Inotiv, Inc. - Annual Report: 2005 (Form 10-K)

PART I

This Report contains certain statements that are "forward-looking statements" within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. Readers of this Report are cautioned that reliance on any forward-looking statement involves risks and uncertainties. Although Bioanalytical Systems, Inc. (the "Company") believes that the assumptions on which the forward-looking statements contained herein are based are reasonable, any of those assumptions could prove to be inaccurate given the inherent uncertainties as to the occurrence or nonoccurrence of future events. There can be no assurance that the forward-looking statements contained in this Report will prove to be accurate. The inclusion of a forward-looking statement herein should not be regarded as a representation by the Company that the Company's objectives will be achieved.

General

The Company, which is a corporation organized in Indiana, provides contract development services and research equipment to many leading global pharmaceutical, medical research and biotechnology companies and institutions. It has played a significant role in understanding the underlying causes of central nervous system disorders, diabetes, osteoporosis and other diseases since its start in 1974.

We offer an efficient, variable cost alternative to our clients' internal product development programs. Outsourcing development work to reduce overhead and speed drug approvals through the Food and Drug Administration ("FDA") is an established alternative to in-house development among pharmaceutical companies. We derive our revenues from sales of our research services and drug development tools, both focused on determining drug safety and efficacy.

We support preclinical and clinical development needs of researchers and clinicians for small molecule through large biomolecule drug candidates. The Company believes its scientists have the skills in analytical instrumentation development, chemistry, computer software development, physiology, medicine, and toxicology to make the services and products it provides increasingly valuable to its current and potential clients. Scientists engaged in analytical chemistry, clinical trials, drug metabolism studies, pharmacokinetics and basic neuroscience research at many of the largest global pharmaceutical companies are our principal clients.

Acquisitions

PharmaKinetics Laboratories, Inc.

On May 26, 2003, PharmaKinetics Laboratories, Inc., a Maryland corporation ("PKLB"), became a majority owned subsidiary of the Company. Following the acquisition, PKLB was renamed BASi Maryland, Inc. The Company acquired this site to broaden its service offering base, which now includes Phase I through III clinical trials services and a fourth bioanalytical lab complementing sites in Indiana, Oregon and the United Kingdom. In addition, the Company wanted to establish a meaningful operating presence physically near current and potential clients on the East Coast of the U.S. This site's operating performance prior to the acquisition had been poor. Since the acquisition, the Company has made significant organizational, managerial, staff, and physical plant changes to improve performance at the Baltimore clinic.

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LC Resources, Inc.

On December 13, 2003, the Company acquired LC Resources, Inc. ("LCR"), a privately held company with its operations in McMinnville, Oregon. The Company believes that LCR had a strong reputation in liquid chromatography and bioanalysis, and provides a location that is significantly closer to clients on the West Coast of the U.S., which is an additional benefit of the acquisition.

Changing Nature of the Pharmaceutical Industry

The Company's services and products are marketed globally to pharmaceutical, medical research and biotech companies and institutions engaged in drug research and development. The research services industry is highly fragmented among many niche vendors led by a small number of larger companies; the latter offer an ever-growing portfolio of cradle-to-grave pharmaceutical development services. The Company's products are also marketed to academic and government institutions. The Company's services and products may have distinctly different customers (often separate divisions in a single large pharmaceutical company) and requirements. The Company believes that all clients are facing increased pressure to outsource facets of their research and development activities and that the following factors will increase client outsourcing:

Accelerated Drug Development

Clients continue to demand faster, more efficient, more selective development of a larger pool of drug candidates. Clients demand fast, high quality service in order to make immediate, well-informed decisions to quickly exclude poor candidates and speed development of successful ones. The need for additional development capacity to exploit more opportunities, accelerate development, extend market exclusivity and increase profitability drives the demand for outsourced services.

Cost Containment

Pharmaceutical companies continue to push for more efficient operations through outsourcing to optimize profitability as development costs climb, staff costs increase, generic competition challenges previously secure profit generators, political and social pressures to reduce health care costs escalate, and shareholder expectations mount.

Patent Expiration

As exclusivity ends with patent expiry, drug companies defend their proprietary positions against generic competition with various patent extension strategies. Both the drug company creating these extensions and the generic competitors should provide additional opportunities for the Company.

Alliances

Strategic alliances allow pharmaceutical companies to share research know-how and to develop and market new drugs faster in more diverse, global markets. The Company believes that alliances will lead to a greater number of potential drugs in testing, many under study by small companies lacking broad technical resources. Those small companies can add shareholder value by further developing new products through outsourcing, reducing risk for potential allies.

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Mergers and Acquisitions

Consolidation in the pharmaceutical industry is commonplace. As firms blend personnel, resources and business activities, the Company believes they will continue to streamline operations, minimizing staffing which should lead to more outsourcing. This may result in short-term disruption in placement of, or progress on, drug development programs as merging companies rationalize their respective drug development pipelines.

Biotechnology Industry and Virtual Drug Company Growth

The biotech industry continues to grow and has introduced many new developmental drugs. Many biotech drug developers do not have in-house resources to conduct development. Many new companies choose only to carry a product to a developed stage sufficient to attract a partner who will manufacture and market the drug. Efficient use of limited funds motivates smaller firms to seek outside service providers like the Company rather than build expensive infrastructure.

Unique Technical Expertise

The increasing complexity of new drugs requires highly specialized, innovative, solution-driven research not available in all client labs. The Company believes that this need for unique technical expertise will increasingly lead to outsourcing of research activity.

Data Management Expertise

Our clients and the FDA require more data, greater access to that data, consistent and auditable management of that data, and greater security and control of that data.

The Company is making significant investments in software throughout its contract services groups to optimize efficiency and ensure it complies with FDA regulations and client expectations.

Globalization of the Marketplace

Foreign firms are relying on independent development companies with experience in the U.S. to provide integrated services through all phases of product development and to assist in preparing complex regulatory submissions. Domestic drug firms are broadening product availability globally, demanding local regulatory approval. The Company believes that domestic service providers with global reach, established regulatory expertise, and a broad range of integrated development services will benefit from this trend. The Company has a significant European presence and experience in managing foreign operations from its West Lafayette offices.

The Company's Role in the Drug Development Process

After a new drug candidate is identified and carried through preliminary screening, the development process for new drugs has three distinct phases.

1)            The preclinical phase includes safety testing to prepare an Investigational New Drug ("IND") exemption for submission to the FDA. The IND must be accepted by the FDA before the drug can be tested in humans. Once a pharmacologically active molecule is fully analyzed to confirm its integrity, the initial dosage form for clinical trials is created. An analytical chemistry method is developed to enable reliable quantification. Stability and purity of the formulation is also determined.

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Clients work with the Company's preclinical services group to establish pharmacokinetics, pharmacodynamics and safety testing of the new drug. These safety studies range from acute safety monitoring on drugs and medical devices to chronic, multi-year oncogenicity studies. Bioanalyses of blood sampled under these protocols by the Company's bioanalytical services group provide kinetic, metabolism and dose-ranging data. Upon successful completion of preclinical safety studies, an IND submission is prepared and provided to the FDA for review prior to human clinical trials.

Many of the Company's products are designed for use in preclinical development. The Culex® APS, a robotic automated pharmacology system, enables researchers to develop pharmacokinetic profiles of drugs during early screening in rodents quickly and cost effectively. Several variations of this technology are in development. Clients and the Company's bioanalytical services group sometimes use the Company's electrochemistry and chromatography products to develop a single, quick, proprietary method to screen drugs in biological samples. Liquid chromatography coupled to mass spectrometry is now a mainstay of the Company's bioanalytical laboratories. The Company has invested heavily in robotics and mass spectrometry systems over the last ten years.

2)            The clinical phase further explores the safety and efficacy of the substance in humans. The sponsor conducts Phase I human clinical trials in a limited number of healthy individuals to determine safety and tolerability. Bioanalytical assays determine the availability and metabolism of the active ingredient following administration. Expertise in method development and validation is critical, particularly for new chemical entities.

