Precipio, Inc. - Quarter Report: 2005 September (Form 10-Q)

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SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

(Mark One)

For the Quarterly Period Ended September 30, 2005

Or

For the transition period from              to             

Commission file number: 000-30975

TRANSGENOMIC, INC.

(Exact name of registrant as specified in its charter)

(402) 452-5400

(Registrant’s telephone number, including area code)

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 and (2) has been subject to such filing requirements for the past 90 days.    Yes  x    No  ¨

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Securities Exchange Act of 1934)    Yes  ¨    No  x

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Securities Exchange Act of 1934)    Yes  ¨    No  x

As of November 14, 2005, the number of shares of common stock outstanding was 49,172,079.

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TRANSGENOMIC INC.

INDEX

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TRANSGENOMIC INC.

PART I. FINANCIAL INFORMATION

Item 1. Financial Statements

UNAUDITED CONDENSED CONSOLIDATED BALANCE SHEETS

(Dollars in thousands except per share data)

See notes to consolidated financial statements.

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TRANSGENOMIC INC.

UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(Dollars in thousands except per share data)

See notes to consolidated financial statements.

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TRANSGENOMIC INC.

UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(Dollars in thousands except per share data)

See notes to consolidated financial statements.

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NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

(Dollars in thousands except per share data)

A. CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

The accompanying unaudited condensed consolidated financial statements of Transgenomic, Inc. and Subsidiaries (the “Company”) have been prepared by the Company pursuant to the rules and regulations of the Securities and Exchange Commission. Certain information and disclosures normally included in annual financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been omitted pursuant to such rules and regulations. In the opinion of management of the Company, all adjustments (consisting of only normal and recurring items) have been made to present fairly the financial positions, the results of operations and cash flows for the periods presented.

The results of operations for the three and nine months ended September 30, 2005 and 2004 are not necessarily indicative of the results to be expected for the full year.

Although the Company believes that the disclosures are adequate to make the information presented not misleading, these financial statements should be read in conjunction with the consolidated financial statements that are included in the Company’s annual report on Form 10-K for the year ended December 31, 2004, as amended.

As discussed in Note L, the Company completed a private placement of additional common stock and warrants subsequent to September 30, 2005 which allowed it to repay outstanding indebtedness to Laurus Master Funds Ltd. (“Laurus”) and provided $5,374 in additional working capital. While we believe that existing sources of liquidity are sufficient to meet expected cash needs through 2006, we have experienced recurring net losses and have historically relied upon cash flows from investing and financing activities to offset significant cash outflows from operating activities. To the extent necessary, the Company’s management believes that they can manage costs and expenses at reduced levels to conserve working capital. The need for any such cost and expense reductions would likely delay implementation of the Company’s business plan. Ultimately, we must achieve sufficient revenues in order to generate positive net earnings and cash flows from operations.

Business Description

The Company develops, manufactures and sells innovative products for the analysis, synthesis and purification of nucleic acids through two operating segments, BioSystems and Nucleic Acids.

The BioSystems operating segment develops, assembles, manufactures and markets versatile products and provides analytical services to the medical research, clinical and pharmaceutical markets for use in genetic variation analysis. Products and services are sold through a direct sales force in the United States and throughout much of Western Europe. For the rest of the world, products and services are sold through more than 25 dealers and distributors located in those local markets. Net sales from this operating segment are categorized as bioinstruments, bioconsumables and Discovery Services.

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TRANSGENOMIC INC.

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (Continued)

(Dollars in thousands except per share data)

The Nucleic Acids operating segment develops, manufactures and markets chemical building blocks for nucleic acid synthesis to biotechnology, pharmaceutical, oligonucleotide synthesis companies and research institutions throughout the world. These products are produced primarily in this operating segment’s only facility in Glasgow, Scotland. Prior to November 11, 2004, this operating segment also manufactured synthesized segments of large-scale, GMP nucleic acids (known as oligonucleotides) in a facility in Boulder, Colorado. On November 11, 2004, the assets associated with this facility were sold to an unaffiliated, third party. As a result, the Nucleic Acids operating segment no longer manufactures and sells these specialized oligonucleotides. A substantial portion of this operating segment’s revenues during 2005 and 2004 have been derived from one customer.

Principles of Consolidation.

The condensed consolidated financial statements include the accounts of Transgenomic, Inc. and its wholly-owned subsidiaries. All intercompany balances and transactions have been eliminated in consolidation.

Use of Estimates.

The preparation of consolidated financial statements requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. In particular, estimates of the valuation of long-term inventory are subject to considerable estimation error due to the inherent uncertainty in projecting sales of this product over a period of years. In addition, estimates and assumptions associated with the determination of fair value of certain assets and related impairments, and the determination of goodwill impairments require considerable judgment by management. Actual results could differ from the estimates and assumptions used in preparing these financial statements.

