing. Many of our principal competitors have considerably greater financial, technical and marketing resources. As new products enter the market, our products may become obsolete or a competitor’s products may be +more effective or more effectively marketed and sold than ours. If we fail to maintain and enhance our competitive position, our customers may decide to use products developed by competitors which could result in a loss of revenues. +We also face competition from products that are sold at a lower price. Where this occurs, customers may choose to buy lower cost products +from third parties or we may be forced to sell our products at a lower price, both of which could result in a loss of revenues or a lower gross margin contribution from the sale of our products. We may also be required to increase our marketing +efforts in order to compete effectively, which would increase our costs. +Our Research, Development and Commercialization +Efforts May Not Succeed and Our Competitors May Develop and Commercialize More Effective or Successful Diagnostic Products. +In order to remain competitive, we must regularly commit substantial resources to research and development and the commercialization of +new or enhanced products. The research and development process generally takes a significant amount of time from product inception to commercial launch. This process is conducted in various stages. During each stage there is a substantial risk that +we will not achieve our goals on a timely basis, or at all, and we may have to abandon a new or enhanced product in which we have invested substantial time and money. +During 2011, 2010 and 2009, we incurred $18.4 million (including $1.0 million of DNAG expenses since the August 2011 acquisition), $13.2 million and $14.3 million, respectively, in research and +development expenses. We expect to continue to incur significant costs related to our research and development activities. +Successful products require significant development and investment, including testing, to demonstrate their cost-effectiveness or other +benefits prior to commercialization. In addition, regulatory approval must be obtained before most products may be sold. Additional development efforts on these products can be required before any regulatory authority will review them. As noted +above, regulatory authorities may not approve these products for commercial sale or can substantially delay or condition approval. In addition, even if a product is developed and +24 +Table of Contents +all applicable regulatory approvals are obtained, there may be little or no market for the product. Accordingly, if we fail to develop and gain commercial acceptance for our products, or if +competitors develop more effective products or a greater number of successful new products, customers may decide to use products developed by our competitors. This would result in a loss of revenues and adversely affect our results of operations, +cash flow and business. +Failure to Achieve Our Financial and Strategic Objectives Could Have a Material Adverse Impact on +Our Business Prospects. +As a result of any number of risk factors identified in this Annual Report, no assurance can be +given that we will be successful in implementing our financial and strategic objectives, including our clinical development programs for a rapid HIV OTC test. In addition, the funds for research, clinical development and other projects have in the +past come primarily from our business operations. If our business slows and we have less money available to fund research and development and clinical programs, we will have to decide at that time which programs to cut, and by how much. Similarly, +if adequate financial, personnel, equipment or other resources are not available, we may be required to delay or scale back our strategic efforts. Our operations will be adversely affected if our total revenue and gross profits do not +correspondingly increase or if our technology, product, clinical and market development efforts are unsuccessful or delayed. Furthermore, our failure to successfully introduce new or enhanced products and develop new markets could have a material +adverse effect on our business and prospects. +If We Lose Our Key Personnel or Are Unable to Attract and Retain Qualified +Personnel as Necessary, Our Business Could be Harmed. +Our success depends to a large extent upon the contributions of our +executive officers, management and sales, marketing, operations and scientific staff. We may not be able to attract or retain a sufficient number of qualified employees in the future due to the intense competition for qualified personnel among +medical products and other life science businesses. We generally do not enter into employment agreements requiring our employees to work for us for any specified period. +If we are not able to attract and retain the necessary personnel to accomplish our business objectives, we may experience constraints that will adversely affect our ability to effectively manufacture, +sell and market our products, to meet the demands of our strategic partners in a timely fashion, or to support research, development and clinical programs. Although we believe we will be successful in attracting and retaining qualified personnel, +competition for experienced scientists and other personnel from numerous companies and academic and other research institutions may limit our ability to do so on acceptable terms. +Acquisitions or Investments May Not Generate the Expected Benefits and Could Disrupt Our Ongoing Business, Distract Our Management, +Increase Our Expenses and Adversely Affect Our Business. +We may enter into strategic acquisitions or investments as a way +to expand our business. These activities, and their impact on our business, are subject to many risk factors, including the following: +• +Suitable acquisitions or investments may not be found or consummated on terms or schedules that are satisfactory to us or consistent with our +objectives; +• +The benefits expected to be derived from an acquisition may not materialize and could be affected by numerous factors, such as regulatory developments, +general economic conditions and increased competition; +• +We may be unable to successfully integrate an acquired company’s personnel, assets, management systems, products and/or technology into our +business; +• +Acquisitions may require substantial expense and management time and could disrupt our business; +25 +Table of Contents +• +An acquisition and subsequent integration activities may require greater capital and other resources than originally anticipated at the time of +acquisition; +• +An acquisition may result in the incurrence of unexpected expenses, the dilution of our earnings or our existing stockholders’ percentage +ownership, or potential losses from undiscovered liabilities not covered by an indemnification from the seller(s) of the acquired business; +• +An acquisition may result in the loss of our or the acquired company’s key personnel, customers, distributors or suppliers; and +• +An acquisition of a foreign business may involve additional risks, including, but not limited to, foreign currency exposure, liability or restrictions +under foreign laws or regulations, and our inability to successfully assimilate differences in foreign business practices or overcome language or cultural barriers. +The occurrence of one or more of the above or other factors may prevent us from achieving all or a significant part of the benefits +expected from an acquisition or investment. This may adversely affect our financial condition, results of operations and ability to grow our business or otherwise achieve our financial and strategic objectives. +In August 2011, we acquired DNAG with the expectation that the acquisition would result in benefits to both companies. However, we may +not realize the financial, tax and other benefits of the acquisition to the extent, or in the timeframe, anticipated. For example, the acquisition could result in the loss of key employees, diversion of each company’s management’s +attention, the disruption or interruption of, or the loss of momentum in, each company’s ongoing business or inconsistencies in standards, controls, procedures and policies, any of which could adversely affect either company’s ability to +maintain relationships with customers, licensors, collaborators, partners, suppliers and employees. These factors and others could negatively impact our ability to achieve the anticipated benefits of the acquisition, or could reduce our earnings or +otherwise adversely affect the business and financial results of the combined company and, as a result, adversely affect the market price of our Common Stock. +Our Revenues Could be Affected by Third-Party Reimbursement Policies and Potential Cost Constraints. +The end-users of our products include hospitals, physicians and other healthcare providers. Use of our products could be adversely impacted if end-users do not receive adequate reimbursement for the cost +of our products from their patients’ healthcare insurers or payors. Our net sales could also be adversely affected by changes in reimbursement policies of governmental or private healthcare payors, including in particular the level of +reimbursement for our products. +In the United States, healthcare providers such as hospitals and physicians who purchase +diagnostic products generally rely on third-party payors, such as private health insurance plans, Medicare and Medicaid, to reimburse all or part of the cost of the product and procedure. The overall escalating cost of medical products and services +has led to, and will continue to lead to, increased pressures on the healthcare industry, both foreign and domestic, to reduce the cost of products and services. Given the efforts to control and reduce healthcare costs in the United States in recent +years, currently available levels of reimbursement may not continue to be available in the future for our existing products or products under development. Third-party reimbursement and coverage may not be available or adequate in either the United +States or international markets, current reimbursement amounts may be decreased in the future and future legislation, and regulation or reimbursement policies of third-party payors, may reduce the demand for our products or our ability to sell our +products on a profitable basis. +Changes in Healthcare Regulation Could Affect Our Revenues, Costs and Financial Condition. +In recent years, there have been numerous initiatives on the federal and state levels for comprehensive reforms affecting +the payment for, the availability of and reimbursement for healthcare services in the United +26 +Table of Contents +States. These initiatives have ranged from proposals to fundamentally change federal and state healthcare reimbursement programs, including providing comprehensive healthcare coverage to the +public under governmental funded programs, to minor modifications to existing programs. One example is the Patient Protection and Affordable Care Act, the Federal healthcare reform law enacted in 2010 (“Affordable Care Act”). Similar +reforms may occur internationally. +Legislative and regulatory bodies are likely to continue to pursue healthcare reform +initiatives and may continue to reduce the funding of the Medicare and Medicaid programs, including Medicare Advantage, in an effort to reduce overall federal healthcare spending. In addition, the new Affordable Care Act imposes a 2.3% excise tax on +certain transactions, including U.S. sales of many medical devices, which we expect will include domestic sales of our products. This new tax is scheduled to take effect in 2013. +The ultimate content or timing of any healthcare reform legislation, and its impact on us, is impossible to predict. If significant +reforms are made to the healthcare system in the United States, or in other jurisdictions, those reforms may increase our costs or otherwise have an adverse effect on our financial condition and results of operations. +New or Changed Testing Guidelines Could Affect Sales of Our Diagnostic Products. +From time to time, governmental agencies such as the Centers for Disease Control and Prevention (“CDC”) +issue diagnostic testing guidelines or recommendations, which can affect the usage of our products. For example, several years ago, the CDC issued guidelines recommending routine HIV screening for all people ages 13 to 64, with more frequent testing +for people at higher risk. These recommendations have resulted in increased HIV testing, including with our OraQuick +ADVANCE ® HIV-1/2 test. The CDC has also issued guidelines with respect to HCV testing and is expected to +issue new HCV testing guidelines later in 2012. The issuance of new testing guidelines, or changes in existing guidelines, and the manner in which these new or changed guidelines are interpreted and applied by healthcare practitioners, could have a +positive or negative impact on the degree to which our OraQuick ® rapid HIV and HCV testing products are +used. New or changed guidelines could affect the number of people tested, the frequency of testing and whether testing products such as our OraQuick ® rapid HIV and HCV tests are used broadly for screening large populations or in a more limited capacity as a confirmatory test. These factors could in turn affect +the level of sales of our products and our results of operations. +Reductions in Government Funding and Research Budgets +Could Adversely Affect Our Business and Financial Results. +We sell our OraQuick ADVANCE ® HIV-1/2 test and certain other products into the public health market which consists of state, county and other +governmental public health agencies, community based organizations, service organizations and similar entities. We also sell these products into the hospital market, including to hospitals owned or operated by agencies of the U.S. government such as +the Veterans Administration. Many of these customers depend to a significant degree on grants or funding provided by governmental agencies to run their operations including programs that use our products. In international markets, we often sell our +products to or through foreign governmental agencies or parties funded by such agencies. +Our subsidiary, DNAG, sells many of +its products to researchers at academic institutions, pharmaceutical and biotechnology companies, government laboratories and private foundations. Many of DNAG’s research customers are dependent for their funding on grants from U.S. +governmental agencies such as the U.S. National Institutes of Health and agencies in other countries. +The level of available +government grants or funding in the U.S. and elsewhere is unpredictable and may be affected by various factors including the current economic downturn, future economic conditions, legislative and regulatory developments, political changes, civil +unrest and changing priorities for research and development activities. Any reduction or delay in government funding could cause our customers to delay, reduce or forego purchases of our products. +27 +Table of Contents +On August 2, 2011, President Obama signed into law the Budget Control Act of 2011, +which was designed to reduce federal spending over the next 10 years by $2.5 trillion. Under that law, a select committee of Congress was tasked with identifying and recommending $1.2 trillion in spending cuts by late November 2011. Because the +committee did not agree on spending cuts within that time frame, certain automatic cuts to discretionary, national defense and Medicare spending will be implemented beginning in January 2013 unless Congress takes further action. These cuts would +result in Medicare payment reductions of up to 2% per fiscal year with a uniform percentage reduction across all Medicare programs starting in 2013. We cannot predict whether Congress will attempt to suspend or restructure the automatic budget +cuts or what other deficit reduction initiatives may be proposed by Congress. Although the full impact is uncertain, additional spending cuts implemented under this new law could adversely affect our customers’ ability to purchase our products. +In addition, other legislative or regulatory changes may be adopted which could adversely affect our ability to sell our current products or successfully develop and commercialize new products. +Increases in Demand for Our Products Could Require Us to Expend Considerable Resources or Harm Our Customer Relationships if We are +Unable to Meet That Demand. +If we experience significant or unexpected increases in the demand for our products, we and +our suppliers may not be able to meet that demand without expending additional capital resources. These capital resources could involve the cost of new machinery or new manufacturing facilities. This would increase our capital costs, which could +adversely affect our earnings. Our suppliers may be unable or unwilling to expend the necessary capital resources or otherwise expand their capacity. In addition, new manufacturing equipment or facilities may require FDA approval before they can be +used to manufacture our products. To the extent we are unable to obtain or are delayed in obtaining such approvals, our ability to meet the demand for our products could be adversely affected. +If we or our suppliers are unable to develop necessary manufacturing capabilities in a timely manner, our sales could be adversely +affected. If we fail to increase production volumes in a cost effective manner or if we experience lower than anticipated yields or production problems as a result of changes that we or our suppliers make in our manufacturing processes to meet +increased demand, we could experience shipment delays or interruptions and increased manufacturing costs, which could also have a material adverse effect on our revenues and profitability. +Unexpected increases in demand for our products may require us to obtain additional raw materials in order to manufacture products to +meet the demand. Some raw materials require significant ordering lead time and some are currently obtained from a sole supplier or a limited group of suppliers. We have long-term supply agreements with many of these suppliers, but these long-term +agreements involve risks for us, such as our potential inability to obtain an adequate supply of raw materials and components and our reduced control over pricing, quality and timely delivery. It is also possible that one or more of these suppliers +may become unwilling or unable to deliver materials to us. Any shortfall in our supply of raw materials and components, or our inability to quickly and cost-effectively obtain alternative sources for this supply, could have a material adverse effect +on our ability to meet increased demand for our products. This could negatively affect our total revenues or cost of sales and related profits. +Our inability to meet customer demand for our products could also harm our customer relationships and impair our reputation within the industry. This, in turn, could have a material adverse effect on our +business and prospects. +We Rely on Information Technology in Our Operations and Any Material Failure, Inadequacy, +Interruption or Security Breach of that Technology Could Harm Our Ability to Efficiently Operate Our Business. +We rely +heavily on information technology systems across our operations, including for management of inventory, purchase orders, invoices, shipping, interactions with our third-party logistics provider, revenue and expense accounting, online business and +various other processes and transactions. Our ability to effectively +28 +Table of Contents +manage our business, coordinate the production, distribution and sale of our products and ensure the timely and accurate recording and disclosure of financial information depends significantly on +the reliability and capacity of these systems. The failure of these systems to operate effectively, problems with transitioning to upgraded or replacement systems, or a breach in security of these systems through a cyber attack or otherwise could +cause delays in product sales and reduced efficiency of our operations. Significant capital investments could be required to remediate any such problem. Security breaches of employee information or other confidential or proprietary data could also +adversely impact our reputation, and could result in litigation against us or the imposition of penalties. +Risks Relating +to Collaborators +The Use of Sole Supply Sources or Third-Party Suppliers For Critical Components of Our Products Could +Adversely Affect Our Business. +We currently purchase certain critical components of our products from +sole supply sources or other third party suppliers. For example, all of the HIV antigens and nitrocellulose required to make our OraQuick ADVANCE ® HIV-1/2 test and OraQuick ® +HCV test is currently purchased from sole source suppliers. Our OraSure QuickFlu™ test is manufactured and supplied by a sole source supplier and the conjugates used in our MICROPLATE oral fluid drugs of abuse assays are obtained from third +party suppliers. +In addition, our subsidiary, DNAG, uses two third party manufacturers to supply +virtually all of its products, including its Oragene ® line of collection kits. Many of the raw materials and +components used in its products are also purchased from third parties, a critical one of which is obtained from a sole source supplier. +If our third-party suppliers are unable or unwilling to supply or manufacture a required component or product or if they make changes to a component, product or manufacturing process or do not supply +materials meeting our specifications, we may need to find another source and/or manufacturer. This could require that we perform additional development work. We may also need to obtain FDA or other regulatory approvals for the use of the alternative +component or changes to our products or manufacturing process. Completing that development and obtaining such approvals could require significant time and expense and such approvals may not occur at all. The availability of critical components and +products from sole supply sources or other third parties could also reduce our control over pricing, quality and timely delivery. These events could either disrupt our ability to manufacture and sell certain of our products into one or more markets +or completely prevent us from doing so, and could increase our costs. Any such event could have a material adverse effect on our results of operations, cash flow and business. +Our Failure to Maintain Existing Distribution Channels, or Develop New Distribution Channels, May Result in Lower Revenues. +We have marketed many of our products by collaborating with laboratories, diagnostic companies and distributors. Our sales depend to a substantial degree on our ability to sell products to these customers +and on the marketing and distribution abilities of the companies with which we collaborate. +Relying on distributors or others +to market and sell our products could harm our business for various reasons, including: +• +Our distributors or other customers may not fulfill their contractual obligations to us or otherwise market and distribute our products in the manner +or at the levels we expect; +• +Agreements with distributors may terminate prematurely due to disagreements or may result in litigation between the parties; +• +We may not be able to renew existing distribution agreements on acceptable terms or at all; +29 +Table of Contents +• +Our distributors may not devote sufficient resources or priority to the sale of our products; +• +Our existing distributor relationships or contracts may preclude or limit us from entering into arrangements with other distributors; and +• +We may not be able to negotiate future distribution agreements on acceptable terms or at all. +Although we will try to maintain and expand our business with distributors and customers and require that they fulfill their contractual +obligations, there can be no assurance that such companies will do so or that new distribution channels will be available on satisfactory terms. As a result, our revenues and business could be adversely affected. +The Unavailability of an FDA-Approved HIV-1 EIA Screening Test Distributed by a Third Party Could Adversely Affect +Sales of Our OraSure ® Oral Fluid Collection Device. +In testing an oral fluid sample collected with an OraSure ® device for HIV-1 in the United States, our customers must use an HIV-1 EIA screening test approved by the FDA for use with our OraSure ® collection device. There is currently only one company, Avioq, Inc., that manufactures and sells such an +FDA-approved screening test. If at some point in the future our customers cannot purchase the Avioq HIV-1 EIA or otherwise obtain an HIV-1 EIA screening test that has been approved by the FDA for use with our OraSure ® collection device, sales of our OraSure ® device could be negatively affected. +We +May Need Strategic Partners to Assist in Developing and Commercializing Some of Our Diagnostic Products. +Although we +intend to pursue some product opportunities independently, opportunities that require a significant level of investment for development and commercialization or a distribution network beyond our existing sales force may necessitate involving one or +more strategic partners. Our strategy for development and commercialization of products may entail entering into arrangements with distributors or other corporate partners, universities, research laboratories, licensees and others. Relying on +collaborative relationships could be risky to our business for a number of reasons, including: +• +We may be required to transfer material rights to such strategic partners, licensees and others; +• +Our collaborators may not devote sufficient resources or attach a sufficiently high priority to the success of our collaboration; +• +Our collaborators may not obtain regulatory approvals necessary to continue the collaborations in a timely manner; +• +Our collaborators may be acquired by another company and decide to terminate our collaborative arrangement or become insolvent; +• +Our collaborators may develop technologies or components competitive with our products; +• +Disagreements with collaborators could result in the termination of the relationship or litigation; +• +Collaborators may not have sufficient capital resources; and +• +We may not be able to negotiate future collaborative arrangements, or renewals of existing collaborative agreements, on acceptable terms or at all. +While we expect that our current and future collaborative partners have and will have an economic +motivation to succeed in performing their contractual responsibilities, there is no assurance that they will do so and the amount and timing of resources to be devoted to these activities will be controlled by others. Consequently, there can be no +assurance that any revenues or profits will be derived from such arrangements. +30 +Table of Contents +We may need to collaborate with one or more third parties in order to +commercialize our OraQuick ® HIV-1/2 test in the United States OTC market should we receive approval from the +FDA. In order to successfully commercialize an OraQuick ® HIV OTC test, we and/or our collaborators may need to +invest significantly in advertising and promotion in order to sell this product. If we are unable to collaborate with a third party having sufficient resources to assist in these efforts or find alternative distribution channels to access the OTC +market, we may need to incur significant costs for advertising and promotion, and our ability to maximize our future revenues and profits from this opportunity could be adversely affected. +Actions of a Third-Party Inventory Management and Logistics Provider Could Adversely Affect Our Ability to Supply Products to our +Customers. +In 2011, in order to improve efficiencies, we began using a third-party logistics provider to store and manage +our finished goods inventory and ship finished product to our customers. We have selected a highly reputable provider with extensive experience in the logistics field and have negotiated a long-term agreement for these services. However, in the +event our provider loses or damages our product, experiences a casualty or catastrophic event at its warehouse or otherwise fails to meet the requirements of our agreement for the safe storage and timely handling and delivery of our products, we +could incur additional costs, experience difficulty in supplying our products to our customers or suffer damage to our reputation in the industry. These events could, in turn, reduce our revenues and adversely affect our results of operations. +Risks Relating to Intellectual Property +Our Success Depends on Our Ability to Protect Our Proprietary Technology. +The diagnostics industry places considerable importance on obtaining patent, trademark and trade secret protection, as well as other +intellectual property rights, for new technologies, products and processes. Our success depends, in part, on our ability to develop and maintain a strong intellectual property portfolio or obtain licenses to patents and technologies both in the +United States and in other countries. If we cannot continue to develop, obtain and protect intellectual property rights, our revenue and gross profits could be adversely affected. Moreover, our current and future licenses or other rights to patents +and other technologies may not be adequate for the operation of our business. +As appropriate, we intend to file patent +applications and obtain patent protection for our proprietary technology. These patent applications and patents will cover, as applicable, compositions of matter for our products, methods of making those products, methods of using those products and +apparatus relating to the use or manufacture of those products. +We will also rely on trade secrets, know-how and continuing +technological advancements to protect our proprietary technology. We have entered, and will continue to enter, into confidentiality agreements with our employees, consultants, advisors and collaborators. Our employees and third-party consultants +also sign agreements requiring that they assign to us interests in inventions and original expressions and any patents or copyrights arising from their work. However, these parties may not honor these agreements. +We cannot guarantee that the process of filing patents, the laws governing trade secrets and proprietary information, or any agreements +we enter into with employees, consultants, advisors or collaborators will provide adequate protection of our intellectual property rights. Moreover, issued patents remain in effect for a fixed period and after expiration will not provide protection +of the inventions they cover. Once our patents expire, we may be faced with increased competition, which could reduce our revenues. We may also not be able to successfully protect our rights to unpatented trade secrets and know-how. Others may +independently develop substantially equivalent proprietary information and techniques or otherwise gain access to our trade secrets and know-how. +31 +Table of Contents +Some of our employees, including scientific and management personnel, were previously +employed by competing companies. Although we encourage and expect all of our employees to abide by any confidentiality agreement with a prior employer, competing companies may allege trade secret violations and similar claims against us. +We may collaborate with universities and governmental research organizations which, as a result, may acquire part of the rights to any +inventions or technical information derived from our collaboration with them. +To facilitate development and commercialization +of a proprietary technology base, we may need to obtain licenses to patents or other proprietary rights from other parties. Obtaining and maintaining such licenses may require the payment of substantial amounts. In addition, if we are unable to +obtain these types of licenses, our product development and commercialization efforts may be delayed or precluded. +We May +Become Involved in Intellectual Property Disputes, Which Could Increase our Costs and Limit or Eliminate Our Ability to Sell Our Products or Use Certain of Our Technologies in the Future. +From time to time, we may seek to enforce our patents or other intellectual property rights through litigation. In addition, there are a +large number of patents and patent applications in our product areas, and additional patents may be issued to third parties relating to our product areas. We or our customers may be sued for infringement of patents or misappropriation of other +intellectual property rights with respect to one or more of our products. Litigation in our industry regarding patent and other intellectual property rights is prevalent and is expected to continue. +Our industry is characterized by a large number of patents, claims of which appear to overlap in many cases. As a result, there is a +significant amount of uncertainty regarding the extent of patent protection and infringement. Companies may have pending patent applications, which are typically confidential for the first eighteen months following filing, that cover technologies we +incorporate in our products. Accordingly, we may be subjected to substantial damages for past infringement or be required to modify our products or stop selling them if it is ultimately determined that our products infringe a third party’s +proprietary rights. In addition, governmental agencies could commence investigations or criminal proceedings against our employees or us relating to claims of misuse or misappropriation of another party’s proprietary rights. +Our involvement in litigation or other legal proceedings with respect to patents or other intellectual property and proprietary +technology, either as a plaintiff or defendant, could adversely affect our revenues, market share, results of operations and business because: +• +As is common with major litigation, it could consume a substantial portion of managerial and financial resources; +• +Its outcome would be uncertain and a court may find that our patents are invalid or unenforceable in response to claims by another party or that the +third-party patent claims are valid and infringed by our products; +• +An adverse outcome could subject us to the loss of the protection of our patents or to liability in the form of past royalty payments, penalties, +reimbursement of litigation costs and legal fees, special and punitive damages, or future royalty payments significantly affecting our future earnings; +• +Failure to obtain a necessary license upon an adverse outcome could prevent us from selling our current products or other products we may develop or +acquire; +• +The pendency of any litigation may in and of itself cause our distributors and customers to reduce purchases of our products; and +• +A court could award a preliminary and/or permanent injunction, which would prevent us from selling our current or future products. +32 +Table of Contents +We may indemnify some customers and strategic partners under our agreements with such +parties if our products or activities have actually or allegedly infringed upon, misappropriated or misused another party’s proprietary rights. Further, our products may contain technology provided to us by other parties, such as contractors, +suppliers or customers, and we may have little or no ability to determine in advance whether such technology infringes the intellectual property rights of a third party. These other parties may also not be required or financially able to indemnify +us in the event that an infringement or misappropriation claim is asserted against us. +We may also become involved in other +types of disputes regarding intellectual property rights, including state, federal or foreign court litigation, and patent interference, patent reexamination, patent reissue, or trademark opposition proceedings in the United States Patent and +Trademark Office. Opposition or revocation proceedings could be instituted in a foreign patent office. An adverse decision in any proceeding regarding intellectual property rights could result in the loss or limitation of our rights to a patent, an +invention or trademark. +The Sales Potential for Our OraQuick ® Products Could be Affected by Our Ability to Obtain Certain Licenses and by Future Litigation. +Our OraQuick ® test platform is a lateral flow assay that tests for specific antibodies or other substances. The term “lateral flow” generally refers to a test strip +through which a sample flows and which provides a test result on a portion of the strip downstream from where the sample is applied. There are numerous patents in the United States and other countries which claim lateral flow assay methods and +devices. There are also patents that cover the type of analyte or antibody (i.e., HIV-1, HIV-2, HCV, etc.) which our +OraQuick ® test is designed to detect. Some of these patents may broadly cover the aspects of our OraQuick ® test and are in force in the United States and other countries. We may not be able to make or sell the OraQuick ® test in the United States or other countries where these patents are in force. +We have obtained licenses under several lateral flow patents, and assays directed at specific analytes, which we +believe are sufficient to permit the manufacturing and sale of the OraQuick ® device as currently contemplated. +However, licenses under additional patents may be required and it is possible that a third party could seek to enforce one or more patents against us. +If we are unable to successfully defend against or resolve patent infringement litigation or it is determined that a license is required and it is not possible to negotiate or otherwise obtain a license +agreement on reasonable terms under a necessary patent, our ability to manufacture and sell OraQuick ® devices +and develop and commercialize new applications using the same technology could be limited and we may incur increased costs or damages. In such case, we may be able to modify the OraQuick ® test to avoid the claim of infringement or the need for a license. However, this alternative could delay or limit our ability to sell the OraQuick ® test in the United States and other markets, which would adversely affect our results of operations, cash flow and +business. +Risks Relating to Products, Marketing and Sales +A Market for Our Products May Not Develop. +Our future success will depend, in part, on the market acceptance, and the timing of such acceptance, of new products +such as our OraQuick ® HCV test, an OraQuick ® HIV OTC test, and other new products or technologies that may be developed or acquired. To achieve market acceptance, we and/or our distributors will likely be +required to undertake substantial marketing efforts and spend significant funds to inform potential customers and the public of the perceived benefits of these products. In addition, governmental funding for the purchase of our products may be +needed to help create market acceptance and expand the use of our products. +33 +Table of Contents +There may be limited evidence on which to evaluate the market reaction +to products that may be developed and our marketing efforts for new products may not be successful. It is also possible that governmental funding may be limited for new products, such as an OraQuick ® HCV test. As such, there can be no assurance that any products will obtain market acceptance and fill the market need that is perceived to exist. +If Acceptance and Adoption of Oral Fluid Testing and Collection Products Does Not Continue, Our Future Results May Suffer. +We have made significant progress in gaining acceptance of oral fluid testing products, particularly for (i) HIV +testing in the public health, hospital, insurance and other markets, and (ii) drugs of abuse testing in the workplace and criminal justice markets. Our subsidiary, DNAG, has also made significant progress in gaining acceptance of oral fluid +collection products that are used with genetic and other molecular testing applications. However, the degree of acceptance for these products is uncertain, and one or more markets may resist the adoption of oral fluid products as a replacement for +other testing or collection methods in use today. As a result, there can be no assurance that we will be able to expand the use of our oral fluid testing products in these or other markets. +Our Customers May Resist Adoption of Rapid Point-of-Care Diagnostic Testing. +We expect sales of our rapid point-of-care diagnostic products, such as our OraQuick ADVANCE ® HIV-1/2 and OraQuick ® HCV tests, to become an increasingly important part of our business. Rapid point-of-care tests are beneficial to healthcare providers because, among other things, +they can be administered by providers in their own facilities without sending samples to central laboratories and can help ensure that test results are delivered to the individuals being tested. +However, clinical reference laboratories and hospital-based laboratories currently provide the majority of diagnostic tests used by +physicians and other healthcare providers in the U.S. In certain international markets such as Europe, diagnostic testing is performed primarily by centralized laboratories. Our future sales will depend, in part, on our ability to expand market +acceptance of rapid point-of-care testing by physicians and other healthcare providers and successfully compete against laboratory testing methods and products. We expect that clinical reference and other hospital-based laboratories will continue to +compete vigorously against our rapid point-of-care products. Even if we can demonstrate that our products are more cost effective, save time, or have better performance or other benefits, physicians and other healthcare providers may resist changing +to rapid point-of-care tests and instead may choose to use competing laboratory tests. Our failure to achieve initial or additional market acceptance of our rapid point-of-care diagnostic tests with customers would have a negative effect on our +future sales growth. +We Expect to Face Intense Competition From Other Providers of Diagnostic Tests and Collection +Products. +Our rapid point-of-care tests compete with similar point-of-care products made by our +competitors. This competition is particularly evident with respect to our OraQuick ADVANCE ® HIV-1/2 test. +In addition, the Oragene ® product line sold by our subsidiary, DNAG, competes against other molecular collection +products, such as blood collection kits and buccal swabs. There are a number of competitors making investments in competing technologies and products, and a number of our competitors may have a competitive advantage because of their greater +financial, technical, research and other resources. Moreover, some competitors offer broader product lines, aggressively discount prices for their products and may have greater name recognition than we have. If our competitors’ products are +more effective than ours or take market share from our products through more effective marketing or competitive pricing, our revenues, margins and operating results could be adversely affected. +34 +Table of Contents +Sales of our OraSure QuickFlu™ Test May be Affected by Factors Beyond our Control. +In 2011, we began selling a new rapid flu test under the tradename OraSure QuickFlu™, primarily in the U.S. hospital +and public health markets. A number of factors that are beyond our control could affect sales of this product, including: +• +Variability in the timing of the onset, length and severity of the flu season, which typically occurs from November of one year to May of the following +year; +• +Competition from other rapid flu tests in the markets we serve; +• +Deficiencies in the manufacture, design or performance of the product or failure by the manufacturer to meet applicable quality and regulatory +standards; +• +The failure of our supplier for this product to obtain a CLIA waiver, which we believe is important to expand sales, particularly in the public health +market; +• +The inability of our supplier to provide sufficient quantities of the product; +• +Changes in the types or strains of influenza during a particular flu season; +• +Lower than expected market penetration of the OraSure QuickFlu™ test; and +• +Our inexperience in selling a rapid flu test. +Our Inability to Carry Out Certain of Our Marketing and Sales Plans May Make it Difficult for Us to Grow or Maintain Our Business. +We have implemented in the past, and we intend to implement in the future, an aggressive sales and marketing plan to expand sales of our +products. Specifically, we will continue to expand the impact of our direct field sales force, use third party distributors and manufacturers’ sales representatives, and implement other sales and marketing programs. If we are unable to +successfully implement these programs or modify these programs in response to evolving market and economic conditions, we may be unable to grow and our business could suffer. +Our Sales Cycles Can be Lengthy, and May Depend on Public Funding, Which Can Cause Variability and Unpredictability in Our Operating Results. +The sales cycles for certain of our products can be lengthy and unpredictable, which makes it more difficult to +accurately forecast revenues in a given period and may cause revenues and operating results to vary from period to period. Sales of our products often involve purchasing decisions by large public and private institutions, may require many levels of +approval and may be dependent on economic or political conditions and the availability of grants or funding from governmental or public health agencies which can vary from period to period in both amount and timing. For example, in past years our +OraQuick ADVANCE ® HIV-1/2 test has been purchased through bulk procurement or other funding provided by +governmental agencies. There can be no assurance that purchases or funding from these agencies will occur or continue, especially if current negative economic conditions continue or intensify. As a result, we may expend considerable resources on +unsuccessful sales efforts or we may not be able to complete transactions at all or on a schedule and in an amount consistent with our objectives. +We May be Sued for Product Liabilities for Injuries Resulting From the Use of Our Products. +We may be held liable if any of our products, or any product which is made with the use or incorporation of any of our technologies, causes injury of any type or is found otherwise unsuitable during +product testing, manufacturing, marketing, sale or usage. There is no assurance that we would be successful in defending any product liability lawsuits brought against us. Regardless of merit or eventual outcome, product liability claims could +result in: +• +Decreased demand for our products; +35 +Table of Contents +• +Lost revenues; +• +Damage to our image or reputation; +• +Costs related to litigation; +• +Diversion of management time and attention; and +• +Incurrence of damages payable to plaintiffs. +We are selling cryosurgical products in the consumer or OTC market in certain countries. We may expand the OTC sales +of these products to other countries and intend eventually to distribute other types of products in the domestic and international OTC markets, such as our OraQuick ® HIV-1/2 test. We believe the sale of products in the OTC market increases the risk of potential product liability exposure. +The Insurance We Purchase to Cover Our Potential Business Risks May be Inadequate. +Although we believe that our present product liability and other insurance coverage is sufficient to cover our current estimated +exposures, we cannot be sure that we will not incur liabilities in excess of our policy limits. In addition, although we believe that we will be able to continue to obtain adequate coverage in the future, there is no assurance that we will be able +to do so at acceptable costs. +We Could Suffer Monetary Damages, Incur Substantial Costs or be Prevented From Using +Technologies Important to Our Products as a Result of Legal Proceedings. +We have been and in the future may become +involved in various legal proceedings arising out of our businesses. These may include commercial disputes, negligence claims or various other lawsuits arising in the ordinary course of our business, including employment matters. Such lawsuits can +seek damages, sometimes in substantial amounts, for commercial or personal injuries allegedly suffered and can include claims for punitive or other special damages. An adverse ruling or rulings in one or more such lawsuits could, individually or in +the aggregate, result in the termination or modification of a material contract or otherwise have a material adverse effect on our sales, operations or financial performance. +Performance of Our Products May Affect Our Revenues, Stock Price and Reputation. +Our products are generally sold with labeling that contains performance claims approved or cleared by the FDA or other regulators. However, our products may not perform as expected. For example, a defect +in one of our diagnostic products or a failure by a customer to follow proper testing procedures, may cause the product to report inaccurate information such as a false positive result or a false negative result. If our products fail to perform in +accordance with the applicable label claims or otherwise in accordance with the expectations or needs of our customers, customers may switch to a competing product or otherwise stop using our products, and our revenues could be adversely affected. +In addition, poor performance by one or more of our products and publicity surrounding such performance could have an adverse effect on our reputation, our continuing ability to sell products and the prevailing market price of our Common Stock. +Our International Presence May Increase Our Risks and Expose Our Business to Regulatory, Cultural or Other Restraints. +We intend to increase revenue derived from international sales of our products. Our international sales accounted for +$14.2 million or 17% of total revenues in 2011, $11.5 million or 15% of total revenues in 2010 and $14.8 million or 19% of total revenues in 2009. In addition, in 2011 we acquired DNAG and as a result now have a direct presence in Canada. +36 +Table of Contents +A number of factors could adversely affect the performance of our business and/or cause us +to incur substantially increased costs because of our international presence and sales, including those set forth below: +• +The uncertainty of foreign laws and the potential for inconsistent imposition of legal and regulatory requirements; +• +Cultural and political differences that favor local competitors or make it difficult to effectively market, sell and gain acceptance of our products; +• +Inexperience in international markets and territories and difficulties in staffing and managing foreign operations; +• +Exchange rates, currency fluctuations, tariffs and other barriers, extended payment terms and dependence on and difficulties in finding and managing +international distributors or representatives; +• +Regulatory requirements (including compliance with applicable customs regulations) and the need for reimbursement approvals; +• +The inability to obtain or maintain ISO certification for our or our suppliers’ manufacturing facilities; +• +Our inability to obtain or maintain regulatory approvals or registrations for our products; +• +Our inability to identify international distributors and negotiate acceptable terms for distribution agreements; +• +The loss of one or more distributors and difficulties or delays in obtaining new or transferred product registrations or approvals for use by a +replacement distributor; +• +The creditworthiness of foreign distributors and customers and difficulty in collecting foreign accounts receivable; +• +Difficulty of enforcing contractual obligations or recovering damages under foreign legal systems; +• +Economic conditions, political instability, the absence of available funding sources, terrorism, civil unrest, war and natural disasters in foreign +countries; +• +Our exposure to liability under the Foreign Corrupt Practices Act and various other laws, rules and/or regulations applicable to us as a result of our +international sales; +• +Long sales cycles in international markets, especially for sales to foreign governments, quasi-governmental agencies and international public health +agencies; +• +The sale of competing products by foreign competitors at prices at or below such competitors’ or our costs; +• +The unavailability of licenses to certain patents in force in a foreign country which cover our products; and +• +Reduced protection for, or enforcement of, our patents and other intellectual property rights in foreign countries. +In addition, we have entered into a contract for the manufacture and supply of our OraQuick ® HIV-1/2 test in Thailand, and the Histofreezer ® cryosurgical product sold in international markets is currently manufactured by a third party in The Netherlands. We may enter into agreements to manufacture these or +other products in additional foreign countries as well. However, economic, cultural and political conditions and foreign regulatory requirements may slow or prevent the manufacture of our products in countries other than the United States. +Interruption of the supply of our products could reduce revenues or cause us to incur significant additional expenses in finding an alternative source of supply. Foreign currency fluctuations and economic conditions in foreign countries could also +increase the costs of manufacturing our products in foreign countries. +37 +Table of Contents +Risks Relating to the Economy, Our Financial Results, Investments, Credit Facilities and +Need for Financing +Continued Economic Volatility and Disruption Could Adversely Affect Our Results of Operations, Cash +Flow and Financial Condition or Those of Our Customers and Suppliers. +The recent global credit and financial crisis could +have a significant adverse effect on our operations. Current volatile economic conditions may continue for the foreseeable future and intensify, and have adversely affected and could continue to adversely affect our financial performance and +condition or those of our customers and suppliers. These circumstances could adversely affect our access to liquidity needed to conduct or expand our business or conduct future acquisitions or make other discretionary investments. Many of our +customers rely on public funding provided by federal, state and local governments, and this funding has been and may continue to be reduced or deferred as a result of current economic conditions. These circumstances may adversely impact our +customers and suppliers, which, in turn, could adversely affect their ability to purchase our products or supply us with necessary equipment, raw materials or components. +We Have a History of Losses and May Not Be Able to Achieve Sustained Profitability. +We have experienced annual net losses since 2008. In addition, as of December 31, 2011, the Company had an accumulated deficit of $147.4 million. Even though we achieved profitability several years +ago, there can be no assurance that we will be able to achieve or sustain profitability in the future. +Our ability to achieve +and sustain profitability in the future will be dependent upon a number of factors including, without limitation, the following: +• +Creating market acceptance for and selling increasing volumes of our OraQuick ADVANCE ® HIV-1/2 test and our +OraQuick ® HCV test in the United States and internationally; +• +The level of expenditures we are required to make in order to develop, obtain regulatory approvals for and successfully commercialize our new products; +• +Our ability to successfully launch new products after receipt of required regulatory approvals or the acquisition of rights to those products; +• +The success and revenue growth of our new subsidiary, DNAG, and the sales of its Oragene ® product line; +• +The degree to which certain of our new products may replace sales of our existing products and the financial impact of that change, including the +degree to which our OraQuick ADVANCE ® HIV-1/2 test will replace our OraSure ® collection device for HIV-1 testing or sales of our cryosurgical wart removal products in OTC markets will replace +sales of our Histofreezer ® product to physicians’ offices or other professional markets; +• +The degree to which our major distributors comply with their contractual obligations, including minimum purchase commitments; +• +Whether we are successful in obtaining and maintaining required regulatory approvals and registrations for our new products; +• +Changes in the level of competition, such as would occur if larger and financially stronger competitors introduced new or lower priced products to +compete with our products; +• +Changes in economic conditions in domestic or international markets, such as economic downturns, reduced demand, inflation and currency fluctuations; +• +Failure to achieve our targets for growth in revenues; +38 +Table of Contents +• +Changes in distributor buying patterns or a buildup of significant quantities in our distributors’ inventories or distribution channels; and +• +The costs and results of patent infringement and other litigation or claims asserted against us. +We May Experience Fluctuations in Our Financial Results or Fail to Meet Our Financial Projections. +Our operating results can fluctuate from quarter to quarter and year to year, which could cause our growth or financial performance to +fall below the expectations of investors and securities analysts. Our financial projections for future periods are based on a number of assumptions, including estimated demand for our products. However, sales to our distributors and other customers +may fall short of expectations because of less than estimated customer demand or other factors, including continued volatility and disruption in economic conditions, reduced governmental funding and other circumstances described elsewhere in this +Annual Report. Infrequent, unusual or unexpected changes in revenues or costs could also contribute to the variability of our financial results. In addition, our products provide different contributions to our gross margin and our operating results +could also fluctuate and be affected by the mix of products sold and the relative prices and gross margin contribution of those products. Failure to achieve operating results consistent with the expectations of investors and securities analysts +could adversely affect our reputation and the price of our Common Stock. +Our Estimates or Judgments Relating to Critical +Accounting Policies Are Based on Assumptions That Can Change or Prove to be Incorrect. +Our discussion and analysis of +financial condition and results of operations is based on our financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of financial statements in conformity with +generally accepted accounting principles requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. On an ongoing basis, we evaluate significant estimates used in +preparing our financial statements, including those related to: +• +Revenue recognition; +• +Allowance for uncollectible accounts receivable; +• +Reserve for inventory write-downs; +• +Stock-based compensation; +• +Potential impairment of long-lived and intangible assets including goodwill; +• +Clinical trial accruals; and +• +Contingencies. +We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances, as provided in our discussion and analysis of financial condition +and results of operations, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these and other estimates if our +assumptions change or if actual circumstances differ from those in our assumptions, which could cause our operating results to fall below the expectations of securities analysts and investors, resulting in a decline in our stock price. +Changes in Foreign Currency Exchange Rates Could Negatively Affect Our Operating Results. +Our financial statements are stated in U.S. Dollars and, historically, most of our international sales have also been denominated in U.S. +Dollars. As a result, in the past our exposure to foreign currency exchange rate risk has not been material. However, in August 2011 we acquired DNAG, a Canadian company. DNAG’s revenues and +39 +Table of Contents +operating results are recorded in Canadian Dollars and certain of its international sales are denominated in local currencies, including the Euro, British Pound and Australian Dollar. Our +expectation is that the DNAG business will continue to grow and our exposure to foreign currency exchange rates may be more significant than in past years. +Exchange rate fluctuations may affect DNAG’s revenues and expenses and the translation of DNAG’s financial results into U.S. Dollars. Unfavorable currency exchange rate fluctuations could +negatively affect our consolidated financial statements including our balance sheet, revenues and results of operations. In the past, we have not generally entered into hedging instruments to manage our currency exchange rate risk, but we may need +to do so in the future. However, our attempts to hedge against these risks may not be successful. If we are unable to successfully hedge against unfavorable foreign currency exchange rate movements, our consolidated financial results may be +adversely impacted. +Our Credit Facilities Contain Certain Financial Covenants Which, if Not Satisfied, Could Result in the +Acceleration of the Amounts Due Under These Facilities and Limit Our Ability to Borrow in the Future. +Our credit facility +with Comerica Bank contains various financial and other covenants with which we must comply on an ongoing or periodic basis. If we enter into new or additional credit facilities or loan agreements, we would expect those arrangements would contain +similar types of covenants. Although we do not expect to violate these covenants and obligations, if such a violation were to occur, the outstanding debt under our credit facility or other arrangement could become immediately due and payable, our +lender could proceed against any collateral securing such indebtedness and our ability to borrow additional funds in the future may be adversely affected. +We May Require Future Additional Capital. +Our future liquidity and ability +to meet our future capital requirements will depend on numerous factors, including, but not limited to, the following: +• +The costs and timing of expansion of sales and marketing activities; +• +The timing and success of the commercial launch of new products; +• +The extent to which we gain or expand market acceptance for existing, new or enhanced products; +• +The costs and timing of the expansion of our manufacturing capacity; +• +The success of our research and product development efforts; +• +The time, cost and degree of success of conducting clinical trials and obtaining regulatory approvals; +• +The magnitude of capital expenditures; +• +Changes in existing and potential relationships with distributors and other business partners; +• +The costs involved in obtaining and enforcing patents, proprietary rights and necessary licenses; +• +The costs and liability associated with patent infringement or other types of litigation; +• +Competing technological and market developments; and +• +The scope and timing of strategic acquisitions. +If additional financing is needed, we may seek to raise funds through the sale of equity or other securities or through bank borrowings. There can be no assurance that financing through the sale of +securities, bank borrowings or otherwise, will be available to us on satisfactory terms, or at all. +40 +Table of Contents +Terrorist Attacks or National Disasters May Adversely Affect Our Business. +Terrorist attacks or natural disasters, and subsequent governmental responses to these events, could cause economic +instability. These actions could adversely affect economic conditions both within and outside the United States and reduce demand for our products. These events could disrupt the operations of our customers and suppliers and eliminate, reduce or +delay our customers’ ability to purchase and use our products and our suppliers’ ability to provide raw materials and finished products. +Our manufacturing facilities are located in Bethlehem, Pennsylvania. Although we have business interruption insurance, our facilities, including some pieces of manufacturing equipment and our computer +systems, may be difficult to replace and could require substantial replacement lead-time. Various types of disasters, including earthquakes, fires, floods and acts of terrorism, may affect our manufacturing facilities and computer systems. In the +event our existing manufacturing facilities or computer systems are affected by man-made or natural disasters, we may have difficulty operating our business and may be unable to manufacture products for sale or meet customer demands or sales +projections. If our manufacturing operations were curtailed or ceased, it would seriously harm our business. +Risks Relating +to Our Common Stock +Our Stock Price Could Continue to be Volatile. +Our stock price has been volatile, has fluctuated substantially in the past, may be volatile in the future and could experience +substantial declines. The following factors, among others, could have a significant impact on the market for our Common Stock: +• +Future announcements concerning us, our products, our competitors or our industry; +• +Clinical results with respect to our products or those of our competitors; +• +Status of clinical studies and pending submissions for required regulatory approvals; +• +The gain or loss of significant contracts and availability of funding for the purchase of our products; +• +Delays in the development, regulatory approval or commercialization of new or enhanced products; +• +Legislative developments; +• +Disputes or developments with key customers, distributors or suppliers; +• +Developments in patent or other proprietary rights; +• +Litigation or threatened litigation; +• +Public concern as to the performance or safety of products that we or others have developed or sold; +• +Failure to achieve, or changes in, financial estimates by securities analysts and comments or opinions about us by securities analysts or major +stockholders; +• +Governmental regulation; +• +Changes in the level of competition; +• +Loss of or declines in sales to major distributors or customers or changes in the mix of products sold; +• +The relatively low trading volume for our Common Stock; +• +Period to period fluctuations in our operating results; +• +Additions or departures of key personnel; +• +General market and economic conditions; and +41 +Table of Contents +• +Terrorist attacks, civil unrest, war and national disasters. +In addition, the stock market in general has experienced extreme price and volume fluctuations that have affected the market price of our +Common Stock, as well as the stock of many companies in the diagnostics and life sciences industries. Often, price fluctuations are unrelated to operating performance of the specific companies whose stock is affected. +In the past, following periods of volatility in the market price of a company’s stock, securities class action litigation has +occurred against the issuing company. If we were subject to this type of litigation in the future, we could incur substantial costs and a diversion of our management’s attention and resources, each of which could have a material adverse effect +on our revenue and earnings. Any adverse determination in this type of litigation could also subject us to significant liabilities. +Future Sales of Our Common Stock by Existing Stockholders, Executive Officers or Directors Could Depress the Market Price of Our Common Stock and Make It More Difficult For Us to Sell Stock in the +Future. +Sales of our Common Stock in the public market, or the perception that such sales may occur, could negatively +impact the market price of our Common Stock. We are unable to estimate the number of shares of our Common Stock that may actually be resold in the public market since this will depend on the market price for our Common Stock, the individual +circumstances of the sellers and other factors. +We have a number of institutional stockholders that own significant blocks of +our Common Stock. If one or more of these stockholders sell large portions of their holdings in a relatively short time, for liquidity or other reasons, the prevailing market price of our Common Stock could be negatively affected. In addition, it is +possible that one or more of our executive officers or non-employee members of our Board of Directors could sell shares of our Common Stock during an open trading window or pursuant to a 10b5-1 sales plan under our Insider Trading Policy. These +transactions and the perceived reasons for these transactions could have a negative effect on the prevailing market price of our Common Stock. +Investor Confidence and Share Value May be Adversely Impacted if We and/or Our Independent Registered Public Accounting Firm Conclude That Our Internal Control Over Financial Reporting is Not +Effective. +As directed by Section 404 of the Sarbanes-Oxley Act of 2002, the SEC adopted rules requiring us, as a +public company, to include a report in our Annual Reports on Form 10-K that contains an assessment by management of the effectiveness of our internal control over financial reporting. In addition, our independent registered public accounting firm +must report on the effectiveness of these internal controls. +We expect that our internal controls will continue to evolve as +our business activities change. Although we seek to diligently and vigorously review our internal control over financial reporting in an effort to ensure compliance with the Section 404 requirements, any control system, regardless of how well +designed, operated and evaluated, can provide only reasonable, not absolute, assurance that its objectives will be met. In addition, the overall quality of our internal controls may be affected by the internal control over financial reporting +implemented by any business we acquire, such as DNAG, and our ability to assess and successfully integrate the internal controls of any such business. +If, during any year, our independent registered public accounting firm is not satisfied with our internal control over financial reporting or the level at which our controls are documented, designed, +operated, tested or assessed, or if the independent registered public accounting firm interprets the requirements, rules or regulations differently than we do, then it may issue a report that is qualified. We also could conclude that our internal +control over financial reporting is not effective. These events could result in an adverse reaction in the financial marketplace due to a loss of investor confidence in the reliability of our financial statements and effectiveness of our internal +controls, which ultimately could negatively impact the market price of our Common Stock. +42 +Table of Contents +Because We Do Not Intend to Pay Cash Dividends on Our Common Stock, an Investor in Our +Common Stock Will Benefit Only if it Appreciates in Value. +We currently intend to retain our current earnings and future +earnings, if any, to finance the expansion of our business and do not expect to pay any cash dividends on our Common Stock in the foreseeable future. As a result, the success of an investment in our Common Stock will depend entirely upon any future +appreciation. There is no guarantee that our Common Stock will appreciate in value or even maintain the price at which investors purchased their shares. +Certain Provisions in Our Certificate of Incorporation and Bylaws and Under Delaware Law Could Make a Third-Party Acquisition of Us Difficult. +Our Certificate of Incorporation and Bylaws contain provisions that could make it more difficult for a third party to acquire us, even if +doing so would be beneficial to our stockholders. We are also subject to certain provisions of Delaware law that could delay, deter or prevent a change in control of us. These provisions could limit the price investors might be willing to pay in the +future for shares of our Common Stock. +Future Sales of Shares of Our Common Stock Could Adversely Affect the Trading Price +of Our Common Stock and Our Ability to Raise Funds in New Equity Offerings. +Future sales of a substantial number of our +shares of Common Stock or equity-related securities in the public market or privately, or the perception that such sales may occur, could adversely affect prevailing trading prices of our Common Stock, and could impair our ability to raise capital +through future offerings of equity or equity-related securities. No prediction can be made as to the effect, if any, that future sales of shares of Common Stock or the availability of shares of Common Stock for future sale will have on the trading +price of our Common Stock. +ITEM 1B. +Unresolved Staff Comments. +Not Applicable. +ITEM 2. +Properties. +We own a +48,000 square foot facility which is our primary corporate office and manufacturing facility, a 31,700 square foot facility that houses our sales and marketing, research and development, human resources, and regulatory and quality offices, and a +33,500 square foot facility which is used for manufacturing activities. Each of these facilities is located in Bethlehem, Pennsylvania, and is subject to a mortgage in favor of Comerica Bank. We also rent additional warehouse space on an as-needed +basis. In addition, our subsidiary, DNAG, leases a 23,500 square foot facility in Ottawa, Canada, which is used as its primary corporate office and houses sales and marketing, research and development, and regulatory and quality operations. +We believe that the facilities described above are adequate for our current requirements. +ITEM 3. +Legal Proceedings. +Cryosurgical Patent Infringement Litigation +In December 2009, we filed legal proceedings in the Patents Court of the High Court of England and Wales against D.D.D. Limited, DioMed Developments Limited and Sixtem Life Srl, alleging that the import +and/or sale of the Bazuka Sub-Zero OTC cryosurgical product by the defendants in the United Kingdom infringes our European Patent (UK) 0 608 954. We are seeking injunctive relief and damages, among other remedies, in this matter. The defendants have +filed a response denying infringement and alleging that our patent is invalid. +43 +Table of Contents +Since the filing of these proceedings, the parties have engaged in discovery and +participated in mediation. A trial in this matter is expected to occur in late April 2012. +ITEM 4. +Mine Safety Disclosures. +Not Applicable. +44 +Table of Contents +PART II +ITEM 5. +Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities. +Market Information +Our +Common Stock is listed for trading on the Global Select Market tier of The Nasdaq Stock Market LLC (“NASDAQ”) under the symbol OSUR. High and low sales prices reported by NASDAQ during the periods indicated are shown below. +Year ended December 31, +2011 +2010 +High +Low +High +Low +First Quarter +$ +7.87 +$ +5.81 +$ +6.09 +$ +4.75 +Second Quarter +9.00 +7.06 +6.80 +4.15 +Third Quarter +10.10 +6.29 +5.09 +3.18 +Fourth Quarter +9.96 +7.52 +6.15 +3.79 +On March 9, 2012, there were 494 holders of record and approximately 9,200 holders in street name of our +Common Stock, and the closing price of our Common Stock was $9.48 per share. +Dividends +We have never paid any cash dividends and our Board of Directors does not anticipate paying cash dividends in the foreseeable future. We +are generally not permitted to pay dividends or make other distributions to our stockholders under the terms of our credit facilities with Comerica Bank, without first obtaining Comerica’s consent. We intend to retain any future earnings to +provide funds for the operation and expansion of our business. +Share Repurchases and Retirements +Pursuant to our Stock Award Plan and in connection with the vesting of restricted shares, we retired 2,697 shares to satisfy minimum tax +withholding obligations during the three months ended December 31, 2011. No shares were repurchased under our $25.0 million share repurchase program during this same period. +45 +Table of Contents +Performance Graph +The performance graph set forth below shall not be deemed “soliciting material” or “filed” for purposes of Section 18 of the Securities Exchange Act of 1934, as amended (the +“Exchange Act”), or otherwise subject to liability under that Section. This graph will not be deemed “incorporated by reference” into any filing under the Securities Act of 1933, as amended, or the Exchange Act, whether such +filing occurs before or after the date hereof, regardless of any general incorporation language in such filing. +The +following graph compares the cumulative total returns to investors in the Company’s Common Stock, the NASDAQ Composite Index and the NASDAQ Biotechnology Index for the period from December 31, 2006 through December 31, 2011. The graph +assumes that $100 was invested on December 31, 2006 in the Company’s Common Stock and in each of the above-mentioned indices, and that all dividends, if any, were reinvested. +The NASDAQ Composite Index was chosen because it is a broad index of companies whose equity securities are traded on the NASDAQ Stock +Market. The NASDAQ Biotechnology Index was chosen because it includes a number of our competitors. Stockholders are cautioned that the graph shows the returns to investors only as of the dates noted and may not be representative of the returns for +any other past or future period. +12/06 +12/07 +12/08 +12/09 +12/10 +12/11 +OraSure Technologies, Inc. +$ +100.00 +$ +107.63 +$ +44.55 +$ +61.50 +$ +69.61 +$ +110.29 +NASDAQ Composite +100.00 +110.26 +65.65 +95.19 +112.10 +110.81 +NASDAQ Biotechnology +100.00 +102.53 +96.57 +110.05 +117.19 +124.54 +46 +Table of Contents +ITEM 6. +Selected Consolidated Financial Data +The following table sets forth selected consolidated financial data of the Company. This information should be read in conjunction with the consolidated financial statements and notes thereto included in +Item 15 and the information set forth in Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations.” +Selected Consolidated Financial Data +(In thousands, except per share +data) +Year ended December 31, +2011 1 +2010 +2009 +2008 +2007 +Operating Results: +Revenues +$ +81,881 +$ +75,015 +$ +77,026 +$ +71,104 +$ +82,686 +Costs and expenses +91,279 +78,369 +85,819 +82,551 +83,905 +Operating loss +(9,397 +) +(3,354 +) +(8,793 +) +(11,447 +) +(1,219 +) +Other income (expense), net +(312 +) +(143 +) +357 +2,699 +5,513 +Income tax provision (benefit) +(869 +) +— +(622 +) +22,527 +2 +1,821 +Net income (loss) +(8,841 +) +(3,497 +) +(7,813 +) +(31,275 +) 2 +2,472 +Earnings (loss) per share +Basic and Diluted +$ +(0.19 +) +$ +(0.08 +) +$ +(0.17 +) +$ +(0.67 +) +$ +0.05 +Shares used in computing earnings (loss) per share +Basic +46,908 +46,187 +45,878 +46,550 +46,325 +Diluted +46,908 +46,187 +45,878 +46,550 +46,878 +Cash Flow: +Cash flows provided by (used in) operating activities +$ +(2,994 +) +$ +3,887 +$ +(293 +) +$ +(2,460 +) +$ +11,584 +December 31, +2011 1 +2010 +2009 +2008 +2007 +Financial Position: +Cash, cash equivalents, and short-term investments +$ +23,878 +$ +75,738 +$ +79,670 +$ +82,523 +$ +95,566 +Working capital +30,860 +77,808 +89,435 +90,936 +105,620 +Deferred tax assets +— +— +— +— +22,327 +Total assets +127,861 +122,520 +126,991 +131,918 +167,353 +Long-term debt, excluding current portion +— +— +7,792 +8,301 +8,818 +Accumulated deficit +(147,426 +) +(138,585 +) +(135,088 +) +(127,275 +) +(96,000 +) +Stockholders’ equity +100,250 +102,843 +103,807 +108,325 +140,055 +1 +Includes DNA Genotek, Inc. beginning on the acquisition date of August 17, 2011 as well as $2.6 million of transaction costs associated with the +acquisition. +2 +Includes an income tax provision of $25,978 resulting from the establishment of a full valuation allowance on our net deferred tax assets. +47 +Table of Contents +ITEM 7. +Management’s Discussion and Analysis of Financial Condition and Results of Operations. +Statements below regarding future events or performance are “forward-looking statements” within the meaning of the Private +Securities Litigation Reform Act of 1995. Our actual results could be quite different from those expressed or implied by the forward-looking statements. Factors that could affect results are discussed more fully under the Item 1A, entitled +“Risk Factors,” and elsewhere in this Annual Report. Although forward-looking statements help to provide complete information about us, readers should keep in mind that forward-looking statements may not be reliable. Readers are cautioned +not to place undue reliance on the forward-looking statements. We undertake no duty to update any forward-looking statements made herein after the date of this Annual Report. +The following discussion should be read in conjunction with the consolidated financial statements contained herein and the notes thereto, +along with the Section entitled “Critical Accounting Policies and Estimates,” set forth below. +Overview +We operate primarily in the in vitro diagnostic business. Our business principally involves the development, manufacture, marketing +and sale of oral fluid diagnostic products and specimen collection devices using our proprietary oral fluid technologies, as well as other diagnostic products including immunoassays and other in vitro diagnostic tests that are used on other +specimen types. We also manufacture and sell medical devices used for the removal of benign skin lesions by cryosurgery, or freezing. Our diagnostic products include tests that are performed on a rapid basis at the point of care and tests that are +processed in a laboratory. These products are sold in the United States and internationally to various clinical laboratories, hospitals, clinics, community-based organizations and other public health organizations, distributors, government agencies, +physicians’ offices, and commercial and industrial entities. One of our products has been sold in the OTC or consumer retail market in North America, Europe, Central and South America, and Australia. +In vitro diagnostic testing is the process of analyzing oral fluid, blood, urine and other bodily fluids or tissue for the +presence of specific substances or markers. We have targeted the use of oral fluid in our products as a differentiating factor and believe that it provides a significant competitive advantage over blood and urine. Our oral fluid tests have +sensitivity and specificity comparable to blood and/or urine tests. When combined with their ease of use, non-invasive nature, and cost effectiveness, our oral fluid tests represent a very competitive alternative to the more traditional testing +methods in the diagnostic space. +On August 17, 2011, we completed the acquisition of our subsidiary, +DNAG. DNAG is based in Ottawa, Canada and manufactures and sells kits that are used to collect samples of genetic material for molecular testing in the academic research, clinical genetic testing, pharmacogenomics, personalized medicine, animal and +livestock genetics markets. DNAG’s lead product line, which is sold under the Oragene ® tradename, provides +an all-in-one system for the collection, stabilization, transportation and storage of DNA from human saliva. DNAG serves customers in multiple countries worldwide, including many leading research universities and hospitals in the world. +We rely heavily on distributors to purchase and resell many of our products. For example, Genomma Labs +(“Genomma”) has exclusive rights to our wart removal product in the OTC market in Mexico, Argentina, Brazil and various other Central and South American countries and Reckitt Benckiser (formerly SSL International plc) has similar rights to +our wart removal product in the OTC footcare market in Europe, Australia and New Zealand. We have contracted with several distributors to sell our OraQuick ADVANCE ® HIV-1/2 test to the U.S. physician office market and our Intercept ® and OraSure ® product lines +are sold by several laboratory distributors. We use distributors to sell our Histofreezer ® product into the +domestic and international physician office markets and we have engaged distributors to sell our OraQuick ® rapid +HIV and HCV tests in international markets. We expect to enter into additional distribution agreements for existing and future products in the U.S. +48 +Table of Contents +and internationally. If our distributors are unable or unwilling to meet the minimum purchase commitments set forth in their agreements or otherwise substantially reduce the volume of their +purchases, our revenues and results of operations could be adversely affected. +Because of the regulatory +approvals needed for most of our products, we often are required to rely on sole source providers for critical components and materials and on related products supplied by third parties. This is particularly true for our OraQuick ADVANCE ® HIV-1/2 test, our OraQuick ® HCV test, our OraSure ® oral +fluid collection device and our oral fluid Western blot HIV-1 confirmatory product. If we are unable to obtain necessary components or materials from these sole sources or if related products become unavailable, the time required and expense +incurred to develop replacements and obtain the required FDA approvals could disrupt our ability to sell the affected products and could adversely impact our revenues and results of operations. Our OraSure QuickFlu ™ test is manufactured and supplied by a sole source supplier and DNAG also utilizes contract manufacturers to supply +all of its products and certain components to these products. Any disruption in the ability of these parties to manufacture and supply finished goods or product components for us or DNAG could adversely impact our revenues and results of operations. +Competitive and Economic Outlook +Competition in the U.S. market for HIV testing is intense and is expected to increase. We believe that our principal competition will come from existing and new point-of-care rapid blood tests, automated +laboratory-based blood tests, or other oral fluid-based tests that may be developed. Our competitors include medical diagnostic companies and specialized biotechnology firms, as well as pharmaceutical companies with biotechnology divisions. +Competing rapid blood tests are often sold at a lower price than we charge for our OraQuick ® HIV test. This +competition can result in lost sales and degradation of the price (and therefore the profit margin) we can charge for our product. +During 2011, our OraQuick ® HCV test was sold primarily to customers +operating CLIA-certified laboratories and competed against other laboratory-based HCV blood tests. However, in November 2011, we received a CLIA waiver for this product, which enables us to sell our HCV product to many other customers that perform +CLIA waived tests, such as outreach clinics, community-based organizations and physician offices. The CLIA-waiver allows us to deploy the test more broadly in both the public health and hospital markets and, with the assistance of our collaborator, +Merck & Co., Inc., (“Merck”), into the physician office market. +We believe the FDA +approval in 2011 of two new therapeutic treatments for HCV, both of which are more effective than previously available treatments, will help drive awareness and testing for HCV, including with our OraQuick ® HCV rapid test. While CLIA waiver opens the opportunity for significant sales growth in 2012, demand for our HCV +product will ultimately depend on the availability of government funds allocated to HCV testing efforts. In addition, sales growth will depend on the success of Merck’s detailing efforts into the physician offices under our HCV collaboration +arrangement. +In Europe and other non-U.S. countries, our rapid HIV and HCV tests compete against other +rapid and laboratory-based tests. Significant sales of these products in Europe have not materialized principally because of differences in European healthcare systems compared to our U.S. systems. Unlike the U.S., adoption of rapid point-of-care +diagnostics is not widespread in Europe because laboratory testing is entrenched and healthcare systems are structured around centralized testing models. In addition, many competing tests in international markets are sold at very low prices. We +intend to continue working to build awareness and develop strategies to expand sales of our OraQuick ® HIV and +HCV tests in European and other international markets. +In the substance abuse testing market, we expect competition for our +products to intensify. Other companies have developed, and will continue to develop, competing oral fluid drug testing products. In particular, there are at least two competitors that sell high-throughput fully automated oral fluid drug testing +products in unregulated settings in the United States. In addition, one of these competitors has received 510(k) clearance of its product. This 510(k) cleared product is being offered by one of our large laboratory distributors and we expect this +49 +Table of Contents +distributor to stop selling our Intercept ® product during +2012. These new products will compete against both our current Intercept ® products and the high-throughput +assays we intend to commercialize jointly with Roche Diagnostics. +DNAG’s primary product, the +Oragene ® collection system, competes against other types of collection devices used for molecular testing, such +as blood collection devices and buccal swabs, that often are sold for prices lower than the prices charged for the +Oragene ® products. Although we believe the Oragene ® device offers a number of advantages over these other products, the availability of lower price competitive devices can result in lost sales and degradation in +pricing and profit margin. +Finally, current economic conditions, including disruptions in the capital and credit markets, may +continue for the foreseeable future and intensify. These conditions have adversely affected and could continue to adversely affect our financial performance and condition or those of our customers and suppliers. These circumstances could adversely +affect our access to liquidity needed to conduct or expand our business or conduct future acquisitions or make other discretionary investments. Many of our customers rely on public funding provided by federal, state and local governments, and this +funding has been and may continue to be reduced or deferred as a result of current economic conditions. These circumstances may adversely impact our customers and suppliers, which, in turn, could adversely affect their ability to purchase our +products or supply us with necessary equipment, raw materials or components. In addition, demand for our products may also be adversely affected by current economic conditions. +Current Consolidated Financial Results +During the year +ended December 31, 2011, our total consolidated revenues were $81.9 million (including $6.2 million from the operations of DNAG), which represents a 9% increase from 2010. Excluding revenues of DNAG, product revenues during the year ended +December 31, 2011 increased 5% when compared to 2010. Licensing and product development revenues decreased in 2011 primarily as a result of the absence of $2.0 million in milestone payments received under the terms of our collaboration +agreement with Merck during the year ended December 31, 2010 for the development and promotion of our +OraQuick ® rapid HCV test in Europe. +Our consolidated net loss for the year ended December 31, 2011 was $8.8 million, or $0.19 per share, compared to +a net loss of $3.5 million, or $0.08 per share, for the year ended December 31, 2010. Our loss for the current period included $7.9 million of clinical trial spending related to the our +OraQuick ® HIV OTC product, $2.6 million of transaction costs incurred in connection with the DNAG acquisition +and $2.1 million of non-cash charges associated with the amortization of intangible assets and certain purchase accounting adjustments related to the DNAG acquisition. +Cash flow used in operating activities for the year ended December 31, 2011 was $3.0 million, compared to the $3.9 million provided by operating activities for the year ended December 31, 2010. +As of December 31, 2011, we had $23.9 million in cash, cash equivalents and short-term investments, compared to $75.7 million at December 31, 2010. During 2011, we used $52.3 million of our cash to fund the DNAG acquisition and related +transaction expenses. +2011 Developments +OraQuick ® HCV Test +During 2011, we continued our efforts to obtain FDA approval of additional applications for our OraQuick ® HCV test. In February 2011, we received FDA approval for use of this device with fingerstick whole blood samples. +This product is now approved for use in the U.S. with both venous whole blood and fingerstick whole blood. Although we currently intend to pursue approval of an oral fluid claim for our OraQuick ® HCV test, the filing of a PMA supplement for oral fluid has been delayed pending the completion of further discussions with the FDA. +50 +Table of Contents +In March 2011, we submitted to the FDA an application for a CLIA waiver +for our OraQuick ® HCV test for use with venous and fingerstick whole blood. This waiver was granted by the FDA +in November 2011. With the receipt of the CLIA waiver, we have begun several sales and marketing initiatives, which include the detailing by Merck of the product into the U.S physician office market under the terms of our HCV collaboration +agreement. Additionally, we are finalizing and implementing distribution agreements with several large distributors to sell into physicians’ offices and federally funded community health centers. We