Exhaustive safety, tolerability and dosing regimens are established in sick humans in Phase II trials. Phase III clinical trials verify efficacy and safety. After successful completion of Phase III trials, the sponsor of the new drug submits a New Drug Application ("NDA") or Product License Application ("PLA") to the FDA requesting that the product be approved for marketing. Early manufacturing demonstrates production of the substance in accordance with FDA Good Manufacturing Practices ("GMP") guidelines. Data are compiled in an NDA, or for biotechnology products a PLA, for submission to the FDA requesting approval to market the drug or product. The Company's bioanalytical work per study grows rapidly from Phase I through III. The number of samples per patient declines as the number of patients grows in later studies. Phase II and III studies take several years, supported by well-proven, consistently applied analytical methods. It is unusual for a sponsor to change laboratories unless there are problems in the quality or timely delivery of results.

The Company's acquisition of its clinic in fiscal 2004 enables it to perform Phase I studies in Baltimore and manage small Phase II and III trials through its Clinical Trials Management group, also in Baltimore. Phase I services include bioavailability testing to monitor the rate and extent to which a drug becomes available in the blood. Bioavailability can also be used to compare the bioequivalence of similar generic and brand name drugs.

3)            Post-approval follows FDA approval of the NDA or PLA. This includes production and continued analytical and clinical monitoring of the drug. The post-approval phase also tracks development and regulatory approval of product modifications and line extensions, including improved dosage forms. The drug manufacturer must comply with quality assurance and quality control requirements throughout production and must continue analytical and stability studies of the drug during commercial production to continue to validate production processes and confirm product shelf life. Samples from each manufactured batch must be tested prior to release of the batch for distribution to the public.

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The Company also provides services in all areas during the post-approval phase, concentrating on bioequivalence studies of new formulations, line extensions, new disease indications and drug interaction studies.

The Company's ability to solve client problems combining its knowledge base, services and products has been a factor in the Company's selection by major pharmaceutical companies to assist in several preclinical and Phase I, II and III clinical trials, as well as in the post-approval phase.

Company Services and Products

Overview

The Company operates in two business segments – contract research services and research products, both of which address the bioanalytical, preclinical, and clinical research needs of drug developers. Both segments arose out of the Company's expertise in a number of core technologies designed to quantify trace chemicals in complex matrices. The Company evaluates performance and allocates resources based on these segments.

Services

The Company's contract research services segment provides screening and pharmacological testing, preclinical safety testing, formulation development, clinical trials, regulatory compliance and quality control testing. Revenues from the Company's services segment were $33.0 million for fiscal 2005. For additional financial information regarding the services segment, please see Note 11 to the Notes to Consolidated Financial Statements included in Item 8 of this report. The following is a description of the services provided by the Company's contract research services segment:

•              Product Characterization, Method Development and Validation: Analytical methods determine potency, purity, chemical composition, structure and physical properties of a compound. Methods are validated to ensure that data generated are accurate, precise, reproducible and reliable and are used consistently throughout the drug development process and in later product support.

•              Bioanalytical Testing: The Company analyzes specimens from preclinical and clinical trials to measure drug and metabolite concentrations in complex biological matrices. Bioanalysis is performed at Company facilities in Indiana, Oregon, Maryland and the UK.

•              Stability Testing: The Company tests stability of drug substances and formulated drug products and maintains secure storage facilities necessary to establish and confirm product purity, potency and shelf life in West Lafayette, Indiana. The Company has multiple ICH (International Conference on Harmonization) validated controlled climate GMP (Good Manufacturing Practices) systems.

•              In Vivo Pharmacology: The Company provides preclinical in vivo sampling services for the continuous monitoring of chemical changes in life, in particular, how a drug enters, travels through, and is metabolized in living systems. Most services are performed in customized facilities in West Lafayette, Indiana using the Company's robotic Culex® APS (Automated Pharmacology System) system and in Evansville, Indiana.

•              Preclinical and Pathology Services: The Company provides pharmacokinetic and safety testing in studies ranging from acute safety monitoring of drugs and medical devices to chronic, multi-year oncogenicity studies in its newly expanded Evansville, Indiana site. Depending on protocol, multiple tissues may be collected to monitor pathological changes.

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•              Phase I, II & III Clinical Trials: The Company performs Phase I human clinical trials in its 110-bed clinic in Baltimore. These are principally bioavailability and bioequivalence studies, both for generic drug and innovator pharmaceutical firms. It also coordinates Phase II and III studies through its Clinical Trials Management group in Baltimore.

Research Products

The Company is focusing its products business on expediting preclinical screening of developmental drugs. The Company competes in very small niches of the multibillion dollar analytical instrument industry. The Company's products business targets, and in some cases dominates, unique niches in life science research. The Company designs, develops, manufactures and markets state-of-the-art:

Revenues for the Company's products segment were $9.4 million for fiscal 2005. For additional financial information regarding the products segment, please see Note 11 to the Notes to Consolidated Financial Statements included in Item 8 of this report. The following is a description of the products offered by the Company:

•              The Culex® APS robotic automated pharmacology system is used by pharmaceutical researchers to monitor drug concentrations and response as a function of time. Compared to current manual methods, the Culex® offers greater than 80% reduction in test model use and comparable reduction in labor. The Culex® also offers computer-controlled blood sampling protocol, behavioral monitoring, flexibility to collect other biological samples, exceptional cost savings, significant reduction in model stress and expeditious data delivery.

•              Bioanalytical separation systems (liquid chromatography) used in connection with Windows® software, detect and quantify low concentrations of substances tracking complex chemical, physiological and behavioral effects in biological fluids and tissues from humans and laboratory animal models.

•              Specialized chemical analyzers monitor trace levels of organic chemicals such as neurotransmitters in biological samples using core electrochemistry, liquid chromatography and enzymology technologies to separate and quantify drugs, xenobiotics, metabolites and other chemicals in blood, cerebrospinal fluid and other biological media.

•              epsilon™ is a single liquid chromatography and electrochemistry instrument control platform for the separation systems and chemical analyzers noted above.

•              A line of miniaturized in vivo sampling devices sold to drug developers and medical research centers, assist in the study of a number of medical conditions including stroke, depression, Alzheimer's and Parkinson's diseases, diabetes and osteoporosis.

•              Vetronics small animal diagnostic ECG and vital signs monitors are used primarily in veterinary clinics with growing applications in preclinical research.

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Clients

Over the past five years, the Company has regularly provided its services and/or products to most of the top 25 pharmaceutical companies in the world, as ranked by 2005 research and development spending.

The Company has been balancing its business development effort between large pharmaceutical developers and the next tier of smaller drug development companies. The Company believes that smaller companies are more inclined to establish a consistent, long-term, strategic relationship with the Company but realizes that they may be poorly funded. The Company has adapted by increasing its focus on a larger number of specialist service buyers at large and small clients and by engaging in a more active and more diversified business development effort staffed with specialists.

Approximately 20% of the Company's products and services revenues are generated from customers outside of North America.

Pfizer (including predecessor companies) is the Company's largest client. Pfizer accounted for approximately 10.1%, 12.5% and 16.0% of the Company's total revenues in fiscal 2005, 2004 and 2003, respectively. Pfizer accounted for 6.0% and 11.0% of total trade accounts receivable at September 30, 2005 and 2004, respectively.

The Company deals with at least 20 different research groups within Pfizer, each focused on a particular development function, each having little intercourse with any other. After the acquisition of Pharmacia in 2003, Pfizer restructured and repatriated their preclinical development effort in Kalamazoo, MI, minimizing outsourcing for the short-term and possibly long-term as well. This change significantly reduced revenue in Evansville for fiscal 2003 and 2004. Subsequently, the Company has redirected its sales effort for its toxicology services offered in Evansville, and, by the end of fiscal 2005, had replaced that revenue with contracts from a variety of pharmaceutical and biotech clients.

There can be no assurance that the Company's business will not continue to be dependent on continued relationships with Pfizer or other clients, or that annual results will not be dependent on a few large projects. In addition, there can be no assurance that significant clients in any one period will continue to be significant clients in other periods. In any given year, there is a possibility that a single pharmaceutical company may account for 5% or more of the Company's total revenue. Since the Company does not have long-term contracts with its clients, the importance of a single client may vary dramatically from year to year.

Sales and Marketing

Capitalizing on its long history of innovation and technical excellence, the current sales and marketing plan of the Company targets key accounts among the top 200 global pharmaceutical companies and approaches smaller companies opportunistically. The Company recognizes that its growth and customer satisfaction depend upon its ability to continually improve client relationships.