Cash and Cash Equivalents.

For purposes of reporting cash flows, cash and cash equivalents include cash and temporary investments with original maturities at acquisition of three months or less.

Accounts Receivable.

Accounts receivable are shown net of allowance for doubtful accounts. The following is a summary of activity for the allowance for doubtful accounts.

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TRANSGENOMIC INC.

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (Continued)

(Dollars in thousands except per share data)

Revenue Recognition.

Revenue on the sales of products is recognized in accordance with the terms of the sales arrangement. Such recognition is based on receipt of an unconditional customer order and transfer of title and risk of ownership to the customer, typically upon shipment of the product. Our sales terms do not provide for the right of return unless the product is damaged or defective. Revenues from certain services associated with our analytical instruments, to be performed subsequent to shipment of the products, is deferred and recognized when the services are provided. Such services, mainly limited to installation and training services that are not essential to the functionality of the instruments, typically are performed in a timely manner subsequent to shipment of the instrument. The Company also enters into various service contracts that cover installed WAVE systems. These contracts cover specific time periods and revenue associated with these contracts is deferred and recognized over the service period. At September 30, 2005 and December 31, 2004, deferred revenue associated with the Company’s service contracts was approximately $1,600 and $1,432 respectively, and is included in “accrued expenses” in the accompanying unaudited consolidated balance sheets.

During the nine months ended September 30, 2004, the Company recognized approximately $646 of product sales under bill-and-hold arrangements. Under these arrangements, the customer had accepted title and risk of ownership to the product, but had requested that the Company store the product on behalf of the customer, in a rented freezer, until the nine months ended September 30, 2004. There were no sales under bill-and-hold arrangements recognized during the nine months ended September 30, 2005.

Stock Based Compensation.

The Company accounts for its employee stock option grants under the provisions of Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees, which utilizes the intrinsic value method. Accordingly, compensation cost for stock options is measured as the excess, if any, of the fair market value of the Company’s common stock at the date of grant over the stock option exercise price. Stock option grants to non-employees are accounted for using the fair value method of accounting in accordance with SFAS No. 123, Accounting for Stock-Based Compensation, using the Black-Scholes model.

The following table illustrates the effect on net loss and loss per share if the Company had applied the fair value recognition provisions of SFAS No. 123 to stock based employee compensation.

The weighted average fair value of options granted during the nine months ended September 30, 2005 and 2004 was $0.63 per share and $1.34 per share, respectively. The fair value of each stock option granted is estimated at the date of grant using the Black-Scholes option pricing model with the following weighted average assumptions for options granted during the nine months ended September 30, 2005 and 2004: no common stock dividends; risk-free interest rates of 4.14% to 4.79%; 95% volatility in 2005 and 85% in 2004; and an expected option life of 3 years. At September 30, 2005, the weighted average remaining contractual life of options outstanding was 5.5 years.

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TRANSGENOMIC INC.

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (Continued)

(Dollars in thousands except per share data)

Translation of Foreign Currency.

Financial statements of subsidiaries outside the U.S. are measured using the local currency as the functional currency. The adjustments to translate those amounts into U.S. dollars are accumulated in a separate account in stockholders’ equity and are included in other comprehensive income. Foreign currency transaction gains or losses resulting from changes in currency exchange rates are included in the determination of net income(loss). Foreign currency transaction adjustments reduced operating expenses by approximately $191 and $263 during the three months ended September 30, 2005 and 2004, respectively. Foreign currency transaction adjustments increased operating expenses by approximately $237 during the nine months ended September 30, 2005 and reduced operating expenses by approximately $135 during the nine months ended September 30, 2004.

Earnings or Loss Per Share.

Basic earnings or loss per share is calculated based on the weighted-average number of common shares outstanding during each period. Diluted earnings or loss per share includes shares issuable upon exercise of outstanding stock options and warrants or conversion of convertible notes, where dilutive. For all periods presented, basic and diluted weighted average shares outstanding and loss per share are identical, since all potentially dilutive securities are antidilutive. Potentially dilutive securities consist of stock options and warrants representing 5,5541,015 and 1,159,421 shares of common stock, respectively, at September 30, 2005,. Additionally, the Company’s gross indebtedness to Laurus totaling $8,263 at September 30, 2005 is convertible into the Company’s common stock at $1.00 per share, which was the closing price of the Company’s common stock on September 30, 2005. As described in Note L, this indebtedness was repaid subsequent to September 30, 2005.

