SECURITIES AND EXCHANGE COMMISSION
WASHINGTON D.C. 20549
___________________________
FORM 10-K
[X] Annual Report Pursuant to Section 13 or 15(d) of the
Securities Exchange Act of 1934
For the Fiscal Year Ended December 31, 1998
or
[ ] Transition Report Pursuant to Section 13 or 15(d) of the
Securities Exchange Act of 1934
For the transition period from _____________ to _______________
Commission File Number 0-25210
NeoPath, Inc.
(Exact name of registrant as specified in its charter)
Washington 91-1436093
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
8271 - 154th Avenue NE, Redmond, Washington 98052
(Address of principal executive offices) (Zip Code)
(425) 869-7284
Registrant's telephone number, including area code
Securities registered pursuant to Section 12(b) of the Act:
Name of each exchange
Title of each class on which registered
___________________ ___________________
None N/A
Securities registered pursuant to Section 12(g) of the Act:
Common Stock, $.01 par value
(Title of Class)
Indicate by check mark whether the registrant (1) has
filed all reports required to be filed by Section 13 or 15(d)
of the Securities Exchange Act of 1934 during the preceding 12
months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to
such filing requirements for the past 90 days.
Yes [X] No [ ]
Indicate by check mark if disclosure of delinquent filers
pursuant to Item 405 of Regulation S-K is not contained herein,
and will not be contained, to the best of registrant's
knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any
amendment to this Form 10-K. [X]
Aggregate market value of voting and nonvoting stock held
by non-affiliates of the registrant as of February 25, 1999 was
$68,986,907.
Number of shares of Common Stock outstanding as of
February 25, 1999: 17,412,504 shares.
DOCUMENTS INCORPORATED BY REFERENCE
Portions of the 1998 Annual Report to Shareholders are
incorporated by reference into Part II.
Part III is incorporated by reference to the definitive
Proxy Statement to be filed in connection with the Company's
Annual Meeting of Shareholders to be held on May 20, 1999.
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PART I
Item 1. BUSINESS
The following Business section includes "forward-looking
statements" within the meaning of the Private Securities
Litigation Reform Act of 1995. The Act provides a "safe harbor"
for forward-looking statements to encourage companies to provide
prospective information about themselves so long as they identify
these statement as forward-looking and provide meaningful
cautionary statements identifying important factors that could
cause actual results to differ from the projected results. All
statements other than statements of historical fact the Company
makes in this document or in any document incorporated by
reference are forward-looking. In particular, the statements
herein regarding industry prospects and the Company's future
results of operations or financial position are forward-looking
statements. Forward-looking statements reflect management's
current expectations and are inherently uncertain. The Company's
actual results may differ significantly from expectations. The
section entitled "Factors Affecting Future Results and Forward-
Looking Statements" describes some, but not all, of the factors
that could cause these differences.
The Company
NeoPath, Inc. ("NeoPath" or the "Company"), a Washington
Corporation incorporated in 1989, develops and markets visual
intelligence technology to increase accuracy in medical testing.
NeoPath's initial 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 Papanicolaou ("Pap") smear slide for
the early detection of cervical cancer.
The United States Food and Drug Administration (the "FDA")
approved NeoPath's AutoPap(R) 300 QC Automatic Pap Screener
System (the "AutoPap QC") in 1995. The AutoPap QC is a
rescreening device used for quality control and rescreening of
previously screened Pap smear slides previously screened by
cytotechnologists. 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.
The FDA approved NeoPath's AutoPap(R) Primary Screening System
(the "AutoPap Screener") in May 1998. The AutoPap 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. Clinical studies have shown that the AutoPap Screener
provides statistically significantly better 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. This feature of
the AutoPap Screener provides customers with an economic
incentive to adopt the technology.
The "AutoPap System" refers to the AutoPap Screener and the
AutoPap QC together.
Background
Cancer of the Uterine Cervix
Cancer of the uterine cervix is one of the most common cancers
among women throughout the world, with approximately 500,000 new
cases reported each year. The American Cancer Society projected
that, in the United States in 1998, approximately 13,700 new
cases of invasive cervical cancer would be diagnosed and
approximately 4,900 women would die of cervical cancer. Almost
all deaths due to cervical cancer could be prevented with early-
stage detection and treatment. Cancer of the uterine cervix is
preceded by a precancerous, curable stage that generally
progresses without symptoms over a period of years until it
reaches an invasive stage. Treating uterine cervical cancer
after it has reached the invasive stage becomes more difficult
and expensive, and may not be successful. Industry sources have
estimated that, of the approximately 50 million Pap tests
conducted annually in the United States, approximately 2.5
million, or 5%, are diagnosed with precancerous conditions or
cancer.
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The Pap Test
The Pap test, developed in the 1940s by Dr. George N.
Papanicolaou, is a screening procedure for the early detection of
precancerous and cancerous conditions of the uterine cervix. The
Pap test was designed to identify abnormalities that may progress
to cervical cancer, thereby facilitating early medical
intervention. If early detection is made, treatment is
relatively inexpensive and almost always successful. To obtain a
Pap smear, a gynecologist or general practitioner scrapes the
surface of a woman's uterine cervix to collect a sample of cells.
The specimen is smeared onto a microscope slide and preserved
with a fixative agent such as alcohol. This Pap smear, along
with patient information, is then sent to a clinical laboratory
for further preparation, screening and diagnosis.
At the laboratory, the specimen, which typically consists of
50,000 to 300,000 cervical cells, is stained to highlight
important cellular features and sealed with a protective
coverslip. The Pap smear is then placed under a microscope and
examined by a cytotechnologist for signs of abnormality.
Cytotechnologists, medical professionals with special training in
cytology (the study of cells), generally require five to ten
minutes to screen each Pap smear slide and complete related
paperwork. Typically, about 90% to 95% of all Pap smears are
classified as normal. In the remaining cases, a cytotechnologist
has detected a suspicious condition that must be reviewed by a
senior cytotechnologist. Those slides confirmed to have signs of
precancerous conditions or cancer, typically about 5% of all
cases, are referred to a cytopathologist, who carefully reviews
the Pap smear and makes a final diagnosis.
Despite the acknowledged success of the Pap test, there are
certain limitations in the current method of manual Pap smear
review. Pap smears are subject to a highly variable false-
negative rate (the percentage of abnormal smears that are
misclassified as normal). In certain laboratories, this false-
negative rate may exceed 25% (that is, one of four abnormal Pap
smears may be misclassified as normal). Partly because physical
and mental stress escalates with the number of Pap smears
examined, thereby increasing the risk of false-negatives, federal
regulations promulgated under the Clinical Laboratory Improvement
Amendments of 1988 ("CLIA") generally limit the number of slides
that a cytotechnologist may screen each day to no more than 100.
As an additional quality control measure, the CLIA regulations
also require that laboratories rescreen a minimum of 10% of all
Pap smears initially classified as normal.
Treatment
In the United States, each Pap smear slide is typically
classified in accordance with The Bethesda System for Reporting
Cervical/Vaginal Cytologic Diagnoses. Any slide classified as
other than normal is considered abnormal and may be precancerous
or cancerous. Abnormalities evident in Pap smears may indicate
various conditions ranging from atypical squamous cells of
undetermined significance ("ASCUS") and atypical glandular cells
of undetermined significance ("AGUS"), both commonly referred to
as "atypia," and low-grade squamous intraepithelial lesions
("LSILs") to high-grade squamous intraepithelial lesions
("HSILs") and cancer. A woman whose Pap smear indicates the
presence of HSILs or cancer will typically receive a colposcopic
examination, and if necessary, a biopsy. Treatment of early-
stage noninvasive cervical cancer, which is relatively curable,
may be accomplished by epithelial treatment in which the
cancerous tissue is removed, for example, by electrocautery.
Once the cancer reaches an invasive stage, the patient's chances
for recovery are diminished and typically require treatment such
as radiation therapy, surgery, or chemotherapy.
Market
The Company believes that clinical analysis of Pap smears
currently represents the largest nonautomated clinical laboratory
procedure. Industry statistics indicate that U.S. clinical
laboratories process over 50 million Pap smears annually and that
laboratories outside the United States process more than 60
million Pap smears annually. Pap smears are generally processed
in hospital-based or independent clinical laboratories.
NeoPath's AutoPap Screener is the only instrument approved by
the FDA that allows Pap smear slides to bypass human review.
This feature of the AutoPap Screener provides customers with an
economic incentive to adopt the technology. In addition, in
recent years there has been an increasing focus on improving the
quality of women's healthcare. The Company 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 will facilitate more timely treatment and will
lower risks of morbidity and mortality.
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Laboratories that fail to accurately identify Pap smears that
contain indications of precancerous conditions or cancer may be
subject to malpractice suits. Because federal law requires all
Pap smears to be retained by laboratories for five years, these
laboratories face significant exposure to liability. The Company
believes that use of its AutoPap System will substantially
improve the current quality of practice, thereby enabling those
laboratories that use the AutoPap System to reduce their exposure
to such liability.
Products
NeoPath's AutoPap Screener and AutoPap QC employ identical
hardware components. The AutoPap Screener, however, contains
enhanced software, including additional cell-classification
algorithms, that allow it to be used for the initial screening of
Pap smears.
The AutoPap System is used on-site by general laboratory
personnel and is compatible with a wide range of staining
procedures used on conventionally prepared Pap smear slides. The
AutoPap System currently requires use of glass coverslips, which
are widely used by most laboratories and provide consistent
optical characteristics. The AutoPap System analyzes a Pap smear
in approximately the same time as a cytotechnologist. The
AutoPap System, which holds approximately 300 Pap smear slides at
a time, is easy to load and unload, and is designed to operate
continuously, or with minimal intervention, for up to 24 hours
per day. The Company provides each clinical laboratory with on-
site training, system documentation, a comprehensive quality
assurance program, and ongoing customer and technical support.
NeoPath believes that its automated image-interpretation
technology has substantial application for other diagnostic tests
that involve microscopic analysis of biological specimens on
glass slides, such as sputum, blood, tissue, or urine samples.
In addition, the Company has identified several other potential
applications for its technology, including automated image
interpretation for lung, breast, bladder and skin cancers. The
Company believes that the technology embodied in the hardware
platform of the AutoPap System is appropriate for other
applications involving analysis of cellular images on microscope
slides. Developing systems for such applications primarily
involves adapting software algorithms developed for the analysis
of Pap smears to the analysis of other tissue specimens. The
Company continues to evaluate the indications on which it may
focus future development efforts, including non-medical
applications.
The Company's research and development expenses were $11.3
million, $14.2 million, and $11.2 million in the years ended
December 31, 1998, 1997, and 1996, respectively.
AutoPap Primary Screener System
The FDA approved the AutoPap Screener in May 1998. The AutoPap
Screener incorporates new diagnostic algorithms (not used in the
AutoPap QC) to improve diagnostic accuracy in the primary
screening of Pap smear slides. The AutoPap Screener identifies
up to approximately 25% of the lowest-ranking slides as "within
normal limits" and requiring no further review. The remaining
approximately 75% of slides are subjected to manual screening
with the assistance of the AutoPap ranked review report. This
ranked review report indicates the relative scores of the
processed slides; at least 15% of the highest-ranking slides that
are classified as within normal limits by manual review undergo
quality control rescreening.
Clinical studies have shown that the AutoPap Screener-assisted
practice identifies more abnormal slides compared to current
practice, and this difference is statistically significant in
favor of the AutoPap Screener-assisted practice. In addition,
the AutoPap Screener-assisted practice shows improved specificity
(the ability to correctly identify normal slides) over current
practice.
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The AutoPap Screener has become the Company'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, potentially reducing 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 AutoPap Screener allows the laboratory to
continue to perform its AutoPap QC-assisted quality control
rescreening without having to process Pap smear slides twice
through the AutoPap System. Because of the AutoPap Screener's
ability to act as a primary Pap smear screener, the Company
intends to charge higher fee-per-use and sale prices for use of
the AutoPap Screener than for the AutoPap QC.
AutoPap 300 QC Automatic Pap Screener System
The AutoPap QC is designed to rescreen Pap smears that have
been previously screened and classified as normal by a
cytotechnologist. Its purpose is to improve the detection of
false-negatives and, thereby, improve diagnostic accuracy. The
AutoPap QC classifies slides based on their likelihood of being
abnormal; a percentage (10% or more) of those slides showing the
highest potential for abnormality are identified as requiring
additional review by a cytotechnologist qualified to perform
quality control. The AutoPap QC is intended for use as either a
quality-control or an adjunct rescreening device for previously
manually screened Pap smears. This flexibility allows
laboratories either to implement the AutoPap QC into their
quality-control procedures or to offer Pap smear rescreening by
the AutoPap QC as an additional service for those women who seek
an additional review of their Pap smears.
Preclinical and clinical trials demonstrated that the AutoPap
QC, operating in a quality-control mode, showed up to a five-fold
improvement in the detection of false negative slides over a 10%
random selection method. By the same standard, the AutoPap QC
achieved up to an eight-fold improvement in the detection of
biopsy-confirmed HSIL and cancer slides. The Company believes
that the substantial improvement over current methodology
demonstrated by the AutoPap QC can result in consistent earlier
detection of precancerous conditions and cancer, thereby
facilitating more timely treatment and reducing the risk of
morbidity and mortality.
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. The Company believes that use of the AutoPap
System will serve to distinguish its customers' laboratories as
providing a higher quality of Pap smear screening compared to
those laboratories that have not adopted the AutoPap System.
The Company recognizes revenue on either a product sale or fee-
per-use basis (subject to service and license agreements, rental
contracts, and minimum payments on certain fee-per-use
contracts). 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 processed.
NeoPath's primary market includes domestic and foreign clinical
laboratories. Domestic revenues are generated primarily through
NeoPath's direct sales activities; international revenues are
derived primarily through distributors. 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. The
Company's market research indicates that over 35% of all U.S. Pap
smears are screened by the three largest laboratories, including
SmithKline Beecham Clinical Laboratories ("SmithKline"), Quest
Diagnostics Incorporated ("Quest"), and Laboratory Corporation of
America. Each of these companies operates multiple laboratory
facilities nationwide.
SmithKline has been NeoPath's largest customer, measured by
total AutoPap Systems installed, since the Company commenced
commercial operations in 1996. SmithKline was also NeoPath's
largest customer in 1998, measured by total revenues. In October
1998, NeoPath announced an agreement with SmithKline pursuant to
which SmithKline has agreed to adopt the AutoPap Screener
throughout its domestic laboratory organization. This four-year
contract is intended to enable SmithKline to process 100% of its
Pap smear volume on AutoPap Screeners. At current AutoPap
processing rates, NeoPath estimates that SmithKline may require
up to 125 AutoPap Screeners to process its nationwide volume of
Pap smears under contract. As of December 31, 1998, SmithKline
had approximately 70 AutoPap Screeners installed at various
laboratory sites.