The Company's products and services are sold directly to the client. The Company has thirteen employees on its business development staff and an equal number providing technical and development support. In late fiscal 2005, this team was reorganized under a new executive vice president, with more clearly defined sales objectives, territories and incentives. Although it is too early to assess the results of the Company's new approaches, management believes that the increasing size and scope of the products and services offered by the Company required additional resources in sales and marketing. The Company also attends multiple trade shows in many disciplines and has created a collection of web sites, catalogs,

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training and technical support literature, media presentations, branding, workshops and academic publications.

Sales, marketing and technical support are based in the Company's corporate headquarters located in West Lafayette, Indiana. The Company also maintains offices in Baltimore, Maryland; Evansville, Indiana; McMinnville, Oregon; and Warwickshire, UK. For additional financial information relating to geographic segments, please see Note 11 to the Notes to Consolidated Financial Statements included in Item 8 of this report.

Bioanalytical Services, Ltd., a wholly owned, UK-based subsidiary, provides a direct liaison with research service clients in Europe and maintains a laboratory to provide those services, as well as a distribution center for the Company's European sales of products. In addition, the Company has a network of 18 established distributors covering Japan, the Pacific Basin, South America, the Middle East, India, South Africa and Eastern Europe. All of the Company's distributor relationships are managed from the Company's headquarters in West Lafayette, Indiana. International growth is planned through stronger local promotion to support the Company's distributor network.

Contractual Arrangements

The Company's service contracts typically establish an estimated fee to be paid for identified services. In most cases, some percentage of the contract costs is paid in advance. While the Company is performing a contract, clients often adjust the scope of services to be provided by the Company based on interim project results. Fees are adjusted accordingly. Generally, the Company's fee-for-service contracts are terminable by the client upon written notice of 30 days or less for a variety of reasons, including the client's decision to forego a particular study, the failure of product prototypes to satisfy safety requirements, and unexpected or undesired results of product testing. Cancellation or delay of ongoing contracts may result in fluctuations in the Company's quarterly and annual results. The Company is generally able to recover at least its invested costs when contracts are terminated.

The Company's products business offers annual service agreements on most product lines.

Backlog

The contracts pursuant to which the Company provides its services are terminable upon written notice of 30 days or less. The Company maintains projections based on bids and contracts to optimize asset utilization. Similarly, virtually all of the Company's products are made to order. Backlog may not be a good indicator of future sales trends. Management does not believe that backlog is material to an understanding of the Company's business taken as a whole.

Competition

Services

The Company competes primarily with in-house research, development, quality control and other support service departments of pharmaceutical and biotechnology companies. There are also full-service Contract Research Organizations ("CROs") that compete in this industry. The largest CRO competitors offering research services similar to the Company's include:

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CROs generally compete on:

Several of the Company's competitors have significantly greater financial resources than the Company.

Products

Culex® APS: Two small vendors have offered simple, semi-automated blood sampling systems. However, the Company does not believe that either vendor presents significant competition for Culex®. In addition, the Company has established strong relationships with the largest vendors of animal models who now provide catheterized "Culex® ready" models to the Company's customers on a just-in-time basis, further increasing convenience and lowering cost to the customer.

Bioanalytical Separation Systems: The Company competes with several large equipment manufacturers, including Agilent, Waters Corporation and Perkin Elmer Corporation. Competitive factors include market presence, product quality, reliability and price. The Company believes it competes well in its niche markets because of its reputation and the quality of its products, together with the technical assistance and service it offers. Many of the Company's competitors are much larger and have greater resources than the Company, which makes it difficult for the Company to capture business from clients other than those who need the Company's unique capabilities.

Vetronics/in vivo sampling devices: There are few competitors in this area of the Company's business. The Company is the largest vendor in these very small, technically demanding niches.

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Government Regulation

The Company is subject to various regulatory requirements designed to ensure the quality and integrity of its data and products. These regulations are governed primarily under the Federal Food, Drug and Cosmetic Act, as well as by associated Good Laboratory Practice ("GLP"), Good Manufacturing Practice ("GMP"), and Good Clinical Practice ("GCP") guidelines administered by the FDA. The standards of GLP, GMP, and GCP are required by the FDA and by similar regulatory authorities around the world. These guidelines demand rigorous attention to employee training; detailed, authorized documentation; equipment validation; careful tracking of changes and routine auditing of compliance. Noncompliance with these standards could result in disqualification of project data collected by the Company. Material violation of GLP, GMP, or GCP guidelines could result in additional regulatory sanctions and, in severe cases, could also result in a discontinuance of selected Company operations.

Analytical Services

Laboratories that provide information included in INDs, NDAs and PLAs must conform to regulatory requirements that are designed to ensure the quality and integrity of the testing process. Most of the Company's contract research services are subject to government standards for laboratory practices that are embodied in guidelines for GLP. The FDA and other regulatory authorities require that test results submitted to such authorities be based on studies conducted in accordance with GLP. These guidelines are set out to help the researcher perform work in compliance with a pre-established plan and standardized procedures. These guidelines include but are not restricted to:

Preclinical Services

The Company must also maintain reports for each study for specified periods for auditing by the study sponsor and by the FDA or similar regulatory authorities in other parts of the world. Noncompliance with GLP can result in the disqualification of data collection during the preclinical trial.

The Company's animal research facilities are subject to a variety of federal and state laws and regulations, including The Animal Welfare Act and the rules and regulations enforced by the United States Department of Agriculture ("USDA") and the National Institutes of Health ("NIH"). These regulations establish the standards for the humane treatment, care and handling of animals by dealers and research facilities. The Company's animal research facilities maintain detailed standard operating procedures and the documentation necessary to comply with applicable regulations for the humane treatment of the animals in its custody. Besides being licensed by the USDA as a research facility, this business is also accredited by the Association for Assessment and Accreditation of Laboratory Animal Care International ("AAALAC") and has registered assurance with the NIH.

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Clinical Services

The Company's Clinical Research Unit in Baltimore is principally subject to GCP and GLP guidelines that cover activities such as obtaining informed consent, verifying qualifications of investigators, complying with Standard Operating Procedures ("SOP"), reporting adverse reactions to drugs and maintaining thorough and accurate records. The Company must maintain source documents for each study for specified periods. Such documents are frequently reviewed by the study sponsor during visits to the Company's facility and may be reviewed by the FDA during audits. In the fall of 2005, the facility was audited by the FDA, and we are awaiting their inspection report.

The Company is subject to regulation and inspection by local, state, federal and foreign agencies where the Company's facilities are located. The Company has not experienced any significant problems to date in complying with the regulations of such agencies and does not believe that any existing or proposed regulations will require material capital expenditures or changes in its method of operation.

Quality Assurance and Information Technology

To assure compliance with applicable regulations, the Company has established quality assurance programs at its facilities that audit test data, train personnel and review procedures and regularly inspect facilities. In addition, FDA regulations and guidelines serve as a basis for the Company's SOPs where applicable. In fiscal 2004 and 2003, the Company endeavored to standardize SOPs across all relevant operations. This standardization is an ongoing process. In addition, the Company purchased software to ensure compliant documentation, handling and reporting of all laboratory generated study data. In fiscal 2004, the Company purchased similar 21 CFR part 11 compliant software for its preclinical research group and is currently revalidating the recent revisions to that software.

Also in fiscal 2004, the Company initiated implementation of a new Enterprise Resource Planning ("ERP") system, which was launched at all the Company's locations in the third quarter of fiscal 2005. The implementation of this system is ongoing, with various additional phases planned for fiscal 2006 and 2007. The introduction of a new ERP system is part of the Company's response to the Sarbanes-Oxley Act (the "Act"). The Company determined that it was not practicable to comply with the control, documentation and testing requirements of Section 404 of the Act while operating on different, decentralized, obsolete systems at its various locations. As part of the implementation of the new system, documentation will be developed, and testing procedures initiated, in preparing for management's assessment and report on internal controls over financial reporting required by the Act for fiscal 2007. Although the Company is working diligently to ensure that the ERP system and related procedures will be adequately installed and successfully tested by September 30, 2007, there can be no assurance that all necessary procedures required by the Act will be completed by that date.