are also continuing to sell the product to +hospitals while expanding our direct sales efforts to public health departments that currently have the infrastructure in place to conduct rapid HIV testing. +OraQuick ® HIV OTC Test +In the third quarter of 2011, we completed the final phase of clinical testing for an OraQuick ® HIV OTC test. In this study, individuals conducted unsupervised self-testing using the investigational OTC version +of our OraQuick ADVANCE ® HIV test with an oral fluid collection. One of the study objectives specified by +the FDA was to identify at least 100 HIV infected, but undiagnosed individuals. In total, we enrolled and tested over 5,800 subjects using 20 clinical sites across the U.S. and identified more than 100 previously undiagnosed HIV infected +individuals. +Our FDA submission for this product was made in three separate parts or modules. The first module was filed in +August 2011 and contained data from all studies performed prior to the final phase. The second module contained information about our manufacturing and Customer Care Call Center and was filed near the end of November. The final module contained the +results of the unobserved clinical trial and was filed in late December 2011. +During 2011, we continued planning for the +commercial launch of our HIV OTC test. We completed an intensive interview process and selected an advertising agency, a sales, distribution and logistics provider, and a public relations firm to help market our test. We also selected a third party +to operate our Customer Care Call Center following commercial launch of this product. In addition, we initiated a new round of market research to refresh our messaging and product positioning and to sharpen our demand forecast. We expect this +research to be completed during the first half of 2012. +According to the Centers for disease Control and Prevention +(“CDC”), there are approximately 1.2 million people in the U.S. that are infected with HIV and approximately 240,000 of them are unaware of their status, despite current HIV testing options. Not only is their own health at risk, they +are also unknowingly responsible for up to 70 % of the approximately 50,000 new HIV infections occurring each year in the U.S. The CDC recommends routine HIV screening for all people ages 13 to 64, with more frequent testing for people at +higher risk. +We believe these CDC figures demonstrate that current HIV testing in the U.S. is inadequate and there is a +market for additional options to capture undiagnosed individuals infected with HIV, such as our HIV OTC test. +OraQuick ® HIV Shelf Life +During the second quarter of 2011, the FDA approved a dating extension for our OraQuick ADVANCE ® HIV-1/2 test from 24 to 30 months. We also received approval from our notified body to extend dating to 30 months in Europe. In addition to being important for +the professional markets that we serve, this shelf life extension is critical for our HIV OTC product. Assuming we receive FDA approval, we believe an HIV OTC product offering would need a minimum shelf life of 24 months or more in order to be +successful. +Oragene ® — Dx 510(k) Clearance +In December 2011, DNAG received FDA 510(k) clearance for its +Oragene ® — Dx collection device, making it the first and only +saliva DNA collection and stabilization device to receive 510(k) clearance. This FDA 510(k) +51 +Table of Contents +clearance permits clinical diagnostics and personalized medicine customers to use the Oragene ® — Dx product with FDA-approved molecular testing applications. This FDA clearance will provide flexibility to +diagnostic customers who wish to offer their patients the non-invasive, reliable and easy-to-use Oragene ® — Dx saliva sample collection device as an alternative to invasive blood collection. In addition, this FDA 510(k) clearance of Oragene ® — Dx will enable molecular diagnostic test manufacturers to streamline their own regulatory submissions and +potentially broaden market accessibility for their genetic testing products. +Substance Abuse Testing +In the first quarter of 2011, the FDA issued 510(k) clearances for use of high throughput oral fluid assays for PCP, +opiates, cocaine and methamphetamines with our Intercept ® oral fluid collection device. These were the first +such clearances resulting from our collaboration with Roche Diagnostics. In the second quarter of 2011, the FDA issued an additional 510(k) clearance for an amphetamines assay. We expect to begin selling a panel of 510(k) cleared assays together +with our Intercept ® device during the first quarter of 2012. Clinical work on an assay for marijuana (THC) is +continuing, and is expected to be completed during the first half of 2012. +Results of Operations +Year Ended December 31, 2011 Compared to December 31, 2010 +Business Segments +We operate our business within two reportable +segments. The first is our core “OraSure” business, which consists of the development, manufacture and sale of oral fluid diagnostic products and specimen collection devices and the manufacture and sale of medical devices used for the +removal of benign skin lesions by cryosurgery. The second segment is the business of our newly acquired subsidiary, DNAG, which is based in Ottawa, Canada and manufactures and sells oral fluid collection devices that are used to collect samples of +genetic material for molecular testing. OraSure revenues consist primarily of product sold into the United States and internationally to various clinical laboratories, hospital, clinics, community-based organizations and other public health +organizations, distributors, government agencies, physicians’ offices, and commercial and industrial entities. OraSure also derives revenues from licensing and production development activities. DNAG revenues consist of product sold into the +medicine, animal and livestock genetics markets. +Consolidated Revenues +Twelve Months Ended December 31, 2011, +Dollars +% +Change +Percentage of +Total Revenues +(in thousands) +2011 +2010 +2011 +2010 +OraSure +$ +74,467 +$ +71,199 +5 +% +91 +% +95 +% +DNAG +6,216 +— +100 +8 +— +Product revenues +80,683 +71,199 +13 +99 +95 +Licensing and product development +1,198 +3,816 +(69 +) +1 +5 +Total revenues +$ +81,881 +$ +75,015 +9 +% +100 +% +100 +% +Consolidated revenues increased 9% to $81.9 million (including $6.2 million attributable to operations of +DNAG) in 2011 from $75.0 million in 2010. Excluding revenue attributable to DNAG, our product revenues increased 5% during the year ended December 31, 2011 when compared to the year ended December 31, 2010. Increased sales of our +infectious disease testing, substance abuse testing and cryosurgical systems products were +52 +Table of Contents +partially offset by lower sales of our insurance risk assessment products. The higher product revenues were partially offset by a $2.6 million reduction in licensing and product development +revenues during 2011 as compared to 2010. +Revenues derived from products sold to customers outside the United States were +$14.2 million and $11.5 million or 17% and 15% of total revenues for the years ended December 31, 2011 and 2010, respectively. Because the majority of our international sales are denominated in U.S. dollars, the impact of fluctuating +foreign currencies was not material to our operating results. However, the revenues and operating results of our newly acquired subsidiary, DNAG, are recorded in Canadian Dollars and certain of its international sales are denominated in local +currencies, including the Euro, British Pound and Australian Dollar. Our expectation is that the DNAG business will continue to grow and, accordingly, we may experience increased foreign currency exposure in the future. +Revenues by Segment +OraSure +Segment +The table below shows the amount of OraSure’s total revenues (in thousands) generated in each of our +principal markets and by licensing and product development activities. +Twelve Months Ended December 31, +Dollars +% +Change +Percentage of +Total Revenues +Market +2011 +2010 +2011 +2010 +Infectious disease testing +$ +44,691 +$ +41,738 +7 +% +60 +% +59 +% +Substance abuse testing +12,498 +11,671 +7 +17 +16 +Cryosurgical systems +12,046 +11,965 +1 +16 +17 +Insurance risk assessment +5,232 +5,825 +(10 +) +7 +8 +Product revenues +$ +74,467 +$ +71,199 +5 +% +100 +100 +% +Infectious Disease Testing Market +Sales to the infectious disease testing market increased 7% to $44.7 million in 2011. OraQuick ® sales totaled $43.3 million and $40.1 million for the years ended December 31, 2011 and 2010, respectively. +The table below shows a breakdown of our total +OraQuick ® revenues (in thousands) during 2011 and 2010. +Twelve Months Ended December 31, +Market +2011 +2010 +% +Change +Domestic HIV +$ +38,722 +$ +38,172 +1 +% +International HIV +3,011 +1,800 +67 +Domestic HCV +890 +46 +1,835 +International HCV +672 +119 +465 +Total OraQuick ® revenues +$ +43,295 +$ +40,137 +8 +% +Domestic OraQuick ® HIV sales remained relatively flat at $38.7 million for the twelve months ended December 31, 2011 compared to $38.2 million for the twelve months ended +December 31, 2010. International sales of our OraQuick ® HIV test increased 67% to $3.0 million for the year +ended December 31, 2011 from $1.8 million for the year ended December 31, 2010. This increase was largely the result of an improved funding environment as certain private and government customers were able to fund purchases. However, +due to the unpredictable nature of the international funding environment, we are unable to predict whether this improved level of sales will continue. +53 +Table of Contents +OraQuick ® revenues for 2011 included $1.6 million of sales of our OraQuick ® HCV test, compared to $165,000 in 2010. As mentioned previously, we received a CLIA waiver for this product in November 2011, enabling us to sell our HCV product to +many other non-CLIA certified customers, such as outreach clinics, community-based organizations and physician offices. While we believe the CLIA waiver provides an opportunity for significant sales growth, demand for our HCV product could be +tempered by the unavailability of government funding allocated to HCV testing efforts. In addition, sales growth will depend on the success of Merck’s detailing efforts into physician offices. +Sales of our OraSure ® oral fluid collection device decreased 23% from $1.6 million in 2010 to $1.2 million in 2011. Some customers who have purchased our OraSure ® device for laboratory HIV-1 testing in the past are now electing to purchase our OraQuick ADVANCE ® test. We believe this is the result of customers recognizing the benefits of rapid HIV testing, especially with oral +fluid., As such, we expect that sales of our OraSure ® device will continue to decline in the future. +During the year ended December 31, 2011, we sold $167,000 of our OraSure QuickFlu ™ product, which we began selling in the first quarter of 2011. Sales of this product came in lower than expected +primarily because the U.S. experienced a weak flu season in 2011. +Substance Abuse Testing Market +Sales to the substance abuse testing market increased 7% from $11.7 million in 2010 to $12.5 million in 2011, as a +result of higher domestic sales of our Intercept ® drug testing system. The table below shows a breakdown of our +total Intercept ® revenues (in thousands) generated in each market during 2011 and 2010. +Twelve Months Ended December 31, +Market +2011 +2010 +% +Change +Domestic +$ +8,004 +$ +7,274 +10 +% +International +1,912 +1,976 +(3 +) +Total Intercept ® revenues +$ +9,916 +$ +9,250 +7 +% +Domestic Intercept ® revenues increased 10% from $7.3 million in 2010 to $8.0 million in 2011. This increase was largely the result of increased interest in oral fluid testing as well as +growth achieved in the workplace market as hiring conditions have slowly begun to improve when compared to 2010. +Pursuant to a development agreement with Roche Diagnostics, homogenous fully-automated oral fluid drugs of abuse assays have been developed for use with our Intercept ® collection device. The FDA issued 510(k) clearances of high throughput assays for PCP, opiates, cocaine, +methamphetamines, and amphetamines during 2011. The assays use Roche’s technology and will run on various automated analyzers to allow oral fluid samples to be processed with the same efficiency currently achieved with urine-based drug tests. +We have also entered into a commercialization agreement with Roche pursuant to which a drug testing system comprised of our Intercept ® device and the newly developed homogenous assays will be marketed and sold on a worldwide basis. +At least two competitors have developed oral fluid tests suitable for use on fully automated homogeneous assay +systems. One of these products has received 510(k) clearance and is being offered by our largest laboratory distributor and we expect this distributor to stop selling our Intercept ® product in 2012. Sales of +Intercept ® to this distributor amounted to $3.5 million in 2011. These new products will compete against both +our Intercept ® products and the high throughput assays we intend to commercialize jointly with Roche +Diagnostics. The loss of Intercept ® sales to this significant distributor is expected to offset any expected +increase in our workplace testing business due to continued economic improvement. +54 +Table of Contents +Cryosurgical Systems Market +Sales of our products in the cryosurgical systems market (which includes both the physicians’ office and OTC markets) remained flat at $12.0 million for the years ended December 31, 2011 and +2010. +The table below shows a breakdown of our total cryosurgical revenues (in thousands) generated in each market during +2011 and 2010. +Twelve Months Ended December 31, +Market +2011 +2010 +% +Change +Professional domestic +$ +6,775 +$ +5,967 +14 +% +Professional international +1,400 +1,385 +1 +Over-the-counter +3,871 +4,613 +(16 +) +Total cryosurgical systems revenues +$ +12,046 +$ +11,965 +1 +% +Sales of our Histofreezer ® product to physicians’ offices in the United States increased 14% to $6.8 million in 2011, compared to $6.0 million in 2010, as a result of higher market +penetration resulting from the continued efforts of our manufacturers’ sales representatives, improved focus by our distributors and an increase in sales to governmental entities. In early 2010, we signed agreements with two manufacturers’ +sales representative organizations to support sales of our Histofreezer ® product in the U.S. Under these +agreements, over 40 additional sales representatives have been working with our physicians’ office distributors throughout the Unites States. +Sales of Histofreezer ® in the international market remained flat at +$1.4 million in 2011 and 2010. +During the year ended December 31, 2011, our OTC cryosurgical sales decreased 16% +primarily due to a decline in sales to our Latin American distributor, Genomma. +During 2011, Genomma had purchases totaling +$1.0 million compared to $2.0 million in 2010. In late 2010, the Mexican government placed limitations on the advertising Genomma could use for our product. In addition, during the first quarter of 2011, Genomma informed us of some changes required +by the Brazilian government to our package insert, which have since been made. Both events negatively impacted sales of our product during 2011. We believe that both of these issues were resolved in 2011. +Sales to our European OTC distributor Reckitt Benckiser remained flat at $2.6 million in 2011 and 2010. Our distributor contract with +Reckitt Benckiser was subject to renewal at the end of 2011. We are currently in negotiations to extend this contract. +Insurance Risk +Assessment Market +Sales to the insurance risk assessment market decreased 10% from $5.8 million in 2010 to $5.2 million in +2011, as a result of variability in the timing of orders, general softness in the life insurance market, and the adoption by some underwriters of a “Simplified Issues” policy. This is a policy where lab-based testing is replaced by having +applicants respond to a questionnaire about their behaviors. Two of our larger customers adopted this new policy in 2011. +Licensing and +Product Development +Licensing and product development revenues decreased 69% to $1.2 million in 2011 +from $3.8 million in 2010. During 2010 we received $2.0 million in milestone payments as a result of our achievement of certain regulatory and commercial objectives pursuant to our collaboration agreement with Merck for the development and promotion +of our OraQuick ® rapid HCV test in Europe. We expect to receive an additional $1.0 million milestone payment +pursuant to the terms of the collaboration agreement in 2012. +55 +Table of Contents +The remaining licensing revenues for these periods represent royalties received on domestic +outsales of Merck’s OTC cryosurgical wart removal product, pursuant to a license and settlement agreement executed in January 2008. In 2011, t he royalty rate decreased pursuant to the terms of our license. Royalties under this +license will no longer be received after certain of our cryosurgical patents expire in August 2013. +DNAG Segment +Molecular Collection Systems +Molecular collection systems revenues primarily represent sales of DNAG’s +Oragene ® product line in the molecular diagnostics and research markets. The $6.2 million in revenues reflect +DNAG sales from the August 17, 2011 acquisition date through December 31, 2011. During the fourth quarter of 2011, DNAG shipped $1.5 million of product to its largest customer, which historically has made bulk purchases once a year. +Consolidated Operating Loss +Consolidated operating loss increased $6.0 million to $9.4 million in 2011, compared to $3.4 million in 2010. The increased loss was primarily caused by higher research and development expenses due to +increased clinical trial costs related to our OraQuick ® HIV OTC test and increased general and administrative +expense resulting from the transaction costs associated with the DNAG acquisition and increased amortization expense associated with the intangible assets acquired in the DNAG acquisition. Consolidated gross margin was 63% for both 2011 and 2010. +Operating Loss by Segment +OraSure Segment +OraSure’s gross margin was 64% in 2011 compared to +63% in 2010. OraSure’s 2011 margin benefited from improved product mix, more efficient manufacturing operations, lower direct labor costs, improved absorption of overhead costs as a result of staffing optimization and a change to automated +manufacturing during 2011. The 2010 margin benefited from the $2.0 million in HCV milestone payments received during that period. +Research and development expenses increased 32% from $13.2 million in 2010 to $17.4 million in 2011, primarily as a result of a $6.2 million increase in clinical trial costs related to the +development of our OraQuick ® HIV OTC test. The higher clinical trial costs related to our OraQuick ® HIV OTC test were partially offset by lower clinical trial costs related to the development of our OraQuick ® HCV test. We expect OraSure’s research and development costs will decrease in 2012. +Sales and marketing expenses declined 3% to $20.1 million in 2011 from $20.7 million in 2010. This decrease was primarily the result of +lower consulting expenses. We expect 2012 sales and marketing expenses to increase from 2011 levels as we prepare for the launch of our HIV OTC product. +General and administrative expenses increased 13% to $19.0 million in 2011 from $16.8 million in 2010, primarily as a result of $2.6 million in transaction costs associated with the DNAG acquisition. We +expect 2012 general and administrative expenses to remain flat when compared to 2011 levels. +DNAG Segment +DNAG’s gross margin for the period from August 17, 2011 through December 31, 2011 was 50% and reflects the impact of a +$852,000 non-cash purchase accounting adjustment to mark up the acquired finished goods inventory to fair value. DNAG’s gross margin also included approximately $499,000 of amortization expense related to the acquisition. Ongoing amortization +expense related to the DNAG acquisition will continue to impact gross margins in future periods. +56 +Table of Contents +DNAG incurred $4.7 million in operating expenses during 2011. This included $1.0 million of +research and development costs. $2.3 million of sales and marketing expenses and $1.4 million of general and administrative expenses. The DNAG expenses also included a total of $714,000 of amortization expense related to the acquisition. Ongoing +amortization expense related to the DNAG acquisition will continue to impact operating expense levels in future periods. +Consolidated +Income Taxes +In 2011, we continued our evaluation of whether the full valuation allowance established in 2008 against +OraSure’s total net deferred tax asset is still appropriate and concluded that the full valuation allowance remained appropriate as the facts and circumstances since the establishment of the allowance had not changed. As a result, no U.S. +income tax benefit was recorded for OraSure’s pre-tax loss in 2011. In connection with the DNAG acquisition, a deferred income tax liability was recorded to reflect the tax effects of basis differences of intangible assets and inventories for +financial reporting and Canadian income tax purposes. A Canadian income tax benefit of $869,000 was also recorded in 2011 associated with the DNAG loss before income taxes and certain Canadian research and development and investment tax credits. +Year Ended December 31, 2010 Compared to December 31, 2009 +During the year ended December 31, 2010, we operated our business within one reportable segment, our core OraSure business. The +results of these operations are described below. +Total revenues decreased 3% to $75.0 million in 2010 from $77.0 million in +2009. Decreased sales in the infectious disease testing, substance abuse testing, and insurance risk assessment markets were partially offset by an increase in sales of our cryosurgical systems products and higher licensing and product development +revenues. Revenues derived from products sold to customers outside the United States were $11.5 million and $14.8 million or 15% and 19% of total revenues for the years ended December 31, 2010 and 2009, respectively. The majority of our +international sales were denominated in U.S. dollars. As such, the impact of foreign currencies was not material to our operating results. +The table below shows the amount of our total revenues (in thousands) generated in each of our principal markets and by licensing and product development activities. +Twelve Months Ended December 31, +Dollars +% +Change +Percentage of +Total Revenues +Market +2010 +2009 +2010 +2009 +Infectious disease testing +$ +41,738 +$ +46,098 +(9 +)% +55 +% +60 +% +Substance abuse testing +11,671 +12,026 +(3 +) +16 +16 +Cryosurgical systems +11,965 +10,888 +10 +16 +14 +Insurance risk assessment +5,825 +6,157 +(5 +) +8 +8 +Product revenues +71,199 +75,169 +(5 +) +95 +98 +Licensing and product development +3,816 +1,857 +105 +5 +2 +Total revenues +$ +75,015 +$ +77,026 +(3 +)% +100 +% +100 +% +Infectious Disease Testing Market +Sales to the infectious disease testing market decreased 9% to $41.7 million in 2010. OraQuick ® sales totaled $40.1 million and $43.8 million for the years ended December 31, 2010 and 2009, respectively. +Sales of our OraSure ® oral fluid collection device totaled $1.6 million and $2.3 million in 2010 and 2009, +respectively. +57 +Table of Contents +The table below shows a breakdown of our total OraQuick ® revenues (in thousands) during 2010 and 2009. +Twelve Months Ended December 31, +Market +2010 +2009 +% +Change +Domestic +$ +38,218 +$ +39,306 +(3 +)% +International +1,919 +4,511 +(57 +) +Total OraQuick ® revenues +$ +40,137 +$ +43,817 +(8 +)% +During 2010, sales of the OraQuick ADVANCE ® HIV test in the U.S. market decreased 3% or $1.1 million, when compared to 2009. This decrease in revenue reflects +lower sales volumes resulting from changes in ordering patterns of one of our larger public health customers and reduced public health funding by state and local governments, as well as a lower average selling price. +International sales of our OraQuick ® HIV test decreased 57% to $1.9 million for the year ended December 31, 2010 from $4.5 million for the year ended December 31, 2009. This decrease resulted +from customer losses due to price competition, changes in the use of our test within government testing algorithms, and a decrease or elimination of funding for HIV testing initiatives. +Sales of our OraSure ® oral fluid collection device decreased 30% from $2.3 million in the 2009 to $1.6 million in 2010 due to reduced public health funding by state and local +governments. In addition, some customers who have purchased our OraSure ® device for laboratory HIV-1 testing in +the past are now electing to purchase our OraQuick ADVANCE ® test. +Substance Abuse Testing Market +Sales to the substance abuse testing market decreased 3% in 2010 primarily as a result of lower sales of our Intercept ® drug testing system and a decrease in laboratory equipment sales. The table below shows a breakdown of our total Intercept ® revenues (in thousands) generated in each market during 2010 and 2009. +Twelve Months Ended December 31, +Market +2010 +2009 +% +Change +Domestic +$ +7,274 +$ +7,405 +(2 +)% +International +1,976 +2,003 +(1 +) +Total Intercept ® revenues +$ +9,250 +$ +9,408 +(2 +)% +Domestic Intercept ® revenues decreased 2% and international revenues remained relatively flat for 2010 when compared to the prior year. +Cryosurgical Systems Market +Sales of our products in the cryosurgical systems market (which includes both the physicians’ office and OTC markets) increased 10% to $12.0 million in 2010 from $10.9 million in 2009. +The table below shows a breakdown of our total cryosurgical revenues (in thousands) generated in each market during 2010 and 2009. +Twelve Months Ended December 31, +Market +2010 +2009 +% +Change +Professional domestic +$ +5,967 +$ +3,902 +53 +% +Professional international +1,385 +1,919 +(28 +) +Over-the-counter +4,613 +5,067 +(9 +) +Total cryosurgical systems revenues +$ +11,965 +$ +10,888 +10 +% +58 +Table of Contents +Sales of our Histofreezer ® product to physicians’ offices in the United States increased 53% to $6.0 million in 2010, compared to $3.9 +million in 2009, largely due to the elimination of the diversion of less expensive international Histofreezer ® +product into the domestic market. In addition, in early 2010, we signed agreements with two manufacturers’ sales representative organizations to support sales of our Histofreezer ® product in the U.S. Under these arrangements, over 40 additional sales representatives are working with our physicians’ office distributors throughout the United +States, resulting in additional domestic Histofreezer ® sales growth during this year. +Sales of Histofreezer ® in the international market decreased 28% in 2010, compared to 2009. This decline was largely due to a discontinuance of sales to certain foreign distributors that we +believe were diverting product to the U.S. market. The selling prices for our Histofreezer ® product are lower in +some foreign countries due to differences in the healthcare systems in those countries. During 2008 and early 2009, some distributors in these countries purchased English-labeled Histofreezer ® product and resold it into the domestic distribution network to distributors who employ alternate sourcing programs. +We also experienced a decline in Histofreezer ® sales in the European market as a result of the negative impact of changing European health regulations. In the European professional marketplace, healthcare +reimbursement has been reduced or eliminated for certain treatment types, including treatments for common warts. +During the +year ended December 31, 2010, our OTC cryosurgical sales decreased 9% primarily due to decreased sales to our Latin American OTC distributor, Genomma. During 2009, Genomma increased its purchases to support the launch of our OTC cryosurgical +wart removal product in Brazil. We did not have this similar pipeline fill in 2010, resulting in a decrease in sales to Genomma of approximately $314,000. +In July 2010, SSL International (“SSL”), our European OTC distributor, was acquired by Reckitt Benckiser Group PLC. Sales to Reckitt for distribution in the European OTC market were $2.6 million +in 2010 and 2009, respectively. +During the first quarter of 2009, we launched our own wart removal +product under the Freeze ‘n Clear Skin Clinic TM +tradename into the U.S. OTC cryosurgical marketplace. This venture resulted in limited revenues. As a result of the product’s limited success, competing priorities and limited corporate funding, management ended its participation in the U.S. +OTC cryosurgical marketplace at the end of 2010. +Insurance Risk Assessment Market +Sales to the insurance risk assessment market decreased 5% from $6.2 million in 2009 to $5.8 million in 2010, as some insurance companies +abandoned pre-screening for lower face value insurance policies. +Licensing and Product Development +Licensing and product development revenues increased to $3.8 million during 2010 from $1.9 million during 2009. This +increase was primarily due to $2.0 million in milestone payments received as a result of our achievement of certain regulatory and commercial objectives pursuant to a collaboration agreement with Merck for the development and promotion of our +OraQuick ® rapid HCV test in international markets. The remaining licensing revenues for both 2010 and 2009 +represent royalties received on domestic outsales of Merck’s OTC cryosurgical wart removal product, pursuant to our license and settlement agreement executed in January 2008. +Gross Margin +OraSure’s gross margin was 63% in 2010, compared to 61% +in 2009. The increase in gross margin in 2010 was primarily the result of the higher licensing and product development revenues. +59 +Table of Contents +Operating Expenses +Research and development expenses decreased 1% from $13.4 million in 2009 to $13.2 million in 2010, as a result of +lower validation and clinical trial costs related to the development of our OraQuick ® HCV test. These decreases +were partially offset by higher laboratory supplies expense related to the development of new infectious disease products and higher clinical trial costs related to the development of our OraQuick ® HIV OTC test. +Sales and marketing expenses +decreased 2% to $20.7 million in 2010 from $21.2 million in 2009. This decrease was primarily the result of lower relocation expenses. +General and administrative expenses remained relatively unchanged at $16.8 million in 2010 and 2009. Lower legal expenses in 2010 were offset by an increase in consulting costs. +In November 2009, we settled the patent infringement lawsuit filed by Inverness Medical and Church & Dwight. +Pursuant to the settlement we paid Inverness $3.0 million. We recorded $1.5 million of the $3.0 million payment as litigation settlement expense in our consolidated statement of operations for 2009. The remaining $1.5 million was recorded as prepaid +royalties and is being expensed in cost of goods sold in relation to estimated OraQuick ADVANCE ® HIV +revenues to be generated through December 31, 2012. +During the second quarter of 2009, we recorded an impairment charge +of $3.0 million related to license payments for certain HCV patents, which we previously capitalized. Management’s intent in capitalizing these payments was to utilize this license in certain developing countries for the marketing and sale of +an existing rapid HCV test supplied by a third-party manufacturer. However, we were unable to penetrate this international marketplace with this third party’s rapid HCV test. Furthermore, given the impact of the current global recession and the +deteriorating status of certain third-world economies, we no longer believed that we would be successful in selling this third party’s rapid HCV test in the foreseeable future. Accordingly, we recorded a non-cash impairment charge for the +remaining unamortized book value of the patent and product rights in the quarter ended June 30, 2009. +Income Taxes +In 2008, we established a full valuation allowance against our total net deferred tax asset. Management has continued to evaluate whether +the full valuation is still appropriate. At December 31, 2010, we concluded that the full valuation allowance remained appropriate as the facts and circumstances since the establishment of the allowance had not changed. As a result, no income +tax benefit was recorded in 2010. +In November 2009, The Worker, Homeownership, and Business Assistance Act of 2009 was +enacted. This new law extended the carryback period for a net operating loss (“NOL”) from two years up to a maximum of five years. The carryback of the NOL can be applied to both regular tax NOLs and alternative minimum tax +(“AMT”) NOLs. The new law also eliminates the 90% limitation on the use of any AMT NOLs. As a result of the elimination of the 90% limitations, we elected to carryback our 2008 AMT NOL to our 2007, 2006, and 2005 tax years and apply for a +refund of the AMT taxes paid for those years. As such, in the fourth quarter of 2009, we recorded a $632,000 federal tax benefit associated with this AMT NOL carryback. Offsetting this benefit was a nominal amount of state income taxes. +Liquidity and Capital Resources +December 31, +2011 +2010 +(In thousands) +Cash and cash equivalents +$ +23,878 +$ +73,843 +Short-term investments +— +1,895 +Working capital +30,860 +77,808 +60 +Table of Contents +Our cash, cash equivalents and short-term investments decreased $51.9 million from $75.7 +million at December 31, 2010 to $23.9 million at December 31, 2011, largely due to the use of $52.3 million in cash to fund the DNAG acquisition and related transaction expenses. Our working capital likewise declined from +$77.8 million at December 31, 2010 to $30.8 million at December 31, 2011 as a result of this significant use of cash. +During 2011, we used $3.0 million in cash to finance our operating activities. Our net loss of $8.8 million was partially offset by non-cash stock-based compensation expense of $4.1 million, depreciation +and amortization of $4.9 million, a non-cash inventory purchase accounting adjustment of $852,000 and a deferred income tax benefit of $869,000. Additional uses of cash in operating activities included a $3.4 million increase in accounts receivable +balances largely caused by end of the quarter customer shipments and a $1.8 million increase in inventory largely due to stocking of our OraQuick ® HIV and HCV tests. Offsetting these uses of cash were a $911,000 increase in accounts payable due to the build of inventory to fulfill fourth quarter 2011 orders, a +$604,000 increase in accrued expenses and other liabilities due to year end accruals for marketing and accounting expenses and management incentive bonuses and a $491,000 decrease in prepaid expenses and other assets as a result of the amortization +of outstanding balances. +We used a total of $50.3 million in investing activities during 2011. In order to acquire DNAG we +used $49.7 million of cash, net of DNAG cash acquired. We also purchased $2.5 million of property and equipment offset by the maturity of $1.9 million of certificates of deposit. +During the year ended December 31, 2012, we expect to invest approximately $4.2 million in capital expenditures, primarily to +purchase additional equipment, upgrade certain older equipment and make improvements to our facilities. +Net cash provided by +financing activities was $3.4 million for 2011, primarily as a result of $4.8 million in proceeds received from the exercise of stock options, partially offset by $500,000 in loan principal repayments and $909,000 used for the repurchase of common +stock related to the vesting of restricted shares. +As of December 31, 2011, we had in place a $10,000,000 credit +facility (the “Credit Facility”) with Comerica Bank (“Comerica”). Pursuant to the terms of the Credit Facility, principal and interest fixed at 4.15% per annum are payable monthly through May 27, 2012, at which time the +remaining unpaid principal balance is payable. As of December 31, 2011, we had no available borrowings under this Credit Facility. We are currently in negotiations with Comerica to refinance this credit facility. +All borrowings from Comerica are collateralized by a first priority security interest in all of OraSure’s assets, including present +and future accounts receivable, chattel paper, contracts and contract rights, equipment and accessories, general intangibles, investments, instruments, inventories, and a mortgage on our three facilities in Bethlehem, Pennsylvania. The Comerica +agreement contains certain covenants that set forth minimum requirements for our quick ratio, liquidity, and tangible net worth. We were in compliance with all covenants as of December 31, 2011. The agreement also restricts our ability to pay +dividends, to make certain investments, to incur additional indebtedness, to sell or otherwise dispose of a substantial portion of assets, and to merge or consolidate operations with an unaffiliated entity, without the consent of Comerica. +Our current cash and cash equivalents is expected to be sufficient to fund our operating and capital +needs through at least the next twelve months. Our cash requirements, however, may vary materially from those now planned due to many factors, including, but not limited to, the scope and timing of future strategic acquisitions, the cost and timing +of the expansion of our manufacturing capacity, the progress of our research and development programs, the scope and results of clinical testing, the cost of any future litigation, the magnitude of capital expenditures, changes in existing and +potential relationships with business partners, the time and cost of obtaining regulatory approvals, the costs involved in obtaining and enforcing patents, proprietary rights and any necessary licenses, the cost and timing of expansion of sales and +marketing activities, the timing of market launch of new products including our OraQuick ® HIV OTC test, +market acceptance of new products, competing technological and market developments, the impact of the ongoing economic downturn and other factors. +61 +Table of Contents +Contractual Obligations and Commercial Commitments +The following sets forth our approximate aggregate obligations as of December 31, 2011 for future payments under contracts and other +contingent commitments, for the year 2012 and beyond: +Payments due by December 31, +Contractual Obligations +Total +2012 +2013 +2014 +2015 +2016 +Thereafter +Long-term debt 1 +$ +7,291,680 +$ +7,291,680 +$ +— +$ +— +$ +— +$ +— +$ +— +Operating leases 2 +1,077,995 +437,419 +427,280 +213,296 +— +— +— +Employment contracts 3 +2,819,000 +2,268,750 +550,250 +— +— +— +— +Purchase obligations 4 +2,265,799 +2,265,799 +— +— +— +— +— +Minimum commitments under contracts 5 +3,291,667 +500,000 +500,000 +500,000 +500,000 +500,000 +791,667 +Total contractual obligations +$ +16,746,141 +$ +12,763,648 +$ +1,477,530 +$ +713,296 +$ +500,000 +$ +500,000 +$ +791,667 +1 +Represents principal repayments required under notes payable to our lenders. See Note 9 of the Notes to the consolidated financial statements included +herein. +2 +Represents payments required under our operating leases. See Note 13 of the Notes to the consolidated financial statements included herein +3 +Represents salary payments payable under the terms of employment agreements executed by us with certain executives. See Note 13 of the Notes to the +consolidated financial statements included herein. +4 +Represents payments required by non-cancellable purchase orders related to inventory, capital expenditures and other goods or services. See Note13 of +the Notes to the consolidated financial statements included herein. +5 +Represents payments required pursuant to certain licensing agreements executed by the Company. These agreements are cancellable within a specified +number of days after communication by the Company of its intent to terminate. See Note 13 of the Notes to the consolidated financial statements included herein. +Off-Balance Sheet Arrangements . We do not have any off-balance sheet arrangements, as defined in +Item 303(a)(4) (ii) of Regulation S-K under the Securities Exchange Act of 1934, as amended. +Critical Accounting Policies and +Estimates +This Management’s Discussion and Analysis of Financial Condition and Results of Operations discusses our +consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires that we make estimates and assumptions +that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenues and expenses during the reporting period. On an on-going +basis, we evaluate our judgments and estimates, including those related to bad debts, inventories, investments, intangible assets, income taxes, revenue recognition, clinical trial accruals, contingencies and litigation. We base our judgments and +estimates on historical experience and on various other factors that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying value of assets and liabilities that are not +readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. +Our significant accounting policies are described in Note 2 of the Notes to the consolidated financial statements included in +Item 15 of this Annual Report. We consider the following accounting estimates, which have been discussed with our Audit Committee, to be most critical in understanding the more complex judgments that are involved in preparing our financial +statements and the uncertainties that could impact our results of operations, financial condition and cash flows. +62 +Table of Contents +Business Combinations . We account for acquisitions or business +combinations in accordance with Accounting Standards Codification 805, “Business Combinations.” Pursuant to the acquisition method of accounting included in that guidance, we allocate the purchase price of a business combination to the +tangible and identifiable intangible assets acquired and the liabilities assumed, based on their estimated fair values. The excess purchase price over those fair values is then recorded as goodwill. In accounting for business combinations, we make +valuation assumptions that require significant estimates, especially with respect to intangible assets. These critical estimates are based on historical experience; information obtained from management of the acquired company or third-party +advisors; and expectations of future cash flows to be derived from customer contracts, customer lists, and acquired developed technologies or products, evaluated at various discount rates. Management estimates fair value based upon assumptions we +believe to be reasonable, but which are inherently uncertain and unpredictable. As such, actual results may differ from these estimates. Estimates associated with the accounting for a business combination may also change as additional information +becomes available regarding the assets acquired and the liabilities assumed. +Revenue +Recognition . We recognize product revenues when there is persuasive evidence that an arrangement exists, the price is fixed or determinable, title has passed and collection is reasonably assured. Product revenues are +recorded net of allowances for any discounts or rebates. We do not grant price protection or product return rights to our customers except for warranty returns. Historically, returns arising from warranty issues have been infrequent and immaterial. +Accordingly, we expense warranty returns as incurred. +Royalty income from the grant of license rights is recognized during +the period in which the revenue is earned and the amount is determinable from the licensee. +We record shipping and handling +charges billed to our customers as product revenue and the related expense as cost of products sold. Taxes assessed by governmental authorities, such as sales or value-added taxes, are excluded from product revenues. +Allowance for Uncollectible Accounts Receivable . Accounts receivable are reduced by an estimated allowance +for amounts that may become uncollectible in the future. On an ongoing basis, we perform credit evaluations of our customers and adjust credit limits based upon the customer’s payment history and creditworthiness, as determined by a review of +their current credit information. We also continuously monitor collections and payments from our customers. +Based upon +historical experience and any specific customer collection issues that are identified, we use our judgment to establish and evaluate the adequacy of our allowance for estimated credit losses, which was $170,000 as of December 31, 2011. While +credit losses have been within our expectations and the allowance provided, these losses can vary from period to period. Furthermore, there is no assurance that we will experience credit losses at the same rates as we have in the past. The current +economic downturn, including disruptions in the capital and credit markets, may continue indefinitely and intensify, and could adversely affect the operations, cash flows and financial condition of our customers. These circumstances may adversely +impact the liquidity or financial position of our customers and could have a material impact on the collectability of our accounts receivable and future operating results. +Inventories . Our inventories are valued at the lower of cost or market, determined on a first-in, first-out basis, and include the cost of raw materials, labor and overhead. +The majority of our inventories are subject to expiration dating. We continually evaluate quantities on hand and the carrying value of our inventories to determine the need for reserves for excess and obsolete inventories based primarily on the +estimated forecast of product sales. When, in the opinion of management, factors indicate that impairment has occurred, either a reserve is established against the inventories’ carrying value or the inventories are completely written off, as in +the case of lapsing expiration dates. During 2011 and 2010, we wrote-off inventory which had a cost of $919,000. In 2009, we wrote-off inventory which had a cost of $1.5 million. These write-offs were as a result of +63 +Table of Contents +quality, scrap and product expiration issues. Although we make every effort to ensure the accuracy of our forecasts of future product demand, any significant unanticipated changes in demand could +have a significant impact on the carrying value of our inventories and reported operating results. +Stock-based +Compensation . We recognize the fair value of equity-based awards as compensation expense in our statement of operations. The fair value of our stock option awards was estimated using a Black-Scholes option valuation model. +This valuation model’s computations incorporate highly subjective assumptions, such as the expected stock price volatility and the estimated life of each award. The fair value of the options, after considering the effect of expected +forfeitures, is then amortized, generally on a straight-line basis, over the related vesting period of the option. The fair value of our restricted shares is based on the market value of the shares at the date of grant and is recognized on a +straight-line basis over the related vesting period of the award. +Long-lived and Intangible +Assets . Our long-lived assets are comprised of property and equipment, intangible assets and goodwill. Together, these assets had a net book value of $75.0 million, or 59% of our total assets, as of December 31, 2011. +Property and equipment and intangible assets are depreciated or amortized on a straight-line basis over their estimated useful lives, which we determine based upon our estimate of the period of time over which each asset will generate revenues. An +impairment of long-lived or intangible assets could occur whenever events or changes in circumstances indicate that the net book value of our assets may not be recoverable. Events which could trigger asset impairment include significant +underperformance relative to historical or projected future operating results, significant changes in the manner of our use of an asset or in our overall business strategy, significant negative industry or economic trends, and shortening of product +life-cycles or changes in technology. If we believe impairment of an asset has occurred, we measure the amount of such impairment by comparing the net book value of the affected assets to the fair value of these assets, which is generally determined +based upon the present value of the expected cash flows associated with the use of these assets. If the net book value exceeds the fair value of the impaired assets, we would incur an impairment expense equal to this difference. +We currently believe the future cash flows to be received from all remaining long-lived and intangible assets as of December 31, +2011 will exceed their book value. We did not recognize any impairment losses for the years ended December 31, 2011 or 2010. Any unanticipated significant impairment in the future, however, could have a material adverse impact to our balance +sheet and future operating results. +Goodwill . Goodwill represents the excess of the purchase +price we paid over the fair value of the net tangible and identifiable intangible assets acquired and liabilities assumed in our acquisition of DNAG. Goodwill is not amortized but rather is tested annually for impairment, or more frequently if we +believe that indicators of impairment exist. Performance of the goodwill impairment test involves a two-step process. The first step involves comparing the fair values of the applicable reporting units with their aggregate carrying values, including +goodwill. If the carrying value of a reporting unit exceeds the reporting unit’s fair value, we perform the second step of the test to determine the amount of the impairment loss. The second step involves measuring the impairment by comparing +the implied fair values of the affected reporting unit’s goodwill and intangible assets with the respective carrying values. +Deferred Tax Assets and Liabilities . At December 31, 2011, we had federal NOL carryforwards of $47.2 million. The net deferred tax assets, before a full valuation +allowance, associated with these NOLs and other temporary differences was $26.1 million at December 31, 2011. In assessing the realizability of net deferred tax assets, we consider whether it is more likely than not that some portion or all of +the deferred tax assets will not be realized. The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income during the period in which those temporary differences become deductible or the NOLs and credit +carryforwards can be utilized. We consider the scheduled reversal of deferred tax liabilities, projected future taxable income and tax planning strategies in making this assessment. +During the fourth quarter of 2008, we evaluated our ability to realize our net deferred tax asset, in order to determine if a valuation +allowance should be recorded against it pursuant to FASB accounting guidance. We +64 +Table of Contents +determined that it was more likely than not that we would not realize the benefits associated with our net deferred tax asset in the immediate future. Accordingly, we recorded an income tax +charge of $26.0 million in the fourth quarter of 2008 to establish a full valuation allowance against our net deferred tax asset. During the past three years, we continued to reevaluate our valuation allowance position and believe that it is more +likely than not that our deferred income tax asset will not be realized in the immediate future. As such, we maintain a full valuation allowance against our net deferred tax assets as of December 31, 2011 and 2010 associated with the operations +subject to income tax in the U.S. +Our ability to use our NOL carryforwards to offset future federal income tax obligations +could be limited by changes in the ownership of our stock. Internal Revenue Code (“IRC”) Section 382 contains provisions that limit the amount of federal NOL carryforwards that can be used in any given year in the event of specified +occurrences, including significant ownership changes. During 2005, the Company completed an analysis, with the assistance of independent tax specialists, to determine if any IRC Section 382 ownership changes had occurred that would limit the +amount of NOLs that could be utilized to offset future taxable income. As a result of this analysis, the Company concluded that prior period ownership changes may impose a limitation on the amount of NOLs that can be utilized in a given year. The +Company does not believe, however, that this limitation will impair our future ability to utilize NOLs to offset our future taxable income. The Company continues to review ownership changes on an annual basis and we have not had a subsequent +ownership change that would impact the NOLs. +In connection with the DNAG acquisition, a deferred tax liability was recorded +to reflect the tax effects of basis differences of intangible assets and inventories for financial reporting and Canadian income tax purposes. For the year ended December 31, 2011 we recorded a Canadian income tax benefit of $869,000 associated +with DNAG’s loss before income taxes and certain Canadian research and development and investment tax credits. The income tax benefit associated with DNAG was considered realizable based upon the scheduled reversal of the deferred tax +liabilities recorded in connection with the acquisition of DNAG. +Clinical Trial Accruals . Some +of our research and development is conducted by third parties, including contract research and development service providers. All such costs are charged to research and development expense systematically as incurred, which may be measured by patient +enrollment or the passage of time. At the end of each quarter, we compare the payments made to each service provider to the estimated progress toward completion of the research or development objectives. Such estimates are subject to change as +additional information becomes available. Depending on the timing of payments to the service providers and the estimated service provided, we record net prepaid or accrued expense relating to these costs. +Contingencies . In the ordinary course of business, we have entered into various contractual relationships +with strategic corporate partners, customers, distributors, research laboratories and universities, licensors, licensees, suppliers, vendors and other parties. As such, we could be subject to litigation, claims or assessments arising from any or all +of these relationships. We record a loss contingency when information available prior to issuance of our financial statements indicates that it is probable that an asset has been impaired or a liability has been incurred at the date of the financial +statements and the amount of the loss can be reasonably estimated. Accounting for contingencies arising from contractual or legal proceedings requires that we use our best judgment when estimating an accrual related to such contingencies. As +additional information becomes known, our accrual for a loss contingency could fluctuate, thereby creating variability in our results of operations from period to period. Likewise, an actual loss arising from a loss contingency which significantly +exceeds the amount accrued for in our financial statements could have a material adverse impact on our operating results for the period in which such actual loss becomes known. +ITEM 7A. +Quantitative and Qualitative Disclosures About Market Risk. +We do not hold any amounts of derivative financial instruments or derivative commodity instruments and, accordingly, we have no material derivative risk to report under this Item. +65 +Table of Contents +In January 2008, we elected to fix the interest rate on our long-term debt at 4.15%. As a +result, we have no exposure to interest rate changes. +As of December 31, 2011, we did not have any foreign currency +exchange contracts or purchase currency options to hedge local currency cash flows. We have operations in Canada, Europe and Africa, which are subject to foreign currency fluctuations. As currency rates change, translation of revenues and expenses +for these operations from foreign currencies to U.S. dollars affects year-to-year comparability of operating results. Sales denominated in a foreign currency were 2.3% of our total revenues for the year ended December 31, 2011 (including +revenues from DNAG). We expect the DNAG business will continue to grow and our exposure to fluctuations in foreign currency exchange rates may increase. +ITEM 8. +Consolidated Financial Statements and Supplementary Data. +Information with respect to this Item is contained in our Consolidated Financial Statements included in Item 15 of this Annual Report on Form 10-K. +ITEM 9. +Changes in and Disagreements with Accountants on Accounting and Financial Disclosure. +Not applicable. +ITEM 9A. +Controls and Procedures. +(a) Evaluation of Disclosure Controls and Procedures. +The Company’s management, with the participation of the Company’s Chief Executive Officer and Chief Financial Officer, has evaluated the effectiveness of the Company’s disclosure controls +and procedures (as defined in Rules 13a-15(e) and 15d-15(e) of the Securities Exchange Act of 1934) as of December 31, 2011. Based on that evaluation, the Company’s management, including such officers, concluded that as of +December 31, 2011 the Company’s disclosure controls and procedures were adequate and effective to ensure that information required to be disclosed by the Company in the reports that we file or submit under the Securities Exchange Act of +1934 is accumulated and communicated to the Company’s management, including the Chief Executive Officer and Chief Financial Officer, to allow timely decisions regarding required disclosure and is recorded, processed, summarized, and reported +within the time periods specified in the rules and forms of the Securities and Exchange Commission. +(b) Management’s +Report on Internal Control Over Financial Reporting. +The Company’s management is responsible for establishing and +maintaining adequate internal control over financial reporting, as such term is defined in Rule 13a-15(f) and 15d-15(f) under the Securities Exchange Act of 1934. Under the supervision and with the participation of the Company’s management, +including our principal executive officer and principal financial officer, we conducted an evaluation of the effectiveness of our internal control over financial reporting based on the framework in Internal Control—Integrated Framework +issued by the Committee of Sponsoring Organizations of the Treadway Commission. As described in paragraph (c) below, this evaluation did not include the internal control over financial reporting for the Company’s newly-acquired +subsidiary, DNAG. Based on our evaluation under the framework, our management concluded that our internal control over financial reporting was effective to provide reasonable assurance regarding the reliability of financial reporting and the +preparation of financial statements for external purposes in accordance with generally accepted accounting principles as of December 31, 2011. +The effectiveness of our internal control over financial reporting as of December 31, 2011 has been audited by KPMG LLP, an independent registered public accounting firm, as stated in their report, +which is included below. +66 +Table of Contents +Because of its inherent limitations, internal control over financial reporting may not +prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies +or procedures may deteriorate. +(c) Changes in Internal Control Over Financial Reporting. +The acquisition of DNAG on August 17, 2011 represented a material change in internal control over financial reporting. As allowed +under the SEC’s guidance, management’s assessment of and conclusion regarding the design and effectiveness of internal control over financial reporting for the period August 18, 2011 to December 31, 2011 excluded the internal +control over financial reporting of DNAG. The financial reporting systems of DNAG have not yet been integrated into the Company’s financial reporting systems and, as such, the Company did not have the practical ability to perform an assessment +of DNAG’s internal control over financial reporting in time for the current period. Management expects to complete its assessment of the effectiveness of internal control over financial reporting for the acquired business within one year of the +date of the acquisition. DNAG operations contributed approximately $6.2 million in revenues to our consolidated financial results for 2011 (representing the period following the August 17, 2011 acquisition date) and DNAG had total assets +of approximately $56.5 million as of December 31, 2011 (of which approximately $51.1 million represented goodwill and identifiable intangible assets). With the exception of the DNAG acquisition as noted above, there were no changes in our +internal control over financial reporting during the fiscal quarter ended December 31, 2011 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting. +(d) Report of Independent Registered Public Accounting Firm +The Board of Directors and Stockholders +OraSure Technologies, Inc.: +We have audited OraSure Technologies, Inc.’s internal control over financial reporting as of December 31, 2011, based on +criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). OraSure Technologies, Inc.’s management is responsible for maintaining effective +internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Management’s Report on Internal Control Over Financial Reporting. Our +responsibility is to express an opinion on the Company’s internal control over financial reporting based on our audit. +We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards +require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control +over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audit also included performing such other procedures +as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion. +A +company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with +generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect +the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting +principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable +67 +Table of Contents +assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements. +Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, +projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. +In our opinion, OraSure Technologies, Inc. maintained, in all material respects, effective internal control over financial +reporting as of December 31, 2011, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). +OraSure Technologies, Inc. acquired DNA Genotek Inc. during 2011 and management excluded from its assessment of the effectiveness of +OraSure Technologies, Inc.’s internal control over financial reporting as of December 31, 2011, DNA Genotek Inc.’s internal control over financial reporting associated with total assets of $56,534,999 (44.2% of total assets, of which +$51,059,969 represents goodwill and intangibles) and total revenues of $6,215,929 (7.6% of total revenues) included in the consolidated financial statements of OraSure Technologies, Inc. and subsidiaries as of and for the year ended +December 31, 2011. Our audit of internal control over financial reporting of OraSure Technologies, Inc. also excluded an evaluation of the internal control over financial reporting of DNA Genotek Inc. +We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated +balance sheets of OraSure Technologies, Inc. and subsidiaries as of December 31, 2011 and 2010, and the related consolidated statements of operations, stockholders’ equity and comprehensive loss, and cash flows for each of the years in the +three-year period ended December 31, 2011, and our report dated March 14, 2012 expressed an unqualified opinion on those consolidated financial statements. +/s/ KPMG LLP +Philadelphia, Pennsylvania +March 14, 2012 +ITEM 9B. +Other Information. +Not +applicable. +68 +Table of Contents +PART III +We have omitted from Part III the information that will appear in our Definitive Proxy Statement for our 2011 Annual Meeting of +Stockholders (the “Proxy Statement”), which will be filed within 120 days after the end of our fiscal year pursuant to Regulation 14A. +ITEM 10. +Directors, Executive Officers and Corporate Governance. +Certain information required by this Item is incorporated by reference to the information under the captions, “Corporate Governance—Committees of the Board—Audit Committee,” “Item +1—Election of Directors,” “Executive Officers,” and “Section 16(a) Beneficial Ownership Reporting Compliance,” in the Proxy Statement. +Our Board of Directors has adopted a Code of Business Conduct and Ethics that applies to our principal executive officer, principal financial officer and principal accounting officer, as well as to the +members of our Board of Directors and our other officers and employees. This Code of Business Conduct and Ethics is available on our website at www.orasure.com . We intend to satisfy the amendment and waiver disclosure requirements under +applicable securities regulations by posting any amendments of, or waivers to, the Code of Business Conduct and Ethics on our website. +ITEM 11. +Executive Compensation. +The information required by this Item is incorporated by reference to the information under the caption, “Executive +Compensation,” in the Proxy Statement. +ITEM 12. +Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters. +The information required by this Item with respect to the securities ownership of certain beneficial owners and management, and equity +compensation plan information, is incorporated by reference to the information under the captions, “Principal Stockholders” and “Executive Compensation—Equity Compensation Plan Information,” in the Proxy Statement. +ITEM 13. +Certain Relationships and Related Transactions, and Director Independence. +The information required by this Item is incorporated by reference to the information under the captions, “Transactions with Related Persons” and “Corporate Governance—Director +Independence,” in the Proxy Statement. +ITEM 14. +Principal Accountant Fees and Services. +The information required by this Item is incorporated by reference to the information under the caption,” Item 2—Ratification of Appointment of Independent Registered Public Accounting +Firm” in the Proxy Statement. +69 +Table of Contents +PART IV +ITEM 15. +Exhibits and Consolidated Financial Statement Schedules. +(a)(1) and (a)(2). Consolidated Financial Statements and Schedules . For a list of the consolidated financial statements filed herewith, see the Index to Consolidated Financial Statements following +the signature page to this Annual Report. No schedules are included with the consolidated financial statements because the required information is inapplicable or is presented in the consolidated financial statements or related notes thereto. +(a)(3). Exhibits . See Index to Exhibits following the consolidated financial statements in this Annual Report. +70 +Table of Contents +SIGNATURES +Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly +authorized, on March 14, 2012. +ORASURE TECHNOLOGIES, INC. +By: +/s/ D OUGLAS A. M ICHELS +Douglas A. Michels +President and Chief Executive Officer +Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed on +March 14, 2012, by the following persons on behalf of the Registrant and in the capacities indicated. +SIGNATURE +TITLE +/s/ D OUGLAS A. M ICHELS +Douglas A. Michels +President, Chief Executive Officer and Director +(Principal Executive Officer) +/s/ R ONALD H. S PAIR +Ronald H. Spair +Chief Operating Officer, Chief Financial Officer and +Director (Principal Financial Officer) +/s/ M ARK L. K UNA +Mark L. Kuna +Senior Vice President, Finance and Controller +(Principal Accounting Officer) +*M ICHAEL C ELANO +Michael Celano +Director +*R ONNY B. L ANCASTER +Ronny B. Lancaster +Director +*G ERALD M. O STROV +Gerald M. Ostrov +Director +*C HARLES W. P ATRICK +Charles W. Patrick +Director +*R OGER L. P RINGLE +Roger L. Pringle +Director +*S TEPHEN S. T ANG +Stephen S. Tang +Director +*D OUGLAS G. W ATSON +Douglas G. Watson +Director +*By: +/s/ J ACK E. J ERRETT +Jack E. Jerrett +(Attorney-in-Fact) +71 +Table of Contents +Index to Consolidated Financial Statements +Page +Report of Independent Registered Public Accounting Firm +F-2 +Consolidated Balance Sheets +F-3 +Consolidated Statements of Operations +F-4 +Consolidated Statements of Stockholders’ Equity and Comprehensive Loss +F-5 +Consolidated Statements of Cash Flows +F-6 +Notes to the Consolidated Financial Statements +F-7 +F-1 +Table of Contents +REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM +The Board of Directors and Stockholders +OraSure Technologies, Inc.: +We have audited the accompanying consolidated balance sheets of +OraSure Technologies, Inc. and subsidiaries as of December 31, 2011 and 2010, and the related consolidated statements of operations, stockholders’ equity and comprehensive loss, and cash flows for each of the years in the three-year period +ended December 31, 2011. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits. +We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that +we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial +statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for +our opinion. +In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial +position of OraSure Technologies, Inc. and subsidiaries as of December 31, 2011 and 2010, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2011, in conformity with +U.S. generally accepted accounting principles. +We also have audited, in accordance with the standards of the Public Company Accounting +Oversight Board (United States), OraSure Technologies, Inc.’s internal control over financial reporting as of December 31, 2011, based on criteria established in Internal Control—Integrated Framework issued by the Committee of +Sponsoring Organizations of the Treadway Commission (COSO), and our report dated March 14, 2012 expressed an unqualified opinion on the effectiveness of the Company’s internal control over financial reporting. +/s/ KPMG LLP +Philadelphia, Pennsylvania +March 14, 2012 +F-2 +Table of Contents +ORASURE TECHNOLOGIES, INC. AND SUBSIDIARIES +CONSOLIDATED BALANCE SHEETS +December 31, +2011 +2010 +ASSETS +CURRENT ASSETS: +Cash and cash equivalents +$ +23,878,002 +$ +73,843,402 +Short-term investments +— +1,895,000 +Accounts receivable, net of allowance for doubtful accounts of $169,916 and $105,954 +17,158,751 +12,471,249 +Inventories +9,620,556 +7,345,594 +Prepaid expenses +1,682,325 +1,579,513 +Other current assets +495,981 +350,595 +Total current assets +52,835,615 +97,485,353 +PROPERTY AND EQUIPMENT, net +19,855,456 +19,610,583 +INTANGIBLE ASSETS, net +30,383,112 +4,806,919 +GOODWILL +24,739,776 +— +OTHER ASSETS +47,383 +617,238 +$ +127,861,342 +$ +122,520,093 +LIABILITIES AND STOCKHOLDERS’ EQUITY +CURRENT LIABILITIES: +Current portion of long-term debt +$ +7,291,680 +$ +7,791,680 +Accounts payable +4,142,173 +2,898,846 +Accrued expenses and other +10,542,155 +8,986,879 +Total current liabilities +21,976,008 +19,677,405 +DEFERRED INCOME TAXES +5,635,633 +— +COMMITMENTS AND CONTINGENCIES (Note 13) +STOCKHOLDERS’ EQUITY +Preferred stock, par value $.000001, 25,000,000 shares authorized, none issued +— +— +Common stock, par value $.000001, 120,000,000 shares authorized, 47,392,711 and 46,225,622 shares issued and +outstanding +47 +46 +Additional paid-in capital +249,639,955 +241,663,337 +Accumulated other comprehensive loss +(1,964,251 +) +(235,264 +) +Accumulated deficit +(147,426,050 +) +(138,585,431 +) +Total stockholders’ equity +100,249,701 +102,842,688 +$ +127,861,342 +$ +122,520,093 +See accompanying notes to the consolidated financial statements. +F-3 +Table of Contents +ORASURE TECHNOLOGIES, INC. AND SUBIDIARIES +CONSOLIDATED STATEMENTS OF OPERATIONS +For the years ended December 31, +2011 +2010 +2009 +REVENUES: +Product +$ +80,683,650 +$ +71,198,520 +$ +75,168,959 +Licensing and product development +1,197,648 +3,816,316 +1,857,267 +81,881,298 +75,014,836 +77,026,226 +COST OF PRODUCTS SOLD +30,163,646 +27,655,507 +29,895,832 +Gross profit +51,717,652 +47,359,329 +47,130,394 +OPERATING EXPENSES: +Research and development +18,406,619 +13,191,917 +13,371,358 +Sales and marketing +22,383,308 +20,727,667 +21,224,125 +General and administrative +20,325,204 +16,793,852 +16,847,920 +Litigation settlement +— +— +1,451,183 +Impairment of patent and product rights +— +— +3,028,375 +61,115,131 +50,713,436 +55,922,961 +Operating loss +(9,397,479 +) +(3,354,107 +) +(8,792,567 +) +INTEREST EXPENSE +(316,313 +) +(316,185 +) +(361,188 +) +INTEREST INCOME +63,990 +151,757 +737,892 +FOREIGN CURRENCY GAIN (LOSS) +(44,253 +) +5,240 +(21,342 +) +OTHER INCOME (EXPENSE) +(15,514 +) +16,350 +1,788 +Loss before income taxes +(9,709,569 +) +(3,496,945 +) +(8,435,417 +) +INCOME TAX BENEFIT +(868,950 +) +— +(622,284 +) +NET LOSS +$ +(8,840,619 +) +$ +(3,496,945 +) +$ +(7,813,133 +) +LOSS PER SHARE: +BASIC AND DILUTED +$ +(0.19 +) +$ +(0.08 +) +$ +(0.17 +) +SHARES USED IN COMPUTING LOSS PER SHARE: +BASIC AND DILUTED +46,908,441 +46,187,332 +45,877,843 +See accompanying notes to the consolidated +financial statements. +F-4 +Table of Contents +ORASURE TECHNOLOGIES, INC. AND SUBSIDIARIES +CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY AND COMPREHENSIVE LOSS +For the years ended December 31, 2011, 2010 and 2009 +Common Stock +Additional +Paid-in +Capital +Accumulated +Other +Comprehensive +Loss +Accumulated +Deficit +Total +Shares +Amount +Balance at January 1, 2009 +45,769,221 +$ +46 +$ +235,862,999 +$ +(262,442 +) +$ +(127,275,353 +) +$ +108,325,250 +Common stock issued upon exercise of options +30,911 +— +24,807 +— +— +24,807 +Vesting of restricted stock +370,457 +— +— +— +— +— +Purchase and retirement of treasury shares +(132,785 +) +— +(391,590 +) +— +— +(391,590 +) +Shares purchased and retired pursuant to the stock repurchase plan +(108,293 +) +— +(308,605 +) +— +(308,605 +) +Compensation cost for restricted stock +— +— +2,621,723 +— +— +2,621,723 +Compensation cost for stock option grants +— +— +1,317,088 +— +— +1,317,088 +Comprehensive loss: +Net loss +— +— +— +— +(7,813,133 +) +(7,813,133 +) +Currency translation adjustments +— +— +— +34,513 +— +34,513 +Unrealized loss on marketable securities +— +— +— +(3,063 +) +— +(3,063 +) +Total comprehensive loss +(7,781,683 +) +Balance at December 31, 2009 +45,929,511 +46 +239,126,422 +(230,992 +) +(135,088,486 +) +103,806,990 +Common stock issued upon exercise of options +2,844 +— +7,977 +— +— +7,977 +Vesting of restricted stock +429,309 +— +— +— +— +— +Purchase and retirement of treasury shares +(136,042 +) +— +(708,785 +) +— +— +(708,785 +) +Compensation cost for restricted stock +— +— +2,354,109 +— +— +2,354,109 +Compensation cost for stock option grants +— +— +883,614 +— +— +883,614 +Comprehensive loss: +Net loss +— +— +— +— +(3,496,945 +) +(3,496,945 +) +Currency translation adjustments +— +— +— +(3,985 +) +— +(3,985 +) +Unrealized loss on marketable securities +— +— +— +(287 +) +— +(287 +) +Total comprehensive loss +(3,501,217 +) +Balance at December 31, 2010 +46,225,622 +46 +241,663,337 +(235,264 +) +(138,585,431 +) +102,842,688 +Common stock issued upon exercise of options +879,766 +1 +4,782,644 +— +— +4,782,645 +Vesting of restricted stock +421,470 +— +— +— +— +— +Purchase and retirement of treasury shares +(134,147 +) +— +(908,884 +) +— +— +(908,884 +) +Compensation cost for restricted stock +— +— +2,520,834 +— +— +2,520,834 +Compensation cost for stock option grants +— +— +1,582,024 +— +— +1,582,024 +Comprehensive loss: +Net loss +— +— +— +— +(8,840,619 +) +(8,840,619 +) +Currency translation adjustments +— +— +— +(1,728,987 +) +— +(1,728,987 +) +Total comprehensive loss +(10,569,606 +) +Balance at December 31, 2011 +47,392,711 +$ +47 +$ +249,639,955 +$ +(1,964,251 +) +$ +(147,426,050 +) +$ +100,249,701 +See accompanying notes to the consolidated financial statements +F-5 +Table of Contents +ORASURE TECHNOLOGIES, INC. AND SUBSIDIARIES +CONSOLIDATED STATEMENTS OF CASH FLOWS +For the years ended December 31, +2011 +2010 +2009 +OPERATING ACTIVITIES: +Net loss +$ +(8,840,619 +) +$ +(3,496,945 +) +$ +(7,813,133 +) +Adjustments to reconcile net loss to net cash (used in) provided by operating activities: +Impairment of patent and product rights +— +— +3,028,375 +Stock-based compensation +4,100,451 +3,228,812 +3,935,737 +Depreciation and amortization +4,891,173 +3,012,270 +3,049,962 +Deferred income taxes +(868,950 +) +— +— +Inventory purchase accounting step-up adjustment +852,367 +— +— +Changes in assets and liabilities, net of effects from acquisition: +Accounts receivable +(3,377,339 +) +1,218,808 +(2,116,410 +) +Inventories +(1,756,710 +) +1,498,898 +1,859,596 +Prepaid expenses and other assets +490,851 +1,413,708 +(2,442,562 +) +Accounts payable +911,141 +(472,461 +) +(501,177 +) +Accrued expenses and other liabilities +603,651 +(2,515,923 +) +706,847 +Net cash (used in) provided by operating activities +(2,993,984 +) +3,887,167 +(292,765 +) +INVESTING ACTIVITIES: +Proceeds from maturities and redemptions of short-term investments +1,895,000 +2,841,000 +44,090,000 +Purchase of short-term investment +— +— +(5,986,000 +) +Acquistion of DNA Genotek Inc., net of cash acquired +(49,729,925 +) +— +— +Payments for patents and product rights +— +(4,500,000 +) +— +Purchases of property and equipment +(2,504,923 +) +(2,105,775 +) +(1,199,551 +) +Net cash (used in) provided by investing activities +(50,339,848 +) +(3,764,775 +) +36,904,449 +FINANCING ACTIVITIES: +Repayments of long-term debt +(500,000 +) +(509,760 +) +(557,897 +) +Proceeds from exercise of stock options +4,782,645 +7,977 +24,807 +Repurchase of common stock +(908,884 +) +(708,785 +) +(700,195 +) +Net cash provided by (used in) financing activities +3,373,761 +(1,210,568 +) +(1,233,285 +) +EFFECT OF FOREIGN EXCHANGE RATE CHANGES ON CASH +(5,329 +) +(2,052 +) +(9,987 +) +NET (DECREASE) INCREASE IN CASH AND CASH EQUIVALENTS +(49,965,400 +) +(1,090,228 +) +35,368,412 +CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD +73,843,402 +74,933,630 +39,565,218 +CASH AND CASH EQUIVALENTS, END OF PERIOD +$ +23,878,002 +$ +73,843,402 +$ +74,933,630 +See accompanying notes to the consolidated financial statements. +F-6 +Table of Contents +ORASURE TECHNOLOGIES, INC. AND SUBSIDIARIES +NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS +1. +THE COMPANY: +We manufacture and market oral fluid diagnostic products and specimen collection devices using our proprietary oral +fluid technologies, as well as other diagnostic products, including immunoassays and other in vitro diagnostic tests that are used on other specimen types. We also manufacture and sell other medical devices used for the removal of benign skin +lesions by cryosurgery, or freezing. Our diagnostic products include tests that are performed on a rapid basis at the point of care and tests that are processed in a laboratory. These products are sold in the United States and internationally to +various clinical laboratories, hospitals, clinics, community-based organizations and other public health organizations, distributors, government agencies, physicians’ offices, and commercial and industrial entities. One of our products has been +sold in the over-the-counter or consumer retail markets in North America, Europe, Central and South America and Australia. +On August 17, 2011, we completed our acquisition of DNA Genotek Inc. (“DNAG”). DNAG is based in Ottawa, Canada and manufactures and sells oral fluid collection devices used to collect +samples of genetic material for molecular testing in the academic research, clinical genetic testing, pharmacogenomics, personalized medicine, and animal genetics markets. DNAG’s lead product, the OraGene ® DNA sample collection kit, provides an all-in-one system for the collection, stabilization, transportation and +purification of DNA from saliva. DNAG will operate as a wholly-owned subsidiary of OraSure. +2. +SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES: +Principles of Consolidation and Basis of Presentation +The consolidated financial statements include the accounts of OraSure and its wholly-owned subsidiary, DNAG (collectively, the +“Company”). All intercompany transactions and balances have been eliminated. +Use of Estimates +The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America +requires management to make estimates and assumptions about future events. These estimates and underlying assumptions affect the amounts of assets and liabilities reported, disclosures about contingent assets and liabilities, and reported amounts of +revenues and expenses. Such estimates include the valuation of accounts receivable, inventories and intangible assets, as well as calculations related to contingencies, accruals and indemnifications, among others. These estimates and assumptions are +based on management’s best estimates and judgment. Management evaluates its estimates and assumptions on an ongoing basis, using historical experience and other factors, which management believes to be reasonable under the circumstances, +including the current economic environment. We adjust such estimates and assumptions when facts and circumstances dictate. Illiquid credit markets, volatile equity, foreign currency and energy markets, and declines in consumer spending have combined +to increase the uncertainty inherent in such estimates and assumptions. As future events and their effects cannot be determined with precision, actual results could differ significantly from these estimates. Changes in those estimates resulting from +continuing changes in the economic environment will be reflected in the financial statements in those future periods. +Cash +and Cash Equivalents +We consider all highly liquid investments with a purchased maturity of ninety days or less to be cash +equivalents. As of December 31, 2010, cash equivalents consisted of money market accounts. We had no cash equivalents at December 31, 2011. +F-7 +Table of Contents +Short-term Investments +We consider all short-term investments to be available-for-sale securities. These securities are comprised of certificates of deposits +with purchased maturities greater than ninety days. Available-for-sale securities are carried at fair value, based upon quoted market prices, with unrealized gains and losses, if any, reported in stockholders’ equity as a component of +accumulated other comprehensive loss. +Our available-for-sale securities as of December 31, 2010 consisted of +certificates of deposits with amortized cost and fair value of $1,895,000. These certificates of deposits matured during the second quarter of 2011. +Supplemental Cash Flow Information +In 2011, 2010 and 2009, we paid +interest of $318,215, $339,281, and $361,121, respectively. In 2010, we capitalized interest of $20,238. No interest was capitalized in 2011 or 2009. +In 2011, we received a refund of $14,976 for federal and state income taxes, net of state taxes paid. In 2010, we received a federal income tax refund of $597,393 related to refundable alternative minimum +taxes paid in previous years, and paid state income taxes of $11,500. In 2009, we paid federal and state income taxes of $16,461. +In 2011 and 2009, we recorded through the consolidated statements of operations an increase in our allowance for doubtful accounts of $64,121 and $93,472, respectively. In 2010, we recorded through the +consolidated statement of operations a decrease in our allowance for doubtful accounts of $114,716. We had write-offs of $35,902 against the allowance for doubtful accounts in 2010. We had no material write-offs against the allowance for doubtful +accounts in 2011 or 2009. +Accounts Receivable +Accounts receivable have been reduced by an estimated allowance for amounts that may become uncollectible in the future. This estimated allowance is based primarily on management’s evaluation of +specific balances as they become past due, the financial condition of our customers and our historical experience related to write-offs. +Inventories +Inventories are stated at the lower of cost or market +determined on a first-in, first-out basis, and include the cost of raw materials, labor and overhead. The majority of our inventories are subject to expiration dating. We continually evaluate quantities on hand and the carrying value of our +inventories to determine the need for reserves for excess and obsolete inventories, based primarily on the estimated forecast of product sales. When factors indicate that impairment has occurred, either a reserve is established against the +inventories’ carrying value or the inventories are completely written off, as in the case of lapsing expiration dates. In addition to reserving for these items identified through specific identification procedures, we also reserve for +unidentified scrap or spoilage under a fixed-formula methodology. +Property and Equipment +Property and equipment are stated at cost. Additions or improvements are capitalized, while repairs and maintenance are charged to +expense. Depreciation and amortization are provided using the straight-line method over the estimated useful lives of the related assets. Buildings are depreciated over twenty to forty years, while computer equipment, machinery and equipment, and +furniture and fixtures are depreciated over two to ten years. Building improvements are amortized over their estimated useful lives. When assets are sold or otherwise disposed of, the related property amounts are relieved from the accounts, and any +gain or loss is recorded in the consolidated statement of operations. +F-8 +Table of Contents +Intangible Assets +Intangible assets consist of customer list, patents and product rights, acquired technology, tradename and non-compete agreements. Patents +and product rights consist of costs associated with the acquisition of patents, licenses and product distribution rights. Customer list, acquired technology, tradename and the non-compete agreements were all part of our acquisition of DNAG. +Intangible assets are amortized using the straight-line method over their estimated useful lives of one to fifteen years. +Goodwill +Goodwill represents the excess of the purchase price we paid over the fair value of the net tangible and identifiable intangible assets +acquired and liabilities assumed in our acquisition of DNAG. Goodwill is not amortized but rather is tested annually for impairment or more frequently if we believe that indicators of impairment exist. Performance of a goodwill impairment test +involves a two-step process. The first step involves comparing the fair values of the applicable reporting units with their aggregate carrying values, including goodwill. If the carrying value of a reporting unit exceeds the reporting unit’s +fair value, we perform the second step of the test to determine the amount of the impairment loss. The second step involves measuring the impairment by comparing the implied fair values of the affected reporting unit’s goodwill and intangible +assets with the respective carrying values. +Since the acquisition of DNAG was completed in August 2011, our first annual +impairment testing for goodwill is not required as of December 31, 2011. As of December 31, 2011, we believe that no indicators of impairment exist. +Impairment of Long-Lived Assets +If indicators of impairment exist, we +assess the recoverability of the affected long-lived assets, which include property and equipment and intangible assets, by determining whether the carrying value of such assets can be recovered through the sum of the undiscounted future cash flows +from the use and eventual disposition of the asset. If impairment is indicated, we measure the amount of such impairment by comparing the carrying value of the assets to the fair value of these assets, which is generally determined based on the +present value of the expected future cash flows associated with the use of the assets. +Revenue Recognition +We recognize product revenues when there is persuasive evidence that an arrangement exists, the price is fixed or determinable, title has +passed and collection is reasonably assured. Product revenues are recorded net of allowances for any discounts or rebates. We do not grant price protection or product return rights to our customers, except for warranty returns. Historically, returns +arising from warranty issues have been infrequent and immaterial. Accordingly, we expense warranty returns as incurred. +Royalty income from the grant of license rights is recognized during the period in which the revenue is earned and the amount is +determinable from the licensee. +We record shipping and handling charges billed to our customers as product revenue and the +related expense as cost of products sold. Taxes assessed by governmental authorities, such as sales or value-added taxes, are excluded from product revenues. +Customer and Vendor Concentrations +We had no significant concentrations +(greater than 10%) in accounts receivable as of December 31, 2011 or in revenues for the years ended December 31, 2011, 2010 or 2009. As of December 31, 2010, one of our customers, Quest Diagnostics, Incorporated, accounted for +approximately 10% of our accounts receivable balances. +F-9 +Table of Contents +We currently purchase certain products and critical components of our products from +sole-supply vendors, and if these vendors are unable or unwilling to supply the required components and products, this could subject us to substantial delays in the delivery of our products to our customers and increased costs. Furthermore, our +subsidiary, DNAG, uses two third-party suppliers to manufacture its products. Our inability to have a timely supply of any of these components and products could have a material adverse effect on our business, as well as our financial condition and +results of operations. +Research and Development +Research and development expenses consist of costs incurred in performing research and development activities, including salaries and +benefits, facilities expenses, overhead expenses, clinical trial and related clinical manufacturing expenses, contract services and other outside expenses. Research and development costs are charged to expense as incurred. Clinical trial expenses +include expenses associated with contract research organizations, or CROs. The invoicing from CROs can precede the services provided or can lag the service period by several months. Invoices paid prior to service being provided are recorded as a +prepaid expense and then expensed appropriately as services are provided. We accrue the cost of services rendered but unbilled by CROs based on purchase order estimates provided by the CROs. Differences between actual and estimated clinical trial +expenses recorded are generally not material and are adjusted for in the period in which they become known. +Advertising +Expenses +Advertising costs are charged to expense as incurred. During 2011, 2010, and 2009, we incurred $129,761, +$223,092, and $198,357, respectively, in advertising expenses. +Stock-Based Compensation +We account for stock-based compensation to employees and directors using the fair value method. We recognize compensation expense for +stock option awards issued to employees and directors on a straight-line basis over the requisite service period of the award. To satisfy the exercise of options or to issue new restricted stock, we issue new shares rather than purchase shares on +the open market. +Income Taxes +We follow the asset and liability method for accounting for income taxes. Under this method, deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences +between the financial statement carrying amounts of existing assets and liabilities and the respective tax basis of assets and liabilities, and operating loss and credit carryforwards. Deferred tax assets and liabilities are measured using enacted +tax rates for the respective taxing jurisdiction that are expected to apply to taxable income in the years in which those temporary differences and operating loss and credit carryforwards are expected to be recovered, settled or utilized. The effect +on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. +We assess the realizability of our net deferred tax assets on a quarterly basis. If, after considering all relevant positive and negative evidence, it is more likely than not that some portion or all of +the net deferred tax assets will not be realized we reduce our net deferred tax assets by a valuation allowance. The realization of the net deferred tax assets is dependent on several factors, including the generation of sufficient taxable income +prior to the expiration of the net operating loss carryforwards. +F-10 +Table of Contents +Foreign Currency Translation +The assets and liabilities of our foreign operations are translated into U.S. dollars at current exchange rates as of the balance sheet +date, and revenues and expenses are translated at average exchange rates for the period. Resulting translation adjustments are reflected in accumulated other comprehensive loss, which is a separate component of stockholders’ equity. +Transaction gains and losses resulting from exchange rate changes on transactions denominated in currencies other than functional +currency are included in income in the period in which the change occurs. +Loss Per Share +Basic and diluted loss per share is computed by dividing net loss by the weighted-average number of shares of common stock outstanding +during the period. Diluted loss per share is generally computed assuming the exercise or vesting of all dilutive securities such as common stock options and unvested restricted stock. Common stock options and unvested restricted stock totaling +6,295,652, 6,295,689, and 6,251,542 shares were outstanding as of December 31, 