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In February 1999, SmithKline and Quest announced that Quest had
agreed to purchase SmithKline. The combined entity would be the
largest clinical laboratory company in the world. NeoPath's
national agreement with SmithKline is binding on successor
organizations, and NeoPath management believes that AutoPap
Systems installed under the SmithKline agreement will continue to
generate revenues in accordance with the underlying agreement.
NeoPath distributes AutoPap Systems in Japan through an
agreement with Nikon Corporation ("Nikon") whereby Nikon markets
products to customers and handles maintenance and service.
NeoPath provides training for Nikon sales personnel and service
engineers, who in turn train Japanese customers. The Japanese
market, with approximately 12 million Pap smear tests conducted
annually, is second only to the United States in current
screening volume for a country. Nikon was NeoPath's largest
customer in 1997 and 1996, based on revenues.
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. In 1997,
NeoPath established NeoPath Europe, located in Belgium, as its
first international branch.
The Company's four largest customers accounted for 41% of total
revenues in 1998, compared to 65% in 1997 and 86% in 1996.
The Company installs the AutoPap System at customer
laboratories. By providing this on-site service, the Company
believes that clinical laboratories will be better able to
integrate use of the AutoPap System into their normal workflow.
Installing the AutoPap System on site also allows clinical
laboratories to maintain control over patient specimens and
associated data, minimize slide handling and avoid delays in
reporting their test results.
As the Company's product development efforts improve the
performance and functionality of the AutoPap System, the Company
intends, subject to obtaining applicable regulatory approvals, to
market upgraded product versions to its customers. The Company
has not yet determined how it will charge for its upgrade
packages, but anticipates that upgrades will result in increases
in its fee-per-use and sale pricing.
Manufacturing
The Company's manufacturing operations are located at its
headquarters in Redmond, Washington and consist of final
assembly, integration and testing of electronic, mechanical and
optical components and modules comprising the AutoPap System. In
its manufacturing process, the Company is required to meet and
adhere to all applicable requirements of U.S. and international
regulatory agencies, including Quality Systems Regulations
("QSR"), as promulgated by the FDA. As part of the FDA
regulatory process, the Company's AutoPap System manufacturing
processes and facilities are subject to periodic FDA QSR
inspections and may be subject to further 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
commercial operations began in 1996.
The Company 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. Certain other components, such as the video cameras, are
currently supplied by single source vendors, and components
provided by additional or replacement suppliers would require
some modification to be incorporated into the AutoPap System.
The establishment of additional or replacement sources of supply
for many AutoPap System components cannot be accomplished
quickly, and substitution of components could require regulatory
approval, the receipt of which cannot be assured. Accordingly, a
vendor's inability to supply acceptable components in a timely
manner and in the quantity required could delay or halt the
Company's manufacture of its products. Any such delay or
cessation could have a material adverse effect on the Company.
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Core AutoPap System Technology
The Company's core AutoPap System technology consists of a
means for acquiring high-quality images through an integrated
high-speed video microscope, comprehensive image interpretation
software to accurately analyze images and classify cells and
slides, and high-speed custom field-of-view ("FOV") computers to
run the software at high speed. This technology is able to
automatically analyze and extract important features of cellular
material and to classify a specimen based on those features.
High-Speed Video Microscope
To capture high-quality images, the Company has designed a high-
speed video microscope consisting of an integrated
mechanical/optical system with a custom microscope and video
cameras that focus, capture and digitize images from a Pap smear.
The microscope and three video cameras are stationary while the
platform holding the Pap smear is moved, which allows the camera
system to scan the Pap smear in a continuous, systematic motion.
The Pap smear is illuminated by high-intensity, narrowband light
from a strobe that enhances cell contrast and freezes each image
without interrupting the motion of the platform holding the Pap
smear.
The mechanical/optical system is controlled by a custom-
designed image capture and focus module that incorporates
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 generally scans the slide in
three separate operations. First, it performs a setup, which
consists of locating the slide, identifying the coverslip area
and mapping 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 integrates a series of
image-interpretation algorithms to examine slide images and
select and analyze those that are the most relevant indicators of
normality and abnormality. An image-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 executed by the
image-interpretation software 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 segments the well-defined cells
or group of cells in each image into objects, while excluding
from further analysis poorly defined objects and obvious
artifacts (blood, mucus, dust particles and similar matter).
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Measurement of Object Features. Once objects or groups of
objects are segmented from other elements of the image,
algorithms measure more than 100 features from each object.
Features are characteristics of the objects that independently
or in combination provide effective discrimination among normal
cells, artifacts and abnormal cells. The algorithms
discriminate on the basis of certain general categories of
features, including the following: 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
contains multiple stages that proceed from easily identifiable
objects to increasingly difficult objects, adding more features
at each level of classification. Three complementary
algorithms are used to analyze the cells and cell groupings
that could indicate normality and abnormality: the single-cell
algorithm, the group algorithm and the thick-group algorithm.
An "anomaly likelihood" value is computed at various steps of
the classification process in which pre-defined thresholds are
applied to provide "alarms," which identify objects that have a
higher likelihood of being abnormal cells. The results of the
three algorithms are integrated to achieve high overall
classification accuracy.
Classification of the Slide. All the gathered and analyzed
information from objects is compiled in a series of scores that
are used to classify the slide for purposes of quality-control
rescreening, adjunct rescreening or primary screening. Other
algorithms evaluate the suitability of the slide for machine
processing (quality of staining, adequacy of cell collection,
presentation of material on the slide and image quality) and
determine the probable presence of certain important cellular
material such as endocervical and squamous cells.
The AutoPap Screener utilizes new diagnostic algorithms that
provide an adjunctive evaluation score, in addition to the
original evaluation score, for superior detection of glandular
abnormalities. This was accomplished by the development of new
algorithms that classify clusters of cells. The adjunctive
evaluation score was implemented as a second opinion to the
decision of the original evaluation score. The combination of
the adjunctive evaluation score and the original evaluation score
produces increased detection sensitivity for all abnormal
categories.
Field-of-View (FOV) Computer
Image-interpretation algorithms are implemented in computer
programs that must be executed by a high-speed computing system.
These algorithms must be run for each Pap smear image, a process
requiring significant computing power. To address this
requirement, NeoPath developed specialized FOV computers, which
are powerful image processors that contain application-specific
integrated circuits and other processing components. The
execution speed of NeoPath's image-interpretation software is
accelerated through the use of these special-purpose computers.
The Company estimates that one FOV can perform elemental pixel
operations at a rate exceeding 1.6 billion per second and at
proportionately higher rates when several FOVs are linked to run
in parallel. The current configuration for the AutoPap System
contains 15 FOVs. The FOVs are fully programmable and can be
programmed to execute algorithms for other applications.
Patents and Proprietary Rights
Because of the substantial length of time and expense
associated with bringing new products through development and
regulatory approval to the marketplace, the medical device
industry places considerable importance on obtaining patent
protection and protecting trade secrets for new technologies,
products and processes. Accordingly, the Company files patent
applications to protect technologies that it believes are
significant to the development of its business. The Company
holds 54 U.S. patents (issued or allowed) and has 26 additional
U.S. patent applications pending. The patents and patent
applications relate to various aspects of the Company's high-
speed image-interpretation technology. The Company holds 7
foreign patents and has applied for patent protection for certain
aspects of its technology in various foreign countries. The
Company 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.
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The medical device industry has been characterized by extensive
litigation regarding patents and other intellectual property
rights, and the Company may institute or otherwise be involved in
such litigation to enforce its patents, protect its trade secrets
or know-how, challenge the validity of proprietary rights of
others or defend against its alleged infringement of proprietary
rights of others. In July 1996, a patent infringement action was
filed against the Company by a competitor; in March 1997, the
Company filed a patent infringement lawsuit against that
competitor. See "Item 3. Legal Proceedings" and "Factors
Affecting Future Results and Forward-Looking Statements --
Dependence on Patents and Proprietary Rights; Risk of Third-Party
Claims of Infringement."
NeoPath relies on a combination of patents, trade secrets and
confidentiality agreements to protect its proprietary technology,
rights and know-how. The Company's policy is to have each
employee or consultant enter into a confidentiality agreement
containing provisions prohibiting disclosure of confidential
information to anyone outside the Company. These provisions also
require disclosure to the Company of ideas, developments,
discoveries or inventions conceived during employment or
consultation, and assignment to the Company of proprietary rights
to such matters related to the business and technology of the
Company.
The Company 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."
The Company 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 payers varies considerably, and the patient
often pays for Pap smears. Third-party healthcare payers in the
United States are increasingly sensitive to containing healthcare
costs and heavily scrutinize new technology as a primary factor
in increased healthcare costs. Third-party payers may influence
the pricing or perceived attractiveness of the Company'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 payers do not reimburse for
the AutoPap System screening, or provide reimbursement
significantly below the amount laboratories charge patients to
perform AutoPap System screening, the Company's potential market
will be significantly reduced. The Company intends to focus on
obtaining coverage and reimbursement from major national and
regional third-party payers 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 the Company's products. In early 1998, NeoPath
established a reimbursement team to work with third-party
insurers and managed care organizations to establish and/or
improve third-party reimbursement levels 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 ("CPT")
codes (established by the American Medical Association) became
effective for the AutoPap Screener. CPT codes are a standardized
system used by physicians and clinical laboratories to identify
specific procedures when billing insurers for their services.
New CPT codes that address utilization of the AutoPap QC became
available on January 1, 1998.
Governmental Regulation
United States
The AutoPap QC and the AutoPap Screener are medical devices
subject to extensive regulation 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.
Preclinical and clinical trials of medical devices must be
conducted in conformity with all applicable FDA regulations. In
addition, state and local permits may be required under
regulations relating to clinical activities.
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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
commencement of marketing, sales and distribution in the United
States. Once a PreMarket Approval ("PMA") application receives
FDA approval and the Company commences marketing the applicable
product, it is required to 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 PMA approval order at the time of
approval, with which NeoPath would be required to comply. In
conjunction with FDA approval of the PMA application and
supplements with respect to the AutoPap System, the Company's
manufacturing operations are subject to FDA QSR inspection. The
Company will continue to be inspected on a routine basis by the
FDA for compliance with QSR regulations with respect to
manufacturing, testing, distribution, storage and control
activities. The FDA also regulates labeling and promotional
activities. The Company is required to establish and maintain a
system for tracking AutoPap Systems through the chain of
distribution and to conduct postmarket surveillance, and is
required to provide periodic reports containing safety and
effectiveness information.
In addition, the Medical Device Reporting ("MDR") regulations
obligate medical device companies such as NeoPath to provide
information to the FDA whenever there is evidence to reasonably
suggest that a device may have caused or contributed to a death
or serious injury. The MDR regulations also apply if the device
malfunctioned and the device or a similar device marketed by the
company would be likely to cause or contribute to a death or
serious injury if the malfunction were to recur.
If, as a result of FDA inspections, MDR reports or information
derived from any other source, the FDA believes that the Company
is not in compliance with the law, it can take one or more of the
following actions:
- refuse to review or clear applications to market the Company's
product in the United States or to allow the Company to enter
into government supply contracts;
- withdraw previously approved applications;
- require notification to users regarding newly found risks;
- request repair, refund or replacement of faulty devices;
- 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 the
Company, its officers or employees.
The FDA, in lieu of or in addition to instituting other legal
action, may assess civil penalties for Food, Drug, and Cosmetic
Act violations. Any such FDA actions could result in disruption
of the Company's operations for an indeterminate period of time.
Various states in which the Company's products may be sold in the
future may impose additional regulatory requirements.
International Markets
Under FDA rules, a Class III medical device that has not been
approved for marketing in the United States may be exported for
sale only after meeting certain criteria. Such exporting may
only occur after the FDA has determined that the exportation of
the device is not contrary to public health and safety and that
the Company has received approval of the country to which the
device is intended for export. Approval of a device by a
comparable regulatory authority of a non-U.S. country must
generally be obtained prior to applying to the FDA for clearance
to export and commence marketing in that country. Sales of
medical devices outside of the United Sates are subject to
foreign regulatory requirements that 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.
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The Company's products are subject to a variety of regulations
in Europe, including the European Union ("EU"). In vitro medical
devices, including the AutoPap System, must now comply with the
EU's In-Vitro Diagnostic Medical Devices Directive ("IVDD"). The
IVDD (Directive 98/79/EC) was published in the Official Journal
of European Communities in December, 1998. The implementation of
the Directive into national law should be completed by the EU
Member States by December, 1999. A transition period, which
begins from the date of publication of the Directive and ends
December, 2003, is in effect for all devices placed on the market
in the EU. During this transition period, both European
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 existing (if
no such national legislation exists, the devices can be freely
placed on the market). By the conclusion of this transition
period, NeoPath Products must comply with the requirements of the
IVDD 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. There can be no assurance that the AutoPap System or any
other product that the Company may develop will obtain any
required regulatory clearance or approval on a timely basis, if
at all.
Regulation of Cervical Pap Smear Analysis
Pursuant to CLIA, Congress directed the Department of Health
and Human Services to promulgate regulations designed to improve
the quality of biomedical analytic services, particularly the
examination of Pap smears. CLIA 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, as well as from patients or groups of patients that are
identified as having 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 may be subject to state regulations,
inspection, and licensing. In recent years, a few states,
including New York and California, have adopted regulations that
limit the number of slides that may be manually examined by a
cytotechnologist within a given period of time. There can be no
assurance that states will not directly regulate the AutoPap
System in the future. The Company cannot predict the effect, if
any, that such 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. NeoPath is aware of three potential direct competitors:
- Neuromedical Systems, Inc. ("Neuromedical"), which has
obtained regulatory approval for a semi-automated system that
rescreens conventional Pap smears and may be developing a semi-
automated primary screener.
- AutoCyte, Inc., which is developing a semi-automated system to
prepare ("PREP") and analyze ("SCREEN") liquid-based Pap smears
(a potential alternative to conventional Pap smears); and
- Morphometrix Technologies Inc., which is developing an
automated system to analyze monolayer Pap smears.
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Neuromedical is marketing its semi-automated Pap smear
rescreening service as an adjunct to human Pap smear screening.
Neuromedical's system in the United States is currently a
computerized image processing service provided to laboratories
for which selected Pap smear slides are sent for processing to a
Neuromedical processing center. NeoPath believes that
Neuromedical is changing its system to be available for placement
in the clinical laboratory and that Neuromedical is conducting a
clinical trial for use of its system in semi-automated primary
screening. The Neuromedical system creates a color video picture
of each of the 128 images of the Pap smear slide deemed by the
Neuromedical system to be most likely to be abnormal. Under
Neuromedical's current practice in the United States, these
images are recorded on a digital tape cassette that, together
with the patient's Pap smear slide, is returned to the clinical
laboratory. Trained laboratory personnel then evaluate each of
the 128 video pictures for each Pap smear slide. If the
cytotechnologist believes that there might be an abnormality
indicated on Neuromedical's images of the Pap smear, then a
cytotechnologist would manually rescreen the Pap smear slide
using a microscope.