Controlled, Hazardous, and Environmentally Threatening Substances

Some of the Company's development and testing activities are subject to the Controlled Substances Act administered by the Drug Enforcement Agency ("DEA"), which strictly regulates all narcotic and habit-forming substances. The Company maintains restricted-access facilities and heightened control procedures for projects involving such substances due to the level of security and other controls required by the DEA. In addition, the Company is subject to other federal and state regulations concerning such matters as occupational safety and health and protection of the environment.

Our U.S. laboratories are subject to licensing and regulation under federal, state and local laws relating to hazard communication and employee right-to-know regulations, the handling and disposal of medical specimens and hazardous waste, as well as the safety and health of laboratory employees. All of our

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laboratories are subject to applicable federal and state laws and regulations relating to the storage and disposal of all laboratory specimens including the regulations of the Environmental Protection Agency, the Department of Transportation, the National Fire Protection Agency and the Resource Conservation and Recovery Act. Although we believe that the Company is currently in compliance in all material respects with such federal, state and local laws, failure to comply could subject the Company to denial of the right to conduct business, fines, criminal penalties and other enforcement actions.

The regulations of the U.S. Department of Transportation, the U.S. Public Health Service and the U.S. Postal Service apply to the surface and air transportation of laboratory specimens. The Company's laboratories also comply with the International Air Transport Association regulations which govern international shipments of laboratory specimens. Furthermore, when materials are sent to a foreign country, the transportation of such materials becomes subject to the laws, rules and regulations of such foreign country.

Safety

In addition to its comprehensive regulation of safety in the workplace, the Occupational Safety and Health Administration has established extensive requirements relating to workplace safety for health care employers whose workers may be exposed to blood-borne pathogens such as HIV and the hepatitis B virus. These regulations, among other things, require work practice controls, protective clothing and equipment, training, medical follow-up, vaccinations and other measures designed to minimize exposure to chemicals, and transmission of blood-borne and airborne pathogens. Furthermore, relevant employees of the Company receive initial and periodic training focusing on compliance with applicable hazardous materials regulations and health and safety guidelines.

HIPAA

The Department of Health and Human Services has promulgated final regulations under the Health Insurance Portability and Accountability Act of 1996 ("HIPAA") that govern the disclosure of confidential medical information in the United States. The Company has had a global privacy policy in place since January 2001, which includes a designated privacy officer, and believe that we are in compliance with the current EU (European Union) and HIPAA requirements. Nevertheless, we will continue to monitor our compliance with these new regulations and we intend to take appropriate steps to ensure compliance as these and other privacy regulations come into effect.

Product Liability and Insurance

The Company maintains product liability and professional errors and omissions liability insurance, providing approximately $6.0 million in coverage on a claims-made basis. Additionally, in certain circumstances the Company seeks to manage its liability risk through contractual provisions with clients requiring the Company to be indemnified by the client or covered by clients' product liability insurance policies. Also, in certain types of engagements the Company seeks to limit its contractual liability to clients to the amount of fees received by the Company. The contractual arrangements are subject to negotiation with clients, and the terms and scope of such indemnification, liability limitation and insurance coverage vary by client and project.

Research and Development

In fiscal 2005, 2004 and 2003 the Company spent $1.3 million, $1.1 million, and $1.3 million, respectively, on research and development. Separate from the Company's contract research services business, the Company maintains applications research and development to enhance its products business.

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Expenditures cover hardware and software engineering costs, laboratory supplies, animals, drugs/reagents, labor, prototype development and laboratory demonstrations of new products and applications for those products.

Hardware and software engineering and prototype development in fiscal 2005 continued to generate Culex®-related products. Laboratory demonstrations are published in peer-reviewed journals, scientific seminars or at scientific association meetings as promotional tools for existing and new products. Culex®-related products and demonstrations consumed most of our research and development dollars in fiscal 2005. The Company also makes small expenditures in novel research and development, some under partial grants.

Intellectual Property

The Company believes that its patents, trademarks, copyrights and other proprietary rights are important to its business and, accordingly, it actively seeks protection for those rights both in the United States and abroad. Where the Company deems it to be an appropriate course of action, it will vigorously prosecute patent infringements. The Company does not believe, however, that the loss of any one of its patents, trademarks, copyrights or other proprietary rights would be material to its consolidated revenues or earnings.

The Company currently holds six federally registered trademarks and has two pending federal trademark applications, as well as one copyright registration for software. The Company also maintains a small pool of issued and pending patents. Most of these patents are related to the Company's Culex® or in vivo product line. Of these patents, most are either issued or pending in the United States, although there are also patents issued and pending in the European Union and Japan. Although the Company believes that at least two of these patents are important to the Culex® product line, the success of the Culex® business is not dependent on the Company's intellectual property rights because the Company also generates client value through continuing client support, hardware and software upgrades, system reliability and accuracy. In addition to these formal intellectual property rights, the Company relies on trade secrets, unpatented know-how and continuing applications research which it seeks to protect through means of reasonable business procedures, such as confidentiality agreements. The Company believes that the greatest value that it generates for its clients comes from these trade secrets, know-how and applications research.

Raw Materials

There are no specialized raw materials that are particularly essential to the Company's business, and the Company has a variety of alternative suppliers for its essential components.

Employees

At September 30, 2005, the Company had 370 full-time employees. All employees enter into confidentiality agreements intended to protect the Company's proprietary information. The Company believes that its relations with its employees are good. None of the employees of the Company are represented by a labor union. The Company's performance depends on its ability to attract and retain qualified professional, scientific and technical staff. The level of competition among employers for skilled personnel is high. The Company believes that its employee benefit plans enhance employee morale, professional commitment and work productivity and provide an incentive for employees to remain with the Company.

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Executive Officers of the Registrant

The following information concerns the persons who served as the executive officers of the Company as of September 30, 2005. Except as indicated in the following paragraphs, the principal occupations of these persons has not changed in the past five years. Officers are elected annually at the annual meeting of the board of directors.

Peter T. Kissinger, Ph.D. founded the Company in 1974 and has served as its Chairman, President and Chief Executive Officer since 1974. He is also a part-time Professor of Chemistry at Purdue University, where he has been teaching since 1975. Dr. Kissinger has a Bachelor of Science degree in Analytical Chemistry from Union College and a Ph.D. in Analytical Chemistry from the University of North Carolina.

Dr. Kissinger is a highly recognized pioneer in hydrodynamic electroanalytical techniques for the neurosciences, modern liquid chromatography and in vivo methodology for drug metabolism. Dr. Kissinger has published over 220 scientific papers and has presented more than 400 invited lectures. He is a Fellow of the AAPS and the AAAS and was a finalist for Ernst & Young Entrepreneur of the Year Award ® in the Indiana Heartland region for 2001 and 2003. Dr. Kissinger is the husband of Candice B. Kissinger.

Ronald E. Shoup, Ph.D. serves as Chief Operating Officer of the Company's Contract Research Services and is Managing Director of BAS Analytics, Ltd. in the UK. His current responsibilities include directing operations at the Company's Contract Research Services sites. He joined the Company in 1980 as an applications chemist, became Research Director in 1983 and launched the Contract Research Services group within the Company in 1988. Dr. Shoup has a Bachelor of Science degree in Mathematics and Chemistry from Purdue University and then attended Michigan State and Purdue University for his Ph.D. in Analytical Chemistry.

Dr. Shoup has served on the editorial board of the Journal of Chromatography, participated in NIH Special study sections, and is a member of the external advisory board to the Purdue University Department of Chemistry. He has published over 40 scientific papers.

Michael R. Cox has been Vice President, Finance, Chief Financial Officer and Treasurer since April 2004. He was Vice President, Finance and CFO of Integrity Pharmaceutical Corporation, a private specialty pharmaceutical company, from October, 2003 until its acquisition and merger in March, 2004. Prior to that he was Senior Vice President, Finance of Intergen Company, a private biotech manufacturing and research products company, from 1997 until its acquisition in 2001, and continued with the acquirer, Serologicals Corporation, on special projects until joining Integrity. Prior to that, Mr. Cox held various executive positions in two environmental services firms and an investment firm. He was a partner in

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Touche Ross & Co., where he began his career after obtaining a BS in business administration from the University of North Carolina.