2011, 2010 and 2009. For the years ended December 31, 2011, 2010 and 2009, these shares were excluded from the respective periods’ computation of diluted +loss per share, as their inclusion would have been anti-dilutive. +Accumulated Other Comprehensive Loss +We classify items of other comprehensive loss by their nature and disclose the balance of other comprehensive loss in the consolidated +statements of stockholders’ equity and comprehensive loss. +The components of accumulated other comprehensive loss for +2011, 2010, and 2009 were as follows: +Foreign +Currency +Translation +Adjustment +Unrealized Gain +(Loss) on +Marketable +Securities +Accumulated +Other +Comprehensive +Loss +Balance at January 1, 2009 +$ +(265,792 +) +$ +3,350 +$ +(262,442 +) +Currency translation adjustments +34,513 +— +34,513 +Unrealized loss on marketable securities +— +(3,063 +) +(3,063 +) +Balance at December 31, 2009 +(231,279 +) +287 +(230,992 +) +Currency translation adjustments +(3,985 +) +— +(3,985 +) +Unrealized loss on marketable securities +— +(287 +) +(287 +) +Balance at December 31, 2010 +(235,264 +) +— +(235,264 +) +Currency translation adjustments +(1,728,987 +) +(1,728,987 +) +Unrealized loss on marketable securities +— +— +— +Balance at December 31, 2011 +$ +(1,964,251 +) +$ +— +$ +(1,964,251 +) +On August 17, 2011, we acquired DNAG, a Canadian based company (see discussion in Note 3). We have +defined Canadian dollars as the functional currency of this reporting entity, and as such, the results of its operations are translated into U.S. dollars, which is the reporting currency of the Company. The $1,728,987 currency translation adjustment +recorded in 2011, is largely the result of the translation of our Canadian operation’s financial statements into U.S. dollars. +Fair Value of Financial Instruments +As of December 31, 2011 and 2010, +the carrying values of cash and cash equivalents, accounts receivable, accounts payable and accrued expenses approximate their respective fair values based on their short-term nature. +F-11 +Table of Contents +In addition, we believe the carrying value of our debt instrument, which does not have a readily ascertainable market value, approximates fair value, given that the interest rate on outstanding +borrowings approximates current market rates and it matures in May 2012. +Fair value measurements of all financial assets and +liabilities that are being measured and reported on a fair value basis are required to be classified and disclosed in one of the following three categories: +Level 1: +Unadjusted quoted prices in active markets that are accessible at the measurement date for identical, unrestricted assets or liabilities; +Level 2: +Quoted prices in markets that are not active, or inputs which are observable, either directly or indirectly, for substantially the full term of the asset or liability; +and +Level 3: +Prices or valuation techniques that require inputs that are both significant to the fair value measurement and unobservable (i.e., supported by little or no market +activity). +All our available for sale securities were classified and measured as Level 1 instruments as of +December 31, 2010. +Recent Accounting Pronouncements +In June 2011, the Financial Accounting Standards Board (“FASB”) issued guidance amending the Other Comprehensive Income +topic of the FASB Codification. The guidance provides an entity with the option to present the total of comprehensive income, the components of net income, and the components of other comprehensive income either in a single continuous statement of +comprehensive income or in two separate but consecutive statements. This guidance will be effective for us in the first quarter of 2012 and will not have a material impact on our financial position, results of operations or cash flows. +In September 2011, the FASB issued guidance amending the Testing Goodwill for Impairment topic of the FASB Codification . +The new guidance allows companies to make a qualitative evaluation about the likelihood of goodwill impairment. If a company concludes that it is more likely than not that the carrying amount of a reporting unit is greater than its fair value, then +it will be required to perform the first step of the two-step quantitative impairment test by calculating the fair value of the reporting unit and comparing the fair value with the carrying amount. Otherwise, performing the two-step impairment test +is unnecessary. This new guidance is effective beginning after January 1, 2012, with early adoption permitted. We do not expect the adoption of the standard update to have a significant impact on our financial position, results of operations or +cash flows. +3. +Business Combination +On August 17, 2011 (the “Acquisition Date”), OraSure, through a wholly-owned subsidiary, acquired all of +the outstanding capital stock of DNAG, pursuant to the terms of a Support Agreement dated July 25, 2011. The purchase price was $49,750,000 CDN ($50,466,725 in U.S. dollars at the Acquisition Date exchange rate) and was funded by OraSure with +cash on hand. This purchase price consists of $50 million CDN ($50,710,000 in U.S. dollars at the Acquisition Date exchange rate) less a $250,000 CDN ($253,550 USD) working capital adjustment received in the fourth quarter 2011. Of the original $50 +million CDN purchase price, $5,000,000 CDN (or $5,071,000 in U.S. dollars at the Acquisition Date exchange rate) was deposited in escrow pursuant to the Support Agreement. The payment for the working capital adjustment was funded from the escrow +account. Subject to certain adjustments and the processing of any indemnification claims, $2,500,000 CDN will be released from the escrow fund in February 2013 with the balance released in February 2014. +F-12 +Table of Contents +The acquisition of DNAG strengthens OraSure’s leadership in oral fluid diagnostics, by +providing OraSure with a complementary portfolio of products that enable easy and reliable collection, stabilization, transportation and storage of high quality nucleic acid (DNA and RNA) samples. These samples can then be used for a wide range of +research and diagnostic applications. +We have accounted for the acquisition of DNAG using the acquisition method of +accounting, in accordance with U.S. GAAP. Under the acquisition method of accounting, the total purchase price is allocated to the tangible and identifiable intangible assets acquired and the liabilities assumed based upon their estimated fair +values as of the Acquisition Date. The excess of the fair value of the consideration paid over the estimated fair value of the assets acquired and liabilities assumed was recorded as goodwill. For purposes of the purchase price allocation, fair +value is defined as an exit price, representing the amount that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants. The fair value guidance also requires that the fair value +measurements reflect the assumptions market participants use in pricing an asset or liability based upon the best information available. Under the acquisition method of accounting, acquisition related transaction costs, such as success-based banking +fees and professional fees, are not included as a component of consideration transferred, but rather are accounted for as expenses in the periods in which the costs are incurred. +During 2011, we incurred a total of $2,634,049 of acquisition related costs, including success-based investment banking fees and +accounting, legal and other professional fees, related to the DNAG acquisition, all of which were expensed and included in general and administrative expenses in the consolidated statement of operations for year ended December 31, 2011. +The $50,466,725 purchase price has been allocated based upon an estimate of the fair values of the tangible and intangible +assets acquired and the liabilities assumed. The determination of the estimated fair value allocation of the purchase price required us to make significant estimates and assumptions. An independent valuation specialist used these estimates and +assumptions to conduct analyses to assist us in determining the estimated fair value of acquired intangibles. The work performed by the independent valuation specialists, while not yet finalized, has been considered in our estimates of the fair +values reflected. +As of September 30, 2011, our preliminary goodwill allocation was $27,493,114 pending receipt of the +final valuation report for identifiable intangible assets. As of December 31, 2011 we have received the preliminary valuation report and we have retrospectively adjusted the purchase price allocation and reduced goodwill by $1,874,286, +increased the income tax accounts by $19,264 and increased identifiable intangible assets by $1,640,000. +The following table +summarizes the allocation of the estimated fair values of the assets acquired and the liabilities assumed at the Acquisition Date: +Current assets +$ +3,734,211 +Property, plant and equipment +714,965 +Other assets +759,901 +Intangible assets +28,502,000 +Goodwill +25,618,828 +Total assets acquired +59,329,905 +Current liabilities +(1,388,056 +) +Deferred tax liability +(7,475,124 +) +Total liabilities assumed +(8,863,180 +) +Purchase price +50,466,725 +Less cash acquired +(736,800 +) +Net cash paid +$ +49,729,925 +F-13 +Table of Contents +The following represents details of the purchased intangible assets as part of the +acquisition: +Description +Estimated Useful +Life (in years) +Amount +Customer list +10 +$ +12,706,000 +Acquired technology +7 +9,869,000 +Tradename +15 +4,870,000 +Non-compete agreements +1-3 +1,057,000 +Total acquired intangible assets +$ +28,502,000 +The acquisition of DNAG will provide us with an opportunity to access and expand its business in the +molecular diagnostic marketplace. This factor contributed to a purchase price resulting in goodwill. The acquired goodwill will not be amortized, and also will not be deductible for income tax purposes. +Included in the current assets acquired in the DNAG acquisition was inventory having an estimated fair value of $1,412,755. This fair +value includes an $892,276 “step-up” adjustment to capitalize the estimated manufacturing profit in acquired finished goods inventory as of the Acquisition Date, of which we expensed $852,367 to cost of products sold during the year ended +December 31, 2011. We will record an additional non-cash charge to cost of products sold over the period in which the remainder of the stepped-up inventory is sold. +The results of operations associated with DNAG have been consolidated with those of the Company since the Acquisition Date. Total revenues of $6,215,929 and a net loss of $693,418, including $852,367 of +inventory step-up as noted above, attributable to DNAG were recognized in the consolidated statement of operations for the year ended December 31, 2011. +The following unaudited condensed consolidated pro forma information sets forth the revenues, net loss and net loss per share of the Company for the year ended December 31, 2011 and 2010, as if the +acquisition had occurred on January 1, 2010. The unaudited pro forma information presented below is not necessarily indicative of the results that would have been attained had the transaction occurred at an earlier date, nor are these results +necessarily indicative of future consolidated results of operations of the Company. +Years Ended December 31, +2011 +2010 +Total revenues +$ +89,965,827 +$ +89,303,346 +Net loss +$ +(10,910,912 +) +$ +(4,842,155 +) +Loss per share: +Basic and diluted +$ +(0.23 +) +$ +(0.10 +) +The supplemental pro forma results for the year ended December 31, 2011 exclude $2,634,049 of +transaction costs incurred by OraSure that were recorded in operating expenses. +4. +INVENTORIES: +December 31, +2011 +2010 +Raw materials +$ +5,767,735 +$ +4,453,560 +Work in process +497,277 +258,335 +Finished goods +3,355,544 +2,633,699 +$ +9,620,556 +$ +7,345,594 +F-14 +Table of Contents +5. +PROPERTY AND EQUIPMENT: +December 31, +2011 +2010 +Land +$ +1,117,788 +$ +1,117,788 +Buildings and improvements +16,531,757 +16,211,986 +Machinery and equipment +17,427,617 +16,375,791 +Computer equipment and software +5,167,284 +4,312,488 +Furniture and fixtures +1,669,612 +1,517,647 +Construction in progress +438,505 +279,200 +42,352,563 +39,814,900 +Less accumulated depreciation +(22,497,107 +) +(20,204,317 +) +$ +19,855,456 +$ +19,610,583 +Depreciation expense was $2,934,342, $2,509,658, and $2,395,202 for 2011, 2010, and 2009, respectively. +6. +GOODWILL AND OTHER INTANGIBLE ASSETS: +The changes in goodwill for the year ended December 31, 2011 is as follows: +2011 +Balance as of January 1 +$ +— +Goodwill from DNAG acquisition +25,618,828 +Decrease related to foreign currency translation +(879,052 +) +Balance as of December 31 +$ +24,739,776 +Intangible assets consist of the following: +Amortization +Period +(Years) +December 31, 2011 +Gross +Accumulated +Amortization +Net +Customer list +10 +$ +12,269,923 +$ +(440,758 +) +$ +11,829,165 +Patents and product rights +3-10 +10,448,620 +(6,385,701 +) +4,062,919 +Acquired technology +7 +9,530,541 +(481,662 +) +9,048,879 +Tradename +15 +4,703,079 +(116,761 +) +4,586,318 +Non-compete agreements +1-3 +1,020,535 +(164,704 +) +855,831 +$ +37,972,698 +$ +(7,589,586 +) +$ +30,383,112 +Amortization +Period +(Years) +December 31, 2010 +Gross +Accumulated +Amortization +Net +Patents and product rights +3-10 +$ +10,448,620 +$ +(5,641,701 +) +$ +4,806,919 +Amortization expense for 2011, 2010, and 2009 was $1,956,831, $502,333, and $542,913, respectively. +Amortization expense for each of the five succeeding fiscal years is estimated as follows: +2012 +$ +3,737,673 +2013 +3,641,102 +2014 +3,483,778 +2015 +3,259,704 +2016 +3,259,704 +Beyond +13,001,151 +F-15 +Table of Contents +Patents and products rights are made up of the following: +December 31, +2011 +2010 +HIV-related +$ +1,900,000 +$ +1,900,000 +HCV-related +4,500,000 +4,500,000 +Lateral flow-related +1,500,000 +1,500,000 +Cryosurgery-related +2,548,620 +2,548,620 +10,448,620 +10,448,620 +Less accumulated amortization +(6,385,701 +) +(5,641,701 +) +$ +4,062,919 +$ +4,806,919 +During 2010, upon achievement of three additional domestic development and commercial milestones, we paid +a total of $4,500,000 in license fees pursuant to the terms of our HCV license agreement. Based on our estimate of the cash flows to be received from future product sales in the domestic market that utilize this HCV technology, we capitalized these +fees as patent and product rights. We are amortizing the amounts to cost of products sold on a straight-line basis over ten years, which represents the expected life of the product. No additional payments are required under this agreement. +The consolidated statement of operations reflects a 2009 impairment charge of $3,028,375 that was recorded related to certain +HCV license, patents and product rights. +7. +PREPAID EXPENSES: +In August 2008, a complaint was filed against the Company in the US District Court for the District +of New Jersey by Inverness Medical Innovations, Inc., and Inverness Medical Switzerland GmbH (collectively, “Inverness”) and Church & Dwight Co. Inc., alleging that the Company’s OraQuick ADVANCE ® Rapid HIV-1/2 Antibody Test infringed US Patent No. 6,485,982 (the “’982 Patent”). In November +2009, the Company entered into a settlement agreement with Inverness and Church & Dwight and the litigation was dismissed with prejudice. Under the settlement agreement, the Company made a $3,000,000 payment to Inverness. Inverness granted +the Company nonexclusive, worldwide, royalty-bearing, non-transferable and nonsublicensable (sub)licenses to certain patent rights, including the ‘982 Patent. In addition, each party received limited supply and distribution rights to certain +other products developed by the other party. We allocated the $3,000,000 payment based upon the relative fair values of the litigation settlement, of which, $1,451,183 was immediately expensed in our 2009 consolidated statement of operations and +$1,548,817 was recorded as prepaid royalties to be expensed to cost of goods sold, based on future OraQuick +ADVANCE ® HIV revenues through December 31, 2012. +8. +ACCRUED EXPENSES AND OTHER: +December 31, +2011 +2010 +Payroll and related benefits +$ +4,866,812 +$ +4,343,350 +Royalties +1,985,875 +1,985,799 +Customer prepayments +1,318,546 +896,531 +Professional fees +834,657 +213,308 +Clinical research obligations +— +400,860 +Other +1,536,265 +1,147,031 +$ +10,542,155 +$ +8,986,879 +F-16 +Table of Contents +9. +LONG-TERM DEBT: +As of December 31, 2011 and 2010, we had in place a $10,000,000 credit facility (the “Credit Facility”), +as amended, with Comerica Bank (“Comerica”). Pursuant to the terms of the Credit Facility, principal and interest fixed at 4.15% per annum are payable monthly through May 27, 2012, at which time the remaining unpaid principal +balance is payable. As of December 31, 2011, we had no available borrowings under this Credit Facility. We are currently in negotiations with Comerica to refinance this credit facility. +All borrowings under the Credit Facility are collateralized by a first priority security interest in all OraSure assets, including +present and future accounts receivable, chattel paper, contracts and contract rights, equipment and accessories, general intangibles, investments, instruments, inventories, and a mortgage on our three facilities in Bethlehem, Pennsylvania. The +Credit Facility contains certain covenants that set forth minimum requirements for our quick ratio, liquidity, and tangible net worth. We were in compliance with all covenants as of December 31, 2011. The Credit Facility also restricts our +ability to pay dividends, to make certain investments, to incur additional indebtedness, to sell or otherwise dispose of a substantial portion of assets, and to merge or consolidate operations with an unaffiliated entity, without the consent of +Comerica. +10. +INCOME TAXES: +Loss before income tax benefit consists of the following: +2011 +2010 +2009 +United States +$ +(8,147,201 +) +$ +(3,496,945 +) +$ +(8,435,417 +) +Canada +(1,562,368 +) +— +— +$ +(9,709,569 +) +$ +(3,496,945 +) +$ +(8,435,417 +) +The components of the income tax provision (benefit) for the years ended December 31, 2011, 2010 and +2009 are as follows: +2011 +2010 +2009 +Current +Federal +$ +— +$ +— +$ +(631,688 +) +State +— +— +9,404 +Canada +— +— +— +— +— +(622,284 +) +Deferred +Federal +(2,673,941 +) +(1,214,773 +) +(2,115,338 +) +State +(273,175 +) +(91,805 +) +(35,591 +) +Canada +(868,950 +) +— +— +(3,816,066 +) +(1,306,578 +) +(2,150,929 +) +Increase in valuation allowance +2,947,116 +1,306,578 +2,150,929 +(868,950 +) +— +— +Total income tax provision (benefit) +$ +(868,950 +) +$ +— +$ +(622,284 +) +For the year ended December 31, 2011 we recorded an income tax benefit of $868,950 associated with +DNAG’s loss before income taxes and certain Canadian research and development and investment tax credits. The income tax benefit associated with DNAG was considered realizable based upon the estimated scheduled reversal of the deferred tax +liabilities recorded in connection with the acquisition of DNAG. +F-17 +Table of Contents +In November 2009, The Worker, Homeownership, and Business Assistance Act of 2009 was +enacted. This new law extended the carryback period for a net operating loss (“NOL”) from two years up to a maximum of five years. The carryback of the NOL can be applied to both regular tax NOLs and alternative minimum tax NOLs (“AMT +NOL”). The new law also eliminates the 90% limitation on the use of any AMT NOLs. As a result of the elimination of the 90% limitations, in 2009 we elected to carryback our 2008 AMT NOL to our 2007, 2006, and 2005 tax years and applied for a +refund of the AMT taxes paid for those years. As such, in the fourth quarter of 2009, we recorded a $632,000 federal benefit associated with the AMT NOL carryback. +A reconciliation of the statutory United States federal income tax rate to our effective tax rate for each of the years ended December 31, 2011, 2010, and 2009 is as follows: +2011 +2010 +2009 +Statutory U.S. federal income tax rate +(34.0 +)% +(34.0 +)% +(34.0 +)% +State income taxes, net of federal benefit +(1.9 +) +(0.9 +) +(0.2 +) +Canadian income taxes +(8.9 +) +— +— +Nondeductible expenses and other +5.3 +6.8 +3.1 +U.S. research and development credits +(5.7 +) +(9.7 +) +(1.8 +) +Change in valuation allowance, federal and state +36.3 +37.8 +25.5 +Effective tax rate +(8.9 +)% +— +% +(7.4 +)% +Deferred income taxes reflect the tax effects of temporary differences between the basis of assets and +liabilities recognized for financial reporting purposes and tax purposes, and net operating loss and tax credit carryforwards. Significant components of our total deferred tax asset as of December 31, 2011 and 2010 are as follows: +2011 +2010 +Deferred tax assets (liabilities): +Net operating loss carryforwards +$ +16,286,412 +$ +17,258,574 +Inventory +1,216,069 +1,001,425 +Capitalized research and development costs +6,489,062 +3,639,949 +Accruals and reserves currently not deductible +1,967,574 +1,228,788 +Patent costs +1,552,456 +1,814,528 +Acquired intangible assets +(6,635,116 +) +— +Depreciation and amortization +(1,019,410 +) +(1,129,974 +) +Stock-based compensation +4,157,055 +3,672,184 +Research and development tax credit carryforward +2,102,935 +1,316,804 +Net deferred tax asset +26,117,037 +28,802,278 +Valuation allowance +(31,752,670 +) +(28,802,278 +) +Net deferred tax liability +$ +(5,635,633 +) +$ +— +In assessing the realizability of our net deferred tax asset, we consider all relevant positive and +negative evidence in determining whether it is more likely than not that some portion or all of the deferred income tax assets will not be realized. The realization of the gross deferred tax assets is dependent on several factors, including the +generation of sufficient taxable income prior to the expiration of the NOL carryforwards. In 2008 we recorded an income tax charge to establish a full valuation allowance against our net deferred tax asset. During the subsequent years, we continued +to reevaluate our valuation allowance position and believe that it is more likely than not that our deferred income tax asset will not be realized in the immediate future. As such, we maintained a full valuation allowance against our net deferred +tax assets as of December 31, 2011 and 2010 associated with our U.S. operations. +F-18 +Table of Contents +Our Federal NOL carryforwards expire as follows: +Year of Expiration +NOLs +2017-2018 +$ +6,020,032 +2019 +12,807,326 +2020-2024 +16,397,737 +2025-2031 +11,954,076 +$ +47,179,171 +The Tax Reform Act of 1986 contains provisions that limit the annual amount of NOLs available to be used +in any given year in the event of a significant change in ownership. On September 29, 2000, two separate companies, STC Technologies, Inc. and Epitope, Inc., merged to form our Company. A significant change in ownership, as defined by +Section 382 of the Internal Revenue Code, occurred in connection with this merger. As such, the utilization of NOLs generated prior to September 29, 2000 is limited to approximately $13,700,000 per year. We do not believe that this +limitation will have a material adverse impact on the utilization of our NOL carryforwards in future years. +As of +December 31, 2011, our gross unrecognized tax benefits totaled $2,014,766 of which, if recognized, $1,943,894 would result in a reduction to our effective tax rate. We record interest and penalties related to unrecognized tax benefits as a +component of income tax expense. Interest and penalties were immaterial in 2011, 2010 and 2009. As a result of our net operating loss carryforward position, we are subject to audit by the Internal Revenue Service for the years 2008 through 2011, as +well as by several state jurisdictions for the years ended December 31, 2001 through 2011. +A reconciliation of the +beginning and ending amount of unrecognized tax benefits is as follows: +2011 +2010 +2009 +Balance as of January 1 +$ +2,089,801 +$ +2,044,929 +$ +2,184,370 +Additions based on tax positions related to the current period +52,979 +51,793 +10,121 +Additions for tax positions of prior periods +18,852 +— +— +Reductions for tax positions of prior periods +(146,866 +) +(6,921 +) +(149,562 +) +Settlements +— +— +— +Balance as of December 31 +$ +2,014,766 +$ +2,089,801 +$ +2,044,929 +11. +STOCKHOLDERS’ EQUITY: +Stock-Based Awards +We grant stock-based awards under the OraSure Technologies, Inc. Stock Award Plan, as amended and restated (the “Stock Plan”). The Stock Plan permits stock-based awards to employees, outside +directors and consultants or other third-party advisors. Awards which may be granted under the Stock Plan include qualified incentive stock options, nonqualified stock options, stock appreciation rights, restricted awards, performance awards and +other stock-based awards. We recognize compensation expense for stock option awards issued to employees and directors on a straight-line basis over the requisite service period of the award. To satisfy the exercise of options or to issue new +restricted stock, we normally issue new shares rather than purchase shares on the open market. +Under the terms of the Stock +Plan, nonqualified options may be granted to eligible employees, including our officers at a price not less than 75 percent of the fair market value of a share of common stock on the date of grant. The option term and vesting schedule of such awards +may be either unlimited or have a specified period in which to vest and be exercised. To date, options generally have been granted with ten-year exercise periods and +F-19 +Table of Contents +an exercise price not less than the fair market value on the date of grant. Options generally vest over four years, with one quarter of the options vesting one year after grant and the remainder +vesting on a monthly basis over the next three years. +As of December 31, 2011, 4,054,041 shares were available for +future grants under the Stock Plan. +The fair value of each stock option was estimated on the date of the grant using the +Black-Scholes option-pricing model using the following weighted-average assumptions: +Years Ended +December 31, +Black-Scholes Option Valuation Assumptions +2011 +2010 +2009 +Risk-free interest rate (1) +1.36 +% +1.89 +% +1.50 +% +Expected dividend yield +— +— +— +Expected stock price volatility (2) +54 +% +54 +% +53 +% +Expected life of stock options (in years) (3) +4 +4 +4 +(1) +Based on the constant maturity interest rate of U.S. Treasury securities whose term is consistent with the expected life of our stock options. +(2) +Expected stock price volatility is based upon historical experience. +(3) +Expected life of stock options is based upon historical experience. +The weighted-average grant date fair value of stock options granted during the years ended December 31, 2011, 2010 and 2009 was +$2.82, $2.24 and $1.22, respectively. +Amounts recognized in the financial statements related to stock options were as +follows: +Years Ended December 31, +2011 +2010 +2009 +Total compensation cost during the year +$ +1,579,321 +$ +876,918 +$ +1,314,014 +Amounts capitalized into inventory during the year +(58,365 +) +(40,332 +) +(55,381 +) +Amounts recognized in cost of products sold for amounts previously capitalized +36,242 +63,001 +128,805 +Amounts charged against income +$ +1,557,198 +$ +899,587 +$ +1,387,438 +The aggregate intrinsic value of options (the amount by which the market price of the stock on the date +of exercise exceeded the exercise price) exercised during the years ended December 31, 2011, 2010 and 2009 was $2,490,449, $9,024, and $79,884, respectively. +F-20 +Table of Contents +The following table summarizes the stock option activity under the Stock Plan: +Options +Weighted-Average +Exercise Price Per +Share +Weighted-Average +Remaining +Contractual Term +(in years) +Aggregate +Intrinsic +Value +Outstanding on January 1, 2009 +5,130,707 +$ +7.58 +Granted +681,708 +2.89 +Exercised +(30,911 +) +0.80 +Forfeited +(349,839 +) +6.61 +Outstanding on December 31, 2009 +5,431,665 +7.09 +Granted +709,230 +5.15 +Exercised +(2,844 +) +2.81 +Forfeited +(634,518 +) +7.19 +Outstanding on December 31, 2010 +5,503,533 +6.83 +Granted +1,143,225 +6.78 +Exercised +(879,766 +) +5.44 +Expired +(163,000 +) +10.74 +Forfeited +(187,806 +) +8.11 +Balance, December 31, 2011 +5,416,186 +$ +6.89 +5.94 +$ +12,488,524 +Vested or expected to vest as of December 31, 2011 +5,354,198 +$ +6.90 +5.90 +$ +12,257,299 +Exercisable on December 31, 2011 +3,806,112 +$ +7.24 +4.75 +$ +7,481,640 +As of December 31, 2011, there was $3,485,676 of unrecognized compensation expense related to +unvested option awards that is expected to be recognized over a weighted-average period of 1.9 years. +Net cash proceeds from +the exercise of stock options were $4,782,645, $7,977 and $24,807 for the years ended December 31, 2011, 2010 and 2009, respectively. As a result of our net operating loss carryforward position, no actual income tax benefit was realized from +stock option exercises for these periods. +The following table summarizes information about stock options outstanding as of +December 31, 2011: +Options outstanding +Options exercisable +Range of exercise prices +Number +Outstanding +Weighted- +average +remaining +life, in +years +Weighted- +average +exercise +price +Number +exercisable +Weighted- +average +exercise +price +$2.55–$4.59 +550,453 +10.17 +$ +3.17 +388,661 +$ +3.26 +$4.75–$5.19 +635,519 +8.98 +5.15 +326,086 +5.11 +$5.28–$6.37 +486,744 +4.35 +5.72 +355,597 +5.65 +$6.63 +786,550 +9.09 +6.63 +— +— +$6.67–$7.76 +875,079 +3.09 +7.38 +735,000 +7.40 +$7.90–$8.18 +413,439 +5.87 +8.05 +403,826 +8.05 +$8.20 +567,897 +2.04 +8.20 +567,897 +8.20 +$8.21–$8.97 +583,502 +5.39 +8.49 +512,042 +8.50 +$9.04–$10.89 +512,003 +4.14 +9.52 +512,003 +9.52 +$10.99 +5,000 +3.83 +10.99 +5,000 +10.99 +5,416,186 +5.94 +$ +6.89 +3,806,112 +$ +7.24 +F-21 +Table of Contents +The Stock Plan also permits us to grant restricted shares of our common stock to eligible +employees, including officers, and our outside directors. Generally, these shares are nontransferable until vested and are subject to vesting requirements and/or forfeiture, as determined by the Compensation Committee of our Board of Directors. The +market value of these shares at the date of grant is recognized on a straight-line basis over the period during which the restrictions lapse. Compensation cost of $2,520,834, $2,354,109 and $2,621,723 related to restricted shares was recognized +during the years ended December 31, 2011, 2010 and 2009, respectively. +The following table summarizes restricted stock +award activity under the Stock Plan: +Shares +Weighted-Average +Grant Date Fair +Value +Issued and unvested, January 1, 2009 +831,488 +$ +8.11 +Granted +429,870 +2.82 +Vested +(370,457 +) +8.39 +Forfeited +(71,024 +) +5.38 +Issued and unvested, December 31, 2009 +819,877 +5.44 +Granted +454,715 +5.19 +Vested +(429,309 +) +5.51 +Forfeited +(53,127 +) +5.15 +Issued and unvested, December 31, 2010 +792,156 +5.28 +Granted +526,880 +6.53 +Vested +(421,470 +) +5.47 +Forfeited +(18,100 +) +6.63 +Issued and unvested, December 31, 2011 +879,466 +$ +5.91 +Issued and expected to vest, December 31, 2011 +879,466 +$ +5.91 +As of December 31, 2011, there was $3,085,982 of unrecognized compensation expense related to +unvested restricted stock awards that is expected to be recognized over a weighted average period of 1.9 years. +In connection +with the vesting of restricted shares during the years ended December 31, 2011, 2010 and 2009, we purchased and immediately retired 134,147, 136,042 and 132,785 shares with aggregate values of $908,884, $708,785 and $391,590, respectively, in +satisfaction of minimum tax withholding obligations. +Share Repurchase Program +On August 5, 2008, our Board of Directors approved a share repurchase program pursuant to which we are permitted to acquire up to +$25,000,000 of our outstanding common shares. No shares were purchased and retired in 2011 or 2010. During the year ended December 31, 2009, we purchased and retired 108,293 shares of common stock at an average price of $2.85 per share. +12. +BUSINESS SEGMENT INFORMATION: +We operate our business within two reportable segments. The first is our core “OraSure” business, which +consists of the development, manufacture and sale of oral fluid diagnostic products and specimen collection devices and the manufacture and sale of medical devices used for the removal of benign skin lesions by cryosurgery. The second segment is the +business of our newly acquired subsidiary, DNAG, which is based in Ottawa, Canada and manufactures and sells oral fluid collection devices that are used to collect samples of genetic material for molecular testing. OraSure revenues consist primarily +of product sold into the United States and internationally to various clinical laboratories, hospital, clinics, community-based organizations and other public health organizations, distributors, government agencies, physicians’ offices, and +commercial and +F-22 +Table of Contents +industrial entities. OraSure also derives revenues from licensing and production development activities. DNAG revenues consist of product sold into the medicine, animal and livestock genetics +markets. +We organized our operating segments according to the nature of the products they offer. The accounting policies of +the segments are the same as those described in the summary of significant accounting policies (see Note 2). We evaluate performance of our operating segments based on revenue and operating income(loss). We do not allocate interest income, interest +expense, other income, other expenses and income taxes to our operating segments. Reportable segments have no inter-segment revenues. +The following table summarizes segment information for the year ended December 31, 2011. During the years ended December 31, 2010 and 2009 we operated within only one reportable segment. +OraSure +DNAG +Totals +Revenues +$ +75,665,369 +$ +6,215,929 +$ +81,881,298 +Operating loss +7,854,800 +1,542,679 +9,397,479 +Depreciation and amortization +3,550,319 +1,340,954 +4,891,273 +Capital expenditures +2,345,172 +159,751 +2,504,923 +Total assets +71,326,343 +56,534,999 +127,861,342 +Our products are sold principally in the United States, Canada and Europe. +The following table represents total revenues by geographic area, based on the location of the customer (amounts in thousands): +For the Years Ended December 31, +2011 +2010 +2009 +United States +$ +67,644 +$ +63,520 +$ +62,209 +Europe +7,506 +6,493 +6,592 +Other regions +6,731 +5,002 +8,225 +$ +81,881 +$ +75,015 +$ +77,026 +The following table represents total long-lived assets by geographic area (amounts in thousands): +For the Years Ended December 31, +2011 +2010 +United States +$ +18,954 +$ +19,454 +Canada +706 +— +Other regions +195 +156 +$ +19,855 +$ +19,610 +F-23 +Table of Contents +13. +COMMITMENTS AND CONTINGENCIES: +Sublicense Agreement +In June 2004, we entered into a sublicense agreement with a third party, pursuant to which we have been granted a limited, worldwide, non-exclusive sublicense to certain HIV-2 patents held by such party. +Under the terms of this sublicense agreement, we are obligated to pay royalties based on a percentage of our net sales of certain products, which incorporate the technology covered by the licensed patents. Future minimum payments under this +agreement are as follows: +2012 +$ +500,000 +2013 +500,000 +2014 +500,000 +2015 +500,000 +2016 +500,000 +Thereafter +791,667 +$ +3,291,667 +Royalties from our commercial sale of products covered by the sublicense can be credited against these +minimum royalty obligations. +Leases +We lease office space for our Canadian subsidiary and warehouse facilities under operating lease agreements. Future payments required under these non-cancelable leases are as follows: +2012 +$ +437,419 +2013 +427,280 +2014 +213,296 +$ +1,077,995 +Rent expense for 2011, 2010 and 2009 was $306,800, $162,584, and $181,124, respectively. +Purchase Commitments +As of December 31, 2011, we had outstanding non-cancelable purchase commitments in the amount of $2,265,799 related to inventory, capital expenditures, and other goods or services. +Employment Agreements +Under terms of employment agreements with certain executive officers, extending through 2014, we are required to pay each individual a base salary for continuing employment with us. The agreements require +payments of $2,268,750 and $550,250 in 2012 and 2013, respectively. +Litigation +From time-to-time, we are involved in certain legal actions arising in the ordinary course of business. In management’s opinion, +based upon the advice of counsel, the outcomes of such actions are not expected to have a material adverse effect on our future financial position or results of operations. +14. +RETIREMENT PLANS: +Substantially all of our U.S. employees are eligible to participate in the OraSure Technologies, Inc. 401(k) Plan (the +“401(k) Plan”). The 401(k) Plan permits voluntary employee contributions to be excluded from an +F-24 +Table of Contents +employee’s current taxable income under provisions of Internal Revenue Code Section 401(k) and the regulations thereunder. The 401(k) Plan also provides for us to match employee +contributions up to $4,000 per year. Contributions to the 401(k) Plan, net of forfeitures, were $533,286, $597,285, and $563,017 in 2011, 2010, and 2009, respectively. +15. +QUARTERLY DATA (Unaudited): +The following tables summarize the quarterly results of operations for each of the quarters in 2011 and 2010. These +quarterly results are unaudited, but in the opinion of management, have been prepared on the same basis as our audited financial information and include all adjustments (consisting only of normal recurring adjustments) necessary for a fair +presentation of the information set forth herein (all amounts in thousands, except per share amounts). +2011 Results +Three months ended +March 31, +2011 +June 30, +2011 +September +30, +2011 (1) +December +31, +2011 (1) +Revenues +$ +17,414 +$ +19,064 +$ +21,714 +$ +23,689 +Costs and expenses +19,967 +21,423 +25,919 +23,970 +Operating income (loss) +(2,553 +) +(2,359 +) +(4,205 +) +(281 +) +Other income (expense), net +(45 +) +(79 +) +(29 +) +(158 +) +Income (loss) before income taxes +(2,598 +) +(2,438 +) +(4,234 +) +(439 +) +Income tax benefit +— +— +(315 +) +(554 +) +Net income (loss) +$ +(2,598 +) +$ +(2,438 +) +$ +(3,919 +) +$ +115 +Earnings (loss) per share +Basic and Diluted +$ +(0.06 +) +$ +(0.05 +) +$ +(0.08 +) +$ +— +2010 Results +Three months ended +March 31, +2010 +June 30, +2010 +September 30, +2010 +December 31, +2010 +Revenues +$ +17,945 +$ +19,218 +$ +19,034 +$ +18,818 +Costs and expenses +20,121 +19,753 +18,745 +19,750 +Operating income (loss) +(2,176 +) +(535 +) +289 +(932 +) +Other income (expense), net +(19 +) +(18 +) +(15 +) +(91 +) +Income (loss) before income taxes +(2,195 +) +(553 +) +274 +(1,023 +) +Income tax benefit +— +— +— +— +Net income (loss) +$ +(2,195 +) +$ +(553 +) +$ +274 +$ +(1,023 +) +Earnings (loss) per share (2) +Basic and Diluted +$ +(0.05 +) +$ +(0.01 +) +$ +0.01 +$ +(0.02 +) +(1) +Includes the results of operations of DNA Genotek Inc. beginning on the acquisition date of August 17, 2011 as well as $2.5 million and $100,000 +of transaction costs associated with the acquisition in the three ended months September 30, 2011 and December 31, 2011, respectively. +(2) +The summation of the quarterly amounts may not equal the year-end amounts as included in the financial statements due to the use of weighted-average +shares for each period. +F-25 +Table of Contents +INDEX TO EXHIBITS +Exhibit +Number +Exhibit +2.1 +Support Agreement, dated July 25, 2011, by and among OraSure Technologies, Inc., Acquisition Sub, DNA Genotek, Inc., 1548674 Ontario, Inc., and the shareholders of 1548674 Ontario, +Inc., is incorporated by reference to Exhibit 2.1 to the Company’s Current Report on Form 8-K filed July 25, 2011. +2.2 +Form of Offer to Purchase and Share Purchase Agreement, between Acquisition Sub and the DNA Genotek, Inc. shareholders signatory thereto, is incorporated by reference to Exhibit 2.2 +to the Company’s Current Report on Form 8-K filed July 25, 2011. +3.1.1 +Certificate of Incorporation of OraSure Technologies, Inc. is incorporated by reference to Exhibit 3.1 to the Company’s Registration Statement on Form S-4 (No. 333-39210), +filed June 14, 2000. +3.1.2 +Certificate of Amendment to Certificate of Incorporation dated May 23, 2000 is incorporated by reference to Exhibit 3.1.1 to the Company’s Registration Statement on Form S-4 +(No. 333-39210), filed June 14, 2000. +3.2 +Bylaws of OraSure Technologies, amended and restated as of August 18, 2008, are incorporated by reference to Exhibit 3 to the Company’s Current Report on Form 8-K filed August +22, 2008. +10.1 +Form of Indemnification Agreement (and list of parties to such agreement) is incorporated by reference to Exhibit 10.1 to Amendment No. 3 to the Company’s Registration +Statement on Form S-4 (No. 333-39210), filed August 30, 2000.* +10.2 +Employment Agreement, dated as of June 22, 2004, between OraSure Technologies, Inc. and Douglas A. Michels, is incorporated by reference to Exhibit 10.3 to the Company’s +Quarterly Report on Form 10-Q for the quarter ended June 30, 2004.* +10.3 +Amendment No. 1 to Employment Agreement, dated as of December 16, 2008, between the Company and Douglas A. Michels, is incorporated by reference to Exhibit 10.2 to the +Company’s Current Report on Form 8-K filed December 19, 2008.* +10.4 +Amendment No. 2 to Employment Agreement, dated as of December 15, 2010, between the Company and Douglas A. Michels, is incorporated by reference to Exhibit 10.4 to the +Company’s Annual Report on Form 10-K for the year ended December 31, 2010.* +10.5 +Employment Agreement, dated as of July 1, 2004, between OraSure Technologies, Inc. and Ronald H. Spair, is incorporated by reference to Exhibit 10.4 to the Company’s +Quarterly Report on Form 10-Q for the quarter ended June 30, 2004.* +10.6 +Amendment No. 1 to Employment Agreement, dated as of December 16, 2008, between the Company and Ronald H. Spair, is incorporated by reference to Exhibit 10.3 to the Company’s +Current Report on Form 8-K filed December 19, 2008.* +10.7 +Amendment No. 2 to the Employment Agreement, dated as of December 15, 2010, between the Company and Ronald H. Spair, is incorporated by reference to Exhibit 10.7 to the +Company’s Annual Report on Form 10-K for the year ended December 31, 2010.* +10.8 +Employment Agreement, dated September 23, 2005, between OraSure Technologies, Inc. and Stephen R. Lee, Ph.D., is incorporated herein by reference to Exhibit 99 to the Company’s +Current Report on Form 8-K filed September 28, 2005.* +10.9 +Amendment No. 1 to Employment Agreement, dated as of December 16, 2008, between the Company and Stephen R. Lee, Ph.D., is incorporated by reference to Exhibit 10.5 to the +Company’s Current Report on Form 8-K filed December 19, 2008.* +Table of Contents +Exhibit +Number +Exhibit +10.10 +Amendment No. 2 to the Employment Agreement, dated as of December 15, 2010, between the Company and Stephen R. Lee, Ph.D., is incorporated by reference to Exhibit 10.10 to the +Company’s Annual Report on Form 10-K for the year ended December 31, 2010.* +10.11 +Employment Agreement, dated as of July 1, 2004, between OraSure Technologies, Inc. and Jack E. Jerrett, is incorporated by reference to Exhibit 10.7 to the Company’s +Quarterly Report on Form 10-Q for the quarter ended June 30, 2004.* +10.12 +Amendment No. 1 to Employment Agreement, dated as of December 16, 2008, between the Company and Jack E. Jerrett, is incorporated by reference to Exhibit 10.6 to the Company’s +Current Report on Form 8-K filed December 19, 2008.* +10.13 +Amendment No. 2 to the Employment Agreement, dated as of December 15, 2010, between the Company and Jack E. Jerrett, is incorporated by reference to Exhibit 10.13 to the +Company’s Annual Report on Form 10-K for the year ended December 31, 2010.* +10.14 +Employment Agreement, dated as of October 2, 2006, between Mark L. Kuna and OraSure Technologies, Inc., is incorporated by reference to Exhibit 99.1 to the Company’s Current +Report on Form 8-K filed October 5, 2006.* +10.15 +Amendment No. 1 to Employment Agreement, dated as of December 16, 2008, between the Company and Mark L. Kuna, is incorporated by reference to Exhibit 10.7 to the Company’s +Current Report on Form 8-K filed December 19, 2008.* +10.16 +Amendment No. 2 to the Employment Agreement, dated as of December 15, 2010, between the Company and Mark L. Kuna, is incorporated by reference to Exhibit 10.16 to the Company’s +Annual Report on Form 10-K for the year ended December 31, 2010.* +10.17 +Employment Agreement, dated as of January 3, 2011, between the Company and Anthony Zezzo II is incorporated by reference to Exhibit 10.17 to the Company’s Annual Report on Form +10-K for the year ended December 31, 2010.* +10.18 +Description of Non-employee Director Compensation Policy, as amended as of February 15, 2010, is incorporated by reference to Exhibit 10.15 to the Company’s Annual Report on +Form 10-K for the year ended December 31, 2009.* +10.19 +Description of Non-employee Director Compensation Policy, as amended as of November 14, 2011.* +10.20 +Amended and Restated Epitope, Inc. 1991 Stock Award Plan is incorporated by reference to Exhibit 10.9 to the Company’s Annual Report on Form 10-K for the year ended December +31, 2002.* +10.21 +OraSure Technologies, Inc. Employee Incentive and Non-Qualified Stock Option Plan, as amended and restated effective September 29, 2000, is incorporated by reference to Exhibit +10.12 to the Company’s Annual Report on Form 10-K for the year ended December 31, 2000.* +10.22 +Amended and Restated OraSure Technologies, Inc. Stock Award Plan, effective as of May 17, 2011, is incorporated by reference to Exhibit 10 to the Company’s Current Report on +Form 8-K filed May 5, 2011.* +10.23 +Form of Restricted Share Grant Agreement (Executive Officers).* +10.24 +Form of Restricted Share Grant Agreement (Non-Employee Directors).* +10.25 +Nonqualified Stock Option Award General Terms and Conditions (Executive Officers).* +10.26 +Nonqualified Stock Option Award General Terms and Conditions (Non-Employee Directors).* +10.27 +Description of the OraSure Technologies, Inc. 2011 Management Incentive Plan is incorporated by reference to Item 5.02 to the Company’s Current Report on Form 8-K filed +February 23, 2011.* +Table of Contents +Exhibit +Number +Exhibit +10.28 +Description of the OraSure Technologies, Inc. Long Term Incentive Plan is incorporated by reference to Item 5.02 to the Company’s Current Report on Form 8-K filed February 23, +2011.* +10.29 +Description of the OraSure Technologies, Inc. 2010 Stock Award Guidelines is incorporated by reference to Item 5.02 to the Company’s Current Report on Form 8-K filed February +19, 2010.* +10.30 +OraSure Technologies, Inc. Deferred Compensation Plan is incorporated by reference to Exhibit 99.1 to the Company’s Current Report on Form 8-K filed December 21, +2011.* +10.31 +Adoption Agreement related to OraSure Technologies, Inc. Deferred Compensation Plan is incorporated by reference to Exhibit 99.2 to the Company’s Current Report on Form 8-K +filed December 21, 2011.* +10.32 +Loan and Security Agreement, dated as of September 10, 2002, between Comerica Bank – California and OraSure Technologies, Inc., is incorporated by reference to Exhibit 10.1 to +the Company’s Quarterly Report on Form 10-Q for the quarter ended September 30, 2002. +10.33 +First Amendment to Loan and Security Agreement, dated as of May 23, 2003, between OraSure Technologies, Inc. and Comerica Bank – California, is incorporated by reference to +Exhibit 10.24 to the Company’s Annual Report on Form 10-K for the year ended December 31, 2003. +10.34 +Second Amendment to Loan and Security Agreement, dated as of September 12, 2003, between OraSure Technologies, Inc. and Comerica Bank, is incorporated by reference to Exhibit 99.1 +to the Company’s Current Report on Form 8-K, dated September 17, 2003. +10.35 +Third Amendment to Loan and Security Agreement, dated as of April 21, 2005, between OraSure Technologies, Inc. and Comerica Bank, is incorporated by reference to Exhibit 10 to the +Company’s Current Report on Form 8-K filed April 27, 2005. +10.36 +Fourth Amendment to Loan and Security Agreement, dated as of June 27, 2006, between OraSure Technologies, Inc. and Comerica Bank, is incorporated by reference to Exhibit 10 to the +Company’s Current Report on Form 8-K filed June 30, 2006. +10.37 +Fifth Amendment to Loan and Security Agreement, dated as of June 28, 2007, between OraSure Technologies, Inc. and Comerica Bank, is incorporated by reference to Exhibit 10 to the +Company’s Current Report on Form 8-K filed July 5, 2007. +10.38 +Sixth Amendment to Loan and Security Agreement, dated as of June 24, 2011, between OraSure Technologies, Inc. and Comerica Bank, is incorporated by reference to Exhibit 10 to the +Company’s Current Report on Form 8-K filed June 27, 2011. +10.39 +Seventh Amendment to Loan and Security Agreement, dated as of August 16, 2011, between OraSure Technologies, Inc. and Comerica Bank, is incorporated by reference to Exhibit 10 to +the Company’s Current Report on Form 8-K filed August 18, 2011. +10.40 +Eighth Amendment to Loan and Security Agreement, dated as of November 18, 2011, between OraSure Technologies, Inc. and Comerica Bank, is incorporated by Reference to Exhibit 10 to +the Company’s Current Report on Form 8-K filed November 23, 2011. +10.41 +Ninth Amendment to Loan and Security Agreement, dated as of February 24, 2012, between OraSure Technologies, Inc. and Comerica Bank, is incorporated by reference to Exhibit 10 +to the Company’s Current Report on Form 8-K filed February 27, 2012. +10.42 +Settlement Agreement, effective as of November 17, 2009, by and among Inverness Medical Innovations, Inc., Inverness Medical Switzerland GmbH and OraSure Technologies, Inc., is +incorporated by reference to Exhibit 10.34 to the Company’s Annual Report on Form 10-K for the year ended December 31, 2009. +Table of Contents +Exhibit +Number +Exhibit +10.43 +License Agreement, effective as of November 17, 2009, by and among Inverness Medical Innovations, Inc., Inverness Medical Switzerland GmbH and OraSure Technologies, Inc., is +incorporated by reference to Exhibit 10.35 to the Company’s Annual Report on Form 10-K for the year ended December 31, 2009. +23 +Consent of KPMG LLP. +24 +Powers of Attorney. +31.1 +Certification of Douglas A. Michels required by Rule 13a-14(a) or Rule 15d-14(a) under the Securities Exchange Act of 1934, as amended. +31.2 +Certification of Ronald H. Spair required by Rule 13a-14(a) or Rule 15d-14(a) under the Securities Exchange Act of 1934, as amended. +32.1 +Certification of Douglas A. Michels required by Rule 13a-14(b) or Rule 15a-14(b) under the Securities Exchange Act of 1934, as amended, and 18 U.S.C. Section 1350, as Adopted +Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. +32.2 +Certification of Ronald H. Spair required by Rule 13a-14(b) or Rule 15a-14(b) under the Securities Exchange Act of 1934, as amended, and 18 U.S.C. Section 1350, as Adopted Pursuant +to Section 906 of the Sarbanes-Oxley Act of 2002. +101.INS +XBRL Instance Document +101.SCH +XBRL Taxonomy Extension Schema Document +101.CAL +XBRL Taxonomy Extension Calculation Linkbase Document +101.DEF +XBRL Taxonomy Extension Definition Linkbase Document +101.LAB +XBRL Taxonomy Extension Label Linkbase Document +101.PRE +XBRL Taxonomy Extension Presentation Linkbase Document +* +Management contract or compensatory plan or arrangement. \ No newline at end of file diff --git a/raw/filings/0001116463/2011/0001193125-12-114853/filing_metadata.csv b/raw/filings/0001116463/2011/0001193125-12-114853/filing_metadata.csv new file mode 100644 index 0000000000000000000000000000000000000000..809f0c42d3a895c66b85963c5f75ed607058c5e4 --- /dev/null +++ b/raw/filings/0001116463/2011/0001193125-12-114853/filing_metadata.csv @@ -0,0 +1,2 @@ +cik,ticker,company_name,form,filing_date,report_date,acceptance_datetime,accession_number,primary_document,primary_doc_description,size,is_xbrl,is_inline_xbrl,document_url,filing_index_url,year,fiscal_year,is_primary_filing +0001116463,OSUR,ORASURE TECHNOLOGIES INC,10-K,2012-03-14,2011-12-31,2012-03-14T20:12:38.000Z,0001193125-12-114853,d279006d10k.htm,FORM 10-K,4381993,1,0,https://www.sec.gov/Archives/edgar/data/1116463/000119312512114853/d279006d10k.htm,https://www.sec.gov/Archives/edgar/data/1116463/000119312512114853/,2011,2011,1 diff --git a/raw/filings/0001116463/2011/0001193125-12-114853/item1.txt b/raw/filings/0001116463/2011/0001193125-12-114853/item1.txt new file mode 100644 index 0000000000000000000000000000000000000000..028020fb6e020aa412888fa17c85ddbf7f387d01 --- /dev/null +++ b/raw/filings/0001116463/2011/0001193125-12-114853/item1.txt @@ -0,0 +1,658 @@ +ITEM 1. +Business. +Our business +principally involves the development, manufacture, marketing and sale of oral fluid diagnostic products and specimen collection devices using our proprietary oral fluid technologies, as well as other diagnostic products including immunoassays and +other in vitro diagnostic tests that are used on other specimen types. We also manufacture and sell medical devices used for the removal of benign skin lesions by cryosurgery or freezing. Our diagnostic products include tests that are +performed on a rapid basis at the point of care and tests that are processed in a laboratory. These products are sold in the United States and internationally to various clinical laboratories, hospitals, clinics, community-based organizations and +other public health organizations, distributors, government agencies, physicians’ offices, and commercial and industrial entities. One of our products has been sold in the over-the-counter (“OTC”) or consumer retail markets in North +America, Europe, Central and South America, and Australia. +In vitro diagnostic testing is the process of analyzing +oral fluid, blood, urine and other bodily fluids or tissue for the presence of specific substances or markers. We have targeted the use of oral fluid in our products as a differentiating factor and believe that it provides a significant competitive +advantage over blood and urine. Our oral fluid tests have sensitivity and specificity comparable to blood and/or urine tests. When combined with their ease of use, non-invasive nature, and cost effectiveness, our oral fluid tests represent a very +competitive alternative to the more traditional testing methods in the diagnostic space. +In August 2011, +we completed the acquisition of DNA Genotek Inc. (“DNAG”), a company based in Ottawa, Canada. DNAG manufactures and sells oral fluid collection kits that are used to collect samples of genetic material (DNA and RNA) for molecular testing +in the academic research, clinical, pharmacogenomics, personalized medicine, animal and livestock genetics markets. DNAG’s lead product, the Oragene ® sample collection kit, provides an all-in-one system for the collection, stabilization, transportation and storage of DNA from saliva. DNAG serves customers in many +countries worldwide, including many leading research universities and hospitals in the world. +1 +Table of Contents +OraSure was formed in May 2000 under Delaware law solely for the purposes of combining two +companies, STC Technologies, Inc. (“STC Technologies”) and Epitope, Inc. (“Epitope”), and changing the state of incorporation of Epitope from Oregon to Delaware. STC Technologies and Epitope were merged into OraSure on +September 29, 2000. Our principal offices are located at 220 East First Street, Bethlehem, Pennsylvania 18015, and our telephone number is (610) 882-1820. +Additional information about us can be found on our website. Our website address is www.orasure.com . We make available free of charge through a link provided at such website our Annual Reports on +Form 10-K, our Quarterly Reports on Form 10-Q, our Current Reports on Form 8-K and our other filings with the Securities and Exchange Commission (“SEC”), as well as any amendments to those Reports and filings. These Reports and filings are +made available as soon as reasonably practicable after they are filed or furnished to the SEC. Our Internet website and the information contained in or connected to that website are not intended to be incorporated by reference into this Annual +Report. +Products +The following is a summary of our principal products and their regulatory and commercial status: +Product +Description +Regulatory Status +Commercial Status +OraQuick +ADVANCE ® HIV-1/2 +A rapid, point-of-care +qualitative test for antibodies to the Human Immunodeficiency Virus Type 1 (“HIV-1”) and Type 2 (“HIV-2” and together with HIV-1, +“HIV-1/2”) that can be visually read in approximately 20 minutes. +Premarket approval (“PMA”) by the U.S. Food and Drug Administration (“FDA”) for use with oral fluid, finger-stick +and venous whole blood, and plasma. +CLIA (Clinical Laboratory Improvement +Amendments of 1988) waived for use with oral fluid, finger-stick and venous whole blood. +CE mark (European Union) approved for use with oral fluid, finger-stick and venous whole blood, serum and plasma. Also registered in various other countries. +Marketed +Marketed +Marketed +OraQuick ® HIV-1/2 OTC +A rapid, point-of-care qualitative oral fluid HIV-1/2 test intended to be sold in various OTC markets. +PMA application for OTC use is pending with FDA. +Not Marketed +OraQuick ® HCV +A rapid, point-of-care qualitative test for antibodies to the hepatitis C virus (“HCV”) that can be visually read in approximately 20 minutes. +PMA approved and CLIA waived for use with venous whole blood and finger-stick whole blood specimens. +Clinical program for oral fluid claim remains pending. +CE mark (European Union) approved for use with oral fluid, finger-stick and venous +whole blood, serum and plasma. Also registered in various other countries. +Marketed +Not Marketed +Marketed +2 +Table of Contents +Product +Description +Regulatory Status +Commercial Status +OraSure QuickFlu™ +Rapid +Flu +A&B Test +A rapid, point-of-care qualitative test for antibodies to influenza (flu) Types A and B, including H1N1 infections, with results available in 10 minutes. +FDA 510(k) cleared for use with nasal swab, nasopharyngeal swab and nasal aspirate/wash. +Marketed +OraSure ® +Oral fluid collection device for the detection of antibodies to HIV-1 and for detection of cocaine and cotinine in an oral fluid sample in a laboratory setting. +PMA approved by FDA for use in detecting antibodies to HIV-1. +FDA 510(k) cleared for use in detecting cocaine and cotinine (an indicator of +nicotine) in oral fluid. +CE marked and registered in various +countries. +Marketed +Marketed +Marketed +Intercept ® +Oral fluid collection device for oral fluid drugs of abuse (“DOA”) testing in a laboratory setting. +FDA 510(k) cleared for use with MICRO-PLATE DOA assays. +CE marked and registered in certain countries. +Marketed +Marketed +MICRO-PLATE DOA Assays +Used to detect the following drugs in an oral fluid sample collected with Intercept ® device: tetrahydrocannabinol (“THC” or marijuana), cocaine, opiates, amphetamines, methamphetamines, phencyclidine (“PCP”), benzodiazepines, +barbiturates and methadone. +Nine drug assays—FDA 510(k) cleared. +Assays CE marked and registered in certain countries. +Marketed +Marketed +Homogeneous DOA Assays +Homogeneous fully-automated oral fluid DOA assays jointly developed with Roche Diagnostics for use on oral fluid samples collected with Intercept ® device. +FDA 510(k) cleared for use of PCP, opiates, cocaine, methamphetamines and amphetamines assays with Intercept ® collection device. Clinical studies for marijuana and barbiturates underway. +Marketed +Cryosurgical Systems—Professional +Cryosurgical (freezing) system for the removal of warts and other benign skin lesions, marketed under the Histofreezer ® tradename primarily to the physicians’ office market. +Nine indications—FDA 510(k) cleared. +CE marked and registered in certain countries. +Marketed +Marketed +Cryosurgical Systems—OTC +Cryosurgical system for the removal of common and plantar warts, sold in various OTC markets. +FDA 510(k) cleared for common and plantar warts. +Registered in Canada for warts and skin tags. +CE marked and registered for warts in certain countries under Scholl Freeze Spray ® and POINTTS ® +names. +CE marked for skin tags. +Marketed +Marketed +Marketed +Not +Marketed +3 +Table of Contents +Product +Description +Regulatory Status +Commercial Status +Oragene ® ·DX +Non-invasive all-in-one system for the collection, stabilization, transportation and storage of human DNA from saliva. +FDA 510(k) cleared for in vitro diagnostic use with FDA-cleared molecular tests. +Marketed +Oragene ® ·DNA +Non-invasive all-in-one system for the collection, stabilization, transportation, and storage of human DNA from saliva. +CE mark and registered as Class 1 Medical Device in Canada. +Registered in various other countries. +Marketed +Oragene ® ·DISCOVER +Non-invasive all-in-one system for the collection, stabilization, transportation, and storage of human DNA from saliva. +Research use only product. +Marketed +Oragene ® ·RNA +Non-invasive all-in-one system for the collection, stabilization and transportation of RNA from human saliva. +Research use only product. +Marketed +ORAcollect™ +All-in-one system for the collection, stabilization, transportation, and storage of human DNA from saliva. +CE marked and registered as Class 1 Medical Device in the U.S. and Canada. +Registered in various other countries. +Marketed +OMNIgene™·DISCOVER +Non-invasive all-in-one system for the collection, stabilization, transportation, and storage of microbial DNA from saliva. +Research use only product. +Marketed +Performagene™· +LIVESTOCK and +Oragene ® ·ANIMAL +All-in-one systems for the collection, stabilization, transportation, and storage of livestock DNA from nasal samples. +Animal research use only +Marketed +In addition to the above products, we also sell certain immunoassay tests and +reagents for insurance risk assessment, substance abuse testing and forensic toxicology applications; an oral fluid Western blot HIV-1 confirmatory test for confirming positive HIV-1 test results obtained from the use of our OraSure ® collection device; and the FDA 510(k) cleared Q.E.D. ® rapid point-of-care saliva alcohol test. +OraQuick ® Rapid HIV Test +OraQuick ® is our rapid point-of-care test platform designed to test oral fluid, whole blood (i.e., both finger-stick and venous), plasma and serum samples for the presence of +various antibodies or analytes. The device uses a porous flat pad to collect an oral fluid specimen. After collection, the pad is inserted into a vial containing a pre-measured amount of developer solution and allowed to develop. When blood, plasma +or serum is to be tested, a loop collection device is used to collect a drop of the specimen and mix it in the developer solution, after which the collection pad is inserted into the solution and allowed to develop. In all cases, the specimen and +developer solution then flow through the testing device where test results are observable in approximately 20 minutes. The +OraQuick ® device is a screening test and generally requires a confirmation test where an initial positive result +is obtained. +4 +Table of Contents +This product is sold under the OraQuick ADVANCE ® name in North America, Europe and certain other countries and under the OraQuick ® name in other developing countries. The test has received PMA approval from the FDA for the detection of antibodies +to both HIV-1 and HIV-2 in oral fluid, finger-stick whole blood, venous whole blood and plasma. This test is available for use by laboratories located in the United States certified under the Clinical Laboratory Improvements Amendment of 1988, or +CLIA, to perform moderately complex tests. We have also received a CLIA waiver for use of the test with oral fluid and finger-stick and venous whole blood. As a result, the test can be used by numerous additional sites in the United States not +certified under CLIA to perform moderately complex tests, such as outreach clinics, community-based organizations and physicians’ offices. +On the international front, we have obtained a CE mark for our OraQuick +ADVANCE ® test so that we can sell this product in Europe and other countries accepting the CE mark for +commercialization and this product is registered in other countries. We have distributors in place for several countries and are seeking to increase awareness and expand our distribution network for this product throughout the world. +We believe that the OraQuick ADVANCE ® device, because it is approved for detecting antibodies to both HIV-1 and HIV-2 in finger-stick and venous whole blood, oral fluid and plasma samples, provides a +significant competitive advantage in the market for rapid HIV testing in the United States and elsewhere. +OraQuick ® HCV Rapid Antibody Test +Another test available on the OraQuick ® platform is the OraQuick ® HCV rapid antibody test. Like the OraQuick ® HIV test, this product is a qualitative test that can detect antibodies to the Hepatitis C virus, or HCV, in a variety of sample types. The OraQuick ® HCV test operates in substantially the same manner as the +OraQuick ® HIV test. +We have received FDA approval for use of the test in detecting HCV antibodies in venous whole blood and finger-stick +whole blood specimens, making it the first rapid HCV test approved by the FDA for use in the United States. In November 2011, we also received a CLIA waiver for use of this product in the same specimen types. Our clinical program for approval of an +oral fluid claim for this product is on hold pending further discussions with the FDA. The OraQuick ® HCV test +has received a CE mark for use with oral fluid, venous whole blood, finger-stick whole blood, plasma and serum and is sold in Europe and other foreign countries. +OraSure QuickFlu™ Rapid Flu A&B Test +The OraSure QuickFlu™ +rapid flu A&B test is an FDA 510(k) cleared rapid qualitative test for the detection of influenza (flu) Types A and B, including H1N1 viral infections. The test utilizes specimen collected with a nasal swab, nasopharyngeal swab or nasal +aspirate/wash. A reagent is first inserted into a test cartridge, the specimen is added and the test is allowed to flow. Results are available in as little as ten minutes. +The OraSure QuickFlu™ test is intended to be used as an aid in the rapid differential diagnosis of influenza and covers a broad range of influenza subtypes, including 2009 H1N1, with proven clinical +detection spanning three flu seasons from 2007 through 2009. The test is highly accurate across all specimen types based on standard culture confirmation with demonstrated sensitivity for influenza Type A at 90% or greater. Additionally, in clinical +studies a significant number of culture negative samples that were tested positive with the OraSure QuickFlu™ product were determined to be true positives by PCR (polymerase chain reaction) testing. +This product is manufactured for us under an agreement with Princeton BioMeditech Corporation. The OraSure QuickFlu™ test is +currently available for sale in certain U.S. markets. +5 +Table of Contents +OraSure ® Collection Device +Our OraSure ® oral fluid collection device is used in conjunction with screening and confirmatory tests for HIV-1 antibodies and other analytes. This device consists of a small, +treated cotton-fiber pad on a handle that is placed in a person’s mouth for two to five minutes. The device collects oral mucosal transudate (“OMT”), a serum-derived fluid that contains higher concentrations of certain antibodies and +analytes than saliva. As a result, OMT testing is a highly accurate method for detecting HIV-1 infection and other analytes. +The OraSure ® collection device is FDA approved for use in the +detection of HIV-1 antibodies and 510(k) cleared for the detection of cocaine and cotinine in oral fluid specimens. In addition, we have received a CE mark for the OraSure ® device and our cocaine and cotinine assays, all of which are sold through distributors in Canada, the United Kingdom, Mexico and certain other foreign countries. +HIV-1 antibody detection using the OraSure ® collection device involves three steps: +• +Collection of an oral fluid specimen using the OraSure ® device; +• +Screening of the specimen for HIV-1 antibodies at a laboratory with an enzyme immunoassay (“EIA”) screening test approved by the FDA for use +with the OraSure ® device; and +• +Laboratory confirmation of any positive screening test results with our oral fluid Western blot HIV-1 confirmatory test (described below). +A trained health care professional then conveys test results and provides appropriate counseling to the +individual who was tested. +We believe that oral fluid testing has several significant advantages over blood or urine-based +systems for infectious disease testing, for both health care professionals and the individuals being tested. These advantages include eliminating the risk of needle-stick accidents, providing a non-invasive collection technique, requiring minimal +training to administer, providing rapid and efficient collection in almost any setting, and reducing the cost of administration by a trained health care professional. +Intercept ® Drug Testing System +A collection device that is substantially similar to the OraSure ® device is sold by us under the name +Intercept ® , and is used to collect OMT for oral fluid drug testing. We have received FDA 510(k) clearance to use +the Intercept ® collection device with laboratory-based EIAs to test for drugs of abuse commonly identified by +the National Institute for Drug Abuse (“NIDA”) as the NIDA-5 (i.e., tetrahydrocannabinol (“THC” or marijuana), cocaine, opiates, amphetamines/methamphetamines and phencyclidine (“PCP”)), and for barbiturates, methadone +and benzodiazepines. Each of these EIAs is also FDA 510(k) cleared for use with the Intercept ® device. Our +Intercept ® device and oral fluid assays are sold in the U.S. primarily through laboratory distributors. +We have received a CE mark for the Intercept ® device and our oral fluid assays and distribute these products in Canada, the United Kingdom and Mexico. +We believe that the Intercept ® device has several advantages over competing urine and other drugs-of-abuse testing products, including its lower total testing cost, its non-invasive nature, +mobility and accuracy, the ease of maintaining a chain-of-custody, the treatment of test subjects with greater dignity, no requirement for specially-prepared collection facilities and difficulty of sample adulteration. The availability of an oral +fluid test is intended to allow our customers to test for drug impairment and eliminate scheduling costs and inconvenience, thereby streamlining the testing process. +In an effort to expand our Intercept ® product line and meet the needs of our laboratory customers, we have jointly developed with Roche Diagnostics a series of homogeneous fully-automated oral fluid drugs +of abuse +6 +Table of Contents +assays. These assays use Roche’s KIMs (kinetic interaction of micro-particles in solution) technology and will run on various automated analyzers to allow oral fluid samples to be processed +with the same efficiency currently achieved by our laboratory customers with urine-based drug tests. FDA 510(k) clearance has been received for assays to detect PCP, opiates, cocaine, methamphetamines and amphetamines. Clinical studies for THC and +barbiturate assays are in process. +The high-throughput assays will be distributed in the U.S. and internationally by OraSure +and Roche pursuant to a commercialization agreement between the parties. Sales of the assays in the U.S. are expected to begin in 2012. +Cryosurgical Systems (Skin Lesion Removal Products) +The Histofreezer ® cryosurgical removal system is a low-cost alternative to liquid nitrogen and other methods for removal of warts and other benign skin lesions by physicians. The +Histofreezer ® product mixes three cryogenic gases in a small aerosol canister. When released, these gases are +delivered to a specially designed foam bud, cooling the bud to a maximum of –50°C to –55°C. The frozen bud is then applied to the wart or lesion for 15 to 40 seconds (depending on the type of lesion) creating localized destruction +of the target area by freezing. We have received 510(k) clearance for use of the Histofreezer ® product to remove +common warts and eight other types of benign skin lesions, and this product has been CE marked and registered for distribution in Canada, throughout Europe and in certain other foreign countries. +Internationally, we sell an OTC cryosurgical product through our distributor Genomma Labs, under the POINTTS tradename, in Mexico and a +number of South and Central American countries. We also sell a CE marked cryosurgical wart removal product into the OTC footcare market in Europe, Australia and New Zealand through our distributor, Reckitt Benckiser (“Reckitt”), under the +Scholl and Dr. Scholl trademarks. Reckitt is the owner of the Scholl and Dr. Scholl trademarks in countries outside North and South America. In 2011, we began selling OTC cryosurgical products for the treatment of both warts and skin tags +to retailers in Canada on a private label basis. +Molecular Collection Systems +Our wholly-owned subsidiary, DNAG, sells a number of products that provide all-in-one systems for the collection, +stabilization, transportation, and storage of DNA and/or RNA from human and animal biologic samples. DNAG’s lead product is sold under the Oragene ® name and is used to collect DNA from human saliva. DNAG products are currently sold to thousands of academic and research customers in many countries worldwide. +DNAG products are available in several different configurations and contain proprietary chemical +solutions that are optimized for the specific application each product is designed for. Product physical design is focused on providing easy-to-use and reliable products for self or assisted collection of samples. For example, several of the Oragene ® products require users to simply hold the product close to their mouth and spit into the collection device. When the +container is closed the reagents stored in the lid of the container are mixed with the captured saliva and immediately protect the nucleic acids in the sample. This non-invasive collection method yields nucleic acid that remains stable at ambient +temperature for extended periods. The stabilizing technology results in high quality and high quantity nucleic acids that are required for most genetic testing and analysis methods. +We believe these products provide significant advantages over competing DNA and RNA collection methods such as blood collection or buccal +swabs, particularly in human genetic applications. Benefits include the reliable collection of high quality genetic samples, use of simple non-invasive collection methods, the ability to store and transport collected samples for extended periods at +ambient temperatures and compatibility with fully-automated laboratory testing systems. +7 +Table of Contents +DNAG products historically have been sold primarily as Class I medical +devices for use by research and academic institutions. In late 2011, DNAG received FDA 510(k) clearance for the +Oragene ® — Dx product and began marketing this product to +clinical diagnostics and personalized medicine customers in the U.S. in the first quarter of 2012. This clearance will enable the Oragene ® — Dx product to be used with other FDA-cleared molecular diagnostic applications. +Immunoassay Tests and Reagents +We develop and sell immunoassay tests in two formats, known as MICRO-PLATE and AUTO-LYTE ® , to meet the specific needs of our customers. +In a MICRO-PLATE kit, the sample to be tested is placed into a small plastic receptacle, called a microwell, along with the reagents. The result of the test is determined by the color of the microwell +upon completion of the reaction. Controlling the reaction involves the use of reagents by laboratory personnel. Test results are analyzed by any of a variety of commercially available laboratory instruments, which we may also provide to our +laboratory customers. MICRO-PLATE tests can be performed on commonly used instruments and can detect drugs in urine, serum and sweat specimens. MICRO-PLATE tests are also used as part of the +Intercept ® product line to detect drugs of abuse in oral fluid specimens. +AUTO-LYTE ® tests are sold in the form of bottles of liquid reagents. These reagents are run on commercially available laboratory-based automated analytical instruments, which +are manufactured by a variety of third parties. AUTO-LYTE ® is typically used in high volume, automated, +commercial reference insurance laboratories to detect certain drugs or chemicals in urine. Test results are produced quickly, allowing for high throughput. Our AUTO-LYTE ® tests continue to face strong competition from cheaper “home-brew” tests developed internally by our laboratory customers. As a result, we may eventually +stop selling our AUTO-LYTE ® tests. +Western blot HIV-1 Confirmatory Test +We sell an oral +fluid Western blot HIV-1 confirmatory test that received premarket approval from the FDA in 1996. This test uses the original specimen collected with the OraSure ® oral fluid collection device to confirm positive results of initial oral fluid HIV-1 EIA screening tests. +Q.E.D. ® Saliva Alcohol Test +Our Q.E.D. ® saliva alcohol test is a point-of-care test device that is a cost-effective alternative to breath or blood alcohol testing. The test is a quantitative, saliva-based +method for the detection of ethanol, has been cleared for sale by the FDA and has received a CLIA waiver. The U.S. Department of Transportation (“DOT”) has also approved the test. +Each Q.E.D. ® test kit contains a collection stick that is used to collect a sample of saliva and a disposable detection device that displays results in a format similar to a +thermometer. The Q.E.D. ® device is easy to operate and instrumentation is not required to read the result. The +product has a testing range of 0 to 0.145% blood alcohol and produces results in approximately two minutes. +Products Under Development +OraQuick ® Platform +We believe +that OraQuick ® has significant potential as a point-of-care testing platform for clinics and other public health +entities, hospitals, physicians’ offices and other markets. Because the OraQuick ® platform is simple to use +and can operate in a non-invasive manner with oral fluid, we believe it will be suitable for use by +8 +Table of Contents +consumers without the assistance of a doctor or other medical professional. We also believe that OraQuick ® provides a platform technology that can be modified for detection of a variety of infectious diseases in addition to HIV, such as viral hepatitis and certain sexually +transmitted diseases. +We are currently devoting significant resources to obtaining FDA approval to sell +our OraQuick ® HIV-1/2 test in the United States OTC market. We have developed an information and referral system +and product packaging and labeling suitable for the OTC market. In 2011, we completed the final phase of clinical testing for this product and submitted the final of three modules to our pre-market approval, or PMA, application to the FDA. +Several other new products based on the OraQuick ® technology platform are in varying stages of development. A second generation rapid HIV-1/2 antibody test, which we believe will provide improved performance compared +to our current product, is being developed and the feasibility of several assays for certain other infectious diseases is being evaluated. +OraSure ® /Intercept ® Applications +Oral mucosal transudate, or OMT, contains many constituents found in blood and serum, although in lower concentrations. We believe the OraSure ® and Intercept ® devices are a +platform technology with a wide variety of potential applications, where laboratory testing is available. For example, the +OraSure ® device may be useful for the collection of a variety of antibodies or markers for infectious diseases +or conditions in addition to HIV-1, such as antibodies to viral hepatitis. +Since January 2011, the Drug +Testing Advisory Board (“DTAB”) has been evaluating oral fluid as a potential alternative specimen to be permitted under the Mandatory Guidelines for Federal Workplace Drug Testing Programs (the “Guidelines”). The Guidelines +govern workplace drug testing of federally-regulated workers. Based on its evaluation, DTAB has recommended that oral fluid be included as an alternative specimen in the Guidelines, and the Substance Abuse and Mental Health Services Administration +has approved this recommendation. If and when issued in final form, these regulations will likely require certain modifications to our Intercept ® product in order to permit its use by federal workers. As a result, we are developing modifications to the +Intercept ® collection device that we anticipate will be required by these regulations or otherwise desired by +our customers. This new version of our Intercept ® device is also expected eventually to be used with the +high-throughput drug assays jointly developed with Roche Diagnostics. +Molecular Collection Systems +Molecular testing in both the research and clinical diagnostics markets continues to evolve at a rapid pace. As a result, we expect to +continue development activities designed to modify the capabilities and fit of the DNAG products to meet the evolving needs of existing and potential molecular testing market applications. To address unique customer needs, we will continue to +develop new chemical and/or physical platforms as needed by our customers. DNAG has a number of development projects underway to expand its product offerings in three primary market segments—human genetics, infectious disease testing and animal +testing. +Research and Development +In 2011, our research and development activities focused primarily on clinical and regulatory activities related to obtaining a CLIA waiver for our +OraQuick ® HCV test, completing the final phase of clinical testing and preparing and filing a PMA application +for FDA approval of an OraQuick ® HIV OTC test, development of next generation versions of our OraQuick ® HIV and Intercept ® products and assessing initial feasibility of certain other products. +From time to time, we have contracted with third parties to conduct research and development activities and we may do so in the future. +9 +Table of Contents +Research and development expenses were $18.4 million in 2011 (including $1.0 million of DNAG +expenses since the August 2011 acquisition), $13.2 million in 2010 and $13.4 million in 2009. These expenses include our costs associated with research and development, regulatory affairs, clinical trials and product support. +Sales and Marketing +We +attempt to reach our major target markets through a combination of direct sales, strategic collaborations and independent distributors. Our marketing strategy is to create or raise awareness through a full array of marketing activities, which +include trade shows, print advertising, special programs and distributor promotions, in order to stimulate sales in each target market. +We market our products in the United States and internationally. Revenues attributable to customers in the United States were $67.6 million, $63.5 million and $62.2 million in 2011, 2010 and 2009, +respectively. Revenues attributable to international customers amounted to $14.2 million, $11.5 million and $14.8 million, or 17%, 15% and 19% of our total revenues, in 2011, 2010 and 2009, respectively. For more information about our revenues and +long-lived assets attributable to U.S. and international customers, please see Note 12 to our consolidated financial statements included elsewhere in this Annual Report. +Infectious Disease Testing +We market the OraQuick +ADVANCE ® rapid HIV-1/2 antibody test directly to customers in the public health market for HIV testing. +This market consists of a broad range of clinics and laboratories and includes states, counties, and other governmental agencies, family planning clinics, colleges and universities, correctional facilities and the military. There are also a number +of organizations in the public health market, such as AIDS service organizations and various community-based organizations, that are set up primarily for the purpose of encouraging and enabling HIV testing. We also sell our OraQuick ADVANCE ® test directly to hospitals in the U.S. and through distributors into the U.S. physician market. In 2010, we engaged +two manufacturers’ representative organizations to assist with sales to U.S. physicians. +Internationally, we distribute our OraQuick ® HIV test in Europe and other foreign countries. We expect to increase the number of countries where this product is sold as we find new distributors and complete +registrations in additional countries. +We market the OraSure ® oral fluid collection device for HIV-1 testing, on its own and as a kit in combination with laboratory testing +services. To better serve our public health customers, we have contracted a commercial laboratory to provide prepackaged +OraSure ® test kits, with prepaid laboratory testing and specimen shipping costs included. We also sell the +OraSure ® device in the international public health market. +Based on the FDA approvals in place during most of 2011, our +OraQuick ® HCV test has been sold primarily to customers operating CLIA-certified laboratories. In late 2011, we +received a CLIA waiver for this product, which will enable us to expand sales to non-CLIA certified settings, primarily in the U.S. public health and physician office markets. We also sell this test in Europe and other countries through +distributors. +We previously entered into agreements with Merck & Co. Inc. (“Merck”) to +collaborate on the development and promotion of our OraQuick ® HCV test. Under the terms of these agreements, we +have been and in the future may be reimbursed by Merck for a portion of our costs to develop the test and obtain regulatory approvals. Merck will also provide detailing and other promotional support for the test in the physicians’ office market +in the United States and internationally. +We have distribution rights to an FDA 510(k) cleared rapid flu A&B test, which +we market under our proprietary OraSure QuickFlu™ tradename. Under our agreement with the supplier of this product, we are permitted to sell this product into the U.S. hospital and public health markets. +10 +Table of Contents +Substance Abuse Testing +Our substance abuse testing products are marketed to laboratories serving the workplace testing, forensic toxicology, criminal justice and +drug rehabilitation markets in the U.S. and in certain international markets. +We have entered into +agreements for the distribution of Intercept ® collection devices and associated MICRO-PLATE assays for +drugs-of-abuse testing in the workplace testing market in the United States and Canada through several laboratory distributors and internationally for workplace, criminal justice and forensic toxicology testing through other distributors. In some +cases, we assist our laboratory customers in customizing their testing services by selling them equipment required to test oral fluid specimens collected with the Intercept ® device. +We also market +the Intercept ® collection device on its own and as a kit in combination with laboratory testing services. To +better serve our workplace customers, we have contracted with commercial laboratories to provide prepackaged +Intercept ® test kits, with prepaid laboratory testing and specimen shipping costs included. +The criminal justice market in the United States for our substance abuse testing products consists of a wide variety of entities in the +criminal justice system that require drug screening, such as pre-trial services, parole and probation offices, police forces, drug courts, prisons, drug treatment programs and community/family service programs. The forensic toxicology market +consists of several hundred laboratories including federal, state and county crime laboratories, medical examiner laboratories and reference laboratories. +As discussed above, the FDA has issued 510(k) clearances for the use of fully-automated high-throughput oral fluid assays for the detection of PCP, opiates, cocaine, methamphetamines and amphetamines with +oral fluid samples collected with our Intercept ® device. In 2012, we expect to begin selling the cleared assays +as part of our Intercept ® drug testing system into the workplace, criminal justice, hospital and government +markets in collaboration with Roche Diagnostics. +We distribute our Q.E.D. ® saliva alcohol test primarily through various distributors in the United States and internationally. The markets for +alcohol testing are relatively small and fragmented with a broad range of legal and procedural barriers to entry. Markets range from law enforcement testing to workplace testing of employees in safety sensitive occupations. Typical usage situations +include pre-employment, random, post-accident, reasonable-cause and return-to-duty testing. +Cryosurgical Systems +Most of our Histofreezer ® sales occur in the United States to distributors that, in turn, resell the product to primary care physicians and podiatrists in the United States. Our major U.S. +distributors include Cardinal Healthcare, McKesson HBOC, Physicians Sales & Service, AmerisourceBergen Corporation, and Henry Schein. We have also engaged two manufacturers’ representative organizations to help our U.S. distributors +promote and sell Histofreezer ® . Internationally, we sell the Histofreezer ® product through a network of distributors in more than 20 countries worldwide. +We distribute cryosurgical wart removal products in the OTC footcare market in Europe, Australia and New Zealand through our distributor, +Reckitt Benckiser, under its Scholl and Dr. Scholl tradenames, and in the OTC markets in Mexico and several Central and South American countries under the POINTTS tradename through our distributor, Genomma Labs. In 2011, we began selling OTC +cryosurgical products for the removal of warts and skin tags under private label arrangements with retailers in Canada. +11 +Table of Contents +Insurance Risk Assessment +We currently market the OraSure ® oral fluid collection device for use in screening life insurance applicants in the United States and internationally to test for three of the most important +underwriting risk factors: HIV-1, cocaine and cotinine (a metabolite of nicotine). Devices are sold to insurance testing laboratories, which in turn sell the devices to insurance companies, usually in combination with testing services. +We also promote use of the OraSure ® device directly to insurance companies for life insurance risk assessment. Insurance companies then make their own decision regarding which laboratory to use to +supply their collection devices and testing services. We sell our OraSure ® Western blot confirmatory test +directly to insurance testing laboratories for use in confirming oral fluid specimens collected with our +OraSure ® device that initially test positive for HIV-1. +There exists a wide range of policy limits where our OraSure ® product is being used. In general, many (but not all) of our insurance company customers use the OraSure ® device in connection with life insurance policies having face amounts of up to $250,000, with some customers using the device for policies of up to $500,000 in +amount. Some insurance companies have chosen to extend their testing to lower policy limits where they did not test at all before, while others have used OraSure ® to replace some of their blood and urine-based testing. More recently, some insurance customers have adopted a “Simplified Issues” policy, where lab testing +is no longer required and instead the applicant completes a questionnaire about personal behaviors. +We +also sell our AUTO-LYTE ® assays and reagents in the insurance testing market directly to certain laboratories. +Molecular Collection Systems +DNAG primarily sells its products directly to its customers through its own global sales force. In some countries distributors are used, particularly in the Asia-Pacific region. Over half of DNAG’s +employees work in the areas of sales, marketing, business development or product management. The significant majority of employees who deal directly with customers have molecular science backgrounds, which we believe is useful in selling and +marketing molecular collection products, and more importantly, in identifying and evaluating new market and business opportunities. +Historically, most of DNAG revenues have been derived from product sales into the academic and research markets. A significant portion of DNAG’s sales is derived from repeat customers. The clinical +diagnostic market for human genetics is still in its early stages with only a few diagnostic customers currently using DNAG’s products. DNAG has a number of established global customers in the livestock market, including breed associations and +research institutions. Finally, a molecular collection product focused on the infectious disease testing market was launched by DNAG in mid-2011. +Significant Products and Customers +Several different +products have contributed significantly to our financial performance, accounting for 10% or more of our total revenues during the past three years. The OraQuick ® rapid HIV testing products, the cryosurgical systems products, and the OraSure ® and Intercept ® oral fluid +collection devices accounted for total revenues of $41.7 million, $12.0 million and $10.7 million in 2011, $40.0 million, $11.9 million and $11.2 million in 2010, and $43.8 million, $10.9 million and $12.5 million in 2009, respectively. +We had no individual customers who accounted for more than 10% of our total revenues in 2011, 2010, or 