<PAGE> 1
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
------------
FORM 8-K
CURRENT REPORT
PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
Date of Report (Date of earliest event reported):
NOVEMBER 18, 1999
TRIPATH IMAGING, INC.
(Exact name of registrant as specified in its charter)
DELAWARE 0-22885 55-1995728
(State or other jurisdiction (Commission File (IRS Employer
of incorporation) Number) Identification No.)
780 PLANTATION DRIVE, BURLINGTON, NORTH CAROLINA 27215
(Address of principal executive offices and zip code)
Registrant's telephone number, including area code:
(336) 222-9707
<PAGE> 2
ITEM 5. OTHER EVENTS.
On September 30, 1999, TriPath Imaging, Inc. ("TriPath"), formerly known as
AutoCyte, Inc., completed its acquisition of NeoPath, Inc. ("NeoPath"). The
acquisition was structured as a merger (the "Merger") of a wholly owned
subsidiary of TriPath with and into NeoPath pursuant to an Agreement and Plan of
Merger dated as of June 4, 1999. The Merger was a tax-free reorganization and is
being accounted for as a pooling of interests.
The assets acquired in the Merger were used by NeoPath in the business of
developing and marketing visual and intelligence technology to increase accuracy
in medical testing. TriPath intends that NeoPath, as a wholly owned subsidiary
of TriPath, will operate in the same business. A substantial portion of the
business of TriPath consists of the business formerly operated by NeoPath.
On November 18, 1999, TriPath's auditors, Ernst & Young LLP, delivered a report
dated November 17, 1999, with respect to the supplemental consolidated financial
statements of the combined company. The supplemental consolidated financial
statements and Management's Discussion and Analysis of Financial Condition and
Results of Operations of TriPath appear as Exhibits 99.1 and 99.2 to this
Current Report on Form 8-K and are incorporated herein by reference.
The business description of NeoPath appears as Exhibit 99.3 to this Current
Report on Form 8-K and is incorporated herein by reference.
ITEM 7. FINANCIAL STATEMENTS, PRO FORMA FINANCIAL INFORMATION AND EXHIBITS.
(c)Exhibits.
23.1 Consent of Ernst & Young LLP, independent auditors of
TriPath Imaging, Inc. Filed herewith.
27.1 Financial Data Schedule. Filed herewith. (For SEC use
only)
99.1 Supplemental consolidated financial statements of TriPath
Imaging, Inc., including independent auditors' report of
Ernst & Young LLP. Filed herewith.
99.2 TriPath Mangement's Discussion and Analysis of Financial
Condition and Results of Operations. Filed herewith.
99.3 Business description of NeoPath, Inc. Filed herewith.
-2-
<PAGE> 3
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934,
the registrant has duly caused this report to be signed on its behalf by the
undersigned hereunto duly authorized.
Date: November 18, 1999 TRIPATH IMAGING, INC.
By: /s/ Eric W. Linsley
----------------------------------
Eric W. Linsley
Vice President, Finance and
Chief Financial Officer
-3-
<PAGE> 4
EXHIBIT INDEX
EXHIBIT
NO. DESCRIPTION
- ------- -----------
23.1 Consent of Ernst & Young LLP, independent auditors of
TriPath Imaging, Inc. Filed herewith.
27.1 Financial Data Schedule. Filed herewith. (For SEC use
only)
99.1 Supplemental consolidated financial statements of TriPath
Imaging, Inc., including independent auditors' report of Ernst &
Young LLP. Filed herewith.
99.2 TriPath Mangement's Discussion and Analysis of Financial
Condition and Results of Operations. Filed herewith.
99.3 Business description of NeoPath, Inc. Filed herewith.
-4-
<PAGE> 1
EXHIBIT 23.1
CONSENT OF INDEPENDENT AUDITORS
We consent to the incorporation by reference in the Registration Statements
(Form S-8 Nos. 333-41465, 333-41467, and 333-88611) of TriPath Imaging, Inc.
(f/k/a AutoCyte, Inc.) ("TriPath") of (i) our report dated February 5, 1999,
with respect to the financial statements of TriPath as of December 31, 1998 and
1997, for the years ended December 31, 1998 and 1997, and for the period from
November 22, 1996 through December 31, 1996 included in TriPath's Annual Report
on Form 10-K for the year ended December 31, 1998, (ii) our report dated June
13, 1997, with respect to the financial statements of the Cytology and Pathology
Automated Business of Roche Imaging Analysis Systems, Inc., as of December 31,
1995 and November 21, 1996, and for the years ended December 31, 1995 and 1994,
and for the period from January 1, 1996 through November 21, 1996 included in
TriPath's Annual Report on Form 10-K for the year ended December 31, 1998, and
(iii) our report dated November 17, 1999 with respect to the supplemental
consolidated financial statements of TriPath Imaging, Inc. included in its
Current Report on Form 8-K dated November 18, 1999, filed with the Securities
and Exchange Commission.
/s/ Ernst & Young LLP
Raleigh, North Carolina
November 18, 1999
<TABLE> <S> <C>
<ARTICLE> 5
<RESTATED>
<S> <C>
<PERIOD-TYPE> YEAR
<FISCAL-YEAR-END> DEC-31-1998
<PERIOD-START> JAN-01-1998
<PERIOD-END> DEC-31-1998
<CASH> 25,565,974
<SECURITIES> 3,374,549
<RECEIVABLES> 4,581,289
<ALLOWANCES> 651,000
<INVENTORY> 9,985,286
<CURRENT-ASSETS> 43,602,391
<PP&E> 13,082,848
<DEPRECIATION> 7,691,084
<TOTAL-ASSETS> 68,175,968
<CURRENT-LIABILITIES> 11,049,640
<BONDS> 0
0
0
<COMMON> 241,929
<OTHER-SE> 54,833,076
<TOTAL-LIABILITY-AND-EQUITY> 68,175,968
<SALES> 0
<TOTAL-REVENUES> 16,848,622
<CGS> 0
<TOTAL-COSTS> 9,693,512
<OTHER-EXPENSES> 44,461,774
<LOSS-PROVISION> 0
<INTEREST-EXPENSE> 273,705
<INCOME-PRETAX> (35,270,653)
<INCOME-TAX> 0
<INCOME-CONTINUING> (35,270,653)
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> (35,270,653)
<EPS-BASIC> (1.46)
<EPS-DILUTED> (1.46)
</TABLE>
<PAGE> 1
Exhibit 99.1
TRIPATH IMAGING, INC.
Report of Independent Auditors
The Board of Directors and Stockholders of
TriPath Imaging, Inc.
(Formerly AutoCyte, Inc.)
We have audited the supplemental consolidated balance sheets of TriPath Imaging,
Inc. (formerly AutoCyte, Inc. and formed as a result of the merger of AutoCyte,
Inc. and NeoPath, Inc.) as of December 31, 1998 and 1997 and the related
supplemental consolidated statements of operations, redeemable convertible
preferred stock and stockholders' equity, and cash flows for each of the three
years in the period ended December 31, 1998. The supplemental consolidated
financial statements give retroactive effect to the merger of AutoCyte, Inc. and
NeoPath, Inc. on September 30, 1999, which has been accounted for using the
pooling of interests method as described in the notes to the supplemental
consolidated financial statements. These supplemental financial statements are
the responsibility of the management of TriPath Imaging, Inc. Our responsibility
is to express an opinion on these supplemental financial statements based on our
audits.
We conducted our audits in accordance with generally accepted auditing
standards. 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 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 supplemental financial statements referred to above present
fairly, in all material respects, the consolidated financial position of TriPath
Imaging, Inc. at December 31, 1998 and 1997, and the consolidated results of its
operations and its cash flows for each of the three years in the period ended
December 31, 1998, after giving retroactive effect to the merger of NeoPath,
Inc., as described in the notes to the supplemental consolidated financial
statements, in conformity with generally accepted accounting principles.
/s/ Ernst & Young LLP
Raleigh, North Carolina
November 17, 1999
<PAGE> 2
TRIPATH IMAGING, INC.
SUPPLEMENTAL CONSOLIDATED BALANCE SHEETS
DECEMBER 31,
--------------------------------
1998 1997
------------- -------------
ASSETS
Current assets:
Cash and cash equivalents $ 25,565,974 $ 31,964,052
Securities available-for-sale 3,374,549 25,409,633
Accounts receivable, less allowance
of $651,000 and $585,000 at
December 31, 1998 and 1997,
respectively 3,930,289 4,769,972
Inventory 9,985,286 9,705,996
Other current assets 746,293 587,657
------------- -------------
Total current assets 43,602,391 72,437,310
Customer use assets 15,504,888 8,855,309
Property and equipment 5,391,764 7,706,871
Other assets 913,850 729,280
Intangible assets, less accumulated
amortization of $315,625 and
$541,617 at December 31,
1998 and 1997, respectively 2,763,075 6,233,038
------------- -------------
Total assets $ 68,175,968 $ 95,961,808
============= =============
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable $ 3,973,040 $ 3,302,195
Accrued expenses 3,447,135 3,691,768
Deferred revenue 962,670 561,877
Current portion of long-term debt 2,666,795 --
------------- -------------
Total current liabilities 11,049,640 7,555,840
Long-term debt, less current portion 1,928,413 --
Other long-term liabilities 122,910 150,640
Stockholders' equity:
Common stock, $0.01 par value;
49,000,000 shares authorized; 24,192,928
and 23,877,337 shares issued and
outstanding at December 31, 1998
and 1997, respectively 241,929 238,773
Additional paid-in capital 191,540,956 190,497,464
Deferred compensation (1,880,516) (2,743,280)
Accumulated deficit (134,811,633) (99,540,980)
Accumulated other comprehensive loss (15,731) (196,649)
------------- -------------
Total stockholders' equity 55,075,005 88,255,328
============= =============
Total liabilities and stockholders' equity $ 68,175,968 $ 95,961,808
============= =============
See accompanying notes
<PAGE> 3
TRIPATH IMAGING, INC.