Recently Issued Accounting Pronouncements

On December 16, 2004, the Financial Accounting Standards Board (FASB) issued SFAS No. 123R, “Share-Based Payment”. SFAS No.123R addresses the accounting for share-based payment transactions in which an enterprise receives employee services in exchange for (a) equity instruments of the enterprise or (b) liabilities that are based on the fair value of the enterprise’s equity instruments or that may be settled by the issuance of such equity instruments. SFAS No. 123R eliminates the ability to account for share-based compensation transactions using Accounting Principles Board Opinion No. 25 and generally requires that such transactions be accounted for using a fair-value-based method. The Company expects to adopt this standard on January 1, 2006. The Company is currently assessing the final impact of this standard on its financial position, results of operations or cash flows. This assessment includes evaluating option valuation methodologies and assumptions as well as potential changes to compensation strategies.

On November 24, 2004, the FASB issued SFAS No. 151, “Inventory Costs” – an amendment of ARB No. 43. SFAS No. 151 requires idle facility expenses, freight, handling costs, and wasted material (spoilage) costs to be excluded from the cost of inventory and expensed when incurred. It also requires that allocation of fixed production overhead be based on the normal capacity of the production facilities. SFAS No. 151 will be effective for the Company on January 1, 2006. The Company is currently assessing the final impact of this standard on its financial position, results of operations or cash flows.

B. INVENTORIES

Inventories consisted of the following:

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TRANSGENOMIC INC.

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (Continued)

(Dollars in thousands except per share data)

The Nucleic Acids operating segment inventory at September 30, 2005 and December 31, 2004 consisted primarily of chemical building blocks for synthetic nucleic acids (know as phosphoramadites) and the raw materials to produce phosphoramadites which are used and produced at the Company’s facility in Glasgow, Scotland. As of September 30, 2005, the Company has classified a portion of this inventory as a long-term other asset based on its existing sales forecasts for these products.

The Company periodically evaluates its inventory of phosphoramadites to determine whether they continue to meet quality and other specifications and over what time period such products are expected to be sold. Product that does not meet quality and other specifications can generally be re-worked to enhance purity. Costs to purify such product and related yield losses are expensed as incurred.

C. GOODWILL

Goodwill totaled $638 at September 30, 2005 and December 31, 2004 and related entirely to the BioSystems operating segment. The following summarizes goodwill adjustments for the nine months ended September 30, 2005 and 2004.

The Company recorded a charge of $9,865 during the nine months ended September 30, 2004 related to the impairment of goodwill associated with the Nucleic Acids operating segment. The amount of the impairment charges was based, in part, on an independent valuation performed by an unaffiliated valuation firm. The charge resulted from an interim period impairment test performed during the second quarter of 2004.

The interim period impairment test became necessary after the Company’s Board of Directors directed management during the second quarter of 2004 to explore strategic alternatives for the Nucleic Acids operating segment. This process included significant due diligence by management, third-party advisors and prospective independent buyers and other interested parties. Information obtained through this process indicated that it was more likely than not that the assets associated with the Nucleic Acids operating segment were impaired.

The Company also recorded a charge of $2,100 during the nine months ended September 30, 2004 related to the impairment of property and equipment associated with the Nucleic Acids operating segment.

D. OTHER ASSETS

Finite lived intangible assets and other assets consisted of the following:

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TRANSGENOMIC INC.

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (Continued)

(Dollars in thousands except per share data)

During the three months ended September 30, 2005, management determined that certain international patent pursuits were no longer consistent with the Company’s strategic plan. Accordingly, the Company recorded an impairment charge of $247 related to the abandonment of such pursuits.

Amortization expense for intangible assets was approximately $222 and $242 during the three months ended September 30, 2005 and 2004, respectively, and $717 and $728 for the nine months ended September 30, 2005 and 2004, respectively. Amortization expense for intangible assets is expected to be approximately $297 for the remainder of 2005, $342 in 2006, $331 in 2007, $62 in 2008, $134 in 2009, $134 in 2010 and $26 in 2011.

E. DEBT

Debt consisted of the following:

Funds available under the Credit Line are determined by a borrowing base equal to 90% of eligible accounts receivable balances plus up to $1,000 related to inventory balances.

On August 31, 2004, Laurus agreed to extend a then existing borrowing base waiver, defer certain payments due under the Term Note and reduce the interest rate on both of the Laurus Loans to 0% for any day the closing sale price of the Company’s common stock is at or above $1.75 per share. In return, the Company lowered the conversion price on each of the Laurus Loans to $1.00 per share and issued a warrant to Laurus covering an additional 400,000 common shares at an exercise price of $1.25 per share. The closing price of the Company’s common stock on August 31, 2004 was $1.20 per share.