On March 26, 1999, Neuromedical announced that it had filed a
voluntary chapter 11 petition for bankruptcy. On the same day,
AutoCyte announced an agreement to purchase certain Neuromedical
technology, including patent rights.
In July 1998, AutoCyte submitted data to the FDA with regard to
a screening system for the semi-automated analysis of PREP
slides.
The Company also faces indirect competition from companies that
manufacture liquid-based or monolayer slide preparation systems
and devices that automate various aspects of cytology. In 1997,
AutoCyte announced the completion of clinical studies for PREP,
its liquid-based Pap smear preparation system, and submitted
these results to the FDA under a PMA. The FDA subsequently
requested that AutoCyte submit additional information to clarify
PREP's ability to differentiate various levels of cervical
disease. In December 1998, AutoCyte announced that it had
resubmitted data as requested by the FDA. Cytyc Corporation 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.
The Company believes that the AutoPap System must remain
competitive in accuracy and effectiveness, cost (including both
charges by NeoPath to the laboratory and the laboratory's labor
and overhead costs), convenience, perception among influential
cytopathologists and laboratories, and processing speed and
reliability.
Employees
At December 31, 1998, the Company employed 174 full-time
equivalent personnel, including 70 in research and development
and regulatory; 64 in administration, customer service and
support, and sales and marketing; and 40 in manufacturing and
operations. None of the Company's employees are represented by a
union or other bargaining group. The Company believes its
relationship with its employees is good.
Factors Affecting Future Results and Forward-Looking Statements
The preceding "Business" section and the documents we
incorporate by reference contain forward-looking statements that
involve risks and uncertainties. The statements in this document
that are not purely historical are forward-looking statements.
Words such as "anticipates," "expects," "intends," "plans,"
"believes," "seeks," estimates," and similar expressions identify
forward-looking statements. But the absence of these words does
not mean the statement is not forward-looking. We cannot
guarantee these statements, which are subject to risks,
uncertainties and assumptions that are difficult to predict. Our
actual results may differ materially from those we forecast in
forward-looking statements due to a variety of factors, including
those set forth in the following risk factors, elsewhere in this
document and in the documents we have incorporated by reference.
We will not update any forward-looking statements due to new
information, future events or otherwise.
History of Losses
We have incurred substantial losses since we began doing
business. As of December 31, 1998, our accumulated deficit was
$113.8 million. We first began recognizing product revenue in
1996. For 1998, 1997, and 1996 combined, we incurred total
losses of $67.4 million on revenues of $26.0 million. We expect
continued losses in 1999 as we market the AutoPap Screener
primarily under a fee-per-use strategy in the United States,
continue product development initiatives (including additional
clinical studies), and expand our manufacturing capability. We
cannot guarantee that the company will ever become profitable.
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Need for Additional Capital
We expect negative cash flow from operations to continue at
least through 1999. At December 31, 1998, NeoPath had
approximately $9 million in cash and, although we received an
additional $14.5 million in a February 1999 equity financing, we
may require additional funds to produce AutoPap Systems for our
fee-per-use program and cover continuing losses. Our future
capital requirements will depend on numerous factors, including:
- sales of AutoPap Systems and fee-per-use revenues;
- research and development programs for the development of
enhanced products;
- additional clinical trials;
- relationships with existing and future corporate
collaborators, if any;
- competing technological and market developments;
- the time and costs involved in obtaining regulatory approvals;
- the costs involved in filing, prosecuting, defending and
enforcing patent claims; and
- the time and costs of manufacturing scale-up and
commercialization activities.
We estimate that our existing cash and cash equivalents will
meet our capital requirements through 1999. We cannot guarantee
that the assumptions underlying our estimates will prove to be
accurate. We intend to seek additional funding through private
debt financing to provide additional resources to support AutoPap
System production. Adequate funds, whether obtained through
financial markets or from collaborative or other arrangements
with corporate partners or other sources, may not be available
when needed or may not be available on favorable terms, if at
all. If we raise additional funds by issuing equity securities,
existing shareholders will suffer dilution of their interest in
NeoPath. In addition, if we obtain additional funds through
arrangements with collaborative partners, we may have to
relinquish rights to certain of our technologies or potential
products that we would otherwise seek to develop or commercialize
ourselves.
Uncertainty of Market Acceptance
Our products may never be commercially successful. NeoPath's
growth depends on market acceptance of the AutoPap System by
clinical laboratories, healthcare providers, third-party
healthcare payers and patients. Our success also depends on
customers' acceptance of our fee-per-use and sale programs. Even
if our products gain market acceptance, the availability of
reimbursement from third-party healthcare payers such as
government and private insurance plans may limit our revenues.
Market Consolidation; Concentration
Medical community or third-party healthcare payers may delay
acceptance of an automated Pap smear screening or rescreening
system that replaces or supplements current laboratory Pap smear
review practices. Moreover, due to consolidation in the clinical
laboratory industry, we expect that the number of potential
domestic customers for our products will decrease. A significant
proportion of our sales is concentrated among a relatively small
number of customers, and this likely will be true for the
foreseeable future. For the year ended December 31, 1998, 41% of
our revenues were from four customers. These factors increase
our dependence on sales to the largest clinical laboratories and
the bargaining power of those potential customers.
Uncertainty of Product Regulatory Clearance
The U.S. government extensively regulates the manufacture and
sale of medical diagnostic devices for commercial use.
Government agencies in certain other countries impose similar
requirements. The AutoPap Screener and AutoPap QC have been
cleared for commercialization in the United States and in Japan,
Canada, Australia, New Zealand, The Netherlands, Italy, Hong
Kong, Korea, and Taiwan.
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Governmental regulatory agencies in the United States or
elsewhere may not approve future commercial enhancements to the
AutoPap System on a timely basis, if at all. Even if these
agencies clear the enhanced products for sale, they may not
confer the clinical indications we request, or the approval may
contain significant limitations, such as warnings, precautions or
contraindications, requests for postmarket studies, or additional
regulatory requirements. Our regulatory applications may be
delayed or rejected based on changes in regulatory policies or
regulations. Although the FDA has inspected our manufacturing
operations for compliance with FDA quality systems regulations,
we remain subject to ongoing FDA quality systems regulation and
inspection.
Limited Marketing, Sales and Service Experience
We market, sell, service, and support the AutoPap System
through a direct sales force (primarily in North America) and
independent foreign distributors. We have limited marketing,
sales and service experience, and may find it difficult to
recruit and retain skilled sales, marketing, service or support
personnel or foreign distributors. Our marketing and sales
efforts may not be successful.
Risks Inherent in International Transactions
We rely primarily on third-party distributors to place AutoPap
Systems internationally. International transactions pose a
number of risks, including regulatory delays or disapprovals with
respect to our products, expenses and delays due to compliance
with government controls, export license requirements, uncertain
sales and collections due to political instability, reduced
revenues due to price controls, reduced sales due to trade
restrictions, changes in tariffs, and difficulties with foreign
distributors.
Sole or Limited Source of Supply
We purchase 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. Certain
other components, such as the video cameras, are currently
supplied by single source vendors, and components provided by
additional or replacement suppliers would require some
modification to be used in the AutoPap System. We would be
unable to quickly establish additional or replacement sources of
supply for many AutoPap System components. In addition, we may
need to obtain regulatory approval to substitute certain
components. We cannot be sure of obtaining the necessary
approvals. If one of our vendors becomes unable to supply
acceptable components in a timely manner and in the quantity
required we may need to delay or halt our manufacturing process.
Any delay or cessation of manufacturing could adversely affect
our business.
Governmental Regulation of Manufacturing
Manufacturers of medical diagnostic devices face strict federal
regulations regarding the quality of manufacturing. For example,
the FDA periodically inspects the manufacturing facilities of
diagnostic device manufacturers to determine compliance with
regulations. Our current and future manufacturing and design
operations must comply with these and all other applicable
regulations, including regulations imposed by other governments.
If we fail to comply with quality systems regulations we could
face civil or criminal penalties or enforcement proceedings.
These proceedings may require us to recall a product or to stop
placing our products in service or selling our products. Similar
results could occur if we violate foreign regulations. We may
not be able to attain or maintain compliance with quality systems
requirements. Any failure to comply with the applicable
manufacturing regulations would have a material adverse effect on
our business.
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Competition
Competition in the medical device industry is intense. To
effectively compete, we must keep pace with the rapid product
development and technological change in our 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. We are aware of three potential direct competitors:
- Neuromedical Systems, Inc., which has obtained regulatory
approval for a semi-automated system that rescreens conventional
Pap smears and may be developing a semi-automated primary
screener.
- AutoCyte, Inc., which is developing a semi-automated system to
prepare and analyze liquid-based Pap smears (a potential
alternative to conventional Pap smears); and
- Morphometrix Technologies Inc., which is developing an
automated system to analyze monolayer Pap smears.
We also face indirect competition from companies that
manufacture liquid-based or monolayer slide preparation systems
and devices that automate various aspects of cytology. AutoCyte
has submitted clinical study data to the FDA with regard to its
liquid-based Pap smear preparation system, PREP, and is awaiting
final approval from the FDA. Cytyc Corporation 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.
We believe that the AutoPap System must remain competitive in
accuracy and effectiveness, cost (including both charges by us to
the laboratory and the laboratory's labor and overhead costs),
convenience, perception among influential cytopathologists and
laboratories, and processing speed and reliability.
Our competitors may develop new technologies and products that
prove to be more effective than the AutoPap System in any of
these ways. Furthermore, other companies may purchase or develop
technologies that compete with the AutoPap System or render it
obsolete. These competitors may manufacture, market and sell
their products or services more successfully than us, which could
adversely affect our business.
Dependence on Reimbursement
Third-party healthcare payers in the United States are
increasingly sensitive to containing healthcare costs and heavily
scrutinize new technology as a primary factor in increased
healthcare costs. Third-party payers may influence the pricing
or perceived attractiveness of our 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 we can charge
for AutoPap System screening or reduce the demand for AutoPap
System screening. If these payers do not reimburse for the
AutoPap System screening, or provide reimbursement significantly
below the amount laboratories charge patients to perform AutoPap
System screening, our potential market will be significantly
reduced. AutoPap System screening may never become widely
reimbursed, and AutoPap reimbursement may not be sufficient to
permit us to generate substantial revenue. Future healthcare
legislation or other changes in the administration or
interpretation of government healthcare or third-party
reimbursement programs may also adversely affect our business.
Third-party reimbursement also may not be available for the
AutoPap System under foreign reimbursement systems.
Dependence on Single Product Line
To date, we have concentrated on development of the AutoPap
System. We have performed only limited research on other
applications of our core technology. Accordingly, our success
will depend primarily on the successful development and marketing
of the AutoPap System to generate revenues. The AutoPap System
may never be a commercial success.
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Product Liability
The commercial screening of Pap smears has generated
significant malpractice litigation. As a result, we face product
liability, errors and omissions or other claims if our products
are alleged to have caused a false-negative diagnosis. Although
we have product liability insurance, it will become increasingly
difficult for us to obtain and maintain reasonable product
liability coverage. Substantial increases in insurance premium
costs often make coverage economically impractical. We may not
be able to obtain adequate product liability insurance at a
reasonable cost. Thus, product liability claims may adversely
affect our business.
Dependence on Patents and Proprietary Rights; Risk of Third-
Party Claims of Infringement
We rely on a combination of patents, trade secrets and
confidentiality agreements to protect our proprietary technology,
rights and know-how. We hold 7 foreign patents, 54 U.S. patents
(issued or allowed), and have 26 additional U.S. patents pending.
Pending patent applications may not ultimately issue as patents
or, if patents do issue, may not be sufficiently broad to protect
our proprietary rights. Competitors may challenge or circumvent
our patents or pending applications. Our patents may never
provide us with any competitive advantages. Our confidentiality
agreements with employees and other parties may not protect the
confidentiality of our trade secrets and proprietary information
or provide meaningful protection for our confidential
information. In addition, our competitors could independently
develop our trade secrets or proprietary information.
On July 15, 1996, Neuromedical filed a lawsuit against NeoPath,
Inc. 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. On
September 5, 1996, we filed our 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 us. The parties have 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. This
lawsuit is still in the discovery stage, and a trial date has not
been set. We believe NeoPath has a strong position in this
action, and we will defend against these claims vigorously.
On March 31, 1997, NeoPath filed a patent infringement lawsuit
against Neuromedical in the United States District Court for the
Western District of Washington. Our 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. We expect trial on the first Washington lawsuit to
begin in 1999. The second Washington lawsuit is currently in the
discovery stage.
On March 26, 1999, Neuromedical announced that it had filed a
voluntary chapter 11 petition for bankruptcy. On the same day,
AutoCyte announced an agreement to purchase certain Neuromedical
technology, including patent rights.
We cannot predict the outcome of this patent litigation. An
unfavorable resolution of any of these issues could adversely
affect our business.
Dependence on Key Personnel
We depend heavily on the principal members of our management
and scientific staff. The loss of their services might impede
achievement of our strategic objectives or research and
development. Our success depends on our ability to retain key
employees and to attract additional qualified employees.
Competition for highly skilled scientific and management
personnel is intense. The failure to recruit such personnel or
the loss of existing personnel could adversely affect our
business. We do not carry key person life insurance on our
executives or other key personnel.
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Highly Volatile Stock Price; Potential Fluctuations in
Future Quarterly Results
The market price of our common stock has been, and may continue
to be, highly volatile. The future price of the common stock is
likely to be significantly influenced by results of our sales and
marketing programs, the outcome of clinical trials by us or our
competitors, concern about the safety or efficacy of our products
or our competitors' products, announcements of technological
innovations or new products, changes in governmental regulation,
changes in healthcare legislation, developments in our patent or
other proprietary rights or the rights of our competitors,
fluctuations in our operating results, and general market and
economic conditions.
We expect our operating results to fluctuate significantly from
quarter to quarter in the future. A number of factors may cause
this fluctuation, including the rate and extent of domestic and
international market acceptance of the AutoPap Screener; the
mixture of fee-per-use and sale contracts; the timing and scope
of clinical studies and corresponding regulatory submissions; the
timing of domestic and foreign regulatory approvals; the level of
research and development spending required for product
enhancements and development of new technologies; the timing of
approvals for AutoPap reimbursement; and the introduction and
market acceptance of competing products or technologies.
Year 2000 Issue
We need to modify or replace certain portions of our internal
systems and product software and certain hardware so that those
systems will properly recognize dates beyond December 31, 1999.
However, we have identified no significant Year 2000 issues that
cannot be resolved through software or hardware upgrades that are
currently available or expected to be available soon. We are
using our existing internal resources to reprogram or replace
noncompliant internal systems and product hardware and software.