SUPPLEMENTAL CONSOLIDATED STATEMENTS OF OPERATIONS
<TABLE>
<CAPTION>
YEAR ENDED
DECEMBER 31,
--------------------------------------------------------------
1998 1997 1996 (1)
------------ ------------ ------------
<S> <C> <C> <C>
Revenues $ 16,848,622 $ 13,492,217 $ 3,191,038
Cost of revenues 9,693,512 6,727,611 2,016,581
------------ ------------ ------------
Gross profit 7,155,110 6,764,606 1,174,457
Operating expenses:
Research and development 15,969,366 18,710,550 11,660,293
Selling, general and administrative 25,408,119 24,278,487 11,819,897
Nonrecurring expenses 3,084,289 -- --
------------ ------------ ------------
44,461,774 42,989,037 23,480,190
------------ ------------ ------------
Operating loss (37,306,664) (36,224,431) (22,305,733)
Interest income 2,309,716 3,171,680 3,784,274
Interest expense, including credit
agreement commitment fee (273,705) (1,529,034) (56,813)
------------ ------------ ------------
Net loss $(35,270,653) $(34,581,785) $(18,578,272)
============ ============ ============
Net loss per common share (basic and
diluted) $ (1.46) $ (1.91)
============ ============
Weighted-average common shares outstanding 24,098,206 18,123,422
============ ============
</TABLE>
(1) Net loss per share is not shown for 1996 as the Company's predecessor
operated as a wholly owned subsidiary of Roche Holding Ltd. prior to
November 22, 1996.
See accompanying notes
<PAGE> 4
TRIPATH IMAGING, INC.
SUPPLEMENTAL CONSOLIDATED STATEMENTS OF REDEEMABLE
CONVERTIBLE PREFERRED STOCK AND STOCKHOLDERS' EQUITY
<TABLE>
<CAPTION>
REDEEMABLE ACCUMULATED
CONVERTIBLE ADDITIONAL OTHER TOTAL
PREFERRED COMMON PAID-IN DEFERRED ACCUMULATED COMPREHENSIVE STOCKHOLDERS'
STOCK STOCK CAPITAL COMPENSATION DEFICIT INCOME (LOSS) EQUITY
----------- -------- ------------ ------------ ------------- ------------- ------------
<S> <C> <C> <C> <C> <C> <C> <C>
Balance at January 1, 1996 $ -- $ 77,603 $ 71,572,368 $ (175,782) $ (46,380,923) $ 39,945 $ 25,133,211
Net assets acquired in
exchange for common stock -- 36,891 5,963,109 -- -- -- 6,000,000
Sale of common stock -- 28,624 61,831,727 -- -- -- 61,860,351
Exercise of options and
warrants -- 7,568 2,881,601 -- -- -- 2,889,169
Issuance of redeemable
convertible preferred stock 9,882,000 -- -- -- -- -- --
Deferred compensation related
to issuance of restricted
stock and grant of stock
options -- -- 1,821,750 (1,821,750) -- -- --
Amortization of deferred
compensation -- -- (23,745) 139,343 -- -- 115,598
Unrealized loss on securities
available-for-sale -- -- -- -- -- (583,103) (583,103)
Net loss -- -- -- -- (18,578,272) -- (18,578,272)
------------
Comprehensive loss (19,161,375)
----------- -------- ------------ ----------- ------------- ------------- ------------
Balance at December 31, 1996 9,882,000 150,686 144,046,810 (1,858,189) (64,959,195) (543,158) 76,836,954
Issuance of redeemable
convertible preferred stock 100,000 -- 432,000 -- -- -- 432,000
and stock options
Issuance of warrants -- -- 1,475,002 -- -- -- 1,475,002
Exercise of options and -- 7,634 4,233,750 -- -- -- 4,241,384
warrants
Sale of common stock -- 31,250 27,862,411 -- -- -- 27,893,661
Issuance of common stock for
purchase of Pathfinder
Product Line -- 384 849,616 -- -- -- 850,000
Conversion of preferred stock (9,982,000) 48,819 9,933,181 -- -- -- 9,982,000
Deferred compensation related
to grant of stock options -- -- 1,664,694 (1,664,694) -- -- --
Amortization of deferred
compensation -- -- -- 779,603 -- -- 779,603
Unrealized appreciation on
securities available-for-sale -- -- -- -- -- 346,509 346,509
Net loss -- -- -- -- (34,581,785) -- (34,581,785)
------------
Comprehensive loss (34,235,276)
----------- -------- ------------ ----------- ------------- ------------- ------------
Balance at December 31, 1997 -- 238,773 190,497,464 (2,743,280) (99,540,980) (196,649) 88,255,328
Exercise of options and
warrants -- 2,692 164,028 -- -- -- 166,720
Release of common stock held
in escrow -- 332 548,946 -- -- -- 549,278
Issuance of common stock under
employee stock purchase plan -- 132 130,518 -- -- -- 130,650
Issuance of stock based
compensation to consultant -- -- 200,000 -- -- -- 200,000
Amortization of deferred
compensation -- -- -- 862,764 -- -- 862,764
Unrealized appreciation on
securities available-for-sale -- -- -- -- -- 180,918 180,918
Net loss -- -- -- -- (35,270,653) -- (35,270,653)
------------
Comprehensive loss (35,089,735)
----------- -------- ------------ ----------- ------------- ------------- ------------
Balance at December 31, 1998 $ -- $241,929 $191,540,956 $(1,880,516) $(134,811,633) $ (15,731) $ 55,075,005
=========== ======== ============ =========== ============= ============= ============
</TABLE>
See accompanying notes.
<PAGE> 5
TRIPATH IMAGING, INC.
SUPPLEMENTAL CONSOLIDATED STATEMENTS OF CASH FLOWS
<TABLE>
<CAPTION>
YEAR ENDED
DECEMBER 31,
----------------------------------------------
1998 1997 1996
------------ ------------ ------------
OPERATING ACTIVITIES
<S> <C> <C> <C>
Net loss $(35,270,653) $(34,581,785) $(18,578,272)
Adjustments to reconcile net loss to net
cash used in operating activities:
Depreciation 5,707,956 4,427,851 2,033,861
Amortization of intangible assets 998,914 525,992 15,625
Amortization of deferred compensation 862,764 779,603 115,598
Write off of intangible assets 3,084,289 -- --
Accrued interest on securities
available-for-sale 562,267 1,152,187 660,623
Issuance of preferred stock and stock options
for services rendered 200,000 432,000 --
Issuance of warrants as consideration for
credit agreement commitment fee -- 1,475,002 --
Changes in operating assets and liabilities:
Accounts receivable 839,683 (3,168,599) (889,048)
Inventory (7,987,234) (8,769,919) (11,181,039)
Other current assets (158,636) (340,725) --
Other long-term assets (184,570) (573,381) --
Accounts payable and accrued expenses 426,212 1,244,915 2,400,276
Deferred revenue 400,793 397,547 --
------------ ------------ ------------
Net cash provided by (used in) operating activities (30,518,215) (36,999,312) (25,422,376)
INVESTING ACTIVITIES
Purchases of property and equipment (2,320,913) (1,827,259) (3,373,011)
Purchases of securities available-for-sale (1,743,949) (5,349,511) (75,750,434)
Maturities of securities available-for-sale 23,397,684 29,750,677 43,169,070
Additions to intellectual property (63,962) (14,738) --
Purchase of Pathfinder product line -- (2,696,114) --
Other (6,756) 3,379 176,424
------------ ------------ ------------
Net cash provided by (used in) investing activities 19,262,104 19,866,434 (35,777,951)
FINANCING ACTIVITIES
Net proceeds from issuance of common stock -- 27,893,661 61,860,351
Net proceeds from issuance of redeemable
convertible preferred stock -- 100,000 9,882,000
Issuance of common stock under employee stock
purchase plan 130,650 -- --
Proceeds from exercise of stock options and
warrants 166,720 4,241,384 2,889,169
Decrease in other long-term liabilities (34,545) (26,790) (193,441)
Payment on Pathfinder short-term note -- (500,000)
Proceeds from long-term debt 5,855,019 -- --
Payments on long-term debt (1,259,811) -- --
------------ ------------ ------------
Net cash provided by financing activities 4,858,033 31,708,255 74,438,079
------------ ------------ ------------
Net increase (decrease) in cash and cash equivalents (6,398,078) 14,575,377 13,237,752
Cash and cash equivalents at beginning of period 31,964,052 17,388,675 4,150,923
------------ ------------ ------------
Cash and cash equivalents at end of period $ 25,565,974 $ 31,964,052 $ 17,388,675
============ ============ ============
SUPPLEMENTAL CASH FLOW INFORMATION
Cash paid for interest $ 273,705 $ 54,032 $ 56,813
============ ============ ============
</TABLE>
See accompanying notes.
<PAGE> 6
TRIPATH IMAGING, INC.
NOTES TO SUPPLEMENTAL CONSOLIDATED FINANCIAL STATEMENTS
1. THE COMPANY
TriPath Imaging, Inc. ("TriPath" or the "Company") develops, manufactures and
markets products to improve cervical cancer screening. Improved slide
preparation technology is delivered through the AutoCyte PREP System(TM)
("PREP"), a proprietary automated thin-layer cytology sample preparation system
that produces representative slides with a homogeneous, thin-layer of cervical
cells, and is one of only two sample preparation systems approved by the FDA as
a replacement for the conventional Pap smear. TriPath also delivers visual
intelligence technology to increase accuracy and productivity in medical testing
through the AutoPap(R) Primary Screening System ("AutoPap"), which utilizes
proprietary technology to distinguish between normal Pap smears and those that
have the highest likelihood of abnormality.
On September 30, 1999, AutoCyte, Inc. ("AutoCyte") completed its acquisition of
NeoPath, Inc. ("NeoPath") in exchange for approximately 13.8 million shares of
AutoCyte common stock. The acquisition was structured as a merger (the "Merger")
of a wholly owned subsidiary of AutoCyte with and into NeoPath. The Merger was a
tax-free reorganization and was accounted for as a pooling of interests. In
conjunction with the Merger, AutoCyte changed its name to TriPath Imaging, Inc.
The accompanying supplemental consolidated financial statements include
operations of the combined companies for all periods presented.
Revenues from sales of products have not generated sufficient cash to support
the Company's operations. Both the Company and its predecessor have incurred
substantial losses since inception. The Company has funded its operations
primarily through the private placement and public sale of equity securities,
debt and lease financing, and limited product sales. The Company continues to be
subject to certain risks and uncertainties common to early stage medical device
companies including the uncertainty of availability of additional financing,
extensive government regulation, uncertainty of market acceptance of its
products, limited manufacturing, marketing and sales experience and uncertainty
of future profitability.