2009. +12 +Table of Contents +Financial Information by Segment +We operate our business within two reportable segments. The first is our core “OraSure” business, which consists of the +development, manufacture and sale of oral fluid diagnostic products and specimen collection devices and the manufacture and sale of medical devices used for the removal of benign skin lesions by cryosurgery. The second segment is the business of our +newly acquired subsidiary, DNAG, which is based in Ottawa, Canada and manufactures and sells oral fluid collection devices that are used to collect samples of genetic material for molecular testing. +OraSure revenues consist primarily of product sold into the United States and internationally to various clinical laboratories, hospital, +clinics, community-based organizations and other public health organizations, distributors, government agencies, physicians’ offices, and commercial and industrial entities. OraSure also derives revenues from licensing and production +development activities. DNAG revenues consist of product sold into the Unites States and internationally in the academic research, clinical genetic testing, pharmacogenomics, personalized medicine, animal and livestock genetics markets. For more +information about our revenues from external customers, income and total assets, please see the sections entitled “Selected Consolidated Financial Data” and “Management’s Discussion and Analysis of Financial Condition and Results +of Operations” and Note 12 to the consolidated financial statements, included elsewhere in this Annual Report. +Supply and +Manufacturing +Our OraQuick ADVANCE ® HIV test, OraQuick ® HCV test, +OraSure ® and Intercept ® collection devices, Western blot HIV-1 confirmatory test, AUTOLYTE and MICRO-PLATE assays and QED ® saliva alcohol test are all manufactured in our Bethlehem, Pennsylvania facilities. We expect to continue to manufacture these products at this location for the +foreseeable future. +We have contracted with a third party in Thailand for the assembly of the OraQuick ® HIV device, in order to supply certain international markets. This supply agreement had an initial term of one year, +and automatically renews for additional annual periods unless either party provides a timely notice of termination prior to the end of an annual period. We believe that other firms would be able to manufacture the OraQuick ® test on terms no less favorable than those set forth in the agreement if the Thailand contractor would be unable or +unwilling to continue manufacturing this product. +We can purchase the HIV antigens and the nitrocellulose +used in the OraQuick ® test, the HCV antigens used in the OraQuick ® HCV test and the antigen used in the Western blot HIV-1 confirmatory test only from a limited number of sources. If +for any reason these suppliers are unwilling or no longer able to supply our antigen or nitrocellulose needs, we believe that alternative supplies could be obtained at a competitive cost. However, a change in any of the antigens or nitrocellulose +used in our products would require FDA approval and some additional development work. This in turn could require significant time to complete and could disrupt our ability to manufacture and sell the affected products. +Our MICROPLATE and AUTO-LYTE assays require the production of highly specific and sensitive antibodies corresponding to the antigen of +interest. Substantially all our antibody requirements are provided by contract suppliers. We believe that we have adequate reserves of antibody supplies and that we have access to sufficient raw materials for these products. +Our OraSure QuickFlu™ test is manufactured and supplied by a third party, Princeton BioMeditech. +The Histofreezer ® product sold in the U.S. is assembled by U.S. vendors and the Histofreezer ® product sold internationally is assembled in the Netherlands by Koninklijke, Utermöhlen, N.V., the company from which we acquired the product in 1998. The +cryosurgical wart removal products distributed in OTC markets are also assembled by vendors located in the United States. We believe that additional suppliers of all of our cryosurgical products are available on terms no less favorable than the +terms of our existing supply agreements in the event that our current suppliers would be unable or unwilling to continue manufacturing these products. +13 +Table of Contents +DNAG has engaged two third-party manufacturers to supply virtually all +of its products, including the Oragene ® product line. Many of the raw materials and components used in these +products are also purchased from third parties, including one critical component that is purchased from a sole source supplier. We believe there are other suppliers that can manufacture and supply the raw materials and components for the DNAG +products. +Employees +As of December 31, 2011, we had 308 full-time employees (including 77 employees at our subsidiary, DNAG), including 105 in sales, marketing and client services; 35 in research and development; 116 in +operations, manufacturing, quality control, information systems, purchasing and shipping; 21 in regulatory affairs; and 31 in administration and finance. This compares to 231 employees as of December 31, 2010. Our employees are not currently +represented by a collective bargaining agreement. +Competition +The diagnostic industry is a multi-billion dollar international industry and is intensely competitive. Many of our competitors are substantially larger than we are, and they have greater financial, +research, manufacturing and marketing resources. +Important competitive factors for our products include product quality, +performance, price, ease of use, customer service and reputation. Industry competition is based on the following: +• +Scientific and technological capability; +• +Proprietary know-how; +• +The ability to develop and market products and processes; +• +The ability to obtain FDA or other regulatory approvals; +• +The ability to manufacture products that meet applicable FDA requirements (i.e., good manufacturing practices); +• +Commercial execution and strength of distribution; +• +Access to adequate capital; +• +The ability to attract and retain qualified personnel; and +• +The availability of patent protection. +A few large corporations produce a wide variety of diagnostic tests and other medical devices and equipment. A larger number of mid-size companies generally compete only in the diagnostic industry and a +significant number of small companies produce only a few diagnostic products. As a result, the diagnostic test industry is highly fragmented and segmented. +The future market for diagnostic tests is expected to be characterized by consolidation, greater cost consciousness and tighter reimbursement policies. The purchasers of diagnostic products are expected +to place increased emphasis on lowering costs, reducing inventory levels, automation, service and volume discounts. The increased complexity of the market is expected to force many competitors to enter into joint ventures or license certain products +or technologies. +We expect competition to intensify as technological advances are made and become more widely known, and as +new products reach the market. Furthermore, new testing methodologies could be developed in the future that render our products impractical, uneconomical or obsolete. There can be no assurance that our competitors +14 +Table of Contents +will not succeed in developing or marketing technologies and products that are more effective than those we develop or that would render our technologies and products obsolete or otherwise +commercially unattractive. In addition, there can be no assurance that our competitors will not succeed in obtaining regulatory approval for these products, or introduce or commercialize them, before we can do so. These developments could have a +material adverse effect on our business, financial condition and results of operations. +Several companies +market or have announced plans to market oral specimen collection devices and tests both within and outside the United States. We expect the number of devices competing with our OraQuick ® , OraSure ® and Intercept ® devices to increase as the benefits of oral fluid-based testing become more widely accepted. +Competition in the HIV testing market is intense and is expected to increase. We believe that the principal +competition will continue to come from existing laboratory-based blood tests, point-of-care rapid blood tests, laboratory-based urine assays or other oral fluid-based tests that may be developed. Our competitors include specialized biotechnology +firms, as well as pharmaceutical companies with biotechnology divisions and medical diagnostic companies. Significant competitors for our OraQuick ADVANCE ® rapid HIV-1/2 test, such as the Ortho Diagnostics division of Johnson & Johnson, Bio-Rad Laboratories and Abbott, sell laboratory-based HIV-1/2 EIAs, and +Maxim Biomedical (formerly Calypte, Inc.) sells an HIV-1 screening test for urine, in the United States. MedMira and Trinity Biotech each sell competing rapid HIV-1 blood tests, and Bio-Rad Laboratories and Alere (formerly Inverness Medical) sell +competing rapid HIV-1/2 blood tests in the United States. These tests compete with our OraQuick ADVANCE ® +test in hospitals and other laboratory settings. In addition, Trinity Biotech and Alere have received CLIA waivers for their rapid HIV tests, and these tests compete with our OraQuick ADVANCE ® test in the markets outside of the traditional hospital and laboratory settings. These companies, or others, may continue to expand the bodily fluids with which a +rapid HIV test may be performed, or develop and commercialize new rapid HIV tests, which would provide further competition for our OraQuick ADVANCE ® test. We believe other companies may also seek FDA approval to sell competing rapid HIV tests in the future. +Internationally, our OraQuick ADVANCE ® HIV test competes against rapid HIV tests sold by a number of other entities, and often these competing tests are sold at prices substantially below the prices we +charge for our OraQuick ADVANCE ® test. Alere and Trinity Biotech sell rapid HIV-1/2 blood tests outside +the United States and Calypte has developed a rapid oral fluid HIV test which is now being sold in certain foreign countries. Lower priced rapid HIV blood tests are also sold internationally by various third parties. +The OraQuick ® HCV test competes against laboratory-based HCV blood tests in the U.S. Major suppliers of these competing tests are Abbott Labs, Siemens, Ortho-Clinical Diagnostics, +Roche and Bio-Rad. In non-U.S. countries, our OraQuick ® HCV test competes against other rapid HCV blood tests in +addition to the laboratory-based tests. +The OraSure QuickFlu™ test competes primarily against other rapid flu tests sold +by various third parties into the U.S. hospital and public health markets. The principal suppliers of these competing tests include Quidel and Alere. +The Intercept ® drug testing system competes with laboratory-based +drug testing products and services using testing matrices such as urine, hair, sweat and oral fluid. Major competitors include Ansys Technologies, Dade Behring, Psychemedics and Immunalysis. +Our MICRO-PLATE oral fluid drug assays, which are sold for use with the Intercept ® and OraSure ® collection devices, continue to come under increasing competitive pressure from “home-brew” assays developed internally by our laboratory customers. Our +oral fluid MICRO-PLATE assays also compete with urine-based homogeneous assays that are run on fully-automated, random access analyzers. These tests provide strong competitive pressure because they provide the benefits of automation, including lower +costs and short +15 +Table of Contents +turn-around times. In addition, we believe our competitors are developing oral fluid tests suitable for use on these fully automated homogeneous assay systems and these assays, if and when they +are developed and commercialized, will represent a significant competitive threat to our oral fluid MICRO-PLATE business. +The fully-automated homogeneous oral fluid drugs of abuse assays, which were jointly developed with Roche Diagnostics for use with our Intercept ® device, compete against both homogeneous urine assays, which have dominated the drug testing market for many years, and other homogeneous oral fluid assays that have +come on the market more recently. Competing homogeneous urine assays are sold by a number of competitors. Competing oral fluid homogeneous assays are sold by Thermo Fisher and Immunologics. +Our MICRO-PLATE drugs-of-abuse reagents sold in the forensic toxicology market are targeted to forensic testing laboratories where +sensitivity, automation and “system solutions” are important. In the past, these laboratories have typically had to rely on radioimmunoassay test methods to provide an adequate level of sensitivity. Radioimmunoassays require radioactive +materials, which have a short shelf-life and disposal problems. Our MICRO-PLATE tests meet the laboratories’ sensitivity needs, run on automated equipment, are not radioimmunoassays, and are offered to the laboratory as a complete system +solution of reagents, instrumentation and software to meet the specific needs of each customer. We compete with both homogeneous and heterogeneous tests manufactured by many companies. Significant competitors in the market for these assays include +Thermo Scientific (formerly Microgenics, Inc.), Roche Diagnostics and Immunalysis. +Sales of our AUTO-LYTE ® urine assays have declined substantially during the past several years, primarily due to competition from +“home-brew” assays developed internally by our laboratory customers, which can be produced at a cost lower than the price typically paid for our products. Many of our customers no longer purchase our AUTO-LYTE ® assays, and we may eventually stop selling this product line. +The Histofreezer ® product’s delivery system and operating temperature, which is warmer than liquid nitrogen, provide us with the opportunity to target sales to primary care +physicians, such as family practitioners, pediatricians and podiatrists. We do not generally target sales to dermatologists because they have the volume of patients required to support the capital costs associated with a liquid nitrogen delivery +system, which is also used to remove warts and other benign skin lesions. Major competitors for the +Histofreezer ® product include Cryosurgery, Inc. in the United States and Wartner in Europe. Competition in the +international OTC markets comes primarily from cryosurgical products sold by Wartner and several other firms. +Q.E.D. ® has two primary competitors, Ansys Technologies and +Chematics. These companies offer semi-quantitative saliva-based alcohol tests and have received U.S. Department of Transportation approval. Indirect competitors who offer breath testing equipment include Intoximeters, Dräger and CMI. Although +there are lower priced tests on the market that use oral fluid or breath as a test medium, these tests are qualitative tests that are believed to be substantially lower in quality and provide fewer benefits than our Q.E.D. ® test. +Finally, DNAG’s Oragene ® product line competes against other +types of collection devices used for molecular testing, such as blood collection devices and buccal swabs. These competing products are offered by a number of companies and are often sold for prices lower than the prices charged for the Oragene ® products. +Patents and Proprietary Information +We seek patents and other intellectual property rights to protect and preserve our proprietary technology and our right to capitalize on the results of our research and development activities. We also +rely on trade secrets, know-how, continuing technological innovations and licensing opportunities to provide competitive advantages for our products in our markets and to accelerate new product introductions. We regularly search for third-party +patents in fields related to our business to shape our own patent and product commercialization strategies as effectively as possible and to identify licensing opportunities. United States patents generally have a maximum term of 20 years from the +date an application is filed. +16 +Table of Contents +We have ten United States patents and numerous foreign patents for the +OraSure ® and Intercept ® collection devices and technology relating to oral fluid collection, containers for oral fluids, methods to test oral fluid, formulations for the manufacture of +synthetic oral fluid, and methods to control the volume of oral fluid collected and dispersed. The patents expire from January 2013 to September 2022. We have also applied for additional patents, in both the United States and certain foreign +countries, on such products and technology. +We have four United States patents for our OraQuick ® platform, and we have several related patent applications pending in the United States and internationally. Three of +these patents expire from March to July 2019 and the fourth in August 2027. We have obtained licenses to certain lateral flow patents and to certain HIV-1 and HIV-2 patents held by other parties. We also have obtained a license to certain HCV +patents which we use to manufacture and sell a rapid HCV test on the OraQuick ® technology platform. We obtained +these licenses through the payment of certain upfront fees and an agreement to pay ongoing royalties. We believe these fees and royalties are comparable to those generally paid by other companies under similar arrangements. +One of the lateral flow patent licenses was obtained as part of a patent infringement litigation settlement with +Alere (formerly Inverness Medical) in 2009. Under that license, royalties on net sales of our OraQuick ® HIV +products begin in 2013 and royalties on net sales of our OraQuick ® HCV test begin in 2012. +We may need to obtain licenses or other rights under, or enter into distribution or other business arrangements in +connection with, certain other intellectual property patents in order to manufacture and sell the OraQuick +ADVANCE ® HIV test or other tests that use the same or similar technology platform. See Section 1A, +entitled “Risk Factors,” for a further discussion of these issues. +We have five United States patents and numerous +foreign patents issued for apparatuses and methods for the topical removal of skin lesions relating to our cryosurgical wart removal products, and we have pending patent applications related to these products in the United States and in certain +foreign countries. These patents expire from July 2012 to September 2025. We have also licensed another patent relating to apparatuses and methods for the topical removal of skin lesions relating to our cryosurgical wart removal products. +We hold, through our subsidiary, DNAG, six United States patents and numerous foreign patents issued for compositions, +methods and apparatus for the collection, stabilization, transportation and storage of nucleic acids (DNA and RNA) from oral fluid and other bodily fluids and tissues. These patents expire from June 2023 through May 2030. +We require our employees, consultants, outside collaborators and other advisors to execute confidentiality agreements upon the +commencement of employment or consulting relationships with us. These agreements provide that all confidential information developed by or made known to the individual during the course of the individual’s relationship with us is to be kept +confidential and not disclosed to third parties except in specific circumstances. In the case of employees, the agreements provide that all inventions conceived by the individual during his or her tenure with us will be our exclusive property. +We own rights to trademarks and service marks that we believe are necessary to conduct our business as +currently operated. In the United States, we own a number of trademarks, including the OraSure ® , Intercept ® , OraQuick ® , OraQuick ADVANCE ® , +Histofreezer ® , OraSure QuickFlu™, Q.E.D. ® , Oragene ® , ORAcollect™, +OMNIgene™, Performagene™ and AUTO-LYTE ® trademarks. We also own many of these marks and others in +several foreign countries. With respect to our international OTC cryosurgical products, the Scholl and Dr. Scholl tradenames are owned by Reckitt Benckiser in Europe, Australia, New Zealand and other countries outside North and South America, +and the POINTTS tradename is owned by Genomma Labs. +Although important, the issuance of a patent or existence of trademark or +trade secret protection does not in itself ensure the success of our business. Competitors may be able to produce products competing with our patented products without infringing our patent rights. Issuance of a patent in one country generally does +not prevent manufacture or sale of the patented product in other countries. The issuance of a patent is not conclusive +17 +Table of Contents +as to validity or as to the enforceable scope of the patent. The validity or enforceability of a patent can be challenged by litigation after its issuance. If the outcome of such litigation is +adverse to the owner of the patent, the owner’s rights could be diminished or withdrawn. Trade secret protection does not prevent independent discovery and exploitation of the secret product or technique. +Government Regulation +General +Most of our products are regulated by the FDA, certain state and local agencies and comparable regulatory bodies in other countries. This +regulated environment governs almost all aspects of development, production and marketing, including product testing, authorizations to market, labeling, promotion, manufacturing and recordkeeping. +All of our FDA-regulated products require some form of action by the FDA before they can be marketed in the United States. After approval +or clearance by the FDA, we must continue to comply with other FDA requirements applicable to marketed products. Both before and after approval or clearance, failure to comply with the FDA’s requirements can lead to significant penalties or +could disrupt our ability to manufacture and sell these products. In addition, the FDA could refuse permission to obtain certificates needed to export our products if the agency determines that we are not in compliance. +Domestic Regulation +Most of our products are regulated in the United States as medical devices. +There are two mechanisms by which regulated medical devices can be placed on the market in the United States. Some products may qualify +for clearance under Section 510(k) of the Federal Food, Drug and Cosmetic Act. To obtain this clearance from the FDA, the manufacturer must provide a premarket notification that it intends to begin marketing the product, and show that the +product is substantially equivalent to another legally marketed product (i.e., that it has the same intended use and is as safe and effective as a legally marketed device and does not raise different questions of safety and effectiveness). In some +cases, the submission must include data from human clinical studies. Marketing may only commence when the FDA issues a clearance letter finding substantial equivalence. An applicant must submit a 510(k) application at least 90 days before marketing +of the affected product commences. Although FDA clearance may be granted within that 90-day period, in some cases as much as a year or more may be required before clearance is obtained, if at all. +If the medical device does not qualify for the 510(k) procedure (either because it is not substantially equivalent to a legally marketed +device or because it is required by statute and the FDA’s regulations to have an approved premarket application, “PMA”), the FDA must approve a PMA before marketing can begin. PMAs must demonstrate, among other matters, that the +medical device provides a reasonable assurance of safety and effectiveness. A PMA is typically a complex submission, including the results of preclinical and clinical studies. Preparing a PMA is a detailed and time-consuming process. Once a PMA has +been submitted, the FDA is required to review the submission within 180 days. However, the FDA’s review may be, and often is, much longer, often requiring one year or more, and may include requests for additional data and facility inspections +before approval is granted, if at all. +Some of our products are used for research only or other non-medical purposes and many +of our drugs-of-abuse products sold to state crime laboratories are for forensic use. The FDA does not currently regulate products used for these purposes. +Every company that manufactures medical devices distributed in the United States must comply with the FDA’s Quality System Regulations (“QSRs”). These regulations govern the manufacturing +process, including design, manufacture, testing, release, packaging, distribution, documentation and purchasing. In complying with the QSRs, manufacturers must continue to expend time, money and effort in the area of production and quality to +18 +Table of Contents +ensure full technical compliance. Companies are also subject to other post-market and general requirements, including restrictions imposed on marketed products, promotional standards and +requirements for recordkeeping and reporting of certain adverse reactions. If there are any modifications made to our marketed devices, a premarket notification or PMA may be required to be submitted to, and cleared or approved by, the FDA, before +the modified device may be marketed. The FDA regularly inspects companies to determine compliance with the QSRs and other post-market requirements. Failure to comply with statutory requirements and the FDA’s regulations can result in warning +letters, monetary penalties, suspension or withdrawal of regulatory approvals, operating restrictions, total or partial suspension of production, injunctions, product recalls, seizure of products and criminal prosecution. +The Clinical Laboratory Improvement Amendments of 1988, or CLIA, prohibit any facility that does laboratory testing +on specimens derived from humans from providing information for the diagnosis, prevention or treatment of any disease or impairment of, or the assessment of, the health of human beings, unless there is in effect for such facility a certificate +issued by the U.S. Department of Health and Human Services applicable to the category of examination or procedure performed. Tests may be waived from this regulatory oversight if they meet certain requirements established under CLIA. We consider the +applicability of the requirements of CLIA in the design and development of our products. We have obtained a waiver of the CLIA requirements for our OraQuick ADVANCE ® rapid HIV-1/2 antibody test, our +OraQuick ® HCV rapid antibody test and our Q.E.D. ® alcohol saliva test and may seek similar waivers for certain other products. A CLIA waiver allows certain customers to use the waived products that may not have been +able to use them without complying with applicable quality control and other requirements. +Certain of our products may also +be affected by state regulations in the United States. We are presently working with legislators or regulators in certain of these states in an effort to modify or remove any restrictions affecting our ability to sell products. +International +We are also subject to regulations in foreign countries governing products, human clinical trials and marketing, and may need to obtain approval from international public health agencies, such as the +World Health Organization, in order to sell products in certain countries. Approval processes vary from country to country, and the length of time required for approval or to obtain other clearances may in some cases be longer than that required for +U.S. governmental approvals. We generally pursue approval only in those countries that we believe have a significant market opportunity. +The International Organization for Standardization (“ISO”) is a worldwide federation of national standards bodies from some 130 countries, established in 1947. The mission of the ISO is to +promote the development of standardization and related activities in the world with a view to facilitating the international exchange of goods and services. ISO certification is a pre-requisite to use of the CE mark and indicates that our quality +system complies with standards applicable to activities ranging from initial product design and development through production and distribution. The CE mark is a European Union (“EU”) requirement to sell products that fall under the scope +of the Medical Devices Directive (“MDD”) and the In Vitro Diagnostic Directive (“IVDD”). The CE mark is evidence that the manufacturer and the product meet the requirements of all applicable directives, including the MDD and +IVDD. +We received authorization to use the CE mark for the OraQuick ADVANCE ® HIV-1/2 test, the OraQuick ® HCV test, the OraSure ® and +Intercept ® collection devices, our Histofreezer ® product line, our OTC cryosurgical removal product and certain of the Oragene ® collection kits sold by DNA Genotek. +We +must also comply with certain registration and licensing requirements as dictated by Health Canada, prior to commencing sales in Canada. We have completed this process for several of our current products and may do so with respect to other products +in the future. In addition, Canadian law requires manufacturers of medical devices to have a quality management system that meets various ISO requirements in order to obtain a license to sell their devices in Canada. +19 +Table of Contents +Anti-Kickback and Other Fraud and Abuse Laws +The Federal Anti-Kickback Statute prohibits the knowing and willful offer, payment, solicitation, or receipt of any form of remuneration +in return for, or to induce: +• +The referral of a person; +• +The furnishing or arranging for the furnishing of items or services reimbursable under Medicare, Medicaid or other governmental programs; or +• +The purchase, lease, or order of, or the arrangement or recommendation of the purchasing, leasing, or ordering of any item or service reimbursable +under Medicare, Medicaid, or other governmental programs. +Our products are or may be purchased by customers +that will seek or receive reimbursement under Medicare, Medicaid or other governmental programs. Noncompliance with the federal anti-kickback legislation can result in exclusion from Medicare, Medicaid or other governmental programs, and/or +restrictions on our ability to operate in certain jurisdictions, as well as civil and criminal penalties, any of which could have an adverse effect on our business and results of operations. +The Federal Civil Monetary Penalties Law prohibits the offering or transferring of remuneration to a Medicare or Medicaid beneficiary +that the person knows or should know is likely to influence the beneficiary’s selection of a particular supplier of Medicare or Medicaid payable items or services. Noncompliance can result in civil monetary penalties for each wrongful act, +assessment of three times the amount claimed for each item or service and exclusion from the Federal healthcare programs. +Many states have also adopted some form of anti-kickback laws. A determination of liability under such laws could result in fines and +penalties and restrictions on our ability to operate in these jurisdictions. +We are also subject to other federal and state +laws targeting fraud and abuse in the healthcare industry, including false claims laws and marketing conduct laws and laws constraining the sales, marketing and other promotional activities of manufacturers of medical devices by limiting the kinds +of financial arrangements, including sales programs, with physicians, hospitals, laboratories and other potential purchasers of medical devices. Violations of these laws may be punishable by criminal or civil sanctions, including substantial fines, +imprisonment and exclusion from participation in government healthcare programs such as Medicare and Medicaid. These laws and regulations are wide ranging and subject to changing interpretation and application. In recent years, there has been +greater scrutiny of marketing practices in the medical device industry which has resulted in several government investigations by various government authorities and the introduction and/or passage of federal and state legislation regulating +interactions between medical device manufacturers and healthcare professionals and providers and requiring the disclosure by medical device manufacturers of gifts or other payments to healthcare professionals and providers. To be in compliance with +such disclosure laws, we have implemented necessary systems for accurately tracking gifts and other payments. +We have +implemented a written Policy on Interactions with Health Care Professionals, which is based on the Code of Conduct for Interactions with Health Care Professionals promulgated by the Advanced Medical Technology Association, or AdvaMed, a leading +trade association representing medical device manufacturers. The Policy applies to all employees and is intended to comply with applicable state and federal laws, regulations and government guidance. The Policy addresses interactions related to +sales and marketing practices, research and development, product training and education, grants and charitable contributions, support of third-party educational conferences, and consulting arrangements. +Foreign Corrupt Practices Act +The U.S. Foreign Corrupt Practices Act (“FCPA”) prohibits corporations and individuals from engaging in certain activities to obtain or retain business or to influence a person working in an +official capacity. It is illegal to pay, offer to pay or authorize the payment of anything of value to any foreign government official, government +20 +Table of Contents +staff member, political party or political candidate in an attempt to obtain or retain business or to otherwise influence a person working in an official capacity. Our present and future business +has and will continue to be subject to the FCPA and various other laws, rules and/or regulations applicable to us as a result of our international sales. +Environmental Regulation +Because of the nature of our current and proposed +research, development, and manufacturing processes, we are subject to stringent federal, state and local laws, rules, regulations and policies governing the use, generation, manufacture, storage, air emission, effluent discharge and handling and +disposal of materials and wastes. +The foregoing discussion of our business should be read in conjunction with the +consolidated financial statements and accompanying notes included in Item 15 of this Annual Report. \ No newline at end of file diff --git a/raw/filings/0001116463/2011/0001193125-12-114853/item13.txt b/raw/filings/0001116463/2011/0001193125-12-114853/item13.txt new file mode 100644 index 0000000000000000000000000000000000000000..1d9d765f602391bad11824e4d821d50ba62ab2e6 --- /dev/null +++ b/raw/filings/0001116463/2011/0001193125-12-114853/item13.txt @@ -0,0 +1,4 @@ +ITEM 13. +Certain Relationships and Related Transactions, and Director Independence. +The information required by this Item is incorporated by reference to the information under the captions, “Transactions with Related Persons” and “Corporate Governance—Director +Independence,” in the Proxy Statement. \ No newline at end of file diff --git a/raw/filings/0001116463/2011/0001193125-12-114853/item9a.txt b/raw/filings/0001116463/2011/0001193125-12-114853/item9a.txt new file mode 100644 index 0000000000000000000000000000000000000000..068049c59ffe5e4aa4b451b31162b21bf6a636d7 --- /dev/null +++ b/raw/filings/0001116463/2011/0001193125-12-114853/item9a.txt @@ -0,0 +1,64 @@ +ITEM 9A. +Controls and Procedures. +(a) Evaluation of Disclosure Controls and Procedures. +The Company’s management, with the participation of the Company’s Chief Executive Officer and Chief Financial Officer, has evaluated the effectiveness of the Company’s disclosure controls +and procedures (as defined in Rules 13a-15(e) and 15d-15(e) of the Securities Exchange Act of 1934) as of December 31, 2011. Based on that evaluation, the Company’s management, including such officers, concluded that as of +December 31, 2011 the Company’s disclosure controls and procedures were adequate and effective to ensure that information required to be disclosed by the Company in the reports that we file or submit under the Securities Exchange Act of +1934 is accumulated and communicated to the Company’s management, including the Chief Executive Officer and Chief Financial Officer, to allow timely decisions regarding required disclosure and is recorded, processed, summarized, and reported +within the time periods specified in the rules and forms of the Securities and Exchange Commission. +(b) Management’s +Report on Internal Control Over Financial Reporting. +The Company’s management is responsible for establishing and +maintaining adequate internal control over financial reporting, as such term is defined in Rule 13a-15(f) and 15d-15(f) under the Securities Exchange Act of 1934. Under the supervision and with the participation of the Company’s management, +including our principal executive officer and principal financial officer, we conducted an evaluation of the effectiveness of our internal control over financial reporting based on the framework in Internal Control—Integrated Framework +issued by the Committee of Sponsoring Organizations of the Treadway Commission. As described in paragraph (c) below, this evaluation did not include the internal control over financial reporting for the Company’s newly-acquired +subsidiary, DNAG. Based on our evaluation under the framework, our management concluded that our internal control over financial reporting was effective to provide reasonable assurance regarding the reliability of financial reporting and the +preparation of financial statements for external purposes in accordance with generally accepted accounting principles as of December 31, 2011. +The effectiveness of our internal control over financial reporting as of December 31, 2011 has been audited by KPMG LLP, an independent registered public accounting firm, as stated in their report, +which is included below. +66 +Table of Contents +Because of its inherent limitations, internal control over financial reporting may not +prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies +or procedures may deteriorate. +(c) Changes in Internal Control Over Financial Reporting. +The acquisition of DNAG on August 17, 2011 represented a material change in internal control over financial reporting. As allowed +under the SEC’s guidance, management’s assessment of and conclusion regarding the design and effectiveness of internal control over financial reporting for the period August 18, 2011 to December 31, 2011 excluded the internal +control over financial reporting of DNAG. The financial reporting systems of DNAG have not yet been integrated into the Company’s financial reporting systems and, as such, the Company did not have the practical ability to perform an assessment +of DNAG’s internal control over financial reporting in time for the current period. Management expects to complete its assessment of the effectiveness of internal control over financial reporting for the acquired business within one year of the +date of the acquisition. DNAG operations contributed approximately $6.2 million in revenues to our consolidated financial results for 2011 (representing the period following the August 17, 2011 acquisition date) and DNAG had total assets +of approximately $56.5 million as of December 31, 2011 (of which approximately $51.1 million represented goodwill and identifiable intangible assets). With the exception of the DNAG acquisition as noted above, there were no changes in our +internal control over financial reporting during the fiscal quarter ended December 31, 2011 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting. +(d) Report of Independent Registered Public Accounting Firm +The Board of Directors and Stockholders +OraSure Technologies, Inc.: +We have audited OraSure Technologies, Inc.’s internal control over financial reporting as of December 31, 2011, based on +criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). OraSure Technologies, Inc.’s management is responsible for maintaining effective +internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Management’s Report on Internal Control Over Financial Reporting. Our +responsibility is to express an opinion on the Company’s internal control over financial reporting based on our audit. +We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards +require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control +over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audit also included performing such other procedures +as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion. +A +company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with +generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect +the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting +principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable +67 +Table of Contents +assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements. +Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, +projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. +In our opinion, OraSure Technologies, Inc. maintained, in all material respects, effective internal control over financial +reporting as of December 31, 2011, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). +OraSure Technologies, Inc. acquired DNA Genotek Inc. during 2011 and management excluded from its assessment of the effectiveness of +OraSure Technologies, Inc.’s internal control over financial reporting as of December 31, 2011, DNA Genotek Inc.’s internal control over financial reporting associated with total assets of $56,534,999 (44.2% of total assets, of which +$51,059,969 represents goodwill and intangibles) and total revenues of $6,215,929 (7.6% of total revenues) included in the consolidated financial statements of OraSure Technologies, Inc. and subsidiaries as of and for the year ended +December 31, 2011. Our audit of internal control over financial reporting of OraSure Technologies, Inc. also excluded an evaluation of the internal control over financial reporting of DNA Genotek Inc. +We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated +balance sheets of OraSure Technologies, Inc. and subsidiaries as of December 31, 2011 and 2010, and the related consolidated statements of operations, stockholders’ equity and comprehensive loss, and cash flows for each of the years in the +three-year period ended December 31, 2011, and our report dated March 14, 2012 expressed an unqualified opinion on those consolidated financial statements. +/s/ KPMG LLP +Philadelphia, Pennsylvania +March 14, 2012 \ No newline at end of file diff --git a/raw/filings/0001116463/2011/0001193125-12-114853/rp_note.txt b/raw/filings/0001116463/2011/0001193125-12-114853/rp_note.txt new file mode 100644 index 0000000000000000000000000000000000000000..e69de29bb2d1d6434b8b29ae775ad8c2e48c5391 diff --git a/raw/filings/0001116463/2011/0001193125-12-114853/rpt_disclosure.txt b/raw/filings/0001116463/2011/0001193125-12-114853/rpt_disclosure.txt new file mode 100644 index 0000000000000000000000000000000000000000..a10e0da0ae70a75afd51d861edb46933589141fb --- /dev/null +++ b/raw/filings/0001116463/2011/0001193125-12-114853/rpt_disclosure.txt @@ -0,0 +1,7 @@ +Transactions With Related Persons +Since January 1, 2011, there have been no transactions with related persons +which would require disclosure in this Proxy Statement. The Audit Committee is required to review and approve in advance all transactions with related persons involving the Company. The Audit Committee may approve a related party transaction if the +transaction is on terms comparable to those that could be obtained in arms’ length dealings with an unrelated third party. The Audit Committee also reviews any public disclosures of a related party transaction contained in our SEC filings. +These responsibilities are described in the Audit Committee’s charter, a copy of which is available on our website at www.orasure.com . +Information regarding employment and severance agreements between our executive officers and the Company is set forth in the Section entitled, “Employment Agreements and Potential Payments Upon +Termination or Change in Control,” in this Proxy Statement. \ No newline at end of file diff --git a/raw/filings/0001116463/2013/0001193125-14-098958/filing.txt b/raw/filings/0001116463/2013/0001193125-14-098958/filing.txt new file mode 100644 index 0000000000000000000000000000000000000000..2cd3cd0a9c94d72d8d3fb2568564e0d039c2c9e6 --- /dev/null +++ b/raw/filings/0001116463/2013/0001193125-14-098958/filing.txt @@ -0,0 +1,5438 @@ +10-K +1 +d654506d10k.htm +FORM 10-K +Form 10-K +Table of Contents +UNITED STATES +SECURITIES AND EXCHANGE COMMISSION +Washington, D.C. 20549 +FORM 10-K +(Mark One) +x +ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 +For the fiscal year ended December 31, 2013 +OR +¨ +TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 +For the transition period from +to +Commission File No. 001-16537 +ORASURE TECHNOLOGIES, INC. +(Exact Name of Registrant as Specified in Its Charter) +Delaware +36-4370966 +(State or Other Jurisdiction of +Incorporation or Organization) +(I.R.S. Employer +Identification No.) +220 East First Street +Bethlehem, Pennsylvania +18015 +(Address of Principal Executive Offices) +(Zip Code) +(610) 882-1820 +(Registrant’s Telephone Number, Including Area Code) +Securities registered pursuant to Section 12(b) of the Act: +Title of Each Class +Name of Each Exchange on Which Registered +Common Stock, $0.000001 par value per share +The NASDAQ Stock Market LLC +Securities registered pursuant to Section 12(g) of the Act: None +Indicate by check mark if the Registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities +Act. Yes ¨ No x +Indicate by check mark if the Registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Exchange +Act. Yes ¨ No x +Indicate by check mark whether the Registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities +Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 +days. Yes x No ¨ +Indicate by check mark whether the Registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data +File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405) during the preceding 12 months (or for such shorter period that the Registrant was required to submit and post such +files). Yes x No ¨ +Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be +contained, to the best of Registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form +10-K. x +Indicate by check mark whether the Registrant is a large accelerated +filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange +Act. +Large accelerated filer +¨ +Accelerated filer +x +Non-accelerated filer +¨ +Smaller reporting company +¨ +Indicate by check mark whether the Registrant is a shell company (as defined in Rule 12b-2 of the Exchange +Act). Yes ¨ No x +State the aggregate market value of the voting and non-voting common equity held by nonaffiliates, computed by reference to the price at which +the common equity was last sold, or the average bid and asked price of such common equity, as of the last business day of the Registrant’s most recently completed second fiscal quarter (June 30, 2013): $212,516,664 +Indicate the number of shares outstanding of each of the Registrant’s classes of common stock, as of March 7, 2014: +55,831,886 shares. +Documents Incorporated by Reference: +Portions of the Registrant’s Definitive Proxy Statement for the 2014 Annual Meeting of Stockholders are incorporated by reference into Part III of this +Annual Report. +Table of Contents +Table of Contents +Page +PART I +ITEM 1. +Business +1 +ITEM 1A. +Risk Factors +23 +ITEM 1B. +Unresolved Staff Comments +47 +ITEM 2. +Properties +47 +ITEM 3. +Legal Proceedings +47 +ITEM 4. +Mine Safety Disclosures +47 +PART II +ITEM 5. +Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities +48 +ITEM 6. +Selected Consolidated Financial Data +50 +ITEM 7. +Management’s Discussion and Analysis of Financial Condition and Results of Operations +51 +ITEM 7A. +Quantitative and Qualitative Disclosures About Market Risk +69 +ITEM 8. +Consolidated Financial Statements and Supplementary Data +69 +ITEM 9. +Changes in and Disagreements with Accountants on Accounting and Financial Disclosure +70 +ITEM 9A. +Controls and Procedures +70 +ITEM 9B. +Other Information +71 +PART III +ITEM 10. +Directors, Executive Officers and Corporate Governance +72 +ITEM 11. +Executive Compensation +72 +ITEM 12. +Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters +72 +ITEM 13. +Certain Relationships and Related Transactions, and Director Independence +72 +ITEM 14. +Principal Accountant Fees and Services +72 +PART IV +ITEM 15. +Exhibits and Consolidated Financial Statement Schedules +73 +Table of Contents +This Report contains certain “forward-looking statements,” within the meaning of the Federal +securities laws. These may include statements about our expected revenues, earnings, expenses or other financial performance, future product performance or development, expected regulatory filings and approvals, planned business transactions, +expected manufacturing performance, views of future industry, competitive or market conditions, and other factors that could affect our future operations, results of operations or financial position. These statements often include words, such as +“believes,” “expects,” “anticipates,” “intends,” “plans,” “estimates,” “may,” “will,” “should,” “could,” or similar expressions. +Forward-looking statements are not guarantees of future performance or results. Known and unknown factors could cause actual performance or results to be +materially different from those expressed or implied in these statements. Factors that could affect our results are discussed more fully under Item 1A., entitled “Risk Factors,” and elsewhere in this Annual Report. Although +forward-looking statements help to provide complete information about us, readers should keep in mind that forward-looking statements may not be reliable. Readers are cautioned not to place undue reliance on the forward-looking statements. The +forward-looking statements are made as of the date of this Annual Report and we undertake no duty to update these statements. +References in this +Annual Report to “OraSure” mean OraSure Technologies, Inc. References in this Annual Report to “we,” “us,” “our,” or the “Company” mean OraSure and its consolidated subsidiaries, unless otherwise +indicated. +PART I +ITEM 1. +Business. +Our business principally involves the development, manufacture, marketing and sale of oral +fluid diagnostic products and specimen collection devices using our proprietary oral fluid technologies, as well as other diagnostic products including immunoassays and other in vitro diagnostic tests that are used on other specimen types. We +also manufacture and sell medical devices used for the removal of benign skin lesions by cryosurgery or freezing. Our diagnostic products include tests that are performed on a rapid basis at the point of care and tests that are processed in a +laboratory. These products are sold in the United States and internationally to various clinical laboratories, hospitals, clinics, community-based organizations and other public health organizations, distributors, government agencies, +physicians’ offices, and commercial and industrial entities. One of our diagnostic products, the OraQuick ® In-Home HIV Test, is the first and only rapid HIV test approved by the U.S. Food +and Drug Administration (“FDA”) for sale in the over-the-counter (“OTC”) or consumer retail market in the United States. We also sell cryosurgical products to consumers in North America, Europe, Central and South America, and +Australia. +In vitro diagnostic testing is the process of analyzing oral fluid, blood, urine and other bodily fluids or tissue for the presence of +specific substances or markers. We have targeted the use of oral fluid in our products as a differentiating factor and believe that it provides a significant competitive advantage over blood and urine. Our oral fluid tests have sensitivity and +specificity comparable to blood and/or urine tests. When combined with their ease of use, non-invasive nature, and cost effectiveness, our oral fluid tests represent a very competitive alternative to the more traditional testing methods in the +diagnostic space. +Through our subsidiary, DNA Genotek Inc. (“DNAG”), a company based in Ottawa, Canada, we manufacture and sell kits that are +used to collect, stabilize, and store samples of genetic material for molecular testing in the consumer genetics, clinical genetic testing, academic research, pharmacogenomics, personalized medicine, and animal genetics markets. Our OraGene ® DNA sample collection kit provides an all-in-one system for the collection, stabilization and transportation of DNA from human saliva. We serve customers in many countries worldwide, including +many leading research universities and hospitals. +1 +Table of Contents +OraSure was formed in May 2000 under Delaware law solely for the purposes of combining two companies, STC +Technologies, Inc. (“STC Technologies”) and Epitope, Inc. (“Epitope”), and changing the state of incorporation of Epitope from Oregon to Delaware. STC Technologies and Epitope were merged into OraSure on September 29, 2000. +Our principal offices are located at 220 East First Street, Bethlehem, Pennsylvania 18015, and our telephone number is (610) 882-1820. +Additional +information about us can be found on our website, www.orasure.com . We make available free of charge through a link provided at such website our Annual Reports on Form 10-K, our Quarterly Reports on Form 10-Q, our Current Reports on Form 8-K +and our other filings with the Securities and Exchange Commission (“SEC”), as well as any amendments to those Reports and filings. These Reports and filings are made available as soon as reasonably practicable after they are filed or +furnished to the SEC. Our Internet website and the information contained in or connected to that website are not intended to be incorporated by reference into this Annual Report. +Products +The following is a summary of our +principal products and their regulatory and commercial status: +Product +Description +Regulatory Status +Commercial +Status +OraQuick ADVANCE ® HIV-1/2 +A rapid, point-of-care qualitative test for antibodies to the Human Immunodeficiency Virus Type 1 (“HIV-1”) and Type 2 (“HIV-2” and together with HIV-1, “HIV-1/2”) that can be visually read +in approximately 20 minutes. +Premarket approval (“PMA”) by the FDA for use with oral fluid, finger-stick and venous whole blood, and plasma. +Marketed +CLIA (Clinical Laboratory Improvement Amendments of 1988) waived for use +with oral fluid, finger-stick and venous whole blood. +Marketed +CE mark (European Union) approved for use with oral fluid, finger-stick +and venous whole blood, serum and plasma. Also registered in various other countries. +Marketed +OraQuick ® In-Home HIV Test +A rapid, point-of-care qualitative oral fluid HIV- 1/2 test for OTC use that can be visually read in approximately 20 minutes. +PMA approved for OTC use. +Marketed +OraQuick ® HCV +A rapid, point-of-care qualitative test for antibodies to the hepatitis C virus (“HCV”) that can be visually read in approximately 20 minutes. +PMA approved and CLIA waived for use with venous whole blood and finger-stick whole blood specimens. +Marketed +2 +Table of Contents +Product +Description +Regulatory Status +Commercial +Status +CE mark (European Union) approved for use with oral fluid, finger-stick and venous whole blood, serum and plasma. Also registered in various other countries. +Marketed +OraSure QuickFlu™ Rapid Flu A&B Test +A rapid, point-of-care qualitative test for antibodies to influenza (flu) Types A and B, including H1N1 infections, with results available in 10 minutes. +FDA 510(k) cleared for use with nasal swab, nasopharyngeal swab and nasal aspirate/wash. +Marketed +OraSure ® +Oral fluid collection device for the detection of antibodies to HIV-1 and for detection of cocaine and cotinine in an oral fluid sample in a laboratory setting. +PMA approved by FDA for use in detecting antibodies to HIV-1. +Marketed +FDA 510(k) cleared for use in detecting cocaine and cotinine (an +indicator of nicotine) in oral fluid. +Marketed +CE marked and registered in various countries. +Marketed +Oragene ® ·DX +Non-invasive all-in-one system for the collection, stabilization, transportation and storage of human DNA from saliva. +FDA 510(k) cleared for in vitro diagnostic use with FDA-cleared molecular tests. +Marketed +Oragene ® ·DNA +Non-invasive all-in-one system for the collection, stabilization, transportation, and storage of human DNA from saliva. +CE marked and registered as Class 1 Medical Device in Canada. +Marketed +Registered in various other countries. +Oragene ® ·DISCOVER +Non-invasive all-in-one system for the collection, stabilization, transportation, and storage of human DNA from saliva. +Research use only product. +Marketed +Oragene ® ·RNA +Non-invasive all-in-one system for the collection, stabilization and transportation of RNA from human saliva. +Research use only product. +Marketed +3 +Table of Contents +Product +Description +Regulatory Status +Commercial +Status +ORAcollect™ +All-in-one system for the collection, stabilization, transportation, and storage of human DNA from saliva. +CE marked and registered as Class 1 Medical Device in the U.S. and Canada. +Marketed +Registered in various other countries. +OMNIgene™·DISCOVER +Non-invasive all-in-one system for the collection, stabilization, transportation, and storage of microbial DNA from saliva. +Research use only product. +Marketed +Performagene™· LIVESTOCK and Oragene ® ·ANIMAL +All-in-one systems for the collection, stabilization, transportation, and storage of livestock DNA from nasal samples. +Animal research use only. +Marketed +HEMAgene™· BUFFY COAT +Reagent for stabilizing DNA from Buffy Coat (blood) for ambient temperate transport and/or storage. +Research use only product. +Marketed +PrepIT TM L2P +Reagent for extraction and preparations of DNA from saliva. +CE marked and registered in the U.S., Canada and various other countries. +Marketed +Intercept ® +Oral fluid collection device for oral fluid drugs-of-abuse (“DOA”) testing in a laboratory setting. +FDA 510(k) cleared for use with nine MICRO-PLATE DOA assays. +Marketed +CE marked and registered in certain countries. +Marketed +MICRO-PLATE DOA Assays +Used to detect the following drugs in an oral fluid sample collected with Intercept ® device: tetrahydrocannabinol (“THC” or marijuana), cocaine, opiates, +amphetamines, methamphetamines, phencyclidine (“PCP”), benzodiazepines, barbiturates and methadone. +Nine drug assays – FDA 510(k) cleared. +Assays CE marked and registered in certain countries. +Marketed +Marketed +Homogeneous DOA Assays +Homogeneous fully- automated oral fluid DOA assays jointly developed with Roche Diagnostics for use on oral fluid samples collected with Intercept ® device. +FDA 510(k) cleared for use with PCP, opiates, cocaine, methamphetamines and amphetamines assays with Intercept ® collection device. +Marketed +4 +Table of Contents +Product +Description +Regulatory Status +Commercial +Status +Cryosurgical Systems – Professional +Cryosurgical (freezing) system for the removal of warts and other benign skin lesions, marketed under the Histofreezer ® tradename primarily to the physicians’ office +market. +FDA 510(k) cleared for nine types of skin lesions. +CE marked and registered in certain countries. +Marketed +Marketed +Cryosurgical Systems – OTC +Cryosurgical system for the removal of common and plantar warts, sold in various OTC markets. +FDA 510(k) cleared for common and plantar warts. +Not Marketed +Registered in Canada for warts and skin tags. +Marketed +CE marked and registered for warts in certain countries under Scholl +Freeze Spray ® and POINTTS ® names. +Marketed +CE marked for skin tags. +Not Marketed +In addition to the above products, we also sell certain immunoassay tests and reagents for insurance risk assessment, +substance abuse testing and forensic toxicology applications; an oral fluid Western blot HIV-1 confirmatory test for confirming positive HIV-1 test results obtained from the use of our +OraSure ® collection device; and the FDA 510(k) cleared Q.E.D. ® rapid point-of-care saliva alcohol test. +OraQuick ® Rapid HIV Test +OraQuick ® is our rapid point-of-care test platform designed to test oral fluid, whole blood (i.e., +both finger-stick and venous), plasma and serum samples for the presence of various antibodies or analytes. The device uses a porous flat pad to collect an oral fluid specimen. After collection, the pad is inserted into a vial containing a +pre-measured amount of developer solution and allowed to develop. When blood, plasma or serum is to be tested, a loop collection device is used to collect a drop of the specimen and mix it in the developer solution, after which the collection pad is +inserted into the solution and allowed to develop. In all cases, the specimen and developer solution then flow through the testing device where test results are observable in approximately 20 minutes. The OraQuick ® device is a screening test and generally requires a confirmation test where an initial positive result is obtained. +This product is sold under the OraQuick ADVANCE ® name in North America, Europe and certain +other countries and under the OraQuick ® name in other developing countries. The test has received PMA approval from the FDA for the detection of antibodies to both HIV-1 and HIV-2 in oral +fluid, finger-stick whole blood, venous whole blood and plasma. This test is available for use by laboratories located in the United States certified under the Clinical Laboratory Improvements Amendment of 1988, or CLIA, to perform moderately +complex tests. We have also received a CLIA waiver for use of the test with oral fluid and finger-stick and venous whole blood. As a result, the test can be used by numerous additional sites in the United States not certified under CLIA to perform +moderately complex tests, such as outreach clinics, community-based organizations and physicians’ offices. +On the international front, we have +obtained a CE mark for our OraQuick ADVANCE ® test so that we can sell this product in Europe and other countries accepting the CE mark for commercialization and this product is +registered in other countries. We have distributors in place for several countries and are seeking to increase awareness and expand our distribution network for this product throughout the world. +5 +Table of Contents +We believe that the OraQuick ADVANCE ® device, +because it is approved for detecting antibodies to both HIV-1 and HIV-2 in finger-stick and venous whole blood, oral fluid and plasma samples, provides a significant competitive advantage in the market for rapid HIV testing in the United States and +elsewhere. +OraQuick ® In-Home HIV Test +The OraQuick ® In-Home HIV test is an over-the-counter version of our OraQuick ADVANCE ® HIV 1/2 Antibody Test. We received PMA approval to sell this test in the U.S. OTC market in mid-2012. The In-Home Test is performed in the same manner as the OraQuick ADVANCE ® test, except that it has product labeling and instructions designed for consumers. In addition, we have established a toll free, 24/7, 365-day per year customer call center to provide additional +information and referral support for consumers. +OraQuick ® HCV Rapid Antibody Test +Another test available on the OraQuick ® platform is the OraQuick ® HCV rapid antibody test. Like the OraQuick ® HIV test, this product is a qualitative test that can detect antibodies to the Hepatitis C +virus, or HCV, in a variety of sample types. The OraQuick ® HCV test operates in substantially the same manner as the OraQuick ® HIV +test. +We have received FDA approval for use of the test in detecting HCV antibodies in venous whole blood and finger-stick whole blood specimens, making +it the first rapid HCV test approved by the FDA for use in the United States. We have also received a CLIA waiver for use of this product in the same specimen types. Our clinical program for approval of an oral fluid claim for this product is on +hold pending further discussions with the FDA. The OraQuick ® HCV test has received a CE mark for use with oral fluid, venous whole blood, finger-stick whole blood, plasma and serum and is sold +in Europe and other foreign countries. +OraSure QuickFlu™ Rapid Flu A&B Test +The OraSure QuickFlu™ rapid flu A&B test is an FDA 510(k) cleared rapid qualitative test for the detection of influenza (flu) Types A and B, including +H1N1 viral infections. The test utilizes specimen collected with a nasal swab, nasopharyngeal swab or nasal aspirate/wash. A reagent is first inserted into a test cartridge, the specimen is added and the test is allowed to flow. Results are +available in as little as ten minutes. This product is manufactured for us under an agreement with Princeton BioMeditech Corporation and is currently sold in certain U.S. markets. +OraSure ® Collection Device +Our OraSure ® oral fluid collection device is used in conjunction with screening and confirmatory tests +for HIV-1 antibodies and other analytes. This device consists of a small, treated cotton-fiber pad on a handle that is placed in a person’s mouth for two to five minutes. The device collects oral mucosal transudate (“OMT”), a serum-derived fluid that contains higher concentrations of certain antibodies and analytes than saliva. As a result, OMT testing is a highly accurate method for detecting HIV-1 infection and other analytes. +The OraSure ® collection device is FDA approved for use in the detection of HIV-1 antibodies and +510(k) cleared for the detection of cocaine and cotinine in oral fluid specimens. HIV-1 antibody detection using the OraSure ® collection device involves three steps: +• +Collection of an oral fluid specimen using the OraSure ® device; +• +Screening of the specimen for HIV-1 antibodies at a laboratory with an enzyme immunoassay (“EIA”) screening test approved by the FDA for use with the +OraSure ® device; and +• +Laboratory confirmation of any positive screening test results with our oral fluid Western blot HIV-1 confirmatory test (described below). +6 +Table of Contents +A trained health care professional then conveys test results and provides appropriate counseling to the +individual who was tested. +We believe that oral fluid testing has several significant advantages over blood or urine-based systems for infectious disease +testing, for both health care professionals and the individuals being tested. These advantages include eliminating the risk of needle-stick accidents, providing a non-invasive collection technique, requiring minimal training to administer, providing +rapid and efficient collection in almost any setting, and reducing the cost of administration by a trained health care professional. +Molecular +Collection Systems +Our wholly-owned subsidiary, DNAG, sells a number of products that provide all-in-one systems for the collection, stabilization, +transportation, and storage of DNA and/or RNA from human and animal biologic samples. DNAG’s lead product is sold under the Oragene ® name and is used to collect DNA from human saliva. +DNAG products are currently sold to thousands of academic and research customers in many countries worldwide. +DNAG products are available in several +different configurations and contain proprietary chemical solutions that are optimized for the specific application for which each product is designed. Product physical design is focused on providing easy-to-use and reliable products for self or +assisted collection of samples. For example, several of the Oragene ® products require users to simply hold the product close to their mouth and spit into the collection device. When the +container is closed, the reagents stored in the lid of the container are mixed with the captured saliva and immediately protect the nucleic acids in the sample. This non-invasive collection method yields nucleic acid that remains stable at ambient +temperature for extended periods. The stabilizing technology results in high quality and high quantity nucleic acids that are required for most genetic testing and analysis methods. +We believe these products provide significant advantages over competing DNA and RNA collection methods such as blood collection or buccal swabs, particularly +in human genetic applications. Benefits include the reliable collection of high quality genetic samples, use of simple non-invasive collection methods, the ability to store and transport collected samples for extended periods at ambient temperatures +and compatibility with fully-automated laboratory testing systems. +DNAG products historically have been sold primarily as Class I medical devices for use +by research and academic institutions. DNAG received FDA 510(k) clearance for the Oragene ® — Dx product in the first quarter of 2012. This +clearance will enable the Oragene ® — Dx product to be used with other FDA-cleared molecular diagnostic applications. +Intercept ® Drug Testing System +A collection device that is substantially similar to the OraSure ® device is sold by us under the name +Intercept ® , and is used to collect OMT for oral fluid drug testing. We have received FDA 510(k) clearance to use the Intercept ® +collection device with laboratory-based EIAs to test for drugs-of-abuse commonly identified by the National Institute for Drug Abuse (“NIDA”) as the NIDA-5 (i.e., tetrahydrocannabinol (“THC” or marijuana), cocaine, opiates, +amphetamines/methamphetamines and phencyclidine (“PCP”)), and for barbiturates, methadone and benzodiazepines. Each of these EIAs is also FDA 510(k) cleared for use with the +Intercept ® device. Our Intercept ® device and oral fluid assays are sold in the U.S. primarily through laboratory distributors. +We believe that the Intercept ® device has several advantages over competing urine and other +drugs-of-abuse testing products, including its lower total testing cost, its non-invasive nature, mobility and accuracy, the ease of maintaining a chain-of-custody, the treatment of test subjects with greater dignity, no requirement for specially-prepared collection facilities and difficulty of sample adulteration. The availability of an oral fluid test is intended to allow our customers to test for drug impairment and eliminate scheduling costs +and inconvenience, thereby streamlining the testing process. +7 +Table of Contents +In an effort to expand our Intercept ® product line and +meet the needs of our laboratory customers, we jointly developed with Roche Diagnostics a series of homogeneous fully-automated oral fluid drugs-of-abuse assays. These assays use Roche’s KIMs (kinetic interaction of micro-particles in solution) +technology and are designed to run on various automated analyzers to allow oral fluid samples to be processed with the same efficiency currently achieved by our laboratory customers with urine-based drug tests. +We had experienced significant delays in completing the development of these assays with Roche, which led to an agreement to terminate the collaboration in +late 2013. As part of this termination, Roche paid us $8.3 million and agreed to continue to supply certain of the assays developed under the collaboration on a transitional basis for up to five years following the termination. We have the right to +stop the supply of assays prior to the end of this five-year period and could receive an additional payment from Roche of up to $5.5 million depending on how early in that five-year period the supply obligation is ended. +Concurrently with the Roche termination, we entered into a new agreement with Thermo Fisher Scientific (“Thermo Fisher”) for the development and +supply of up to 12 homogeneous fully-automated oral fluid drugs-of-abuse assays. These assays are intended to replace the Roche assays and will be used with a new +version of our Intercept ® collection device. Under this new agreement, a NIDA-5 panel of assays is initially expected to be sold with our new Intercept ® device in the domestic criminal justice and forensics markets beginning in the second half of 2014. Eventually, the parties expect to complete development of several more assays and obtain FDA +510(k) clearance and approvals in certain foreign countries. The assays will be optimized as needed to comply with new oral fluid guidelines expected to be issued by the Substance Abuse and Mental Health Services Administration (SAMHSA) for the +federally-regulated market and certain other markets that follow Federal drug testing guidelines, none of which is currently served by OraSure. +Cryosurgical Systems (Skin Lesion Removal Products) +The +Histofreezer ® cryosurgical removal system is a low-cost alternative to liquid nitrogen and other methods for removal of warts and other benign skin lesions by physicians. The Histofreezer ® product mixes three cryogenic gases in a small aerosol canister. When released, these gases are delivered to a specially designed foam bud, cooling the bud to a maximum of –50°C to +–55°C. The frozen bud is then applied to the wart or lesion for 15 to 40 seconds (depending on the type of lesion) creating localized destruction of the target area by freezing. We have received 510(k) clearance for use of the Histofreezer ® product to remove common warts and eight other types of benign skin lesions, and this product has been CE marked and registered for distribution in Canada, throughout Europe and in certain other +foreign countries. +Internationally, we sell an OTC cryosurgical product through our distributor Genomma Labs (“Genomma”), under the POINTTS +tradename, in Mexico and a number of South and Central American countries. We also sell a CE marked cryosurgical wart removal product into the OTC footcare market in Europe, Australia and New Zealand through our distributor, Reckitt Benckiser +(“Reckitt”), under the Scholl and Dr. Scholl trademarks. Reckitt is the owner of the Scholl and Dr. Scholl trademarks in countries outside North and South America. We also sell OTC cryosurgical products for the treatment of both +warts and skin tags to retailers in Canada on a private label basis. +Immunoassay Tests and Reagents +We develop and sell immunoassay tests in two formats, known as MICRO-PLATE and AUTO-LYTE ® , to meet the +specific needs of our customers. +8 +Table of Contents +In a MICRO-PLATE kit, the sample to be tested is placed into a small plastic receptacle, called a microwell, +along with the reagents. The result of the test is determined by the color of the microwell upon completion of the reaction. Controlling the reaction involves the use of reagents by laboratory personnel. Test results are analyzed by any of a variety +of commercially available laboratory instruments, which we may also provide to our laboratory customers. MICRO-PLATE tests can be performed on commonly used instruments and can detect drugs in urine, serum and sweat specimens. MICRO-PLATE tests are +also used as part of the Intercept ® product line to detect drugs-of-abuse in oral fluid specimens. +AUTO-LYTE ® tests are sold in the form of bottles of liquid reagents. These reagents are run on +commercially available laboratory-based automated analytical instruments, which are manufactured by a variety of third parties. AUTO-LYTE ® is typically used in high volume, automated, +commercial reference insurance laboratories to detect certain drugs or chemicals in urine. Test results are produced quickly, allowing for high throughput. Our AUTO-LYTE ® tests continue to +face strong competition from cheaper “home-brew” tests developed internally by our laboratory customers. As a result, we may eventually stop selling our AUTO-LYTE ® tests. +Western blot HIV-1 Confirmatory Test +We sell an oral +fluid Western blot HIV-1 confirmatory test that received premarket approval from the FDA in 1996. This test uses the original specimen collected with the OraSure ® oral fluid collection device +to confirm positive results of initial oral fluid HIV-1 EIA screening tests. +Q.E.D. ® Saliva +Alcohol Test +Our Q.E.D. ® saliva alcohol test is a point-of-care test device that is a +cost-effective alternative to breath or blood alcohol testing. The test is a quantitative, saliva-based method for the detection of ethanol, has been cleared for sale by the FDA and has received a CLIA waiver. The U.S. Department of Transportation +(“DOT”) has also approved the test. +Each Q.E.D. ® test kit contains a collection stick +that is used to collect a sample of saliva and a disposable detection device that displays results in a format similar to a thermometer. The Q.E.D. ® device is easy to operate and +instrumentation is not required to read the result. The product has a testing range of 0 to 0.145% blood alcohol and produces results in approximately two minutes. +Research and Development +In 2013, our research +and development activities focused primarily on development of a next generation Intercept ® collection device and assessing initial feasibility of certain other products. From time to time, we +have contracted with third parties to conduct research and development activities and we may do so in the future. +Research and development expenses were +$10.9 million in 2013, $12.4 million in 2012 and $18.4 million in 2011. These expenses include our costs associated with research and development, regulatory affairs, clinical trials and product support. +Sales and Marketing +We attempt to reach our major +target markets through a combination of direct sales, strategic collaborations and independent distributors. Our marketing strategy is to create or raise awareness through a full array of marketing activities, which include trade shows, print +advertising, special programs, distributor promotions, telemarketing and the use of digital and social media in order to stimulate sales in each target market. +9 +Table of Contents +We market our products in the United States and internationally. Revenues attributable to customers in the United +States were $77.2 million, $67.5 million and $67.6 million in 2013, 2012 and 2011, respectively. Revenues attributable to international customers amounted to $21.7 million, $20.3 million and $14.2 million, or 22%, 23% and 17% of our total revenues, +in 2013, 2012 and 2011, respectively. For more information about our revenues and long-lived assets attributable to U.S. and international customers, please see Note 11 to our consolidated financial statements included elsewhere in this Annual +Report. +Infectious Disease Testing - Professional +We market the OraQuick ADVANCE ® rapid HIV-1/2 antibody test directly to customers in the public +health market for HIV testing. This market consists of a broad range of clinics and laboratories and includes states, counties, and other governmental agencies, family planning clinics, colleges and universities, correctional facilities and the +military. There are also a number of organizations in the public health market, such as AIDS service organizations and various community-based organizations, that are set up primarily for the purpose of encouraging and enabling HIV testing. We also +sell our OraQuick ADVANCE ® test directly to hospitals in the U.S. and through distributors into the U.S. physician office market and to retail clinics operated by pharmacies. We have +engaged two manufacturers’ representative organizations to assist with sales to U.S. physicians and retail clinics. Internationally, we distribute our OraQuick ® HIV test in Europe and +certain other foreign countries. +We market the OraSure ® oral fluid collection device for HIV-1 +testing, on its own and as a kit in combination with laboratory testing services. To better serve our public health customers, we have contracted a commercial laboratory to provide prepackaged +OraSure ® test kits, with prepaid laboratory testing and specimen shipping costs included. We also sell the OraSure ® device in the +international public health market. +Our OraQuick ® HCV test is sold primarily to the same markets +where our OraQuick ® ADVANCE HIV test is sold, including public health organizations, hospitals, physicians and retail clinics. We also sell this test in Europe and other countries through +distributors. +We have distribution rights to an FDA 510(k) cleared rapid flu A&B test, which we market under our proprietary OraSure QuickFlu™ +tradename. Under our agreement with the supplier of this product, we are permitted to sell this product into the U.S. hospital and public health markets. +Infectious Disease Testing - OTC +We sell our OraQuick ® In-Home test in the U.S. retail or consumer market. Retailers carrying the product include CVS, Walgreens, Rite Aid, Wal-Mart and Kroger. The product is also available for purchase on-line +through certain retailers and our website, www.oraquick.com . The primary target population for our HIV-OTC test is comprised of young, sexually active adults, with greater purchase intent found in high-risk sub groups, such as men who have +sex with men, African Americans and Latino Americans. In order to increase awareness and consumer sales of this product, we engage in significant public relations and advertising activities related to this product. +To support individuals that purchase and use our test, we have established a toll-free customer support center that operates on a 24/7, 365-day per year +basis. Through this center, consumers will have access to highly-trained, bi-lingual representatives who can answer questions about HIV/AIDS and the use of our test, and refer consumers to appropriate +resources for follow-up confirmatory testing, counseling and medical treatment. +Molecular Collection Systems +DNAG primarily sells its products directly to its customers through its own global sales force. In some countries distributors are used, particularly in the +Asia-Pacific region. Over half of DNAG’s employees work in the areas of sales, marketing, business development or product management. The significant majority of employees who +10 +Table of Contents +deal directly with customers have molecular science backgrounds, which we believe is useful in selling and marketing molecular collection products, and more importantly, in identifying and +evaluating new market and business opportunities. +Historically, most of DNAG’s revenues have been derived from product sales into the academic and +research markets. However, sales to commercial customers providing consumer genetics and clinical diagnostic services have been increasing and now account for a majority of DNAG’s revenues. A significant portion of DNAG’s sales is derived +from repeat customers, in both markets. DNAG also has a number of established global customers in the livestock market, including breed associations and research institutions. A molecular collection product focused on the infectious disease research +market has also been launched by DNAG. +Substance Abuse Testing +Our substance abuse testing products are marketed to laboratories serving the workplace testing, forensic toxicology, criminal justice and drug rehabilitation +markets in the U.S. and in certain international markets. +We have entered into agreements for the distribution of Intercept ® collection devices and associated MICRO-PLATE assays for drugs-of-abuse testing in the workplace testing market in the United States and Canada through +several laboratory distributors and internationally for workplace, criminal justice and forensic toxicology testing through other distributors. We also market the Intercept ® collection device +on its own and as a kit in combination with laboratory testing services. To better serve our workplace customers, we have contracted with commercial laboratories to provide prepackaged +Intercept ® test kits, with prepaid laboratory testing and specimen shipping costs included. +The +criminal justice market in the United States for our substance abuse testing products consists of a wide variety of entities in the criminal justice system that require drug screening, such as pre-trial services, parole and probation offices, police +forces, drug courts, prisons, drug treatment programs and community/family service programs. The forensic toxicology market consists of several hundred laboratories including federal, state and county crime laboratories, medical examiner +laboratories and reference laboratories. +As discussed above we continue to sell 510(k)-cleared fully-automated high-throughput oral fluid assays +developed with Roche Diagnostics for the detection of PCP, opiates, cocaine, methamphetamines and amphetamines with oral fluid samples collected with our Intercept ® device. These assays are +being made available on a transitional basis until we can replace them with similar assays developed under our new collaboration with Thermo Fisher for use with a new version of our Intercept ® +collection device. +We distribute our Q.E.D. ® saliva alcohol test primarily through various +distributors in the United States and internationally. The markets for alcohol testing are relatively small and fragmented with a broad range of legal and procedural barriers to entry. Markets range from law enforcement testing to workplace testing +of employees in safety sensitive occupations. Typical usage situations include pre-employment, random, post-accident, reasonable-cause and return-to-duty testing. +Cryosurgical Systems +Most of our Histofreezer ® sales occur in the United States to distributors that, in turn, resell the product to primary care physicians and podiatrists in the United States. Our major U.S. distributors include Cardinal +Healthcare, McKesson Medical-Surgical, AmerisourceBergen Corporation, and Henry Schein. We have also engaged two manufacturers’ representative organizations to help our U.S. distributors promote and sell Histofreezer ® . Internationally, we sell the Histofreezer ® product through a network of distributors in more than 20 countries worldwide. +11 +Table of Contents +We distribute cryosurgical wart removal products in the OTC footcare market in Europe, Australia and New Zealand +through our distributor, Reckitt Benckiser, under its Scholl and Dr. Scholl tradenames, and in the OTC markets in Mexico and several Central and South American countries under the POINTTS tradename through our distributor, Genomma. We also sell +OTC cryosurgical products for the removal of warts and skin tags under private label arrangements with retailers in Canada. +Insurance Risk Assessment +We currently market the OraSure ® oral fluid collection device for use in screening life +insurance applicants in the United States and internationally to test for three of the most important underwriting risk factors: HIV-1, cocaine and cotinine (a metabolite of nicotine). Devices are sold to insurance testing laboratories, which in +turn sell the devices to insurance companies, usually in combination with testing services. +We also promote use of the OraSure ® device directly to insurance companies for life insurance risk assessment. Insurance companies then make their own decision regarding which laboratory to use to supply their collection devices +and testing services. We sell our OraSure ® Western blot confirmatory test directly to insurance testing laboratories for use in confirming oral fluid specimens collected with our OraSure ® device that initially test positive for HIV-1. +There exists a wide range of policy limits where our +OraSure ® product is being used. In general, many (but not all) of our insurance company customers use the OraSure ® device in connection +with life insurance policies having face amounts of up to $250,000, with some customers using the device for policies of up to $500,000 in amount. Some insurance companies have chosen to extend their testing to lower policy limits where they did not +test at all before, while others have used OraSure ® to replace some of their blood and urine-based testing. More recently, some insurance customers have adopted a “Simplified Issues” +policy, where lab testing is no longer required and instead the applicant completes a questionnaire about personal behaviors. +We also sell our AUTO-LYTE ® assays and reagents in the insurance testing market directly to certain laboratories. +Significant Products and Customers +Several +different products have contributed significantly to our financial performance, accounting for 10% or more of our total revenues during the past three years. The OraQuick ® rapid HIV testing +products, the cryosurgical systems products, and our OraGene ® product line accounted for total revenues of $44.8 million, $14.5 million and $20.4 million in 2013 and $37.9 million, $14.9 +million and $14.3 million in 2012, respectively. The OraQuick ® rapid HIV testing products, the cryosurgical systems products, and the +OraSure ® and Intercept ® oral fluid collection devices accounted for total revenues of $41.7 million, $12.0 million and $10.7 million in +2011. +We had no individual customers who accounted for more than 10% of our total revenues in 2013, 2012 or 2011. +Financial Information by Segment +We operate our +business within two reportable segments. The first is our “OSUR” business, which consists of the development, manufacture and sale of oral fluid diagnostic products and specimen collection devices and medical devices used for the removal +of benign skin lesions by cryosurgery. The second is our “DNAG” or molecular collection systems business, which consists of the development, manufacture and sale of oral fluid collection devices that are used to collect, stabilize, and +store samples of genetic material for molecular testing. +OSUR revenues consist primarily of product sold into the United States and internationally to +various clinical laboratories, hospital, clinics, community-based organizations, public health organizations, distributors, +12 +Table of Contents +government agencies, physicians’ offices, and commercial and industrial entities. OSUR also derives revenues from licensing and product development activities. DNAG revenues consist of +product sold into the academic research, consumer genetics, clinical genetic testing, pharmacogenomics, personalized medicine and animal genetics markets. For more information about our revenues from external customers, income and total assets, +please see the sections entitled “Selected Consolidated Financial Data” and “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and Note 11 to the consolidated financial statements, +included elsewhere in this Annual Report. +Supply and Manufacturing +Our OraQuick ADVANCE ® HIV test, +OraQuick ® In-Home HIV test, OraQuick ® HCV test, OraSure ® and Intercept ® collection devices, Western blot HIV-1 confirmatory test, AUTOLYTE and MICRO-PLATE assays and QED ® saliva alcohol test are all +manufactured in our Bethlehem, Pennsylvania facilities. We expect to continue to manufacture these products at this location for the foreseeable future. +We have contracted with a third party in Thailand for the assembly of the OraQuick ® HIV device, in +order to supply certain international markets. This supply agreement had an initial term of one year, and automatically renews for additional annual periods unless either party provides a timely notice of termination prior to the end of an annual +period. We believe that other firms would be able to manufacture the OraQuick ® test on terms no less favorable than those set forth in the agreement if the Thailand contractor would be unable +or unwilling to continue manufacturing this product. +We can purchase the HIV antigens, the nitrocellulose and certain other critical components used in +the OraQuick ® HIV product lines, the HCV antigens used in the OraQuick ® HCV test and the antigen used in the Western blot HIV-1 +confirmatory test only from a limited number of sources. If for any reason these suppliers are unwilling or no longer able to supply our antigen or nitrocellulose needs, we believe that alternative supplies could be obtained at a competitive cost. +However, a change in any of the antigens, the nitrocellulose or other critical components used in our products would require FDA approval and some additional development work. This in turn could require significant time to complete and could disrupt +our ability to manufacture and sell the affected products. +Our MICROPLATE and AUTO-LYTE assays require the production of highly specific and sensitive +antibodies corresponding to the antigen of interest. Substantially all our antibody requirements are provided by contract suppliers. We believe that we have adequate reserves of antibody supplies and that we have access to sufficient raw materials +for these products. +Our OraSure QuickFlu™ test is manufactured and supplied by a third party, Princeton BioMeditech. There is no other supply source +for this product. +The Histofreezer ® product sold in the U.S. is assembled by U.S. vendors and +the Histofreezer ® product sold internationally is assembled in the Netherlands by Koninklijke, Utermöhlen, N.V. (“Utermöhlen”), the company from which we acquired the +product in 1998. The cryosurgical wart removal products distributed in OTC markets are also assembled by vendors located in the United States. We believe that additional suppliers of all of our cryosurgical products are available on terms no less +favorable than the terms of our existing supply agreements in the event that our current suppliers would be unable or unwilling to continue manufacturing these products. Our supply agreement with Utermöhlen has expired, and we are in the +process of transferring our supply arrangement to one or more other vendors. +DNAG has engaged two contract manufacturers to supply virtually all of its +products, including the Oragene ® product line. Many of the raw materials and components used in these products are also purchased from