We do not expect the total cost of the Year 2000 project to be
material. We plan to complete the project by mid-1999.
We have asked our significant suppliers and subcontractors
about their Year 2000 compliance status. To date, we are not
aware of any external agent with Year 2000 problems that would
materially affect our results of operations, liquidity, or
capital resources. However, we have no means of ensuring that
these agents will be Year 2000 ready. If our suppliers and
subcontractors do not complete their Year 2000 resolution process
in a timely fashion we could face significant business
interruptions that could harm our business. We cannot accurately
predict the effect of non-compliance by external agents.
We believe that we have developed an effective program to
resolve the Year 2000 issues within our control in a timely
manner. With modifications to NeoPath's products, existing
internal software and conversions to new software, the Year 2000
issue should not pose significant operational problems for our
computer systems. However, if we or others do not make necessary
modifications and conversions, or do not complete them on time,
the Year 2000 issue could disrupt NeoPath's operations and
materially affect its business, financial condition, and results
of operations.
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Item 2. PROPERTIES
The Company 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. Management believes that the Redmond facility and other
available office space are adequate for the Company's current
needs. Management also believes that additional space is
available in the area, should it be needed. The Company also
leases office space in Brussels, Belgium under an operating lease
expiring in August 2007.
Item 3. LEGAL PROCEEDINGS
On July 15, 1996, Neuromedical Systems, Inc. filed a lawsuit
against NeoPath, Inc. 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. On September 5, 1996, the Company 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 have 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. This lawsuit is still
in the discovery stage, and a trial date has not been set. The
Company believes it has a strong position in this action and
continues to defend itself vigorously.
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. The Company expects trial on the first Washington
lawsuit to begin in 1999. The second Washington lawsuit is
currently in the discovery stage.
On March 26, 1999, Neuromedical announced that it had filed a
voluntary chapter 11 petition for bankruptcy. On the same day,
AutoCyte, Inc. announced an agreement to purchase certain Neuromedical
technology, including patent rights.
Item 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
No matters were submitted to a vote of security holders during
the fourth quarter of 1998.
Page 17
<PAGE>
PART II
Item 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED
SHAREHOLDER MATTERS
The information required by Item 5 is hereby incorporated by
reference to the Company's 1998 Annual Report to Shareholders,
page 34.
Item 6. SELECTED FINANCIAL DATA
The information required by Item 6 is hereby incorporated by
reference to the Company's 1998 Annual Report to Shareholders,
page 10.
Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS
The information required by Item 7 is hereby incorporated by
reference to the Company's 1998 Annual Report to Shareholders,
pages 11-18.
Item 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
The information required by this item is incorporated by
reference from the section labeled "Market Risks" of the
Company's 1998 Annual Report to Shareholders, page 15.
Item 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
The information required by Item 8 is hereby incorporated by
reference to the Company's 1998 Annual Report to Shareholders,
pages 19-33.
Item 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON
ACCOUNTING AND FINANCIAL DISCLOSURE
None.
Page 18
<PAGE>
PART III
Item 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
The information required by Item 10 is hereby incorporated by
reference to the section entitled "Election of Directors and
Management Information" in the Company's definitive Proxy
Statement relating to its 1999 annual meeting of Shareholders
(the "Proxy Statement"). Such Proxy Statement will be filed
within 120 days of the Company's last fiscal year end, December
31, 1998.
Item 11. EXECUTIVE COMPENSATION
The information required by Item 11 is hereby incorporated by
reference to the section entitled "Executive Compensation" in the
Proxy Statement.
Item 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND
MANAGEMENT
The information required by Item 12 is hereby incorporated by
reference to the section entitled "Security Ownership of Certain
Beneficial Owners and Management" in the Proxy Statement.
Item 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
Not applicable.
Page 19
<PAGE>
PART IV
Item 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON
FORM 8-K
(a) Index to list of documents filed as part of this report.
1. Financial Statements
The following financial statements of NeoPath, Inc. are
included in Item 8 by reference to the Company's 1998 Annual
Report to Shareholders:
Annual Report
Page #
______
Balance Sheets at December 31, 1998 and 1997 19
Statements of Operations for the years ended 20
December 31, 1998, 1997 and 1996
Statements of Shareholders' Equity for the years ended 21
December 31, 1998, 1997 and 1996
Statements of Cash Flows for the years ended 22
December 31, 1998, 1997 and 1996
Notes to Financial Statements 23-31
2. Financial Statement Schedule
Schedule II -- Valuation and Qualifying Accounts
All other schedules have been omitted because they were
not applicable.
3. Exhibits
3.1 (1) Articles of Incorporation of the registrant
3.2 (1) Bylaws of the registrant
10.1 (5) NeoPath, Inc. 1989 Stock Option Plan,
Amended and Restated on December 10, 1996
10.2 (5) NeoPath, Inc. Stock Option Plan for
Nonemployee Directors, Amended and Restated on
February 27, 1997
10.3 (1) Form of Indemnification Agreement for
officers and directors of the registrant
10.4 (1) Consolidated Amended and Restated
Shareholders Agreement dated March 27, 1992, by
and among NeoPath, Inc. and the Shareholders
listed on Exhibit A thereto and First Amendment
to Consolidated Amended and Restated Agreement
dated January 14, 1994
10.8 (1) Form of Agreement regarding clinical
study of the AutoPap 300 QC System:
Confidentiality of Records and Indemnification
10.9 (1) Agreement by and between NeoPath, Inc.
and Kyto Diagnostic, L.P. regarding clinical
study of the AutoPap 300 QC System:
Confidentiality of Records and Indemnification
Page 20
<PAGE>
10.10 (1) Product Development and Supply
Agreement between Applied Precision, Inc. and
NeoPath, Inc. dated January 1, 1992
10.14 (2) Master Equipment Lease by and between
NeoPath, Inc. and Haworth Leasing dated January 31, 1995
10.17 (3) NeoPath, Inc. Proposal to SmithKline
Beecham Clinical Laboratories dated as of
October 4, 1995, countersigned by SmithKline
Beecham Clinical Laboratories on October 4, 1995
10.18 (3) NeoPath, Inc. Proposal to Corning
Clinical Laboratories Inc. executed as of
October 11, 1995, countersigned by Corning
Clinical Laboratories on October 13, 1995
10.19 (3) Master Equipment Lease by and between
NeoPath, Inc. and Pacific Office Automation
dated as of September 30, 1995
10.20 (4) NeoPath, Inc. Proposal to SmithKline
Beecham Clinical Laboratories, accepted May 9, 1996
10.21 (4) NeoPath, Inc. Proposal to Laboratory
Corporation of America Holdings, accepted May 15, 1996
10.22 (4) NeoPath, Inc. Amended and Restated
Proposal to Kaiser IMMC Agreement No. 0249,
accepted June 25, 1996
10.23 (5) Form of Senior Management Employment Agreement
10.24 (5) International Distribution Agreement
between NeoPath, Inc. and Nikon Corporation,
dated as of December 19, 1996
10.25 (6) Purchase and Sale Agreement between
CompuCyte Corporation and NeoPath, Inc., Dated
as of June 23, 1997
10.26 (6) NeoPath, Inc. Registration Rights
Agreement, Dated as of June 23, 1997
10.27 (7) NeoPath, Inc. 1997 Employee Stock Purchase Plan
10.28 (8) Third Amendment to Lease by and
between Teachers Insurance & Annuity Association
and NeoPath, Inc. dated November 6, 1997
10.29 (9) Equipment User Agreement with
SmithKline Beecham Clinical Laboratories dated
as of September 29, 1998
10.30 (10) Common Stock Purchase Agreement,
dated as of February 8, 1999
10.31 (10) Investor Rights Agreement, dated as
of February 8, 1999
13.1 1998 Annual Report to Shareholders
23.1 Consent of Ernst & Young LLP, Independent Auditors
27 Financial Data Schedule
_____________________________
(1) Filed as an exhibit to the registrant's Registration
Statement on Form S-1 (File No. 33-86822) and
incorporated herein by reference.
Page 21
<PAGE>
(2) Filed as an exhibit to the registrant's Report on form 10-Q
filed on March 29, 1995 and incorporated herein by reference.
(3) Filed as an exhibit to the registrant's Report on Form 10-Q
filed on November 14, 1995 as amended on December 12, 1995 and
incorporated herein by reference.
(4) Filed as an exhibit to the registrant's Report on Form 10-Q
filed on August 14, 1996 and incorporated herein by reference.
(5) Filed as an exhibit to the registrant's Report on Form 10-K
filed on March 28, 1997 and incorporated herein by reference.
(6) Filed as an exhibit to the registrant's Report on Form 10-Q
filed on August 12, 1997 and incorporated herein by reference.
(7) Filed as an exhibit to the registrant's Registration
Statement on Form S-8 (File No. 333-40371) and incorporated
herein by reference.
(8) Filed as an exhibit to the registrant's Report on Form 10-K
filed on March 30, 1998 and incorporated herein by reference.
(9) Filed as an exhibit to the registrant's Report on Form 10-Q
filed on November 16, 1998 and incorporated herein by
reference.
(10) Filed as an exhibit to the registrant's report on Form 8-K
filed on February 26, 1999.
(b) Reports on Form 8-K:
None.
Page 22
<PAGE>
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act
of 1934, the registrant has duly caused this report to be signed
on its behalf by the undersigned, thereunto duly authorized in
the City of Redmond, State of Washington on the 26th day of
March, 1999.
NEOPATH, INC.
By: /s/ RONALD R. BROMFIELD
________________________
Ronald R. Bromfield
President and Chief Executive Officer
Pursuant to the requirements of the Securities Exchange Act
of 1934, this report has been signed below by the following
persons on behalf of the registrant and in the capacities
indicated below on this 26th day of March, 1999.
Signature Title
_________ _____
/s/ RONALD R. BROMFIELD President and Chief Executive Officer
________________________ (Principal Executive Officer)
Ronald R. Bromfield
/s/ ALAN C. NELSON Chairman of the Board
___________________
Alan C. Nelson, Ph.D.
/s/ THOMAS A. BONFIGLIO Director
________________________
Thomas A. Bonfiglio, M.D.
/s/ CRISTINA H. KEPNER Director
_______________________
Cristina H. Kepner
/s/ WALTER L. ROBB Director
___________________
Walter L. Robb, Ph.D.
/s/ WILLIAM L. SCOTT Director
_____________________
William L. Scott
/s/ DAVID A. THOMPSON Director
______________________
David A. Thompson
/s/ GAIL R. WILENSKY Director
_____________________
Gail R. Wilensky, Ph.D.
/s/ ROBERT C. BATEMAN Vice President and Chief Financial Officer
______________________ (Principal Accounting Officer)
Robert C. Bateman
Page 23
<PAGE>
SCHEDULE II
NEOPATH, INC.
VALUATION AND QUALIFYING ACCOUNTS
<TABLE>
<CAPTION>
Balance at Charged to Charged to Balance at
Beginning Costs & Other End of
of Period Expenses Accounts Deductions Period
_________ ________ ________ __________ ______
<S> <C> <C> <C> <C> <C>
Description
Allowance for
doubtful accounts:
Year ended $ 500,000 $ -- $ -- $ 33,882 $ 466,118
December 31, 1998
Year ended 175,000 325,000 -- -- 500,000
December 31, 1997
Year ended December -- 175,000 -- -- 175,000
December 31, 1996
</TABLE>
<PAGE>
NEOPATH, INC.
INDEX TO EXHIBITS
Exhibit No. Description
___________ ___________
3.1 (1) Articles of Incorporation of the registrant
3.2 (1) Bylaws of the registrant
10.1 (5) NeoPath, Inc. 1989 Stock Option Plan,
Amended and Restated on December 10, 1996
10.2 (5) NeoPath, Inc. Stock Option Plan for
Nonemployee Directors, Amended and Restated on
February 27, 1997
10.3 (1) Form of Indemnification Agreement for
officers and directors of the registrant
10.4 (1) Consolidated Amended and Restated
Shareholders Agreement dated March 27, 1992, by
and among NeoPath, Inc. and the Shareholders
listed on Exhibit A thereto and First Amendment
to Consolidated Amended and Restated Agreement
dated January 14, 1994
10.8 (1) Form of Agreement regarding clinical
study of the AutoPap 300 QC System:
Confidentiality of Records and Indemnification
10.9 (1) Agreement by and between NeoPath, Inc.
and Kyto Diagnostic, L.P. regarding clinical
study of the AutoPap 300 QC System:
Confidentiality of Records and Indemnification
10.10 (1) Product Development and Supply
Agreement between Applied Precision, Inc. and
NeoPath, Inc. dated January 1, 1992
10.14 (2) Master Equipment Lease by and between
NeoPath, Inc. and Haworth Leasing dated January 31, 1995
10.17 (3) NeoPath, Inc. Proposal to SmithKline
Beecham Clinical Laboratories dated as of
October 4, 1995, countersigned by SmithKline
Beecham Clinical Laboratories on October 4, 1995
10.18 (3) NeoPath, Inc. Proposal to Corning
Clinical Laboratories Inc. executed as of
October 11, 1995, countersigned by Corning
Clinical Laboratories on October 13, 1995
10.19 (3) Master Equipment Lease by and between
NeoPath, Inc. and Pacific Office Automation
dated as of September 30, 1995
10.20 (4) NeoPath, Inc. Proposal to SmithKline Beecham Clinical
Laboratories, accepted May 9, 1996
10.21 (4) NeoPath, Inc. Proposal to Laboratory Corporation of
America Holdings, accepted May 15, 1996
10.22 (4) NeoPath, Inc. Amended and Restated
Proposal to Kaiser IMMC Agreement No. 0249,
accepted June 25, 1996
10.23 (5) Form of Senior Management Employment Agreement
<PAGE>
10.24 (5) International Distribution Agreement
between NeoPath, Inc. and Nikon Corporation,
dated as of December 19, 1996
10.25 (6) Purchase and Sale Agreement between
CompuCyte Corporation and NeoPath, Inc., Dated
as of June 23, 1997
10.26 (6) NeoPath, Inc. Registration Rights
Agreement, Dated as of June 23, 1997
10.27 (7) NeoPath, Inc. 1997 Employee Stock Purchase Plan
10.28 (8) Third Amendment to Lease by and
between Teachers Insurance & Annuity Association
and NeoPath, Inc. dated November 6, 1997
10.29 (9) Equipment User Agreement with
SmithKline Beecham Clinical Laboratories dated
as of September 29, 1998
10.30 (10) Common Stock Purchase Agreement,
dated as of February 8, 1999
10.31 (10) Investor Rights Agreement, dated as
of February 8, 1999
13.1 1998 Annual Report to Shareholders
23.1 Consent of Ernst & Young LLP, Independent Auditors
27 Financial Data Schedule
_____________________________
(1) Filed as an exhibit to the registrant's Registration
Statement on Form S-1 (File No. 33-86822) and incorporated herein
by reference.