2. SIGNIFICANT ACCOUNTING POLICIES
Principles of Consolidation
The supplemental consolidated financial statements include the accounts of
TriPath and its wholly-owned subsidiaries. All significant intercompany balances
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.
Revenue Recognition
Revenue is recognized from product sales and fee-per-use arrangements, including
service and license agreements, rental contracts, and minimum fee-per-use
contracts. Product sales revenue is generally recognized when products are
shipped. Fee-per-use revenue is recognized as earned.
Cash and Cash Equivalents
The Company considers all highly liquid investments with a maturity of three
months or less when purchased to be cash equivalents.
Securities Available-for-Sale
TriPath's investment portfolio is classified as available-for-sale, and such
securities are stated at fair value, with unrealized gains and losses included
in other comprehensive income or loss. Interest earned on securities
available-for-sale is included in interest income. The amortized cost of
investments in this category is adjusted for amortization of premiums and
accretion of discounts to maturity. Such amortization and accretion are included
in interest income. The cost of securities sold is calculated using the specific
identification method.
<PAGE> 7
TRIPATH IMAGING, INC.
NOTES TO SUPPLEMENTAL CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
Inventory
Inventory is stated at the lower of cost or net realizable value (first in first
out basis). Net realizable value of inventory is reviewed in detail on an
on-going basis, with consideration given to deterioration, obsolescence and
other factors.
Customer-Use Assets
PREP and AutoPap systems manufactured for rental or fee-per-use placements are
carried in inventory until the systems are shipped, at which time they are
reclassified to customer-use assets (non-current assets). Customer-use assets
are depreciated on a straight-line basis over an estimated useful life of four
years. Depreciation expense of customer-use assets amounted to $2,431,152,
$1,587,128, and $569,401 during 1998, 1997 and 1996, respectively.
Property and Equipment
Property and equipment is stated at cost. Depreciation is computed using the
straight-line method over the estimated useful lives (three to seven years) of
the individual assets. Depreciation expense of property and equipment amounted
to $3,276,804, $2,774,491, and $1,464,460 during 1998, 1997 and 1996,
respectively.
Asset Impairment
The Company periodically reviews the value of its long-lived assets to determine
if an impairment has occurred. In accordance with Statement of Financial
Accounting Standards ("SFAS") No. 121, "Accounting for the Impairment of
Long-Lived Assets and for Long-Lived Assets to Be Disposed Of", if this review
indicates that the assets will not be recoverable, as determined based on an
analysis of undiscounted cash flows over the remaining amortization period, the
Company would reduce the carrying value of its long-lived assets accordingly.
During 1998, the Company recognized such a loss for the write-off of intangible
assets related to the Pathfinder product line. There were no such losses
recognized in 1997 or 1996.
Research and Development Costs
Research and development costs are charged to operations as incurred.
Stock Based Compensation
The Company accounts for stock options issued to employees in accordance with
Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to
Employees" ("APB 25"). Under APB 25, no compensation expense is recognized for
stock or stock options issued with an exercise price equivalent to the fair
value of the Company's Common Stock. For stock options granted at exercise
prices below the deemed fair value, the Company records deferred compensation
expense for the difference between the exercise price of the shares and the
deemed fair value. Any resulting deferred compensation expense is amortized
ratably over the vesting period of the individual options.
In October 1995, the FASB issued SFAS No. 123, "Accounting for Stock Based
Compensation". For companies that continue to account for stock based
compensation arrangements under APB 25, SFAS 123 requires disclosure of the pro
forma effect on net income (loss) and earnings (loss) per share as if the fair
value based method prescribed by SFAS 123 had been applied. The Company has
adopted the pro forma disclosure requirements of SFAS 123.
Advertising Expense
The cost of advertising is expensed as incurred. Advertising and marketing
expense, including trade show expense, amounted to $1,335,580, $903,292 and
$303,900 during 1998, 1997 and 1996, respectively.
Income Taxes
The Company accounts for income taxes using the liability method. Under the
liability method, deferred tax assets and liabilities are determined based on
differences between the financial reporting and tax bases of assets and
liabilities.
<PAGE> 8
TRIPATH IMAGING, INC.
NOTES TO SUPPLEMENTAL CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
Net Loss Per Common Share
The Company incurred losses during all periods presented therefore the effect of
options, warrants and convertible preferred stock is anti-dilutive. Accordingly,
there is no difference between basic and diluted loss per share. Net loss per
share is not shown for 1996 as the Company's predecessor operated as a wholly
owned subsidiary of Roche Holding Ltd. prior to November 22, 1996.
Comprehensive Income
As of January 1, 1998, the Company adopted SFAS No. 130, "Reporting
Comprehensive Income." SFAS 130 established new rules for the reporting and
display of comprehensive income or loss and its components; however, the
adoption of this statement had no impact on the Company's operating results or
stockholders' equity. SFAS 130 requires unrealized gains or losses on the
Company's securities available-for-sale, which prior to adoption were reported
within stockholders' equity, to be included in other comprehensive income or
loss.
Business Segments and Markets
TriPath currently operates in a single business segment and is engaged in the
development and sale of cytology and pathology automation systems for use in
clinical laboratory applications.
TriPath's domestic revenues are generated primarily through the Company's direct
sales activities; international revenues are derived primarily through
distributors. International revenues accounted for 31%, 49% and 43% of total
revenues during 1998, 1997 and 1996, respectively. The Company's four largest
customers accounted for 33% of total revenues in 1998, compared to 48% in 1997
and 82% in 1996.
Concentration of Credit Risk
The Company's principal financial instruments subject to potential concentration
of credit risk are cash, cash equivalents, securities available-for-sale and
unsecured accounts receivable. The Company invests its funds in highly rated
institutions, and limits its investment in any individual debtor. The Company
provides an allowance for doubtful accounts equal to the estimated losses to be
incurred in the collection of accounts receivable, which have historically been
minimal and within management's expectations.
Recently Issued Accounting Standards
In June 1999, the FASB approved the Exposure Draft to defer for one year the
effective date of SFAS No. 133, "Accounting for Derivative Instruments and
Hedging Activities," which is now effective for years beginning after June 15,
2000. SFAS 133 establishes a comprehensive and consistent standard for the
recognition and measurement of derivatives and hedging activities. The Company
will adopt SFAS 133 in 2001, which may result in additional disclosures. The
application of the new rules is not expected to have a significant impact on the
Company's financial position or results from operations.
3. SECURITIES AVAILABLE-FOR-SALE
Securities available-for-sale consist of the following:
GROSS GROSS
AMORTIZED UNREALIZED UNREALIZED
DECEMBER 31, 1998 COST GAINS LOSSES FAIR VALUE
- ----------------- ----------- ------ --------- -----------
Corporate Bonds $ 3,390,280 $5,608 $ (21,339) $ 3,374,549
=========== ====== ========= ===========
GROSS GROSS
AMORTIZED UNREALIZED UNREALIZED
DECEMBER 31, 1997 COST GAINS LOSSES FAIR VALUE
- ----------------- ----------- ------ --------- -----------
Corporate Bonds $17,888,047 $ 835 $(112,479) $17,776,403
Government Bonds 7,718,235 -- (85,005) 7,633,230
----------- ------ --------- -----------
$25,606,282 $ 835 $(197,484) $25,409,633
=========== ====== ========= ===========
<PAGE> 9
TRIPATH IMAGING, INC.
NOTES TO SUPPLEMENTAL CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
4. BALANCE SHEET INFORMATION
Detailed balance sheet information is as follows:
DECEMBER 31,
-------------------------------
1998 1997
------------ ------------
Inventory
Raw materials $ 3,779,243 $ 5,698,462
Work-in-process 2,365,472 1,061,900
Finished goods 3,840,571 2,945,634
------------ ------------
$ 9,985,286 $ 9,705,996
============ ============
Customer-use assets
Customer-use systems $ 19,421,820 $ 10,949,075
Accumulated depreciation (3,916,932) (2,093,766)
------------ ------------
$ 15,504,888 $ 8,855,309
============ ============
Property and equipment
Demonstration equipment $ 1,291,105 $ 1,236,161
Machinery and equipment 5,069,144 5,418,352
Furniture, fixtures and improvements 1,317,692 1,196,027
Leasehold Improvements 1,222,093 1,210,930
Computer equipment and software 4,182,814 3,669,376
------------ ------------
Total property and equipment 13,082,848 12,730,846
Accumulated depreciation (7,691,084) (5,023,975)
------------ ------------
$ 5,391,764 $ 7,706,871
============ ============
Accrued expenses
Accrued payroll and related benefits $ 1,843,171 $ 2,570,488
Accrued warranty costs 687,643 458,209
Other accrued expenses 916,321 663,071
------------ ------------
$ 3,447,135 $ 3,691,768
============ ============
5. PATHFINDER SYSTEM PRODUCT LINE
In the quarter ended December 31, 1998, the Company wrote off $3.1 million of
intangible assets related to the Pathfinder System product line. The Company
acquired the Pathfinder System product line in June 1997 for an initial purchase
price of $4.1 million. The initial purchase price included cash of $2.7 million
(including transaction-related expenses), a $500,000 short-term note paid in
October 1997, and the issuance of shares of common stock valued at approximately
$1.4 million. As a result of the purchase, TriPath recognized $4.3 million in
intangible assets that were to be amortized over five years. Due to continuing
low sales levels of Pathfinder systems, and related losses attributable directly
to the Pathfinder product line, the Company identified indications of impairment
in the fourth quarter of 1998 and later decided to discontinue development and
commercialization of this product line. The Company compared the carrying value
of these intangible assets to expected future cash flows applicable to the
Pathfinder product and, as a result, wrote off the remaining balance of
intangible assets. Pathfinder product sales accounted for approximately 2% total
revenues in 1998 and 1997.
<PAGE> 10
TRIPATH IMAGING, INC.
NOTES TO SUPPLEMENTAL CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
6. LONG-TERM OBLIGATIONS AND COMMITMENTS
Note Payable to Bank
In April 1998, TriPath entered into a loan agreement with a bank pursuant to
which the Company could borrow amounts based on the manufacturing cost of
AutoPap systems placed on fee-per-use contracts. Accordingly, in June 1998, the
Company borrowed $5.0 million under the loan agreement. At December 31, 1998,
the Company had outstanding borrowings of $3.7 million under the agreement. The
bank debt is secured by substantially all of the Company's assets, excluding
intellectual property, and amounts are repaid over 24 months from the date of
each drawdown. In addition, the Company must comply with certain financial
covenants. As of December 31, 1998, the bank facility was secured by $2.0
million in restricted cash in an interest-bearing account with the bank. The
restricted cash is included in cash and cash equivalents on the balance sheet.