third parties, including one critical component that is +purchased from a sole source supplier. We believe there are other suppliers that can manufacture and supply the raw materials and components for the DNAG products. +13 +Table of Contents +Employees +As of December 31, 2013, we had 293 full-time employees (including 75 employees at our subsidiary, DNAG). Of this total, there were 98 in sales, marketing +and client services; 34 in research and development; 113 in operations, manufacturing, quality control, information systems, purchasing and shipping; 16 in quality assurance and regulatory affairs; and 32 in administration and finance. This compares +to 313 employees as of December 31, 2012. Our employees are not currently represented by a collective bargaining agreement. +Competition +The diagnostic industry is a multi-billion dollar international industry and is intensely competitive. Many of our competitors are substantially +larger than we are, and have greater financial, research, manufacturing and marketing resources. +Important competitive factors for our products include +product quality, performance, price, ease of use, customer service and reputation. Industry competition is based on the following: +• +Scientific and technological capability; +• +Proprietary know-how; +• +The ability to develop and market products and processes; +• +The ability to obtain FDA or other regulatory approvals; +• +The ability to manufacture products that meet applicable FDA requirements (i.e., good manufacturing practices); +• +Commercial execution and strength of distribution; +• +Access to adequate capital; +• +The ability to attract and retain qualified personnel; and +• +The availability of patent protection. +A few large corporations produce a wide variety of diagnostic tests +and other medical devices and equipment. A larger number of mid-size companies generally compete only in the diagnostic industry and a significant number of small companies produce only a few diagnostic products. As a result, the diagnostic test +industry is highly fragmented and segmented. +The future market for diagnostic products is expected to be characterized by consolidation, greater cost +consciousness, the development of new technologies, and tighter reimbursement policies. The purchasers of diagnostic products are expected to place increased emphasis on lowering costs, reducing inventory levels, obtaining better performing +products, automation, service and volume discounts. The increased complexity of the market is expected to force many competitors to enter into joint ventures or license certain products or technologies. +We expect competition to intensify as technological advances are made and become more widely known, and as new products reach the market. Furthermore, new +testing methodologies could be developed in the future that render our products impractical, uneconomical or obsolete. There can be no assurance that our competitors will not succeed in developing or marketing technologies and products that are more +effective than those we develop or that would render our technologies and products obsolete or otherwise commercially unattractive. In addition, there can be no assurance that our competitors will not succeed in obtaining regulatory approval for +these products, or introduce or commercialize them, before we can do so. These developments could have a material adverse effect on our business, financial condition and results of operations. +14 +Table of Contents +Several companies market or have announced plans to market oral specimen collection devices and tests both within +and outside the United States. We expect the number of devices competing with our OraQuick ® , OraSure ® and Intercept ® devices to increase as the benefits of oral fluid-based testing become more widely accepted. +Competition in the U.S. market for infectious disease testing in medical settings is intense and is expected to increase. Our principal competition for HIV +testing in the professional market comes from existing and new point-of-care rapid blood tests, automated laboratory-based blood tests, or other oral fluid-based tests that may be developed. One of our competitors has received FDA approval for a +rapid oral fluid HIV test, although this product has not yet received a CLIA waiver. Our OraQuick ® rapid HCV test competes against laboratory-based blood tests in the U.S., as there currently +are no other rapid HCV testing products approved by the FDA. Our competitors include medical diagnostic companies and specialized biotechnology firms, as well as pharmaceutical companies with biotechnology divisions. Competing tests are often sold +at a lower price than we charge for our products. This competition can result in lost sales and degradation of the price (and therefore the applicable profit margins) we can charge for our HIV and HCV tests. +Outside the U.S., our rapid HIV and HCV tests compete against other rapid and laboratory-based tests. Significant sales of these products in Europe have not +materialized principally because of differences in European healthcare systems compared to U.S. systems. Unlike the U.S., adoption of rapid point-of-care diagnostics is not widespread in Europe because laboratory testing is entrenched and healthcare +systems are structured around centralized testing models. In addition, many competing tests in international markets are sold at very low prices. We intend to continue to build awareness and develop strategies to expand sales of our OraQuick ® HIV and HCV tests in European and other international markets. +Our OraQuick ® In-Home HIV oral fluid test is the only rapid HIV test approved by the FDA for sale in the U.S. OTC market. We compete against one other non-rapid HIV blood test available in the OTC market, +which requires consumers to self-collect a blood sample and then send it to a laboratory for testing. +The OraSure QuickFlu™ test competes primarily +against other rapid flu tests sold by various third parties in the U.S. hospital and public health markets. +Our Oragene ® collection system competes against other types of collection devices used for molecular testing, such as blood collection devices and buccal swabs, which often are sold for prices lower than the +prices charged for the Oragene ® products. Although we believe the Oragene ® device offers a number of advantages over these other +products, the availability of lower price competitive devices can result in lost sales and degradation in pricing and profit margin. +In the substance +abuse testing market, our Intercept ® drug testing system competes with laboratory-based drug testing products using sample matrices such as urine, hair, sweat and oral fluid. We expect +competition for our products to intensify, particularly from other domestic and international companies that have developed, or may develop, competing oral fluid drug testing products. There are at least two competitors that sell fully-automated +high-throughput oral fluid drug testing products in unregulated settings in the United States. +Our MICRO-PLATE oral fluid drug assays, which are sold for +use with the Intercept ® and OraSure ® collection devices, also continue to come under increasing competitive pressure from +“home-brew” assays developed internally by our laboratory customers. Our oral fluid MICRO-PLATE assays also compete with urine-based homogeneous assays that are run on fully-automated, random access analyzers. These tests provide strong +competitive pressure because they provide the benefits of automation, including lower costs and short turn-around times. +Our MICRO-PLATE drugs-of-abuse reagents sold in the forensic toxicology market are targeted to forensic testing laboratories where sensitivity, automation and +“system solutions” are important. In the past, these +15 +Table of Contents +laboratories have typically had to rely on radioimmunoassay test methods to provide an adequate level of sensitivity. Radioimmunoassays require radioactive materials, which have a short +shelf-life and disposal problems. Our MICRO-PLATE tests meet the laboratories’ sensitivity needs, run on automated equipment, are not radioimmunoassays, and are offered to the laboratory as a complete system solution of reagents, +instrumentation and software to meet the specific needs of each customer. We compete with both homogeneous and heterogeneous tests manufactured by many companies. +Sales of our AUTO-LYTE ® urine assays have declined substantially during the past several years, +primarily due to competition from “home-brew” assays developed internally by our laboratory customers, which can be produced at a cost lower than the price typically paid for our products. Many of our customers no longer purchase our +AUTO-LYTE ® assays, and we may eventually stop selling this product line. +Q.E.D. ® competes against other semi-quantitative saliva-based alcohol tests that have received U.S. Department of Transportation approval as well as breath alcohol tests. Although there are lower priced +tests on the market that use oral fluid or breath as a test medium, these tests are qualitative tests that are believed to be substantially lower in quality and provide fewer benefits than our +Q.E.D. ® test. +Our professional cryosurgical product is sold primarily to physicians, including +family practitioners, pediatricians and podiatrists. This product primarily competes against other portable cryosurgical systems used for the removal of benign skin lesions in both the U.S. and Europe. Our OTC cryosurgical products compete against +other cryosurgical products in certain international OTC markets. +Patents and Proprietary Information +We seek patents and other intellectual property rights to protect and preserve our proprietary technology and our right to capitalize on the results of our +research and development activities. We also rely on trade secrets, know-how, continuing technological innovations and licensing opportunities to provide competitive advantages for our products in our markets +and to accelerate new product introductions. We regularly search for third-party patents in fields related to our business to shape our own patent and product commercialization strategies as effectively as possible and to identify licensing +opportunities. United States patents generally have a maximum term of 20 years from the date an application is filed. +We have eight United States patents +and numerous foreign patents for the OraSure ® and Intercept ® collection devices and technology relating to oral fluid collection, +containers for oral fluids, methods to test oral fluid, formulations for the manufacture of synthetic oral fluid, and methods to control the volume of oral fluid collected and dispersed. The patents expire from November 2015 to December 2026. We +have also applied for additional patents, in both the United States and certain foreign countries, on such products and technology. +We have five United +States patents for our OraQuick ® platform, as well as corresponding related international patents. We also have patent applications pending in the United States and internationally. Four of +the U.S. patents expire from March to July 2019 and the fifth in July 2028. We have obtained licenses to certain lateral flow patents and to certain HIV-1 and HIV-2 patents held by other parties. We also have obtained a license to certain HCV +patents which we use to manufacture and sell a rapid HCV test on the OraQuick ® technology platform. We obtained these licenses through the payment of certain upfront fees and an agreement to +pay ongoing royalties. We believe these fees and royalties are comparable to those generally paid by other companies under similar arrangements. +We may +need to obtain licenses or other rights under, or enter into distribution or other business arrangements in connection with, certain other intellectual property patents in order to manufacture and sell the OraQuick ADVANCE ® HIV test or other tests that use the same or similar technology platform. See Section 1A, entitled “Risk Factors,” for a further discussion of these issues. +16 +Table of Contents +We hold, through our subsidiary, DNAG, ten United States patents and numerous foreign patents issued for +compositions, methods and apparatus for the collection, stabilization, transportation and storage of nucleic acids (DNA and RNA) from oral fluid and other bodily fluids and tissues. These patents expire from June 2023 through June 2028. +We have one United States patent and numerous foreign patents issued for apparatuses and methods for the topical removal of skin lesions relating to our +cryosurgical wart removal products, and we have pending patent applications related to these products in the United States and in certain foreign countries. These patents expire from September 2025 to June 2029. We have also licensed another patent +relating to apparatuses and methods for the topical removal of skin lesions relating to our cryosurgical wart removal products. +We require our employees, +consultants, outside collaborators and other advisors to execute confidentiality agreements upon the commencement of employment or consulting relationships with us. These agreements provide that all confidential information developed by or made +known to the individual during the course of the individual’s relationship with us is to be kept confidential and not disclosed to third parties except in specific circumstances. In the case of employees, the agreements provide that all +inventions conceived by the individual during his or her tenure with us will be our exclusive property. +We own rights to trademarks and service marks +that we believe are necessary to conduct our business as currently operated. In the United States, we own a number of trademarks, including the OraSure ® , Intercept ® , OraQuick ® , OraQuick ADVANCE ® , Histofreezer ® , OraSure QuickFlu ® , Q.E.D. ® , +Oragene ® , ORAcollect™, OMNIgene™, Performagene™, PrepIT™, HEMAgene™, and AUTO-LYTE ® trademarks. We also own +many of these marks and others in several foreign countries. With respect to our international OTC cryosurgical products, the Scholl and Dr. Scholl tradenames are owned by Reckitt Benckiser in Europe, Australia, New Zealand and other countries +outside North and South America, and the POINTTS tradename is owned by Genomma. +Although important, the issuance of a patent or existence of trademark or +trade secret protection does not in itself ensure the success of our business. Competitors may be able to produce products competing with our patented products without infringing our patent rights. Issuance of a patent in one country generally does +not prevent manufacture or sale of the patented product in other countries. The issuance of a patent is not conclusive as to validity or as to the enforceable scope of the patent. The validity or enforceability of a patent can be challenged by +litigation after its issuance. If the outcome of such litigation is adverse to the owner of the patent, the owner’s rights could be diminished or withdrawn. Trade secret protection does not prevent independent discovery and exploitation of the +secret product or technique. +Government Regulation +General +Most of our products are regulated by the FDA, +along with other federal, state and local agencies and comparable regulatory bodies in other countries. This regulated environment governs almost all aspects of development, production and marketing, including product testing, authorizations to +market, labeling, promotion, manufacturing and recordkeeping. We believe that our products and procedures are in material compliance with all applicable FDA regulations, but the regulations regarding the manufacture and sale of our products are +subject to change. We cannot predict the effect, if any, that these changes might have on our business, financial condition or results of operations. +All +of our FDA-regulated products require some form of action by the FDA before they can be marketed in the United States. After approval or clearance by the FDA, we must continue to comply with other FDA requirements applicable to marketed products. +Both before and after approval or clearance, failure to comply with the FDA’s requirements can lead to significant penalties or could disrupt our ability to manufacture and sell +17 +Table of Contents +these products. In addition, the FDA could refuse permission to obtain certificates needed to export our products if the agency determines that we are not in compliance. +Domestic Regulation +Most of our products are regulated +in the United States as medical devices. +There are two mechanisms by which regulated medical devices can be placed on the market in the United States. +Some products may qualify for clearance under Section 510(k) of the Federal Food, Drug and Cosmetic Act. To obtain this clearance from the FDA, the manufacturer must provide a premarket notification that it intends to begin marketing the +product, and show that the product is substantially equivalent to another legally marketed product (i.e., that it has the same intended use and is as safe and effective as a legally marketed device and does not raise different questions of safety +and effectiveness). In some cases, the submission must include data from human clinical studies. Marketing may only commence when the FDA issues a clearance letter finding substantial equivalence. An applicant must submit a 510(k) application at +least 90 days before marketing of the affected product commences. Although FDA clearance usually takes from four to twelve months, in some cases more than a year may be required before clearance is obtained, if at all. +If the medical device does not qualify for the 510(k) procedure (either because it is not substantially equivalent to a legally marketed device or because it +is required by statute and the FDA’s regulations to have an approved PMA), the FDA must approve a PMA before marketing can begin. PMAs must demonstrate, among other matters, that the medical device provides a reasonable assurance of safety and +effectiveness. A PMA is typically a complex submission, supported by valid scientific evidence, including the results of preclinical and clinical studies. Preparing a PMA is a detailed and time-consuming process. Once a PMA has been submitted, the +FDA is required to review the submission within 180 days. However, the FDA’s review may be, and often is, much longer, in many cases requiring one to three years or more, and may include requests for additional data and facility inspections +before approval is granted, if at all. +If the FDA approves the PMA, it may place restrictions on the device. If the FDA’s evaluation of the PMA or +the manufacturing facility is not favorable, the FDA may deny approval of the PMA application or issue a “not approvable” letter. The FDA may also require additional clinical trials, which can delay the PMA approval process by several +years. In addition, if the FDA discovers that an applicant has submitted false or misleading information, the FDA may refuse to review submissions until certain requirements are met pursuant to its Application Integrity Policy (AIP). Delays in +receipt of or failure to receive such clearances or approvals, the loss of previously received clearances or approvals, or the failure to comply with existing or future regulatory requirements could have a material adverse effect on our business, +financial condition and results of operations. +If there are any modifications made to our marketed devices, a premarket notification or PMA may be +required to be submitted to, and cleared or approved by, the FDA, before the modified device may be marketed. A new PMA or a PMA supplement is required for modifications that affect the safety or effectiveness of the device, including, for example, +certain types of modifications to the device’s indications for use, manufacturing process, manufacturing facility, labeling and design. +A clinical +trial may be required in support of a 510(k) submission and generally is required for a PMA application. These trials generally require an Investigational Device Exemption, or IDE, application approved in advance by the FDA for a specified number of +patients, unless the proposed study is deemed a non-significant risk study, which is eligible for an exemption from the IDE requirements. The IDE application must be supported by appropriate data, such as laboratory testing results. Clinical trials +may begin if the IDE application is approved by the FDA and the appropriate institutional review boards, or IRBs, at the clinical trial sites. Submission of an IDE application does not give assurance that the FDA will issue the IDE. If the IDE +application is approved, there can be no assurance the FDA will determine that the data derived from the trials support the safety and effectiveness of the device or warrant the continuation of clinical trials. An IDE supplement must be submitted to +18 +Table of Contents +and approved by the FDA before a sponsor or investigator may make a change to the investigational plan in such a way that may affect its scientific soundness, study indication or the rights, +safety or welfare of human subjects. The trial must also comply with the FDA’s regulations, including the requirement that informed consent be obtained from each subject. Even if a trial is completed, the results of clinical testing may not +adequately demonstrate the safety and efficacy of the device or may otherwise not be sufficient to obtain FDA clearance to market the product in the United States. +Some of our products are used for research only or other non-medical purposes and many of our drugs-of-abuse products sold to state crime laboratories are for +forensic use. The FDA does not currently regulate products used for these purposes, although other state and federal regulatory requirements may apply. +Every company that manufactures medical devices distributed in the United States must comply with the FDA’s Quality System Regulations +(“QSRs”), including current good manufacturing practices. These regulations govern the manufacturing process, including design, manufacture, testing, release, packaging, distribution, documentation and purchasing as well as complaint +handling, corrective and preventative actions and internal auditing. In complying with the QSRs, manufacturers must continue to expend time, money and effort in the area of production and quality to ensure full technical compliance. +We believe that our facilities and procedures are in material compliance with FDA’s QSR regulations, but the regulations are subject to change, and we +cannot be sure that FDA investigators will agree with our compliance with the QSR requirements. Companies are also subject to other post-market and general requirements, including product listing and establishment regulations, which help facilitate +FDA inspections and other regulatory action, post-market surveillance requests, restrictions imposed on marketed products, promotional standards and requirements for recordkeeping and reporting of certain adverse reactions. Medical device reporting +regulations require that manufacturers report if their device may have caused or contributed to a death or serious injury, or has malfunctioned in a way that would likely cause or contribute to a death or serious injury if the malfunction of the +device or a similar device were to recur. +The FDA regularly inspects companies to determine compliance with the QSRs and other post-market requirements. +Failure to comply with statutory requirements and the FDA’s regulations can result in an FDA Form 483 (which is issued by FDA at the conclusion of an inspection when an investigator has observed any conditions that may constitute violations), +public warning letters, monetary penalties against a company or its officers and employees, suspension or withdrawal of regulatory approvals, operating restrictions, total or partial suspension of production, injunctions, product recalls, product +detentions, refusal to provide export certificates, seizure of products and criminal prosecution. +On December 23, 2013, our molecular collection +systems subsidiary, DNAG, received a warning letter from the FDA. The warning letter primarily focused on DNAG’s response to two Form 483 observations issued by the FDA as a result of an inspection of DNAG’s Ottawa, Canada facilities in +September 2013. +Specifically, the warning letter indicated the need for additional documentation regarding design and development activities for +DNAG’s products and focused in particular on the design planning and design history file for DNAG’s 510(k)-cleared OrageneDx collection device. In addition, the warning letter requested additional documentation related to finished product +acceptance testing activities for DNAG’s ORAcollect OC-100 collection device. The letter further noted that DNAG does not currently have in place an approved PMA or 510(k) clearance for its ORAcollect OC-100 device. This product accounted for +less than 3% of DNAG’s sales and less than 0.5% of our consolidated revenues during 2013. +DNAG has submitted a formal response and is actively +engaged and working with the FDA to address the issues referenced in the warning letter. While this warning letter remains pending, DNAG intends to continue to sell and market all of its products. We expect no material impact to product sales or our +consolidated financial performance for the forseeable future as a result of the issues raised by the warning letter. +19 +Table of Contents +The Clinical Laboratory Improvement Amendments of 1988, or CLIA, prohibit any facility that does laboratory +testing on specimens derived from humans from providing information for the diagnosis, prevention or treatment of any disease or impairment of, or the assessment of, the health of human beings, unless there is in effect for such facility a +certificate issued by the U.S. Department of Health and Human Services applicable to the category of examination or procedure performed. Tests may be waived from this regulatory oversight if they meet certain requirements established under CLIA. We +consider the applicability of CLIA requirements in the design and development of our products. We have obtained a waiver of the CLIA requirements for our OraQuick ADVANCE ® rapid HIV-1/2 +antibody test, our OraQuick ® HCV rapid antibody test and our Q.E.D. ® alcohol saliva test and may seek similar waivers for certain other +products. A CLIA waiver allows certain customers to use the waived products that may not have been able to use them without complying with applicable quality control and other requirements. +Certain of our products may also be affected by state regulations in the United States. We are presently working with legislators or regulators in certain of +these states in an effort to modify or remove any restrictions affecting our ability to sell products. +Advertising and Promotion +Advertising and promotion of medical devices, in addition to being regulated by the FDA, are also regulated by the Federal Trade Commission (“FTC”) +and by other federal and state regulatory and enforcement authorities, including the Department of Justice, the Office of Inspector General of the Department of Health and Human Services, and various state attorney generals. Although physicians are +permitted to exercise medical judgment to use medical devices for indications other than those cleared or approved by the FDA, we may not promote our products for such “off-label” uses and can only market our products for cleared or +approved uses. Recently, promotional activities for FDA-regulated products of other companies have been the subject of enforcement actions brought under healthcare reimbursement laws and consumer protection statutes. In addition, under the federal +Lanham Act and similar state laws, competitors and others can initiate litigation relating to advertising claims. If the FDA determines that our promotional materials or training constitute promotion of an uncleared or unapproved use, it could +request that we modify our training or promotional materials or subject us to regulatory or enforcement actions, including the issuance of an untitled letter, a notice of violation, a warning letter, injunction, seizure, civil fine or criminal +penalties. FTC enforcement actions often result in consent decrees that constrain future actions. If an enforcement action is brought by the FDA or FTC, our reputation could be damaged and sales of our products could be impaired. +Import and Export Requirements +Products for export from +the United States are subject to foreign countries’ import requirements and the exporting requirements of the FDA or European regulating bodies, as applicable. In particular, international sales of medical devices manufactured in the United +States that are not approved or cleared by the FDA for use in the United States, or are banned or deviate from lawful performance standards, are subject to FDA export requirements. +Foreign countries often require, among other things, an FDA certificate for products for export, also called a Certificate for Foreign Government. To obtain +this certificate from the FDA, the device manufacturer must apply to the FDA. The FDA certifies that the product has been granted clearance or approval in the United States and that the manufacturing facilities were in compliance with QSR +regulations at the time of the last FDA inspection. If the FDA determines that our facilities or procedures do not comply with the QSR regulations, it may refuse to provide such certificates until we resolve the issues to the FDA’s +satisfaction. +20 +Table of Contents +International +We are also subject to regulations in foreign countries governing products, human clinical trials and marketing, and may need to obtain approval from +international public health agencies, such as the World Health Organization, in order to sell products in certain countries. Approval processes vary from country to country, and the length of time required for approval or to obtain other clearances +may in some cases be longer than that required for U.S. governmental approvals. We generally pursue approval only in those countries that we believe have a significant market opportunity. +The International Organization for Standardization (“ISO”) is a worldwide federation of national standards bodies from some 130 countries, +established in 1947. The mission of the ISO is to promote the development of standardization and related activities in the world with a view to facilitating the international exchange of goods and services. ISO certification indicates that our +quality system complies with standards applicable to activities ranging from initial product design and development through production and distribution. +In the European Union (“EU”), products that fall under the scope of the Medical Devices Directive (“MDD”) and the In Vitro Diagnostic +Directive (“IVDD”) must comply with certain essential requirements listed in those directives. ISO certification creates a rebuttable presumption that the product satisfies the applicable requirements. Compliance with these requirements +allows us to affix the CE mark to our products, without which they may not be placed on the market in the EU. +We have received authorization to use the +CE mark for the OraQuick ADVANCE ® HIV-1/2 test, the OraQuick ® HCV test, our Histofreezer ® product line, our OTC cryosurgical removal product and certain of the Oragene ® collection kits sold by DNAG. +We must also comply with certain registration and licensing requirements as dictated by Health Canada, prior to commencing sales in Canada. We have completed +this process for several of our current products and may do so with respect to other products in the future. In addition, Canadian law requires manufacturers of medical devices to have a quality management system that meets various ISO requirements +in order to obtain a license to sell their devices in Canada. +Anti-Kickback and Other Fraud and Abuse Laws +The Federal Anti-Kickback Statute prohibits the knowing and willful offer, payment, solicitation, or receipt of any form of remuneration in return for, or to +induce: +• +The referral of an individual to a person for the furnishing or arranging for the furnishing of items or services reimbursable under Medicare, Medicaid or other governmental healthcare programs; or +• +The purchase, lease, or order of, or the arrangement or recommendation of the purchasing, leasing, or ordering of any item or service reimbursable under Medicare, Medicaid, or other governmental healthcare programs. +Our products are or may be purchased by customers that will seek or receive reimbursement under Medicare, Medicaid or other governmental +healthcare programs. Noncompliance with the federal anti-kickback statute can result in exclusion from Medicare, Medicaid or other governmental healthcare programs, and/or restrictions on our ability to operate in certain jurisdictions, as well as +civil and criminal penalties, any of which could have an adverse effect on our business and results of operations. +The Federal Civil Monetary Penalties +Law prohibits the offering or transferring of remuneration to a Medicare or Medicaid beneficiary that the person knows or should know is likely to influence the beneficiary’s selection of a particular provider, practitioner or supplier of +Medicare or Medicaid payable items or services. Noncompliance can result in civil monetary penalties for each wrongful act, assessment of three times the amount claimed for each item or service and exclusion from the Federal healthcare programs. +21 +Table of Contents +Many states have also adopted some form of anti-kickback laws. A determination of liability under such laws could +result in fines and penalties, restrictions on our ability to operate in these jurisdictions and significant damage to our reputation. +We are also +subject to other federal and state laws targeting fraud and abuse in the healthcare industry, including false claims laws, marketing conduct laws and laws constraining the sales, marketing and other promotional activities of manufacturers of medical +devices by limiting the kinds of financial arrangements, including sales programs, such manufacturers can enter into with physicians, hospitals, laboratories and other potential purchasers of medical devices. Violations of these laws may be +punishable by criminal or civil sanctions, including substantial fines, imprisonment and exclusion from participation in government healthcare programs such as Medicare and Medicaid. These laws and regulations are wide ranging and subject to +changing interpretation and application. In recent years, there has been greater scrutiny of marketing practices in the medical device industry which has resulted in several government investigations by various government authorities and the +introduction and/or passage of federal and state legislation regulating interactions between medical device manufacturers and healthcare professionals and providers and requiring the disclosure by medical device manufacturers of gifts or other +payments to healthcare professionals and providers. For example, under the Sunshine Act provisions of the Affordable Care Act, device manufacturers are subject to new federal reporting and disclosure requirements with regard to payments or other +transfers of value made to physicians and teaching hospitals. Reports submitted under the Sunshine Act will be placed in a public database. Device manufacturers were required to begin collecting data in August 2013 and will be required to submit +reports March 31, 2014 (and annually thereafter). To be in compliance with such disclosure laws, we have implemented necessary systems for accurately tracking gifts and other payments. +We have implemented a written Policy on Interactions with Health Care Professionals, which is based on the Code of Conduct for Interactions with Health Care +Professionals promulgated by the Advanced Medical Technology Association, or AdvaMed, a leading trade association representing medical device manufacturers. The Policy applies to all employees and is intended to comply with applicable state and +federal laws, regulations and government guidance. The Policy addresses interactions related to sales and marketing practices, research and development, product training and education, grants and charitable contributions, support of third-party +educational conferences, and consulting arrangements. +Foreign Corrupt Practices Act +The U.S. Foreign Corrupt Practices Act (“FCPA”) prohibits corporations and individuals from engaging in certain activities to obtain or retain +business or to influence a person working in an official capacity. It is illegal to use any means of interstate commerce corruptly in the furtherance of any offer, payment, promise to pay or authorization of payment of anything of value to any +foreign government official, government staff member, political party or political candidate in an attempt to obtain or retain business or to otherwise influence a person working in an official capacity. Our present and future business has and will +continue to be subject to the FCPA and various other laws, rules and/or regulations applicable to us as a result of our international sales. +Environmental Regulation +Because of the nature of our +current and proposed research, development, and manufacturing processes, we are subject to stringent federal, state and local laws, rules, regulations and policies governing the use, generation, manufacture, storage, air emission, effluent discharge +and handling and disposal of solid wastes, hazardous materials and hazardous wastes. Products that we sell in Europe are subject to regulation in European Union, or EU, markets under the Restriction of the Use of Hazardous Substances Directive, or +RoHS. RoHS prohibits companies from selling products which contain certain hazardous materials, including lead, mercury, cadmium, chromium, polybrominated biphenyls and polybrominated diphenyl ethers, in EU member states. In addition, the EU’s +Registration, Evaluation, Authorization, and Restriction of Chemicals Directive also restricts substances of very high concern in products. +22 +Table of Contents +Future environmental laws may require us to alter our manufacturing processes, thereby increasing our +manufacturing costs. We believe that our products and manufacturing processes at our facilities comply in all material respects with applicable environmental laws and worker health and safety laws; however, the risk of environmental liabilities +cannot be completely eliminated. +The foregoing discussion of our business should be read in conjunction with the consolidated financial statements and +accompanying notes included in Item 15 of this Annual Report. +ITEM 1A. +Risk Factors +You should carefully consider the risks and uncertainties described below, together +with all of the other information included in this Annual Report and our other SEC filings, in considering our business and prospects. The risks and uncertainties described below are not the only ones facing us. Additional risks and uncertainties +not disclosed or not presently known to us or that we currently deem immaterial also may impair our business operations. The occurrence of any of the following risks could harm our business, financial condition or results of operations. +Regulatory Risks +The Need to Obtain +Regulatory Approvals Could Increase Our Costs and Adversely Affect Our Financial Performance. +Many of our proposed and existing products are subject +to regulation by the FDA and other governmental or public health agencies. In particular, we are subject to strict governmental controls on the development, manufacture, labeling, distribution and marketing of our products. In addition, we or our +distributors are often required to obtain approval or registration with foreign governments or regulatory bodies before we can import and sell our products in foreign countries. +The process of obtaining required approvals or registrations from governmental or public health agencies can involve lengthy and detailed laboratory testing, +human clinical trials, sampling activities and other costly, time-consuming procedures. These approvals and registrations can require the submission of a large amount of clinical data which can be expensive +and may require significant time to obtain. It is also possible that a product will not perform at a level needed to generate the clinical data required to obtain approval or registration. The submission of an application to the FDA or other +regulatory authority does not guarantee that an approval or registration to market or import the product will be received. A regulatory authority may impose requirements as a condition to granting an approval or registration, may include significant +restrictions or limitations as part of any approval or clearance it grants and may delay or refuse to grant approval or registration, even though a product has been approved or registered without restrictions or limitations in another country or by +another agency. +All in vitro diagnostic products that are to be sold in the EU must bear the CE mark indicating conformance with the essential +requirements of the IVDD. We have obtained the CE mark for several of our existing products. We also intend to apply for CE marks for certain of our future products and are not aware of any material reason why we would be unable to obtain those +marks. However, there can be no assurance that compliance with all provisions of the IVDD will be demonstrated and the CE mark will be obtained or maintained for all products that we desire to sell in the EU. The failure to obtain or maintain the CE +mark for one or more of our products could lead to the termination of strategic alliances and agreements for sales of those products in the EU. +Our +Ability to Respond to Changes in Regulatory Requirements Could Adversely Affect Our Business. +Newly promulgated regulations could require changes to +our products, necessitate additional clinical trials or procedures, or make it impractical or impossible for us to market our products for certain uses, in certain +23 +Table of Contents +markets, or at all. In addition, the FDA and other regulatory authorities have the ability to change the requirements for obtaining product approval and/or impose new or additional requirements +as part of the approval process. These changes or new or additional requirements may occur after the completion of substantial clinical work and other costly development activities. The implementation of such changes or new or additional +requirements may result in additional clinical trials and substantial additional costs and could delay or make it more difficult or complicated to obtain product approvals. +Failure to Comply With FDA or Other Regulatory Requirements May Require Us to Suspend Production of Our Products or Institute a Recall Which Could Result +in Higher Costs and a Loss of Revenues. +Regulation by the FDA and other federal, state and foreign regulatory agencies impacts many aspects of our +operations, and the operations of our suppliers and distributors, including manufacturing, labeling, packaging, adverse event reporting, storage, advertising, promotion and record keeping. For example, our manufacturing facilities and those of our +suppliers and distributors are, or can be, subject to periodic regulatory inspections. The FDA and foreign regulatory agencies may require post-marketing testing and surveillance to monitor the performance of approved products or place conditions on +any product approvals that could restrict the commercial applications of those products. Regulatory agencies may impose restrictions on our or our distributors’ advertising and promotional activities or preclude these activities altogether if a +noncompliance is believed to exist. In addition, the subsequent discovery of previously unknown problems with a product may result in restrictions on the product, including withdrawal of the product from the market. We are also subject to routine +inspection by the FDA and other agencies for compliance with Quality System Requirement and Medical Device Reporting requirements in the United States and other applicable regulations worldwide, including but not limited to ISO regulations. +Failure to comply with the applicable requirements can result in, among other things, 483 notices, warning letters, administrative or judicially imposed +sanctions such as injunctions, civil penalties, recall or seizure of products, total or partial suspension of production, refusal to grant premarket clearance or PMA approval for devices, withdrawal of marketing clearances or approvals, or criminal +prosecution. The ability of our suppliers to supply critical components or materials and of our distributors to sell our products could also be adversely affected if their operations are determined to be out of compliance. Such actions by the FDA +and other regulatory bodies could adversely affect our revenues, costs and results of operations. +In the ordinary course of business, we must frequently +make subjective judgments with respect to compliance with applicable laws and regulations. If regulators subsequently disagree with the manner in which we have sought to comply with these regulations, we could be subjected to substantial civil and +criminal penalties, as well as product recall, seizure or injunction with respect to the sale of our products. The assessment of any civil and criminal penalties against us could severely impair our reputation within the industry and any limitation +on our ability to manufacture and market our products could have a material adverse effect on our business. +Our Inability to Manufacture Products in +Accordance With Applicable Specifications, Performance Standards or Quality Requirements Could Adversely Affect Our Business. +The materials and +processes used to manufacture our products must meet detailed specifications, performance standards and quality requirements to ensure our products will perform in accordance with their label claims, our customers’ expectations and applicable +regulatory requirements. As a result, our products and the materials used in their manufacture or assembly undergo regular inspections and quality testing. Factors such as defective materials or processes, mechanical failures, human errors, +environmental conditions, changes in materials or production methods by our vendors, and other events or conditions could cause our products or the materials used to produce or assemble our products to fail inspections and quality testing or +otherwise not perform in accordance with our label claims or the expectations of our customers. +24 +Table of Contents +Any failure or delay in our ability to meet the applicable specifications, performance standards, quality +requirements or customer expectations could adversely affect our ability to manufacture and sell our products or comply with regulatory requirements. These events could, in turn, adversely affect our revenues and results of operations. +We Are Subject to Numerous Government Regulations in Addition to FDA Requirements, Which Could Increase Our Costs and Affect Our Operations. +In addition to the FDA and other regulations described previously, laws and regulations in some states may restrict our ability to sell products in those +states. While we intend to work with state legislators and regulators to remove or modify any applicable restrictions, there is no guarantee we will be successful in these efforts. +We must also comply with numerous laws relating to such matters as safe working conditions, manufacturing practices, environmental protection, fire hazard +control, disposal of hazardous substances and labor or employment practices. Compliance with these laws or any new or changed laws regulating our business could result in substantial costs. Because of the number and extent of the laws and +regulations affecting our industry, and the number of governmental agencies whose actions could affect our operations, it is impossible to reliably predict the full nature and impact of these requirements. To the extent the costs and procedures +associated with complying with these laws and requirements are substantial or it is determined that we do not comply, our business and results of operations could be adversely affected. +Compliance With Regulations Governing Public Company Corporate Governance and Reporting is Complex and Expensive. +Many laws and regulations impose obligations on public companies, which have increased the scope, complexity and cost of corporate governance, reporting and +disclosure practices. Examples include the Sarbanes-Oxley Act of 2002, the requirements of The NASDAQ Global Market, The Dodd-Frank Wall Street Reform and Consumer Protection Act, the SEC’s requirements for public companies to provide financial +statements in interactive data format using the eXtensible Business Reporting Language (“XBRL”), and the International Financial Reporting Standards conversion requirements. Our implementation of certain aspects of these laws and +regulations has required and will continue to require substantial management time and oversight and may require us to incur significant additional accounting and legal costs. We continually evaluate and monitor developments with respect to new and +proposed rules and cannot predict or estimate the ultimate amount of additional costs we may incur or the timing of such costs. These laws and regulations are also subject to varying interpretations, in many cases due to their lack of specificity, +and as a result, their application in practice may evolve over time as new guidance is provided by regulatory and governing bodies. This could result in continuing uncertainty regarding compliance matters and higher costs necessitated by ongoing +revisions to disclosure and governance practices. Although we are committed to maintaining high standards of corporate governance and public disclosure, if we fail to comply with any of these requirements, legal proceedings may be initiated against +us, which may adversely affect our business. +Evolving Legislative, Judicial and Ethical Standards on the Use of Technology and Biotechnology Could +Affect Our Molecular Collection Systems Business. +The adoption of genetic testing is occurring within the broader context of a myriad of decisions +related to genetic patenting and genotyping. Issues associated with regulatory requirements, health insurance, data access, intellectual property protection, national and international legislative initiatives and other variables impact the +widespread adoption of genetic testing or specific segments or tests within the genetic testing market. These developments could impact sales of our molecular collection systems products. +25 +Table of Contents +Federal and State Laws Pertaining to Healthcare Fraud and Abuse Could Adversely Affect Our Business, Financial +Condition and Results of Operations. +We are subject to various federal and state laws targeting fraud and abuse in the healthcare industry, including +anti-kickback laws, false claims laws, and laws constraining the sales, marketing and other promotional activities of manufacturers of medical devices by limiting the kinds of financial arrangements we may enter into with physicians, hospitals, +laboratories and other potential purchasers of medical devices. Violations of these laws are punishable by criminal or civil sanctions, including substantial fines, imprisonment and exclusion from participation in government healthcare programs such +as Medicare and Medicaid. Many of the existing requirements are new and have not been definitively interpreted by state authorities or courts, and available guidance is limited. Unless and until we are in full compliance with these laws, we could +face enforcement action and fines and other penalties, and could receive adverse publicity, all of which could materially harm our business. In addition, changes in or evolving interpretations of these laws, regulations, or administrative or +judicial interpretations, may require us to change our business practices or subject our business practices to legal challenges, which could have a material adverse effect on our business, financial condition and results of operations. +Risks Relating to Our Industry, Business and Strategy +Our Ability to Sell Products Could be Adversely Affected by Competition From New and Existing Diagnostic Products. +The diagnostics industry is focused on the testing of biological specimens in a laboratory or at the point of care and is highly competitive and rapidly +changing. Many of our principal competitors have considerably greater financial, technical and marketing resources. As new products enter the market, our products may become obsolete or a competitor’s products may be more effective or more +effectively marketed and sold than ours. If we fail to maintain and enhance our competitive position, our customers may decide to use products developed by competitors which could result in a loss of revenues. +We also face competition from products that are sold at a lower price. Where this occurs, customers may choose to buy lower cost products from third parties +or we may be forced to sell our products at a lower price, both of which could result in a loss of revenues or a lower gross margin contribution from the sale of our products. We may also be required to increase our marketing efforts in order to +compete effectively, which would increase our costs. +Our Research, Development and Commercialization Efforts May Not Succeed and Our Competitors May +Develop and Commercialize More Effective or Successful Diagnostic Products. +In order to remain competitive, we must regularly commit substantial +resources to research and development and the commercialization of new or enhanced products. The research and development process generally takes a significant amount of time from product inception to commercial launch. This process is conducted in +various stages. During each stage there is a substantial risk that we will not achieve our goals on a timely basis, or at all, and we may have to abandon a new or enhanced product in which we have invested substantial time and money. +During 2013, 2012 and 2011, we incurred $10.9 million, $12.4 million and $18.4 million, respectively, in research and development expenses. We expect to +continue to incur significant costs related to our research and development activities. +Successful products require significant development and +investment, including testing to demonstrate their performance capabilities, cost-effectiveness or other benefits prior to commercialization. In addition, regulatory approval must be obtained before most products may be sold. Additional development +efforts on these products +26 +Table of Contents +may be required before any regulatory authority will review them. As noted above, regulatory authorities may not approve these products for commercial sale or may substantially delay or condition +approval. In addition, even if a product is developed and all applicable regulatory approvals are obtained, there may be little or no market for the product. Accordingly, if we fail to develop and gain commercial acceptance for our products, or if +competitors develop more effective products or a greater number of successful new products, customers may decide to use products developed by our competitors. This would result in a loss of revenues and adversely affect our results of operations, +cash flow and business. +Failure to Achieve Our Financial and Strategic Objectives Could Have a Material Adverse Impact on Our Business Prospects. +As a result of any number of risk factors identified in this Annual Report, no assurance can be given that we will be successful in implementing our +financial and strategic objectives, including our efforts to increase sales of our newest products, the OraQuick ® In-Home HIV test and the +OraQuick ® HCV test, or continue growing our molecular collection systems business. In addition, the funds for research, clinical development and other projects have in the past come primarily +from our business operations. If our business slows and we have less money available to fund research and development and clinical programs, we will have to decide at that time which programs to cut, and by how much. Similarly, if adequate +financial, personnel, equipment or other resources are not available, we may be required to delay or scale back our business. Our operations will be adversely affected if our total revenue and gross profits do not correspondingly increase or if our +technology, product, clinical and market development efforts are unsuccessful or delayed. Furthermore, our failure to successfully introduce new or enhanced products and develop new markets could have a material adverse effect on our business and +prospects. +If We Lose Our Key Personnel or Are Unable to Attract and Retain Qualified Personnel as Necessary, Our Business Could be Harmed. +Our success depends to a large extent upon the contributions of our executive officers, management and sales, marketing, operations and scientific staff. We +may not be able to attract or retain a sufficient number of qualified employees in the future due to the intense competition for qualified personnel among medical products and other life science businesses. We generally do not enter into employment +agreements requiring our employees to work for us for any specified period. +If we are not able to attract and retain the necessary personnel to +accomplish our business objectives, we may experience constraints that will adversely affect our ability to effectively manufacture, sell and market our products, to meet the demands of our strategic partners in a timely fashion, or to support +research, development and clinical programs. Although we believe we will be successful in attracting and retaining qualified personnel, competition for experienced scientists and other personnel from numerous companies and academic and other +research institutions may limit our ability to do so on acceptable terms. +Acquisitions or Investments May Not Generate the Expected Benefits and Could +Disrupt Our Ongoing Business, Distract Our Management, Increase Our Expenses and Adversely Affect Our Business. +We may enter into strategic +acquisitions or investments as a way to expand our business. These activities, and their impact on our business, are subject to many risks, including the following: +• +Suitable acquisitions or investments may not be found or consummated on terms or schedules that are satisfactory to us or consistent with our objectives; +• +The benefits expected to be derived from an acquisition may not materialize and could be affected by numerous factors, such as regulatory developments, insurance reimbursement, general economic conditions and increased +competition; +27 +Table of Contents +• +We may be unable to successfully integrate an acquired company’s personnel, assets, management systems, products and/or technology into our business; +• +Worse than expected performance of an acquired business may result in the impairment of intangible assets; +• +Acquisitions may require substantial expense and management time and could disrupt our business; +• +We may not be able to accurately forecast the performance or ultimate impact of an acquired business; +• +An acquisition and subsequent integration activities may require greater capital and other resources than originally anticipated at the time of acquisition; +• +An acquisition may result in the incurrence of unexpected expenses, the dilution of our earnings or our existing stockholders’ percentage ownership, or potential losses from undiscovered liabilities not covered by +an indemnification from the seller(s) of the acquired business; +• +An acquisition may result in the loss of our or the acquired company’s key personnel, customers, distributors or suppliers; and +• +An acquisition of a foreign business may involve additional risks, including, but not limited to, foreign currency exposure, liability or restrictions under foreign laws or regulations, and our inability to successfully +assimilate differences in foreign business practices or overcome language or cultural barriers. +The occurrence of one or more of the above +or other factors may prevent us from achieving all or a significant part of the benefits expected from an acquisition or investment. This may adversely affect our financial condition, results of operations and ability to grow our business or +otherwise achieve our financial and strategic objectives. +Our Revenues Could be Affected by Third-Party Reimbursement Policies and Potential Cost +Constraints. +The end-users of our products include hospitals, physicians and other healthcare providers. Use of our products could be adversely +impacted if end-users do not receive adequate reimbursement for the cost of our products from their patients’ healthcare insurers or payors. Our net sales could also be adversely affected by changes in reimbursement policies of governmental or +private healthcare payors, including in particular the level of reimbursement for our products. +In the United States, healthcare providers such as +hospitals and physicians who purchase diagnostic products generally rely on third-party payors, such as private health insurance plans, Medicare and Medicaid, to reimburse all or part of the cost of the product and procedure. The overall escalating +cost of medical products and services has led to, and will continue to lead to, increased pressures on the healthcare industry, both foreign and domestic, to reduce the cost of products and services. Given the efforts to control and reduce +healthcare costs in the United States in recent years, currently available levels of reimbursement may not continue to be available in the future for our existing products or products under development. Third-party reimbursement and coverage may not +be available or adequate in either the United States or international markets, current reimbursement amounts may be decreased in the future and future legislation, and regulation or reimbursement policies of third-party payors, may reduce the demand +for our products or our ability to sell our products on a profitable basis. In addition, consolidation among healthcare providers or other participants in the healthcare industry is occurring and has resulted, and may continue to result, in fewer, +more powerful healthcare groups with increased purchasing power and the ability to drive down the prices paid for our products. +28 +Table of Contents +Changes in Healthcare Regulation Could Affect Our Revenues, Costs and Financial Condition. +In recent years, there have been numerous initiatives at the federal and state level for comprehensive reforms affecting the payment for, the availability of +and reimbursement for healthcare services in the United States. These initiatives have ranged from proposals to fundamentally change federal and state healthcare reimbursement programs, including providing comprehensive healthcare coverage to the +public under government-funded programs, to minor modifications to existing programs. One example is the Patient Protection and Affordable Care Act, the Federal healthcare reform law enacted in 2010 (“Affordable Care Act”). Similar reforms +may occur internationally. +Legislative and regulatory bodies are likely to continue to pursue healthcare reform initiatives and may continue to reduce +funding in an effort to lower overall federal healthcare spending. The ultimate content and timing of any healthcare reform legislation and its resulting impact on us are impossible to predict. If significant reforms are made to the healthcare +system in the United States, or in other jurisdictions, those reforms may increase our costs or otherwise have an adverse effect on our financial condition and results of operations. +The new Affordable Care Act imposes a 2.3% excise tax on certain transactions, including U.S. sales of many medical devices, which includes domestic sales of +certain of our products. This new tax became effective in January 2013. It is unclear whether and to what extent other unanticipated developments resulting from the Affordable Care Act, such as an increase in the number of people with health +insurance, will provide us with additional revenue to help offset this tax. If such additional revenue does not materialize or our efforts to offset the excise tax through spending cuts, price increases or other actions are unsuccessful, the +increased tax burden will adversely affect our financial performance. +New or Changed Testing Guidelines Could Affect Sales of Our Diagnostic Products. +From time to time, governmental agencies such as the Centers for Disease Control and Prevention (“CDC”) issue diagnostic testing guidelines +or recommendations, which can affect the usage of our HIV and HCV testing products. In addition, some states have promulgated, or may in the future promulgate, laws and regulations that affect HIV or HCV testing. The issuance of new laws or +guidelines, or changes in existing laws or guidelines, and the manner in which these new or changed laws and guidelines are interpreted and applied by healthcare practitioners, could impact the degree to which our OraQuick ® rapid HIV and HCV testing products are used. New or changed laws or guidelines could affect the number of people tested, the frequency of testing and whether testing products such as our OraQuick ® HIV and HCV tests are used broadly for screening large populations or in a more limited capacity as a confirmatory test or otherwise. These factors could in turn affect the level of sales of our +products and our results of operations. +Reductions in Government Funding and Research Budgets Could Adversely Affect Our Business and Financial +Results. +We sell our OraQuick ADVANCE ® HIV-1/2 test and our OraQuick ® HCV test into the public health market which consists of state, county and other governmental public health agencies, community based organizations, service organizations and similar entities. We +also sell these products into the hospital market, including to hospitals owned or operated by agencies of the U.S. government. Many of these customers depend to a significant degree on grants or funding provided by governmental agencies to run +their operations including programs that use our products. In international markets, we often sell our products to or through foreign governmental agencies or parties funded by such agencies. +Our subsidiary, DNAG, sells many of its products to researchers at academic institutions, pharmaceutical and biotechnology companies, government laboratories +and private foundations. Many of DNAG’s research customers are dependent for their funding on grants from U.S. governmental agencies such as the U.S. National Institutes of Health and agencies in other countries. +29 +Table of Contents +The level of available government grants or funding in the U.S. and elsewhere is unpredictable and may be +affected by various factors including the current economic downturn, future economic conditions, legislative and regulatory developments, political changes, civil unrest and changing priorities for research and development activities. Any reduction +or delay in government funding could cause our customers to delay, reduce or forego purchases of our products. +In August 2011, President Obama signed +into law the Budget Control Act of 2011, which was designed to reduce federal spending over the next 10 years by $2.5 trillion. Under that law, a select committee of Congress was tasked with identifying and recommending $1.2 trillion in spending +cuts by late November 2011. Because the committee did not agree on spending cuts within that time frame, certain automatic cuts to discretionary, national defense and Medicare spending became effective on March 1, 2013. We cannot predict +whether Congress will attempt to suspend or restructure the automatic budget cuts or what other deficit reduction initiatives may be proposed by Congress. Although their full impact is uncertain, the spending cuts implemented under this law have +adversely affected and are expected to continue to adversely affect our customers’ ability to purchase our products. In addition, other legislative or regulatory changes may be adopted which could adversely affect our ability to sell our +current products or successfully develop and commercialize new products. +Increases in Demand for Our Products Could Require Us to Expend Considerable +Resources or Harm Our Customer Relationships if We are Unable to Meet That Demand. +If we experience significant or unexpected increases in the demand +for our products, we and our suppliers may not be able to meet that demand without expending additional capital resources. These capital resources could involve the cost of new machinery or new manufacturing facilities. This would increase our +capital costs, which could adversely affect our earnings. Our suppliers may be unable or unwilling to expend the necessary capital resources or otherwise expand their capacity. In addition, new manufacturing equipment or facilities may require FDA +approval before they can be used to manufacture our products. To the extent we are unable to obtain or are delayed in obtaining such approvals, our ability to meet the demand for our products could be adversely affected. +If we or our suppliers are unable to develop necessary manufacturing capabilities in a timely manner, our sales could be adversely affected. If we fail to +increase production volumes in a cost effective manner or if we experience lower than anticipated yields or production problems as a result of changes that we or our suppliers make in our manufacturing processes to meet increased demand, we could +experience shipment delays or interruptions and increased manufacturing costs, which could also have a material adverse effect on our revenues and profitability. +Unexpected increases in demand for our products may require us to obtain additional raw materials in order to manufacture products to meet the demand. Some +raw materials require significant ordering lead time and some are currently obtained from a sole supplier or a limited group of suppliers. We have long-term supply agreements with certain of these suppliers, but these long-term agreements involve +risks for us, such as our potential inability to obtain an adequate supply of raw materials and components and our reduced control over pricing, quality and timely delivery. It is also possible that one or more of these suppliers may become +unwilling or unable to deliver materials to us. Any shortfall in our supply of raw materials and components, or our inability to quickly and cost-effectively obtain alternative sources for this supply, could +have a material adverse effect on our ability to meet increased demand for our products. This could negatively affect our total revenues or cost of sales and related profits. +Our inability to meet customer demand for our products could also harm our customer relationships and impair our reputation within the industry. This, in +turn, could have a material adverse effect on our business and prospects. +30 +Table of Contents +We Rely on Information Technology in Our Operations and Any Material Failure, Inadequacy, Interruption or +Security Breach of that Technology Could Harm Our Ability to Efficiently Operate Our Business. +We rely heavily on information technology systems +across our operations and on the internet, including for management of inventory, purchase orders, invoices, shipping, interactions with our third-party logistics provider, revenue and expense accounting, online business and various other processes +and transactions. Our ability to effectively manage our business, coordinate the production, distribution and sale of our products and ensure the timely and accurate recording and disclosure of financial information depends significantly on the +reliability and capacity of these systems and the internet. +The failure of these systems to operate effectively, problems with transitioning to upgraded +or replacement systems, a breach in security of these systems through a cyber attack or otherwise, or disruptions in the operation of the internet, could cause delays in product sales and reduced efficiency of our operations. Significant capital +investments could be required to remediate any such problem. Security breaches of employee information or other confidential or proprietary data could also adversely impact our reputation, and could result in litigation against us or the imposition +of penalties. +Risks Relating to Collaborators +The Use of Sole Supply Sources or Third-Party Suppliers For Critical Components of Our Products Could Adversely Affect Our Business. +We currently purchase certain critical components of our products from sole supply sources or other third-party suppliers. For example, the biological +antigens, nitrocellulose and certain other components required to make our OraQuick ADVANCE ® HIV-1/2 test, OraQuick ® In-Home HIV +test and OraQuick ® HCV test are currently purchased from sole source suppliers. Our OraSure QuickFlu™ test is manufactured and supplied by a sole source supplier and the conjugates used +in our MICROPLATE oral fluid drugs-of-abuse assays are obtained from third party suppliers. +In addition, our subsidiary, DNAG, uses two third-party +manufacturers to supply virtually all of its products, including its Oragene ® line of collection kits. Many of the raw materials and components used in its products are also purchased from +third parties, a critical one of which is obtained from a sole source supplier. +If our third-party suppliers are unable or unwilling to supply or +manufacture a required component or product or if they make changes to a component, product or manufacturing process or do not supply materials meeting our specifications, we may need to find another source and/or manufacturer. This could require +that we perform additional development work. We may also need to obtain FDA or other regulatory approvals for the use of an alternative component or for changes to our products or manufacturing process. Completing that development and obtaining such +approvals could require significant time and expense and such approvals may not occur at all. The availability of critical components and products from sole supply sources or other third parties could also reduce our control over pricing, quality +and timely delivery. These events could either disrupt our ability to manufacture and sell certain of our products into one or more markets or completely prevent us from doing so, and could increase our costs. Any such event could have a material +adverse effect on our results of operations, cash flow and business. +Our Failure to Maintain Existing Distribution Channels, or Develop New +Distribution Channels, May Result in Lower Revenues. +We have marketed many of our products by collaborating with laboratories, diagnostic companies +and distributors. Our sales depend to a substantial degree on our ability to sell products to these customers and on the marketing and distribution abilities of the companies with which we collaborate. +31 +Table of Contents +Relying on distributors or others to market and sell our products could harm our business for various reasons, +including: +• +Our distributors or other customers may not fulfill their contractual obligations to us or otherwise market and distribute our products in the manner or at the levels we expect; +• +We do not control the incentives provided by our distributors to their sales personnel and the effectiveness of these incentives could affect sales of our products; +• +Agreements with distributors may terminate prematurely due to disagreements or may result in litigation between the parties; +• +We may not be able to renew existing distribution agreements on acceptable terms or at all; +• +Our distributors may not devote sufficient resources or priority to the sale of our products; +• +Our existing distributor relationships or contracts may preclude or limit us from entering into arrangements with other distributors; and +• +We may not be able to negotiate future distribution agreements on acceptable terms or at all. +Although we +will try to maintain and expand our business with distributors and customers and require that they fulfill their contractual obligations, there can be no assurance that such companies will do so or that new distribution channels will be available on +satisfactory terms. As a result, our revenues and business could be adversely affected. +The Unavailability of an FDA-Approved HIV-1 EIA Screening Test +Distributed by a Third Party Could Adversely Affect Sales of Our OraSure ® Oral Fluid Collection Device. +In testing an oral fluid sample collected with an OraSure ® device for HIV-1 in the United States, our +customers must use an HIV-1 EIA screening test approved by the FDA for use with our OraSure ® collection device. There is currently only one company, Avioq, Inc., that manufactures and sells +such an FDA-approved screening test. If at some point in the future our customers cannot purchase the Avioq HIV-1 EIA or otherwise obtain an HIV-1 EIA screening test that has been approved by the FDA for use with our OraSure ® collection device, sales of our OraSure ® device could be negatively affected. +We May Need Strategic Partners to Assist in Developing and Commercializing Some of Our Diagnostic Products. +Although we may elect to pursue some product opportunities independently, opportunities that require a technology controlled by a third party, a significant +level of investment for development and commercialization or a distribution network beyond our existing sales force may necessitate involving one or more strategic partners. Our strategy for development and commercialization of products may entail +entering into arrangements with distributors or other corporate partners, universities, research laboratories, licensees and others. Relying on collaborative relationships could be risky to our business for a number of reasons, including: +• +We may be required to transfer material rights to such strategic partners, licensees and others; +• +Our collaborators may not devote sufficient resources or attach a sufficiently high priority to the success of our collaboration; +• +Our collaborators may not obtain regulatory approvals necessary to continue the collaborations in a timely manner; +• +Our collaborators may be acquired by another company, decide to terminate our collaborative arrangement or become insolvent; +32 +Table of Contents +• +Our collaborators may develop technologies or components competitive with our products; +• +Disagreements with collaborators could result in the termination of the relationship or litigation; +• +Collaborators may not have sufficient capital resources; and +• +We may not be able to negotiate future collaborative arrangements, or renewals of existing collaborative agreements, on acceptable terms or at all. +While we generally expect that our collaborative partners will have an economic motivation to succeed in performing their contractual responsibilities, there +is no assurance that they will do so and the amount and timing of resources to be devoted to these activities will be controlled by others. Consequently, there can be no assurance that any revenues or profits will be derived from such arrangements. +Actions of Third-Party Inventory Management and Logistics Providers Could Adversely Affect Our Ability to Supply Products to Our Customers. +We use third-party logistics providers to store and manage our finished goods inventory and ship finished product to our customers. We have selected highly +reputable providers with extensive experience in the logistics field for these services. However, in the event any of our providers lose or damage our products, experience a casualty or catastrophic event at a warehouse or otherwise fail to provide +safe storage and timely handling and delivery of our products, we could incur additional costs, experience difficulty in supplying our products to our customers or suffer damage to our reputation in the industry. These events could, in turn, reduce +our revenues and adversely affect our results of operations. +Risks Relating to Intellectual Property +Our Success Depends on Our Ability to Protect Our Proprietary Technology. +The diagnostics industry places considerable importance on obtaining patent, trademark and trade secret protection, as well as other intellectual property +rights, for new technologies, products and processes. Our success depends, in part, on our ability to develop and maintain a strong intellectual property portfolio or obtain licenses to patents and technologies both in the United States and in other +countries. If we cannot continue to develop, obtain and protect intellectual property rights, our revenue and gross profits could be adversely affected. Moreover, our current and future licenses or other rights to patents and other technologies may +not be adequate for the operation of our business. +As appropriate, we intend to file patent applications and obtain patent protection for our proprietary +technology. These patent applications and patents will cover, as applicable, compositions of matter for our products, methods of making those products, methods of using those products and apparatus relating to the use or manufacture of those +products. However, there have been recent changes to the patent laws and proposed changes to the rules of the U.S. Patent and Trademark Office, which may impact our ability to protect our technology and enforce our intellectual property rights. For +example, in September 2011, the U.S. enacted sweeping changes to the U.S. patent system under the Leahy-Smith America Invents Act, including changes that would transition the U.S. from a “first-to-invent” system to a +“first-to-file” system and alter the processes for challenging issued patents. These changes could increase the uncertainties and costs surrounding the prosecution of our patent applications and the enforcement or defense of our issued +patents. +We also rely on trade secrets, know-how and continuing technological advancements to protect our proprietary technology. We have entered, and +will continue to enter, into confidentiality agreements with our employees, consultants, advisors and collaborators. Our employees and third-party consultants also sign agreements +33 +Table of Contents +requiring that they assign to us interests in inventions and original expressions and any patents or copyrights arising from their work. However, these parties may not honor these agreements. +We cannot guarantee that the process of filing patents, the laws governing trade secrets and proprietary information, or any agreements we enter into +with employees, consultants, advisors or collaborators will provide adequate protection of our intellectual property rights. For example, employees, consultants and others who participate in the development of our products may breach their +agreements with us regarding our intellectual property, and we may not have adequate remedies for the breach. We also may not be able to effectively protect our intellectual property rights in some foreign countries, as many countries do not offer +the same level of legal protection for intellectual property as the United States. Furthermore, for a variety of reasons, we may decide not to file for patent, copyright or trademark protection outside of the U.S. Our trade secrets could become +known through other unforeseen means. Notwithstanding our efforts to protect our intellectual property, our competitors may independently develop similar or alternative technologies or products that are equal or superior to our technology. Our +competitors may also develop similar products without infringing on any of our intellectual property rights or design around our proprietary technologies. +Moreover, issued patents remain in effect for a fixed period and after expiration will not provide protection of the inventions they cover. Once our patents +expire, we may be faced with increased competition, which could reduce our revenues. We may also not be able to successfully protect our rights to unpatented trade secrets and know-how. +Some of our employees, including scientific and management personnel, were previously employed by competing companies. Although we encourage and expect all of +our employees to abide by any confidentiality agreement with a prior employer, competing companies may allege trade secret violations and similar claims against us. +We may collaborate with universities and governmental research organizations which, as a result, may acquire part of the rights to any inventions or technical +information derived from our collaboration with them. +To facilitate development and commercialization of a proprietary technology base, we may need to +obtain licenses to patents or other proprietary rights from other parties. Obtaining and maintaining such licenses may require the payment of substantial amounts. In addition, if we are unable to obtain these types of licenses, our product +development and commercialization efforts may be delayed or precluded. +We May Become Involved in Intellectual Property Disputes, Which Could Increase +our Costs and Limit or Eliminate Our Ability to Sell Products or Use Certain Technologies. +From time to time, we may seek to enforce our patents or +other intellectual property rights through litigation. In addition, there are a large number of patents and patent applications in our product areas, and additional patents may be issued to third parties relating to our product areas. We or our +customers may be sued for infringement of patents or misappropriation of other intellectual property rights with respect to one or more of our products. Litigation in our industry regarding patent and other intellectual property rights is prevalent +and is expected to continue. We may also have disputes with parties that license patents to us if we believe the license is no longer needed for our products or the licensed patents are no longer valid or enforceable. +Our industry is characterized by a large number of patents, and the claims of these patents appear to overlap in many cases. As a result, there is a +significant amount of uncertainty regarding the extent of patent protection and infringement. Companies may have pending patent applications, which are typically confidential for the first eighteen months following filing, that cover technologies we +incorporate in our products. Accordingly, we may be subjected to substantial damages for past infringement or be required to modify our products or stop selling them if it is ultimately determined that our products infringe a third party’s +proprietary rights. In addition, governmental agencies could commence investigations or criminal proceedings against our employees or us relating to claims of misuse or misappropriation of another party’s proprietary rights. +34 +Table of Contents +Our involvement in litigation or other legal proceedings with respect to patents or other intellectual property +and proprietary technology, either as a plaintiff or defendant, could adversely affect our revenues, market share, results of operations and business because: +• +As is common with major litigation, it could consume a substantial portion of managerial and financial resources; +• +Its outcome would be uncertain and a court may find that our patents are invalid or unenforceable in response to claims by another party or that the third-party patent claims are valid and infringed by our products; +• +An adverse outcome could subject us to the loss of the protection of our patents or to liability in the form of past royalty payments, penalties, reimbursement of litigation costs and legal fees, special and punitive +damages, or future royalty payments, any of which could significantly affect our future earnings; +• +Failure to obtain a necessary license upon an adverse outcome could prevent us from selling our current products or other products we may develop or acquire; +• +The pendency of any litigation may in and of itself cause our distributors and customers to reduce or terminate purchases of our products; and +• +A court could award a preliminary and/or permanent injunction, which would prevent us from selling our current or future products. +We may indemnify some customers and strategic partners under our agreements with such parties if our products or activities have actually or allegedly +infringed upon, misappropriated or misused another party’s proprietary rights. Further, our products may contain technology provided to us by other parties, such as contractors, suppliers or customers, and we may have little or no ability to +determine in advance whether such technology infringes the intellectual property rights of a third party. These other parties may also not be required or financially able to indemnify us in the event that an infringement or misappropriation claim is +asserted against us. +We may also become involved in other types of disputes regarding intellectual property rights, including state, federal or foreign +court litigation, and patent interference, patent reexamination, patent reissue, or trademark opposition proceedings in the United States Patent and Trademark Office. Opposition or revocation proceedings could be instituted in a foreign patent +office as well. An adverse decision in any proceeding regarding intellectual property rights could result in the loss or limitation of our rights to a patent, an invention or trademark. +The Sales Potential for Our OraQuick ® Products Could be Affected by Our Ability to Obtain Certain +Licenses and by Future Litigation. +Our OraQuick ® test platform is a lateral flow assay that +tests for specific antibodies or other substances. The term “lateral flow” generally refers to a test strip through which a sample flows and which provides a test result on a portion of the strip downstream from where the sample is +applied. There are numerous patents in the United States and other countries which claim lateral flow assay methods and devices. There are also patents that cover the type of analyte or antibody (i.e., HIV-1, HIV-2, HCV, etc.) which our OraQuick ® test is designed to detect. Some of these patents may broadly cover the aspects of our OraQuick ® test and are in force in the United +States and other countries. We may not be able to make or sell the OraQuick ® test in the United States or other countries where these patents are in force. +We have obtained licenses under several lateral flow patents, and patents covering assays directed at specific analytes, which we believe are sufficient to +permit the manufacturing and sale of the OraQuick ® device as currently contemplated. However, licenses under additional patents may be required and it is possible that a third party could seek +to enforce one or more patents against us. +35 +Table of Contents +If we are unable to successfully defend against or resolve patent infringement litigation or it is determined +that a license is required and it is not possible to negotiate or otherwise obtain a license agreement on reasonable terms under a necessary patent, our ability to manufacture and sell +OraQuick ® devices and develop and commercialize new applications using the same technology could be limited and we may incur increased costs or damages. In such case, we may be able to modify +the OraQuick ® test to avoid the claim of infringement or the need for a license. However, this alternative could preclude or limit our ability to sell the OraQuick ® test in the United States and other markets, which would adversely affect our results of operations, cash flow and business. +Risks Relating to Products, Marketing and Sales +Our Future Success Depends Upon Market Acceptance of Our Existing and Future Products. +Our future success will depend, in part, on the market acceptance, and the timing of such acceptance, of new products such as our OraQuick ® HCV test, our OraQuick ® In-Home HIV test, and other new products or technologies that may be developed or acquired. To achieve market +acceptance, we and/or our distributors will likely be required to undertake substantial marketing efforts and spend significant funds to inform potential customers and the public of the existence and perceived benefits of these products. In +addition, governmental funding for the purchase of our products may be needed to help create market acceptance and expand the use of our products. +There +may be limited evidence on which to evaluate the market reaction to products that may be developed and our marketing efforts for new products may not be successful. It is also possible that governmental funding may be limited for new products, such +as our OraQuick ® HCV test. As such, there can be no assurance that any products will obtain significant market acceptance and fill the market need that is perceived to exist on a timely basis, +or at all. +If Acceptance and Adoption of Oral Fluid Testing and Collection Products Does Not Continue, Our Future Results May Suffer. +We have made significant progress in gaining acceptance of oral fluid testing products, particularly for (i) HIV testing in the public health, hospital, +insurance and other markets, and (ii) drugs-of-abuse testing in the workplace and criminal justice markets. Our subsidiary, DNAG, has also made significant progress in gaining acceptance of oral fluid collection products that are used with +molecular testing applications. However, the degree of acceptance for these products is uncertain, and one or more markets may resist the adoption of oral fluid products as a replacement for other testing or collection methods in use today. As a +result, there can be no assurance that we will be able to expand the use of our oral fluid testing products in these or other markets. +Our Customers +May Resist Adoption of Rapid Point-of-Care Diagnostic Testing. +Sales of our rapid point-of-care diagnostic products, such