Edward M. Chait, Ph.D. has been Executive Vice President, Chief Scientific Officer since August, 2005. Prior to that, from August 2003, Dr. Chait served as the Chief Executive Officer of Spectral Genomics, Inc., a developer of products and services related to molecular genetics and diagnostics enabling the identification of the causal factors of disease at the genetic level. From 2001 to 2003, Dr. Chait served as the Chief Executive Officer of PharmaCore, Inc., a small-molecule drug discovery company providing molecular building blocks, custom organic synthesis and GMP services to biotechnology and pharmaceutical companies. From 1991 to 2001, Dr Chait was Senior Vice President in charge of Business Development for Intergen Company, a manufacturer of cell culture, diagnostic and research products. Since 2002, Dr. Chait has also served as an advisor to the Purdue Cancer Center, a National Cancer Center designated basic-research cancer center. From 1968 to 1991, Dr. Chait held positions of increasing responsibility in marketing and business development at DuPont in instrument and life science products. Dr. Chait has a Ph.D. in chemistry from Purdue.

Candice B. Kissinger currently devotes all of her time to branding, client relationship management, sales, product development, and managing installation and service for in vivo products and services, principally the Culex® APS. She was named Senior Vice President, Marketing in January 2000 and is currently Director of Research. From 1981 to 2000 she served as Vice President, International Sales and Marketing. Ms. Kissinger has a Bachelor of Science degree in Microbiology from Ohio Wesleyan University and a Master of Science degree in Food Science from the University of Massachusetts. Dr. Peter Kissinger is the husband of Ms. Kissinger. She has served as a director and Secretary of the Company since 1978.

Craig S. Bruntlett, Ph.D. has been Senior Vice President of International Sales since January 2000. From 1992 to 1999 he was Vice President, Electrochemical Products. From 1980 to 1990, Dr. Bruntlett was Director of New Products Development for the Company. Dr. Bruntlett has a Bachelor of Arts degree in Chemistry and Mathematics from St. Cloud State University in Minnesota and a Ph.D. in Chemistry from Purdue University.

Lina L. Reeves-Kerner has been Vice President, Human Resources since 1995 and is responsible for the administrative support functions of the Company, including shareholder relations, human resources and community relations. From 1980 to 1990, Ms. Reeves-Kerner served as an Administrative Assistant with the Company. Ms. Reeves-Kerner has a Bachelor of Science degree in Business Administration from Indiana Wesleyan University.

Michael P. Silvon, Ph.D. has been Vice President Planning and Development since March 1997, with responsibility for mergers and acquisitions, and investor relations. Dr. Silvon served as General Manager of BAS Evansville from 2000 through 2003 and directed its expansion. Prior to January 1997, Dr. Silvon was principal in his own consulting firm and Vice President Sales and Marketing at Hi-Port, Inc. in Houston, Texas. Before October 1993, Dr. Silvon was Regional Business Manager, Americas-Fine Chemicals for Zeneca, Inc. He has a Bachelor of Science in Chemistry from Loyola University of Chicago, a Master of Business Administration from Sacred Heart University and a Ph.D. in Chemistry from the University of Vermont.

The Company operates in the following locations all of which are owned by the Company, except as otherwise indicated:

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•              West Lafayette, IN: principal executive offices are located at 2701 Kent Avenue, West Lafayette, Indiana 47906, and constitutes multiple buildings with approximately 135,000 square feet of operations, manufacturing, and administrative space. Both the services segment and the products segment conduct operations at this facility. A new 20,000 square foot ADME preclinical research facility became fully functional in April, 2005. It is custom-designed to provide contract pharmacokinetic and ADME research services based on its Culex® Automated Pharmacology system. Both the new facility and the prior portion of the building have been financed by mortgages.

•              BAS Evansville occupies 10 buildings with roughly 100,000 square feet of operating and administrative space on 52 acres. Most of this site is engaged in preclinical toxicology testing of developmental drugs in animal models. A recent addition was financed by a mortgage.

•              BASi Clinical Research Unit (BASi Maryland) in Baltimore, Maryland occupies a seven story, 126,000 square foot historic building in downtown Baltimore. On January 5, 2005, this building was sold to a developer and the Company and the developer entered into a three-year lease back for approximately 85% of the space in the building. This site contains a 110 bed, three ward, Phase I Clinical Trials facility and a roughly 20,000 square foot analytical laboratory along with administrative offices committed to recruitment and enrollment of study participants, medical and clinical trials staff, data management, and later phase Clinical Trials Management. The Company intends to use the lease back period to develop its long-term space alternatives.

•              Bioanalytical Systems, Ltd., Warwickshire, UK contains the Company's contract services and instruments operations in roughly 12,000 square feet of leased space for laboratories, sales and technical support services in the United Kingdom.

•              BASi Northwest Laboratory is in McMinnville, Oregon, approximately 40 miles from Portland. The Company leases roughly 8,600 square feet of laboratory and administrative space, principally used for bioanalytical services.

The Company believes that its facilities are adequate for the Company's operations and that suitable additional space will be available if and when needed. The terms of any mortgages and leases for the above properties are detailed in Item 7 and Notes 4, 6 and 7 to the Notes to Consolidated Financial Statements.

Not applicable.

Not applicable.

PART II

You can find information regarding the market for the Company's common shares and related stockholder matters under the heading "Common Shares" in our 2005 Annual Report. That information is incorporated herein by reference.

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Equity Compensation Plan Information

The Company maintains stock option plans that allow for the granting of options to certain key employees and directors of the Company. The following table gives information about equity awards under the stock option plans of the Company:

(1) Includes option to purchase 25,000 shares at $4.57 granted April 1, 2004, 25,000 shares at $5.69 granted August 1, 2005. Each of these grants vest over one year and expire after 10 years.

For additional information regarding the Company's stock option plans approved by security holders, please see Note 9 to the Notes to Consolidated Financial Statements included in Item 8 of this report.

You can find Selected Financial Data for each of our five most recent fiscal years in our 2005 Annual Report under "Selected Consolidated Financial Data". That information is incorporated herein by reference.

Item 7.               Management's Discussion and Analysis of Financial Condition and Results of Operations.

This report contains statements that constitute forward looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Those statements appear in a number of places in this Report and may include statements regarding the intent, belief or current expectations of the Company or its management with respect to, but are not limited to (i) the Company's strategic plans; (ii) trends in the demand for the Company's products; (iii) trends in the industries that consume the Company's products; (iv) the Company's ability to refinance its debt; (v) the ability of the Company to develop new products; and (vi) the ability of the Company to make capital expenditures and finance operations. Readers are cautioned that any such forward looking statements are not guarantees of future performance and involve risks and uncertainties. Actual results may differ materially from those in the forward looking statements as a result of various factors, many of which are beyond the control of the company.

In addition, the Company has based these forward-looking statements on its current expectations and projections about future events. Although the Company believes that the assumptions on which the forward-looking statements contained herein are based are reasonable, any of those assumptions could prove to be inaccurate, and as a result, the forward-looking statements based upon those assumptions also could be incorrect. The following discussion and analysis should be read in conjunction with Selected Consolidated Financial Data and the Company's Consolidated Financial Statements and notes

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thereto included or incorporated by reference elsewhere in this Report. In addition to the historical information contained herein, the discussions in this Report may contain forward-looking statements that involve risks and uncertainties which are discussed in Exhibit 99 to this Form 10-K. The Company's actual results could differ materially from those discussed in the forward-looking statements.

Overview

The business of Bioanalytical Systems, Inc. is dependent on the level of pharmaceutical and biotech companies' efforts in new drug discovery and approval. Our services segment is the direct beneficiary of these efforts, through outsourcing by these companies of research work, and our products segment is the indirect beneficiary, as increased drug development leads to capital expansion providing opportunities to sell the equipment we produce and the consumable supplies we provide that support our products.

Developments within the industries we serve have a direct, and sometimes material, impact on our operations. Currently, many large pharmaceutical companies have major "block-buster" drugs that are nearing the end of their patent protections. This puts significant pressure on these companies both to develop new drugs with large market appeal, and to re-evaluate their cost structures and the time-to- market of their products. Contract research organizations ("CRO's") have benefited from these developments, as the pharmaceutical industry has turned to out-sourcing to both reduce fixed costs, and to increase the speed of research and data development necessary for new drug applications.

The number of significant drugs that have reached or are nearing the end of their patent protection has also benefited the generic drug industry. That sector of the drug industry has seen significant growth in the past decade, and, we believe, will continue to experience strong growth in the foreseeable future. Generic drug companies provide a significant source of new business for CRO's as they develop, test and manufacture their generic compounds.