Borrowings under this agreement bear interest at the bank's prime rate plus 1
percent per annum (8.75% at December 31, 1998).
Note Payable to Finance Company
In December 1998, the Company entered into an agreement with an equipment
financing company to provide the Company with a $5,000,000 line of credit to
finance certain of the Company's equipment purchases. At December 31, 1998, the
Company had outstanding borrowings of $881,577 under the agreement with a loan
term of 48 months. The loan is secured by a security interest in the financed
equipment. Interest is calculated based on the four-year Treasury Bill Weekly
Average rate (4.447% at December 31, 1998) + 6.121%.
At December 31, 1998, maturities of the outstanding debt are as follows:
1999 $2,666,795
2000 1,451,706
2001 236,715
2002 239,992
----------
$4,595,208
==========
The fair value of the Company's long term debt, which approximates its carrying
value, is estimated using discounted cash flow analysis based on the Company's
current incremental borrowing rates for similar type borrowing arrangements.
Leases
The Company leases its office and manufacturing facilities and certain office
equipment under operating leases expiring at various times through 2007.
At December 31, 1998, future minimum lease payments under these leases are as
follows:
1999 $1,200,833
2000 425,511
2001 392,511
2002 358,191
2003 358,191
Thereafter 563,934
----------
$3,299,171
==========
Rent expense amounted to $1,211,594, $1,113,407, and $646,140 during 1998, 1997
and 1996, respectively.
<PAGE> 11
TRIPATH IMAGING, INC.
NOTES TO SUPPLEMENTAL CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
7. INCOME TAXES
As of December 31, 1998, the Company had net operating loss carryforwards of
approximately $139 million and research and development credit carryforwards of
approximately $3.4 million for federal income tax purposes, which expire between
2004 and 2014. Due to the prior issuance and sale of shares of preferred stock,
the Company has incurred "ownership changes" pursuant to applicable regulations
in effect under the Internal Revenue Code of 1986, as amended. Therefore, the
Company's use of losses incurred through the date of these ownership changes
will be limited during the carryforward period. The Company estimates that the
use of approximately $28.0 million of losses incurred prior to one or more of
the ownership changes would be limited in the carryforward periods. To the
extent that any single-year loss is not utilized to the full amount of the
limitation, such unused loss is carried over to subsequent years until the
earlier of its utilization or the expiration of the relevant carryforward
period. Approximately $5.1 million of the net operating loss carryforward is
attributed to the deduction for stock options, the tax effect of which will be
credited to equity when recognized.
Deferred income taxes reflect the net tax effects of temporary differences
between the tax basis of assets and liabilities and the corresponding financial
statement amounts. Significant components of the Company's deferred income tax
assets (liabilities) at December 31 are as follows:
DECEMBER 31,
-------------------------------
1998 1997
------------ ------------
NEOPATH
Net operating loss carryforwards $ 37,904,000 $ 29,416,000
Research and development credits 3,377,000 2,374,000
Amortization and write-off of
intangible assets 1,331,000 85,000
Research and development costs 335,000 548,000
Allowance for doubtful accounts 243,000 238,000
Deferred compensation 192,000 168,000
Accrued vacation 155,000 219,000
Charitable contribution carryforwards 126,000 125,000
Other 475,000 387,000
Property and equipment (501,000) 97,000
Valuation allowance (43,637,000) (33,657,000)
------------ ------------
$ -- $ --
============ ============
AUTOCYTE
Inventory $ 735,000 $ 1,174,000
Property and equipment 1,517,000 2,161,000
Intangible assets 672,000 737,000
Net operating loss carry forward 8,728,000 4,429,000
Other 176,000 189,000
Valuation allowance (11,828,000) (8,690,000)
------------ ------------
Net deferred taxes $ -- $ --
============ ============
Due to the uncertainty of the Company's ability to generate taxable income to
realize its deferred tax assets, a valuation allowance has been established for
financial reporting purposes equal to the amount of the net deferred tax assets.
The combined Company's valuation allowance was $55,468,000 and $42,347,000 at
December 31, 1998 and 1997, respectively.
<PAGE> 12
TRIPATH IMAGING, INC.
NOTES TO SUPPLEMENTAL CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
8. CONVERTIBLE REDEEMABLE PREFERRED STOCK AND STOCKHOLDERS' EQUITY
Convertible Redeemable Preferred Stock
The 9,925,000 shares of Series A Convertible Preferred Stock automatically
converted into 4,881,936 shares of Common Stock upon completion of AutoCyte's
initial public offering in September 1997.
Pursuant to the Company's amended and restated Certificate of Incorporation, the
Board of Directors has the authority, without further vote or action by the
stockholders, to issue up to 1,000,000 shares of Preferred Stock in one or more
series and to fix the relative rights, preferences, privileges, qualifications,
limitations and restrictions thereof, including dividend rights, dividend rates,
conversion rights, voting rights, terms of redemption, redemption prices,
liquidation preferences, sinking fund terms and the number of shares
constituting any series or the designation of such series, any or all of which
may be greater than the rights of Common Stock. At December 31, 1998 there were
no shares of Preferred Stock outstanding.
Equity Incentive Plans
The Company has stock option plans (the "Plans") under which incentive and
non-statutory stock options, stock appreciation rights and restricted stock may
be granted to employees, directors or consultants of the Company. Generally,
options and restricted stock grants vest ratably over a 48-month term. Stock
options expire ten years from the date of grant.
A summary of activity under the Plans is as follows:
OPTIONS OUTSTANDING
--------------------------------
NUMBER OF WEIGHTED-AVERAGE
SHARES EXERCISE PRICE
---------- ----------------
Outstanding at December 31, 1996 1,957,651 $ 5.47
Options granted 1,017,785 19.53
Options exercised (203,483) 2.90
Options canceled/expired (234,009) 13.01
---------- ------
Outstanding at December 31, 1997 2,537,944 12.01
Options granted 1,875,927 16.74
Options exercised (265,533) 0.58
Options canceled/expired (1,507,398) 24.54
---------- ------
Outstanding at December 31, 1998 2,640,940 $12.57
========== ======
<TABLE>
<CAPTION>
OPTIONS OUTSTANDING OPTIONS EXERCISABLE
------------------------------------------------ ----------------------------
WEIGHTED- NUMBER
NUMBER AVERAGE EXERCISABLE
OUTSTANDING AT REMAINING WEIGHTED- AT WEIGHTED-
DECEMBER 31, CONTRACTUAL LIFE AVERAGE DECEMBER 31, AVERAGE
PRICE RANGE 1998 (YEARS) EXERCISE PRICE 1998 EXERCISE PRICE
- -------------- -------------- ---------------- -------------- ------------ --------------
<S> <C> <C> <C> <C> <C>
$0.20 718,713 8.0 $ 0.20 220,169 $ 0.20
0.76 - 1.52 28,026 4.2 1.46 27,434 1.46
2.28 - 3.13 132,223 6.3 3.01 109,617 3.01
4.19 - 11.39 552,851 9.3 5.02 141,296 4.53
14.24 - 16.45 1,135,368 9.4 16.45 454,245 16.45
17.40 - 29.90 73,759 7.7 24.81 61,401 24.16
- -------------- -------------- ---------------- -------------- ------------ --------------
$0.20 - $29.90 2,640,940 8.7 $ 9.01 1,014,162 $ 9.84
============== ============== ================ ============== ============ ==============
</TABLE>
In 1996, the Company sold 590,260 shares of restricted Common Stock with a
deemed fair value of $1.63 per share to the Company's Chief Executive Officer at
a price of $0.20 per share. Under the terms of the restricted stock purchase
agreement, the shares vest ratably over a 48-month term and are subject to
repurchase by the Company at the issuance price if the CEO ceases to be employed
by the Company. Under the terms of an amendment to the restricted stock purchase
agreement, in the event that the Chief Executive Officer terminates employment
with the Company other than for cause, in addition to all other shares that have
vested pursuant to the original agreement, 50% of the unvested shares as of the
date of departure shall become vested as of that date.
<PAGE> 13
TRIPATH IMAGING, INC.
NOTES TO SUPPLEMENTAL CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
SFAS 123
The Company has adopted the disclosure-only provisions of SFAS 123. In
accordance with SFAS 123, the fair value of each option grant was determined by
using the Black-Scholes option-pricing model with the following weighted average
assumptions:
YEAR ENDED
DECEMBER 31,
-----------------------------------
1998 1997 1996
--------- --------- ---------
Risk-free interest rate 5.29% 6.20% 5.92%
Expected dividend yield 0.00% 0.00% 0.00%
Expected lives 48 months 48 months 48 months
Expected volatility 0.75 0.71 0.60
Weighted-average fair value of grants $5.87 $7.72 $6.06
Had compensation cost for the Company's stock options been determined based on
the fair value at the date of grant consistent with the provisions of SFAS 123,
the Company's pro forma net loss and net loss per share would have been:
<TABLE>
<CAPTION>
YEAR ENDED
DECEMBER 31,
------------------------------------------------
1998 1997 1996
------------ ------------ ------------
<S> <C> <C> <C>
Net loss:
As reported $(35,270,653) $(34,581,785) $(18,578,272)
Pro forma $(42,469,238) $(38,918,555) $(21,646,300)
Net loss per common share (basic &
diluted):
As reported $ (1.46) $ (1.91) n/a
Pro forma $ (1.76) $ (2.15) n/a
</TABLE>
Warrants
On June 27, 1997, the Company entered into a credit agreement with certain of
its institutional stockholders and the Company's Chief Executive Officer. The
agreement provided the Company with access to a credit line of up to $8,000,000
at an interest rate of prime plus 1%. As consideration for this agreement, the
Company issued warrants to purchase 207,291 shares of its Common Stock at an
exercise price of $2.033 per share. The warrants were immediately exercisable,
with an expiration date ten years from the date of issuance. The Company
estimated the expense associated with the warrant issuance to be approximately
$1,475,000, all of which was expensed at the time of issuance as a credit
agreement commitment fee. No borrowings were made under this credit arrangement,
which expired in September 1997. On October 24, 1997, all of the outstanding
warrants were exercised.