as our OraQuick +ADVANCE ® HIV-1/2 and OraQuick ® HCV tests, are an important part of our business. Rapid point-of-care tests are beneficial to +healthcare providers because, among other things, they can be administered by providers in their own facilities without sending samples to central laboratories and can help ensure that test results are delivered to the individuals being tested. +However, clinical reference laboratories and hospital-based laboratories currently provide the majority of diagnostic tests used by physicians and other +healthcare providers in the U.S. In certain international markets such as Europe, diagnostic testing is performed primarily by centralized laboratories. Our future sales will depend, in part, on our ability to expand market acceptance of rapid +point-of-care testing by physicians and other healthcare providers and successfully compete against laboratory testing methods and products. We expect that clinical reference and other hospital-based laboratories will continue to compete vigorously +against our rapid point-of-care products. Even if we can demonstrate that our products are more cost effective, save time, or have +36 +Table of Contents +better performance or other benefits, physicians and other healthcare providers may resist changing to rapid point-of-care tests and instead may choose to use competing laboratory tests. Our +failure to achieve and expand market acceptance of our rapid point-of-care diagnostic tests with customers would have a negative effect on our future sales growth. +We Expect to Face Intense Competition From Other Providers of Diagnostic Tests and Sample Collection Products. +Our rapid point-of-care tests compete with similar point-of-care products made by our competitors. This competition is particularly evident with respect to +our OraQuick ADVANCE ® HIV-1/2 test. In addition, the Oragene ® product line sold by our subsidiary, DNAG, competes against other +molecular collection products, such as blood collection kits and buccal swabs. There are a number of competitors making investments in competing technologies and products, and a number of our competitors may have a competitive advantage because of +their greater financial, technical, research and other resources. Some competitors offer broader product lines, aggressively discount prices for their products and may have greater name recognition than we have. If our competitors’ products +take market share from our products through more effective marketing or competitive pricing, our revenues, margins and operating results could be adversely affected. In addition, our revenues and operating results could be negatively impacted if +some of our customers internally develop or acquire their own sample collection devices and use those devices in place of our products in order to reduce costs. +Our Future Growth Depends, In Part, on Our Ability to Commercialize the OraQuick ® In-Home HIV +Test. +Our future growth will depend, in part, on our ability to commercialize and market the +OraQuick ® In-Home HIV test in the OTC market. Successful commercialization of the OraQuick ® In-Home HIV test will depend +on a number of factors, including achieving widespread awareness and adoption of the product among the targeted consumer base, initiating and maintaining relationships with suppliers and retailers, reducing the use of security devices and other +barriers to purchase in retail stores, protecting against and effectively responding to any claims by holders of patents and other intellectual property rights that our OTC product infringes their rights, obtaining and maintaining sufficient +inventory of the product, the performance of our toll-free customer support center and our comprehensive consumer website relating to the product, and our ability to successfully market the product at the projected selling price. There can be no +assurance that we will be successful in these endeavors. Because of the need to build broad awareness for this new product, our advertising and marketing expenditures have been substantial. If we continue advertising and marketing expenditures +consistent with historic levels, our operating results will be negatively impacted unless we are successful in substantially increasing sales of this product. Conversely, if we decide to reduce these expenditures, our costs will be lower but sales +of our OraQuick ® In-Home test could be adversely impacted. In addition, retailers generally have broad product return rights which may be exercised if sufficiently high sales to consumers are +not achieved. Successful commercialization of this product will also depend on whether any unanticipated adverse effects result from use of the product, or unfavorable publicity develops in respect of the product, as well as the emergence of new or +existing products as competition, which are proven to be more clinically or cost-effective. +Sales of Our OraSure QuickFlu™ Test May be Affected +by Factors Beyond Our Control. +We sell a rapid flu test under the tradename OraSure QuickFlu™, primarily in the U.S. hospital and public health +markets. A number of factors that are beyond our control could affect sales of this product, including: +• +Variability in the timing of the onset, length and severity of the flu season, which typically occurs from November of one year to May of the following year; +• +Competition from other rapid flu tests in the markets we serve; +37 +Table of Contents +• +Deficiencies in the manufacture, design or performance of the product or failure by the manufacturer to meet applicable quality and regulatory standards; +• +The inability of our supplier to provide sufficient quantities of the product; +• +Changes in the types or strains of influenza during a particular flu season; +• +Lower than expected market penetration of the OraSure QuickFlu™ test; and +• +Our inexperience in selling a rapid flu test. +Our Inability to Carry Out Certain of Our Marketing and +Sales Plans May Make it Difficult for Us to Grow or Maintain Our Business. +We have implemented in the past, and we intend to implement in the future, +an aggressive sales and marketing plan to expand sales of our products. Specifically, we will continue to expand the impact of our direct field sales force, use third-party distributors and manufacturers’ sales representatives, and implement +other sales and marketing programs. If we are unable to successfully implement these programs or modify these programs in response to evolving market and economic conditions, we may be unable to grow and our business could suffer. +Our Sales Cycles Can be Lengthy, and May Depend on Public Funding, Which Can Cause Variability and Unpredictability in Our Operating Results. +The sales cycles for certain of our products can be lengthy and unpredictable, which makes it more difficult to accurately forecast revenues in a given period +and may cause revenues and operating results to vary from period to period. Sales of our products often involve purchasing decisions by large public and private institutions, may require many levels of approval and may be dependent on economic or +political conditions and the availability of grants or funding from governmental or public health agencies which can vary from period to period in both amount and timing. For example, in past years our OraQuick ADVANCE ® HIV-1/2 test has been purchased through bulk procurement or other funding provided by governmental agencies. Our OraQuick ® HCV test has +been purchased by customers who receive government funding, and we believe increased funding from the CDC and other agencies will be required to substantially increase the volume of HCV testing, especially in the public health market. There can be +no assurance that purchases or funding from these agencies will occur or continue, especially if current negative economic conditions continue or intensify. As a result, we may expend considerable resources on unsuccessful sales efforts or we may +not be able to complete transactions at all or on a schedule and in an amount consistent with our objectives. +We May Face Product Liability Claims for +Injuries Resulting From the Use of Our Products. +We may be held liable if any of our products, or any product which is made with the use or +incorporation of any of our technologies, causes injury of any type or is found otherwise unsuitable during product testing, manufacturing, marketing, sale or usage. There is no assurance that we would be successful in defending any product +liability lawsuits brought against us. Regardless of merit or eventual outcome, product liability claims could result in: +• +Decreased demand for our products; +• +Lost revenues; +• +Damage to our image or reputation; +• +Costs related to litigation; +• +Diversion of management time and attention; and +• +Incurrence of damages payable to plaintiffs. +38 +Table of Contents +We are selling cryosurgical products in the consumer or OTC market in certain countries and we may expand OTC +sales of these products into other countries. We also launched the OraQuick ® In-Home HIV test in the United States OTC market, and we are considering the expansion of this product +internationally. We believe the sale of products in the OTC market increases our potential exposure to product liability and other claims. +The +Insurance We Purchase to Cover Our Potential Business Risks May be Inadequate. +Although we believe that our present product liability and other +insurance coverage is sufficient to cover our current estimated exposures, we cannot be sure that we will not incur liabilities in excess of our policy limits. In addition, although we believe that we will be able to continue to obtain adequate +coverage in the future, there is no assurance that we will be able to do so at acceptable costs. +We Could Suffer Monetary Damages, Incur Substantial +Costs or be Prevented From Using Technologies Important to Our Products as a Result of Legal Proceedings. +We have been and in the future may become +involved in various legal proceedings arising out of our businesses. These may include commercial disputes, negligence claims or various other lawsuits arising in the ordinary course of our business, including employment matters. Such lawsuits can +seek damages, sometimes in substantial amounts, for commercial or personal injuries allegedly suffered and can include claims for punitive or other special damages. An adverse ruling or rulings in one or more such lawsuits could, individually or in +the aggregate, result in the termination or modification of a material contract or otherwise have a material adverse effect on our sales, operations or financial performance. +Performance of Our Products May Affect Our Revenues, Stock Price and Reputation. +Our products are generally sold with labeling that contains performance claims approved or cleared by the FDA or other regulators. However, our products may +not perform as expected. For example, a defect in one of our diagnostic products or a failure by a customer to follow proper testing procedures, may cause the product to report inaccurate information such as a false positive result or a false +negative result. A false positive or negative result can also occur even when there is no apparent product defect and the customer has apparently used our product properly. Identifying the root cause of a product performance or quality issue can be +difficult and time consuming. +If our products fail to perform in accordance with the applicable label claims or otherwise in accordance with the +expectations or needs of our customers, customers may switch to a competing product or otherwise stop using our products, and our revenues could be adversely affected. Under such circumstances, we may be required to implement shipment holds or +product recalls and incur warranty obligations, which would increase our costs. In addition, poor performance by one or more of our products and publicity surrounding such performance could have an adverse effect on our reputation, our continuing +ability to sell products and the prevailing market price of our Common Stock. +Our International Presence May Increase Our Risks and Expose Our +Business to Regulatory, Cultural or Other Restraints. +We seek to increase revenue derived from international sales of our products. Our international +sales accounted for $21.7 million or 22% of consolidated net revenues in 2013, $20.3 million or 23% of consolidated net revenues in 2012 and $14.2 million or 17% of consolidated net revenues in 2011. In addition, our molecular collection systems +business, which accounted for $20.4 million or 21% of consolidated net revenues in 2013, is operated in Canada. +39 +Table of Contents +A number of factors could adversely affect the performance of our business and/or cause us to incur substantially +increased costs because of our international presence and sales, including those set forth below: +• +Uncertainty in the application of foreign laws and the interpretation of contracts with foreign parties; +• +The potential for inconsistent imposition of legal and regulatory requirements; +• +Cultural and political differences that favor local competitors or make it difficult to effectively market, sell and gain acceptance of our products; +• +Inexperience in international markets and territories and difficulties in staffing and managing foreign operations; +• +Exchange rates, currency fluctuations, tariffs and other barriers, extended payment terms and dependence on international distributors or representatives; +• +Regulatory requirements (including compliance with applicable customs regulations) and the need for reimbursement approvals; +• +The inability to obtain or maintain ISO certification for our or our suppliers’ manufacturing facilities; +• +Our inability to obtain or maintain regulatory approvals or registrations for our products; +• +Our inability to identify international distributors and negotiate acceptable terms for distribution agreements; +• +Diversion to the U.S. of our products sold at lower prices into international markets; +• +The loss of one or more distributors and difficulties or delays in obtaining new or transferred product registrations or approvals for use by a replacement distributor; +• +The creditworthiness of foreign distributors and customers and difficulty in collecting foreign accounts receivable; +• +Difficulty of enforcing contractual obligations or recovering damages under foreign legal systems; +• +Economic conditions, political instability, the absence of available funding sources, terrorism, civil unrest, war and natural disasters in foreign countries; +• +Our exposure to liability under the Foreign Corrupt Practices Act and various other laws, rules and/or regulations applicable to us as a result of our international sales; +• +Long sales cycles in international markets, especially for sales to foreign governments, quasi-governmental agencies and international public health agencies; +• +The sale of competing products by foreign competitors at prices at or below the prices we offer for our products; +• +Restrictions on our ability to repatriate investments and earnings from foreign operations; +• +Changes in shipping costs; +• +The unavailability of licenses to certain patents in force in a foreign country which cover our products; and +• +Reduced protection for, or enforcement of, our patents and other intellectual property rights in foreign countries. +40 +Table of Contents +In addition, we have contracted with a third party in Thailand for the manufacture of a portion of our OraQuick ® HIV-1/2 tests, and all of DNAG’s products are produced in Canada. In addition, the Histofreezer ® cryosurgical product sold in +international markets is currently manufactured by a third party in The Netherlands. We may enter into agreements to manufacture these or other products in additional foreign countries as well. However, economic, cultural and political conditions +and foreign regulatory requirements may slow or prevent the manufacture of our products in countries other than the United States. Interruption of the supply of our products could reduce revenues or cause us to incur significant additional expenses +in finding an alternative source of supply. Foreign currency fluctuations and economic conditions in foreign countries could also increase the costs of manufacturing our products in foreign countries. +Risks Relating to the Economy, Our Financial Results, Investments, Credit Facilities and Need for Financing +Continued Economic Volatility and Disruption Could Adversely Affect Our Results of Operations, Cash Flow and Financial Condition or Those of Our Customers +and Suppliers. +Current volatile economic conditions may continue for the foreseeable future and intensify. These conditions have adversely affected +and could continue to adversely affect our financial performance and condition or those of our customers and suppliers. These circumstances could adversely affect our access to liquidity needed to conduct or expand our business or conduct future +acquisitions or make other discretionary investments. Many of our customers rely on public funding provided by federal, state and local governments, and this funding has been and may continue to be reduced or deferred as a result of economic +conditions. These circumstances may adversely impact our customers and suppliers, which, in turn, could adversely affect their ability to purchase our products or supply us with necessary equipment, raw materials or components. Even with the +improvement of economic conditions, it may take time for our customers and suppliers to establish new budgets and return to normal purchasing and shipping patterns. We cannot predict the reoccurrence of any economic slowdown or the strength or +sustainability of the economic recovery. +We Have a History of Losses and May Not Be Able to Achieve Sustained Profitability. +We have experienced annual net losses since 2008. In addition, as of December 31, 2013, the Company had an accumulated deficit of $173.7 million. Even +though we achieved profitability a number of years ago, there can be no assurance that we will be able to achieve or sustain profitability in the future. +Our ability to achieve and sustain profitability in the future will be dependent upon a number of factors including, without limitation, the following: +• +Creating market acceptance for and selling increasing volumes of our OraQuick ADVANCE ® HIV-1/2 test and our OraQuick ® HCV test in the United States and internationally; +• +Our ability to successfully commercialize our OraQuick ® In-Home HIV test and the magnitude of promotional costs related to this product; +• +The success and revenue growth of our molecular collection systems business; +• +The level of expenditures we are required to make in order to develop, obtain regulatory approvals for and successfully commercialize our new products; +• +Our ability to successfully launch new products after receipt of required regulatory approvals or the acquisition of rights to those products; +• +The degree to which our major distributors comply with their contractual obligations, including minimum purchase commitments; +• +Whether we are successful in obtaining and maintaining required regulatory approvals and registrations for our new products; +41 +Table of Contents +• +Changes in the level of competition, such as would occur if larger and financially stronger competitors introduced new or lower priced products to compete with our products; +• +Changes in economic conditions in domestic or international markets, such as economic downturns, reduced demand, inflation and currency fluctuations; +• +Failure to achieve our targets for growth in revenues; +• +Changes in distributor buying patterns or a buildup of significant quantities in our distributors’ inventories or distribution channels; and +• +The costs and results of patent infringement, product liability and other litigation or claims asserted against us. +We May Experience Fluctuations in Our Financial Results or Fail to Meet Our Financial Projections. +Our operating results can fluctuate from quarter to quarter and year to year, which could cause our growth or financial performance to fall below the +expectations of investors and securities analysts. Our financial projections for future periods are based on a number of assumptions, including estimated demand for our products. However, sales to our distributors and other customers may fall short +of expectations because of lower than estimated customer demand or other factors, including continued volatility and disruption in economic conditions, increasing competition, reduced governmental funding and other circumstances described elsewhere +in this Annual Report. Infrequent, unusual or unexpected changes in revenues or costs could also contribute to the variability of our financial results. In addition, our products provide different contributions to our gross margin. Accordingly, our +operating results could also fluctuate and be affected by the mix of products sold and the relative prices and gross margin contribution of those products. Failure to achieve operating results consistent with the expectations of investors and +securities analysts could adversely affect our reputation and the price of our Common Stock. +Our Estimates or Judgments Relating to Critical +Accounting Policies Are Based on Assumptions That Can Change or Prove to be Incorrect. +Our discussion and analysis of financial condition and results +of operations is based on our financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of financial statements in conformity with generally accepted accounting +principles requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. On an ongoing basis, we evaluate significant estimates used in preparing our financial statements, +including those related to: +• +Revenue recognition; +• +Potential impairment of long-lived and intangible assets including goodwill; +• +Customer sales returns and allowances; +• +Allowance for uncollectible accounts receivable; +• +Reserve for inventory write-downs; +• +Stock-based compensation; +• +Income taxes; and +• +Contingencies. +We base our estimates on historical experience and on various other assumptions that we +believe to be reasonable under the circumstances, as provided in our discussion and analysis of financial condition and results of +42 +Table of Contents +operations, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may +differ from these and other estimates if our assumptions change or if actual circumstances differ from those in our assumptions, which could cause our operating results to fall below the expectations of securities analysts and investors, resulting +in a decline in our stock price. +Changes in Foreign Currency Exchange Rates Could Negatively Affect Our Operating Results. +Our financial statements are stated in U.S. Dollars and, historically, most of our international sales have also been denominated in U.S. Dollars. As a +result, in the past our exposure to foreign currency exchange rate risk has not been material. Nonetheless, these sales are subject to currency risks, since changes in the values of foreign currencies relative to the value of the U.S. dollar can +render our products comparatively more expensive. These exchange rate fluctuations could negatively impact international sales of our products, as could changes in the general economic conditions in those markets. +In addition, the revenues and operating results of our subsidiary, DNAG, are recorded in Canadian Dollars and certain of its international sales are +denominated in local currencies, including the Euro, British Pound and Australian Dollar. In 2013, DNAG reported total revenues of U.S. $20.4 million. Our expectation is that the DNAG business will continue to grow and our exposure to foreign +currency exchange rates may be more significant than in past years. +Exchange rate fluctuations may affect DNAG’s revenues and expenses and the +translation of DNAG’s financial results into U.S. Dollars. Unfavorable currency exchange rate fluctuations could negatively affect our consolidated financial statements including our balance sheet, revenues and results of operations. In the +past, we have not generally entered into hedging instruments to manage our currency exchange rate risk, but we may need to do so in the future. However, our attempts to hedge against these risks may not be successful. If we are unable to +successfully hedge against unfavorable foreign currency exchange rate movements, our consolidated financial results may be adversely impacted. +Changes +in Tax Laws or Their Application Could Adversely Affect Our Results of Operations. +Changes in tax laws or their application could increase our costs +and adversely affect our results of operations. Such changes could affect applicable tax rates, utilization of tax loss carryforwards, and treatment of inter-company debt and interest payments. +We May Require Future Additional Capital. +Our future +liquidity and ability to meet our future capital requirements will depend on numerous factors, including, but not limited to, the following: +• +The costs and timing of expansion of sales and marketing activities; +• +The timing and success of the commercial launch of new products; +• +The extent to which we gain or expand market acceptance for existing, new or enhanced products; +• +The costs and timing of the expansion of our manufacturing capacity; +• +The success of our research and product development efforts; +• +The time, cost and degree of success of conducting clinical trials and obtaining regulatory approvals; +• +The magnitude of capital expenditures; +43 +Table of Contents +• +Changes in existing and potential relationships with distributors and other business partners; +• +The costs involved in obtaining and enforcing patents, proprietary rights and necessary licenses; +• +The costs and liability associated with patent infringement or other types of litigation; +• +Competing technological and market developments; and +• +The scope and timing of strategic acquisitions. +If additional financing is needed, we may seek to raise funds +through the sale of equity or other securities or through bank borrowings. There can be no assurance that financing through the sale of securities, bank borrowings or otherwise will be available to us on satisfactory terms, or at all. +Terrorist Attacks or Natural Disasters May Adversely Affect Our Business. +Terrorist attacks or natural disasters, and subsequent governmental responses to these events, could cause economic instability. These actions could adversely +affect economic conditions both within and outside the United States and reduce demand for our products. These events could disrupt the operations of our customers and suppliers and eliminate, reduce or delay our customers’ ability to purchase +and use our products and our suppliers’ ability to provide raw materials and finished products. +Although we have business interruption insurance, +our facilities, including some pieces of manufacturing equipment and our computer systems, may be difficult to replace and could require substantial replacement lead-time. Various types of disasters, including earthquakes, fires, floods and acts of +terrorism, may affect our manufacturing facilities and computer systems. In the event our existing manufacturing facilities or computer systems are affected by man-made or natural disasters, we may have difficulty operating our business and may be +unable to manufacture products for sale or meet customer demands or sales projections. If our manufacturing operations were curtailed or shut down entirely, it would seriously harm our business. +Risks Relating to Our Common Stock +Our Stock Price Could Continue to be Volatile. +Our +stock price has been volatile, has fluctuated substantially in the past, may be volatile in the future and could experience substantial declines. The following factors, among others, could have a significant impact on the market for our Common +Stock: +• +Future announcements concerning us and our products, including with respect to significant acquisitions, strategic collaborations and joint ventures; +• +The performance of our business, including our efforts to commercialize the OraQuick ® In-Home HIV test and increase sales +of our HCV testing and molecular collection systems products; +• +Clinical results with respect to our products or those of our competitors; +• +The status of clinical studies and pending submissions for required regulatory approvals; +• +The announcement of regulatory or enforcement actions by the FDA or other agencies against us, our products or one or more of our customers; +• +The gain or loss of significant contracts and availability of funding for the purchase of our products; +44 +Table of Contents +• +Delays in the development, regulatory approval or commercialization of new or enhanced products; +• +Legislative developments and industry or competitive trends; +• +Disputes or developments with key customers, distributors or suppliers; +• +Developments in patent or other proprietary rights; +• +Litigation or threatened litigation; +• +Complaints or concerns about the performance or safety of our products and publicity about those issues, including publicity expressed through social media or otherwise over the internet; +• +Failure to achieve, or changes in, financial estimates by securities analysts and comments or opinions about us by securities analysts or major stockholders; +• +Governmental regulation; +• +Changes in the level of competition; +• +Loss of or declines in sales to major distributors or customers or changes in the mix of products sold; +• +The relatively low trading volume for our Common Stock; +• +Period-to-period fluctuations in our operating results; +• +Additions or departures of key personnel; +• +General market and economic conditions; and +• +Terrorist attacks, civil unrest, war and national disasters. +In addition, the stock market in general has +experienced extreme price and volume fluctuations that have affected the market price of our Common Stock, as well as the stock of many companies in the diagnostics and life sciences industries. Often, price fluctuations are unrelated to the +operating performance of the specific companies whose stock is affected. +In the past, following periods of volatility in the market price of a +company’s stock, securities class action litigation has occurred against the issuing company. If we were subject to this type of litigation in the future, we could incur substantial costs and a diversion of our management’s attention and +resources, each of which could have a material adverse effect on our revenue and earnings. Any adverse determination in this type of litigation could also subject us to significant liabilities. +Future Sales of Our Common Stock by Existing Stockholders, Executive Officers or Directors Could Depress the Market Price of Our Common Stock and Make It +More Difficult For Us to Sell Stock in the Future. +Sales of our Common Stock in the public market, or the perception that such sales may occur, could +negatively impact the market price of our Common Stock. We are unable to estimate the number of shares of our Common Stock that may actually be resold in the public market since this will depend on the market price for our Common Stock, the +individual circumstances of the sellers and other factors. +We have a number of institutional stockholders that own significant blocks of our Common +Stock. If one or more of these stockholders sell large portions of their holdings in a relatively short time, for liquidity or other reasons, the prevailing market price of our Common Stock could be negatively affected. In addition, it is possible +that one or more of our executive officers or non-employee members of our Board of Directors could sell shares of our +45 +Table of Contents +Common Stock during an open trading window or pursuant to a 10b5-1 sales plan under our Insider Trading Policy. These transactions and the perceived reasons for these transactions could have a +negative effect on the prevailing market price of our Common Stock. +Investor Confidence and Share Value May be Adversely Impacted if We and/or Our +Independent Registered Public Accounting Firm Conclude That Our Internal Control Over Financial Reporting is Not Effective. +As directed by +Section 404 of the Sarbanes-Oxley Act of 2002, the SEC adopted rules requiring us, as a public company, to include a report in our Annual Reports on Form 10-K that contains an assessment by management of the effectiveness of our internal +control over financial reporting. In addition, our independent registered public accounting firm must report on the effectiveness of these internal controls. +We expect that our internal controls will continue to evolve as our business activities change. Although we seek to diligently and vigorously review our +internal control over financial reporting in an effort to ensure compliance with the Section 404 requirements, any control system, regardless of how well designed, operated and evaluated, can provide only reasonable, not absolute, assurance +that its objectives will be met. In addition, the overall quality of our internal controls may be affected by the internal control over financial reporting implemented by any business we acquire and our ability to assess and successfully integrate +the internal controls of any such business. +If, during any year, our independent registered public accounting firm is not satisfied with our internal +control over financial reporting or the level at which our controls are documented, designed, operated, tested or assessed, or if the independent registered public accounting firm interprets the requirements, rules or regulations differently than we +do, then it may issue a report that is qualified. We also could conclude that our internal control over financial reporting is not effective. These events could result in an adverse reaction in the financial marketplace due to a loss of investor +confidence in the reliability of our financial statements and effectiveness of our internal controls, which ultimately could negatively impact the market price of our Common Stock. +Because We Do Not Intend to Pay Cash Dividends on Our Common Stock, an Investor in Our Common Stock Will Benefit Only if it Appreciates in Value. +We currently intend to retain our current earnings and future earnings, if any, to finance the expansion of our business and do not expect to pay any cash +dividends on our Common Stock in the foreseeable future. As a result, the success of an investment in our Common Stock will depend entirely upon any future appreciation. There is no guarantee that our Common Stock will appreciate in value or even +maintain the price at which investors purchased their shares. +Certain Provisions in Our Certificate of Incorporation and Bylaws and Under Delaware Law +Could Make a Third-Party Acquisition of Us Difficult. +Our Certificate of Incorporation and Bylaws contain provisions that could make it more +difficult for a third party to acquire us, even if doing so would be beneficial to our stockholders. We are also subject to certain provisions of Delaware law that could delay, deter or prevent a change in control of us. These provisions could limit +the price investors might be willing to pay in the future for shares of our Common Stock. +Future Sales of Shares of Our Common Stock Could Adversely +Affect the Trading Price of Our Common Stock and Our Ability to Raise Funds in New Equity Offerings. +Future sales of a substantial number of our +shares of Common Stock or equity-related securities in the public market or privately, or the perception that such sales may occur, could adversely affect prevailing trading prices +46 +Table of Contents +of our Common Stock, and could impair our ability to raise capital through future offerings of equity or equity-related securities. No prediction can be +made as to the effect, if any, that future sales of shares of Common Stock or the availability of shares of Common Stock for future sale will have on the trading price of our Common Stock. +ITEM 1B. +Unresolved Staff Comments. +Not Applicable. +ITEM 2. +Properties. +We own a 48,000 square foot facility which is OraSure’s primary corporate office and +manufacturing facility, a 31,700 square foot facility that houses our sales and marketing, research and development, human resources, and regulatory and quality offices, and a 33,500 square foot facility which is used for manufacturing activities. +Each of these facilities is located in Bethlehem, Pennsylvania. We also rent additional warehouse space on an as-needed basis. In addition, our subsidiary, DNAG, leases a 23,500 square foot facility in Ottawa, +Canada, which is used as its primary corporate office and houses sales and marketing, research and development, and regulatory and quality operations. +We +believe that the facilities described above are adequate for our current requirements. +ITEM 3. +Legal Proceedings. +Employment Termination Claim +In August 2012, DNA Genotek Inc. (“DNAG”) received a Statement of Claim filed by a former employee with the Ontario Superior Court of Justice +alleging, among other things, that DNAG had wrongfully terminated this individual and had breached the terms of his employment. In so doing, DNAG is also alleged to have violated this individual’s rights under the Ontario Human Rights Code. The +Statement of Claim is seeking to recover in excess of $500,000 CDN in damages from DNAG. A Statement of Defence denying the allegations was filed by DNAG in October 2012. DNAG has also served discovery requests on the complainant but has not yet +received any response. We believe the claims asserted by the complainant are without merit and DNAG intends to vigorously defend this matter. +ITEM 4. +Mine Safety Disclosures. +Not Applicable. +47 +Table of Contents +PART II +ITEM 5. +Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities. +Market Information +Our Common Stock is listed for trading +on the Global Select Market tier of The Nasdaq Stock Market LLC (“NASDAQ”) under the symbol OSUR. High and low sales prices reported by NASDAQ during the periods indicated are shown below. +Year ended December 31, +2013 +2012 +High +Low +High +Low +First Quarter +$ +7.52 +$ +5.25 +$ +11.78 +$ +9.17 +Second Quarter +5.45 +3.75 +12.28 +8.90 +Third Quarter +6.46 +3.86 +14.01 +9.39 +Fourth Quarter +7.25 +5.64 +11.34 +6.56 +On March 6, 2014, there were 436 holders of record and approximately 13,000 holders in street name of our Common Stock, and +the closing price of our Common Stock was $8.13 per share. +Dividends +We have never paid any cash dividends and our Board of Directors does not anticipate paying cash dividends in the foreseeable future. We intend to retain any +future earnings to provide funds for the operation and expansion of our business. +Share Repurchases and Retirements +Pursuant to our Stock Award Plan and in connection with the vesting of restricted shares, we retired 124 shares to satisfy minimum tax withholding obligations +during the three months ended December 31, 2013. No shares were repurchased under our $25.0 million share repurchase program during the same period. +48 +Table of Contents +Performance Graph +The performance graph set forth below shall not be deemed “soliciting material” or “filed” for purposes of Section 18 of the +Securities Exchange Act of 1934, as amended (the “Exchange Act”), or otherwise subject to liability under that Section. This graph will not be deemed “incorporated by reference” into any filing under the Securities Act of 1933, +as amended, or the Exchange Act, whether such filing occurs before or after the date hereof, regardless of any general incorporation language in such filing . +The following graph compares the cumulative total returns to investors in the Company’s Common Stock, the NASDAQ Composite Index and the NASDAQ +Biotechnology Index for the period from December 31, 2008 through December 31, 2013. The graph assumes that $100 was invested on December 31, 2008 in the Company’s Common Stock and in each of the above-mentioned indices, and that +all dividends, if any, were reinvested. +The NASDAQ Composite Index was chosen because it is a broad index of companies whose equity securities are traded +on NASDAQ. The NASDAQ Biotechnology Index was chosen because it includes a number of our competitors. Stockholders are cautioned that the graph shows the returns to investors only as of the dates noted and may not be representative of the returns +for any other past or future period. +12/08 +12/09 +12/10 +12/11 +12/12 +12/13 +OraSure Technologies, Inc. +100.00 +138.04 +156.25 +247.55 +195.11 +170.92 +NASDAQ Composite +100.00 +144.84 +170.58 +171.34 +200.03 +283.43 +NASDAQ Biotechnology +100.00 +104.67 +112.89 +127.04 +169.50 +288.38 +49 +Table of Contents +ITEM 6. +Selected Consolidated Financial Data +The following table sets forth selected +consolidated financial data of the Company. This information should be read in conjunction with the consolidated financial statements and notes thereto included in Item 15 and the information set forth in Item 7, “Management’s +Discussion and Analysis of Financial Condition and Results of Operations.” +Selected Consolidated Financial Data +(In thousands, except per share data) +Years ended December 31, +2013 +2012 +2011 (4) +2010 +2009 +Operating Results: +Net revenues +$ +98,940 +(1) +$ +87,820 +$ +81,881 +$ +75,015 +$ +77,026 +Costs and expenses +111,102 +(2) +104,090 +91,278 +78,369 +85,819 +Operating loss +(12,162 +) +(16,270 +) +(9,397 +) +(3,354 +) +(8,793 +) +Other income (expense), net +200 +(242 +) +(313 +) +(143 +) +357 +Income tax benefit +(772 +) +(1,397 +) +(869 +) +— +(622 +) +Net loss +(11,190 +) +(15,115 +) +(8,841 +) +(3,497 +) +(7,813 +) +Basic and diluted loss per share +$ +(0.20 +) +$ +(0.29 +) +$ +(0.19 +) +$ +(0.08 +) +$ +(0.17 +) +Shares used in computing basic and diluted loss per share +55,555 +51,457 +46,908 +46,187 +45,878 +Cash Flow: +Cash flows provided by (used in) operating activities +$ +8,385 +(2) +$ +(5,373 +) +$ +(2,994 +) +$ +3,887 +$ +(293 +) +December 31, +2013 +2012 (3) +2011 (4) +2010 +2009 +Financial Position: +Cash, cash equivalents, and short-term investments +$ +93,191 +$ +87,888 +$ +23,878 +$ +75,738 +$ +79,670 +Working capital +100,590 +103,483 +30,860 +77,808 +89,435 +Total assets +184,245 +191,439 +127,861 +122,520 +126,991 +Long-term debt, excluding current portion +— +— +— +— +7,792 +Accumulated deficit +(173,731 +) +(162,541 +) +(147,426 +) +(138,585 +) +(135,088 +) +Stockholders’ equity +161,146 +170,315 +100,250 +102,843 +103,807 +(1) +Includes a non-recurring net favorable $2.5 million adjustment to account for a change in the Company’s revenue recognition policy related to its OraQuick ® +In-Home HIV tests. +(2) +Includes an $8.3 million gain from the termination of the Company’s oral fluid assay collaboration with Roche Diagnostics, which was recorded as a reduction of operating expenses in the current period. +(3) +We received net proceeds of $70.2 million from a secondary stock offering of 6,100,000 common shares completed on July 11, 2012. +(4) +Includes the results of DNA Genotek, Inc. from the acquisition date of August 17, 2011, as well as $2.6 million of transaction costs associated with the acquisition. +50 +Table of Contents +ITEM 7. +Management’s Discussion and Analysis of Financial Condition and Results of Operations. +Statements below regarding future events or performance are “forward-looking statements” within the meaning of the Private Securities Litigation +Reform Act of 1995. Our actual results could be quite different from those expressed or implied by the forward-looking statements. Factors that could affect results are discussed more fully under the Item 1A, entitled “Risk Factors,” +and elsewhere in this Annual Report. Although forward-looking statements help to provide complete information about us, readers should keep in mind that forward-looking statements may not be reliable. Readers are cautioned not to place undue +reliance on the forward-looking statements. We undertake no duty to update any forward-looking statements made herein after the date of this Annual Report. +The following discussion should be read in conjunction with the consolidated financial statements contained herein and the notes thereto, along with the +Section entitled “Critical Accounting Policies and Estimates,” set forth below. +Overview +We develop, manufacture, market and sell oral fluid diagnostic products and specimen collection devices using our proprietary oral fluid technologies, as well +as other diagnostic products including immunoassays and other in vitro diagnostic tests that are used on other specimen types. Our diagnostic products include tests that are performed on a rapid basis at the point of care and tests that are +processed in a laboratory. In September 2012, we began selling our OraQuick ® In-Home HIV test, the first and only rapid point-of-care HIV test approved for use in the domestic consumer retail +market. We also manufacture and sell oral fluid collection devices used to collect, stabilize, and store samples of genetic material for molecular testing in the clinical genetic testing, academic research, pharmacogenomics, personalized medicine, +and animal genetics markets. Lastly, we manufacture and sell medical devices used for the removal of benign skin lesions by cryosurgery, or freezing. Our products are sold in the United States and internationally to various clinical laboratories, +hospitals, clinics, community-based organizations and other public health organizations, research and academic institutions, distributors, government agencies, physicians’ offices, and commercial and industrial entities. Our over-the-counter +(“OTC”) HIV and cryosurgery products are sold to retail pharmacies and mass merchandisers and to consumers over the internet. +Current +Consolidated Financial Results +During the year ended December 31, 2013, our consolidated net revenues were $98.9 million compared to $87.8 +million for the year ended December 31, 2012. Net product revenues during the year ended December 31, 2013 increased 15% when compared to 2012, primarily due to sales of our +OraQuick ® In-Home HIV test, which was commercially launched during the third quarter of 2012. In December 2013, we recorded a favorable non-recurring $2.5 million net revenue adjustment to +account for a change in the revenue recognition policy associated with this product. Also contributing to the increased net revenues for the year were higher sales from our molecular collection systems business, and higher international sales of our +OraQuick ® HCV and HIV tests. Licensing and product development revenues for 2013 decreased 70% primarily as a result of the absence of a $1.0 million milestone payment received in the first +quarter of 2012 related to the achievement of certain regulatory and commercial objectives pursuant to the terms of our HCV collaboration agreement with Merck. No similar payment was received during 2013 because the collaboration agreement with +Merck was terminated in November 2012. +Our consolidated net loss for the year ended December 31, 2013 was $11.2 million, or $0.20 per share, +compared to a net loss of $15.1 million, or $0.29 per share, for the year ended December 31, 2012. Our loss for the current period included $18.8 million in advertising and promotional expenses associated with our OraQuick ® In-Home HIV test, as compared to $9.9 million of similar expenses in 2012. Our current period loss also included an $8.3 million gain (recorded as a reduction to operating expenses) for a +settlement payment received for the termination of our assay collaboration with Roche Diagnostics. +51 +Table of Contents +Cash provided by operating activities for the year ended December 31, 2013 was $8.4 million, compared to +$5.4 million used during the year ended December 31, 2012 and included the $8.3 million settlement payment from Roche. As of December 31, 2013, we had $93.2 million in cash and cash equivalents compared to $87.9 million at +December 31, 2012. +2013 Developments +OraQuick ® In-Home HIV Test Revenue Recognition Change +We began selling our OraQuick ® In-Home HIV test in the third quarter of 2012. From launch through +November 2013, our revenue practices with respect to the OraQuick ® In-Home HIV test were different than those customarily used in the consumer package goods industry. Under U.S. generally +accepted accounting principles, product revenue cannot be recognized unless the amount of future returns can be reasonably estimated. Because our OraQuick ® In-Home HIV test was a new product +for which we did not have a historical record of returns, we did not believe we could reasonably determine a return rate. As a result, we initially did not recognize revenue when we shipped to the retail trade. For these product shipments, we +invoiced the retailer or distributor, recorded deferred revenue at the gross invoice sales price, and classified the cost basis of the product held by the retailer or distributor as a component of inventory. We then recognized revenue upon the +consummation of a sale to the retail customer either in a store or over the internet. +With the passage of time, however, we concluded that we have +sufficient data and visibility into our distribution channel to develop a reasonable estimate of the level of expected returns. As such, commencing in December 2013, we recognized previously deferred revenue and its related cost of goods sold, and +began to recognize revenue for this product upon shipment to the retailers or distributors. For the year ended December 31, 2013, we recorded net revenues of $9.1 million related to our +OraQuick ® In-Home HIV test. Included in these net revenues was a $2.7 million gross revenue adjustment made in December 2013 to recognize previously deferred revenue, reduced by an estimated +allowance for expected returns of $206,000. +Drugs-of-Abuse Assay Collaboration Agreements +On November 21, 2013, we terminated our assay collaboration agreement with Roche Diagnostics. Under the termination agreement, Roche paid us $8.3 million +which was recorded as a reduction of operating expense on our consolidated statement of operations. Roche agreed to provide certain transitional product support services and will continue to supply certain of the assays developed under the +collaboration on a transitional basis for up to five years following the termination. We have the right to stop the supply of assays prior to the end of this five-year period and could receive an additional payment from Roche of up to $5.5 million +depending on how early in that five-year period the supply authorization is ended. +Concurrently with the termination of our agreement with Roche, we +entered into a new agreement with Thermo Fisher for the development and supply of up to 12 homogeneous fully-automated oral fluid drugs-of-abuse assays. These assays will be used with a new version of our Intercept ® collection device. Under this new agreement, a NIDA-5 panel of assays is expected to be initially sold with our new Intercept ® device in +the domestic criminal justice and forensics markets beginning in the second half of 2014. Eventually, the parties expect to complete development of several more assays and obtain FDA 510(k) clearance and approvals in certain foreign countries. The +assays will be optimized as needed to comply with new oral fluid guidelines expected to be issued by the SAMHSA for the federally-regulated market and certain other markets that follow Federal drug testing guidelines, none of which are currently +served by OraSure. +HCV Screening Grade Change +In +June 2013, the U.S. Preventive Services Task Force (“USPSTF”) issued new recommendations giving HCV screening for both at-risk individuals and individuals born between 1945 and 1965 a ‘B’ grade. Under the +52 +Table of Contents +Affordable Care Act, preventive services that have received an “A” or “B” grade from the USPSTF must be covered by insurance policies without cost-sharing and will be part of +essential health benefits for those individuals eligible for Medicare. These recommendations became effective in January 2014 and are expected to have a positive impact on testing for HCV over time, including with our OraQuick ® HCV rapid antibody test. +Economic Outlook +Many of our customers rely on public funding provided by federal, state and local governments, and this funding has been and may continue to be reduced or +deferred as a result of current economic conditions. These circumstances may adversely impact our customers and suppliers, which, in turn, could adversely affect their ability to purchase our products or supply us with necessary equipment, raw +materials or components. In addition, these circumstances could adversely affect our access to liquidity that may be needed to conduct or expand our business, conduct future acquisitions or make other discretionary investments. +On August 2, 2011, President Obama signed into law the Budget Control Act of 2011, which was designed to reduce federal spending over the next 10 years +by $2.5 trillion. Under that law, a select committee of Congress was tasked with identifying and recommending $1.2 trillion in spending cuts by late November 2011. Because the committee did not agree on spending cuts within that time frame, certain +automatic cuts to discretionary, national defense and Medicare spending (often referred to as Federal sequestration) became effective on March 1, 2013. We cannot predict whether Congress will attempt to suspend or restructure the automatic +budget cuts or what other deficit reduction initiatives may be proposed by Congress. Although their full impact is difficult to ascertain, the spending cuts implemented under this law have adversely affected, and are expected to continue to +adversely affect our customers’ ability to purchase our products. In addition, other legislative or regulatory changes may be adopted which could adversely affect our ability to sell our current products or successfully develop and +commercialize new products. +Business Segments +We +operate our business within two reportable segments: our “OSUR” business, which consists of the development, manufacture and sale of oral fluid diagnostic products, specimen collection devices, and medical devices used for the removal of +benign skin lesions by cryosurgery; and our “DNAG” or molecular collection systems business, which consists primarily of the development, manufacture and sale of oral fluid collection devices that are used to collect, stabilize, and store +samples of genetic material for molecular testing. OSUR revenues are derived primarily from products sold into the United States and internationally to various clinical laboratories, hospitals, clinics, community-based organizations, public health +organizations, distributors, government agencies, physicians’ offices, and commercial and industrial entities. Revenues from OSUR’s OTC products primarily result from sales to retail pharmacies and mass merchandisers and to consumers over +the internet. OSUR also derives revenues from licensing and product development activities. DNAG revenues result primarily from products sold into the commercial market, which consists of companies and other entities engaged in consumer genetics, +clinical genetic testing, pharmacogenomics, personalized medicine, and animal genetic testing, as well as products sold into the academic research market, which consists of research laboratories, universities and hospitals. +53 +Table of Contents +Results of Operations +Year Ended December 31, 2013 Compared to December 31, 2012 +CONSOLIDATED NET REVENUES +The table +below shows the amount of total net product revenues generated by each of our business segments and net revenues generated by licensing and product development activities (dollars in thousands). +Year Ended December 31, +Dollars +Percentage of Total +Net Revenues +2013 +2012 +% +Change +2013 +2012 +OSUR +$ +77,936 +$ +71,495 +9 +% +78 +% +82 +% +DNAG +20,381 +14,258 +43 +21 +16 +Net product revenues +98,317 +85,753 +15 +99 +98 +Licensing and product development +623 +2,067 +(70 +) +1 +2 +Net revenues +$ +98,940 +$ +87,820 +13 +% +100 +% +100 +% +Consolidated net revenues increased 13% to $98.9 million in 2013 from $87.8 million in 2012. Net product revenues increased +15% during the year ended December 31, 2013 when compared to the year ended December 31, 2012, primarily as a result of higher sales of our infectious disease testing and molecular collection systems products. These increases were +partially offset by lower sales of our substance abuse testing, insurance risk assessment, and cryosurgical systems products. Licensing and product development revenues decreased in the current year compared to the prior year primarily as a result +of the absence of a $1.0 million milestone payment received in the first quarter of 2012 related to the achievement of certain regulatory and commercial objectives pursuant to the terms of our HCV collaboration agreement with Merck. No similar +payment was received during 2013 because the collaboration agreement with Merck was terminated in November 2012. +Consolidated net revenues derived from +products sold to customers outside the U.S. were $21.7 million and $20.3 million, or 22% and 23% of total net revenues, for the years ended December 31, 2013 and 2012, respectively. Because the majority of our international sales are +denominated in U.S. dollars, the impact of fluctuating foreign currency exchange rates was not material to our total net revenues. +54 +Table of Contents +Net Revenues by Segment +OSUR Segment +The table below shows +the amount of total net revenues generated by our OSUR segment in each of our principal markets and by licensing and product development activities (dollars in thousands). +Year Ended December 31, +Dollars +% +Change +Percentage of Total +Net Revenues +Market +2013 +2012 +2013 +2012 +Infectious disease testing +$ +50,961 +$ +42,728 +19 +% +65 +% +58 +% +Substance abuse testing +8,571 +9,407 +(9 +) +11 +13 +Cryosurgical systems +14,468 +14,876 +(3 +) +18 +20 +Insurance risk assessment +3,936 +4,484 +(12 +) +5 +6 +Net product revenues +77,936 +71,495 +9 +% +99 +97 +% +Licensing and product development +623 +2,067 +(70 +) +1 +3 +Net revenues +$ +78,559 +$ +73,562 +7 +% +100 +% +100 +% +Infectious Disease Testing Market +Sales to the infectious disease testing market increased 19% to $51.0 million in 2013 from $42.7 million in 2012, primarily due to sales of our OraQuick ® In-Home HIV test and higher sales of our OraQuick ® HCV and HIV products in international markets. +The table below shows a breakdown of our total net OraQuick ® revenues (dollars in thousands) during +2013 and 2012. +Year Ended December 31, +Market +2013 +2012 +% +Change +Domestic HIV +$ +32,301 +$ +34,265 +(6 +)% +International HIV +3,365 +3,061 +10 +Domestic OTC HIV +9,106 +546 +1,568 +Net HIV revenues +44,772 +37,872 +18 +Domestic HCV +2,847 +2,805 +1 +International HCV +2,268 +1,059 +114 +Net HCV revenues +5,115 +3,864 +32 +Net OraQuick ® revenues +$ +49,887 +$ +41,736 +20 +% +Domestic OraQuick ® HIV sales decreased 6% to $32.3 million in 2013 +from $34.3 million in 2012. This decrease was primarily caused by competition from other rapid and automated laboratory-based HIV tests and reductions in government funding. We expect that sales of our professional HIV product will continue to be +challenged by these factors in future periods. International sales of our OraQuick ® HIV test increased 10% to $3.4 million in 2013 from $3.1 million in 2012 primarily as a result of higher +sales in Mexico, Africa, and Europe. +In 2013, we recorded $9.9 million in gross revenues from sales of our OraQuick ® In-Home HIV test, including $2.7 million ($2.5 million, net of estimated returns) of previously deferred gross revenue recognized in December 2013 when we changed our revenue recognition policy +for this product. These gross revenues were +55 +Table of Contents +partially offset by $764,000 in customer allowances, including cooperative advertising, cash discounts, and other allowances, which were netted against gross revenues in accordance with U.S. +generally accepted accounting principles. Sales during 2013 also included approximately $701,000 of direct sales to certain public health customers compared to $19,000 in 2012. We anticipate that some public health entities may continue to use a +portion of their funding to purchase our OTC product in lieu of our or a competitor’s professional rapid HIV testing product. +We began shipping our +OraQuick ® In-Home HIV test to the retail outlets at the end of September 2012. In 2012, we recorded $902,000 in gross revenues from product sales to retail customers either in a store or over +the internet. These revenues were offset by $356,000 in customer allowances, including cooperative advertising, cash discounts, and other allowances. +Domestic OraQuick ® HCV sales remained flat at $2.8 million in 2013 and 2012. International sales of +our OraQuick ® HCV test increased 114% to $2.3 million in 2013 from $1.1 in 2012, primarily as a result of a first-time order from a multi-national +humanitarian organization. We believe our HCV product represents an opportunity for future sales growth, especially as new therapies for treating HCV come to market. However, demand for our HCV product, particularly in the public health marketplace, +has been, and will likely continue to be, tempered by the limited availability of government funding allocated to HCV testing efforts and the time and effort required to build awareness and demand for rapid HCV testing. +International orders for both our HIV and HCV products can be sporadic in nature and are often predicated upon the availability of governmental funding, the +impact of competition and other factors. As such, there is no assurance that such sales will continue at the same levels in future periods. +Substance Abuse Testing Market +Net +substance abuse testing revenues decreased 9% to $8.6 million in 2013 from $9.4 million in 2012, as a result of lower sales of our Intercept ® drug testing system. The table below shows a +breakdown of our total net Intercept ® revenues (dollars in thousands) generated in each market during 2013 and 2012. +Year Ended December 31, +Market +2013 +2012 +% +Change +Domestic +$ +5,693 +$ +6,335 +(10 +)% +International +500 +706 +(29 +) +Net Intercept ® revenues +$ +6,193 +$ +7,041 +(12 +)% +Domestic Intercept ® sales decreased 10% to $5.7 million in 2013 from +$6.3 million in 2012. In 2011, our largest laboratory distributor began selling its own competing oral specimen collection device and a panel of oral fluid drug assays suitable for use on fully-automated high throughput homogenous processing +systems. As a result, by the end of 2012, this distributor had significantly reduced its purchases of our Intercept ® product line. +Intercept ® sales to this distributor were $67,000 for the year ended December 31, 2013 compared to $1.4 million for the year ended December 31, 2012. Intercept ® sales in 2013 were also negatively impacted by the continued consolidation of drug testing laboratories. +International Intercept ® sales decreased 29% to $500,000 in 2013 from $706,000 in 2012, as a result +of lower purchases by our UK laboratory distributor, which totaled $316,000 in 2013 compared to $610,000 in 2012. In 2012, this UK distributor began selling its own competing oral specimen collection device and we expect this distributor to +discontinue its purchases of our product in future periods. +56 +Table of Contents +Cryosurgical Systems Market +Sales of our products in the cryosurgical systems market (which includes both the physicians’ office and OTC markets) decreased to $14.5 million for the +year ended December 31, 2013 from $14.9 million for the year ended December 31, 2012. +The table below shows a breakdown of our total net +cryosurgical systems revenues (dollars in thousands) generated in each market during 2013 and 2012. +Year Ended December 31, +Market +2013 +2012 +% +Change +Domestic professional +$ +6,020 +$ +7,159 +(16 +)% +International professional +1,441 +1,462 +(1 +) +International OTC +7,007 +6,255 +12 +Net cryosurgical systems revenues +$ +14,468 +$ +14,876 +(3 +)% +Sales of our Histofreezer ® product to physicians’ offices in the +United States decreased 16% to $6.0 million in 2013, compared to $7.2 million in 2012. This decrease was the result of higher distributor purchases made in the fourth quarter of 2012 in anticipation of price increases implemented in early January +2013, a decline in sales to the military during 2013 as a result of the U.S. withdrawal of troops overseas and lower sales to our Canadian distributor. International sales of Histofreezer ® +remained relatively flat at $1.4 million in 2013 and $1.5 million in 2012. +Sales of our OTC cryosurgical products during 2013 increased 12% to $7.0 +million from $6.3 million in 2012. This increase was largely the result of higher sales to both our Latin American distributor, Genomma, and our European distributor, Reckitt Benckiser. In 2013, Genomma purchased $3.3 million compared to $2.7 +million during 2012, largely due to increased sales into Brazil. Sales to Reckitt Benckiser increased to $3.6 million in 2013 from $3.3 million in 2012 as a result of higher sales in new geographic territories, partially offset by lower sales to +existing markets resulting from a reallocation of advertising resources by the distributor. +Insurance Risk Assessment Market +Sales to the insurance risk assessment market decreased 12% to $3.9 million in 2013 from $4.5 million in 2012, as a result of reduced demand in the domestic +life insurance market, as well as the adoption by some underwriters of a “Simplified Issues” policy, pursuant to which lab-based testing is replaced by having applicants respond to a questionnaire about their behaviors. +Licensing and Product Development +Licensing and product development revenues for 2013 decreased 70% primarily as a result of the absence of a $1.0 million milestone payment received in the +first quarter of 2012 related to the achievement of certain regulatory and commercial objectives pursuant to the terms of our HCV collaboration agreement with Merck. No similar payment was received during 2013 because the collaboration agreement +with Merck was terminated in November 2012. +Also contributing to the decline in product development revenues in 2013 was a decrease in royalties received +on domestic outsales of Merck’s OTC cryosurgical wart removal product. Pursuant to a license and settlement agreement executed in January 2008, the receipt of royalties stopped in August 2013 when certain of our cryosurgical patents expired. +57 +Table of Contents +DNAG Segment +Molecular Collection Systems +Net +molecular collection systems revenues, which primarily represent sales of our Oragene ® product line, increased 43% to $20.4 million in 2013 from $14.3 million in 2012. Sales of Oragene ® in the commercial market increased in 2013 primarily due to a substantial increase in orders received from an existing customer partially offset by lower sales in the academic research market in +2013 when compared to 2012 due to continued constrained research funding, particularly in North America. +CONSOLIDATED OPERATING LOSS +Consolidated gross margin was 59% in 2013 compared to 63% in 2012. This decrease was largely due to higher royalty expenses, an unfavorable change in +product mix, and the absence of the $1.0 million HCV milestone payment which was received in 2012. These negative effects on gross margin were partially offset by an improvement in overhead absorption during 2013 when compared to the prior year +period. +Consolidated operating loss decreased $4.1 million to $12.2 million in 2013, compared to $16.3 million in 2012. Our 2013 operating loss reflects +the $8.3 million settlement payment received for the termination of our assay collaboration agreement with Roche Diagnostics partially offset by higher sales and marketing expenses associated with the promotion of our OraQuick ® In-Home HIV test. +Operating Loss by Segment +OSUR Segment +OSUR’s gross +margin was 57% in 2013 compared to 62% in 2012. OSUR’s 2013 margin was negatively impacted by higher lateral flow patent royalties on sales of our OraQuick ® HIV products, an unfavorable +change in product mix, and the absence of the $1.0 million HCV milestone payment received from Merck in the first quarter of 2012. The negative impact of these items was partially offset by an improvement in overhead absorption. +Research and development expenses declined 13% to $8.4 million in 2013 from $9.7 million in 2012, largely due to lower staffing costs and decreased spending +on lab supplies. We expect OSUR’s research and development costs will increase in 2014 when compared to 2013 levels. +Sales and marketing expenses +increased 29% to $39.5 million in 2013 from $30.5 million in 2012. This increase was primarily the result of higher spending associated with advertising and promotional activities for our +OraQuick ® In-Home HIV test. During 2013, we launched three large promotional campaigns including one in association with Earvin “Magic” Johnson, a multi-city promotional campaign to +encourage consumers to get tested for HIV, and another focused on increasing brand awareness among men who have sex with men and African American consumers. We also increased our use of radio, television, print and digital advertising. Advertising +and promotional costs for our OraQuick ® In-Home HIV test were $18.8 million in 2013, compared to $9.9 million in 2012. We expect 2014 sales and marketing expenses to decline from 2013 levels, +as a result of lower spending on advertising and promotional activities related to the OraQuick ® In-Home HIV test. +General and administrative expenses decreased 4% to $18.2 million in 2013 from $19.0 million in 2012 due to lower legal and consulting expenses, partially +offset by higher staffing costs. We expect general and administrative expenses to increase in 2014 when compared to 2013 levels. +All the above +contributed to OSUR’s operating loss of $12.8 million, which included non-cash charges of $3.2 million for depreciation and amortization expense and $5.3 million for stock-based compensation expense. +58 +Table of Contents +DNAG Segment +DNAG’s gross margin was 67% in 2013 compared to 68% in 2012. This decrease was primarily the result of increased sales to a lower margin commercial +customer. +Research and development expenses decreased 7% to $2.6 million in 2013 from $2.8 million in 2012 due largely to lower staffing costs and +amortization expense. Sales and marketing expenses increased 7% to $7.0 million in 2013 from $6.6 million in 2012 largely due to higher staffing costs and higher sales commission expenses. General and administrative expenses remained relatively flat +at $3.4 million in 2013 as compared to $3.3 million in 2012. We expect DNAG’s 2014 operating expenses to increase across all categories when compared to 2013 levels. +All of the above contributed to operating income of $687,000 for DNAG in 2013, which also included non-cash charges of $3.3 million for depreciation and +amortization expense and $238,000 for stock-based compensation expense. +CONSOLIDATED INCOME TAXES +We continue to believe the full valuation allowance established in 2008 against OSUR’s total U.S. net deferred tax asset is appropriate as the facts and +circumstances necessitating the allowance have not changed. As a result, no U.S. income tax benefit was recorded for OraSure’s pre-tax loss in 2013 and 2012. A Canadian income tax benefit of $772,000 and $1.4 million was recorded in 2013 and +2012, respectively, which was associated with certain Canadian research and development and investment tax credits and the DNAG loss before income taxes in 2012. The Canadian income tax benefit is considered realizable based upon the scheduled +reversal of the deferred tax liabilities recorded in connection with the acquisition of DNAG. +Year Ended December 31, 2012 Compared to +December 31, 2011 +CONSOLIDATED NET REVENUES +The table below shows the amount of total net product revenues generated by each of our business segments and net revenues generated by licensing and product +development activities (dollars in thousands). +Year Ended December 31, +Dollars +% +Change +Percentage of Total +Revenues +2012 +2011 +2012 +2011 +OSUR +$ +71,495 +$ +74,467 +(4 +)% +82 +% +91 +% +DNAG +14,258 +6,216 +129 +16 +8 +Net product revenues +85,753 +80,683 +6 +98 +99 +Licensing and product development +2,067 +1,198 +73 +2 +1 +Net revenues +$ +87,820 +$ +81,881 +7 +% +100 +% +100 +% +Consolidated net revenues increased 7% to $87.8 million in 2012 from $81.9 million in 2011. Net product revenues in 2012 +included $14.3 million in net revenues from our molecular collection systems subsidiary, DNAG, compared to $6.2 million in 2011. Results for 2012 reflect a full twelve months of molecular collection systems sales, while 2011 results include only +those revenues generated from the August 17, 2011 acquisition date of DNAG through year end. +59 +Table of Contents +Net product revenues increased 6% during the year ended December 31, 2012 when compared to the year ended +December 31, 2011, primarily as a result of the higher molecular collection system sales and higher sales of our cryosurgical systems products. These increases were partially offset by lower sales of our infectious disease testing, substance +abuse testing and insurance risk assessment products. Licensing and product development revenues also increased in 2012 as compared to the prior year. +Consolidated net revenues derived from products sold to customers outside the U.S. were $20.3 million and $14.2 million, or 23% and 17% of total net revenues, +for the years ended December 31, 2012 and 2011, respectively. This increase was primarily caused by the inclusion of a full twelve months of revenues from DNAG. Because the majority of our international sales are denominated in U.S. dollars, +the impact of fluctuating foreign currency exchange rates was not material to our operating results. +Net Revenues by Segment +OSUR Segment +The table below shows +the amount of total net revenues (dollars in thousands) generated by our OSUR segment in each of our principal markets and by licensing and product development activities. +Year Ended December 31, +Dollars +% +Change +Percentage of Total +Revenues +Market +2012 +2011 +2012 +2011 +Infectious disease testing +$ +42,728 +$ +44,691 +(4 +)% +58 +% +59 +% +Substance abuse testing +9,407 +12,498 +(25 +) +13 +16 +Cryosurgical systems +14,876 +12,046 +23 +20 +16 +Insurance risk assessment +4,484 +5,232 +(14 +) +6 +7 +Net product revenues +71,495 +74,467 +(4 +) +97 +98 +Licensing and product development +2,067 +1,198 +73 +3 +2 +Net revenues +$ +73,562 +$ +75,665 +(3 +)% +100 +% +100 +% +Infectious Disease Testing Market +Sales to the infectious disease testing market decreased 4% to $42.7 million in 2012 from $44.7 million in 2011, primarily due to lower OraQuick ® sales. OraQuick ® sales totaled $41.7 million and $43.3 million for the years ended December 31, 2012 and 2011, respectively. +60 +Table of Contents +The table below shows a breakdown of our total net +OraQuick ® revenues (dollars in thousands) during 2012 and 2011. +Year Ended December 31, +Market +2012 +2011 +% +Change +Domestic HIV +$ +34,265 +$ +38,722 +(12 +)% +International HIV +3,061 +3,011 +2 +Domestic OTC HIV +546 +— +N/A +Total HIV revenues +37,872 +41,733 +(9 +) +Domestic HCV +2,805 +890 +215 +International HCV +1,059 +672 +58 +Total HCV revenues +3,864 +1,562 +147 +Net OraQuick ® revenues +$ +41,736 +$ +43,295 +(4 +)% +Domestic OraQuick ® HIV sales decreased 12% to $34.3 million in 2012 +from $38.7 million in 2011. This decrease was due to changes in public health testing programs and their timing of purchases, reductions in government funding, price competition and a shift to automated laboratory-based blood tests by certain +customers. International sales of our OraQuick ® HIV test increased 2% to $3.1 million in 2012 from $3.0 million in 2011 as a result of higher sales in Africa due to changes in existing +distributor order patterns. +We began shipping our OraQuick ® In-Home HIV test to the retail +outlets at the end of September 2012. We recorded $902,000 in gross revenues from product sales to retail customers either in a store or over the internet. These revenues were offset by $356,000 in customer allowances, including cooperative +advertising, cash discounts, and other allowances, which were netted against gross revenues in accordance with U.S. generally accepted accounting principles. +Domestic OraQuick ® HCV sales increased to $2.8 million in 2012 from $890,000 in 2011 as result of +broader adoption of our product by customers who are able to use a CLIA-waived product. We received a CLIA waiver for this product in November 2011, allowing us to sell our HCV product to many non-CLIA certified customers, such as outreach clinics, +community-based organizations and physician offices. International sales of our OraQuick ® HCV test increased 58% to $1.1 million in 2012 from $672,000 in 2011, largely as a result of higher +sales into Latin America and Europe. +Substance Abuse Testing Market +Net substance abuse testing revenues decreased 25% to $9.4 million in 2012 from $12.5 million in 2011, as a result of lower sales of our Intercept ® drug testing system. The table below shows a breakdown of our total net Intercept ® revenues (dollars in thousands) generated in each +market during 2012 and 2011. +Year Ended December 31, +Market +2012 +2011 +% +Change +Domestic +$ +6,335 +$ +8,004 +(21 +)% +International +706 +1,912 +(63 +) +Net Intercept ® revenues +$ +7,041 +$ +9,916 +(29 +)% +Domestic Intercept ® sales decreased 21% to $6.3 million in 2012 from +$8.0 million in 2011. In 2011, our largest laboratory distributor began selling its own competing oral specimen collection device and a panel of oral fluid drug +61 +Table of Contents +assays suitable for use on fully-automated high throughput homogenous processing systems. As a result, by the end of 2012, this distributor had significantly reduced its purchases of our +Intercept ® product line. Intercept ® sales to this distributor were $1.5 million for the year ended December 31, 2012 compared to +$3.5 million for the year ended December 31, 2011. +International Intercept ® sales decreased +63% to $706,000 in 2012 from $1.9 million in 2011, as a result of lower purchases by our UK laboratory distributor as it also has begun selling its own competing oral specimen collection device. +Intercept ® sales to this distributor were $610,000 for the year ended December 31, 2012 compared to $1.9 million in the year ended December 31, 2011. +Cryosurgical Systems Market +Sales of our products in the +cryosurgical systems market (which includes both the physicians’ office and OTC markets) increased to $14.9 million for the year ended December 31, 2012 from $12.1 million for the year ended December 31, 2011. +The table below shows a breakdown of our total net cryosurgical revenues (dollars in thousands) generated in each market during 2012 and 2011. +Year Ended December 31, +Market +2012 +2011 +% +Change +Domestic professional +$ +7,159 +$ +6,775 +6 +% +International professional +1,462 +1,400 +4 +International OTC +6,255 +3,871 +62 +Net cryosurgical systems revenues +$ +14,876 +$ +12,046 +23 +% +Sales of our Histofreezer ® product to physicians’ offices in the +United States increased 6% to $7.2 million in 2012, compared to $6.8 million in 2011, due to the success of sales and promotional efforts by our distributors. During the year ended December 31, 2012, international sales of Histofreezer ® increased 4% to $1.5 million compared to $1.4 million in the prior year, largely as a result of higher out-sales in Australia by our distributor in that new market. +Sales of our OTC cryosurgical products during 2012 increased 62% to $6.3 million from $3.9 million in 2011. This increase was largely the result of higher +sales to both our Latin American distributor, Genomma, and our European distributor, Reckitt Benckiser. +In 2012, Genomma purchased $2.7 million compared +to $990,000 during 2011. Early in 2011, the Mexican government placed limitations on the advertising Genomma could use for our product. At the same time, the Brazilian government also required changes to our package insert. Both of these events +negatively impacted sales of our product to Genomma during 2011, but were resolved by the end of that year. +Sales to Reckitt Benckiser increased to $3.3 +million in 2012 from $2.6 million in 2011 as a result of increased advertising and promotional activities and expansion into additional European countries. +Insurance Risk Assessment Market +Sales +to the insurance risk assessment market decreased 14% to $4.5 million in 2012 from $5.2 million in 2011, largely as a result of the loss of one of our larger customers who changed its underwriting methodologies in 2011. +62 +Table of Contents +Licensing and Product Development +Licensing and product development revenues increased 73% to $2.1 million in 2012 from $1.2 million in 2011. During the first quarter of 2012, we received a +$1.0 million milestone payment as a result of our achievement of certain regulatory and commercial objectives pursuant to our collaboration agreement with Merck for the development and promotion of our OraQuick ® rapid HCV test in international markets. No such milestone payments were received in the prior year. +The remaining licensing revenues for these periods represent royalties paid on domestic outsales of Merck’s OTC cryosurgical wart removal product, +pursuant to a license and settlement agreement executed in January 2008. In the latter half of 2011, t he royalty rate decreased pursuant to the terms of our license. +DNAG Segment +Molecular Collection Systems +Net +molecular collection systems revenues primarily represent sales of the Oragene ® product line by our subsidiary, DNAG, which we acquired in August 2011. During 2012, net DNAG revenues included +several new orders from large commercial customers as well as continued strong sales into the academic research market despite funding challenges in both Canada and the United States. +CONSOLIDATED OPERATING LOSS +Consolidated +gross margin remained unchanged at 63% for both 2012 and 2011. +Consolidated operating loss increased $6.9 million to $16.3 million in 2012, compared to +$9.4 million in 2011. The increased loss was primarily the result of higher sales and marketing expenses associated with the commercialization of our OraQuick ® In-Home HIV test and the +inclusion of a full year of DNAG operating expenses. These higher expenses were partially offset by lower research and development costs due to decreased clinical trial costs related to our +OraQuick ® In-Home HIV test. +Operating Loss by Segment +OSUR Segment +OSUR’s gross +margin was 62% in 2012 compared to 64% in 2011. OSUR’s 2012 margin was negatively impacted by the overall decrease in sales volume which caused a decline in absorption of our labor and fixed overhead costs. This decline was partially offset by +the beneficial impact of the $1.0 million HCV milestone payment received in the first quarter of 2012. +Research and development expenses declined 44% to +$9.7 million in 2012 from $17.4 million in 2011, primarily as a result of lower clinical trial costs related to the development of our OraQuick ® In-Home HIV test. +Sales and marketing expenses increased 52% to $30.5 million in 2012 from $20.1 million in 2011. This increase was primarily the result of approximately $9.9 +million of spending associated with the commercialization of our OraQuick ® In-Home HIV test. +General and administrative expenses remained flat at $19.0 million in both 2012 and 2011. +All the above contributed to OSUR’s operating loss of $13.4 million, which included non-cash charges of $3.5 million for depreciation and amortization +expense and $5.0 million of stock-based compensation expense. +63 +Table of Contents +DNAG Segment +DNAG’s gross margin increased to 68% in 2012 from 50% in the comparable period of 2011. DNAG’s 2011 gross margin included the impact of an $852,000 +non-cash purchase accounting adjustment to mark up the acquired finished goods inventory to fair value. Gross margin for 2012 also included $1.3 million of intangibles amortization expense compared to $499,000 recorded for the period August 17, +2011 through December 31, 2011. +DNAG incurred $12.6 million in operating expenses during 2012 compared to $4.7 million incurred in 2011 from the +August 17, 2011 acquisition date through December 31, 2011. Expenses for 2012 included $2.8 million of research and development costs, $6.6 million of sales and marketing costs and $3.3 million of general and administrative costs. Expenses +for the period August 17, 2011 through December 31, 2011 included $1.0 million of research and development costs, $2.3 million of sales and marketing costs and $1.4 million of general and administrative costs. +All of the above contributed to DNAG’s 2012 operating loss of $2.9 million, which included non-cash charges of $3.7 million for depreciation and +amortization expense and $189,000 of stock-based compensation expense. +CONSOLIDATED INCOME TAXES +As of December 31, 2012, we believed the full valuation allowance established in 2008 against OSUR’s total U.S. net deferred tax asset was +appropriate as the facts and circumstances necessitating the allowance had not changed. As a result, no U.S. income tax benefit was recorded for OraSure’s pre-tax loss in 2012. A Canadian income tax benefit of $1.4 million was recorded in 2012 +which was associated with the DNAG loss before income taxes and certain Canadian research and development and investment tax credits. The income tax benefit in 2012 was negatively impacted by a $428,000 adjustment to DNAG’s deferred tax +liability recorded in the second quarter to reflect a change in the enacted Canadian provincial tax rates. +Liquidity and Capital Resources +December 31, +2013 +2012 +(In thousands) +Cash +$ +93,191 +$ +87,888 +Working capital +100,590 +103,483 +Our cash increased $5.3 million to $93.2 million at December 31, 2013 from $87.9 million at December 31, 2012. Our +working capital decreased to $100.6 million at December 31, 2013 from $103.5 million at December 31, 2012. +During 2013, we generated $8.4 +million in cash from operating activities. Our net loss of $11.2 million and deferred income tax benefit of $772,000 were largely offset by non-cash stock-based compensation expense of $5.6 million and depreciation and amortization expense of $6.5 +million. Included in our net loss in 2013 was an $8.3 million gain recorded for cash received as a settlement payment received from Roche Diagnostics for the termination of our assay collaboration agreement. Also contributing to the cash generated +in operating activities was a $5.4 million increase in accrued expenses and other liabilities due to higher year-end accruals for management incentive bonuses and royalty obligations, a $4.3 million decrease in accounts receivable resulting from the +collection of outstanding balances due at the end of 2012, a $1.5 million increase in accounts payable related to year-end inventory purchases and advertising and marketing services associated with our OraQuick ® In-Home HIV test, and a $1.3 million decrease in inventory associated with our OraQuick ® In-Home HIV test. Offsetting these increases to +cash was a $4.4 million decrease in deferred revenue resulting from the recognition of previously deferred OraQuick ® In-Home HIV test revenues and the realization of certain customer +prepayments. +64 +Table of Contents +We used a total of $2.5 million in investing activities during 2013 to acquire property and equipment. During the +year ended December 31, 2014, we expect to invest approximately $4.0 million in capital expenditures, primarily to purchase additional equipment, upgrade certain older equipment and make improvements to our facilities. +Net cash used in financing activities was $420,000 in 2013, which resulted from the use of $829,000 for the repurchase of common stock related to the vesting +of restricted shares partially offset by $409,000 in proceeds received from the exercise of stock options. +Our current cash balance is expected to be +sufficient to fund our current operating and capital needs through at least the next twelve months. Our cash requirements, however, may vary materially from those now planned due to many factors, including, but not limited to, the timing and amount +of promotional costs for our products including our OraQuick ® In-Home HIV test, the scope and timing of future strategic acquisitions, the progress of our research and development +programs, the scope and results of clinical testing, the cost of any future litigation, the magnitude of capital expenditures, changes in existing and potential relationships with business partners, the time and cost of obtaining regulatory +approvals, the costs involved in obtaining and enforcing patents, proprietary rights and any necessary licenses, the cost and timing of expansion of sales and marketing activities, market acceptance of new products, competing technological and +market developments, the impact of the ongoing economic downturn and other factors. +Contractual Obligations and Commercial Commitments +The following sets forth our approximate aggregate obligations as of December 31, 2013 (in thousands) for future payments under contracts and other +contingent commitments, for the year 2014 and beyond: +Payments due by December 31, +Contractual Obligations +Total +2014 +2015 +2016 +2017 +2018 +Thereafter +Operating leases 1 +$ +853 +$ +438 +$ +409 +$ +6 +$ +— +$ +— +$ +— +Employment contracts 2 +2,943 +2,072 +581 +290 +— +— +— +Purchase obligations 3 +3,685 +3,685 +— +— +— +— +— +Minimum commitments under contracts 4 +2,292 +500 +500 +500 +500 +292 +— +Total contractual obligations +$ +9,773 +$ +6,695 +$ +1,490 +$ +796 +$ +500 +$ +292 +$ +— +1 +Represents payments required under our operating leases. See Note 13 of the Notes to the consolidated financial statements included herein. +2 +Represents salary payments payable under the terms of employment agreements executed by us with certain executives. See Note 13 of the Notes to the consolidated financial statements included herein. +3 +Represents payments required by non-cancellable purchase orders related to inventory, capital expenditures and other goods or services. See Note 13 of the Notes to the consolidated financial statements included herein. +4 +Represents payments required pursuant to certain licensing agreements executed by the Company. These agreements are cancellable within a specified number of days after communication by the Company of its intent to +terminate. See Note 13 of the Notes to the consolidated financial statements included herein. +Off-Balance Sheet Arrangements . We do +not have any off-balance sheet arrangements, as defined in Item 303(a)(4) (ii) of Regulation S-K under the Securities Exchange Act of 1934, as amended. +Critical Accounting Policies and Estimates +This +Management’s Discussion and Analysis of Financial Condition and Results of Operations discusses our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of +America. The preparation of these financial statements requires that we make estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent +65 +Table of Contents +assets and liabilities at the date of the financial statements, and the reported amounts of revenues and expenses during the reporting period. On an on-going basis, we evaluate our judgments and +estimates, including those related to bad debts, customer sales returns, inventories, intangible assets, income taxes, revenue recognition, contingencies and litigation. We base our judgments and estimates on historical experience and on various +other factors that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying value of assets and liabilities that are not readily apparent from other sources. Actual results +may differ from these estimates under different assumptions or conditions. +Our significant accounting policies are described in Note 2 of the Notes to +the consolidated financial statements included in Item 15 of this Annual Report. We consider the following accounting estimates, which have been discussed with our Audit Committee, to be most critical in understanding the more complex judgments +that are involved in preparing our financial statements and the uncertainties that could impact our results of operations, financial condition and cash flows. +Revenue Recognition . We recognize product revenues when there is persuasive evidence that an arrangement exists, the price is fixed or determinable, +title has passed and collection is reasonably assured. Product revenues are recorded net of allowances for any discounts or rebates. Other than for our OraQuick ® In-Home HIV tests, we do not +grant price protection or product return rights to our customers except for warranty returns. Historically, returns arising from warranty issues have been infrequent and immaterial. Accordingly, we expense warranty returns as incurred. +We began selling our OraQuick ® In-Home HIV test in the third quarter of 2012. From commercial launch +through November 2013, our revenue practices with respect to the OraQuick ® In-Home HIV test were different than those customarily used in the consumer package goods industry. Under U.S. +generally accepted accounting principles, product revenue cannot be recognized unless the amount of future returns can be reasonably estimated. Because our OraQuick ® In-Home HIV test was a new +product for which we did not have a historical record of returns, we did not believe we could reasonably determine a return rate. As a result we did not recognize revenue when we shipped to the retail trade. For these product shipments, we invoiced +the retailer or distributor, recorded deferred revenue at gross invoice sales price, and classified the cost basis of the