A significant portion of innovation in the pharmaceutical industry is now being driven by biotech and small, venture capital funded, drug development companies. Many of these companies are "single-molecule" entities, whose success depends on one innovative compound. While several of the biotech companies have reached the status of major pharmaceuticals, the industry is still characterized by smaller entities. These developmental companies generally do not have the resources to perform much of the clinical research within their organizations, and are therefore dependent on the CRO industry for both their research and for guidance in preparing their FDA submissions. These companies have provided significant new opportunities for the CRO industry, including BASi. They do, however, provide challenges in selling, as they frequently have only one product in development, which causes CRO's to be unable to develop a flow of projects from a single company. These companies may expend all their available funds and cease operations prior to fully developing a product. Additionally, the funding of these companies is subject to investment market fluctuations, which change the risk profile and appetite of investors.

Although the past year has not seen large mergers in either the pharmaceutical or CRO industries, consolidation continues at a smaller pace in the CRO sector. We believe that consolidation of the CRO sector will continue to be a factor in our markets.

Research services are capital intensive. The investment in equipment and facilities to serve our markets is substantial and continuing. While our physical facilities are excellent to meet market needs for the near term, rapid changes in automation, precision, speed and technologies necessitate a constant investment in equipment and software to meet market demands. We are also impacted by the heightened regulatory environment and the need to improve our business infrastructure to support our increasingly diverse operations, which will necessitate additional capital investment. Our ability to generate capital to reinvest

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in our capabilities, both through operations and financial transactions, is critical to our success. While we are currently committed to fully utilizing recent additions to our capacity, sustained growth will require additional investment in future periods.

Results of Operations

The following table summarizes the consolidated statement of operations as a percentage of total revenues:

Year Ended September 30, 2005, Compared with Year Ended September 30, 2004

Total revenue for the year ended September 30, 2005 increased 14% to $42.4 million from $37.2 million for the year ended September 30, 2004. Service revenue increased to $33.0 million for the year ended September 30, 2005 from $24.9 million for the year ended September 30, 2004, an increase of 33%. This increase came from all domestic locations, as we had strong growth in our bioanalytical laboratories, our toxicology facility, and our clinical research unit. Our laboratory in the UK had a decline in revenues. Our revenues from products declined in the current year to $9.4 million, a 23% decline from last year's product revenues of $12.2 million. This decline was across our product line, following a particularly strong year in product sales in fiscal 2004. In the fiscal year ended September 30, 2005, we did not have any major new adopters of our Culex® system, whereas the prior fiscal year's sales had been strongly influenced by some major buying programs by our customers. Our sales of Culex® supplies, on the other hand, increased due to the larger installed base of Culex® users. Inflation in prices did not have a material impact on revenue increases.

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Costs of revenue increased 6% to $27.1 million for the year ended September 30, 2005 from $25.6 million for the year ended September 30, 2004. This increase of $1.5 million was due to increases in the cost of service revenue as a result of the significant increase in the volume of our services business in fiscal 2005, partially offset by a reduction in the cost of product revenue resulting from the the decrease in the number of products sold and a change in product mix. Cost of service revenue as a percentage of service revenues decreased due to the higher utilization of capacity in our Services segment. A significant portion of our costs in our Services segment are relatively fixed, which results in increasing margins as we increase our utilization of facilities. Costs of revenue for the Company's products segment increased to 36.7% as a percentage of product revenue for the year ended September 30, 2005 from 34.9% of product revenue for the year ended September 30, 2004. This small change was the result of lower utilization of manufacturing capacity.

Selling expenses for the year ended September 30, 2005 decreased by 4% to $2.6 million from $2.7 million during the year ended September 30, 2004, due to decreased headcount in sales. Research and development expenses for the year ended September 30, 2005 increased 18% to $1.3 million from $1.1 million for the year ended September 30, 2004. This increase is primarily due to additional research activities around our Culex® product line.

General and administrative expenses for the year ended September 30, 2005 increased 36% to $10.2 million from $7.5 million for the year ended September 30, 2004. Approximately $1.7 million of the increase was in our Baltimore clinical unit, where we had approximately $700,000 of additional personnel expense as a result of increased business, more expensive new hires and compensation increases, and $800,000 of occupancy cost relating to the sale and leaseback of our building. In our West Lafayette facility, we commissioned approximately 19,000 square feet of new research and laboratory space, causing approximately $500,000 of additional depreciation and other space related costs. The remainder of the increase was related to compensation increases, increases in liability, property and health care coverages, and higher energy costs.

Other income (expense), net, was $(969,000) in the year ended September 30, 2005 as compared to $(832,000) in the year ended September 30, 2004, as a result of increased interest expense. We reduced our average outstanding borrowings from the second fiscal quarter due to the sale of our Baltimore building, but added $1.1 million of capital leases to finance new laboratory equipment and had higher interest rates on our floating rate revolving credit facility.

The Company's effective tax rate was 135% for fiscal 2005 as a result of foreign taxable losses which reduced our pre-tax income by approximately $800,000, without corresponding tax benefit. The prior year's tax benefit was the result of a U.S. loss which we could carry back against prior year's income, and foreign income for which foreign tax loss carryforwards were available.

As a result of the above, the Company earned $0.00 per share in fiscal 2005, both basic and diluted, compared to a net loss fiscal 2004 of $0.04 per share, both basic and diluted.

Year Ended September 30, 2004, Compared with Year Ended September 30, 2003

Total revenue for the year ended September 30, 2004 increased 25% to $37.2 million from $29.8 million for the year ended September 30, 2003. Service revenue increased to $24.9 million for the year ended September 30, 2004 from $20.0 million for the year ended September 30, 2003. The inclusion of two acquired businesses for the entire year in fiscal 2004, compared to the inclusion from the date of acquisition in the prior year, caused a 9% increase in the year-to-year revenues. The other 16% of revenue growth came from increased sales at all operating locations, except West Lafayette research services, which had a decline. These increases were the result of increased sales efforts in the Baltimore

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and Evansville locations, and improvement in our facilities from recent capital expenditures. Product revenue increased to $12.2 million for the year ended September 30, 2004 from $9.9 million for the year ended September 30, 2003, primarily due to sales of the Culex® Automated Blood Sampling System. The increase in Culex® sales was a result of continuing acceptance of the technology by new customers, as well as strong re-orders by existing customers. Inflation in prices did not have a material impact on sales increases.

Costs of revenue increased 32% to $25.6 million for the year ended September 30, 2004 from $19.4 million for the year ended September 30, 2003. This increase of $6.2 million was due to the inclusion of the acquired businesses mentioned in the revenue discussion and the costs of additional revenues. Cost of revenue as a percentage of service revenues increased due to the lower utilization of capacity of the acquired businesses – costs of idle capacity are charged to cost of service revenue. Costs of revenue for the Company's products segment decreased to 35% as a percentage of product revenue for the year ended September 30, 2004 from 39% of product revenue for the year ended September 30, 2003, as a result of product sales growth being driven by Culex® sales, which command higher margins than the Company's older product lines.

Selling expenses for the year ended September 30, 2004 decreased by 7% to $2.7 million from $2.9 million during the year ended September 30, 2003, due to decreased headcount in sales. Research and development expenses, which are net of grant reimbursements, for the year ended September 30, 2004 decreased 15% to $1.1 million from $1.3 million for the year ended September 30, 2003. The decrease of $227,000 is primarily due to reducing the number of research projects in the current year.

General and administrative expenses, for the year ended September 30, 2004 increased 39% to $7.5 million from $5.4 million for the year ended September 30, 2003, as a result of the acquired business mentioned above. The Company also incurred $500,000 of non-recurring consulting expenses necessitated by turnover in the Company's finance department for the first six months of fiscal 2004. The Company utilized a contract chief accounting officer and additional financial consultants to compensate for the resignation of both the chief financial officer and chief accounting officer.

Other income (expense), net, was $(832,285) in the year ended September 30, 2004 as compared to $(592,178) in the year ended September 30, 2003, as a result of the increase in interest expense from $710,000 to $943,000 due to increased borrowings for the acquisitions and additional construction of facilities, and a non-recurring gain from sale of an excess facility of $363,000 in fiscal 2003.