In 1998, the Company issued a warrant to a consultant to purchase 47,418 shares
of common stock at $5.45 per share, which was the closing price of the Company's
common stock on the date of the initial agreement. The Company has also issued a
comparable stock option grant to the same consultant. As a result, in 1998 the
Company recognized $200,000 in non-cash expenses related to the consulting
agreement and will continue to recognize expenses during the one-year agreement.
As of December 31, 1998, there were 219,632 warrants outstanding with a
weighted-average exercise price of $8.68. These warrants expire at various dates
through 2004.
<PAGE> 14
TRIPATH IMAGING, INC.
NOTES TO SUPPLEMENTAL CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
Common Stock Reserved for Future Issuance
At December 31, 1998, the Company has reserved authorized shares of Common Stock
for future issuance as follows:
DECEMBER 31,
1998
---------
Outstanding stock options 2,640,940
Possible future issuance under equity incentive plans 1,124,582
Common stock warrants 219,632
---------
Total shares reserved 3,985,154
=========
Deferred Compensation
The Company recorded deferred compensation for the difference between the
exercise price and the deemed fair value of the Company's common stock option
and restricted stock grants. The amount is being amortized over the vesting
period of the individual options, generally 48 months. Amortization of deferred
compensation amounted to $862,764, $779,603, and $139,343 during 1998, 1997 and
1996, respectively.
9. RELATED PARTY TRANSACTIONS
The Company has entered into certain ongoing arrangements with Laboratory
Corporation of America Holdings, Inc. ("LabCorp"), a public company partially
owned by Roche Holding Ltd. ("Roche"), for selling its products to LabCorp.
Roche is a shareholder of the Company and the Company's Chief Executive Officer
is a Director of LabCorp. Sales to LabCorp amounted to $634,884, $127,399 and
$39,813 during 1998, 1997 and 1996, respectively.
The Company has a continuing arrangement with LabCorp for leasing a portion of
LabCorp's facility in Elon College, North Carolina. Total rent paid to LabCorp
amounted to $61,995, $111,375, and $11,600 during 1998, 1997 and 1996,
respectively. Additionally, the Company owed approximately $249,000 and $348,000
at December 31, 1998 and December 31, 1997, respectively, to Roche or its
affiliates for services provided.
10. EMPLOYEE BENEFITS
The Company maintains qualified 401(k) Retirement Plans covering substantially
all employees that provide for voluntary salary deferral contributions. Total
expense for the plans, including employer contributions, amounted to $128,541,
$82,198 and $5,572 during 1998, 1997 and 1996, respectively.
<PAGE> 15
TRIPATH IMAGING, INC.
NOTES TO SUPPLEMENTAL CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
11. PRO FORMA COMBINED RESULTS OF OPERATIONS
AutoCyte was formed on October 24, 1996 to acquire the cytology and pathology
automation business then owned by Roche Image Analysis Systems, Inc. ("RIAS"), a
wholly-owned subsidiary of Roche. On November 22, 1996, AutoCyte entered into a
Contribution Agreement with Roche and RIAS whereby the Company acquired the net
assets and liabilities of the cytology and pathology automation business of RIAS
in exchange for 3,689,129 shares of Common Stock valued at $6.0 million. The
transaction was accounted for as a purchase transaction in accordance with
Accounting Principles Board Opinion No. 16, "Business Combinations". The pro
forma combined results of operations for 1996 as if TriPath had acquired the
predecessor entity on January 1, 1996 and had been in operation for the entire
year as a combined entity would have been as follows:
YEAR ENDED
DECEMBER 31, 1996
TRIPATH PREDECESSOR (PRO FORMA COMBINED)
------------ ------------ ------------------
Revenues $ 3,191,038 $ 1,747,209 $ 4,938,247
Cost of revenues 2,016,581 2,796,802 4,813,383
------------ ------------ ------------
Gross profit (loss) 1,174,457 (1,049,593) 124,864
Operating expenses:
Research and development 11,660,293 3,907,682 15,567,975
Selling, general and
administrative 11,819,897 11,965,813 23,785,710
------------ ------------ ------------
23,480,190 15,873,495 39,353,685
------------ ------------ ------------
Operating loss (22,305,733) (16,923,088) (39,228,821)
Interest income, net 3,727,461 -- 3,727,461
------------ ------------ ------------
Net loss $(18,578,272) $(16,923,088) $(35,501,360)
============ ============ ============
<PAGE> 1
EXHIBIT 99.2
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
OPERATIONS:
OVERVIEW
TriPath Imaging, Inc. ("TriPath" or the "Company"), formerly known as AutoCyte,
Inc., develops, manufactures and markets products to improve cervical cancer
screening. Improved slide preparation technology is delivered through the
AutoCyte PREP System(TM) ("PREP"), a proprietary automated thin-layer cytology
sample preparation system that produces representative slides with a
homogeneous, thin-layer of cervical cells, and is one of only two sample
preparation systems approved by the FDA as a replacement for the conventional
Pap smear. TriPath also delivers visual intelligence technology to increase
accuracy and productivity in medical testing through the AutoPap(R) Primary
Screening System ("AutoPap"), which utilizes proprietary technology to
distinguish between normal Pap smears and those that have the highest likelihood
of abnormality. In May 1998, AutoPap was approved by the U.S. Food and Drug
Administration as the first and only fully automated device for primary
screening of Pap smear slides.
The financial results for 1998, 1997 and 1996 have been restated to include the
results of NeoPath, Inc., which was acquired on September 30, 1999. The
acquisition was structured as a merger (the "Merger") of a wholly owned
subsidiary of TriPath with and into NeoPath. The Merger was a tax-free
reorganization and was accounted for as a pooling of interests. For the purposes
of this discussion, information for 1996 includes the operations of AutoCyte's
predecessor, the cytology and pathology automation business of Roche Image
Analysis Systems.
RESULTS OF OPERATIONS
YEARS ENDED DECEMBER 31, 1998 AND 1997
Revenues - Revenues for 1998 were $16.8 million, a 25% increase from $13.5
million in 1997. This increase was due primarily to a $1.0 million increase in
AutoPap fee-per-use revenue. The increase in fee-per-use revenues resulted from
higher overall per-slide pricing and increased placements during 1998. Also
contributing to the increase in revenues was a $500,000 increase in sales of
PREP units and related consumables and a $1.7 million increase in Pathology
Workstation revenues.
Gross Margin - Gross margin for 1998 was 42%, a decrease from 50% in 1997. This
decrease was primarily attributable to discounts and incentives the Company
offered in AutoPap QC sale pricing in the first half of 1998 as customers
anticipated FDA approval of the AutoPap Primary Screener, as well as pricing
incentives the Company offered in the second half of the year as it signed
initial orders for AutoPap Primary Screeners. Additionally, due to
lower-than-optimal usage of certain AutoPap Systems on fee-per-use contracts,
the overall gross margin percentage on fee-per-use revenues was lower than the
gross margin percentage on AutoPap Systems sold.
Research and Development - Research and development expenses for 1998 were $16.0
million, a 15% reduction from $18.7 million in 1997. The Company incurred higher
research and development costs in 1997 than in 1998 primarily due to its AutoPap
Screener clinical study, which the Company completed in 1997.
<PAGE> 2
Selling, General and Administrative - Selling, general and administrative
expenses remained relatively flat, increasing 5% from $24.3 in 1997 to $25.4 in
1998. Although the Company increased expenses in the first half of 1998 to
launch the AutoPap Primary Screener, the Company reduced overall spending in the
second half of 1998 as it carefully focused corporate spending.
Nonrecurring Expenses - During the fourth quarter of 1998, the Company wrote off
$3.1 million of intangible assets related to the Pathfinder System product line.
The write-off did not require any cash expenditure. The Company acquired the
Pathfinder System product line in June 1997 and recognized $4.3 million in
intangible assets that were to be amortized over five years. Due to continuing
low sales levels of Pathfinder systems, and related losses attributable directly
to the Pathfinder product line, the Company identified indications of impairment
in the fourth quarter of 1998 and later decided to discontinue development and
commercialization of this product line. The Company compared the carrying value
of these intangible assets to expected future cash flows applicable to the
Pathfinder product and, as a result, wrote off the remaining balance of
intangible assets. Pathfinder product sales accounted for approximately 2% total
revenues in 1998 and 1997.
Net Loss from Operations - Net loss from operations for 1998 was $37.3 million.
Excluding the nonrecurring transaction, net loss from operations was $34.2
million, a 6% improvement from $36.2 million in 1997.
Interest Income and Expense - Interest income for 1998 was $2.3 million, a 27%
decrease from $3.2 million during 1997, primarily attributable to the lower
average cash balance during 1998. Interest expense for 1998 was $274,000, a
decrease from $1.5 million in the corresponding period of 1997. The significant
interest expense in 1997 was due to the one-time, non-cash expense resulting
from the issuance of warrants as a commitment fee for a credit agreement between
the Company and certain of its principal stockholders.
YEARS ENDED DECEMBER 31, 1997 AND 1996
Revenues - Revenues for the year ended December 31, 1997 were $13.5 million, a
173% increase from revenues of $4.9 million for 1996. The increase in revenues
was primarily attributable to a $2.3 million increase in AutoPap fee-per-use
revenue, a $5.3 million increase in AutoPap product sales, and a $1.2 million
increase in PREP revenue. These increases were due to increased placements of
both AutoPap systems and PREP systems. These increases were partially offset by
a decrease in sales of Pathology Workstation products.
Gross Margin - Gross margin increased from 3% in 1996 to 50% in 1997.
Contributing to the increase in 1997 was an increase in margins on international
sales of AutoPap Screeners. The low gross margin in 1996 was due primarily to
the write-off of $1.4 million of obsolete inventory in the fourth quarter of
1996 as a result of management's decision to focus on the development of
cervical cytology products.
Research and Development - Research and development expenses for 1997 were $18.7
million, a 20% increase from $15.6 million in 1996. This increase was primarily
attributable to the AutoPap Primary Screener clinical study performed in 1997.
Selling, General and Administrative - Selling, general and administrative
expenses for 1997 were $24.3 million, a 2% increase from $23.8 million in 1996.
The Company incurred additional
<PAGE> 3
expenses related to selling and marketing for the AutoPap product rollout in
1997. In 1996, the Company incurred nonrecurring acquisition charges and a $3.1
million write down in fixed assets.
Net Loss from Operations - Net loss from operations during 1997 was $36.2
million, an 8% improvement from $39.2 million in 1996.