(2) Filed as an exhibit to the registrant's Report on form 10-Q
filed on March 29, 1995 and incorporated herein by reference.
(3) Filed as an exhibit to the registrant's Report on Form 10-Q
filed on November 14, 1995 as amended on December 12, 1995 and
incorporated herein by reference.
(4) Filed as an exhibit to the registrant's Report on Form 10-Q
filed on August 14, 1996 and incorporated herein by reference.
(5) Filed as an exhibit to the registrant's Report on Form 10-K
filed on March 28, 1997 and incorporated herein by reference.
(6) Filed as an exhibit to the registrant's Report on Form 10-Q
filed on August 12, 1997 and incorporated herein by reference.
(7) Filed as an exhibit to the registrant's Registration
Statement on Form S-8 (File No. 333-40371) and incorporated
herein by reference.
(8) Filed as an exhibit to the registrant's Report on Form 10-K
filed on March 30, 1998 and incorporated herein by reference.
(9) Filed as an exhibit to the registrant's Report on Form 10-Q
filed on November 16, 1998 and incorporated herein by reference.
(10) Filed as an exhibit to the registrant's report on Form 8-K
filed on February 26, 1999.
<PAGE>
Exhibit 23.1
CONSENT OF ERNST & YOUNG LLP, INDEPENDENT AUDITORS
We consent to the incorporation by reference in this Annual
Report (Form 10-K) of NeoPath, Inc. of our report dated
February 9, 1999, included in the 1998 Annual Report to
Shareholders of NeoPath, Inc.
Our audits also included the financial statement schedule of
NeoPath, Inc. listed in Item 14(a). This schedule is the
responsibility of management. Our responsibility is to express
an opinion based on our audits. In our opinion, the financial
statement schedule referred to above, when considered in relation
to the basic financial statements taken as a whole, presents
fairly in all material respects the information set forth
therein.
We also consent to the incorporation by reference in the
Registration Statement (Form S-3 No. 33-72261) of NeoPath, Inc.
and in the related Prospectus, the Registration Statements (Form
S-8 No. 33-40371) pertaining to the NeoPath, Inc. Stock Option
Plan for Nonemployee Directors, as amended and restated on
February 27, 1997, the NeoPath, Inc. 1989 Stock Option Plan,
amended and restated on December 10, 1996, and the NeoPath, Inc.
1997 Employee Stock Purchase Plan, of our report dated
February 9, 1999, with respect to the financial statements
incorporated by reference in this Annual Report (Form 10-K) for
the year ended December 31, 1998.
/s/ ERNST & YOUNG LLP
Seattle, Washington
March 26, 1999
<PAGE>
SELECTED FIVE-YEAR
FINANCIAL DATA
(IN THOUSANDS,
EXCEPT PER SHARE DATA)
YEAR ENDED DECEMBER 31,
<TABLE>
<CAPTION>
1998 1997 1996 1995 1994
______________________________________________________
<S> <C> <C> <C> <C> <C>
Statement of Operations Data
Revenues $ 12,079 $ 10,824 $ 3,062 $ -- $ --
Gross margin 5,368 6,049 1,157 -- --
Operating expenses:
Research and development 11,269 14,249 11,202 9,384 9,183
Selling, general
and administrative 17,950 17,746 11,295 6,626 3,320
Write-off of intangible
assets (1) 3,084 -- -- -- --
Net loss (26,181) (23,597) (17,655) (14,365) (12,324)
Basic and diluted net
loss per share (2) (1.81) (1.66) (1.36) (1.59) --
Pro forma (excluding write-off
of intangible assets)
Loss (23,097) (23,597) (17,655) (14,365) (12,324)
Basic and diluted loss per share (1.60) (1.66) (1.36) (1.59) --
Balance Sheet Data
Cash, cash equivalents, and
securities available-for-sale $ 8,954 $ 28,719 $ 58,488 $ 23,430 $ 2,295
Working capital 10,438 34,673 60,821 22,876 2,316
Total assets 38,150 58,941 76,132 28,016 5,193
Long-term obligations,
less current portion 1,257 102 183 258 176
Total shareholders' equity 28,228 53,228 71,602 25,133 3,602
</TABLE>
The comparability of the above data is affected by the Company's initial
public offering completed in February 1995 and follow on public offering
completed in January 1996. See Note 7 of Notes to Financial Statements.
(1) See Note 4 of Notes to Financial Statements.
(2) The basis for determining the number of shares used in computing basic
and diluted net loss per share is described in Note 1 of Notes to
Financial Statements. Basic and diluted net loss per share for 1994
is not considered meaningful due to changes in the Company's capital
structure.
10
<PAGE>
MANAGEMENT'S DISCUSSION
AND ANALYSIS OF
FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
OVERVIEW
NeoPath, Inc. ("NeoPath" or the "Company")
develops and markets visual intelligence technology
to increase accuracy in medical testing. NeoPath's
initial 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 Papanicolaou ("Pap") smear slide for the early
detection of cervical cancer.
The United States Food and Drug Administration
(the "FDA") approved NeoPath's AutoPap(R)
300 QC Automatic Pap Screener System (the "AutoPap
QC") in 1995. The AutoPap QC is a rescreening device
used for quality control and rescreening of Pap smear
slides previously screened by cytotechnologists.
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.
The FDA approved NeoPath's AutoPap(R) Primary
Screening System (the "AutoPap Screener")
in May 1998. The AutoPap 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. Clinical
studies have shown that the AutoPap Screener provides
statistically significantly better 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. This feature of the AutoPap
Screener provides customers with an economic
incentive to adopt the technology.
The "AutoPap System" refers to the AutoPap
Screener and the AutoPap QC together.
RESULTS OF OPERATIONS
CHANGE FROM CHANGE FROM
(IN THOUSANDS) 1998 PRIOR YEAR 1997 PRIOR YEAR 1996
_____________________________________________________________________________
Revenues $ 12,079 $ 1,255 $ 10,824 $ 7,762 $ 3,062
12% 254%
NeoPath began recognizing product revenues in
1996. The Company recognizes revenue on either a
product sale or fee-per-use basis (subject to
service and license agreements, rental contracts,
and minimum payments on certain fee-per-use
contracts). 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 processed. The cost of each
AutoPap System is reclassified from inventories to
depreciable equipment upon shipment to a fee-per-use
customer site. Such equipment, reflected on the
balance sheet under "fee-per-use systems, net," is
depreciated on a straight-line basis over a four-
year period, commencing upon commercial operation.
Because the AutoPap Screener is the only FDA-
approved system for automated primary screening of
Pap smears, NeoPath has implemented a strategy in
the United States to take advantage of this
competitive opportunity by offering AutoPap
Screeners to customers with initial fee-per-use
pricing in line with existing laboratory economics.
Per-slide pricing is designed to increase during
contract periods to reflect expected increases in
third-party reimbursement levels. NeoPath also
continues to offer traditional, fixed-price fee-per-
use contracts.
11
<PAGE>
In October 1998, NeoPath announced an agreement
with SmithKline Beecham Clinical Laboratories
("SmithKline") pursuant to which SmithKline agreed
to adopt the AutoPap Screener throughout its
domestic laboratory organization. This four-year
contract is intended to enable SmithKline to process
100% of its Pap smear volume on AutoPap Screeners.
At current AutoPap processing rates, NeoPath
estimates that SmithKline may require up to 125
AutoPap Screeners to process its nationwide volume
of Pap smears. During the fourth quarter of 1998,
NeoPath shipped more than 40 additional AutoPap
Screeners to SmithKline. These shipments, combined
with existing AutoPap QCs at SmithKline sites that
were previously upgraded to AutoPap Screeners, total
approximately 70 AutoPap Screeners at SmithKline as
of December 31, 1998.
In February 1999, SmithKline and Quest
Diagnostics Incorporated ("Quest") announced that
Quest had agreed to purchase SmithKline. The
combined entity would be the largest clinical
laboratory company in the world. NeoPath's national
agreement with SmithKline is binding on successor
organizations, and NeoPath management believes that
the AutoPap Screeners installed under the SmithKline
agreement will continue to generate revenues in
accordance with the underlying agreement.
In October 1998, NeoPath announced a national
agreement with Kaiser Permanente ("Kaiser"), which
is the largest non-profit group health plan in the
United States. This national agreement allows
Kaiser and affiliated entities to purchase AutoPap
Screeners during the two-year term of the agreement,
with additional annual service and licensing fees
due over four years. At current AutoPap processing
rates, NeoPath estimates that Kaiser may require up
to 35 AutoPap Screeners to process its nationwide
volume of Pap smears. The timing of specific
purchase orders -- and related AutoPap Screener
shipments -- is subject to the adoption plans of
Kaiser laboratories and affiliates. No product
revenues were recognized under this agreement in
1998.
NeoPath's AutoPap System placements have
consisted primarily of fee-per-use contracts in the
United States and sale contracts internationally.
Because sale contracts result in immediate revenue
recognition, whereas fee-per-use contracts provide a
recurring revenue stream over several years,
NeoPath's total revenues have included a significant
sale component. In the past three years, sale
revenues (including upgrades) have accounted for 61%
to 65% of total revenues. Remaining revenues
consisted primarily of fee-per-use contract
billings.
Fee-per-use revenues in 1998 increased 31%
from the prior year, with much of the increase
occurring in the fourth quarter of 1998. The
increase in NeoPath's fee-per-use business was the
result of higher overall per-slide pricing and
increased System placements during the fourth
quarter of 1998, primarily at SmithKline sites.
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. International revenues in prior
years included initial system orders under a
distribution agreement in Japan. NeoPath's AutoPap
technology is now available internationally at
commercial laboratories in Taiwan, Japan, China
(Hong Kong), Korea, Australia, and in Europe. Total
1998 revenues included additional AutoPap System
placements in Taiwan, Hong Kong and Japan. The
Company's international product placements have
primarily been denominated in U.S. dollars; however,
future product revenues may be subject to foreign
exchange rate fluctuations.
12
<PAGE>
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 the Company's products. In early
1998, NeoPath established a reimbursement team to
work with third-party insurers and managed care
organizations to establish and/or improve third-
party reimbursement levels for the AutoPap System.
These reimbursement specialists also work closely
with NeoPath's field sales personnel throughout the
United States. On January 1, 1999, revised
Physicians' Current Procedural Terminology ("CPT")
codes (established by the American Medical
Association) became effective for the AutoPap
Screener. CPT codes are a standardized system used
by physicians and clinical laboratories to identify
specific procedures when billing insurers for their
services. New CPT codes that address utilization of
the AutoPap QC became available on January 1, 1998.
<TABLE>
<CAPTION>
PERCENTAGE OF PERCENTAGE OF PERCENTAGE OF
(IN THOUSANDS) 1998 REVENUES 1997 REVENUES 1996 REVENUES
_______________________________________________________________________________________________________
<S> <C> <C> <C> <C> <C> <C>
Cost of revenues $ 6,711 56% $ 4,775 44% $ 1,905 62%
Gross margin 5,368 44% 6,049 56% 1,157 38%
</TABLE>
The primary components of fee-per-use cost of
revenues include depreciation and allocated service
and support costs. For AutoPap Systems sold, cost
of revenues include the related manufacturing cost
and estimated one-year warranty expense.
NeoPath's 1998 gross margin reflects discounts
and incentives included in AutoPap QC sale pricing
in the first half of the year as customers
anticipated the FDA's approval of the AutoPap
Screener, as well as pricing incentives offered in
the second half of the year as initial primary
screening placements were made. The higher
comparative gross margin in 1997 was attributable to
international sales under a distribution agreement
with higher initial AutoPap System pricing. Primary
screening systems are expected to process a greater
number of slides, on average, than the prior
installed base of AutoPap QCs, which is expected to
improve the fee-per-use gross margin percentage.
Fee-per-use revenues in the periods included lower-
margin initial AutoPap QC placements.
<TABLE>
<CAPTION>
CHANGE FROM CHANGE FROM
(IN THOUSANDS) 1998 PRIOR YEAR 1997 PRIOR YEAR 1996
__________________________________________________________________________________________
<S> <C> <C> <C> <C> <C>
Research and
development expenses $ 11,269 $ (2,980) $ 14,249 $ 3,047 $ 11,202
(21%) 27%
</TABLE>
NeoPath's research and development expenses
include salaries and benefits of scientific,
engineering, and regulatory personnel; costs
relating to clinical studies and submission of
applications to the FDA; testing equipment;
components used in prototypes; relevant consulting
services; and the costs of preparing and filing
applications for patent protection of NeoPath's
technologies.
The Company incurred higher research and
development costs in 1997 due primarily to NeoPath's
AutoPap Screener clinical study, which was completed
in 1997. NeoPath continues to focus research and
development efforts primarily on AutoPap
enhancements, as well as on other applications of
AutoPap technology.
13
<PAGE>
<TABLE>
<CAPTION>
CHANGE FROM CHANGE FROM
(IN THOUSANDS) 1998 PRIOR YEAR 1997 PRIOR YEAR 1996
______________________________________________________________________________________
<S> <C> <C> <C> <C> <C>
Selling, general and
administrative
expenses $ 17,950 $ 204 $ 17,746 $ 6,451 $ 11,295
1% 57%
</TABLE>
Selling, general and administrative expenses
include salaries and benefits of sales, marketing,
administrative, and financial personnel; non-patent
application legal expenses; amortization of
intangible assets; and certain facility-related
costs.
Overall expenses in 1998 remained flat in
comparison to the prior year, despite significant
increased expenses in the first half of 1998 to
launch the AutoPap Screener. NeoPath reduced
overall spending in the second half of 1998 as the
Company carefully focused corporate spending.
The increased spending in 1997 was due primarily
to significant new sales and marketing initiatives,
costs related to the purchase and integration of the
Pathfinder System product line (including
amortization of intangible assets), increased
personnel-related expenses, and increased legal
expenses relating primarily to the Neuromedical
Systems, Inc. lawsuits (see Note 9 of Notes to
Financial Statements).
CHANGE FROM CHANGE FROM
(IN THOUSANDS) 1998 PRIOR YEAR 1997 PRIOR YEAR 1996
________________________________________________________________________________
Write-off of
intangible assets $ 3,084 $ 3,084 $ -- $ -- $ --
In the quarter ended December 31, 1998, NeoPath
wrote off intangible assets related to the
Pathfinder System product line. The write-off did
not involve any cash expenditure. NeoPath acquired
the Pathfinder System product line in June 1997 for
a total purchase price of $4.6 million, including
transaction-related expenses. As a result of the
purchase, the Company recorded $4.3 million in
intangible assets that were to be amortized over
five years. As a result of 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 immediate continued
development and commercialization of this product
line. The Company then 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 3% of total revenues in each of the
two years ended December 31, 1998 and 1997.