The Company's effective tax rate was a benefit of 66% for 2004 as a result of having a U.S. taxable loss that can be carried back for refunds against prior years' taxes, coupled with profitable operations in the United Kingdom, where the Company is utilizing loss carryforwards to offset taxable income. The Company has tax net operating loss carryforwards for its subsidiaries in the United Kingdom. Such carryforwards, which have an indefinite life, are available to offset taxable income generated by those subsidiaries as provided by United Kingdom tax regulations. The prior year's tax rate was the result of taxable U.S. income with a foreign loss generating no offsetting benefit.

As a result of the above, the Company lost $0.04 per share in fiscal 2004, both basic and diluted, compared to net income in fiscal 2003 of $0.02 per share, both basic and diluted.

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Liquidity and Capital Resources

Comparative Cash Flow Analysis

Since its inception, the Company's principal sources of cash have been cash flow generated from operations and funds received from bank borrowings and other financings. At September 30, 2005, the Company had cash and cash equivalents of $1.3 million compared to $0.8 million at September 30, 2004.

The Company's net cash used by operating activities was $0.5 million for the year ended September 30, 2005. Cash used by operations during the year ended September 30, 2005 consisted of net loss of $101,000, net non-cash charges of $2.8 million and net cash used of $3.2 million related to changes in operating assets and liabilities. The most significant items affecting the change in operating assets and liabilities was an increase in accounts receivable of $6.6 million, offset by increases in customer advances and payables $4.4 million. The increases in accounts receivable and customer advances are the result of higher service revenue activity at the end of fiscal 2005 over 2004. The Company had a decrease in deferred income taxes as a result of the turnaround of earlier year's higher depreciation for tax than for financial statements.

Cash provided by investing activities increased to $3.6 million for the year ended September 30, 2005 compared to cash used of $3.5 million and $4.7 million for the years ended September 30, 2004 and 2003, respectively. During the current fiscal year, the Company sold and leased back its building in Baltimore, compared to the prior two years when the Company was investing in expanding facilities and acquisitions. This transaction resulted in net cash to the Company of $5.9 million, which helped finance the $2.3 million investment in capital assets in the current year.

Cash used by financing activities for the year ended September 30, 2005 was $2.8 million, compared to cash provided of $0.3 million and $2.4 million respectively for fiscal 2004 and 2003. In the current year, the Company utilized the proceeds from the sale of the Baltimore building to reduce outstanding borrowings under its revolving credit facility, plus payments on debt incurred with acquisitions and lease payments on capital leases.

In January, 2005 the Company sold and leased back its facility in Baltimore, Maryland. The sales price was $6.5 million, and the Company leased back much of the space through December, 2007. After transaction expenses, the Company generated $5.9 million in cash from this transaction, which was used to reduce outstanding debt and increase working capital.

Capital Resources

Total expenditures by the Company for property and equipment were $2.3 million (funded by proceeds from the sale of the Baltimore building), $3.6 million (funded by funds generated from operations, long-term debt and revolving credit) and $5.3 million (funded by long-term debt), in fiscal 2005, 2004 and 2003, respectively. Expenditures made in connection with the expansion of the Company's operating facilities in West Lafayette and Evansville, Indiana and in the United Kingdom, physical plant improvements in Baltimore (2004), and purchase or upgrade of laboratory equipment account for the largest portions of these expenditures in prior years. The decline in capital expenditures in fiscal 2005 is the result of the completion of expansion programs. Capital investments for the purchase of additional laboratory equipment are driven by anticipated increases in research services to be provided by the Company, and by the replacement or upgrading of the Company's equipment. Additionally, the Company funded $1.1 million of laboratory equipment in fiscal 2005 through capital leases. Although the Company may consider strategic acquisition opportunities it does not intend to aggressively pursue additional acquisitions until the Company is fully utilizing existing capacity.

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During fiscal 2003 and 2004, the Company expanded facilities at its preclinical site in Evansville, Indiana at a total cost of $3.5 million. During 2003 through April 2005, the Company expanded facilities at its site in West Lafayette, Indiana at a cost of $3.5 million. The Company obtained financing for these construction projects with a bank (discussed below).

On December 13, 2002, the Company acquired LCR, a privately held company with headquarters in Walnut Creek, California and contract research laboratory in McMinnville, Oregon. The Company purchased all of the outstanding shares of LCR for approximately $2.0 million. The purchase price consisted of approximately $200,000 in cash and $1.8 million in 10% subordinated notes maturing on October 1, 2007. The holders of the notes have the option to require the Company to repay up to 20% of the outstanding principal balance of the notes on each October 1 prior to maturity, commencing October 1, 2004. These payments were made in both 2004 and 2005.

On June 30, 2003, the Company completed its acquisition of PKLB through the exchange of approximately 228,857 shares of the Company common stock valued at approximately $1.2 million for all of the outstanding common stock and Class B preferred stock of PKLB, and the issuance of $4.0 million of 6% convertible notes payable due 2008 for all of PKLB's Class A redeemable preferred stock. The notes are convertible at $16 per share into shares of the Company's common stock (no principal payments or conversions have occurred as of December 31, 2005). The Company paid cash aggregating approximately $1.5 million representing acquisition costs and cash advances made to PKLB from June 2002 through May 2003.

The Company has a revolving credit facility of $6 million with a commercial bank and three mortgage notes payable to another bank aggregating $8.9 million. Borrowings under these credit agreements are collateralized by substantially all assets related to the Company's operations and all common stock of the Company's United States subsidiaries and 65% of the common stock of its non-United States subsidiaries, and the assignment of a life insurance policy on the Company's Chairman and CEO. Under the terms of these credit agreements, the Company has agreed to restrict advances to subsidiaries, limit additional indebtedness and capital expenditures as well as to comply with certain financial covenants outlined in the borrowing agreements. These credit agreements contain cross-default provisions. Details of each debt issue are discussed below.

The maximum amount available under the terms of the Company's revolving line of credit is $6 million with outstanding borrowings limited to the borrowing base as defined in the agreement. As of September 30, 2005 the outstanding balance on this line of credit was $920,000. Interest accrues monthly on the outstanding balance at the bank's prime rate to prime rate plus up to 25 basis points or at the Eurodollar rate plus 250 to 300 basis points, depending in each case upon the ratio of the Company's interest-bearing indebtedness (less subordinated debt) to EBITDA, as elected by the Company. As of September 30, 2005 interest on the entire outstanding balance was based on the prime rate of 6.75%. The Company pays a fee equal to 25 basis points on the unused portion of the line of credit. Borrowings under the facility are based on a lending formula utilizing the Company's accounts receivable and inventory. At September 30, 2005 the Company had $2.3 million available under the facility after offsetting outstanding borrowings and a $2.8 million outstanding letter of credit which secures the Baltimore lease (this letter of credit reduces to $2.0 million in January 2006). The Company's line of credit is a revolver against which the Company applies cash receipts, and draws cash as needed. The line of credit is committed until January, 2008.

The Company has three outstanding mortgages with a commercial bank on its facilities in West Lafayette and Evansville, Indiana, with essentially the same terms, which total $8.9 million. The Company has fixed the interest rate on the mortgages at 5.69% through June, 2007. See Note 7 to the Consolidated Financial Statements.

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The following table summarizes the cash payments under the Company's contractual term debt and lease obligations at September 30, 2005 and the effect such obligations are expected to have on its liquidity and cash flows in future periods (amounts in thousands). The table does not include the Company's revolving credit facility..

The Company expects to spend approximately $2.5 million in fiscal 2006 on capital assets, primarily laboratory equipment. As of September 30, 2005, no firm commitments had been made.

The covenants in the Company's credit agreement requiring the maintenance of certain ratios of interest-bearing indebtedness (not including subordinated debt) to EBITDA and net cash flow to debt servicing requirements may restrict the amount the Company can borrow to fund future operations, acquisitions and capital expenditures.

Based on its current business activities, the Company believes cash generated from its operations and amounts available under its existing credit facilities will be sufficient to fund the Company's working capital and capital expenditure requirements for the foreseeable future and through September 30, 2006.

Inflation

The Company believes that inflation has not had a material adverse effect on its business, operations or financial condition.