Interest Income and Expense - Interest income for 1997 was $3.2 million, a 16%
decrease from $3.8 million during 1996, primarily attributable to the lower
average cash balance during 1997. Interest expense for 1997 was $1.5 million
compared to $57,000 during 1996. The significant interest expense in 1997 was
due to the one-time, non-cash expense resulting from the issuance of warrants as
a commitment fee for a credit agreement between the Company and certain of its
principal stockholders.
<PAGE> 1
EXHIBIT 99.3
BUSINESS OF NEOPATH
NeoPath develops and markets visual intelligence technology to increase
accuracy in medical testing. NeoPath's products include two automated screening
systems that integrate proprietary high-speed morphology computers, video
imaging technology and sophisticated image interpretation software to capture
and analyze thousands of microscopic images from a Pap smear slide for the early
detection of cervical cancer.
The FDA approved the AutoPap(R) 300 QC Automatic Pap Screener System in
1995. The AutoPap QC is a rescreening device used for quality control and
rescreening of previously screened Pap smear slides. Clinical studies have shown
that the AutoPap QC detects a significantly higher proportion of undetected
abnormal slides than procedures typically employed by clinical laboratories to
meet federal rescreening requirements. These studies were performed by
independent laboratories, and NeoPath funded the studies that support the FDA
claims.
The FDA approved the AutoPap(R) Primary Screening System in May 1998. The
AutoPap Primary Screener uses the same hardware components as the AutoPap QC,
but uses enhanced software to perform the initial screening of Pap smear slides
and to classify up to 25% of such slides as requiring no further review. NeoPath
also has funded clinical studies of the effectiveness of the AutoPap Screener by
independent laboratories. These clinical studies showed that the AutoPap Primary
Screener provides superior sensitivity and specificity when compared to existing
laboratory practice. Currently it is the only instrument approved by the FDA
that allows Pap smear slides to bypass human review. NeoPath believes that this
feature of the AutoPap Primary Screener gives customers an economic incentive to
adopt the technology. The AutoPap Screener provides customers with the
functionality of both the AutoPap QC as well as a primary screening system;
therefore, NeoPath is focusing its sales effort on the AutoPap Screener.
The AutoPap System refers to the AutoPap Primary Screener and the AutoPap
QC together.
MARKET
NeoPath believes that clinical analysis of Pap smears is the largest
nonautomated clinical laboratory procedure. U.S. clinical laboratories process
over 50 million Pap smears annually, and laboratories outside the United States
process more than 60 million Pap smears annually.
The AutoPap Screener is the only instrument approved by the FDA to process
Pap smears without human review. In addition, in recent years the medical
community has increasingly focused on improving the quality of women's
healthcare. NeoPath believes that the AutoPap System will allow laboratories to
better detect precancerous cervical conditions and cervical cancer, thereby
improving the standard of care for their female patients. Earlier detection and
treatment should lower risks of morbidity and mortality.
Laboratories that fail to accurately identify abnormal Pap smears may face
malpractice suits. Because federal law requires all laboratories to retain Pap
smears for five years, they face significant exposure to liability. NeoPath
believes that use of the AutoPap System will substantially improve the current
quality of practice, and will reduce exposure to liability for laboratories that
use the AutoPap System.
PRODUCTS
The AutoPap QC and AutoPap Screener use identical hardware components. The
AutoPap Screener, however, contains enhanced software, including additional
cell-classification algorithms, for use in the initial screening of Pap smears.
The AutoPap System works with a wide range of staining procedures used on
conventionally prepared Pap smear slides. The AutoPap System analyzes a Pap
smear in about the same time as a cytotechnologist. It holds 288 Pap smear
slides at a time, is easy to load and unload, and can operate continuously, with
minimal intervention, for up to 24 hours per day. NeoPath provides each clinical
<PAGE> 2
laboratory with on-site training, system documentation, a comprehensive quality
assurance program, and ongoing customer and technical support.
NeoPath believes that its automated visual intelligence technology can be
used for other diagnostic tests that involve microscopic analysis of biological
specimens on glass slides, such as sputum, blood, or urine samples. In addition,
NeoPath has identified several other potential uses for its technology,
including automated tissue analysis, breast and skin cancers. To develop its
systems for other applications, NeoPath must adapt software algorithms developed
for the analysis of Pap smears to the analysis of other tissue specimens.
NeoPath continues to evaluate other applications for future development efforts,
including non-medical applications. In July 1999, NeoPath announced a
collaborative research agreement with Bayer Diagnostics to develop an automated
screening system for the detection of early lung cancer.
AUTOPAP 300 QC AUTOMATIC PAP SCREENER SYSTEM
The AutoPap QC rescreens Pap smears that have already been screened and
classified as normal by a cytotechnologist. Laboratories use the AutoPap QC to
improve the detection of false-negatives and to improve diagnostic accuracy. The
AutoPap QC classifies slides based on their likelihood of being abnormal; it
classifies 10% or more of slides showing the highest potential for abnormality
as requiring additional review by a cytotechnologist qualified to perform
quality control. Laboratories can use the AutoPap QC as either a quality-control
or an adjunctive rescreening device for manually screened Pap smears. This
allows laboratories to implement the AutoPap QC into their quality-control
procedures or to offer rescreening as an additional service for women who
request additional review of their Pap smears.
Preclinical and clinical trials demonstrated that the AutoPap QC, operating
in a quality-control mode, detected up to five times more low-grade and worse
false negative slides than a 10% random selection method. The AutoPap QC
achieved up to an eight-fold improvement in the detection of biopsy-confirmed
high-grade and cancer slides. NeoPath believes that use of the AutoPap QC
provides consistent earlier detection of precancerous conditions and cancer,
earlier treatment and reduced risk of morbidity and mortality.
AUTOPAP PRIMARY SCREENER SYSTEM
The FDA approved the AutoPap Screener in May 1998. The AutoPap Screener
uses new diagnostic algorithms to improve accuracy in the primary screening of
Pap smear slides. As approved by the FDA, the AutoPap Screener identifies up to
about 25% of slides as "within normal limits" and requiring no further review.
Cytotechnologists then manually screen the remaining approximately 75% of slides
with the assistance of the AutoPap ranked review report. This ranked review
report shows the relative scores of the processed slides. At least 15% of the
highest-ranking slides that are classified normal by manual review then undergo
quality control rescreening.
The AutoPap Screener has been approved in certain foreign countries to
identify up to 50% of slides "within normal limits." Clinical studies have shown
that the AutoPap Screener-assisted practice identifies significantly more
abnormal slides compared to current practice. This difference is statistically
significant in favor of the AutoPap Screener-assisted practice. In addition, the
AutoPap Screener-assisted practice is better able to correctly identify normal
slides than current practice.
The AutoPap Screener is NeoPath's principal product for the Pap smear
screening market. By reducing the number of Pap smears requiring
cytotechnologist review, the AutoPap Screener increases the number of Pap smears
a laboratory can process. This reduces the per-slide processing cost while
improving overall laboratory accuracy. Because the AutoPap Screener is an
upgrade, designed to incorporate the features of the AutoPap QC, the laboratory
can continue to perform its AutoPap QC-assisted quality control rescreening
without having to process Pap smear slides twice through the AutoPap System.
<PAGE> 3
MARKETING AND SALES
The AutoPap System is the only fully automated Pap smear screening device
to receive regulatory clearance for marketing in the United States. NeoPath
believes that use of the AutoPap System will distinguish its customers'
laboratories as providing a higher standard of care for Pap smear screening.
NeoPath recognizes revenue on either a product sale or fee-per-use basis.
Under its fee-per-use program, NeoPath retains ownership of AutoPap Systems
placed at customer sites and assesses customers a charge for each Pap smear
slide they process.
NeoPath markets the AutoPap System to domestic and foreign clinical
laboratories through direct sales activities in the U.S. and primarily through
distributors in international markets. Approximately 19% of NeoPath's revenues
in 1998 were from customers outside of the United States, compared to 51% in
1997 and 45% in 1996. NeoPath believes that over 35% of all U.S. Pap smears are
screened by the three largest laboratories, including SmithKline Beecham
Clinical Laboratories, Quest Diagnostics Incorporated, and Laboratory
Corporation of America. Each of these companies operates multiple laboratory
facilities nationwide.
NeoPath distributes AutoPap Systems in Japan through an agreement with
Nikon Corporation. Under this agreement, Nikon markets NeoPath products to
customers and handles maintenance and service, and NeoPath provides training for
Nikon sales personnel and service engineers, who in turn train Japanese
customers. The Japanese market, which conducts about 12 million Pap smear tests
annually, is second only to the United States in current screening volume.
In 1997, NeoPath established NeoPath Europe, located in Belgium, as its
first international branch.
NeoPath's largest customers have accounted for a significant percentage of
total revenues, as noted below.
<TABLE>
<CAPTION>
SIX MONTHS YEAR ENDED DECEMBER 31,
ENDED -------------------------
JUNE 30, 1999 1998 1997 1996
------------- ----- ----- -----
<S> <C> <C> <C> <C>
Smith Kline Beecham Clinical Laboratories............... 44% 18% 15% 22%
Nikon Corporation (Japan)............................... * * 38% 33%
Chang's Instrument Company Limited (Taiwan)............. * 10% * *
Immuno Bio Systems (Australia).......................... * * * 12%
Cascade Pathology Services Corporation.................. * * * 19%
Unilab Corporation...................................... 17% * * *
</TABLE>
- ---------------
* Less than 10%
NeoPath installs the AutoPap System at customer laboratories. By providing
this on-site service, NeoPath believes that clinical laboratories will be better
able to integrate use of the AutoPap System into their normal workflow. By
installing the AutoPap System on site, clinical laboratories can maintain
control over patient specimens data, minimize slide handling and avoid delays in
reporting their test results.
As its product development efforts improve the performance of the AutoPap
System, NeoPath intends, subject to obtaining applicable regulatory approvals,
to offer upgraded products to its customers. NeoPath has not yet determined how
it will charge for its upgrade packages, but anticipates that upgrades will
increase its fee-per-use and sale pricing.
MANUFACTURING
NeoPath's manufacturing operations are located at its headquarters in
Redmond, Washington, where it conducts final assembly, integration and testing
of the electronic, mechanical and optical components and modules of the AutoPap
System. In its manufacturing process, NeoPath must meet and adhere to all
applicable requirements of U.S. and international regulatory agencies, including
Quality Systems Regulations issued by the FDA. As part of the FDA regulatory
process, NeoPath faces periodic FDA
<PAGE> 4
inspections and other periodic inspections by U.S. and foreign regulatory
agencies. See "Governmental Regulation." NeoPath's manufacturing operations have
produced sufficient AutoPap Systems to meet customer demand since it began
commercial operations in 1996.