product held by the retailer or distributor as a component of inventory. We then recognized revenue upon the consummation of a +sale to the retail customer either in a store or over the internet. With the passage of time, however, we concluded that we have sufficient data and visibility into our distribution channel to develop a reasonable estimate of the level of expected +returns. As such, commencing in December 2013, we recognized previously deferred revenue and its related cost of goods sold, and began to recognize revenue upon shipment to the retailers or distributors. +Our net revenues recorded on sales of the OraQuick ® In-Home HIV test represent total gross revenues +less an allowance for expected returns, and customer allowances for cooperative advertising discounts, rebates, and chargebacks. All of these allowances are estimates established by management, based on currently available information which are +adjusted to reflect known changes in the factors that impact those estimates. These allowances are recorded as a reduction of gross revenue when recognized in our statement of operations. +Royalty income from the grant of license rights is recognized during the period in which the revenue is earned and the amount is determinable from the +licensee. +We record shipping and handling charges billed to our customers as product revenue and the related expense as cost of products sold. Taxes +assessed by governmental authorities, such as sales or value-added taxes, are excluded from product revenues. +Customer Sales Returns and +Allowances . We do not grant product return rights to our customers, except for our OraQuick ® In-Home HIV test. Accordingly, we have recorded an estimate of expected returns as a reduction +of gross OraQuick ® In-Home HIV product revenues in our consolidated statement of operations. This estimate +66 +Table of Contents +reflects our historical experience of sales to retailers and consumers, as well as other retail factors, and is reviewed regularly to ensure that it reflects potential product returns. As of +December 31, 2013, the reserve for sales returns and allowances was $279. If actual product returns differ materially from our reserve, or if a determination is made that this product’s distribution would be discontinued in whole or in +part by certain retailers, then we would need to adjust our reserve. Should the actual level of product returns vary significantly from our estimates, our operating and financial results could be materially affected. +Allowance for Uncollectible Accounts Receivable . Accounts receivable are reduced by an estimated allowance for amounts that may become uncollectible in +the future. On an ongoing basis, we perform credit evaluations of our customers and adjust credit limits based upon the customer’s payment history and creditworthiness, as determined by a review of their current credit information. We also +continuously monitor collections and payments from our customers. +Based upon historical experience and any specific customer collection issues that are +identified, we use our judgment to establish and evaluate the adequacy of our allowance for estimated credit losses, which was $299,000 as of December 31, 2013. While credit losses have been within our expectations and the allowance provided, +these losses can vary from period to period. Furthermore, there is no assurance that we will experience credit losses at the same rates as we have in the past. The current economic environment could adversely affect the operations, cash flows and +financial condition of our customers. These circumstances may adversely impact the liquidity or financial position of our customers and could have a material impact on the collectability of our accounts receivable and future operating results. +Inventories . Our inventories are valued at the lower of cost or market, determined on a first-in, first-out basis, and include the cost of raw +materials, labor and overhead. The majority of our inventories are subject to expiration dating. We continually evaluate quantities on hand and the carrying value of our inventories to determine the need for reserves for excess and obsolete +inventories based primarily on the estimated forecast of product sales. When, in the opinion of management, factors indicate that impairment has occurred, either a reserve is established against the inventories’ carrying value or the +inventories are completely written off, as in the case of lapsing expiration dates. In 2013 and 2012, we wrote-off inventory which had a cost of $1.3 million in each year. During 2011, we wrote-off inventory which had a cost of $919,000. These +write-offs were as a result of quality, scrap and product expiration issues. Although we make every effort to ensure the accuracy of our forecasts of future product demand, any significant unanticipated changes in demand could have a significant +impact on the carrying value of our inventories and reported operating results. +Stock-Based Compensation . We recognize the fair value of +equity-based awards as compensation expense in our statement of operations. The fair value of our stock option awards is estimated using a Black-Scholes option valuation model. This valuation model’s computations incorporate highly subjective +assumptions, such as the expected stock price volatility and the estimated life of each award. The fair value of the options, after considering the effect of expected forfeitures, is then amortized, generally on a straight-line basis, over the +related vesting period of the option. The fair value of our restricted shares is based on the market value of the shares at the date of grant and is recognized on a straight-line basis over the related vesting period of the award. +Long-Lived and Intangible Assets . Our long-lived assets are comprised of property and equipment, intangible assets and goodwill. Together, these assets +had a net book value of $63.9 million, or 35% of our total assets, as of December 31, 2013. Property and equipment and intangible assets are depreciated or amortized on a straight-line basis over their estimated useful lives, which we determine +based upon our estimate of the period of time over which each asset will generate revenues. An impairment of long-lived or intangible assets could occur whenever events or changes in circumstances indicate that the net book value of our assets may +not be recoverable. Events which could trigger asset impairment include significant underperformance relative to historical or projected future operating results, significant changes in the manner of our use of an asset or in our overall business +strategy, significant negative industry or economic trends, and shortening of product life-cycles or changes in technology. If we believe impairment of an asset has occurred, we measure the amount of such impairment by +67 +Table of Contents +comparing the net book value of the affected assets to the fair value of these assets, which is generally determined based upon the present value of the expected cash flows associated with the +use of these assets. If the net book value exceeds the fair value of the impaired assets, we would incur an impairment expense equal to this difference. +We currently believe the future cash flows to be received from all remaining long-lived and intangible assets as of December 31, 2013 will exceed their +book value. We did not recognize any impairment losses for the years ended December 31, 2013 or 2012. Any unanticipated significant impairment in the future, however, could have a material adverse impact to our balance sheet and future +operating results. +Goodwill . Goodwill represents the excess of the purchase price we paid over the fair value of the net tangible and +identifiable intangible assets acquired and liabilities assumed in our acquisition of DNAG in August 2011. Goodwill is not amortized but rather is tested annually for impairment or more frequently if we believe that indicators of impairment exist. +Current U.S. generally accepted accounting principles permit us to make a qualitative evaluation about the likelihood of goodwill impairment. If we conclude that it is more likely than not that the fair value of a reporting unit is greater than its +carrying amount, then we would not be required to perform the two-step quantitative impairment test. Otherwise, performing the two-step impairment test is necessary. The first step of the two-step quantitative impairment test involves comparing the +fair values of the applicable reporting units with their aggregate carrying values, including goodwill. If the carrying value of a reporting unit exceeds the reporting unit’s fair value, we perform the second step of the test to determine the +amount of the impairment loss, if any. The second step involves measuring any impairment by comparing the implied fair values of the affected reporting unit’s goodwill and intangible assets with the respective carrying values. +We performed our annual impairment assessment as of July 31, 2013 utilizing a qualitative evaluation and concluded that it was more likely than not that +the fair value of our DNAG reporting unit is greater than its carrying amount. We performed our last quantitative impairment test for goodwill as of July 31, 2012 and determined there was no impairment. That quantitative assessment determined +that our DNAG reporting unit had a fair value in excess of its carrying value (including goodwill of $25,179) by approximately 13%. We believe we have made reasonable estimates and assumptions to calculate the fair value of our reporting unit. If +actual future results are not consistent with management’s estimates and assumptions, we may have to take an impairment charge in the future related to our goodwill. Future impairment tests will continue to be performed annually in the fiscal +third quarter, or sooner if a triggering event occurs. +Deferred Tax Assets and Liabilities . At December 31, 2013, we had federal NOL +carryforwards of $73.3 million. The net deferred tax assets, before the valuation allowance, associated with these NOLs and other temporary differences was $37.6 million at December 31, 2013. In assessing the realizability of net deferred tax +assets, we consider whether it is more likely than not that some portion or all of the deferred tax assets will not be realized. The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income during the +period in which those temporary differences become deductible or the NOLs and credit carryforwards can be utilized. We consider the scheduled reversal of deferred tax liabilities, projected future taxable income and tax planning strategies in making +this assessment. +We currently have a full valuation allowance recorded against our total U.S. net deferred tax asset as we had determined in 2008 that it +was more likely than not that we would not realize the benefits associated with our net deferred tax asset in the immediate future. Each year, we continued to reevaluate our valuation allowance position and believe that it is more likely than not +that our U.S. deferred income tax asset will not be realized in the immediate future. As such, we maintain a full valuation allowance against our net deferred tax assets as of December 31, 2013 and 2012 associated with the operations subject to +income tax in the U.S. +68 +Table of Contents +Our ability to use our federal NOL carryforwards to offset future federal income tax obligations could be limited +by changes in the ownership of our stock. Internal Revenue Code (“IRC”) Section 382 contains provisions that limit the amount of federal NOL carryforwards that can be used in any given year in the event of specified occurrences, +including significant ownership changes. During 2005, the Company completed an analysis, with the assistance of independent tax specialists, to determine if any IRC Section 382 ownership changes had occurred that would limit the amount of NOLs +that could be utilized to offset future taxable income. As a result of this analysis, the Company concluded that prior period ownership changes may impose a limitation on the amount of NOLs that can be utilized in a given year. The Company does not +believe, however, that this limitation will impair our future ability to utilize NOLs to offset our future taxable income. The Company continues to review ownership changes on an annual basis and we do not believe we have had a subsequent ownership +change that would impact the NOLs. +In connection with the DNAG acquisition in August 2011, a deferred tax liability was recorded to reflect the tax +effects of basis differences of intangible assets and inventories for financial reporting and Canadian income tax purposes. For the years ended December 31, 2013, 2012 and 2011, we recorded a Canadian income tax benefit of $772,000, $1.4 +million and $869,000, respectively, associated with certain Canadian research and development and investment tax credits and DNAG’s loss before income taxes in 2012 and 2011. The income tax benefit associated with DNAG was considered realizable +based upon the scheduled reversal of the deferred tax liabilities recorded in connection with the acquisition of DNAG. +Contingencies . In the +ordinary course of business, we have entered into various contractual relationships with strategic corporate partners, customers, distributors, research laboratories and universities, licensors, licensees, suppliers, vendors and other parties. As +such, we could be subject to litigation, claims or assessments arising from any or all of these relationships. We record a loss contingency when information available prior to issuance of our financial statements indicates that it is probable that +an asset has been impaired or a liability has been incurred at the date of the financial statements and the amount of the loss can be reasonably estimated. Accounting for contingencies arising from contractual or legal proceedings requires that we +use our best judgment when estimating an accrual related to such contingencies. As additional information becomes known, our accrual for a loss contingency could fluctuate, thereby creating variability in our results of operations from period to +period. Likewise, an actual loss arising from a loss contingency which significantly exceeds the amount accrued for in our financial statements could have a material adverse impact on our operating results for the period in which such actual loss +becomes known. +ITEM 7A. +Quantitative and Qualitative Disclosures About Market Risk. +We do not hold any amounts of derivative +financial instruments or derivative commodity instruments and, accordingly, we have no material derivative risk to report under this Item. +As of +December 31, 2013, we did not have any foreign currency exchange contracts or purchase currency options to hedge local currency cash flows. We have operations in Canada and Europe, which are subject to foreign currency fluctuations. As currency +rates change, translation of revenues and expenses for these operations from foreign currencies to U.S. dollars affects year-to-year comparability of operating results. Sales denominated in a foreign currency were 5.0% of our total consolidated net +revenues for the year ended December 31, 2013. We expect our international business will continue to grow and our exposure to fluctuations in foreign currency exchange rates may increase. +ITEM 8. +Consolidated Financial Statements and Supplementary Data. +Information with respect to this Item is +contained in our Consolidated Financial Statements included in Item 15 of this Annual Report on Form 10-K. +69 +Table of Contents +ITEM 9. +Changes in and Disagreements with Accountants on Accounting and Financial Disclosure. +Not applicable. +ITEM 9A. +Controls and Procedures. +(a) Evaluation of Disclosure Controls and Procedures . +The Company’s management, with the participation of the Company’s Chief Executive Officer and Chief Financial Officer, has evaluated the +effectiveness of the Company’s disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) of the Securities Exchange Act of 1934) as of December 31, 2013. Based on that evaluation, the Company’s management, +including such officers, concluded that as of December 31, 2013 the Company’s disclosure controls and procedures were adequate and effective to ensure that information required to be disclosed by the Company in the reports that we file or +submit under the Securities Exchange Act of 1934 is accumulated and communicated to the Company’s management, including the Chief Executive Officer and Chief Financial Officer, to allow timely decisions regarding required disclosure and is +recorded, processed, summarized, and reported within the time periods specified in the rules and forms of the Securities and Exchange Commission. +(b) +Management’s Report on Internal Control Over Financial Reporting . +The Company’s management is responsible for establishing and +maintaining adequate internal control over financial reporting, as such term is defined in Rule 13a-15(f) and 15d-15(f) under the Securities Exchange Act of 1934. Under the supervision and with the participation of the Company’s management, +including our principal executive officer and principal financial officer, we conducted an evaluation of the effectiveness of our internal control over financial reporting based on the framework in Internal Control—Integrated Framework +(1992) issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on our evaluation under the framework, our management concluded that our internal control over financial reporting was effective to provide +reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles as of December 31, 2013. +The effectiveness of our internal control over financial reporting as of December 31, 2013 has been audited by KPMG LLP, an independent registered public +accounting firm, as stated in their report, which is included below. +Because of its inherent limitations, internal control over financial reporting may +not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the +policies or procedures may deteriorate. +(c) Changes in Internal Control Over Financial Reporting . +There were no changes in our internal control over financial reporting during the fiscal quarter ended December 31, 2013 that have materially affected, +or are reasonably likely to materially affect, our internal control over financial reporting. +(d) Report of Independent Registered Public Accounting +Firm +The Board of Directors and Stockholders +OraSure +Technologies, Inc.: +We have audited OraSure Technologies, Inc.’s internal control over financial reporting as of December 31, 2013, based on +criteria established in Internal Control—Integrated Framework (1992) issued by the Committee of +70 +Table of Contents +Sponsoring Organizations of the Treadway Commission (COSO). OraSure Technologies, Inc.’s management is responsible for maintaining effective internal control over financial reporting and for +its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Management’s Report on Internal Control Over Financial Reporting. Our responsibility is to express an opinion on the Company’s +internal control over financial reporting based on our audit. +We conducted our audit in accordance with the standards of the Public Company Accounting +Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included +obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audit +also included performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion. +A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial +reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that +(1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as +necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors +of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements. +Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of +effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. +In our opinion, OraSure Technologies, Inc. maintained, in all material respects, effective internal control over financial reporting as of December 31, +2013, based on criteria established in Internal Control—Integrated Framework (1992) issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). +We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of +OraSure Technologies, Inc. and subsidiaries as of December 31, 2013 and 2012, and the related consolidated statements of operations, comprehensive loss, stockholders’ equity and cash flows for each of the years in the three-year period +ended December 31, 2013, and our report dated March 14, 2014 expressed an unqualified opinion on those consolidated financial statements. +/s/ KPMG LLP +Philadelphia, Pennsylvania +March 14, 2014 +ITEM 9B. +Other Information. +Not applicable. +71 +Table of Contents +PART III +We have omitted from Part III the information that will appear in our Definitive Proxy Statement for our 2014 Annual Meeting of Stockholders (the “Proxy +Statement”), which will be filed within 120 days after the end of our fiscal year pursuant to Regulation 14A. +ITEM 10. +Directors, Executive Officers and Corporate Governance. +Certain information required by this Item is +incorporated by reference to the information under the captions, “Corporate Governance—Committees of the Board—Audit Committee,” “Executive Officers,” “Item 1—Election of Directors” and “Section +16(a) Beneficial Ownership Reporting Compliance,” in the Proxy Statement. +Our Board of Directors has adopted a Code of Business Conduct and Ethics +that applies to our principal executive officer, principal financial officer and principal accounting officer, as well as to the members of our Board of Directors and our other officers and employees. This Code of Business Conduct and Ethics is +available on our website at www.orasure.com . We intend to satisfy the amendment and waiver disclosure requirements under applicable securities regulations by posting any amendments of, or waivers to, the Code of Business Conduct and Ethics on +our website. +ITEM 11. +Executive Compensation. +The information required by this Item is incorporated by reference to the +information under the caption, “Executive Compensation,” in the Proxy Statement. +ITEM 12. +Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters. +The +information required by this Item with respect to the securities ownership of certain beneficial owners and management, and equity compensation plan information, is incorporated by reference to the information under the captions, “Stock +Ownership of Certain Beneficial Owners and Management” and “Executive Compensation—Equity Compensation Plan Information,” in the Proxy Statement. +ITEM 13. +Certain Relationships and Related Transactions, and Director Independence. +The information required by +this Item is incorporated by reference to the information under the captions, “Transactions with Related Persons,” “Corporate Governance—Director Independence” and “Corporate Governance—Committees of the +Board,” in the Proxy Statement. +ITEM 14. +Principal Accountant Fees and Services. +The information required by this Item is incorporated by +reference to the information under the caption,” Item 2—Ratification of Appointment of Independent Registered Public Accounting Firm” in the Proxy Statement. +72 +Table of Contents +PART IV +ITEM 15. +Exhibits and Consolidated Financial Statement Schedules. +(a)(1) and (a)(2). Consolidated Financial +Statements and Schedules . For a list of the consolidated financial statements filed herewith, see the Index to Consolidated Financial Statements following the signature page to this Annual Report. No schedules are included with the consolidated +financial statements because the required information is inapplicable or is presented in the consolidated financial statements or related notes thereto. +(a)(3). Exhibits . See Index to Exhibits following the consolidated financial statements in this Annual Report. +73 +Table of Contents +SIGNATURES +Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on +its behalf by the undersigned, thereunto duly authorized, on March 14, 2014. +ORASURE TECHNOLOGIES, INC. +By: +/s/ Douglas A. Michels +Douglas A. Michels +President and Chief Executive Officer +Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed on March 14, 2014, by +the following persons on behalf of the Registrant and in the capacities indicated. +SIGNATURE +TITLE +/s/ Douglas A. Michels +President, Chief Executive Officer and Director (Principal Executive Officer) +Douglas A. Michels +/s/ Ronald H. Spair +Chief Operating Officer, Chief Financial Officer and Director (Principal Financial Officer) +Ronald H. Spair +/s/ Mark L. Kuna +Senior Vice President, Finance and Controller (Principal Accounting Officer) +Mark L. Kuna +*MICHAEL CELANO +Director +Michael Celano +*RONNY B. LANCASTER +Director +Ronny B. Lancaster +*GERALD M. OSTROV +Director +Gerald M. Ostrov +*CHARLES W. PATRICK +Director +Charles W. Patrick +*ROGER L. PRINGLE +Director +Roger L. Pringle +*STEPHEN S. TANG +Director +Stephen S. Tang +*DOUGLAS G. WATSON +Director +Douglas G. Watson +*By: +/s/ Jack E. Jerrett +Jack E. Jerrett +(Attorney-in-Fact) +74 +Table of Contents +Index to Consolidated Financial Statements +Page +Report of Independent Registered Public Accounting Firm +F-2 +Consolidated Balance Sheets +F-3 +Consolidated Statements of Operations +F-4 +Consolidated Statements of Comprehensive Loss +F-5 +Consolidated Statements of Stockholders’ Equity +F-6 +Consolidated Statements of Cash Flows +F-7 +Notes to the Consolidated Financial Statements +F-8 +F-1 +Table of Contents +REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM +The Board of Directors and Stockholders +OraSure Technologies, +Inc.: +We have audited the accompanying consolidated balance sheets of OraSure Technologies, Inc. and subsidiaries as of December 31, 2013 and 2012, +and the related consolidated statements of operations, comprehensive loss, stockholders’ equity, and cash flows for each of the years in the three-year period ended December 31, 2013. These consolidated financial statements are the +responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits. +We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we +plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial +statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for +our opinion. +In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of +OraSure Technologies, Inc. and subsidiaries as of December 31, 2013 and 2012, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2013, in conformity with U.S. +generally accepted accounting principles. +We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United +States), OraSure Technologies, Inc.’s internal control over financial reporting as of December 31, 2013, based on criteria established in Internal Control—Integrated Framework (1992) issued by the Committee of Sponsoring +Organizations of the Treadway Commission (COSO), and our report dated March 14, 2014 expressed an unqualified opinion on the effectiveness of the Company’s internal control over financial reporting. +/s/ KPMG LLP +Philadelphia, Pennsylvania +March 14, 2014 +F-2 +Table of Contents +ORASURE TECHNOLOGIES, INC. AND SUBSIDIARIES +CONSOLIDATED BALANCE SHEETS +(in thousands, except per share amounts) +December 31, +2013 +2012 +ASSETS +CURRENT ASSETS: +Cash +$ +93,191 +$ +87,888 +Accounts receivable, net of allowance for doubtful accounts of $299 and $285 +12,957 +17,469 +Inventories +11,444 +12,758 +Prepaid expenses +1,712 +1,719 +Deferred income taxes +71 +— +Other current assets +200 +283 +Total current assets +119,575 +120,117 +PROPERTY AND EQUIPMENT, net +17,933 +18,546 +INTANGIBLE ASSETS, net +22,226 +27,207 +GOODWILL +23,782 +25,445 +OTHER ASSETS +729 +124 +$ +184,245 +$ +191,439 +LIABILITIES AND STOCKHOLDERS’ EQUITY +CURRENT LIABILITIES: +Accounts payable +$ +4,834 +$ +3,380 +Deferred revenue +1,119 +5,504 +Accrued expenses +13,032 +7,750 +Total current liabilities +18,985 +16,634 +OTHER LIABILITIES +677 +89 +DEFERRED INCOME TAXES +3,437 +4,401 +COMMITMENTS AND CONTINGENCIES (Note 13) +STOCKHOLDERS’ EQUITY +Preferred stock, par value $.000001, 25,000 shares authorized, none issued +— +— +Common stock, par value $.000001, 120,000 shares authorized, 55,632 and 55,281 shares issued and outstanding +— +— +Additional paid-in capital +338,674 +333,522 +Accumulated other comprehensive loss +(3,797 +) +(666 +) +Accumulated deficit +(173,731 +) +(162,541 +) +Total stockholders’ equity +161,146 +170,315 +$ +184,245 +$ +191,439 +See accompanying notes to the consolidated financial statements. +F-3 +Table of Contents +ORASURE TECHNOLOGIES, INC. AND SUBIDIARIES +CONSOLIDATED STATEMENTS OF OPERATIONS +(in thousands, except per share amounts) +For the years ended December 31, +2013 +2012 +2011 +NET REVENUES: +Product +$ +98,317 +$ +85,753 +$ +80,683 +Licensing and product development +623 +2,067 +1,198 +98,940 +87,820 +81,881 +COST OF PRODUCTS SOLD +40,351 +32,249 +30,164 +Gross profit +58,589 +55,571 +51,717 +OPERATING EXPENSES: +Research and development +10,932 +12,445 +18,406 +Sales and marketing +46,465 +37,087 +22,383 +General and administrative +21,654 +22,309 +20,325 +Gain on contract termination settlement +(8,300 +) +— +— +70,751 +71,841 +61,114 +Operating loss +(12,162 +) +(16,270 +) +(9,397 +) +INTEREST EXPENSE +— +(172 +) +(316 +) +OTHER INCOME (EXPENSE) +200 +(70 +) +3 +Loss before income taxes +(11,962 +) +(16,512 +) +(9,710 +) +INCOME TAX BENEFIT +(772 +) +(1,397 +) +(869 +) +NET LOSS +$ +(11,190 +) +$ +(15,115 +) +$ +(8,841 +) +LOSS PER SHARE: +BASIC +$ +(0.20 +) +$ +(0.29 +) +$ +(0.19 +) +DILUTED +$ +(0.20 +) +$ +(0.29 +) +$ +(0.19 +) +SHARES USED IN COMPUTING LOSS PER SHARE: +BASIC +55,555 +51,457 +46,908 +DILUTED +55,555 +51,457 +46,908 +See +accompanying notes to the consolidated financial statements. +F-4 +Table of Contents +ORASURE TECHNOLOGIES, INC. AND SUBIDIARIES +CONSOLIDATED STATEMENTS OF COMPREHENSIVE LOSS +(in thousands) +For the years ended December 31, +2013 +2012 +2011 +NET LOSS +$ +(11,190 +) +$ +(15,115 +) +$ +(8,841 +) +OTHER COMPEHENSIVE INCOME (LOSS) +Currency translation adjustments +(3,131 +) +1,298 +(1,729 +) +Other comprehensive income (loss) +(3,131 +) +1,298 +(1,729 +) +COMPREHENSIVE LOSS +$ +(14,321 +) +$ +(13,817 +) +$ +(10,570 +) +See accompanying notes to the consolidated financial statements. +F-5 +Table of Contents +ORASURE TECHNOLOGIES, INC. AND SUBSIDIARIES +CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY +For the years ended December 31, 2013, 2012 and 2011 +(in thousands) +Common Stock +Additional Paid-in +Capital +Accumulated +Other +Comprehensive +Loss +Accumulated +Deficit +Total +Shares +Amount +Balance at January 1, 2011 +46,226 +$ +— +$ +241,663 +$ +(235 +) +$ +(138,585 +) +$ +102,843 +Common stock issued upon exercise of options +880 +— +4,783 +— +— +4,783 +Vesting of restricted stock +421 +— +— +— +— +— +Purchase and retirement of treasury shares +(134 +) +— +(909 +) +— +— +(909 +) +Compensation cost for restricted stock +— +— +2,521 +— +— +2,521 +Compensation cost for stock option grants +— +— +1,582 +— +— +1,582 +Net loss +— +— +— +— +(8,841 +) +(8,841 +) +Currency translation adjustments +— +— +— +(1,729 +) +— +(1,729 +) +Balance at December 31, 2011 +47,393 +— +249,640 +(1,964 +) +(147,426 +) +100,250 +Common stock issued upon exercise of options +1,476 +— +10,040 +— +— +10,040 +Vesting of restricted stock +454 +— +— +— +— +— +Issuance of common stock for public equity offering +6,100 +70,246 +— +— +70,246 +Purchase and retirement of treasury shares +(142 +) +— +(1,560 +) +— +— +(1,560 +) +Compensation cost for restricted stock +— +— +2,894 +— +— +2,894 +Compensation cost for stock option grants +— +— +2,262 +— +— +2,262 +Net loss +— +— +— +(15,115 +) +(15,115 +) +Currency translation adjustments +— +— +— +1,298 +— +1,298 +Balance at December 31, 2012 +55,281 +— +333,522 +(666 +) +(162,541 +) +170,315 +Common stock issued upon exercise of options +80 +— +409 +— +— +409 +Vesting of restricted stock +395 +— +— +— +— +— +Purchase and retirement of treasury shares +(124 +) +— +(829 +) +— +— +(829 +) +Compensation cost for restricted stock +— +— +2,878 +— +— +2,878 +Compensation cost for stock option grants +— +— +2,694 +— +— +2,694 +Net loss +— +— +— +— +(11,190 +) +(11,190 +) +Currency translation adjustments +— +— +— +(3,131 +) +— +(3,131 +) +Balance at December 31, 2013 +55,632 +$ +0 +$ +338,674 +$ +(3,797 +) +$ +(173,731 +) +$ +161,146 +See accompanying notes to the consolidated financial +statements +F-6 +Table of Contents +ORASURE TECHNOLOGIES, INC. AND SUBSIDIARIES +CONSOLIDATED STATEMENTS OF CASH FLOWS +(in thousands) +For the years ended December 31 +2013 +2012 +2011 +OPERATING ACTIVITIES: +Net loss +$ +(11,190 +) +$ +(15,115 +) +$ +(8,841 +) +Adjustments to reconcile net loss to net cash provided by (used in) operating activities: +Stock-based compensation +5,572 +5,197 +4,100 +Depreciation and amortization +6,552 +7,250 +4,891 +Deferred income taxes +(772 +) +(1,397 +) +(868 +) +Inventory purchase accounting step-up adjustment +— +16 +852 +Changes in assets and liabilities +Accounts receivable +4,337 +(220 +) +(3,377 +) +Inventories +1,268 +(3,139 +) +(1,757 +) +Prepaid expenses and other assets +51 +(99 +) +491 +Accounts payable +1,510 +(791 +) +911 +Deferred revenue +(4,365 +) +4,178 +112 +Accrued expenses and other liabilities +5,422 +(1,253 +) +492 +Net cash provided by (used in) operating activities +8,385 +(5,373 +) +(2,994 +) +INVESTING ACTIVITIES: +Proceeds from maturities and redemptions of short-term investments +— +— +1,895 +Acquisition of DNA Genotek Inc., net of cash acquired +— +— +(49,730 +) +Purchases of property and equipment +(2,462 +) +(2,019 +) +(2,505 +) +Net cash used in investing activities +(2,462 +) +(2,019 +) +(50,340 +) +FINANCING ACTIVITIES: +Repayments of long-term debt +— +(7,292 +) +(500 +) +Proceeds from the issuance of common stock, net of expenses +— +70,246 +— +Proceeds from exercise of stock options +409 +10,040 +4,783 +Repurchase of common stock +(829 +) +(1,560 +) +(909 +) +Net cash (used in) provided by financing activities +(420 +) +71,434 +3,374 +EFFECT OF FOREIGN EXCHANGE RATE CHANGES ON CASH +(200 +) +(32 +) +(5 +) +NET INCREASE (DECREASE) IN CASH +5,303 +64,010 +(49,965 +) +CASH, BEGINNING OF PERIOD +87,888 +23,878 +73,843 +CASH, END OF PERIOD +$ +93,191 +$ +87,888 +$ +23,878 +See accompanying notes to the consolidated financial statements. +F-7 +Table of Contents +ORASURE TECHNOLOGIES, INC. AND SUBSIDIARIES +NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS +(in thousands, except per share amounts, unless otherwise indicated) +1. +THE COMPANY: +We manufacture and market oral fluid diagnostic products and specimen collection devices using our proprietary oral fluid +technologies, as well as other diagnostic products, including immunoassays and other in vitro diagnostic tests that are used on other specimen types. Our diagnostic products include tests that are performed on a rapid basis at the point of +care and tests that are processed in a laboratory. In September 2012, we began selling our OraQuick ® In-Home HIV test, the first and only rapid point-of-care HIV test approved for use in the +domestic consumer retail or over-the-counter (“OTC”) market. We also manufacture and sell oral fluid collection devices used to collect, stabilize and store samples of genetic material for molecular testing in the consumer genetic, +clinical genetic testing, academic research, pharmacogenomics, personalized medicine, and animal genetics markets. Lastly, we manufacture and sell medical devices used for the removal of benign skin lesions by cryosurgery, or freezing. Our products +are sold in the United States and internationally to various clinical laboratories, hospitals, clinics, community-based organizations, public health organizations, research and academic institutions, distributors, government agencies, +physicians’ offices, and commercial and industrial entities. Our OTC HIV and cryosurgical products are sold to retail pharmacies and mass merchandisers, and to consumers over the internet. +2. +SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES: +Principles of Consolidation and Basis of Presentation +The consolidated financial statements include the accounts of OraSure and its wholly-owned subsidiary, DNA Genotek Inc. (“DNAG” and, +collectively with OraSure, the “Company”). All intercompany transactions and balances have been eliminated. Certain amounts have been reclassified to conform to the current year presentation. +Use of Estimates +The +preparation of consolidated financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions about future events. These estimates and underlying +assumptions affect the amounts of assets and liabilities reported, disclosures about contingent assets and liabilities, and reported amounts of revenues and expenses. Such estimates include the valuation of accounts receivable and inventories and +assumptions utilized in impairment testing for intangible assets and goodwill, as well as calculations related to contingencies and accruals, among others. These estimates and assumptions are based on management’s best estimates and judgment. +Management evaluates its estimates and assumptions on an ongoing basis, using historical experience and other factors, which management believes to be reasonable under the circumstances, including the current economic environment. We adjust such +estimates and assumptions when facts and circumstances dictate. Illiquid credit markets, volatile equity and foreign currency markets, reductions in government funding, and declines in consumer spending have combined to increase the uncertainty +inherent in such estimates and assumptions. As future events and their effects cannot be determined with precision, actual results could differ significantly from these estimates. Changes in those estimates resulting from continuing changes in the +economic environment and other factors will be reflected in the financial statements in those future periods. +Supplemental Cash Flow +Information +On July 30, 2012, we repaid the balance of our long-term debt so we paid no interest during 2013. In 2012 and 2011, +we paid interest of $199 and $318, respectively. +F-8 +Table of Contents +In 2013, we paid state income taxes of $27. In 2012, we paid foreign and state income taxes of +$22. In 2011, we received a refund of $15 for federal and state income taxes, net of state taxes paid. +In 2013, 2012 and 2011, we +recorded through the consolidated statements of operations an increase in our allowance for doubtful accounts of $18, $115 and $64, respectively. +Accounts Receivable +Accounts receivable have been reduced by an estimated allowance for amounts that may become uncollectible in the future. This estimated +allowance is based primarily on management’s evaluation of specific balances as they become past due, the financial condition of our customers and our historical experience related to write-offs. +Inventories +Inventories +are stated at the lower of cost or market determined on a first-in, first-out basis, and include the cost of raw materials, labor and overhead. The majority of our inventories are subject to expiration dating. We continually evaluate quantities on +hand and the carrying value of our inventories to determine the need for reserves for excess and obsolete inventories, based primarily on the estimated forecast of product sales. When factors indicate that impairment has occurred, either a reserve +is established against the inventories’ carrying value or the inventories are completely written off, as in the case of lapsing expiration dates. In addition to reserving for these items identified through specific identification procedures, we +also reserve for unidentified scrap or spoilage under a fixed-formula methodology. +Property and Equipment +Property and equipment are stated at cost. Additions or improvements are capitalized, while repairs and maintenance are charged to expense. +Depreciation and amortization are provided using the straight-line method over the estimated useful lives of the related assets. Buildings are depreciated over twenty to forty years, while computer equipment, machinery and equipment, and furniture +and fixtures are depreciated over two to ten years. Building improvements are amortized over their estimated useful lives. When assets are sold or otherwise disposed of, the related property amounts are relieved from the accounts, and any gain or +loss is recorded in the consolidated statement of operations. +Intangible Assets +Intangible assets consist of a customer list, patents and product rights, acquired technology, tradenames and non-compete agreements. Patents +and product rights consist of costs associated with the acquisition of patents, licenses and product distribution rights. The customer list, acquired technology, tradenames and non-compete agreements were all part of our acquisition of DNAG in +August 2011. Intangible assets are amortized using the straight-line method over their estimated useful lives of one to fifteen years. +Goodwill +Goodwill +represents the excess of the purchase price we paid over the fair value of the net tangible and identifiable intangible assets acquired and liabilities assumed in our acquisition of DNAG in August 2011. Goodwill is not amortized but rather is tested +annually for impairment or more frequently if we believe that indicators of impairment exist. Current U.S. generally accepted accounting principles permit us to make a qualitative evaluation about the likelihood of goodwill impairment. If we +conclude that it is more likely than not that the fair value of a reporting unit is greater than its carrying amount, then we would not be required to perform the two-step quantitative impairment test. Otherwise, performing the two-step impairment +test is necessary. The first step of the two-step quantitative impairment test involves comparing the fair values of the +F-9 +Table of Contents +applicable reporting units with their aggregate carrying values, including goodwill. If the carrying value of a reporting unit exceeds the reporting unit’s fair value, we perform the second +step of the test to determine the amount of the impairment loss, if any. The second step involves measuring any impairment by comparing the implied fair values of the affected reporting unit’s goodwill and intangible assets with the respective +carrying values. +We performed our annual impairment assessment as of July 31, 2013 utilizing a qualitative evaluation and concluded +that it was more likely than not that the fair value of our DNAG reporting unit is greater than its carrying amount. We performed our last quantitative impairment test for goodwill as of July 31, 2012 and determined there was no impairment. +That quantitative assessment determined that our DNAG reporting unit had a fair value in excess of its carrying value (including goodwill of $25,179), of approximately 13%. We believe we have made reasonable estimates and assumptions to calculate +the fair value of our reporting unit. If actual future results are not consistent with management’s estimates and assumptions, we may have to take an impairment charge in the future related to our goodwill. Future impairment tests will continue +to be performed annually in the fiscal third quarter, or sooner if a triggering event occurs. As of December 31, 2013, we believe no indicators of impairment exist. +Impairment of Long-Lived Assets +We assess the recoverability of the affected long-lived assets, which include property and equipment and intangible assets, by determining +whether the carrying value of such assets can be recovered through the sum of the undiscounted future cash flows from the use and eventual disposition of the asset. If indicators of impairment exist, we measure the amount of such impairment by +comparing the carrying value of the assets to the fair value of these assets, which is generally determined based on the present value of the expected future cash flows associated with the use of the assets. +Revenue Recognition +We +recognize product revenues when there is persuasive evidence that an arrangement exists, the price is fixed or determinable, title has passed and collection is reasonably assured. Product revenues are recorded net of allowances for any discounts or +rebates. Other than for our OraQuick ® In-Home HIV tests, we do not grant price protection or product return rights to our customers except for warranty returns. Historically, returns arising +from warranty issues have been infrequent and immaterial. Accordingly, we expense warranty returns as incurred. +We began selling our +OraQuick ® In-Home HIV test in the third quarter of 2012. From launch through November 2013, our revenue practices with respect to the +OraQuick ® In-Home HIV test were different than those customarily used in the consumer package goods industry. Under U.S. generally accepted accounting principles, product revenue cannot be +recognized unless the amount of future returns can be reasonably estimated. Because our OraQuick ® In-Home HIV test was a new product for which we did not have a historical record of returns, +we did not believe we could reasonably determine a return rate. As a result we initially did not recognize revenue when we shipped to the retail trade. For these product shipments, we invoiced the retailer or distributor, recorded deferred revenue +at gross invoice sales price, and classified the cost basis of the product held by the retailer or distributor as a component of inventory. We then recognized revenue upon the consummation of a sale to the retail customer either in a store or over +the internet. With the passage of time, however, we concluded that we have sufficient data and visibility into our distribution channel to develop a reasonable estimate of the level of expected returns. As such, commencing in December 2013, we +recognized previously deferred revenue and its related cost of goods sold, and began to recognize revenue for this product upon shipment to the retailers or distributors. +Our net revenues recorded on sales of the OraQuick ® In-Home HIV test represent total +gross revenues, less an allowance for expected returns, and customer allowances for cooperative advertising discounts, rebates, and chargebacks. All of these allowances are estimates established by management, based on currently available +information and are adjusted to reflect known changes in the factors that impact those estimates. These allowances are recorded as a reduction of gross revenue when recognized in our statement of operations. +F-10 +Table of Contents +Royalty income from the grant of license rights is recognized during the period in which the +revenue is earned and the amount is determinable from the licensee. +We record shipping and handling charges billed to our customers as +product revenue and the related expense as cost of products sold. Taxes assessed by governmental authorities, such as sales or value-added taxes, are excluded from product revenues. +Customer Sales Returns and Allowances +We do not grant product return rights to our customers, except for our OraQuick ® +In-Home HIV test. Accordingly, we have recorded an estimate of expected returns as a reduction of gross OraQuick ® In-Home HIV product revenues in our consolidated statement of operations. This +estimate reflects our historical experience of sales to retailers and consumers, as well as other retail factors, and is reviewed regularly to ensure that it reflects potential product returns. As of December 31, 2013, the reserve for sales +returns and allowances was $279. If actual product returns differ materially from our reserve amount, or if a determination is made that this product’s distribution would be discontinued in whole or in part by certain retailers, then we would +need to adjust our reserve. Should the actual level of product returns vary significantly from our estimates, our operating and financial results could be materially affected. +Deferred Revenue +We +record deferred revenue when funds are received prior to the recognition of the associated revenue. Deferred revenue at December 31, 2013 and 2012 included customer prepayments of $1,119 and $1,880, respectively. As of December 31, 2012, +it also included $3,700 related to OraQuick ® In-Home HIV tests, representing the value of product held by those retailers or distributors having product return rights. As previously discussed, +in December 2013 we recognized all of the previously deferred revenue related to our OraQuick ® In-Home HIV test. +Customer and Vendor Concentrations +We had no significant concentrations (greater than 10%) in accounts receivable as of December 31, 2013. As of December 31, 2012, one +of our customers, CVS Distribution, Inc., accounted for approximately 11% of our accounts receivable balance. We had no significant concentrations (greater than 10%) in revenues for the years ended December 31, 2013, 2012 or 2011. +We currently purchase certain products and critical components of our products from sole-supply vendors, and if these vendors are unable or +unwilling to supply the required components and products, we could be subject to increased costs and substantial delays in the delivery of our products to our customers. Also, our subsidiary, DNAG, uses two third-party suppliers to manufacture its +products. Our inability to have a timely supply of any of these components and products could have a material adverse effect on our business, as well as our financial condition and results of operations. +Research and Development +Research and development expenses consist of costs incurred in performing research and development activities, including salaries and benefits, +facilities expenses, overhead expenses, clinical trial and related clinical manufacturing expenses, contract services and other outside expenses. Research and development costs are charged to expense as incurred. Clinical trial expenses include +costs associated with contract research organizations, or CROs. The invoicing from CROs can precede the services provided or can lag the service period by several months. Invoices paid prior to services being provided are recorded as a prepaid +expense and then expensed appropriately as services are provided. We accrue the cost of services rendered but unbilled by CROs based on purchase order estimates provided by the CROs. Differences between actual and estimated clinical trial expenses +recorded are generally not material and are adjusted for in the period in which they become known. +F-11 +Table of Contents +Advertising Expenses +Advertising costs are charged to expense as incurred. During 2013, 2012, and 2011, we incurred $17,142, $6,310, and $130, respectively, in +advertising expenses. 2013 and 2012 expenses include costs associated with our OraQuick ® In-Home HIV test which we began selling in the consumer retail market in the fourth quarter of 2012. +Stock-Based Compensation +We account for stock-based compensation to employees and directors using the fair value method. We recognize compensation expense for stock +option and restricted stock awards issued to employees and directors on a straight-line basis over the requisite service period of the award. To satisfy the exercise of options or to issue restricted stock, we issue new shares rather than purchase +shares on the open market. +Income Taxes +We follow the asset and liability method for accounting for income taxes. Under this method, deferred tax assets and liabilities are recognized +for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and the respective tax basis of assets and liabilities, and operating loss and credit carryforwards. +Deferred tax assets and liabilities are measured using enacted tax rates for the respective taxing jurisdiction that are expected to apply to taxable income in the years in which those temporary differences and operating loss and credit +carryforwards are expected to be recovered, settled or utilized. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. +We assess the realizability of our net deferred tax assets on a quarterly basis. If, after considering all relevant positive and negative +evidence, it is more likely than not that some portion or all of the net deferred tax assets will not be realized, we reduce our net deferred tax assets by a valuation allowance. The realization of the net deferred tax assets is dependent on several +factors, including the generation of sufficient taxable income prior to the expiration of our net operating loss carryforwards. +Foreign Currency Translation +The assets and liabilities of our foreign operations are translated into U.S. dollars at current exchange rates as of the balance sheet date, +and revenues and expenses are translated at average exchange rates for the period. Resulting translation adjustments are reflected in accumulated other comprehensive loss, which is a separate component of stockholders’ equity. +Transaction gains and losses resulting from exchange rate changes on transactions denominated in currencies other than functional currency are +included in income in the period in which the change occurs. +Loss Per Share +Basic and diluted loss per share is computed by dividing net loss by the weighted-average number of shares of common stock outstanding during +the period. Diluted loss per share is generally computed assuming the exercise or vesting of all dilutive securities such as common stock options and unvested restricted stock. Common stock options and unvested restricted stock totaling 5,924, +5,314, and 6,296 shares were outstanding as of December 31, 2013, 2012 and 2011, respectively. As a result of our net losses for the years ended December 31, 2013, 2012 and 2011, these shares were excluded from the respective period’s +computation of diluted loss per share, as their inclusion would have been anti-dilutive. +Accumulated Other Comprehensive Loss +We classify items of other comprehensive loss by their nature and disclose the accumulated balance of other comprehensive loss separately from +accumulated deficit and additional paid-in capital in the stockholders’ equity section of our balance sheet. +F-12 +Table of Contents +Our accumulated other comprehensive loss for 2013, 2012, and 2011 consisted of foreign currency +translation adjustments. +We have defined the Canadian dollar as the functional currency of our Canadian subsidiary, DNAG, and as such, +the results of its operations are translated into U.S. dollars, which is the reporting currency of the Company. The ($3,131), $1,298 and ($1,729) currency translation adjustments recorded in 2013, 2012 and 2011, respectively, are largely the result +of the translation of our Canadian operation’s financial statements into U.S. dollars. +Fair Value of Financial Instruments +As of December 31, 2013 and 2012, the carrying values of cash, accounts receivable, accounts payable and accrued expenses +approximate their respective fair values based on their short-term nature. +Fair value measurements of all financial assets and +liabilities that are being measured and reported on a fair value basis are required to be classified and disclosed in one of the following three categories: +Level 1: +Unadjusted quoted prices in active markets that are accessible at the measurement date for identical, unrestricted assets or liabilities; +Level 2: +Quoted prices in markets that are not active, or inputs which are observable, either directly or indirectly, for substantially the full term of the asset or liability; and +Level 3: +Prices or valuation techniques that require inputs that are both significant to the fair value measurement and unobservable (i.e., supported by little or no market activity). +We offer a nonqualified deferred compensation plan for highly compensated employees. The assets of the plan +are held in the name of the Company at a third-party financial institution. Separate accounts are maintained for each participant to reflect the amounts deferred by the participant and all earnings and losses on those deferred amounts. The assets of +the plan are held in mutual funds and Company stock. The fair value of the plan assets as of December 31, 2013 and 2012 was $677 and $89, respectively, and was calculated using the quoted market price of the assets as of those dates. All +investments in the plan are classified as trading securities and measured as Level 1 instruments. +3. +BUSINESS COMBINATION: +On August 17, 2011 (the “Acquisition Date”), we acquired all of the outstanding capital stock of DNAG, +pursuant to the terms of a Support Agreement dated July 25, 2011. The purchase price was $49,750 CDN ($50,467 in U.S. dollars at the Acquisition Date exchange rate) and was funded by OraSure with cash on hand. The purchase price consisted of +$50,000 CDN ($50,710 million in U.S. dollars at the Acquisition Date exchange rate) less a $250 CDN ($254 U.S. dollars) working capital adjustment received in the fourth quarter of 2011. Of the original $50,000 CDN purchase price, $5,000 CDN (or +$5,071 in U.S. dollars at the Acquisition Date exchange rate) was deposited in escrow pursuant to the related support agreement. The payment for the working capital adjustment was funded from the escrow account. Subject to certain adjustments and +the processing of any indemnification claims, $1.9 million CDN was released from the escrow fund to the seller in February 2013 with the balance released in February 2014. +We have accounted for the acquisition of DNAG using the acquisition method of accounting. Under the acquisition method of accounting, the +total purchase price is allocated to the tangible and identifiable intangible assets acquired and the liabilities assumed based upon their estimated fair values as of the Acquisition Date. The excess of the fair value of the consideration paid over +the estimated fair value of the assets acquired and liabilities assumed was recorded as goodwill. For purposes of the purchase price allocation, fair value is defined as an exit price, representing the amount that would be received to sell an asset +or paid to transfer a liability in an +F-13 +Table of Contents +orderly transaction between market participants. The fair value guidance also requires that the fair value measurements reflect the assumptions market participants use in pricing an asset or +liability based upon the best information available. Under the acquisition method of accounting, acquisition related transaction costs, such as success-based banking fees and professional fees, are not included as a component of consideration +transferred, but rather are accounted for as expenses in the periods in which the costs are incurred. +During 2011, we incurred a total of +$2,634 of acquisition related costs, including success-based investment banking fees and accounting, legal and other professional fees, related to the DNAG acquisition, all of which were expensed and included in general and administrative expenses +in the consolidated statement of operations for the year ended December 31, 2011. +The following table summarizes the allocation of +the fair values of the assets acquired and the liabilities assumed at the Acquisition Date: +Current assets +$ +3,734 +Property, plant and equipment +715 +Other assets +760 +Intangible assets +28,502 +Goodwill +25,619 +Total assets acquired +59,330 +Current liabilities +(1,388 +) +Deferred tax liability +(7,475 +) +Total liabilities assumed +(8,863 +) +Purchase price +50,467 +Less cash acquired +(737 +) +Net cash paid +$ +49,730 +Included in the current assets acquired in the DNAG acquisition was inventory having an estimated fair value +of $1,413. This fair value includes an $892 “step-up” adjustment to capitalize the estimated manufacturing profit in acquired finished goods inventory as of the Acquisition Date, of which we expensed $16 and $852 to cost of products sold +during the years ended December 31, 2012 and 2011, respectively. +The results of operations associated with DNAG have been +consolidated with those of the Company since the Acquisition Date. Total revenues of $6,216 and a net loss of $693, including $852 of inventory step-up as noted above, attributable to DNAG were recognized in the consolidated statement of operations +for the year ended December 31, 2011. +The following unaudited condensed consolidated pro forma information sets forth the revenues, +net loss and net loss per share of the Company for the year ended December 31, 2011, as if the acquisition had occurred on January 1, 2010. The unaudited pro forma information presented below is not necessarily indicative of the results +that would have been attained had the transaction occurred at an earlier date, nor are these results necessarily indicative of future consolidated results of operations of the Company. +Total revenues +$ +89,966 +Net loss +(10,911 +) +Loss per share: +Basic and diluted +$ +(0.23 +) +The supplemental pro forma results for the year ended December 31, 2011 exclude $2,634 of transaction +costs incurred by OraSure that were recorded in operating expenses. +F-14 +Table of Contents +4. +INVENTORIES: +December 31, +2013 +2012 +Raw materials +$ +6,700 +$ +6,777 +Work in process +833 +393 +Finished goods +3,911 +5,588 +$ +11,444 +$ +12,758 +5. +PROPERTY AND EQUIPMENT: +December 31, +2013 +2012 +Land +$ +1,118 +$ +1,118 +Buildings and improvements +16,977 +16,589 +Machinery and equipment +19,199 +18,423 +Computer equipment and software +6,443 +5,989 +Furniture and fixtures +1,731 +1,692 +Construction in progress +855 +581 +46,323 +44,392 +Less accumulated depreciation +(28,390 +) +(25,846 +) +$ +17,933 +$ +18,546 +Depreciation expense was $3,026, $3,347, and $2,934 for 2013, 2012, and 2011, respectively. +6. +GOODWILL AND OTHER INTANGIBLE ASSETS: +The changes in goodwill are as follows: +December 31, +2013 +2012 +Balance as of January 1 +$ +25,445 +$ +24,740 +Increase (decrease) related to foreign currency translation +(1,663 +) +705 +Balance as of December 31 +$ +23,782 +$ +25,445 +Intangible assets consist of the following: +December 31, 2013 +Amortization +Period (Years) +Gross +Accumulated +Amortization +Net +Customer list +10 +$ +11,795 +$ +(2,701 +) +$ +9,094 +Patents and product rights +3-10 +10,449 +(7,466 +) +2,983 +Acquired technology +7 +9,162 +(2,952 +) +6,210 +Tradename +15 +4,521 +(715 +) +3,806 +Non-compete agreements +1-3 +787 +(654 +) +133 +$ +36,714 +$ +(14,488 +) +$ +22,226 +F-15 +Table of Contents +December 31, 2012 +Amortization +Period (Years) +Gross +Accumulated +Amortization +Net +Customer list +10 +$ +12,619 +$ +(1,673 +) +$ +10,946 +Patents and product rights +3-10 +10,449 +(6,926 +) +3,523 +Acquired technology +7 +9,802 +(1,829 +) +7,973 +Tradename +15 +4,837 +(443 +) +4,394 +Non-compete agreements +1-3 +842 +(471 +) +371 +$ +38,549 +$ +(11,342 +) +$ +27,207 +Patents and products rights are made up of the following: +December 31, +2013 +2012 +HIV-related +$ +1,900 +$ +1,900 +HCV-related +4,500 +4,500 +Lateral flow-related +1,500 +1,500 +Cryosurgery-related +2,549 +2,549 +10,449 +10,449 +Less accumulated amortization +(7,466 +) +(6,926 +) +$ +2,983 +$ +3,523 +Amortization expense for 2013, 2012, and 2011 was $3,526, $3,903, and $1,957, respectively. +Amortization expense for each of the five succeeding fiscal years and beyond is estimated as follows: +2014 +$ +3,394 +2015 +3,216 +2016 +3,216 +2017 +3,216 +2018 +3,212 +Beyond +5,972 +7. +ACCRUED EXPENSES: +December 31, +2013 +2012 +Payroll and related benefits +$ +5,827 +$ +4,248 +Royalties +4,374 +1,948 +Professional fees +749 +413 +Other +2,082 +1,141 +$ +13,032 +$ +7,750 +F-16 +Table of Contents +8. +LONG-TERM DEBT: +As of December 31, 2011, we had in place a $10,000,000 credit facility (the “Credit Facility”), as amended, +with Comerica Bank (“Comerica”). Pursuant to the terms of the Credit Facility, principal and interest fixed at 4.15% per annum were payable monthly through August 27, 2012, at which time the remaining unpaid principal balance was +payable. On July 30, 2012, we repaid the $7,042 principal balance outstanding under the Credit Facility and it was terminated. +9. +INCOME TAXES: +Income (loss) before income tax benefit consists of the following: +Years Ended December 31, +2013 +2012 +2011 +United States +$ +(12,833 +) +$ +(13,515 +) +$ +(8,147 +) +Canada +871 +(2,997 +) +(1,563 +) +$ +(11,962 +) +$ +(16,512 +) +$ +(9,710 +) +The components of the income tax benefit for the years ended December 31, 2013, 2012 and 2011 are as +follows: +2013 +2012 +2011 +Deferred +Federal +$ +(4,280 +) +$ +(4,370 +) +$ +(2,674 +) +State +(323 +) +(272 +) +(273 +) +Canada +(772 +) +(1,397 +) +(869 +) +(5,375 +) +(6,039 +) +(3,816 +) +Increase in valuation allowance +4,603 +4,642 +2,947 +Total income tax benefit +$ +(772 +) +$ +(1,397 +) +$ +(869 +) +For the years ended December 31, 2013, 2012 and 2011, we recorded a foreign deferred tax benefit of $772, +$1,397 and $869, respectively, associated with certain Canadian research and development and investment tax credits and DNAG’s loss before income taxes in 2012 and 2011. The income tax benefit associated with DNAG was considered realizable +based upon the estimated scheduled reversal of the deferred tax liabilities recorded in connection with the acquisition of DNAG. The deferred tax benefit for the year ended December 31, 2012 was negatively impacted by a $428 adjustment to +DNAG’s deferred tax liability recorded in the second quarter of 2012 to reflect a change in the enacted Canadian provincial tax rates. +A reconciliation of the statutory United States federal income tax rate to our effective tax rate for each of the years ended +December 31, 2013, 2012, and 2011 is as follows: +2013 +2012 +2011 +Statutory U.S. federal income tax rate +(34.0 +)% +(34.0 +)% +(34.0 +)% +State income taxes, net of federal benefit +(1.6 +) +(1.2 +) +(1.9 +) +Canadian income taxes +(6.5 +) +(8.5 +) +(8.9 +) +Nondeductible expenses and other +(0.4 +) +1.0 +5.3 +U.S. research and development credits +— +(0.3 +) +(5.7 +) +Change in valuation allowance, federal and state +36.0 +34.5 +36.3 +Effective tax rate +(6.5 +)% +(8.5 +)% +(8.9 +)% +F-17 +Table of Contents +Deferred income taxes reflect the tax effects of temporary differences between the basis of +assets and liabilities recognized for financial reporting purposes and tax purposes, and net operating loss and tax credit carryforwards. Significant components of our deferred tax assets (liabilities) as of December 31, 2013 and 2012 are as +follows: +2013 +2012 +Deferred tax assets (liabilities): +Net operating loss carryforwards +$ +25,751 +$ +21,207 +Inventories +1,531 +1,781 +Capitalized research and development costs +5,276 +6,148 +Accruals and reserves currently not deductible +2,048 +1,205 +Patent costs +865 +1,202 +Acquired intangible assets +(5,099 +) +(6,278 +) +Depreciation and amortization +(751 +) +(744 +) +Stock-based compensation +4,704 +4,176 +Investment tax credit carryforward +1,230 +918 +Research and development tax credit carryforward +2,076 +2,378 +Net deferred tax asset +37,631 +31,993 +Valuation allowance +(40,997 +) +(36,394 +) +Net deferred tax liability +$ +(3,366 +) +$ +(4,401 +) +In assessing the realizability of our net deferred tax asset, we consider all relevant positive and negative +evidence in determining whether it is more likely than not that some portion or all of the deferred income tax assets will not be realized. The realization of the gross deferred tax assets is dependent on several factors, including the generation of +sufficient taxable income prior to the expiration of the NOL carryforwards. In 2008, we established a full valuation allowance against our U.S. net deferred tax asset, and management believes the full valuation allowance is still appropriate as of +December 31, 2013 and 2012 since the facts and circumstances necessitating the allowance have not changed. As a result, no U.S. federal or state income tax benefit was recorded for the years ended December 31, 2013, 2012, or 2011. +Our Federal NOL carryforwards expire as follows: +Year of Expiration +NOLs +2018 - 2019 +$ +16,377 +2020 - 2024 +16,398 +2025 - 2031 +14,476 +2032 - 2033 +26,030 +$ +73,281 +The Tax Reform Act of 1986 contains provisions that limit the annual amount of NOLs available to be used in +any given year in the event of a significant change in ownership. On September 29, 2000, two separate companies, STC Technologies, Inc. and Epitope, Inc., merged to form OraSure. A significant change in ownership, as defined by Section 382 +of the Internal Revenue Code, occurred in connection with this merger. As such, the utilization of NOLs generated prior to September 29, 2000 is limited to approximately $13,700 per year. We do not believe that this limitation will have a +material adverse impact on the utilization of our Federal NOL carryforwards in future years. +As of December 31, 2013, our gross +unrecognized tax benefits totaled $2,051 and based upon the valuation allowance for our U.S. operations, the recognition of any tax benefit would not impact our effective tax rate. +F-18 +Table of Contents +We record interest and penalties related to unrecognized tax benefits as a component of income tax expense. Interest and penalties were immaterial in 2013, 2012 and 2011. As a result of our net +operating loss carryforward position, we are subject to audit by the Internal Revenue Service since our inception, as well as by several state jurisdictions for the years ended December 31, 2001 through 2013. +A reconciliation of the beginning and ending amount of unrecognized tax benefits is as follows: +2013 +2012 +2011 +Balance as of January 1 +$ +2,011 +$ +2,015 +$ +2,090 +Additions based on tax positions related to the current period +— +— +53 +Additions for tax positions of prior periods +40 +67 +19 +Reductions for tax positions of prior periods +— +(71 +) +(147 +) +Balance as of December 31 +$ +2,051 +$ +2,011 +$ +2,015 +10. +STOCKHOLDERS’ EQUITY: +Stock-Based Awards +We grant stock-based awards under the OraSure Technologies, Inc. Stock Award Plan, as amended and restated (the “Stock Plan”). The +Stock Plan permits stock-based awards to employees, outside directors and consultants or other third-party advisors. Awards which may be granted under the Stock Plan include qualified incentive stock options, nonqualified stock options, stock +appreciation rights, restricted awards, performance awards and other stock-based awards. We recognize compensation expense for stock option and restricted stock awards issued to employees and directors on a straight-line basis over the requisite +service period of the award. To satisfy the exercise of options or to issue restricted stock, we normally issue new shares rather than purchase shares on the open market. +Under the terms of the Stock Plan, nonqualified options may be granted to eligible employees, including our officers at a price not less than +75 percent of the fair market value of a share of common stock on the date of grant. The option term and vesting schedule of such awards may be either unlimited or have a specified period in which to vest and be exercised. To date, options generally +have been granted with ten-year exercise periods and an exercise price not less than the fair market value on the date of grant. Options generally vest over four years, with one quarter of the options vesting one year after grant and the remainder +vesting on a monthly basis over the next three years. +As of December 31, 2013, 2,019 shares were available for future grants under +the Stock Plan. +The fair value of each stock option was estimated on the date of the grant using the Black-Scholes option-pricing model +using the following weighted-average assumptions: +Years Ended December 31, +Black-Scholes Option Valuation Assumptions +2013 +2012 +2011 +Risk-free interest rate (1) +1.47 +% +0.99 +% +1.36 +% +Expected dividend yield +— +— +— +Expected stock price volatility (2) +51 +% +52 +% +54 +% +Expected life of stock options (in years) (2) +7 +6 +4 +(1) +Based on the constant maturity interest rate of U.S. Treasury securities whose term is consistent with the expected life of our stock options. +(2) +Based upon historical experience. +F-19 +Table of Contents +The weighted-average grant date fair value of stock options granted during the years ended +December 31, 2013, 2012 and 2011 was $3.58, $5.38 and $2.82, respectively. +Compensation expense recognized in the financial +statements related to stock options was as follows: +Years Ended December 31, +2013 +2012 +2011 +Total compensation cost during the year +$ +2,694 +$ +2,262 +$ +1,579 +Amounts capitalized into inventory during the year +(128 +) +(90 +) +(58 +) +Amounts recognized in cost of products sold for amounts previously capitalized +99 +58 +36 +Amounts charged against income +$ +2,665 +$ +2,230 +$ +1,557 +The aggregate intrinsic value of options exercised during the years ended December 31, 2013, 2012 and +2011 (the amount by which the market price of the stock on the date of exercise exceeded the exercise price) was $125, $6,961, and $2,490, respectively. +The following table summarizes the stock option activity under the Stock Plan: +Options +Weighted-Average +Exercise Price Per +Share +Weighted-Average +Remaining +Contractual Term +(in years) +Aggregate +Intrinsic +Value +Outstanding on January 1, 2011 +5,504 +$ +6.83 +Granted +1,143 +6.78 +Exercised +(880 +) +5.44 +Expired +(163 +) +10.74 +Forfeited +(188 +) +8.11 +Outstanding on December 31, 2011 +5,416 +6.89 +Granted +783 +11.18 +Exercised +(1,476 +) +6.80 +Expired +(12 +) +6.07 +Forfeited +(67 +) +7.49 +Outstanding on December 31, 2012 +4,644 +7.64 +Granted +984 +6.94 +Exercised +(80 +) +5.07 +Expired +(82 +) +7.59 +Forfeited +(195 +) +7.87 +Outstanding on December 31, 2013 +5,271 +$ +7.54 +6.0 +$ +1,595 +Vested or expected to vest as of December 31, 2013 +5,152 +$ +7.54 +6.0 +$ +1,591 +Exercisable on December 31, 2013 +3,705 +$ +7.39 +5.0 +$ +1,555 +As of December 31, 2013, there was $5,141 of unrecognized compensation expense related to unvested option +awards that is expected to be recognized over a weighted-average period of 2.5 years. +Net cash proceeds from the exercise of stock +options were $409, $10,040 and $4,783 for the years ended December 31, 2013, 2012 and 2011, respectively. As a result of our net operating loss carryforward position, no actual income tax benefit was realized from stock option exercises for +these periods. +F-20 +Table of Contents +The following table summarizes information about stock options outstanding as of +December 31, 2013: +Options outstanding +Options exercisable +Range of exercise prices +Number +Outstanding +Weighted- +Average +Remaining +Contractual +Term +(in years) +Weighted- +Average +Exercise +Price Per +Share +Number +Exercisable +Weighted- +Average +Exercise +Price Per +Share +$2.55 - $5.19 +860 +8.2 +$ +4.47 +846 +$ +4.46 +$5.60 - $6.37 +396 +4.9 +5.79 +279 +5.73 +$6.63 +704 +6.9 +6.63 +506 +6.63 +$6.67 +1 +4.2 +6.67 +1 +6.67 +$7.05 +809 +9.0 +7.05 +— +— +$7.33 - $8.20 +833 +3.0 +8.00 +773 +8.05 +$8.21 - $9.04 +567 +3.4 +8.53 +562 +8.53 +$9.05 - $10.99 +415 +2.0 +9.63 +411 +9.62 +$11.30 +684 +7.9 +11.30 +325 +11.30 +$12.14 +2 +4.6 +12.14 +2 +12.14 +5,271 +6.0 +$ +7.54 +3,705 +$ +7.39 +The Stock Plan also permits us to grant restricted shares of our common stock to eligible employees, including +officers, and our outside directors. Generally, these shares are nontransferable until vested and are subject to vesting requirements and/or forfeiture, as determined by the Compensation Committee of our Board of Directors. The market value of these +shares at the date of grant is recognized on a straight-line basis over the period during which the restrictions lapse. Compensation cost of $2,878, $2,894 and $2,521 related to restricted shares was recognized during the years ended +December 31, 2013, 2012 and 2011, respectively. +The following table summarizes restricted stock award activity under the Stock Plan: +Shares +Weighted-Average +Grant Date Fair +Value +Issued and unvested, January 1, 2011 +792 +$ +5.28 +Granted +527 +6.53 +Vested +(422 +) +5.47 +Forfeited +(18 +) +6.63 +Issued and unvested, December 31, 2011 +879 +5.91 +Granted +259 +11.31 +Vested +(454 +) +5.56 +Forfeited +(14 +) +7.77 +Issued and unvested, December 31, 2012 +670 +8.19 +Granted +438 +6.30 +Vested +(395 +) +7.81 +Forfeited +(60 +) +8.27 +Issued and unvested, December 31, 2013 +653 +$ +7.15 +Issued and expected to vest, December 31, 2013 +653 +$ +7.15 +As of December 31, 2013, there was $2,403 of unrecognized compensation expense related to unvested +restricted stock awards that is expected to be recognized over a weighted average period of 1.5 years. +F-21 +Table of Contents +In connection with the vesting of restricted shares during the years ended December 31, +2013, 2012 and 2011, we purchased and immediately retired 124, 142 and 134 shares with aggregate values of $829, $1,560 and $909, respectively, in satisfaction of minimum tax withholding obligations. +Share Repurchase Program +On August 5, 2008, our Board of Directors approved a share repurchase program pursuant to which we are permitted to acquire up to $25,000 +of our outstanding common shares. No shares were purchased and retired in 2013, 2012 or 2011. +Public Equity Offering +On July 11, 2012, we completed a public offering of 6,100 common shares, at a price of $12.30 per share, raising $75,030 before expenses +of the offering. In connection with the offering, we paid $4,502 in underwriting discounts and commissions and incurred $282 in additional offering expenses. +11. +TERMINATION SETTLEMENT: +On November 21, 2013, we terminated our assay collaboration agreement with Roche Diagnostics (“Roche”). Pursuant to this +termination agreement, Roche paid us $8,300 which was recorded as a reduction of operating expense on our consolidated statement of operations. Roche agreed to provide certain transitional product support services to us and will continue to supply +certain of the assays developed under the collaboration on a transitional basis for up to five years following the termination. We have the right to stop the supply of assays prior to the end of this five-year period and could receive an additional +payment from Roche of up to $5.5 million depending on how early in that five-year period the supply authorization is ended. +12. +BUSINESS SEGMENT INFORMATION: +We operate our business within two reportable segments: our “OSUR” business, which consists of the development, +manufacture and sale of oral fluid diagnostic products and specimen collection devices and the manufacture and sale of medical devices used for the removal of benign skin lesions by cryosurgery; and our molecular collection systems or +“DNAG” business, which consists primarily of the manufacture, development and sale of oral fluid collection devices that are used to collect, stabilize and store samples of genetic material for molecular testing. OSUR revenues are derived +primarily from products sold in the United States and internationally to various clinical laboratories, hospitals, clinics, community-based organizations, public health organizations, distributors, government agencies, physicians’ offices, and +commercial and industrial entities. Revenues from OSUR’s OTC products primarily result from sales to retail pharmacies and mass merchandisers and to consumers over the internet. OSUR also derives revenues from licensing and product development +activities. DNAG revenues result primarily from products sold into the commercial market which consists of companies and other entities engaged in consumer genetics, clinical genetic testing, pharmacogenomics, personalized medicine, and animal and +livestock genetic testing, as well as products sold into the academic research market, which consists of research laboratories, universities and hospitals. +We organized our operating segments according to the nature of the products included in those segments. The accounting policies of the +segments are the same as those described in the summary of significant accounting policies (see Note 2). We evaluate performance of our operating segments based on revenue and operating income (loss). We do not allocate interest income, interest +expense, other income, other expenses or income taxes to our operating segments. Reportable segments have no inter-segment revenues. +F-22 +Table of Contents +The following table summarizes segment information for the years ended December 31, 2013, +2012, and 2011: +Years Ended December 31, +2013 +2012 +2011 +Net revenues: +OSUR +$ +78,559 +$ +73,562 +$ +75,665 +DNAG +20,381 +14,258 +6,216 +Total +$ +98,940 +$ +87,820 +$ +81,881 +Operating income (loss): +OSUR +$ +(12,849 +) +$ +(13,395 +) +$ +(7,855 +) +DNAG +687 +(2,875 +) +(1,542 +) +Total +$ +(12,162 +) +$ +(16,270 +) +$ +(9,397 +) +Depreciation and amortization: +OSUR +$ +3,225 +$ +3,530 +$ +3,550 +DNAG +3,327 +3,720 +1,341 +Total +$ +6,552 +$ +7,250 +$ +4,891 +Capital expenditures: +OSUR +$ +1,687 +$ +1,794 +$ +2,345 +DNAG +775 +225 +160 +Total +$ +2,462 +$ +2,019 +$ +2,505 +December 31, +2013 +2012 +Total assets: +OSUR +$ +130,848 +$ +137,258 +DNAG +53,397 +54,181 +Total +$ +184,245 +$ +191,439 +Our products are sold principally in the United States, Canada and Europe. +The following table represents total net revenues by geographic area, based on the location of the customer: +For the Years Ended December 31, +2013 +2012 +2011 +United States +$ +77,194 +$ +67,460 +$ +67,644 +Europe +11,081 +10,131 +7,506 +Other regions +10,665 +10,229 +6,731 +$ +98,940 +$ +87,820 +$ +81,881 +F-23 +Table of Contents +The following table represents total long-lived assets by geographic area: +December 31, +2013 +2012 +United States +$ +16,925 +$ +17,868 +Canada +975 +589 +Other regions +33 +89 +$ +17,933 +$ +18,546 +13. +COMMITMENTS AND CONTINGENCIES: +Sublicense Agreement +In June 2004, we entered into a sublicense agreement with a third party, pursuant to which we have been granted a limited, worldwide, +non-exclusive sublicense to certain HIV-2 patents held by such party. Under the terms of this sublicense agreement, we are obligated to pay royalties based on a percentage of our net sales of certain products, which incorporate the technology +covered by the licensed patents. Royalties are expensed as an element of cost of goods sold. Future minimum payments under this agreement are as follows: +2014 +$ +500 +2015 +500 +2016 +500 +2017 +500 +2018 +292 +$ +2,292 +Royalties from our commercial sale of products covered by the sublicense can be credited against these minimum +royalty obligations. +Leases +We lease office space for our Canadian subsidiary and domestic warehouse facilities under operating lease agreements. Future payments required +under these non-cancelable leases are as follows: +2014 +$ +438 +2015 +409 +2016 +6 +$ +853 +Rent expense for 2013, 2012 and 2011 was $600, $510, and $307, respectively. +Purchase Commitments +As +of December 31, 2013, we had outstanding non-cancelable purchase commitments in the amount of $3,685 related to inventory, capital expenditures, and other goods or services. +F-24 +Table of Contents +Employment Agreements +Under terms of employment agreements with certain executive officers, which extend through 2016, we are required to pay each individual a base +salary for continuing employment with us. The agreements require payments totaling $2,072, $581, and $290 in 2014, 2015, and 2016, respectively. +Litigation +From +time-to-time, we are involved in certain legal actions arising in the ordinary course of business. In management’s opinion, based upon the advice of counsel, the outcomes of such actions are not expected to have a material adverse effect on our +future financial position or results of operations. +14. +RETIREMENT PLANS: +Substantially all of our U.S. employees are eligible to participate in the OraSure Technologies, Inc. 401(k) Plan (the +“401(k) Plan”). The 401(k) Plan permits voluntary employee contributions to be excluded from an employee’s current taxable income under provisions of Internal Revenue Code Section 401(k) and the regulations thereunder. The 401(k) +Plan also provides for us to match employee contributions up to $4 per year. Contributions to the 401(k) Plan, net of forfeitures, were $553, $592, and $533 in 2013, 2012, and 2011, respectively. +In addition to our 401(k) plan, we offer a nonqualified deferred compensation plan to permit eligible highly compensated employees of the +Company to defer receipt and taxation of their compensation each year. We also may make discretionary contributions to the accounts of the participating employees in any amount either in cash or stock. Participants in the plan may not purchase +OraSure stock as an investment vehicle. As of December 31, 2013 and 2012, the value of the assets associated with this plan was $677 and $89, respectively, and is included in other assets in our consolidated balance sheet. Our obligation +related to the deferred compensation plan is included in other liabilities in our consolidated balance sheet. As of December 31, 2013 and 2012, our total obligation under this plan was $677 and $89, respectively. +Effective January 2, 2012, all regular full-time employees of DNAG are eligible to participate in the DNA Genotek Registered Retirement +Savings Plan (the “RRSP”). The RRSP permits voluntary employee contributions to be excluded from an employee’s current taxable income and receive tax preferred treatment with Revenue Canada. The RRSP also provides for DNAG to match +employee contributions up to $2 per year. Contributions to the RRSP were $126 and $113 in 2013 and 2012, respectively. +F-25 +Table of Contents +15 . +QUARTERLY DATA (Unaudited): +The following tables summarize the quarterly results of operations for each of the quarters in 2013 and 2012. These +quarterly results are unaudited, but in the opinion of management, have been prepared on the same basis as our audited financial information and include all adjustments (consisting only of normal recurring adjustments) necessary for a fair +presentation of the information set forth herein. +2013 Results +Three months ended +March 31, +2013 +June 30, +2013 +September 30, +2013 +December 31, +2013 +Net revenues +$ +21,164 +$ +24,337 +$ +24,671 +$ +28,768 +(1) +Costs and expenses +31,753 +29,913 +26,731 +22,705 +(2) +Operating income (loss) +(10,589 +) +(5,576 +) +(2,060 +) +6,063 +Other income (expense), net +(47 +) +42 +41 +164 +Income (loss) before income taxes +(10,636 +) +(5,534 +) +(2,019 +) +6,227 +Income tax expense (benefit) +(410 +) +(249 +) +(127 +) +14 +Net income (loss) +$ +(10,226 +) +$ +(5,285 +) +$ +(1,892 +) +$ +6,213 +Earnings (loss) per share +Basic +$ +(0.18 +) +$ +(0.10 +) +$ +(0.03 +) +$ +0.11 +Diluted +$ +(0.18 +) +$ +(0.10 +) +$ +(0.03 +) +$ +0.11 +(1) +Includes a non-recurring net favorable $2.5 million adjustment to account for a change in the Company’s revenue recognition policy related to its OraQuick ® +In-Home HIV tests. +(2) +Includes an $8.3 million gain from the termination of the Company’s oral fluid assay collaboration with Roche Diagnostics, which was recorded as a reduction of operating expenses in the current period. +2012 Results +Three months ended +March 31, +2012 +June 30, +2012 +September 30, +2012 +December 31, +2012 +Net revenues +$ +20,944 +$ +22,616 +$ +22,115 +$ +22,145 +Costs and expenses +24,596 +26,156 +25,043 +28,295 +Operating loss +(3,652 +) +(3,540 +) +(2,928 +) +(6,150 +) +Other income (expense), net +(120 +) +(113 +) +(35 +) +26 +Loss before income taxes +(3,772 +) +(3,653 +) +(2,963 +) +(6,124 +) +Income tax benefit +(521 +) +(91 +) +(527 +) +(258 +) +Net loss +$ +(3,251 +) +$ +(3,562 +) +$ +(2,436 +) +$ +(5,866 +) +Loss per share +Basic +$ +(0.07 +) +$ +(0.07 +) +$ +(0.04 +) +$ +(0.11 +) +Diluted +$ +(0.07 +) +$ +(0.07 +) +$ +(0.04 +) +$ +(0.11 +) +F-26 +Table of Contents +INDEX TO EXHIBITS +Exhibit +Number +Exhibit +3.1.1 +Certificate of Incorporation of OraSure Technologies, Inc. is incorporated by reference to Exhibit 3.1 to the Company’s Registration Statement on Form S-4 (No. 333-39210), filed June 14, 2000. +3.1.2 +Certificate of Amendment to Certificate of Incorporation dated May 23, 2000 is incorporated by reference to Exhibit 3.1.1 to the Company’s Registration Statement on Form S-4 (No. 333-39210), filed June 14, +2000. +3.2 +Bylaws of OraSure Technologies, Inc., amended and restated as of August 18, 2008, are incorporated by reference to Exhibit 3 to the Company’s Current Report on Form 8-K filed August 22, 2008. +10.1 +Form of Indemnification Agreement (and list of parties to such agreement) is incorporated by reference to Exhibit 10.1 to Amendment No. 3 to the Company’s Registration Statement on +Form S-4 (No. 333-39210), filed August 30, 2000.* +10.2 +Employment Agreement, dated as of June 22, 2004, between OraSure Technologies, Inc. and Douglas A. Michels, is incorporated by reference to Exhibit 10.3 to the Company’s Quarterly Report on Form 10-Q for the +quarter ended June 30, 2004.* +10.3 +Amendment No. 1 to Employment Agreement, dated as of December 16, 2008, between the Company and Douglas A. Michels, is incorporated by reference to Exhibit 10.2 to the Company’s Current Report on Form 8-K +filed December 19, 2008.* +10.4 +Amendment No. 2 to Employment Agreement, dated as of December 15, 2010, between the Company and Douglas A. Michels, is incorporated by reference to Exhibit 10.4 to the Company’s Annual Report on Form 10-K +for the year ended December 31, 2010.* +10.5 +Employment Agreement, dated as of July 1, 2004, between OraSure Technologies, Inc. and Ronald H. Spair, is incorporated by reference to Exhibit 10.4 to the Company’s Quarterly Report on Form 10-Q for the +quarter ended June 30, 2004.* +10.6 +Amendment No. 1 to Employment Agreement, dated as of December 16, 2008, between the Company and Ronald H. Spair, is incorporated by reference to Exhibit 10.3 to the Company’s Current Report on Form 8-K filed +December 19, 2008.* +10.7 +Amendment No. 2 to the Employment Agreement, dated as of December 15, 2010, between the Company and Ronald H. Spair, is incorporated by reference to Exhibit 10.7 to the Company’s Annual Report on Form 10-K +for the year ended December 31, 2010.* +10.8 +Employment Agreement, dated September 23, 2005, between OraSure Technologies, Inc. and Stephen R. Lee, Ph.D., is incorporated herein by reference to Exhibit 99 to the Company’s Current Report on Form 8-K filed +September 28, 2005.* +10.9 +Amendment No. 1 to Employment Agreement, dated as of December 16, 2008, between the Company and Stephen R. Lee, Ph.D., is incorporated by reference to Exhibit 10.5 to the Company’s Current Report on Form 8-K +filed December 19, 2008.* +10.10 +Amendment No. 2 to the Employment Agreement, dated as of December 15, 2010, between the Company and Stephen R. Lee, Ph.D., is incorporated by reference to Exhibit 10.10 to the Company’s Annual Report on +Form 10-K for the year ended December 31, 2010.* +10.11 +Employment Agreement, dated as of July 1, 2004, between OraSure Technologies, Inc. and Jack E. Jerrett, is incorporated by reference to Exhibit 10.7 to the Company’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2004.* +10.12 +Amendment No. 1 to Employment Agreement, dated as of December 16, 2008, between the Company and Jack E. Jerrett, is incorporated by reference to Exhibit 10.6 to the Company’s Current Report on Form 8-K +filed December 19, 2008.* +Table of Contents +Exhibit +Number +Exhibit +10.13 +Amendment No. 2 to the Employment Agreement, dated as of December 15, 2010, between the Company and Jack E. Jerrett, is incorporated by reference to Exhibit 10.13 to the Company’s Annual Report on +Form 10-K for the year ended December 31, 2010.* +10.14 +Employment Agreement, dated as of October 2, 2006, between Mark L. Kuna and OraSure Technologies, Inc., is incorporated by reference to Exhibit 99.1 to the Company’s Current Report on Form 8-K filed +October 5, 2006.* +10.15 +Amendment No. 1 to Employment Agreement, dated as of December 16, 2008, between the Company and Mark L. Kuna, is incorporated by reference to Exhibit 10.7 to the Company’s Current Report on Form 8-K +filed December 19, 2008.* +10.16 +Amendment No. 2 to the Employment Agreement, dated as of December 15, 2010, between the Company and Mark L. Kuna, is incorporated by reference to Exhibit 10.16 to the Company’s Annual Report on +Form 10-K for the year ended December 31, 2010.* +10.17 +Employment Agreement, dated as of January 3, 2011, between the Company and Anthony Zezzo II is incorporated by reference to Exhibit 10.17 to the Company’s Annual Report on Form 10-K for the year ended +December 31, 2010.* +10.18 +Description of Non-Employee Director Compensation Policy, as amended as of November 14, 2011, is incorporated by reference to Exhibit 10.19 to the Company’s Annual Report on +Form 10-K for the year ended December 31, 2011.* +10.19 +Amended and Restated Epitope, Inc. 1991 Stock Award Plan is incorporated by reference to Exhibit 10.9 to the Company’s Annual Report on Form 10-K for the year ended December 31, 2002.* +10.20 +OraSure Technologies, Inc. Employee Incentive and Non-Qualified Stock Option Plan, as amended and restated effective September 29, 2000, is incorporated by reference to Exhibit 10.12 to the Company’s Annual Report on +Form 10-K for the year ended December 31, 2000.* +10.21 +Amended and Restated OraSure Technologies, Inc. Stock Award Plan, effective as of February 12, 2013 is incorporated by reference to Exhibit 10.21 to the Company’s Annual Report on Form 10-K for the year ended +December 31, 2012.* +10.22 +Form of Restricted Share Grant Agreement (Executive Officers) is incorporated by reference to Exhibit 10.23 to the Company’s Annual Report on Form 10-K for the year ended December 31, 2011.* +10.23 +Form of Restricted Share Grant Agreement (Non-Employee Directors) is incorporated by reference to Exhibit 10.24 to the Company’s Annual Report on Form 10-K for the year ended December 31, 2011.* +10.24 +Nonqualified Stock Option Award General Terms and Conditions (Executive Officers) is incorporated by reference to Exhibit 10.25 to the Company’s Annual Report on Form 10-K for the year ended December 31, +2011.* +10.25 +Nonqualified Stock Option Award General Terms and Conditions (Non-Employee Directors) is incorporated by reference to Exhibit 10.26 to the Company’s Annual Report on Form 10-K for the year ended December 31, +2011.