Critical Accounting Policies

"Management's Discussion and Analysis of Financial Condition and Results of Operations" and "Liquidity and Capital Resources" discusses the consolidated financial statements of the Company, which have been prepared in accordance with accounting principles generally accepted in the United States. Preparation of these financial statements requires management to make judgments and estimates that affect the reported amounts of assets, liabilities, revenues and expenses, and the disclosures of contingent assets and liabilities. Certain significant accounting policies applied in the preparation of the financial statements require management to make difficult, subjective or complex judgments, and are considered critical accounting policies by the Company. The Company has identified the following areas as critical accounting policies.

Revenue Recognition

The majority of the Company's service contracts involve the processing of bioanalytical samples for pharmaceutical companies. These contracts generally provide for a fixed fee for each assay method developed or sample processed and revenue is recognized under the specific performance method of accounting. Under the specific performance method, revenue and related direct costs are recognized when services are performed. The Company's other service contracts generally consist of preclinical and clinical trial studies for pharmaceutical companies. Service revenue is recognized based on the ratio of

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direct costs incurred to total estimated direct costs under the proportional performance method of accounting. Losses on contracts are provided in the period in which the loss becomes determinable. Revisions in profit estimates are reflected on a cumulative basis in the period in which such revisions become known. The establishment of contract prices and total contract costs involves estimates made by the Company at the inception of the contract period. These estimates could change during the term of the contract which could impact the revenue and costs reported in the consolidated financial statements. Projected losses on contracts are provided for in their entirety when known. Revisions to estimates have not been material to the Company. Service contract fees received upon acceptance are deferred and classified within customer advances, until earned. Unbilled revenues represent revenues earned under contracts in advance of billings.

The Company's product revenue is derived primarily from sales of equipment utilized for scientific research. Revenue from equipment not requiring installation, testing or training is recognized upon shipment to customers. One Company product includes internally developed software and requires installation, testing and training, which occur concurrently. Revenue is recognized upon completion of the installation, testing and training.

Impairment of Long-Lived Assets, Including Goodwill

Long lived assets, such as property and equipment, and purchased intangibles subject to amortization, are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability of assets to be held and used is measured by a comparison of the carrying amount of an asset to estimated undiscounted future cash flows expected to be generated by the asset. If the carrying amount of an asset exceeds its estimated future cash flows, an impairment charge is recognized by the amount by which the carrying amount of the asset exceeds the fair value of the asset. Assets to be disposed of would be separately presented in the balance sheet and reported at the lower of the carrying amount or fair value less costs to sell, and are no longer depreciated. The assets and liabilities of a disposal group classified as held for sale would be presented separately in the appropriate asset and liability sections of the balance sheet.

Goodwill and other indefinite lived intangible assets, collectively referred to as "indefinite lived assets", are tested annually for impairment, and are tested for impairment more frequently if events and circumstances indicate that the asset might be impaired. An impairment loss is recognized to the extent that the carrying amount exceeds the asset's fair value. This determination is made at the reporting unit level and consists of two steps. First, the Company determines the fair value of a reporting unit and compares it to its carrying amount. Second, if the carrying amount of a reporting unit exceeds its fair value, an impairment loss is recognized for any excess of the carrying amount of the reporting unit's indefinite lived assets over the implied fair value of those indefinite lived assets. The implied fair value of the indefinite lived assets is determined by allocating the fair value of the reporting unit in a manner similar to a purchase price allocation, in accordance with FASB Statement No. 141, Business Combinations. The residual fair value after this allocation is the implied fair value of the reporting unit's indefinite lived assets.

Of the $1,251,000 of intangible assets acquired from LCR, $180,000 was assigned to methodologies, $359,000 to the customer relationships, and $712,000 to the regulated facility/FDA compliant laboratory site. The Company estimated the economic useful life of the acquired methodologies and customer relationships to be 5 years with amortization recognized using the straight-line method. The Company has determined that the acquired regulated facility/FDA compliant laboratory site is an indefinite-lived intangible not subject to amortization.

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Of the $1,691,000 in value of the intangible assets acquired from PKLB, $575,000 in value was assigned to methodologies, $562,000 in value to subject relationships, and $555,000 in value to the regulated facility/FDA compliant laboratory site. The Company estimated the economic useful life of the acquired methodologies and subject relationships to be 5 years with amortization recognized using the straight-line method. The Company has determined that the acquired regulated facility/FDA compliant laboratory site is an indefinite-lived intangible not subject to amortization.

The Company's estimates of fair values and allocation of the purchase prices were determined with the analyses and assistance of an independent valuation firm.

Income Tax Accounting

Income taxes are accounted for in accordance with SFAS No. 109, "Accounting for Income Taxes." SFAS No. 109 requires recognition of deferred tax liabilities and assets for the expected future tax consequences of events that have been included in the financial statements or tax returns. Under this method, deferred tax assets and liabilities are determined based on the difference between the financial statement and tax bases of assets and liabilities. These deferred taxes are measured by applying the provisions of tax laws expected to be in effect at the time the differences reverse.

The Company recognizes deferred tax assets in its balance sheet which typically represent items deducted currently in the financial statements that will be deducted in future periods in tax returns. In accordance with SFAS No. 109, a valuation allowance is recorded against these deferred tax assets to reduce the total deferred tax assets to an amount that will, more likely than not, be realized in future periods. The valuation allowance is based, in part, on management's estimate of future taxable income, the expected utilization of tax loss carry forwards and the expiration dates of tax loss carry forwards. Significant assumptions are used in developing the analysis of future taxable income for purposes of determining the valuation allowance for deferred tax assets which, in the opinion of management, are reasonable under the circumstances.

The Company has an accumulated net deficit in its UK subsidiaries, consequently, United States deferred tax liabilities on such earnings have not been recorded.

New Accounting Pronouncements

The following two pronouncement will be adopted by the Company for periods beginning October 1, 2005.

In November, 2004, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards ("SFAS") Number 151 dealing with inventory costs. The statement clarifies what costs can be included in inventory, requiring that absorption factors be based on normal capacities of manufacturing facilities and excess capacity be expensed as incurred. The Company's current costing methodology substantially conforms with the new standard. The Company does not expect a material change in costing methods from adoption of this statement.

In December, 2004, SFAS 123 (Revised) was issued dealing with Share-Based Payments. In general, this statement requires that companies compute the fair value of options and other stock based employee incentives, and charge this value to operations over the period earned, generally the vesting period. The only instruments we use that are governed by this statement are stock options for Directors and employees. The impact on reported results of adoption of this statement, required for interim and annual periods for years beginning after June 15, 2005, is presented in note 1 (k) to the Consolidated Financial Statements. The impact on operations in future periods will be determined by amortizing the remaining value of our currently outstanding options, plus the value imputed to future option grants using those methods. Based on currently outstanding options, the impact on net earnings for fiscal 2006 will be to reduce net earnings by approximately $175,000. There is no impact on cash flow.

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The Company's primary market risk exposure with regard to financial instruments is the changes in interest rates. The Revolving Credit Agreement between the Company and National City Bank bears interest at a rate of either the bank's prime rate plus 0 to 25 basis points, or at LIBOR plus 250 to 300 basis points, depending in each case upon the ratio of the Company's interest-bearing indebtedness (less subordinated debt) to EBITDA, at the Company's option. Historically, the Company has not used derivative financial instruments to manage exposure to interest rate changes. The Company estimates that a hypothetical 10% adverse change in interest rates would not materially affect the consolidated operating results of the Company. While the Company's revolving line of credit is at variable rates, the Company's real estate mortgages are fixed at 5.69% interest until June 2007.

The Company operates internationally and is, therefore, subject to potentially adverse movements in foreign currency rates change. The effect of movements in the exchange rates was not material to the consolidated operating results of the Company in fiscal years 2005, 2004 and 2003. The Company estimates that a hypothetical 10% adverse change in foreign currency exchange rates would not materially affect the consolidated operating results of the Company.

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REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

The Board of Directors

Bioanalytical Systems, Inc.:

We have audited the accompanying consolidated balance sheets of Bioanalytical Systems, Inc. and subsidiaries as of September 30, 2005 and 2004, and the related consolidated statements of operations, shareholders' equity and comprehensive income (loss), and cash flows for the years then ended. These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Bioanalytical Systems, Inc. and subsidiaries as of September 30, 2005 and 2004, and the results of their operations and their cash flows for the years then ended in conformity with U.S. generally accepted accounting principles.

/s/ KPMG LLP

Indianapolis, Indiana

January 7, 2006

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