CHANGE FROM CHANGE FROM
(IN THOUSANDS) 1998 PRIOR YEAR 1997 PRIOR YEAR 1996
________________________________________________________________________________
Interest income $ 1,009 $ (1,390) $ 2,399 $ (1,343) $ 3,742
(58%) (36%)
The decrease in interest income over the past two
years is due to NeoPath's negative operating cash
flow during the periods and the resulting decreased
cash available for investment purposes.
14
<PAGE>
LIMITATION ON USE OF
NET OPERATING LOSS AND
TAX CREDIT CARRYFORWARDS
As of December 31, 1998, the Company had net
operating loss carryforwards of approximately $111.5
million and research and development credit
carryforwards of approximately $3.4 million for
federal income tax purposes, which expire between
2004 and 2013. Due to the issuance and sale of
shares of preferred stock prior to 1995 and the
Company's initial public offering completed in 1995,
the Company 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. See
Note 6 of Notes to Financial Statements.
MARKET RISKS
The Company is exposed to market risk related to
changes in interest rates, which could adversely
affect the value of the Company's investments in
securities available-for-sale or increase the
interest expense on outstanding debt. The Company
does not use derivative financial instruments.
NeoPath maintains a short-term investment
portfolio consisting of interest-bearing securities
with an average maturity of less than two years.
These securities are classified as "available-for-
sale" securities. The interest-bearing securities
are subject to interest rate risk and will fall in
value if market interest rates increase. If market
interest rates were to increase immediately and
uniformly by 10% from levels at December 31, 1998,
the fair value of the portfolio would decline by an
immaterial amount.
In like manner, a 10% increase in market
interest rates would have an immaterial effect on
the Company's long-term obligations. The Company
does not expect its operating results or cash flows
to be affected to any significant degree by a sudden
change in market interest rates.
LIQUIDITY AND CAPITAL RESOURCES
As of December 31, 1998, the Company had $9.0
million in cash, cash equivalents, and securities
available-for-sale, compared to $28.7 million as of
December 31, 1997. The decrease was a result of
cash used in the Company's operations during the
year, offset by $5 million in cash obtained from a
bank debt facility (of which $3.7 million remained
outstanding as of December 31, 1998). 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. The Company's cash used in operating
activities was $22.6 million in 1998, $28.7 million
in 1997, and $25.0 million in 1996. Total operating
cash usage included amounts for inventories and
manufacturing of AutoPap fee-per-use systems as
follows: $7.0 million in 1998, $8.2 million in
1997, and $11.1 million in 1996. The Company
expended cash for property and equipment, excluding
AutoPap Systems reclassified to either fee-per-use
systems or reclassified to property and equipment,
of $0.6 million in 1998, $1.0 million in 1997, and
$3.3 million in 1996.
On February 9, 1999, NeoPath completed a $14.5
million private equity transaction in which the
Company issued 2.9 million shares of common stock to
investors at a price of $5.00 per share. On
February 12, 1999, NeoPath filed a shelf
registration statement on Form S-3 that will, when
declared effective by the Securities and Exchange
Commission, allow resale of the newly issued shares.
NeoPath must use its best efforts to keep this
registration statement effective for two years.
15
<PAGE>
NeoPath's fee-per-use business strategy requires
a significant investment in the production of
AutoPap Systems, as well as sufficient resources to
meet operating expenses while this recurring revenue
stream grows. The Company expects negative cash
flow from operations to continue at least through
1999. The Company may require additional funds to
produce AutoPap Systems for its fee-per-use program
and cover continuing losses. NeoPath's future
capital requirements will depend on numerous
factors, including the following:
- sales of AutoPap Systems;
- fee-per-use revenues;
- research and development programs
for the development of enhanced products;
- additional clinical trials;
- relationships with existing and
future corporate collaborators, if any;
- competing technological and market developments;
- the time and costs involved in
obtaining regulatory approvals;
- the costs involved in filing,
prosecuting, defending and enforcing patent
claims; and
- the time and costs of manufacturing scale-up and
commercialization activities.
The Company estimates that existing cash and
cash equivalents will meet capital requirements
through 1999. The Company cannot guarantee that the
assumptions underlying its estimates will prove to
be accurate. The Company intends to seek additional
funding through private debt financing to provide
additional resources to support AutoPap System
production. Adequate funds, whether obtained
through financial markets or from collaborative or
other arrangements with corporate partners or other
sources, may not be available when needed or may not
be available on favorable terms, if at all. If the
Company raises additional funds by issuing equity
securities, existing shareholders will suffer
dilution of their interest in NeoPath. In addition,
if the Company obtains additional funds through
arrangements with collaborative partners, NeoPath
may have to relinquish rights to certain
technologies or potential products that the Company
would otherwise seek to develop or commercialize
itself. Insufficient funds may require the Company
to delay, scale back or eliminate some of its
manufacturing, sales and marketing, research and
development or clinical programs.
16
<PAGE>
IMPACT OF YEAR 2000
The Year 2000 issue is the result of computer
programs being written using two digits rather than
four to define the applicable year. Any of the
Company's internal or product computer programs or
hardware that have date-sensitive software or
embedded chips may recognize a date using "00" as
the year 1900 rather than the year 2000. This could
result in system errors or failures, and could
significantly disrupt normal business activities.
Based on assessments made in 1998, the Company
determined that it would be required to modify or
replace certain portions of its internal systems and
product software and certain hardware so that those
systems will properly recognize dates beyond
December 31, 1999. To date, the Company has
completed its assessment of all internal and product
systems that could be significantly affected by the
Year 2000 issue. The assessment indicated that
certain of the Company's internal and product
systems could be affected. However, no significant
Year 2000 issues have been identified that cannot be
resolved through software or hardware upgrades that
are currently available or expected to be available
soon. The Company presently believes that with
modifications or replacements of existing software
and certain hardware, the Year 2000 issue as it
relates to the Company's internal systems and
products can be effectively mitigated. However, if
such modifications and replacements are not made, or
are not completed in a timely manner, the Year 2000
issue could have a material impact on NeoPath's and
its customers' operations. In addition, the Company
has gathered information about the Year 2000
compliance status of its significant suppliers and
subcontractors and continues to monitor their
compliance.
The Company utilizes existing internal resources
to reprogram or replace, test, and implement the
internal systems and product software and certain
hardware modifications necessary for Year 2000
compliance. The total cost of the Year 2000 project
has been borne primarily by operating departments
with existing personnel and infrastructure;
therefore, incremental costs have not been material
and remaining incremental costs are estimated at
less than $100,000. The project is estimated to be
completed by mid-1999.
The Company has queried its significant
suppliers and subcontractors as to their Year 2000
compliance status. To date, the Company is not
aware of any external agent with Year 2000 problems
that would materially impact the Company's results
of operations, liquidity, or capital resources.
However, the Company has no means of ensuring that
external agents will be Year 2000 ready. The
inability of external agents to complete their Year
2000 resolution process in a timely fashion could
materially impact the Company. The Company cannot
determine the effect of non-compliance by external
agents.
The Company currently has no contingency plans
in place in the event it does not complete all
phases of the Year 2000 program, including the possibility
that its external agents are not Year 2000 ready. The
Company plans to evaluate the status of its own Year
2000 program, in the first half of 1999 and
determine whether such a plan is necessary. NeoPath
management believes it has an effective program in
place to resolve the Year 2000 issues within its
control in a timely manner. The Company believes
that with modifications to NeoPath's products,
existing internal software and conversions to new
software, the Year 2000 issue will not pose
significant operational problems for its computer
systems. However, in the worst case scenario, if
the Company or external agents do not make necessary
modifications and conversions, or do not complete
them on time, the Year 2000 issue could disrupt
NeoPath's operations and materially affect its
business, financial condition, and results of
operations.
17
<PAGE>
FORWARD-LOOKING STATEMENTS
The preceding Management's Discussion and
Analysis of Financial Condition and Results of
Operations contains "forward-looking statements"
that reflect the Company's current views with
respect to future events and financial performance.
These forward-looking statements are subject to
certain risks and uncertainties that could cause
actual results to differ materially from historical
results or those anticipated. The words "plan,"
"expect," "anticipate," "believe," and similar
expressions identify forward-looking statements.
Readers are cautioned not to place undue reliance on
these forward-looking statements, which speak only
as of their dates. The Company undertakes no
obligation to publicly update or revise any forward-
looking statements, whether as a result of new
information, future events, or otherwise.
Factors that could cause actual results to
differ materially from historical results or those
anticipated include, without limitation, the
following:
- history of losses and uncertainty
of profitable operations;
- potential need for additional capital;
- uncertainty of market acceptance
of NeoPath's products;
- market consolidation and
concentration among a few large customers;
- uncertainty of product regulatory clearance;
- sole or limited source of supply
for key components;
- governmental regulation of NeoPath's manufacturing;
- competition in the industry;
- dependence on third-party reimbursement;
- dependence on a single product line;
- product liability and availability of adequate
insurance;
- dependence on patents and proprietary rights;
- risk of third-party claims ofinfringement;
- dependence on key personnel;
- highly volatile stock price;
- potential fluctuations in future
quarterly results; and
- Year 2000 issue.
For a more detailed discussion of these factors,
see "Factors Affecting Future Results and Forward-
Looking Statements" in the Company's Form 10-K for
the fiscal year ended December 31, 1998.
18
<PAGE>
BALANCE SHEETS
DECEMBER 31 1998 1997
_______________________________________________________________________________
Assets
Current assets:
Cash and cash equivalents $ 5,579,867 $ 3,308,970
Securities available-for-sale 3,374,549 25,409,633
Accounts receivable, net 3,011,078 3,863,818
Inventories 6,744,417 7,514,001
Other current assets 392,415 187,147
_____________________________
Total current assets 19,102,326 40,283,569
Fee-per-use systems, net 14,602,963 8,564,189
Property and equipment, net 3,530,694 5,979,849
Intangible assets, net -- 3,383,925
Deposits and other assets 913,850 729,280
_____________________________
Total assets $ 38,149,833 $ 58,940,812
=============================
Liabilities and Shareholders' Equity
Current liabilities:
Accounts payable $ 2,944,252 $ 2,173,179
Salaries and wages payable 1,681,710 2,357,045
Customer deposits 332,485 431,877
Other accrued liabilities 1,157,077 567,759
Current portion of long-term obligations 2,549,151 80,966
_____________________________
Total current liabilities 8,664,675 5,610,826
Long-term obligations, less current portion 1,257,027 101,872
Commitments and contingencies
Shareholders' equity:
Preferred stock, $.01 par value;
10,000,000 shares authorized; none
issued and outstanding -- --
Common stock, $.01 par value; 40,000,000 shares
authorized; 14,504,623 and 14,389,378 shares
issued and outstanding at December 31, 1998
and 1997, respectively 142,057,561 141,057,881
Accumulated deficit (113,813,699) (87,633,118)
Accumulated other comprehensive loss (15,731) (196,649)
_____________________________
Total shareholders' equity 28,228,131 53,228,114
_____________________________
Total liabilities and shareholders' equity $ 38,149,833 $ 58,940,812
=============================
See accompanying notes.
19
<PAGE>
STATEMENTS OF OPERATIONS
YEAR ENDED DECEMBER 31, 1998 1997 1996
_____________________________________________________________________________
Revenues $ 12,078,936 $ 10,824,380 $ 3,061,849
Cost of revenues 6,711,314 4,774,920 1,904,559
__________________________________________________
Gross margin 5,367,622 6,049,460 1,157,290
Operating expenses:
Research and development 11,269,363 14,248,669 11,202,375
Selling, general and
administrative 17,950,151 17,745,936 11,295,228
Write-off of
intangible assets 3,084,289 -- --
__________________________________________________
32,303,803 31,994,605 22,497,603
__________________________________________________
Loss from operations (26,936,181) (25,945,145) (21,340,313)
Interest income 1,008,638 2,399,117 3,741,843
Interest expense (253,038) (50,884) (56,813)
__________________________________________________
Net loss $ (26,180,581) $ (23,596,912) $ (17,655,283)
==================================================
Basic and diluted net
loss per share $ (1.81) $ (1.66) $ (1.36)
==================================================
Weighted average common
shares outstanding 14,467,902 14,197,307 13,029,314
==================================================
See accompanying notes.
20
<PAGE>
STATEMENTS OF SHAREHOLDERS' EQUITY
<TABLE>
<CAPTION>
COMMON STOCK ACCUMULATED
___________________________ OTHER
NUMBER OF DEFERRED ACCUMULATED COMPREHENSIVE
SHARES AMOUNT COMPENSATION DEFICIT INCOME (LOSS) TOTAL
_______________________________________________________________________________________________
<C> <C> <C> <C> <C> <C>
Balance at January 1, 1996 9,819,487 $ 71,649,971 $ (175,782) $ (46,380,923) $ 39,945 $ 25,133,211
Follow on public
offering -- common
stock, net of
issuance costs of
$4,384,649 2,875,000 61,740,351 -- -- -- 61,740,351
Exercise of options
and warrants 957,669 2,889,169 -- -- -- 2,889,169
Amortization of deferred
compensation -- (23,745) 101,536 -- -- 77,791
Unrealized loss on securities
available-for-sale -- -- -- -- (583,103) (583,103)
Net loss -- -- -- (17,655,283) -- (17,655,283)
____________
Comprehensive loss (18,238,386)
_______________________________________________________________________________________________
Balance at December 31, 1996 13,652,156 136,255,746 (74,246) (64,036,206) (543,158) 71,602,136
Exercise of options
and warrants 688,658 3,952,135 -- -- -- 3,952,135
Amortization of deferred
compensation -- -- 74,246 -- -- 74,246
Common stock issued on
purchase of Pathfinder
System product line 48,564 850,000 -- -- -- 850,000
Unrealized appreciation
on securities
available-for-sale -- -- -- -- 346,509 346,509
Net loss -- -- -- (23,596,912) -- (23,596,912)
____________
Comprehensive loss (23,250,403)
________________________________________________________________________________________________
Balance at December 31, 1997 14,389,378 141,057,881 -- (87,633,118) (196,649) 53,228,114
Exercise of options
and warrants 56,520 119,752 -- -- -- 119,752
Release of common stock
held in escrow 42,050 549,278 -- -- -- 549,278
Issuance of common stock
under employee stock
purchase plan 16,675 130,650 -- -- -- 130,650
Stock-based compensation to
consultants -- 200,000 -- -- -- 200,000
Unrealized appreciation on
securities available-for-sale -- -- -- -- 180,918 180,918
Net loss -- -- -- (26,180,581) -- (26,180,581)
____________
Comprehensive loss (25,999,663)
_______________________________________________________________________________________________
Balance at December 31, 1998 14,504,623 $ 142,057,561 $ -- $ (113,813,699) $ (15,731) $ 28,228,131
===============================================================================================
</TABLE>
See accompanying notes.