* +10.26 +Description of the OraSure Technologies, Inc. 2013 Management Incentive Plan is incorporated by reference to Item 5.02 to the Company’s Current Report on Form 8-K filed April 16, 2013.* +10.27 +Description of Long-Term Incentive Plan, as amended, is incorporated by reference to Item 5.02 to the Company’s Current Report on Form 8-K filed April 16, 2013.* +10.28 +OraSure Technologies, Inc. Deferred Compensation Plan is incorporated by reference to Exhibit 99.1 to the Company’s Current Report on Form 8-K filed December 21, +2011.* +Table of Contents +Exhibit +Number +Exhibit +10.28 +Adoption Agreement related to OraSure Technologies, Inc. Deferred Compensation Plan is incorporated by reference to Exhibit 99.2 to the Company’s Current Report on Form 8-K filed December 21, 2011.* +10.29 +Settlement Agreement, effective as of November 17, 2009, by and among Inverness Medical Innovations, Inc., Inverness Medical Switzerland GmbH and OraSure Technologies, Inc., is incorporated by reference to Exhibit 10.34 to +the Company’s Annual Report on Form 10-K for the year ended December 31, 2009. +10.30 +License Agreement, effective as of November 17, 2009, by and among Inverness Medical Innovations, Inc., Inverness Medical Switzerland GmbH and OraSure Technologies, Inc., is incorporated by reference to Exhibit 10.35 to +the Company’s Annual Report on Form 10-K for the year ended December 31, 2009. +10.32 +Settlement and Restated Supply Agreement, dated as of November 18, 2013, between F. Hoffman-La Roche Ltd., Roche Diagnostics GmbH, Roche Diagnostics Operations, Inc. and OraSure Technologies, Inc.** +21 +Subsidiaries of the Registrant. +23 +Consent of KPMG LLP. +24 +Powers of Attorney. +31.1 +Certification of Douglas A. Michels required by Rule 13a-14(a) or Rule 15d-14(a) under the Securities Exchange Act of 1934, as amended. +31.2 +Certification of Ronald H. Spair required by Rule 13a-14(a) or Rule 15d-14(a) under the Securities Exchange Act of 1934, as amended. +32.1 +Certification of Douglas A. Michels required by Rule 13a-14(b) or Rule 15a-14(b) under the Securities Exchange Act of 1934, as amended, and 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the +Sarbanes-Oxley Act of 2002. +32.2 +Certification of Ronald H. Spair required by Rule 13a-14(b) or Rule 15a-14(b) under the Securities Exchange Act of 1934, as amended, and 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the +Sarbanes-Oxley Act of 2002. +101.INS +XBRL Instance Document +101.SCH +XBRL Taxonomy Extension Schema Document +101.CAL +XBRL Taxonomy Extension Calculation Linkbase Document +101.DEF +XBRL Taxonomy Extension Definition Linkbase Document +101.LAB +XBRL Taxonomy Extension Label Linkbase Document +101.PRE +XBRL Taxonomy Extension Presentation Linkbase document +* +Management contract or compensatory plan or arrangement. +** +Portions of this exhibit were omitted pursuant to an application for confidential treatment and filed separately with the Securities and Exchange Commission. \ No newline at end of file diff --git a/raw/filings/0001116463/2013/0001193125-14-098958/filing_metadata.csv b/raw/filings/0001116463/2013/0001193125-14-098958/filing_metadata.csv new file mode 100644 index 0000000000000000000000000000000000000000..26e60deb1dec80dc3f7073b10acef43ab3b90b68 --- /dev/null +++ b/raw/filings/0001116463/2013/0001193125-14-098958/filing_metadata.csv @@ -0,0 +1,2 @@ +cik,ticker,company_name,form,filing_date,report_date,acceptance_datetime,accession_number,primary_document,primary_doc_description,size,is_xbrl,is_inline_xbrl,document_url,filing_index_url,year,fiscal_year,is_primary_filing +0001116463,OSUR,ORASURE TECHNOLOGIES INC,10-K,2014-03-14,2013-12-31,2014-03-14T13:09:24.000Z,0001193125-14-098958,d654506d10k.htm,FORM 10-K,7882696,1,0,https://www.sec.gov/Archives/edgar/data/1116463/000119312514098958/d654506d10k.htm,https://www.sec.gov/Archives/edgar/data/1116463/000119312514098958/,2013,2013,1 diff --git a/raw/filings/0001116463/2013/0001193125-14-098958/item1.txt b/raw/filings/0001116463/2013/0001193125-14-098958/item1.txt new file mode 100644 index 0000000000000000000000000000000000000000..3a7720df406fe08acfcf01d7464e6c2a455f6386 --- /dev/null +++ b/raw/filings/0001116463/2013/0001193125-14-098958/item1.txt @@ -0,0 +1,700 @@ +ITEM 1. +Business. +Our business principally involves the development, manufacture, marketing and sale of oral +fluid diagnostic products and specimen collection devices using our proprietary oral fluid technologies, as well as other diagnostic products including immunoassays and other in vitro diagnostic tests that are used on other specimen types. We +also manufacture and sell medical devices used for the removal of benign skin lesions by cryosurgery or freezing. Our diagnostic products include tests that are performed on a rapid basis at the point of care and tests that are processed in a +laboratory. These products are sold in the United States and internationally to various clinical laboratories, hospitals, clinics, community-based organizations and other public health organizations, distributors, government agencies, +physicians’ offices, and commercial and industrial entities. One of our diagnostic products, the OraQuick ® In-Home HIV Test, is the first and only rapid HIV test approved by the U.S. Food +and Drug Administration (“FDA”) for sale in the over-the-counter (“OTC”) or consumer retail market in the United States. We also sell cryosurgical products to consumers in North America, Europe, Central and South America, and +Australia. +In vitro diagnostic testing is the process of analyzing oral fluid, blood, urine and other bodily fluids or tissue for the presence of +specific substances or markers. We have targeted the use of oral fluid in our products as a differentiating factor and believe that it provides a significant competitive advantage over blood and urine. Our oral fluid tests have sensitivity and +specificity comparable to blood and/or urine tests. When combined with their ease of use, non-invasive nature, and cost effectiveness, our oral fluid tests represent a very competitive alternative to the more traditional testing methods in the +diagnostic space. +Through our subsidiary, DNA Genotek Inc. (“DNAG”), a company based in Ottawa, Canada, we manufacture and sell kits that are +used to collect, stabilize, and store samples of genetic material for molecular testing in the consumer genetics, clinical genetic testing, academic research, pharmacogenomics, personalized medicine, and animal genetics markets. Our OraGene ® DNA sample collection kit provides an all-in-one system for the collection, stabilization and transportation of DNA from human saliva. We serve customers in many countries worldwide, including +many leading research universities and hospitals. +1 +Table of Contents +OraSure was formed in May 2000 under Delaware law solely for the purposes of combining two companies, STC +Technologies, Inc. (“STC Technologies”) and Epitope, Inc. (“Epitope”), and changing the state of incorporation of Epitope from Oregon to Delaware. STC Technologies and Epitope were merged into OraSure on September 29, 2000. +Our principal offices are located at 220 East First Street, Bethlehem, Pennsylvania 18015, and our telephone number is (610) 882-1820. +Additional +information about us can be found on our website, www.orasure.com . We make available free of charge through a link provided at such website our Annual Reports on Form 10-K, our Quarterly Reports on Form 10-Q, our Current Reports on Form 8-K +and our other filings with the Securities and Exchange Commission (“SEC”), as well as any amendments to those Reports and filings. These Reports and filings are made available as soon as reasonably practicable after they are filed or +furnished to the SEC. Our Internet website and the information contained in or connected to that website are not intended to be incorporated by reference into this Annual Report. +Products +The following is a summary of our +principal products and their regulatory and commercial status: +Product +Description +Regulatory Status +Commercial +Status +OraQuick ADVANCE ® HIV-1/2 +A rapid, point-of-care qualitative test for antibodies to the Human Immunodeficiency Virus Type 1 (“HIV-1”) and Type 2 (“HIV-2” and together with HIV-1, “HIV-1/2”) that can be visually read +in approximately 20 minutes. +Premarket approval (“PMA”) by the FDA for use with oral fluid, finger-stick and venous whole blood, and plasma. +Marketed +CLIA (Clinical Laboratory Improvement Amendments of 1988) waived for use +with oral fluid, finger-stick and venous whole blood. +Marketed +CE mark (European Union) approved for use with oral fluid, finger-stick +and venous whole blood, serum and plasma. Also registered in various other countries. +Marketed +OraQuick ® In-Home HIV Test +A rapid, point-of-care qualitative oral fluid HIV- 1/2 test for OTC use that can be visually read in approximately 20 minutes. +PMA approved for OTC use. +Marketed +OraQuick ® HCV +A rapid, point-of-care qualitative test for antibodies to the hepatitis C virus (“HCV”) that can be visually read in approximately 20 minutes. +PMA approved and CLIA waived for use with venous whole blood and finger-stick whole blood specimens. +Marketed +2 +Table of Contents +Product +Description +Regulatory Status +Commercial +Status +CE mark (European Union) approved for use with oral fluid, finger-stick and venous whole blood, serum and plasma. Also registered in various other countries. +Marketed +OraSure QuickFlu™ Rapid Flu A&B Test +A rapid, point-of-care qualitative test for antibodies to influenza (flu) Types A and B, including H1N1 infections, with results available in 10 minutes. +FDA 510(k) cleared for use with nasal swab, nasopharyngeal swab and nasal aspirate/wash. +Marketed +OraSure ® +Oral fluid collection device for the detection of antibodies to HIV-1 and for detection of cocaine and cotinine in an oral fluid sample in a laboratory setting. +PMA approved by FDA for use in detecting antibodies to HIV-1. +Marketed +FDA 510(k) cleared for use in detecting cocaine and cotinine (an +indicator of nicotine) in oral fluid. +Marketed +CE marked and registered in various countries. +Marketed +Oragene ® ·DX +Non-invasive all-in-one system for the collection, stabilization, transportation and storage of human DNA from saliva. +FDA 510(k) cleared for in vitro diagnostic use with FDA-cleared molecular tests. +Marketed +Oragene ® ·DNA +Non-invasive all-in-one system for the collection, stabilization, transportation, and storage of human DNA from saliva. +CE marked and registered as Class 1 Medical Device in Canada. +Marketed +Registered in various other countries. +Oragene ® ·DISCOVER +Non-invasive all-in-one system for the collection, stabilization, transportation, and storage of human DNA from saliva. +Research use only product. +Marketed +Oragene ® ·RNA +Non-invasive all-in-one system for the collection, stabilization and transportation of RNA from human saliva. +Research use only product. +Marketed +3 +Table of Contents +Product +Description +Regulatory Status +Commercial +Status +ORAcollect™ +All-in-one system for the collection, stabilization, transportation, and storage of human DNA from saliva. +CE marked and registered as Class 1 Medical Device in the U.S. and Canada. +Marketed +Registered in various other countries. +OMNIgene™·DISCOVER +Non-invasive all-in-one system for the collection, stabilization, transportation, and storage of microbial DNA from saliva. +Research use only product. +Marketed +Performagene™· LIVESTOCK and Oragene ® ·ANIMAL +All-in-one systems for the collection, stabilization, transportation, and storage of livestock DNA from nasal samples. +Animal research use only. +Marketed +HEMAgene™· BUFFY COAT +Reagent for stabilizing DNA from Buffy Coat (blood) for ambient temperate transport and/or storage. +Research use only product. +Marketed +PrepIT TM L2P +Reagent for extraction and preparations of DNA from saliva. +CE marked and registered in the U.S., Canada and various other countries. +Marketed +Intercept ® +Oral fluid collection device for oral fluid drugs-of-abuse (“DOA”) testing in a laboratory setting. +FDA 510(k) cleared for use with nine MICRO-PLATE DOA assays. +Marketed +CE marked and registered in certain countries. +Marketed +MICRO-PLATE DOA Assays +Used to detect the following drugs in an oral fluid sample collected with Intercept ® device: tetrahydrocannabinol (“THC” or marijuana), cocaine, opiates, +amphetamines, methamphetamines, phencyclidine (“PCP”), benzodiazepines, barbiturates and methadone. +Nine drug assays – FDA 510(k) cleared. +Assays CE marked and registered in certain countries. +Marketed +Marketed +Homogeneous DOA Assays +Homogeneous fully- automated oral fluid DOA assays jointly developed with Roche Diagnostics for use on oral fluid samples collected with Intercept ® device. +FDA 510(k) cleared for use with PCP, opiates, cocaine, methamphetamines and amphetamines assays with Intercept ® collection device. +Marketed +4 +Table of Contents +Product +Description +Regulatory Status +Commercial +Status +Cryosurgical Systems – Professional +Cryosurgical (freezing) system for the removal of warts and other benign skin lesions, marketed under the Histofreezer ® tradename primarily to the physicians’ office +market. +FDA 510(k) cleared for nine types of skin lesions. +CE marked and registered in certain countries. +Marketed +Marketed +Cryosurgical Systems – OTC +Cryosurgical system for the removal of common and plantar warts, sold in various OTC markets. +FDA 510(k) cleared for common and plantar warts. +Not Marketed +Registered in Canada for warts and skin tags. +Marketed +CE marked and registered for warts in certain countries under Scholl +Freeze Spray ® and POINTTS ® names. +Marketed +CE marked for skin tags. +Not Marketed +In addition to the above products, we also sell certain immunoassay tests and reagents for insurance risk assessment, +substance abuse testing and forensic toxicology applications; an oral fluid Western blot HIV-1 confirmatory test for confirming positive HIV-1 test results obtained from the use of our +OraSure ® collection device; and the FDA 510(k) cleared Q.E.D. ® rapid point-of-care saliva alcohol test. +OraQuick ® Rapid HIV Test +OraQuick ® is our rapid point-of-care test platform designed to test oral fluid, whole blood (i.e., +both finger-stick and venous), plasma and serum samples for the presence of various antibodies or analytes. The device uses a porous flat pad to collect an oral fluid specimen. After collection, the pad is inserted into a vial containing a +pre-measured amount of developer solution and allowed to develop. When blood, plasma or serum is to be tested, a loop collection device is used to collect a drop of the specimen and mix it in the developer solution, after which the collection pad is +inserted into the solution and allowed to develop. In all cases, the specimen and developer solution then flow through the testing device where test results are observable in approximately 20 minutes. The OraQuick ® device is a screening test and generally requires a confirmation test where an initial positive result is obtained. +This product is sold under the OraQuick ADVANCE ® name in North America, Europe and certain +other countries and under the OraQuick ® name in other developing countries. The test has received PMA approval from the FDA for the detection of antibodies to both HIV-1 and HIV-2 in oral +fluid, finger-stick whole blood, venous whole blood and plasma. This test is available for use by laboratories located in the United States certified under the Clinical Laboratory Improvements Amendment of 1988, or CLIA, to perform moderately +complex tests. We have also received a CLIA waiver for use of the test with oral fluid and finger-stick and venous whole blood. As a result, the test can be used by numerous additional sites in the United States not certified under CLIA to perform +moderately complex tests, such as outreach clinics, community-based organizations and physicians’ offices. +On the international front, we have +obtained a CE mark for our OraQuick ADVANCE ® test so that we can sell this product in Europe and other countries accepting the CE mark for commercialization and this product is +registered in other countries. We have distributors in place for several countries and are seeking to increase awareness and expand our distribution network for this product throughout the world. +5 +Table of Contents +We believe that the OraQuick ADVANCE ® device, +because it is approved for detecting antibodies to both HIV-1 and HIV-2 in finger-stick and venous whole blood, oral fluid and plasma samples, provides a significant competitive advantage in the market for rapid HIV testing in the United States and +elsewhere. +OraQuick ® In-Home HIV Test +The OraQuick ® In-Home HIV test is an over-the-counter version of our OraQuick ADVANCE ® HIV 1/2 Antibody Test. We received PMA approval to sell this test in the U.S. OTC market in mid-2012. The In-Home Test is performed in the same manner as the OraQuick ADVANCE ® test, except that it has product labeling and instructions designed for consumers. In addition, we have established a toll free, 24/7, 365-day per year customer call center to provide additional +information and referral support for consumers. +OraQuick ® HCV Rapid Antibody Test +Another test available on the OraQuick ® platform is the OraQuick ® HCV rapid antibody test. Like the OraQuick ® HIV test, this product is a qualitative test that can detect antibodies to the Hepatitis C +virus, or HCV, in a variety of sample types. The OraQuick ® HCV test operates in substantially the same manner as the OraQuick ® HIV +test. +We have received FDA approval for use of the test in detecting HCV antibodies in venous whole blood and finger-stick whole blood specimens, making +it the first rapid HCV test approved by the FDA for use in the United States. We have also received a CLIA waiver for use of this product in the same specimen types. Our clinical program for approval of an oral fluid claim for this product is on +hold pending further discussions with the FDA. The OraQuick ® HCV test has received a CE mark for use with oral fluid, venous whole blood, finger-stick whole blood, plasma and serum and is sold +in Europe and other foreign countries. +OraSure QuickFlu™ Rapid Flu A&B Test +The OraSure QuickFlu™ rapid flu A&B test is an FDA 510(k) cleared rapid qualitative test for the detection of influenza (flu) Types A and B, including +H1N1 viral infections. The test utilizes specimen collected with a nasal swab, nasopharyngeal swab or nasal aspirate/wash. A reagent is first inserted into a test cartridge, the specimen is added and the test is allowed to flow. Results are +available in as little as ten minutes. This product is manufactured for us under an agreement with Princeton BioMeditech Corporation and is currently sold in certain U.S. markets. +OraSure ® Collection Device +Our OraSure ® oral fluid collection device is used in conjunction with screening and confirmatory tests +for HIV-1 antibodies and other analytes. This device consists of a small, treated cotton-fiber pad on a handle that is placed in a person’s mouth for two to five minutes. The device collects oral mucosal transudate (“OMT”), a serum-derived fluid that contains higher concentrations of certain antibodies and analytes than saliva. As a result, OMT testing is a highly accurate method for detecting HIV-1 infection and other analytes. +The OraSure ® collection device is FDA approved for use in the detection of HIV-1 antibodies and +510(k) cleared for the detection of cocaine and cotinine in oral fluid specimens. HIV-1 antibody detection using the OraSure ® collection device involves three steps: +• +Collection of an oral fluid specimen using the OraSure ® device; +• +Screening of the specimen for HIV-1 antibodies at a laboratory with an enzyme immunoassay (“EIA”) screening test approved by the FDA for use with the +OraSure ® device; and +• +Laboratory confirmation of any positive screening test results with our oral fluid Western blot HIV-1 confirmatory test (described below). +6 +Table of Contents +A trained health care professional then conveys test results and provides appropriate counseling to the +individual who was tested. +We believe that oral fluid testing has several significant advantages over blood or urine-based systems for infectious disease +testing, for both health care professionals and the individuals being tested. These advantages include eliminating the risk of needle-stick accidents, providing a non-invasive collection technique, requiring minimal training to administer, providing +rapid and efficient collection in almost any setting, and reducing the cost of administration by a trained health care professional. +Molecular +Collection Systems +Our wholly-owned subsidiary, DNAG, sells a number of products that provide all-in-one systems for the collection, stabilization, +transportation, and storage of DNA and/or RNA from human and animal biologic samples. DNAG’s lead product is sold under the Oragene ® name and is used to collect DNA from human saliva. +DNAG products are currently sold to thousands of academic and research customers in many countries worldwide. +DNAG products are available in several +different configurations and contain proprietary chemical solutions that are optimized for the specific application for which each product is designed. Product physical design is focused on providing easy-to-use and reliable products for self or +assisted collection of samples. For example, several of the Oragene ® products require users to simply hold the product close to their mouth and spit into the collection device. When the +container is closed, the reagents stored in the lid of the container are mixed with the captured saliva and immediately protect the nucleic acids in the sample. This non-invasive collection method yields nucleic acid that remains stable at ambient +temperature for extended periods. The stabilizing technology results in high quality and high quantity nucleic acids that are required for most genetic testing and analysis methods. +We believe these products provide significant advantages over competing DNA and RNA collection methods such as blood collection or buccal swabs, particularly +in human genetic applications. Benefits include the reliable collection of high quality genetic samples, use of simple non-invasive collection methods, the ability to store and transport collected samples for extended periods at ambient temperatures +and compatibility with fully-automated laboratory testing systems. +DNAG products historically have been sold primarily as Class I medical devices for use +by research and academic institutions. DNAG received FDA 510(k) clearance for the Oragene ® — Dx product in the first quarter of 2012. This +clearance will enable the Oragene ® — Dx product to be used with other FDA-cleared molecular diagnostic applications. +Intercept ® Drug Testing System +A collection device that is substantially similar to the OraSure ® device is sold by us under the name +Intercept ® , and is used to collect OMT for oral fluid drug testing. We have received FDA 510(k) clearance to use the Intercept ® +collection device with laboratory-based EIAs to test for drugs-of-abuse commonly identified by the National Institute for Drug Abuse (“NIDA”) as the NIDA-5 (i.e., tetrahydrocannabinol (“THC” or marijuana), cocaine, opiates, +amphetamines/methamphetamines and phencyclidine (“PCP”)), and for barbiturates, methadone and benzodiazepines. Each of these EIAs is also FDA 510(k) cleared for use with the +Intercept ® device. Our Intercept ® device and oral fluid assays are sold in the U.S. primarily through laboratory distributors. +We believe that the Intercept ® device has several advantages over competing urine and other +drugs-of-abuse testing products, including its lower total testing cost, its non-invasive nature, mobility and accuracy, the ease of maintaining a chain-of-custody, the treatment of test subjects with greater dignity, no requirement for specially-prepared collection facilities and difficulty of sample adulteration. The availability of an oral fluid test is intended to allow our customers to test for drug impairment and eliminate scheduling costs +and inconvenience, thereby streamlining the testing process. +7 +Table of Contents +In an effort to expand our Intercept ® product line and +meet the needs of our laboratory customers, we jointly developed with Roche Diagnostics a series of homogeneous fully-automated oral fluid drugs-of-abuse assays. These assays use Roche’s KIMs (kinetic interaction of micro-particles in solution) +technology and are designed to run on various automated analyzers to allow oral fluid samples to be processed with the same efficiency currently achieved by our laboratory customers with urine-based drug tests. +We had experienced significant delays in completing the development of these assays with Roche, which led to an agreement to terminate the collaboration in +late 2013. As part of this termination, Roche paid us $8.3 million and agreed to continue to supply certain of the assays developed under the collaboration on a transitional basis for up to five years following the termination. We have the right to +stop the supply of assays prior to the end of this five-year period and could receive an additional payment from Roche of up to $5.5 million depending on how early in that five-year period the supply obligation is ended. +Concurrently with the Roche termination, we entered into a new agreement with Thermo Fisher Scientific (“Thermo Fisher”) for the development and +supply of up to 12 homogeneous fully-automated oral fluid drugs-of-abuse assays. These assays are intended to replace the Roche assays and will be used with a new +version of our Intercept ® collection device. Under this new agreement, a NIDA-5 panel of assays is initially expected to be sold with our new Intercept ® device in the domestic criminal justice and forensics markets beginning in the second half of 2014. Eventually, the parties expect to complete development of several more assays and obtain FDA +510(k) clearance and approvals in certain foreign countries. The assays will be optimized as needed to comply with new oral fluid guidelines expected to be issued by the Substance Abuse and Mental Health Services Administration (SAMHSA) for the +federally-regulated market and certain other markets that follow Federal drug testing guidelines, none of which is currently served by OraSure. +Cryosurgical Systems (Skin Lesion Removal Products) +The +Histofreezer ® cryosurgical removal system is a low-cost alternative to liquid nitrogen and other methods for removal of warts and other benign skin lesions by physicians. The Histofreezer ® product mixes three cryogenic gases in a small aerosol canister. When released, these gases are delivered to a specially designed foam bud, cooling the bud to a maximum of –50°C to +–55°C. The frozen bud is then applied to the wart or lesion for 15 to 40 seconds (depending on the type of lesion) creating localized destruction of the target area by freezing. We have received 510(k) clearance for use of the Histofreezer ® product to remove common warts and eight other types of benign skin lesions, and this product has been CE marked and registered for distribution in Canada, throughout Europe and in certain other +foreign countries. +Internationally, we sell an OTC cryosurgical product through our distributor Genomma Labs (“Genomma”), under the POINTTS +tradename, in Mexico and a number of South and Central American countries. We also sell a CE marked cryosurgical wart removal product into the OTC footcare market in Europe, Australia and New Zealand through our distributor, Reckitt Benckiser +(“Reckitt”), under the Scholl and Dr. Scholl trademarks. Reckitt is the owner of the Scholl and Dr. Scholl trademarks in countries outside North and South America. We also sell OTC cryosurgical products for the treatment of both +warts and skin tags to retailers in Canada on a private label basis. +Immunoassay Tests and Reagents +We develop and sell immunoassay tests in two formats, known as MICRO-PLATE and AUTO-LYTE ® , to meet the +specific needs of our customers. +8 +Table of Contents +In a MICRO-PLATE kit, the sample to be tested is placed into a small plastic receptacle, called a microwell, +along with the reagents. The result of the test is determined by the color of the microwell upon completion of the reaction. Controlling the reaction involves the use of reagents by laboratory personnel. Test results are analyzed by any of a variety +of commercially available laboratory instruments, which we may also provide to our laboratory customers. MICRO-PLATE tests can be performed on commonly used instruments and can detect drugs in urine, serum and sweat specimens. MICRO-PLATE tests are +also used as part of the Intercept ® product line to detect drugs-of-abuse in oral fluid specimens. +AUTO-LYTE ® tests are sold in the form of bottles of liquid reagents. These reagents are run on +commercially available laboratory-based automated analytical instruments, which are manufactured by a variety of third parties. AUTO-LYTE ® is typically used in high volume, automated, +commercial reference insurance laboratories to detect certain drugs or chemicals in urine. Test results are produced quickly, allowing for high throughput. Our AUTO-LYTE ® tests continue to +face strong competition from cheaper “home-brew” tests developed internally by our laboratory customers. As a result, we may eventually stop selling our AUTO-LYTE ® tests. +Western blot HIV-1 Confirmatory Test +We sell an oral +fluid Western blot HIV-1 confirmatory test that received premarket approval from the FDA in 1996. This test uses the original specimen collected with the OraSure ® oral fluid collection device +to confirm positive results of initial oral fluid HIV-1 EIA screening tests. +Q.E.D. ® Saliva +Alcohol Test +Our Q.E.D. ® saliva alcohol test is a point-of-care test device that is a +cost-effective alternative to breath or blood alcohol testing. The test is a quantitative, saliva-based method for the detection of ethanol, has been cleared for sale by the FDA and has received a CLIA waiver. The U.S. Department of Transportation +(“DOT”) has also approved the test. +Each Q.E.D. ® test kit contains a collection stick +that is used to collect a sample of saliva and a disposable detection device that displays results in a format similar to a thermometer. The Q.E.D. ® device is easy to operate and +instrumentation is not required to read the result. The product has a testing range of 0 to 0.145% blood alcohol and produces results in approximately two minutes. +Research and Development +In 2013, our research +and development activities focused primarily on development of a next generation Intercept ® collection device and assessing initial feasibility of certain other products. From time to time, we +have contracted with third parties to conduct research and development activities and we may do so in the future. +Research and development expenses were +$10.9 million in 2013, $12.4 million in 2012 and $18.4 million in 2011. These expenses include our costs associated with research and development, regulatory affairs, clinical trials and product support. +Sales and Marketing +We attempt to reach our major +target markets through a combination of direct sales, strategic collaborations and independent distributors. Our marketing strategy is to create or raise awareness through a full array of marketing activities, which include trade shows, print +advertising, special programs, distributor promotions, telemarketing and the use of digital and social media in order to stimulate sales in each target market. +9 +Table of Contents +We market our products in the United States and internationally. Revenues attributable to customers in the United +States were $77.2 million, $67.5 million and $67.6 million in 2013, 2012 and 2011, respectively. Revenues attributable to international customers amounted to $21.7 million, $20.3 million and $14.2 million, or 22%, 23% and 17% of our total revenues, +in 2013, 2012 and 2011, respectively. For more information about our revenues and long-lived assets attributable to U.S. and international customers, please see Note 11 to our consolidated financial statements included elsewhere in this Annual +Report. +Infectious Disease Testing - Professional +We market the OraQuick ADVANCE ® rapid HIV-1/2 antibody test directly to customers in the public +health market for HIV testing. This market consists of a broad range of clinics and laboratories and includes states, counties, and other governmental agencies, family planning clinics, colleges and universities, correctional facilities and the +military. There are also a number of organizations in the public health market, such as AIDS service organizations and various community-based organizations, that are set up primarily for the purpose of encouraging and enabling HIV testing. We also +sell our OraQuick ADVANCE ® test directly to hospitals in the U.S. and through distributors into the U.S. physician office market and to retail clinics operated by pharmacies. We have +engaged two manufacturers’ representative organizations to assist with sales to U.S. physicians and retail clinics. Internationally, we distribute our OraQuick ® HIV test in Europe and +certain other foreign countries. +We market the OraSure ® oral fluid collection device for HIV-1 +testing, on its own and as a kit in combination with laboratory testing services. To better serve our public health customers, we have contracted a commercial laboratory to provide prepackaged +OraSure ® test kits, with prepaid laboratory testing and specimen shipping costs included. We also sell the OraSure ® device in the +international public health market. +Our OraQuick ® HCV test is sold primarily to the same markets +where our OraQuick ® ADVANCE HIV test is sold, including public health organizations, hospitals, physicians and retail clinics. We also sell this test in Europe and other countries through +distributors. +We have distribution rights to an FDA 510(k) cleared rapid flu A&B test, which we market under our proprietary OraSure QuickFlu™ +tradename. Under our agreement with the supplier of this product, we are permitted to sell this product into the U.S. hospital and public health markets. +Infectious Disease Testing - OTC +We sell our OraQuick ® In-Home test in the U.S. retail or consumer market. Retailers carrying the product include CVS, Walgreens, Rite Aid, Wal-Mart and Kroger. The product is also available for purchase on-line +through certain retailers and our website, www.oraquick.com . The primary target population for our HIV-OTC test is comprised of young, sexually active adults, with greater purchase intent found in high-risk sub groups, such as men who have +sex with men, African Americans and Latino Americans. In order to increase awareness and consumer sales of this product, we engage in significant public relations and advertising activities related to this product. +To support individuals that purchase and use our test, we have established a toll-free customer support center that operates on a 24/7, 365-day per year +basis. Through this center, consumers will have access to highly-trained, bi-lingual representatives who can answer questions about HIV/AIDS and the use of our test, and refer consumers to appropriate +resources for follow-up confirmatory testing, counseling and medical treatment. +Molecular Collection Systems +DNAG primarily sells its products directly to its customers through its own global sales force. In some countries distributors are used, particularly in the +Asia-Pacific region. Over half of DNAG’s employees work in the areas of sales, marketing, business development or product management. The significant majority of employees who +10 +Table of Contents +deal directly with customers have molecular science backgrounds, which we believe is useful in selling and marketing molecular collection products, and more importantly, in identifying and +evaluating new market and business opportunities. +Historically, most of DNAG’s revenues have been derived from product sales into the academic and +research markets. However, sales to commercial customers providing consumer genetics and clinical diagnostic services have been increasing and now account for a majority of DNAG’s revenues. A significant portion of DNAG’s sales is derived +from repeat customers, in both markets. DNAG also has a number of established global customers in the livestock market, including breed associations and research institutions. A molecular collection product focused on the infectious disease research +market has also been launched by DNAG. +Substance Abuse Testing +Our substance abuse testing products are marketed to laboratories serving the workplace testing, forensic toxicology, criminal justice and drug rehabilitation +markets in the U.S. and in certain international markets. +We have entered into agreements for the distribution of Intercept ® collection devices and associated MICRO-PLATE assays for drugs-of-abuse testing in the workplace testing market in the United States and Canada through +several laboratory distributors and internationally for workplace, criminal justice and forensic toxicology testing through other distributors. We also market the Intercept ® collection device +on its own and as a kit in combination with laboratory testing services. To better serve our workplace customers, we have contracted with commercial laboratories to provide prepackaged +Intercept ® test kits, with prepaid laboratory testing and specimen shipping costs included. +The +criminal justice market in the United States for our substance abuse testing products consists of a wide variety of entities in the criminal justice system that require drug screening, such as pre-trial services, parole and probation offices, police +forces, drug courts, prisons, drug treatment programs and community/family service programs. The forensic toxicology market consists of several hundred laboratories including federal, state and county crime laboratories, medical examiner +laboratories and reference laboratories. +As discussed above we continue to sell 510(k)-cleared fully-automated high-throughput oral fluid assays +developed with Roche Diagnostics for the detection of PCP, opiates, cocaine, methamphetamines and amphetamines with oral fluid samples collected with our Intercept ® device. These assays are +being made available on a transitional basis until we can replace them with similar assays developed under our new collaboration with Thermo Fisher for use with a new version of our Intercept ® +collection device. +We distribute our Q.E.D. ® saliva alcohol test primarily through various +distributors in the United States and internationally. The markets for alcohol testing are relatively small and fragmented with a broad range of legal and procedural barriers to entry. Markets range from law enforcement testing to workplace testing +of employees in safety sensitive occupations. Typical usage situations include pre-employment, random, post-accident, reasonable-cause and return-to-duty testing. +Cryosurgical Systems +Most of our Histofreezer ® sales occur in the United States to distributors that, in turn, resell the product to primary care physicians and podiatrists in the United States. Our major U.S. distributors include Cardinal +Healthcare, McKesson Medical-Surgical, AmerisourceBergen Corporation, and Henry Schein. We have also engaged two manufacturers’ representative organizations to help our U.S. distributors promote and sell Histofreezer ® . Internationally, we sell the Histofreezer ® product through a network of distributors in more than 20 countries worldwide. +11 +Table of Contents +We distribute cryosurgical wart removal products in the OTC footcare market in Europe, Australia and New Zealand +through our distributor, Reckitt Benckiser, under its Scholl and Dr. Scholl tradenames, and in the OTC markets in Mexico and several Central and South American countries under the POINTTS tradename through our distributor, Genomma. We also sell +OTC cryosurgical products for the removal of warts and skin tags under private label arrangements with retailers in Canada. +Insurance Risk Assessment +We currently market the OraSure ® oral fluid collection device for use in screening life +insurance applicants in the United States and internationally to test for three of the most important underwriting risk factors: HIV-1, cocaine and cotinine (a metabolite of nicotine). Devices are sold to insurance testing laboratories, which in +turn sell the devices to insurance companies, usually in combination with testing services. +We also promote use of the OraSure ® device directly to insurance companies for life insurance risk assessment. Insurance companies then make their own decision regarding which laboratory to use to supply their collection devices +and testing services. We sell our OraSure ® Western blot confirmatory test directly to insurance testing laboratories for use in confirming oral fluid specimens collected with our OraSure ® device that initially test positive for HIV-1. +There exists a wide range of policy limits where our +OraSure ® product is being used. In general, many (but not all) of our insurance company customers use the OraSure ® device in connection +with life insurance policies having face amounts of up to $250,000, with some customers using the device for policies of up to $500,000 in amount. Some insurance companies have chosen to extend their testing to lower policy limits where they did not +test at all before, while others have used OraSure ® to replace some of their blood and urine-based testing. More recently, some insurance customers have adopted a “Simplified Issues” +policy, where lab testing is no longer required and instead the applicant completes a questionnaire about personal behaviors. +We also sell our AUTO-LYTE ® assays and reagents in the insurance testing market directly to certain laboratories. +Significant Products and Customers +Several +different products have contributed significantly to our financial performance, accounting for 10% or more of our total revenues during the past three years. The OraQuick ® rapid HIV testing +products, the cryosurgical systems products, and our OraGene ® product line accounted for total revenues of $44.8 million, $14.5 million and $20.4 million in 2013 and $37.9 million, $14.9 +million and $14.3 million in 2012, respectively. The OraQuick ® rapid HIV testing products, the cryosurgical systems products, and the +OraSure ® and Intercept ® oral fluid collection devices accounted for total revenues of $41.7 million, $12.0 million and $10.7 million in +2011. +We had no individual customers who accounted for more than 10% of our total revenues in 2013, 2012 or 2011. +Financial Information by Segment +We operate our +business within two reportable segments. The first is our “OSUR” business, which consists of the development, manufacture and sale of oral fluid diagnostic products and specimen collection devices and medical devices used for the removal +of benign skin lesions by cryosurgery. The second is our “DNAG” or molecular collection systems business, which consists of the development, manufacture and sale of oral fluid collection devices that are used to collect, stabilize, and +store samples of genetic material for molecular testing. +OSUR revenues consist primarily of product sold into the United States and internationally to +various clinical laboratories, hospital, clinics, community-based organizations, public health organizations, distributors, +12 +Table of Contents +government agencies, physicians’ offices, and commercial and industrial entities. OSUR also derives revenues from licensing and product development activities. DNAG revenues consist of +product sold into the academic research, consumer genetics, clinical genetic testing, pharmacogenomics, personalized medicine and animal genetics markets. For more information about our revenues from external customers, income and total assets, +please see the sections entitled “Selected Consolidated Financial Data” and “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and Note 11 to the consolidated financial statements, +included elsewhere in this Annual Report. +Supply and Manufacturing +Our OraQuick ADVANCE ® HIV test, +OraQuick ® In-Home HIV test, OraQuick ® HCV test, OraSure ® and Intercept ® collection devices, Western blot HIV-1 confirmatory test, AUTOLYTE and MICRO-PLATE assays and QED ® saliva alcohol test are all +manufactured in our Bethlehem, Pennsylvania facilities. We expect to continue to manufacture these products at this location for the foreseeable future. +We have contracted with a third party in Thailand for the assembly of the OraQuick ® HIV device, in +order to supply certain international markets. This supply agreement had an initial term of one year, and automatically renews for additional annual periods unless either party provides a timely notice of termination prior to the end of an annual +period. We believe that other firms would be able to manufacture the OraQuick ® test on terms no less favorable than those set forth in the agreement if the Thailand contractor would be unable +or unwilling to continue manufacturing this product. +We can purchase the HIV antigens, the nitrocellulose and certain other critical components used in +the OraQuick ® HIV product lines, the HCV antigens used in the OraQuick ® HCV test and the antigen used in the Western blot HIV-1 +confirmatory test only from a limited number of sources. If for any reason these suppliers are unwilling or no longer able to supply our antigen or nitrocellulose needs, we believe that alternative supplies could be obtained at a competitive cost. +However, a change in any of the antigens, the nitrocellulose or other critical components used in our products would require FDA approval and some additional development work. This in turn could require significant time to complete and could disrupt +our ability to manufacture and sell the affected products. +Our MICROPLATE and AUTO-LYTE assays require the production of highly specific and sensitive +antibodies corresponding to the antigen of interest. Substantially all our antibody requirements are provided by contract suppliers. We believe that we have adequate reserves of antibody supplies and that we have access to sufficient raw materials +for these products. +Our OraSure QuickFlu™ test is manufactured and supplied by a third party, Princeton BioMeditech. There is no other supply source +for this product. +The Histofreezer ® product sold in the U.S. is assembled by U.S. vendors and +the Histofreezer ® product sold internationally is assembled in the Netherlands by Koninklijke, Utermöhlen, N.V. (“Utermöhlen”), the company from which we acquired the +product in 1998. The cryosurgical wart removal products distributed in OTC markets are also assembled by vendors located in the United States. We believe that additional suppliers of all of our cryosurgical products are available on terms no less +favorable than the terms of our existing supply agreements in the event that our current suppliers would be unable or unwilling to continue manufacturing these products. Our supply agreement with Utermöhlen has expired, and we are in the +process of transferring our supply arrangement to one or more other vendors. +DNAG has engaged two contract manufacturers to supply virtually all of its +products, including the Oragene ® product line. Many of the raw materials and components used in these products are also purchased from third parties, including one critical component that is +purchased from a sole source supplier. We believe there are other suppliers that can manufacture and supply the raw materials and components for the DNAG products. +13 +Table of Contents +Employees +As of December 31, 2013, we had 293 full-time employees (including 75 employees at our subsidiary, DNAG). Of this total, there were 98 in sales, marketing +and client services; 34 in research and development; 113 in operations, manufacturing, quality control, information systems, purchasing and shipping; 16 in quality assurance and regulatory affairs; and 32 in administration and finance. This compares +to 313 employees as of December 31, 2012. Our employees are not currently represented by a collective bargaining agreement. +Competition +The diagnostic industry is a multi-billion dollar international industry and is intensely competitive. Many of our competitors are substantially +larger than we are, and have greater financial, research, manufacturing and marketing resources. +Important competitive factors for our products include +product quality, performance, price, ease of use, customer service and reputation. Industry competition is based on the following: +• +Scientific and technological capability; +• +Proprietary know-how; +• +The ability to develop and market products and processes; +• +The ability to obtain FDA or other regulatory approvals; +• +The ability to manufacture products that meet applicable FDA requirements (i.e., good manufacturing practices); +• +Commercial execution and strength of distribution; +• +Access to adequate capital; +• +The ability to attract and retain qualified personnel; and +• +The availability of patent protection. +A few large corporations produce a wide variety of diagnostic tests +and other medical devices and equipment. A larger number of mid-size companies generally compete only in the diagnostic industry and a significant number of small companies produce only a few diagnostic products. As a result, the diagnostic test +industry is highly fragmented and segmented. +The future market for diagnostic products is expected to be characterized by consolidation, greater cost +consciousness, the development of new technologies, and tighter reimbursement policies. The purchasers of diagnostic products are expected to place increased emphasis on lowering costs, reducing inventory levels, obtaining better performing +products, automation, service and volume discounts. The increased complexity of the market is expected to force many competitors to enter into joint ventures or license certain products or technologies. +We expect competition to intensify as technological advances are made and become more widely known, and as new products reach the market. Furthermore, new +testing methodologies could be developed in the future that render our products impractical, uneconomical or obsolete. There can be no assurance that our competitors will not succeed in developing or marketing technologies and products that are more +effective than those we develop or that would render our technologies and products obsolete or otherwise commercially unattractive. In addition, there can be no assurance that our competitors will not succeed in obtaining regulatory approval for +these products, or introduce or commercialize them, before we can do so. These developments could have a material adverse effect on our business, financial condition and results of operations. +14 +Table of Contents +Several companies market or have announced plans to market oral specimen collection devices and tests both within +and outside the United States. We expect the number of devices competing with our OraQuick ® , OraSure ® and Intercept ® devices to increase as the benefits of oral fluid-based testing become more widely accepted. +Competition in the U.S. market for infectious disease testing in medical settings is intense and is expected to increase. Our principal competition for HIV +testing in the professional market comes from existing and new point-of-care rapid blood tests, automated laboratory-based blood tests, or other oral fluid-based tests that may be developed. One of our competitors has received FDA approval for a +rapid oral fluid HIV test, although this product has not yet received a CLIA waiver. Our OraQuick ® rapid HCV test competes against laboratory-based blood tests in the U.S., as there currently +are no other rapid HCV testing products approved by the FDA. Our competitors include medical diagnostic companies and specialized biotechnology firms, as well as pharmaceutical companies with biotechnology divisions. Competing tests are often sold +at a lower price than we charge for our products. This competition can result in lost sales and degradation of the price (and therefore the applicable profit margins) we can charge for our HIV and HCV tests. +Outside the U.S., our rapid HIV and HCV tests compete against other rapid and laboratory-based tests. Significant sales of these products in Europe have not +materialized principally because of differences in European healthcare systems compared to U.S. systems. Unlike the U.S., adoption of rapid point-of-care diagnostics is not widespread in Europe because laboratory testing is entrenched and healthcare +systems are structured around centralized testing models. In addition, many competing tests in international markets are sold at very low prices. We intend to continue to build awareness and develop strategies to expand sales of our OraQuick ® HIV and HCV tests in European and other international markets. +Our OraQuick ® In-Home HIV oral fluid test is the only rapid HIV test approved by the FDA for sale in the U.S. OTC market. We compete against one other non-rapid HIV blood test available in the OTC market, +which requires consumers to self-collect a blood sample and then send it to a laboratory for testing. +The OraSure QuickFlu™ test competes primarily +against other rapid flu tests sold by various third parties in the U.S. hospital and public health markets. +Our Oragene ® collection system competes against other types of collection devices used for molecular testing, such as blood collection devices and buccal swabs, which often are sold for prices lower than the +prices charged for the Oragene ® products. Although we believe the Oragene ® device offers a number of advantages over these other +products, the availability of lower price competitive devices can result in lost sales and degradation in pricing and profit margin. +In the substance +abuse testing market, our Intercept ® drug testing system competes with laboratory-based drug testing products using sample matrices such as urine, hair, sweat and oral fluid. We expect +competition for our products to intensify, particularly from other domestic and international companies that have developed, or may develop, competing oral fluid drug testing products. There are at least two competitors that sell fully-automated +high-throughput oral fluid drug testing products in unregulated settings in the United States. +Our MICRO-PLATE oral fluid drug assays, which are sold for +use with the Intercept ® and OraSure ® collection devices, also continue to come under increasing competitive pressure from +“home-brew” assays developed internally by our laboratory customers. Our oral fluid MICRO-PLATE assays also compete with urine-based homogeneous assays that are run on fully-automated, random access analyzers. These tests provide strong +competitive pressure because they provide the benefits of automation, including lower costs and short turn-around times. +Our MICRO-PLATE drugs-of-abuse reagents sold in the forensic toxicology market are targeted to forensic testing laboratories where sensitivity, automation and +“system solutions” are important. In the past, these +15 +Table of Contents +laboratories have typically had to rely on radioimmunoassay test methods to provide an adequate level of sensitivity. Radioimmunoassays require radioactive materials, which have a short +shelf-life and disposal problems. Our MICRO-PLATE tests meet the laboratories’ sensitivity needs, run on automated equipment, are not radioimmunoassays, and are offered to the laboratory as a complete system solution of reagents, +instrumentation and software to meet the specific needs of each customer. We compete with both homogeneous and heterogeneous tests manufactured by many companies. +Sales of our AUTO-LYTE ® urine assays have declined substantially during the past several years, +primarily due to competition from “home-brew” assays developed internally by our laboratory customers, which can be produced at a cost lower than the price typically paid for our products. Many of our customers no longer purchase our +AUTO-LYTE ® assays, and we may eventually stop selling this product line. +Q.E.D. ® competes against other semi-quantitative saliva-based alcohol tests that have received U.S. Department of Transportation approval as well as breath alcohol tests. Although there are lower priced +tests on the market that use oral fluid or breath as a test medium, these tests are qualitative tests that are believed to be substantially lower in quality and provide fewer benefits than our +Q.E.D. ® test. +Our professional cryosurgical product is sold primarily to physicians, including +family practitioners, pediatricians and podiatrists. This product primarily competes against other portable cryosurgical systems used for the removal of benign skin lesions in both the U.S. and Europe. Our OTC cryosurgical products compete against +other cryosurgical products in certain international OTC markets. +Patents and Proprietary Information +We seek patents and other intellectual property rights to protect and preserve our proprietary technology and our right to capitalize on the results of our +research and development activities. We also rely on trade secrets, know-how, continuing technological innovations and licensing opportunities to provide competitive advantages for our products in our markets +and to accelerate new product introductions. We regularly search for third-party patents in fields related to our business to shape our own patent and product commercialization strategies as effectively as possible and to identify licensing +opportunities. United States patents generally have a maximum term of 20 years from the date an application is filed. +We have eight United States patents +and numerous foreign patents for the OraSure ® and Intercept ® collection devices and technology relating to oral fluid collection, +containers for oral fluids, methods to test oral fluid, formulations for the manufacture of synthetic oral fluid, and methods to control the volume of oral fluid collected and dispersed. The patents expire from November 2015 to December 2026. We +have also applied for additional patents, in both the United States and certain foreign countries, on such products and technology. +We have five United +States patents for our OraQuick ® platform, as well as corresponding related international patents. We also have patent applications pending in the United States and internationally. Four of +the U.S. patents expire from March to July 2019 and the fifth in July 2028. We have obtained licenses to certain lateral flow patents and to certain HIV-1 and HIV-2 patents held by other parties. We also have obtained a license to certain HCV +patents which we use to manufacture and sell a rapid HCV test on the OraQuick ® technology platform. We obtained these licenses through the payment of certain upfront fees and an agreement to +pay ongoing royalties. We believe these fees and royalties are comparable to those generally paid by other companies under similar arrangements. +We may +need to obtain licenses or other rights under, or enter into distribution or other business arrangements in connection with, certain other intellectual property patents in order to manufacture and sell the OraQuick ADVANCE ® HIV test or other tests that use the same or similar technology platform. See Section 1A, entitled “Risk Factors,” for a further discussion of these issues. +16 +Table of Contents +We hold, through our subsidiary, DNAG, ten United States patents and numerous foreign patents issued for +compositions, methods and apparatus for the collection, stabilization, transportation and storage of nucleic acids (DNA and RNA) from oral fluid and other bodily fluids and tissues. These patents expire from June 2023 through June 2028. +We have one United States patent and numerous foreign patents issued for apparatuses and methods for the topical removal of skin lesions relating to our +cryosurgical wart removal products, and we have pending patent applications related to these products in the United States and in certain foreign countries. These patents expire from September 2025 to June 2029. We have also licensed another patent +relating to apparatuses and methods for the topical removal of skin lesions relating to our cryosurgical wart removal products. +We require our employees, +consultants, outside collaborators and other advisors to execute confidentiality agreements upon the commencement of employment or consulting relationships with us. These agreements provide that all confidential information developed by or made +known to the individual during the course of the individual’s relationship with us is to be kept confidential and not disclosed to third parties except in specific circumstances. In the case of employees, the agreements provide that all +inventions conceived by the individual during his or her tenure with us will be our exclusive property. +We own rights to trademarks and service marks +that we believe are necessary to conduct our business as currently operated. In the United States, we own a number of trademarks, including the OraSure ® , Intercept ® , OraQuick ® , OraQuick ADVANCE ® , Histofreezer ® , OraSure QuickFlu ® , Q.E.D. ® , +Oragene ® , ORAcollect™, OMNIgene™, Performagene™, PrepIT™, HEMAgene™, and AUTO-LYTE ® trademarks. We also own +many of these marks and others in several foreign countries. With respect to our international OTC cryosurgical products, the Scholl and Dr. Scholl tradenames are owned by Reckitt Benckiser in Europe, Australia, New Zealand and other countries +outside North and South America, and the POINTTS tradename is owned by Genomma. +Although important, the issuance of a patent or existence of trademark or +trade secret protection does not in itself ensure the success of our business. Competitors may be able to produce products competing with our patented products without infringing our patent rights. Issuance of a patent in one country generally does +not prevent manufacture or sale of the patented product in other countries. The issuance of a patent is not conclusive as to validity or as to the enforceable scope of the patent. The validity or enforceability of a patent can be challenged by +litigation after its issuance. If the outcome of such litigation is adverse to the owner of the patent, the owner’s rights could be diminished or withdrawn. Trade secret protection does not prevent independent discovery and exploitation of the +secret product or technique. +Government Regulation +General +Most of our products are regulated by the FDA, +along with other federal, state and local agencies and comparable regulatory bodies in other countries. This regulated environment governs almost all aspects of development, production and marketing, including product testing, authorizations to +market, labeling, promotion, manufacturing and recordkeeping. We believe that our products and procedures are in material compliance with all applicable FDA regulations, but the regulations regarding the manufacture and sale of our products are +subject to change. We cannot predict the effect, if any, that these changes might have on our business, financial condition or results of operations. +All +of our FDA-regulated products require some form of action by the FDA before they can be marketed in the United States. After approval or clearance by the FDA, we must continue to comply with other FDA requirements applicable to marketed products. +Both before and after approval or clearance, failure to comply with the FDA’s requirements can lead to significant penalties or could disrupt our ability to manufacture and sell +17 +Table of Contents +these products. In addition, the FDA could refuse permission to obtain certificates needed to export our products if the agency determines that we are not in compliance. +Domestic Regulation +Most of our products are regulated +in the United States as medical devices. +There are two mechanisms by which regulated medical devices can be placed on the market in the United States. +Some products may qualify for clearance under Section 510(k) of the Federal Food, Drug and Cosmetic Act. To obtain this clearance from the FDA, the manufacturer must provide a premarket notification that it intends to begin marketing the +product, and show that the product is substantially equivalent to another legally marketed product (i.e., that it has the same intended use and is as safe and effective as a legally marketed device and does not raise different questions of safety +and effectiveness). In some cases, the submission must include data from human clinical studies. Marketing may only commence when the FDA issues a clearance letter finding substantial equivalence. An applicant must submit a 510(k) application at +least 90 days before marketing of the affected product commences. Although FDA clearance usually takes from four to twelve months, in some cases more than a year may be required before clearance is obtained, if at all. +If the medical device does not qualify for the 510(k) procedure (either because it is not substantially equivalent to a legally marketed device or because it +is required by statute and the FDA’s regulations to have an approved PMA), the FDA must approve a PMA before marketing can begin. PMAs must demonstrate, among other matters, that the medical device provides a reasonable assurance of safety and +effectiveness. A PMA is typically a complex submission, supported by valid scientific evidence, including the results of preclinical and clinical studies. Preparing a PMA is a detailed and time-consuming process. Once a PMA has been submitted, the +FDA is required to review the submission within 180 days. However, the FDA’s review may be, and often is, much longer, in many cases requiring one to three years or more, and may include requests for additional data and facility inspections +before approval is granted, if at all. +If the FDA approves the PMA, it may place restrictions on the device. If the FDA’s evaluation of the PMA or +the manufacturing facility is not favorable, the FDA may deny approval of the PMA application or issue a “not approvable” letter. The FDA may also require additional clinical trials, which can delay the PMA approval process by several +years. In addition, if the FDA discovers that an applicant has submitted false or misleading information, the FDA may refuse to review submissions until certain requirements are met pursuant to its Application Integrity Policy (AIP). Delays in +receipt of or failure to receive such clearances or approvals, the loss of previously received clearances or approvals, or the failure to comply with existing or future regulatory requirements could have a material adverse effect on our business, +financial condition and results of operations. +If there are any modifications made to our marketed devices, a premarket notification or PMA may be +required to be submitted to, and cleared or approved by, the FDA, before the modified device may be marketed. A new PMA or a PMA supplement is required for modifications that affect the safety or effectiveness of the device, including, for example, +certain types of modifications to the device’s indications for use, manufacturing process, manufacturing facility, labeling and design. +A clinical +trial may be required in support of a 510(k) submission and generally is required for a PMA application. These trials generally require an Investigational Device Exemption, or IDE, application approved in advance by the FDA for a specified number of +patients, unless the proposed study is deemed a non-significant risk study, which is eligible for an exemption from the IDE requirements. The IDE application must be supported by appropriate data, such as laboratory testing results. Clinical trials +may begin if the IDE application is approved by the FDA and the appropriate institutional review boards, or IRBs, at the clinical trial sites. Submission of an IDE application does not give assurance that the FDA will issue the IDE. If the IDE +application is approved, there can be no assurance the FDA will determine that the data derived from the trials support the safety and effectiveness of the device or warrant the continuation of clinical trials. An IDE supplement must be submitted to +18 +Table of Contents +and approved by the FDA before a sponsor or investigator may make a change to the investigational plan in such a way that may affect its scientific soundness, study indication or the rights, +safety or welfare of human subjects. The trial must also comply with the FDA’s regulations, including the requirement that informed consent be obtained from each subject. Even if a trial is completed, the results of clinical testing may not +adequately demonstrate the safety and efficacy of the device or may otherwise not be sufficient to obtain FDA clearance to market the product in the United States. +Some of our products are used for research only or other non-medical purposes and many of our drugs-of-abuse products sold to state crime laboratories are for +forensic use. The FDA does not currently regulate products used for these purposes, although other state and federal regulatory requirements may apply. +Every company that manufactures medical devices distributed in the United States must comply with the FDA’s Quality System Regulations +(“QSRs”), including current good manufacturing practices. These regulations govern the manufacturing process, including design, manufacture, testing, release, packaging, distribution, documentation and purchasing as well as complaint +handling, corrective and preventative actions and internal auditing. In complying with the QSRs, manufacturers must continue to expend time, money and effort in the area of production and quality to ensure full technical compliance. +We believe that our facilities and procedures are in material compliance with FDA’s QSR regulations, but the regulations are subject to change, and we +cannot be sure that FDA investigators will agree with our compliance with the QSR requirements. Companies are also subject to other post-market and general requirements, including product listing and establishment regulations, which help facilitate +FDA inspections and other regulatory action, post-market surveillance requests, restrictions imposed on marketed products, promotional standards and requirements for recordkeeping and reporting of certain adverse reactions. Medical device reporting +regulations require that manufacturers report if their device may have caused or contributed to a death or serious injury, or has malfunctioned in a way that would likely cause or contribute to a death or serious injury if the malfunction of the +device or a similar device were to recur. +The FDA regularly inspects companies to determine compliance with the QSRs and other post-market requirements. +Failure to comply with statutory requirements and the FDA’s regulations can result in an FDA Form 483 (which is issued by FDA at the conclusion of an inspection when an investigator has observed any conditions that may constitute violations), +public warning letters, monetary penalties against a company or its officers and employees, suspension or withdrawal of regulatory approvals, operating restrictions, total or partial suspension of production, injunctions, product recalls, product +detentions, refusal to provide export certificates, seizure of products and criminal prosecution. +On December 23, 2013, our molecular collection +systems subsidiary, DNAG, received a warning letter from the FDA. The warning letter primarily focused on DNAG’s response to two Form 483 observations issued by the FDA as a result of an inspection of DNAG’s Ottawa, Canada facilities in +September 2013. +Specifically, the warning letter indicated the need for additional documentation regarding design and development activities for +DNAG’s products and focused in particular on the design planning and design history file for DNAG’s 510(k)-cleared OrageneDx collection device. In addition, the warning letter requested additional documentation related to finished product +acceptance testing activities for DNAG’s ORAcollect OC-100 collection device. The letter further noted that DNAG does not currently have in place an approved PMA or 510(k) clearance for its ORAcollect OC-100 device. This product accounted for +less than 3% of DNAG’s sales and less than 0.5% of our consolidated revenues during 2013. +DNAG has submitted a formal response and is actively +engaged and working with the FDA to address the issues referenced in the warning letter. While this warning letter remains pending, DNAG intends to continue to sell and market all of its products. We expect no material impact to product sales or our +consolidated financial performance for the forseeable future as a result of the issues raised by the warning letter. +19 +Table of Contents +The Clinical Laboratory Improvement Amendments of 1988, or CLIA, prohibit any facility that does laboratory +testing on specimens derived from humans from providing information for the diagnosis, prevention or treatment of any disease or impairment of, or the assessment of, the health of human beings, unless there is in effect for such facility a +certificate issued by the U.S. Department of Health and Human Services applicable to the category of examination or procedure performed. Tests may be waived from this regulatory oversight if they meet certain requirements established under CLIA. We +consider the applicability of CLIA requirements in the design and development of our products. We have obtained a waiver of the CLIA requirements for our OraQuick ADVANCE ® rapid HIV-1/2 +antibody test, our OraQuick ® HCV rapid antibody test and our Q.E.D. ® alcohol saliva test and may seek similar waivers for certain other +products. A CLIA waiver allows certain customers to use the waived products that may not have been able to use them without complying with applicable quality control and other requirements. +Certain of our products may also be affected by state regulations in the United States. We are presently working with legislators or regulators in certain of +these states in an effort to modify or remove any restrictions affecting our ability to sell products. +Advertising and Promotion +Advertising and promotion of medical devices, in addition to being regulated by the FDA, are also regulated by the Federal Trade Commission (“FTC”) +and by other federal and state regulatory and enforcement authorities, including the Department of Justice, the Office of Inspector General of the Department of Health and Human Services, and various state attorney generals. Although physicians are +permitted to exercise medical judgment to use medical devices for indications other than those cleared or approved by the FDA, we may not promote our products for such “off-label” uses and can only market our products for cleared or +approved uses. Recently, promotional activities for FDA-regulated products of other companies have been the subject of enforcement actions brought under healthcare reimbursement laws and consumer protection statutes. In addition, under the federal +Lanham Act and similar state laws, competitors and others can initiate litigation relating to advertising claims. If the FDA determines that our promotional materials or training constitute promotion of an uncleared or unapproved use, it could +request that we modify our training or promotional materials or subject us to regulatory or enforcement actions, including the issuance of an untitled letter, a notice of violation, a warning letter, injunction, seizure, civil fine or criminal +penalties. FTC enforcement actions often result in consent decrees that constrain future actions. If an enforcement action is brought by the FDA or FTC, our reputation could be damaged and sales of our products could be impaired. +Import and Export Requirements +Products for export from +the United States are subject to foreign countries’ import requirements and the exporting requirements of the FDA or European regulating bodies, as applicable. In particular, international sales of medical devices manufactured in the United +States that are not approved or cleared by the FDA for use in the United States, or are banned or deviate from lawful performance standards, are subject to FDA export requirements. +Foreign countries often require, among other things, an FDA certificate for products for export, also called a Certificate for Foreign Government. To obtain +this certificate from the FDA, the device manufacturer must apply to the FDA. The FDA certifies that the product has been granted clearance or approval in the United States and that the manufacturing facilities were in compliance with QSR +regulations at the time of the last FDA inspection. If the FDA determines that our facilities or procedures do not comply with the QSR regulations, it may refuse to provide such certificates until we resolve the issues to the FDA’s +satisfaction. +20 +Table of Contents +International +We are also subject to regulations in foreign countries governing products, human clinical trials and marketing, and may need to obtain approval from +international public health agencies, such as the World Health Organization, in order to sell products in certain countries. Approval processes vary from country to country, and the length of time required for approval or to obtain other clearances +may in some cases be longer than that required for U.S. governmental approvals. We generally pursue approval only in those countries that we believe have a significant market opportunity. +The International Organization for Standardization (“ISO”) is a worldwide federation of national standards bodies from some 130 countries, +established in 1947. The mission of the ISO is to promote the development of standardization and related activities in the world with a view to facilitating the international exchange of goods and services. ISO certification indicates that our +quality system complies with standards applicable to activities ranging from initial product design and development through production and distribution. +In the European Union (“EU”), products that fall under the scope of the Medical Devices Directive (“MDD”) and the In Vitro Diagnostic +Directive (“IVDD”) must comply with certain essential requirements listed in those directives. ISO certification creates a rebuttable presumption that the product satisfies the applicable requirements. Compliance with these requirements +allows us to affix the CE mark to our products, without which they may not be placed on the market in the EU. +We have received authorization to use the +CE mark for the OraQuick ADVANCE ® HIV-1/2 test, the OraQuick ® HCV test, our Histofreezer ® product line, our OTC cryosurgical removal product and certain of the Oragene ® collection kits sold by DNAG. +We must also comply with certain registration and licensing requirements as dictated by Health Canada, prior to commencing sales in Canada. We have completed +this process for several of our current products and may do so with respect to other products in the future. In addition, Canadian law requires manufacturers of medical devices to have a quality management system that meets various ISO requirements +in order to obtain a license to sell their devices in Canada. +Anti-Kickback and Other Fraud and Abuse Laws +The Federal Anti-Kickback Statute prohibits the knowing and willful offer, payment, solicitation, or receipt of any form of remuneration in return for, or to +induce: +• +The referral of an individual to a person for the furnishing or arranging for the furnishing of items or services reimbursable under Medicare, Medicaid or other governmental healthcare programs; or +• +The purchase, lease, or order of, or the arrangement or recommendation of the purchasing, leasing, or ordering of any item or service reimbursable under Medicare, Medicaid, or other governmental healthcare programs. +Our products are or may be purchased by customers that will seek or receive reimbursement under Medicare, Medicaid or other governmental +healthcare programs. Noncompliance with the federal anti-kickback statute can result in exclusion from Medicare, Medicaid or other governmental healthcare programs, and/or restrictions on our ability to operate in certain jurisdictions, as well as +civil and criminal penalties, any of which could have an adverse effect on our business and results of operations. +The Federal Civil Monetary Penalties +Law prohibits the offering or transferring of remuneration to a Medicare or Medicaid beneficiary that the person knows or should know is likely to influence the beneficiary’s selection of a particular provider, practitioner or supplier of +Medicare or Medicaid payable items or services. Noncompliance can result in civil monetary penalties for each wrongful act, assessment of three times the amount claimed for each item or service and exclusion from the Federal healthcare programs. +21 +Table of Contents +Many states have also adopted some form of anti-kickback laws. A determination of liability under such laws could +result in fines and penalties, restrictions on our ability to operate in these jurisdictions and significant damage to our reputation. +We are also +subject to other federal and state laws targeting fraud and abuse in the healthcare industry, including false claims laws, marketing conduct laws and laws constraining the sales, marketing and other promotional activities of manufacturers of medical +devices by limiting the kinds of financial arrangements, including sales programs, such manufacturers can enter into with physicians, hospitals, laboratories and other potential purchasers of medical devices. Violations of these laws may be +punishable by criminal or civil sanctions, including substantial fines, imprisonment and exclusion from participation in government healthcare programs such as Medicare and Medicaid. These laws and regulations are wide ranging and subject to +changing interpretation and application. In recent years, there has been greater scrutiny of marketing practices in the medical device industry which has resulted in several government investigations by various government authorities and the +introduction and/or passage of federal and state legislation regulating interactions between medical device manufacturers and healthcare professionals and providers and requiring the disclosure by medical device manufacturers of gifts or other +payments to healthcare professionals and providers. For example, under the Sunshine Act provisions of the Affordable Care Act, device manufacturers are subject to new federal reporting and disclosure requirements with regard to payments or other +transfers of value made to physicians and teaching hospitals. Reports submitted under the Sunshine Act will be placed in a public database. Device manufacturers were required to begin collecting data in August 2013 and will be required to submit +reports March 31, 2014 (and annually thereafter). To be in compliance with such disclosure laws, we have implemented necessary systems for accurately tracking gifts and other payments. +We have implemented a written Policy on Interactions with Health Care Professionals, which is based on the Code of Conduct for Interactions with Health Care +Professionals promulgated by the Advanced Medical Technology Association, or AdvaMed, a leading trade association representing medical device manufacturers. The Policy applies to all employees and is intended to comply with applicable state and +federal laws, regulations and government guidance. The Policy addresses interactions related to sales and marketing practices, research and development, product training and education, grants and charitable contributions, support of third-party +educational conferences, and consulting arrangements. +Foreign Corrupt Practices Act +The U.S. Foreign Corrupt Practices Act (“FCPA”) prohibits corporations and individuals from engaging in certain activities to obtain or retain +business or to influence a person working in an official capacity. It is illegal to use any means of interstate commerce corruptly in the furtherance of any offer, payment, promise to pay or authorization of payment of anything of value to any +foreign government official, government staff member, political party or political candidate in an attempt to obtain or retain business or to otherwise influence a person working in an official capacity. Our present and future business has and will +continue to be subject to the FCPA and various other laws, rules and/or regulations applicable to us as a result of our international sales. +Environmental Regulation +Because of the nature of our +current and proposed research, development, and manufacturing processes, we are subject to stringent federal, state and local laws, rules, regulations and policies governing the use, generation, manufacture, storage, air emission, effluent discharge +and handling and disposal of solid wastes, hazardous materials and hazardous wastes. Products that we sell in Europe are subject to regulation in European Union, or EU, markets under the Restriction of the Use of Hazardous Substances Directive, or +RoHS. RoHS prohibits companies from selling products which contain certain hazardous materials, including lead, mercury, cadmium, chromium, polybrominated biphenyls and polybrominated diphenyl ethers, in EU member states. In addition, the EU’s +Registration, Evaluation, Authorization, and Restriction of Chemicals Directive also restricts substances of very high concern in products. +22 +Table of Contents +Future environmental laws may require us to alter our manufacturing processes, thereby increasing our +manufacturing costs. We believe that our products and manufacturing processes at our facilities comply in all material respects with applicable environmental laws and worker health and safety laws; however, the risk of environmental liabilities +cannot be completely eliminated. +The foregoing discussion of our business should be read in conjunction with the consolidated financial statements and +accompanying notes included in Item 15 of this Annual Report. \ No newline at end of file diff --git a/raw/filings/0001116463/2013/0001193125-14-098958/item13.txt b/raw/filings/0001116463/2013/0001193125-14-098958/item13.txt new file mode 100644 index 0000000000000000000000000000000000000000..284195478d5f7274d1c6a523649ab31bb4f761ba --- /dev/null +++ b/raw/filings/0001116463/2013/0001193125-14-098958/item13.txt @@ -0,0 +1,5 @@ +ITEM 13. +Certain Relationships and Related Transactions, and Director Independence. +The information required by +this Item is incorporated by reference to the information under the captions, “Transactions with Related Persons,” “Corporate Governance—Director Independence” and “Corporate Governance—Committees of the +Board,” in the Proxy Statement. \ No newline at end of file diff --git a/raw/filings/0001116463/2013/0001193125-14-098958/item9a.txt b/raw/filings/0001116463/2013/0001193125-14-098958/item9a.txt new file mode 100644 index 0000000000000000000000000000000000000000..a7a6e7ccf03486a8272a6268b40efb5b7d790e49 --- /dev/null +++ b/raw/filings/0001116463/2013/0001193125-14-098958/item9a.txt @@ -0,0 +1,54 @@ +ITEM 9A. +Controls and Procedures. +(a) Evaluation of Disclosure Controls and Procedures . +The Company’s management, with the participation of the Company’s Chief Executive Officer and Chief Financial Officer, has evaluated the +effectiveness of the Company’s disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) of the Securities Exchange Act of 1934) as of December 31, 2013. Based on that evaluation, the Company’s management, +including such officers, concluded that as of December 31, 2013 the Company’s disclosure controls and procedures were adequate and effective to ensure that information required to be disclosed by the Company in the reports that we file or +submit under the Securities Exchange Act of 1934 is accumulated and communicated to the Company’s management, including the Chief Executive Officer and Chief Financial Officer, to allow timely decisions regarding required disclosure and is +recorded, processed, summarized, and reported within the time periods specified in the rules and forms of the Securities and Exchange Commission. +(b) +Management’s Report on Internal Control Over Financial Reporting . +The Company’s management is responsible for establishing and +maintaining adequate internal control over financial reporting, as such term is defined in Rule 13a-15(f) and 15d-15(f) under the Securities Exchange Act of 1934. Under the supervision and with the participation of the Company’s management, +including our principal executive officer and principal financial officer, we conducted an evaluation of the effectiveness of our internal control over financial reporting based on the framework in Internal Control—Integrated Framework +(1992) issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on our evaluation under the framework, our management concluded that our internal control over financial reporting was effective to provide +reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles as of December 31, 2013. +The effectiveness of our internal control over financial reporting as of December 31, 2013 has been audited by KPMG LLP, an independent registered public +accounting firm, as stated in their report, which is included below. +Because of its inherent limitations, internal control over financial reporting may +not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the +policies or procedures may deteriorate. +(c) Changes in Internal Control Over Financial Reporting . +There were no changes in our internal control over financial reporting during the fiscal quarter ended December 31, 2013 that have materially affected, +or are reasonably likely to materially affect, our internal control over financial reporting. +(d) Report of Independent Registered Public Accounting +Firm +The Board of Directors and Stockholders +OraSure +Technologies, Inc.: +We have audited OraSure Technologies, Inc.’s internal control over financial reporting as of December 31, 2013, based on +criteria established in Internal Control—Integrated Framework (1992) issued by the Committee of +70 +Table of Contents +Sponsoring Organizations of the Treadway Commission (COSO). OraSure Technologies, Inc.’s management is responsible for maintaining effective internal control over financial reporting and for +its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Management’s Report on Internal Control Over Financial Reporting. Our responsibility is to express an opinion on the Company’s +internal control over financial reporting based on our audit. +We conducted our audit in accordance with the standards of the Public Company Accounting +Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included +obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audit +also included performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion. +A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial +reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that +(1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as +necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors +of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements. +Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of +effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. +In our opinion, OraSure Technologies, Inc. maintained, in all material respects, effective internal control over financial reporting as of December 31, +2013, based on criteria established in Internal Control—Integrated Framework (1992) issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). +We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of +OraSure Technologies, Inc. and subsidiaries as of December 31, 2013 and 2012, and the related consolidated statements of operations, comprehensive loss, stockholders’ equity and cash flows for each of the years in the three-year period +ended December 31, 2013, and our report dated March 14, 2014 expressed an unqualified opinion on those consolidated financial statements. +/s/ KPMG LLP +Philadelphia, Pennsylvania +March 14, 2014 \ No newline at end of file diff --git a/raw/filings/0001116463/2013/0001193125-14-098958/rp_note.txt b/raw/filings/0001116463/2013/0001193125-14-098958/rp_note.txt new file mode 100644 index 0000000000000000000000000000000000000000..e69de29bb2d1d6434b8b29ae775ad8c2e48c5391 diff --git a/raw/filings/0001116463/2013/0001193125-14-098958/rpt_disclosure.txt b/raw/filings/0001116463/2013/0001193125-14-098958/rpt_disclosure.txt new file mode 100644 index 0000000000000000000000000000000000000000..766a0ce392e711bc3ee39bb3477c4072343e8120 --- /dev/null +++ b/raw/filings/0001116463/2013/0001193125-14-098958/rpt_disclosure.txt @@ -0,0 +1,7 @@ +Transactions With Related Persons +Since January 1, 2013, there have been no transactions with related persons which would require disclosure in this Proxy Statement. +The Audit Committee is required to review and approve in advance all transactions with related persons involving the Company. The Audit Committee may approve a related party transaction if the transaction is on terms comparable to those that could +be obtained in arms’ length dealings with an unrelated third party. The Audit Committee also reviews any public disclosures of a related party transaction contained in our SEC filings. These responsibilities are described in the Audit +Committee’s charter, a copy of which is available on our website at www.orasure.com . +Information regarding +employment and severance agreements between our executive officers and the Company is set forth in the Section entitled, “Employment Agreements and Potential Payments Upon Termination or Change in Control,” in this Proxy Statement. \ No newline at end of file