NeoPath purchases all components for the AutoPap System from outside
vendors. A major component of the AutoPap System, the slide tray motion system,
is supplied by a sole-source vendor, Applied Precision, Inc. In addition,
NeoPath purchases all of its AutoPap System optics from Nikon Corporation, and
all of its video cameras from Sony Electronics, Inc. Certain other components
are currently purchased from single-source vendors. NeoPath would need to modify
any components provided by additional or replacement suppliers for use in the
AutoPap System. NeoPath would be unable to quickly establish additional or
replacement sources of supply for many AutoPap System components. In addition,
NeoPath may need to obtain regulatory approval to substitute certain components.
NeoPath cannot be sure of obtaining the necessary approvals. If one of its
vendors becomes unable to supply acceptable components in a timely manner and in
the quantity required NeoPath may need to delay or halt its manufacturing
process. Any delay or cessation of manufacturing could adversely affect its
business.
CORE AUTOPAP SYSTEM TECHNOLOGY
NeoPath's core AutoPap System technology consists of:
- an integrated high-speed video microscope that can capture high-quality
images,
- comprehensive image interpretation software that accurately analyzes
images and classifies cells and slides, and
- high-speed custom field-of-view computers that run the software at high
speed.
This technology can automatically analyze and extract important features of
cellular material and can classify a specimen based on those features according
to likelihood of abnormality.
HIGH-SPEED VIDEO MICROSCOPE
To capture high-quality images, NeoPath has designed a high-speed video
microscope with an integrated mechanical/optical system, a custom microscope and
video cameras that focus, capture and digitize images from a Pap smear. The
microscope and three video cameras remain stationary while the platform holding
the Pap smear is moved. This allows the camera system to scan the Pap smear in a
continuous, systematic motion. High-intensity, narrow band light from a strobe
illuminates the Pap Smear, which enhances cell contrast and freezes each image
without interrupting the motion of the platform holding the Pap smear.
A custom-designed image capture and focus module controls the
mechanical/optical system. This module uses specialized integrated circuits and
software. This module calibrates the image acquisition system, automatically
focuses the system to obtain diagnostically relevant images and adjusts for the
non-uniform background and cell distributions of a conventional Pap smear. The
image capture and focus module also digitizes images, evaluates image and focus
quality, decides whether to accept or reject the image for analysis and
identifies the location of a rejected image for a repeat scan.
The mechanical/optical system scans the slide in three separate operations.
First, it performs a setup in which it locates the slide, identifies the
coverslip area and maps three-dimensional surface irregularities of the Pap
smear. The system then captures and analyzes low-magnification images from the
slide in a systematic scan of the slide coverslip area. Finally, using
information from the low-magnification scan, the system captures
high-magnification images from those areas of the slide having the greatest
diagnostic interest.
IMAGE-INTERPRETATION SOFTWARE
NeoPath's image-interpretation software uses a series of
image-interpretation algorithms to examine slide images and select and analyze
those that best indicate normality and abnormality. An image-
<PAGE> 5
interpretation algorithm consists of multiple-step mathematical and algorithmic
processes that detect and classify an object or collection of objects based on
shape, structure, optical density, contextual features and other measurable
characteristics. The process consists of five steps:
- selecting images from a slide,
- segmenting the images into objects,
- measuring object features,
- classifying objects, and
- classifying the slide.
SELECTION OF IMAGES. By analyzing images from a low-magnification scan of
the slide coverslip area, algorithms first identify the areas most likely to
contain cellular material of diagnostic significance. This information then
guides the high-speed video microscope to analyze the locations of greatest
diagnostic interest in a separate high-magnification scan. The AutoPap System
also accumulates and stores information gathered in this first step for later
use in the slide classification process.
SEGMENTATION INTO OBJECTS. In the high-magnification scan, the AutoPap
System locates and separates the well-defined cells or group of cells in each
image from poorly defined objects and obvious artifacts such as blood, mucus,
dust particles and similar matter.
MEASUREMENT OF OBJECT FEATURES. Once the system separates objects or
groups of objects from other elements of the image, algorithms measure more than
100 features from each object. These features independently or in combination
distinguish normal cells, artifacts and abnormal cells. The algorithms
discriminate on the basis of such categories as density, texture, size, shape
and context. Density features are measures of the optical density of various
portions of the cell, such as the cytoplasm and nucleus, and the ratios of these
densities to each other. Texture is a localized measure of optical density
variation. Size features refer to the physical areas of the segmented objects
and their ratios to each other. Shape features measure the boundary complexity
of the segmented objects, can differentiate cell types, and are used to
discriminate among isolated and overlapping objects. Context compares an object
to its surroundings and the proximity of objects to each other.
CLASSIFICATION OF OBJECTS. Using the measured object features, a series of
algorithms then classifies the objects contained in the images. Each
classification algorithm proceeds from easily identifiable objects to
increasingly difficult objects, adding more features at each level of
classification. Three complementary algorithms analyze the cells and cell
groupings that could indicate normality and abnormality: the single-cell
algorithm, the group algorithm and the thick-group algorithm. The algorithm
computes an "anomaly likelihood" value at various steps of the classification
process and generates "alarms," that identify objects that are more likely to be
abnormal cells. The results of the three algorithms are combined to achieve a
high level of accuracy.
CLASSIFICATION OF THE SLIDE. The system compiles all the gathered and
analyzed information from objects in a series of scores that the system uses to
classify the slide. Other algorithms evaluate the suitability of the slide for
machine processing based on the quality of staining, adequacy of cell
collection, presentation of material on the slide and image quality. Others
determine the probable presence of certain important cellular material such as
endocervical and squamous cells.
The AutoPap Screener uses new diagnostic algorithms that provide an
additional evaluation score, in addition to the original evaluation score, for
superior detection of glandular abnormalities. The screener uses new algorithms
that classify clusters of cells. The additional evaluation score provides a
second opinion to the decision of the original evaluation score. The combined
scores better detect abnormalities in all categories.
<PAGE> 6
FIELD-OF-VIEW COMPUTER
The AutoPap System requires a high-speed computing system, with significant
computing power to run its image-interpretation algorithms. To address this
requirement, NeoPath developed specialized field-of-view computers, which are
powerful image processors that contain application-specific integrated circuits
and other processing components. These special purpose computers accelerate the
execution speed of NeoPath's image-interpretation software. NeoPath estimates
that one field-of-view computer can perform over 1.6 billion elemental pixel
operations per second and at proportionately higher rates when several
field-of-view computers are linked to run in parallel. The current AutoPap
System contains 15 field-of-view computers. The field-of-view computer can be
programmed to execute algorithms for other applications.
PATENTS AND PROPRIETARY RIGHTS
Because of the substantial length of time and expense required to bring new
products through development and regulatory approval to the marketplace, the
medical device industry relies heavily on patent protection and protecting trade
secrets for new technologies, products and processes. NeoPath files patent
applications to protect technologies that it believes are significant to the
development of its business. NeoPath holds 58 U.S. patents (issued or allowed)
and has 22 additional U.S. patent applications pending. The patents and patent
applications relate to various aspects of its high-speed image-interpretation
technology. NeoPath holds 7 foreign patents and has applied for patent
protection for certain aspects of its technology in various foreign countries.
NeoPath intends to continue to pursue patent protection where it is available
and cost-effective, both in the United States as well as in other countries.
Companies in the medical device industry have engaged in extensive
litigation regarding patents and other intellectual property rights. NeoPath may
face such litigation to enforce its patents, protect its trade secrets or
know-how, challenge the validity of proprietary rights of others or defend
against alleged infringement of proprietary rights of others.
NeoPath relies on a combination of patents, trade secrets and
confidentiality agreements to protect its proprietary technology, rights and
know-how. NeoPath requires each of its employees and consultants to enter into a
confidentiality agreement that prohibits them from disclosing confidential
information to anyone outside NeoPath. These agreements also require employees
and consultants to disclose to NeoPath ideas, developments, discoveries or
inventions they conceive during employment or consultation. They also must
assign their proprietary rights in such matters if the matters relate to NeoPath
business and technology.
NeoPath has registered trademarks in the United States, Australia, Japan,
Canada, France, the Benelux countries, Germany, the United Kingdom, Italy and
Spain for "NeoPath" and "AutoPap." NeoPath also has registered trademarks for
"Pathfinder" and "PapMap" in the United States. NeoPath has applied for
registration of its trademarks in several other foreign countries.
THIRD-PARTY REIMBURSEMENT
Some private third-party medical insurance providers and governmental
agencies offer reimbursement for laboratory testing associated with routine
medical examinations, including Pap smears. In the United States, the level of
reimbursement by those third-party payors varies considerably, and the patient
often pays for Pap smears. Third-party healthcare payors in the United States
are increasingly sensitive to containing healthcare costs and heavily scrutinize
new technology. Third-party payors may influence the pricing or perceived
attractiveness of NeoPath's products and services by regulating the maximum
amount of reimbursement they provide or by not providing any reimbursement.
Restrictions on reimbursement may limit the price NeoPath can charge for
AutoPap System screening or reduce the demand for AutoPap System screening. If
these payors do not reimburse for the AutoPap System screening, or provide
reimbursement significantly below the amount laboratories charge patients to
perform AutoPap System screening, NeoPath's potential market will shrink.
NeoPath intends to
<PAGE> 7
focus on obtaining coverage and reimbursement from major national and regional
third-party payors in the United States.
NeoPath believes that increased third-party reimbursement of Pap smears in
general, and increased reimbursement for screening utilizing the AutoPap System
in particular, would increase market acceptance of its products. Virtually all
of NeoPath's revenues are dependent on customers who rely on third-party
reimbursement. In early 1998, NeoPath established a reimbursement team to work
with third-party insurers and managed care organizations to establish and
improve third-party reimbursement rates for the AutoPap System. These
reimbursement specialists work closely with NeoPath's field sales personnel
throughout the United States. On January 1, 1999, revised Physicians' Current
Procedural Terminology codes established by the American Medical Association
became effective for the AutoPap Screener. These codes are a standardized system
used by physicians and clinical laboratories to identify specific procedures
when billing insurers for their services. New codes that address utilization of
the AutoPap QC were established on January 1, 1998.
GOVERNMENTAL REGULATION
UNITED STATES
Medical devices like the AutoPap QC and the AutoPap Screener are heavily
regulated in the United States by the FDA and by other federal, state and local
authorities. The FDA regulates the research, development, clinical studies,
manufacturing, packaging, labeling, distribution, promotion and postmarket
surveillance of medical devices in the United States. FAA regulations govern all
preclinical and clinical trials of medical devices. In addition, state and local
authorities may require permits under regulations relating to clinical
activities.
Under the Federal Food, Drug, and Cosmetic Act, the AutoPap System is a
Class III medical device, subject to stringent FDA review to ensure that the
device is safe and effective before it is marketed, sold and distributed in the
United States. Once a PreMarket Approval application receives FDA approval and
the company begins marketing a product, it must register with the FDA and to
submit device listing information for products in commercial distribution. In
addition, the FDA may impose certain post-approval requirements in a pre-market
approval order at the time of approval. In conjunction with FDA approval of the
pre-market application and supplements with respect to the AutoPap System,
NeoPath's manufacturing operations are subject to FDA inspection. NeoPath will
continue to be inspected on a routine basis by the FDA for compliance with
regulations with respect to manufacturing, testing, distribution, storage and
control activities. The FDA also regulates labeling and promotional activities.
NeoPath must establish and maintain a system for tracking AutoPap Systems
through the chain of distribution and conduct postmarket surveillance, and must
provide periodic reports containing safety and effectiveness information.
In addition, the FDA's Medical Device Reporting regulations require medical
device companies such as NeoPath to provide information to the FDA whenever
evidence reasonably suggests that a device may have caused or contributed to a
death or serious injury. These regulations also apply if the device malfunctions
and the device or a similar device sold by the company would be likely to cause
or contribute to a death or serious injury if the malfunction were to recur.
If the FDA believes that NeoPath has not complied with the law, it can take
one or more of the following actions:
- refuse to review or clear applications to market its products in the
United States
- refuse to allow NeoPath to enter into government supply contracts;
- withdraw approvals already granted;
- require that NeoPath notify users regarding newly found risks;
- request repair, refund or replacement of faulty devices;
<PAGE> 8
- request corrective advertisements, recalls or temporary marketing
suspension; or
- initiate legal proceedings to detain or seize products, enjoin future
violations or assess criminal penalties against NeoPath or its officers
or employees.
The FDA also may assess civil penalties for Food, Drug, and Cosmetic Act
violations. These actions could disrupt NeoPath's operations for an indefinite
period of time. Various states in which NeoPath products are sold also may
impose additional regulatory requirements.
INTERNATIONAL MARKETS
Under FDA rules, companies can export a Class III medical device that has
not been approved for marketing in the United States only after meeting certain
criteria. The FDA must determine that exportation does not threaten public
health and safety and that the company has received approval of the country to
which the device will be exported. Companies usually must obtain approval by a
comparable regulatory authority of a non-U.S. country before applying to the FDA
for clearance to export and begin marketing in that country. Foreign regulatory
requirements for sales of medical devices vary widely from country to country.
In addition to regulatory approvals in the United States, the AutoPap
System is approved for primary screening and quality control rescreening in
Japan, Canada, Australia, New Zealand, The Netherlands, Italy, Hong Kong, Korea,
and Taiwan. NeoPath intends to pursue additional product registrations in other
foreign countries.
NeoPath's products are subject to a variety of regulations in Europe,
including the European Union. In vitro medical devices, including the AutoPap
System, must now comply with the EU's In-Vitro Diagnostic Medical Devices
Directive. The Directive was published in the Official Journal of European
Communities in December, 1998. The EU member states will likely implement the
Directive into national law by December 1999. A transition period, which begins
from the date of publication of the Directive and ends December, 2003, applies
to all devices placed on the market in the EU. During this transition period,
both Directive "CE" marked and non CE-marked devices may be placed on the
market. In other words, companies may choose to follow either the CE mark or the
national legislation, if any. If no such national legislation exists, the
devices can be freely placed on the market. By the conclusion of this transition
period, NeoPath's products must comply with the requirements of the Directive
and member state local language requirements.
Other European countries may enact national laws that would conform to the
Directive. Member states of the EU and the European Economic Area may enact
requirements in addition to those imposed by the Directive. Some European
countries have established national regulations relating to in vitro diagnostic
medical devices. EU directives and national laws impose requirements for
electrical safety and electromagnetic compatibility that apply to the AutoPap
System. NeoPath has performed the requisite testing procedures and related
documentation to apply the European CE mark to the AutoPap System. NeoPath
cannot guarantee that the AutoPap System or any other product it may develop
will obtain any required regulatory clearance or approval on a timely basis, if
at all.
REGULATION OF CERVICAL PAP SMEAR ANALYSIS
Congress has directed the Department of Health and Human Services to issue
regulations designed to improve the quality of biomedical analytic services,
particularly the examination of Pap smears. These regulations require clinical
laboratories to rescreen at least 10% of the Pap smears classified on initial
manual screen as normal. This 10% must include normal cases selected from the
laboratory's total caseload, and from patients or groups of patients that are
have a high probability of developing cervical cancer based on available patient
information. The AutoPap System is not intended to replace a laboratory's
current practices regarding screening or rescreening Pap smears of "high-risk"
patients.
In addition, laboratories often must comply with state regulations,
inspection, and licensing. In recent years, a few states, including New York and
California, have adopted regulations that limit the number of
<PAGE> 9
slides that may be manually examined by a cytotechnologist within a given period
of time. NeoPath cannot guarantee that states will not directly regulate the
AutoPap System in the future. NeoPath cannot predict the effect, if any,
regulation may have on its business or operations.
COMPETITION
Competition in the medical device industry is intense. To effectively
compete, NeoPath must keep pace with the rapid product development and
technological change in the industry. The AutoPap System competes with existing
manual methods of screening Pap smears and with semi-automated systems. To
compete effectively, the AutoPap System must demonstrate accuracy and cost
effectiveness that equals or exceeds manual review of Pap smears. The AutoPap
System must remain competitive in accuracy and effectiveness, cost, convenience,
perception among influential cytopathologists and laboratories, and processing
speed and reliability.
NeoPath is aware of two potential direct competitors:
- AutoCyte, which is developing a semi-automated system to analyze
liquid-based Pap smears, a potential alternative to conventional Pap
smears; and
- Morphometrix Technologies Inc., which is developing an automated system
to analyze liquid-based Pap smears
Neuromedical Systems, Inc., had obtained regulatory approval for a
semi-automated system that rescreens conventional Pap smears and was developing
a semi-automated primary screener. On March 26, 1999, Neuromedical announced
that it had filed a voluntary Chapter 11 petition for bankruptcy. On March 26,
1999, AutoCyte announced an agreement to purchase certain Neuromedical
technology, including patent rights, for $4.0 million in cash and 1.4 million
shares of AutoCyte common stock. On April 26, 1999, NeoPath and AutoCyte
announced an agreement in which NeoPath may acquire an undivided interest in the
intellectual property estate of Neuromedical that AutoCyte had agreed to
acquire. If the Merger of AutoCyte and NeoPath does not occur, NeoPath will pay
AutoCyte $2.2 million in cash and issue AutoCyte 1.2 million shares of NeoPath
common stock. On May 18, 1999, AutoCyte announced that it had completed its
acquisition of the Neuromedical technology.
NeoPath also faces indirect competition from companies such as AutoCyte
that manufacture liquid-based or monolayer slide preparation systems and devices
that automate various aspects of cytology. Cytyc Corporation also is approved to
market its ThinPrep System that prepares slides for cervical cancer screening
using a liquid-based sampling and preparation technique as a replacement for the
conventional Pap smear method.
EMPLOYEES
At June 30, 1999, NeoPath employed 100 full-time equivalent personnel,
including 41 in research and development and regulatory; 35 in administration,
customer service and support, and sales and marketing; and 24 in manufacturing
and operations. None of its employees is represented by a union or other
bargaining group. NeoPath believes its relationship with its employees is good.
PROPERTIES
NeoPath leases approximately 72,000 square feet of office and manufacturing
space in Redmond, Washington under operating leases expiring through January
2000, with various renewal options. NeoPath believes that the Redmond facility
and other available office space are adequate for its current needs and that
additional space is available in the area, should it be needed. NeoPath also
leases office space in Brussels, Belgium under an operating lease expiring in
August 2007.
<PAGE> 10
LEGAL PROCEEDINGS
On July 15, 1996, Neuromedical filed a lawsuit against NeoPath in the
United States District Court for the Southern District of New York. The
complaint alleged patent infringement, unfair competition, false advertising,
and related claims and requested monetary damages and injunctive relief. On
September 5, 1996, NeoPath filed its answer and counter claims. In May 1998, a
judge in the United States District Court for the Southern District of New York
denied Neuromedical's motion for a preliminary injunction against NeoPath. The
parties agreed to dismiss their claims and counterclaims on all but the patent
issues, and Neuromedical accordingly served an amended complaint on July 27,
1998 asserting only patent infringement claims. Virtually all of NeoPath's
domestic revenues, which represented 81% of its total revenues in 1998, are
derived from products that incorporate technology covered by this patent.
NeoPath believes it has a strong position in this action and will defend against
these claims vigorously. On March 26, 1999, Neuromedical announced that it had
filed a voluntary chapter 11 petition for bankruptcy. On April 6, 1999, the
court removed the case from its active docket pending further developments in
Neuromedical's bankruptcy proceedings.
On March 31, 1997, NeoPath filed a patent infringement lawsuit against
Neuromedical in the United States District Court for the Western District of
Washington. The complaint alleges patent infringement and seeks permanent
injunctions against Neuromedical. In March and April 1998 this lawsuit was
amended, and NeoPath filed an additional related patent lawsuit against
Neuromedical. Neuromedical filed a motion for summary judgment, which the court
denied in April 1998. In October 1998, Neuromedical filed another motion for
summary judgment that the court denied. By court order on March 30, 1999,
proceedings were stayed pending resolution of Neuromedical's bankruptcy
proceedings. The court ordered that these cases be removed from the court's
active caseload.
The intellectual property acquisition agreement between NeoPath and
AutoCyte provides that the patent infringement litigation between NeoPath and
Neuromedical will be terminated.