21
<PAGE>
STATEMENTS OF CASH FLOWS
<TABLE>
<CAPTION>
YEAR ENDED DECEMBER 31, 1998 1997 1996
_________________________________________________________________________________________________
<S> <C> <C> <C>
Operating activities
Net loss $ (26,180,581) $ (23,596,912) $ (17,655,283)
Adjustments to reconcile
net loss to net cash
used in operating activities:
Write-off of intangible assets 3,084,289 -- --
Depreciation and amortization 5,699,537 4,326,157 1,994,064
Stock-based compensation 200,000 74,246 77,791
Accrued interest on
securities available-for-sale 562,267 1,152,187 660,623
Net change in operating accounts:
Accounts receivable 852,740 (3,023,562) (840,256)
Inventories and
fee-per-use systems (7,048,460) (8,243,774) (11,093,253)
Accounts payable and accrued
liabilities 585,664 1,208,837 1,839,915
Other (364,591) (594,194) 40,888
________________________________________________________
Net cash used in operating activities (22,609,135) (28,697,015) (24,975,511)
Investing activities
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
Purchase of Pathfinder
System product line -- (2,696,114) --
Additions to property and equipment (640,689) (950,424) (3,325,122)
Other (6,756) 3,379 166,396
________________________________________________________
Net cash provided by (used in)
investing activities 21,006,290 20,758,007 (35,740,090)
Financing activities
Proceeds from note payable to bank 4,950,000 -- --
Payments on note payable to bank (1,236,369) -- --
Principal payments on obligations
under capital leases (90,291) (75,558) (193,441)
Payment on short-term
note payable issued in purchase
of Pathfinder System product line -- (500,000) --
Exercise of options and warrants 119,752 3,952,135 2,889,169
Issuance of common stock under
employee stock purchase plan 130,650 -- --
Issuance of common stock, net -- -- 61,740,351
________________________________________________________
Net cash provided by
financing activities 3,873,742 3,376,577 64,436,079
________________________________________________________
Net increase (decrease) in
cash and cash equivalents 2,270,897 (4,562,431) 3,720,478
Cash and cash equivalents:
Beginning of year 3,308,970 7,871,401 4,150,923
________________________________________________________
End of year $ 5,579,867 $ 3,308,970 $ 7,871,401
========================================================
Noncash transactions
AutoPap Systems reclassified
to fee-per-use systems, net $ 8,745,621 $ 4,152,386 $ 6,563,537
AutoPap Systems reclassified
to (from) property and
equipment, net (663,839) 2,457,367 729,362
</TABLE>
See accompanying notes.
22
<PAGE>
NOTES TO
FINANCIAL STATEMENTS
DECEMBER 31, 1998
NOTE 1 DESCRIPTION OF BUSINESS AND SUMMARY OF SIGNIFICANT
ACCOUNTING POLICIES
BUSINESS NeoPath, Inc. ("NeoPath" or the
"Company") develops and markets visual intelligence
technology to increase accuracy in medical testing.
NeoPath's initial 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 Papanicolaou ("Pap") smear
slide for the early detection of cervical cancer.
The AutoPap(R) 300 QC Automatic Pap Screener
System (the "AutoPap QC") is a rescreening device
used for quality control and rescreening of
previously screened Pap smear slides. The
AutoPap(R) Primary Screening System (the "AutoPap
Screener") is an enhanced system that classifies up
to 25% of a clinical laboratory's volume of Pap smear
slides as requiring no further review.
The "AutoPap System" refers to the AutoPap
Screener and the AutoPap QC together.
REVENUES AND MARKETS NeoPath's primary market
includes domestic and foreign clinical laboratories.
Domestic revenues are generated primarily through
NeoPath's direct sales activities; international
revenues are derived primarily through distributors.
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. The
Company's four largest customers accounted for 41%
of total revenues in 1998, compared to 65% in 1997
and 86% in 1996. The Company recognizes revenue on
either a product sale or fee-per-use basis (subject
to service and license agreements, rental contracts,
and minimum payments on certain fee-per-use
contracts). Fee-per-use revenues commence in the
month an AutoPap System is initially placed in
commercial use at the customer site. Sales of
AutoPap Systems are generally recognized at date of
shipment. In the past three years, sale revenues
(including upgrades) have accounted for 61% to 65% of
total revenues. Remaining revenues consisted
primarily of fee-per-use contract billings.
CASH EQUIVALENTS Short-term investments with
an original maturity of three months or less are
considered to be cash equivalents. Cash equivalents
are carried at cost, which approximates market
value.
SECURITIES AVAILABLE-FOR-SALE NeoPath's
investment portfolio is classified as available-for-
sale, and such securities are stated at fair value,
with the 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.
INVENTORIES Inventories are valued at the
lower of cost or market (first in, first out basis).
FEE-PER-USE SYSTEMS AutoPap Systems
manufactured for fee-per-use placements are carried
in inventories until the AutoPap Systems are
shipped, at which time they are reclassified to fee-
per-use systems (non-current assets). Fee-per-use
systems are depreciated on a straight-line basis
over an estimated useful life of four years.
NeoPath purchases all components for the AutoPap
System from outside vendors, including certain
components from sole-source or single vendors. The
establishment of additional or replacement sources
of supply for the AutoPap System could require
regulatory approval. In addition, a vendor's
inability to supply acceptable components in a
timely manner and in the quantity required could
delay or halt the Company's manufacture of its
products.
23
<PAGE>
PROPERTY AND EQUIPMENT Property and equipment
are recorded at cost, less accumulated depreciation
and amortization. Depreciation is calculated on a
straight-line basis over the estimated useful lives
of the related assets, ranging from three to seven
years. Leasehold improvements are amortized over
the lesser of their estimated useful lives or the
term of the lease.
ASSET IMPAIRMENT 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," the
Company recognizes impairment losses on long-lived
assets used in operations when indicators of
impairment are present and the discounted cash flows
estimated to be generated by those assets are less
than the assets' carrying amounts. During 1998, the
Company recognized such a loss for the write down of
intangible assets related to the Pathfinder System
product line (see Note 4). There were no such
losses recognized in 1997 or 1996.
STOCK-BASED COMPENSATION NeoPath has elected
to follow the intrinsic value method prescribed by
Accounting Principles Board Opinion No. 25,
"Accounting for Stock Issued to Employees," and
related Interpretations in accounting for its stock
options. Because the exercise price of the
Company's stock options generally equals the market
price of the underlying stock on the date of grant,
no corresponding compensation expense has been
recognized since NeoPath's initial public stock
offering. (See Note 7 for SFAS No. 123, "Accounting
for Stock-Based Compensation," pro forma
disclosures.)
In accordance with applicable accounting
standards, NeoPath recognizes compensation expense
for options and warrants granted to consultants in
lieu of cash payment.
ADVERTISING EXPENSES Advertising expenses are
expensed as incurred. Total advertising expenses
incurred during 1998, 1997, and 1996 were $1.1
million, $0.7 million, and $0.3 million,
respectively.
BASIC AND DILUTED NET LOSS PER SHARE Basic
and diluted net loss per share is computed based on
the weighted average number of shares of common
stock outstanding. Because NeoPath's stock options
and warrants are not dilutive (due to net losses)
there is no difference between basic net loss per
share and diluted net loss per share.
COMPREHENSIVE INCOME As of January 1, 1998,
NeoPath adopted SFAS No. 130, "Reporting
Comprehensive Income." Statement 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
shareholders' equity. Statement 130 requires
unrealized gains or losses on the Company's
securities available-for-sale, which prior to
adoption were reported within shareholders' equity,
to be included in other comprehensive income or
loss. Statement 130 also requires presentation of
accumulated other comprehensive income or loss
separately in shareholders' equity. Accordingly,
prior year financial statements have been
reclassified to conform to these requirements.
BUSINESS SEGMENTS NeoPath currently operates
in a single business segment -- clinical laboratories --
and management evaluates its operating performance
based on this single segment.
CONCENTRATIONS OF CREDIT RISK The Company
invests its excess cash in accordance with
guidelines that limit the credit exposure to any one
financial institution and to any one type of
investment. The guidelines also specify that the
financial instruments are issued by institutions
with strong credit ratings. The securities are
generally not collateralized and mature within two
years.
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.
24
<PAGE>
NOTE 2 SECURITIES AVAILABLE-FOR-SALE
Securities available-for-sale consist of the following:
<TABLE>
<CAPTION>
GROSS GROSS
AMORTIZED UNREALIZED UNREALIZED
DECEMBER 31, 1998 COST GAINS LOSSES FAIR VALUE
______________________________________________________________________________________
<S> <C> <C> <C> <C>
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
================================================================
</TABLE>
There were realized gains of $5,092 and realized
losses of $43,472 on sales of securities available-
for-sale for the year ended December 31, 1998.
There were no realized gains or losses on sales of
securities available-for-sale for the years ended
December 31, 1997 and 1996. The net adjustment for
unrealized holding gains and losses on securities
available-for-sale, included in other comprehensive
income or loss, was a gain of $180,918 in 1998, a
gain of $346,509 in 1997, and a loss of $583,103 in
1996. The fair value of securities available-for-
sale maturing within one year totals $1,282,882.
The fair value of securities available-for-sale
maturing between one and two years totals
$2,091,667. The Company considers all securities
available-for-sale as available for use in current
operations.
25
<PAGE>
NOTE 3 BALANCE SHEET INFORMATION
Detailed balance sheet data is as follows:
DECEMBER 31, 1998 1997
________________________________________________________________________
Accounts receivable
Receivables $ 3,477,196 $ 4,363,818
Allowance for doubtful accounts (466,118) (500,000)
_________________________________
$ 3,011,078 $ 3,863,818
=================================
Inventories
Raw materials $ 2,093,748 $ 3,819,830
Work-in-process 2,365,472 1,061,900
Finished goods 2,285,197 2,632,271
_________________________________
$ 6,744,417 $ 7,514,001
=================================
Finished goods consist of AutoPap Systems that
will be reclassified to fee-per-use systems (non-
current assets) when placed in commercial use,
AutoPap Systems to be sold, and AutoPap Systems used
internally on a temporary basis.
Fee-per-use systems
Systems $ 18,249,245 $ 10,628,468
Accumulated depreciation (3,646,282) (2,064,279)
_________________________________
$ 14,602,963 $ 8,564,189
=================================
Property and equipment
Laboratory and other equipment $ 7,987,377 $ 8,206,222
Furniture and fixtures 1,156,863 1,108,168
Leasehold improvements 1,222,093 1,210,930
_________________________________
Total property and equipment 10,366,333 10,525,320
Accumulated depreciation
and amortization (6,835,639) (4,545,471)
_________________________________
$ 3,530,694 $ 5,979,849
=================================
At December 31, 1998 and 1997, the Company held
equipment under capitalized leases with an original
cost of $317,594 and $373,432, and a net book value
of $73,172 and $147,219, respectively.
Intangible assets
Intangible assets $ -- $ 3,759,917
Accumulated amortization -- (375,992)
_________________________________
$ -- $ 3,383,925
=================================
26
<PAGE>
NOTE 4 PATHFINDER SYSTEM PRODUCT LINE
In the quarter ended December 31, 1998, NeoPath
wrote off $3.1 million of intangible assets related
to the Pathfinder System product line. The write-
off did not involve any cash expenditure. NeoPath
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
48,564 shares of NeoPath common stock. In addition,
certain shares of NeoPath common stock were issued
and were held in escrow until April 1998, when the
Company released the remaining 42,050 shares, which
added approximately $550,000 to Pathfinder
intangible assets. As a result of the purchase,
NeoPath recognized $4.3 million in intangible assets
that were to be amortized over five years. As a
result of 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 immediate
continued development and commercialization of this
product line. The Company then 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 3% of total revenues in
each of the two years ended December 31, 1998 and
1997.
NOTE 5 LONG-TERM OBLIGATIONS AND COMMITMENTS
NOTE PAYABLE TO BANK In April 1998, NeoPath
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,
NeoPath borrowed $5.0 million under the loan
agreement. The bank debt is secured by
substantially all of NeoPath's assets, excluding
intellectual property, and amounts are repaid over
24 months from the date of each drawdown. In
addition, NeoPath 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).
LEASE AGREEMENTS NeoPath leases certain
property and equipment under capital leases pursuant
to master equipment lease agreements. Under such
agreements, the Company entered into multiple
capital leases for property and equipment. The
agreements included lease terms ranging from 36 to
60 months and purchase options at the end of each
lease. Interest rates on capitalized leases
approximate 10%.
The Company leases office and operating
facilities under operating leases expiring in
January 1999 through August 2007, with various
renewal options, and other leased items through
2002. Operating lease expense was $833,590 in 1998,
compared to $831,983 in 1997, and $620,895 in 1996.
Minimum future payments as of December 31, 1998
are as follows:
LEASES
NOTE PAYABLE _____________________________
TO BANK CAPITAL OPERATING
________________________________________________________________________________
1999 $ 2,475,000 $ 80,168 $ 806,807
2000 1,238,631 19,050 31,328
2001 -- -- 31,328
2002 -- -- 31,328
2003 -- -- 31,328
Thereafter -- -- 44,926
____________ _____________________________
Total minimum payments 99,218 $ 977,045
==========
Less amount representing
interest 6,671
_________
Present value of
minimum payments 3,713,631 92,547
Current portion 2,475,000 74,151
____________ _________
Long-term obligations,
less current portion $ 1,238,631 $ 18,396
============ =========
27
<PAGE>
NOTE 6 INCOME TAXES
As of December 31, 1998, the Company had net
operating loss carryforwards of approximately $111.5
million and research and development credit
carryforwards of approximately $3.4 million for
federal income tax purposes, which expire between
2004 and 2013. Due to the issuance and sale of
shares of preferred stock prior to 1995 and the
Company's initial public offering completed in 1995,
the Company 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 common stock 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, 1998
and 1997 are as follows:
DECEMBER 31, 1998 1997
______________________________________________________________________________
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)
______________________________________
$ -- $ --
======================================
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
Company's valuation allowance increased $10.0
million and $9.5 million for the years ended
December 31, 1998 and 1997, respectively.
28
<PAGE>
NOTE 7 SHAREHOLDERS' EQUITY
COMMON STOCK On February 9, 1999, NeoPath
completed a $14.5 million private equity transaction
in which the Company issued 2.9 million shares of
common stock to investors at a price of $5.00 per
share. In connection with the financing, NeoPath
issued to Invemed Associates, Inc., a related party,
five-year warrants to purchase 100,000 shares of
common stock at an exercise price of $5.89 per
share.
STOCK OPTION PLANS The Company has two
stock option plans that provide for option grants to
employees, directors, and others. The options
generally vest over four years or as otherwise
determined by the plan administrator. Options to
purchase shares expire no later than ten years after
the date of grant.
In May 1998, Neopath's Board of Directors
approved a plan to allow all Company personnel the
opportunity to surrender previously granted stock
options in exchange for a new option at the current
market price. In total, 1,357,836 options were
surrendered and canceled; a corresponding number of
new options were issued with an exercise price of
$13.00 per share.
A summary of the Company's stock option activity
and related information follows:
OUTSTANDING EXERCISABLE
_____________________ __________________
WEIGHTED WEIGHTED
AVERAGE AVERAGE
EXERCISE EXERCISE
SHARES PRICE SHARES PRICE
____________________________________________________ __________________
Balance, January 1, 1996 1,027,242 $ 6.59 483,974 $ 1.66
Granted 838,218 22.91 ==================
Exercised (195,429) 2.60
Canceled (65,811) 10.66
_____________________
Balance, December 31, 1996 1,604,220 15.39 524,318 $ 5.12
Granted 845,025 16.46 ==================
Exercised (225,165) 2.07
Canceled (285,532) 20.18
_____________________
Balance, December 31, 1997 1,938,548 16.68 655,156 $ 13.56
Granted 1,785,083 12.35 ==================
Exercised (51,904) 1.73
Canceled (1,808,561) 18.01
=====================
Balance, December 31, 1998 1,863,166 $ 11.64 839,279 $ 11.16
===================== ==================
Available for grant at
December 31, 1998 1,065,020
=========
29
<PAGE>
Outstanding and exercisable stock options by price
range as of December 31, 1998 are as follows:
<TABLE>
<CAPTION>
OUTSTANDING EXERCISABLE
___________________________________________ ___________________________
WEIGHTED WEIGHTED WEIGHTED
RANGE OF SHARES AVERAGE AVERAGE SHARES AVERAGE
EXERCISE PRICE AS OF REMAINING EXERCISE AS OF EXERCISE
PER SHARE DEC. 31, 1998 TERM (YEARS) PRICE DEC. 31, 1998 PRICE
__________________________________________________________________ ___________________________
<S> <C> <C> <C> <C> <C>
$ 0.60 - $ 1.20 35,463 4.24 $ 1.15 34,713 $ 1.15
1.80 - 2.40 136,939 5.53 2.38 136,939 2.38
4.00 - 6.00 103,128 9.68 4.64 13,178 4.28
6.50 - 9.00 57,676 9.58 6.88 1,979 8.77
11.25 - 12.69 51,500 8.36 11.86 16,000 11.25
13.00 - 13.00 1,385,129 9.41 13.00 558,775 13.00
13.75 - 23.63 93,331 7.70 19.61 77,695 19.09
__________________________________________________________________ ___________________________
$ 0.60 - $ 23.63 1,863,166 8.93 $ 11.64 839,279 $ 11.16
================================================================== ===========================
</TABLE>
Pro forma information regarding net loss and net
loss per share is required by SFAS 123 and has been
determined as if the Company had accounted for its
employee stock options under the fair value method
of SFAS 123. The fair value for these options was
estimated at the date of grant using a Black-Scholes
multiple option pricing model with the following
weighted-average assumptions for 1998, 1997, and
1996, respectively: risk-free interest rates of
5.18%, 6.08%, and 6.01%; dividend yields of 0%;
volatility factors of the expected market price of
the Company's common stock of 0.8992, 0.6589, and
0.5512; and a weighted-average expected life of the
option of 1.47, 1.47, and 1.46 years after vest
date.
The Black-Scholes option value model was
developed for use in estimating the fair value of
traded options that have no vesting restrictions and
are fully transferable. In addition, option
valuation models require the input of highly
subjective assumptions, including the expected stock
price volatility. Because the Company's stock
options have characteristics significantly different
from those of traded options, and because changes in
the subjective input assumptions can materially
affect the fair value estimate, in management's
opinion, the existing models do not necessarily
provide a reliable single measure of the fair value
of its stock options.
For purposes of pro forma disclosures, the
estimated fair value of the options is amortized to
expense over the options' vesting period. The
Company's pro forma information follows:
YEAR ENDED DECEMBER 31, 1998 1997 1996
______________________________________________________________________________
Pro forma net loss $ (32,951,440) $ (27,930,575) $ (20,717,024)
Pro forma basic and diluted
net loss per share (2.28) (1.97) (1.59)
SFAS No. 123 pro forma disclosures above are not
necessarily indicative of future pro forma
disclosures because of the manner in which SFAS 123
calculations are phased in over time.
The weighted average fair value for options granted
during 1998, 1997, and 1996 using the Black-Scholes
multiple option pricing model is $6.99, $8.81, and $10.86,
respectively.
WARRANTS In 1998, NeoPath issued a warrant to
a consultant to purchase 60,000 shares of NeoPath
common stock at $4.31 per share, which was the
closing price of the Company's common stock on the
date of the initial agreement. The Company 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 non-cash expenses during the one-year
agreement.
Common stock warrants outstanding at December 31,
1998 totaled 278,910 at a weighted average exercise
price per share of $6.86. These warrants expire at
various dates through 2004.
30
<PAGE>
During 1998, warrants were exercised to purchase
4,616 shares of NeoPath's common stock. During
1997, warrants were exercised to purchase 463,493
shares of the Company's common stock, of which
13,273 shares were issued through "net exercise"
rights, for which the Company received no proceeds.
Such rights allow the warrant holder to exercise the
warrant and "pay" the warrant price through the
intrinsic value of the warrants; therefore, fewer
shares of common stock are issued as a result.
During 1996, warrants were exercised to purchase
762,240 shares of the Company's common stock, of
which 346,468 shares were issued through net
exercise rights. The remaining warrants outstanding
as of December 31, 1998 have net exercise rights.
COMMON STOCK RESERVED At December 31, 1998,
common stock was reserved for the following
purposes:
Stock options 2,928,186
Common stock warrants 278,910
Employee stock purchase plan 133,325
_________
3,340,421
=========
NOTE 8 EMPLOYEE BENEFITS
The Company has a retirement plan covering
substantially all employees that provides for
voluntary salary deferral contributions on a pre-tax
basis in accordance with Section 401(k) of the
Internal Revenue Code of 1986, as amended. To date,
the Company has made no contributions to the plan.
In May 1997, NeoPath's shareholders approved the
1997 Employee Stock Purchase Plan (the "ESPP") and
authorized the issuance of up to 150,000 shares of
the Company's common stock under the ESPP. The ESPP
permits eligible employees of the Company to
purchase common stock at not less than 85% of fair
market value as defined in the ESPP through payroll
deductions of up to 15% of their compensation,
provided that no employee may purchase common stock
worth more than $25,000 in any calendar year.
Participants are required to hold ESPP stock for a
minimum of six months following the purchase date.
The ESPP will expire in 2007.
NOTE 9 LITIGATION
On July 15, 1996, Neuromedical Systems, Inc.
("Neuromedical") filed a lawsuit against NeoPath
in the United States District Court for the Southern
District of New York. The complaint alleges patent
infringement, unfair competition, false advertising,
and related claims. 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 the
Company. The parties have agreed to dismiss their
claims and counter claims on all but the patent
issues, and Neuromedical accordingly served an
amended complaint on July 27, 1998 asserting only
patent infringement claims. This lawsuit is still
in the discovery stage, and a trial date has not
been set. The Company believes it has a strong
position in this action and continues to defend
itself vigorously.
On March 31, 1997, the Company 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. The Company expects
trial on the first Washington lawsuit to begin in
1999. The second Washington lawsuit is currently in
the discovery stage.
31
<PAGE>
MANAGEMENT'S
STATEMENT
OF FINANCIAL
RESPONSIBILITY
The management of NeoPath, Inc. is responsible
for the fair and accurate presentation of the
financial information in this annual report. We
have prepared the financial statements and related
notes in accordance with generally accepted
accounting principles based on Company records and
other sources. Certain financial information is, of
necessity, based on judgment and estimation.
We believe that adequate accounting systems and
financial controls are maintained to ensure that
NeoPath's records are free from material
misstatement and to protect the Company's assets
from loss or unauthorized use. In addition, the
Audit Committee of the Board of Directors
periodically meets with NeoPath management and with
Ernst & Young LLP, the Company's independent
auditors.
/s/ ALAN C. NELSON
___________________
Alan C. Nelson, Ph.D.
Chairman of the Board
/s/ RONALD R. BROMFIELD
________________________
Ronald R. Bromfield
President and
Chief Executive Officer
/s/ ROBERT C. BATEMAN
______________________
Robert C. Bateman
Vice President and
Chief Financial Officer
32
<PAGE>
REPORT OF
ERNST & YOUNG LLP,
INDEPENDENT AUDITORS
The Board of Directors and Shareholders
NeoPath, Inc.
We have audited the accompanying balance sheets
of NeoPath, Inc. as of December 31, 1998 and 1997,
and the related statements of operations,
shareholders' equity, and cash flows for each of the
three years in the period ended December 31, 1998.
These financial statements are the responsibility of
the Company's management. Our responsibility is to
express an opinion on these financial statements
based on our audits.
We conducted our audits in accordance with
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 the financial statements. An audit
also includes assessing the accounting principles
used and significant estimates made by management,
as well as evaluating the overall financial
statement presentation. We believe that our audits
provide a reasonable basis for our opinion.
In our opinion, the financial statements referred
to above present fairly, in all material respects,
the financial position of NeoPath, Inc. as of
December 31, 1998 and 1997, and the results of its
operations and its cash flows for each of the three
years in the period ended December 31, 1998,
in conformity with generally accepted accounting
principles.
/s/ ERNST & YOUNG LLP
Seattle, Washington
February 9, 1999
33
<PAGE>
COMMON STOCK
INFORMATION
Neopath's common stock trades on The Nasdaq
Stock Market(R) (or "Nasdaq") under the symbol
"NPTH." Nasdaq uses computers and telecommunications
to unite its participants in a screen-based market.
It enables market participants to compete with each
other for investor orders in each Nasdaq security,
and it facilitates the trading and surveillance of
thousands of securities. As of February 25, 1999,
there were 291 holders of record of the common stock
of the Company and 17,412,504 shares outstanding.
Since shares of NeoPath's common stock are also held
in street name, there are additional beneficial
holders of the Company's common stock.
The following table sets forth, for the periods
indicated, the high and the low trade prices for
NeoPath's common stock as reported by Nasdaq:
1998 1997
___________________ __________________
HIGH LOW HIGH LOW
___________________ __________________
First Quarter $ 18.19 $ 11.25 $ 19.75 $ 13.50
Second Quarter 16.00 5.63 23.00 11.50
Third Quarter 8.63 3.88 20.00 15.00
Fourth Quarter 8.75 3.06 20.38 12.63
The Company has not declared or paid cash
dividends on its common stock. The Company
currently intends to retain all earnings for use in
its business and does not anticipate paying cash
dividends in the foreseeable future.
34
<PAGE>
CORPORATE
INFORMATION
DIRECTORS
Alan C. Nelson, Ph.D.
Chairman of the Board
Thomas A. Bonfiglio, M.D.
Senior Attending Pathologist and Director of Cytology,
The Genesee Hospital
William L. Scott
Retired General Manager, Boston Scientific
Corporation -- Northwest Technology Center
Cristina H. Kepner
Director and Executive Vice President,
Invemed Associates, Inc.
Walter L. Robb, Ph.D.
President, Vantage Management, Inc.
David A. Thompson
Retired Senior Vice President,
Abbott Laboratories
Gail R. Wilensky, Ph.D.
John M. Olin Senior Fellow, Project HOPE
OFFICERS
Alan C. Nelson, Ph.D.
Chairman of the Board
Ronald R. Bromfield
President and Chief Executive Officer
Robert C. Bateman
Vice President and Chief Financial Officer
Shih-Jong James Lee, Ph.D.
Vice President and Chief Technical Officer
Larry A. Nelson
Vice President, Intellectual Property and New
Business Development
Mary K. Norton
Vice President, Regulatory/Government Affairs and
Quality Assurance
David H. Robison
Vice President, Operations
35
<PAGE>
CORPORATE
INFORMATION
CORPORATE HEADQUARTERS
NeoPath, Inc.
8271 - 154th Avenue NE
Redmond, WA 98052
Phone: (425) 869-7284
Fax: (425) 869-5325
LEGAL COUNSEL
Perkins Coie LLP
1201 Third Avenue
Seattle, WA 98101
TRANSFER AGENT
American Stock Transfer & Trust Company
40 Wall Street
New York, NY 10005
INDEPENDENT AUDITORS
Ernst & Young LLP
999 Third Avenue, Suite 3500
Seattle, WA 98104
ANNUAL MEETING
The Annual Meeting of Shareholders will be held at
8:30 a.m. (Pacific Daylight Time) on Thursday, May
20, 1999 at NeoPath, Inc. Corporate Headquarters,
8271 - 154th Avenue NE, Redmond, Washington 98052
SHAREHOLDER INQUIRIES
Copies of the Company's Form 10-K, as filed with the
Securities and Exchange Commission, may be obtained
without charge by writing:
Attn: Investor Relations
NeoPath, Inc.
8271 - 154th Avenue NE
Redmond, WA 98052
36
<PAGE>
<TABLE> <S> <C>
<ARTICLE> 5
<LEGEND>
This schedule contains summary financial information extracted from the Form
10-K405 and documents incorporated by reference for the year ended December 31,
1998, and is qualified in its entirety by reference to such financial statements
and footnotes.
</LEGEND>
<MULTIPLIER> 1
<S> <C>
<PERIOD-TYPE> YEAR
<FISCAL-YEAR-END> DEC-31-1998
<PERIOD-END> DEC-31-1998
<CASH> 5,579,867
<SECURITIES> 3,374,549
<RECEIVABLES> 3,477,196
<ALLOWANCES> 466,118
<INVENTORY> 6,744,417
<CURRENT-ASSETS> 19,102,326
<PP&E> 10,366,333
<DEPRECIATION> 6,835,639
<TOTAL-ASSETS> 38,149,833
<CURRENT-LIABILITIES> 8,664,675
<BONDS> 0
0
0
<COMMON> 142,057,561
<OTHER-SE> (113,829,430)
<TOTAL-LIABILITY-AND-EQUITY> 38,149,833
<SALES> 0
<TOTAL-REVENUES> 12,078,936
<CGS> 0
<TOTAL-COSTS> 6,711,314
<OTHER-EXPENSES> 32,303,803
<LOSS-PROVISION> 0
<INTEREST-EXPENSE> 253,038
<INCOME-PRETAX> (26,180,581)
<INCOME-TAX> 0
<INCOME-CONTINUING> (26,180,581)
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> (26,180,581)
<EPS-PRIMARY> (1.81)<F1>
<EPS-DILUTED> 0
<FN>
<F1>Basic and diluted net loss per share are the same amount.
</FN>
</TABLE>