The August 31, 2004 Laurus modifications were treated as extinguishments for financial reporting purposes since the change in present value of expected cash flows between the original and modified agreements is greater than 10%. As such, the Company recorded a loss on extinguishment of debt of $2,859 at August 31, 2004 reflecting the difference between (i) the recorded amount of debt, net of related discounts, of $7,427 and (ii) the fair value of

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TRANSGENOMIC INC.

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (Continued)

(Dollars in thousands except per share data)

the new debt instrument of $10,287 plus the fair value of the new warrants of $111. The difference between the fair value of the new debt of $10,287 and the face value of the debt of $8,572 represents a premium, which will be reflected as a reduction of interest expense over the life of the new debt.

On March 18, 2005, Laurus agreed to further extend the waiver of the borrowing base until March 31, 2006. In connection with this extension, the Company agreed to allow Laurus to convert $1,879 of the outstanding principal balance under the Credit Line into 3,600,000 shares of its common stock at $0.52 per share. In addition, on March 24, 2005 the Company agreed to allow Laurus to convert $650 of the outstanding principal balance of the Term Note into 1,250,000 shares of common stock at $0.52 per share. Laurus agreed to apply this Term Note conversion against substantially all remaining 2005 scheduled principal payments on such loan. The closing market price of the Company’s common stock the day before each of these conversions was $0.58 per share. No other provisions of the Company’s Credit Line or Term Note (collectively, the “Laurus Loans”) were modified, including the $1.00 conversion price for remaining debt. In conjunction with these conversions, the Company accelerated amortization of $409 of related debt premiums and discounts and recorded a charge of $1,365 related to the fair value of incremental shares received by Laurus.

Interest expense consisted of the following:

As of September 30, 2005 principal repayments under the Term Note are scheduled as follows: $0 for the remainder of 2005, $875 in 2006, and $800 in 2007. As describe in Note L, the Company repaid the entire principal balance and terminated the Laurus Loans subsequent to September 30, 2005 with the proceeds from the private placement. Accordingly, the Company no longer has any borrowings which require scheduled principal and interest payments.

F. COMMITMENTS AND CONTINGENCIES

The Company is subject to a number of claims of various amounts, which arise out of the normal course of business. In the opinion of management, the disposition of claims currently pending will not have a material adverse effect on the Company’s financial position, results of operations or cash flows.

The Company leases certain equipment, vehicles and operating facilities. The Company’s leases related to its operating facilities currently expire on various dates through 2010. At September 30, 2005, the future minimum lease payments required under non-cancelable lease provisions were approximately $359 for the remainder of 2005, $1,233 in 2006, $443 in 2007, $189 in 2008, $193 in 2009, and $167 in 2010. Rent expense related to all operating leases was approximately $306 and $521 for the three months ended September 30, 2005 and 2004, respectively, and $968 and $1,689 for the nine months ended September 30, 2005 and 2004, respectively.

At September 30, 2005, the Company had firm commitments totaling $872 to purchase components used in WAVE Systems.

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TRANSGENOMIC INC.

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (Continued)

(Dollars in thousands except per share data)

G. INCOME TAXES

Income tax recorded during the three and nine months ended September 30, 2005 and 2004 related to income taxes in states, foreign countries and other local jurisdictions offset by refunds received.

Due to the Company’s cumulative losses, expected losses in future years and inability to utilize any additional losses as carrybacks, the Company has not provided for an income tax benefit during the three and nine months ended September 30, 2005 or 2004 based on management’s determination that it was more likely than not that such benefits would not be realized. The Company will continue to assess the recoverability of deferred tax assets and the related valuation allowance. To the extent the Company begins to generate taxable income in future periods and it determines that such valuation allowance is no longer required, the tax benefit of the remaining deferred tax assets will be recognized at such time. As of September 30, 2005 and December 31, 2004, the Company’s deferred tax assets were offset by a valuation allowance of approximately $41,227 and $38,287, respectively.

H. STOCKHOLDERS’ EQUITY

The following shows changes to the components of stockholders’ equity during the nine months ended September 30, 2005.

During the three and nine months ended September 30, 2005, the Company issued zero and 4,900,000 shares, respectively, of common stock in conjunction with conversions under the Laurus Loans.

I. STOCK OPTIONS

Options representing 951,000 and 1,123,500 shares of the Company’s common stock were granted during the three and nine months ended September 30, 2005, respectively, with weighted average exercise prices of $1.03 per share and $1.04 per share, respectively. The following table summarizes activity under the 1997 Stock Option Plan during the nine months ended September 30, 2005.

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TRANSGENOMIC INC.

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (Continued)

(Dollars in thousands except per share data)

The following table summarizes information about options outstanding as of September 30, 2005: