Analysis of Financial Condition and Results of Operations" included elsewhere in this Annual Report on Form 10-K.

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

Overview

        We provide innovative products and services for the synthesis, purification and analysis of nucleic acids. Our products and services include automated instrument systems, associated consumables, nucleic acid chemical building blocks, nucleic acid synthesis products, novel chemistry development for nucleic acids, process development services and genetic variation discovery services. Our technologies center around three core competencies: separation chemistries, enzymology, and nucleic acid chemistries. We develop, assemble, manufacture and market our products and services$0.5 million to the life sciences industry to be used in research focused on molecular genetics of humans and other organisms. Such research could lead to development of new diagnostics and therapeutics. Our products can be used to analyze DNA or RNA at the molecular level, amplify, separate, and isolate nucleic acid fragments of particular interest and synthesize conventional or chemically-modified nucleic acid molecules. These capabilities are central to research seeking to discover and understand variations in the genetic code, the relationship of these variations to disease and, ultimately, to develop diagnostics and therapeutics based on this understanding. Our business plan is to participate in the value chain associated with these activities by providing key technology, tools, consumables, and biochemical reagents to those entities engaged in basic biomedical research and the development of diagnostics and therapeutic agents.

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        Prior to 2002 the Company was managed and operated on a fully integrated basis in one operating segment. During 2002, management determined it was appropriate to evaluate the Company's operations based upon the nature of the products and services provided. Accordingly, the Company has determined that it operates in two reportable segments, BioSystems and Nucleic Acids. Operations for these segments are evaluated based upon specific identification of revenues and expenses associated with the business activities resulting in a segment operating income. Expenses that cannot be directly identified to an operating activity or are considered corporate overhead are not allocated to the segments in arriving at operating income for the segment.

        The BioSystems operating segment generates revenue from the sale of automated instrument systems and associated consumable products and services. This segments products are based upon two of the Company's three core competencies, separations chemistries and enzymology. Specifically, this segment's main products are the WAVE system, related bioconsumables and research services.

        The Nucleic Acids operating segment generates revenue from the sale of products and services based upon all three of the Company's core competencies, nucleic acid chemistries, separations chemistries and enzymology. Specifically, this segments main products are nucleic acid building blocks or "phosphoramidites", oligonucleotides, fluorescent markers, dyes and associated reagents and novel chemistry and process development services.

        During the fiscal year ended December 31, 2002, we sold over 185 WAVE Systems to major academic and government research centers and commercial and biopharmaceutical companies. Since the WAVE System product introduction in 1997 we have sold over 900 instruments to customers in over 30 countries. Revenues from the sale of consumable and nucleic acid products increased during 2002 and represented approximately 50% of our net sales as compared to approximately 40% in 2001. We expect that over the next five years, sales from consumable and nucleic acid products will increase both in amount and as a percentage of our net sales.

        We have incurred significant losses resulting principally from costs incurred in research and development and selling, general and administrative costs associated with our operations. At December 31, 2002, we had an accumulated deficit of $49.8 million. We expect to continue to incur substantial research and development and selling, general and administrative costs.

Critical Accounting Policies

        Accounting policies used in the preparation of the consolidated financial statements may involve the use of management judgments and estimates. Certain of the Company's accounting policies are considered critical as they are both important to the portrayal of the Company's financial statements and they require significant or complex judgments on the part of management. Our judgments and estimates are based on experience and assumptions that we believe are reasonable under the circumstances. Further, we evaluate our judgments and estimates from time to time as circumstances change. Actual financial results based on judgment or estimates may vary under different assumptions or circumstances. The following are certain critical accounting policies that may involve the use of judgment or estimates.

        Allowance for Doubtful Accounts    Accounts receivable are shown net of an allowance for doubtful accounts. In determining an allowance for doubtful accounts, we consider the following.

•

The age of the accounts receivable,



•

Customer credit history,



•

Customer financial information,



•

Reasons for non-payment, and



•

Our knowledge of the customer.

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        If our customers' financial condition were to deteriorate, resulting in a change in their ability to make payment, additional allowances may be required.

        Inventories.    Inventories are stated at the lower of cost or market. Cost is computed using standard costs for finished goods and average or latest actual cost for raw materials and work in process.

        Depreciation and Amortization of Long-Lived Assets.    The Company's long-lived assets consist primarily of property, plant and equipment, goodwill, patents, intellectual property and capitalized software development costs. We believe the useful lives we assigned to these assets are reasonable. If our assumptions about these assets change as a result of events or circumstances and we believe the assets may have declined in value we may record impairment charges resulting in lower profits. Property and equipment are carried at cost. Depreciation and amortization are computed using straight-line and accelerated methods over the estimated useful lives of the related assets ranging from 3 to 15 years. The Company capitalizes the external and in-house legal costs and filing fees associated with obtaining patents on its new discoveries and amortizes these costs using the straight-line method over the shorter of the legal life of the patent or its economic life, generally 17 years, beginning on the date the patent is issued. Intellectual property, which is purchased technology, is recorded at cost and is amortized over its estimated useful life.

        Impairment of Long-Lived Assets.    The Company evaluates goodwill for impairment on an annual basis. The Company assesses the recoverability of long-lived assets whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. These computations utilize judgments and assumptions inherent in management's estimate of future undiscounted and discounted cash flows to determine recoverability of these assets. If management's assumptions about these assets were to change as a result of events or circumstances, the Company may be required to record an impairment loss.

        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.

Results of Operations

Years Ended December 31, 2002 and 2001

        Net Sales.    Net sales decreased 2% to $37.6 million in 2002 from $38.5 million in 2001. Sales in our BioSystems operating segment decreased 14% to $24.2 million in 2002 from $28.0 million in 2001. Total revenues from sales of WAVE Systems decreased 19% to $18.8 million in 2002 from $23.1 million in 2001. Bioconsumable product sales included in this operating segment increased 10% to $5.4 million in 2002 from $4.9 million in 2001. Sales in our Nucleic Acid operating segment increased 28% to $13.3 million in 2002 from $10.4 million in 2001. Sales of WAVE systems declined mainly due to lower sales volumes to our commercial and industrial customer base and our North American customer base. Systems sold to our commercial and industrial customers accounted for approximately 6% of unit sales in 2002 as compared to approximately 34% in 2001. Systems sold in North America accounted for approximately 25% of unit sales in 2002 as compared to approximately 40% in 2001. Sales of WAVE related consumable products increased as the installed base of WAVE Systems has increased and as researchers begin to use them more extensively in place of other methods of DNA analysis. The increase in nucleic acid product sales is attributable to the timing of our acquisition of Annovis, Inc. in May 2001. Part of our business strategy for

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2003 is to position ourselves as a unique partner to biopharmaceutical and pharmaceutical companies in the early stages of their efforts to develop genomic-based diagnostics and therapeutics. As part of this strategy we are focusing our sales efforts on large consumers of our Synthetic Nucleic Acid products who are willing to commit to long-term supply agreements. While we expect to see increased sales of these products based upon this strategy, we also may see varying demand depending largely on the success of the biopharmaceutical and pharmaceutical companies on which we are targeting our sales efforts and thus we may see large variations in revenue flows for these products.

        Cost of Goods Sold.    Cost of goods sold increased 14% to $19.6 million in 2002 from $17.2 million in 2001, representing 52% of net sales in 2002 and 45% of net sales in 2001. Both total cost of goods sold and cost of goods sold as a percent of sales increased year over year due to the mix of products sold. BioSystems sales margins improved year over year mainly due to higher average selling prices per system resulting from greater sales of our higher margin high throughput WAVE system. The average sales price per instrument increased approximately 10% in 2002. The higher margins on our BioSystems products were offset by lower margins in our nucleic acid operating segment. Currently our nucleic acid products, which have become a larger percentage of our total revenues, are sold at lower margins compared to our WAVE systems. The margins in our Nucleic Acids operating segment are lower due to bulk sales of nucleic acid building block products and higher manufacturing costs due largely to our plant expansion efforts in Glasgow, Scotland and Boulder, Colorado. In 2003 we anticipate that our cost of goods sold for our BioSystems products will remain within historical averages or improve slightly. Overall we anticipate that our cost of goods sold will be consistent with 2002 or slightly higher. This is the result of the under utilization of our new oligonucleotide production facility in Boulder, Colorado. After 2003, we anticipate that the overall cost of goods sold percentage will improve as we refine our systems configurations potentially reducing material costs, improve upon production methods in our Nucleic Acid operating segment which currently result in higher overall manufacturing costs and as product revenues increase thereby spreading our fixed production costs over a larger revenue base.

        Selling, General and Administrative Expenses.    Selling, general and administrative expenses increased 12% to $24.1 million in 2002 from $21.5 million in 2001. This increase is the result of additional personnel and personnel-related expenses, bad debt expense and the write-off of a portion of notes receivable. These increases were offset by a reduction in goodwill amortization and foreign currency exchange rate gains. Combined these items accounted for over 90% of the total increase. Direct personnel expenses increased due to our expanded employee base during 2002. Bad debt expense increased as we felt it was appropriate to increase the allowance for bad debt given our increased levels of accounts receivable. The decrease in goodwill amortization is the result of our adoption of Statement of Financial Accounting Standards (SFAS) No. 142,Goodwill and Other Intangible Assets. Total selling, general and administrative expenses represented 64% of net sales in 2002 versus 56% of net sales in 2001. During the fourth quarter of 2002 management formulated a restructuring plan for the Company and executed a significant portion of the plan. The plan included employee terminations, office closures, the termination of collaborations and write-offs of intellectual property. It is expected that, as a result of the restructuring, our total operating expenses will be initially decreased by 20% to 25% from 2002 levels.

        Research and Development Expenses.    Research and development expenses increased 30% to $12.2 million in 2002 from $9.4 million in 2001. Research and development expenses consist of salaries and related personnel costs of researchers and software developers, material costs for prototypes and test units, legal expenses relating to intellectual property research and application development activities, testing and enhancement of our products, and amortization of intellectual property. We expense our research and development costs in the year in which they are incurred with the exception of certain capitalized software development costs. The increase in these expenses is attributable to increased personnel and personnel related expenses resulting from an expanded employee base during 2002, depreciation, amortization and supplies offset by increased amounts of capitalized software expenses related to the WAVE system operating software. Combined these items accounted for over 90% of the total increase. Total research and

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development expenses represented 32% of net sales in 2002 versus 24% of net sales in 2001. During the fourth quarter of 2002 management formulated a restructuring plan for the Company and executed a significant portion of the plan. The plan included employee terminations, office closures, the termination of collaborations and write-offs of intellectual property. It is expected that, as a result of the restructuring, our total operating expenses will be initially decreased by 20% to 25% from 2002 levels.

        Stock Based Compensation.    Stock based compensation expense was $131,000 in 2002 as compared to $139,000 in 2001. This expense represents the amortization of deferred compensation related to stock options issued.

        Restructuring Charges.    During the fourth quarter of 2002 management formulated and executed a significant portion of a restructuring plan. The plan was developed to reduce expenses thereby better aligning the Company's expense structure with current business prospects. The plan included employee terminations, office closures, termination of collaborations and write-offs of abandoned intellectual property. Specifically, in the fourth quarter of 2002 the Company notified approximately 60 employees of their termination, notified landlords of our intent to close four facilities and reduce our space commitment under lease at two other facilities, terminated certain consulting and collaboration agreements and abandoned certain patents. As a result of the plan $3.3 million in restructuring charges were recorded and are included in operating expenses. These charges consisted of approximately $800,000 of employee severance costs, $1.2 million in office closure related costs, $400,000 of collaboration and other agreement termination charges and $900,000 in write-offs of abandoned intellectual property. Approximately 45% of the total charges were for non-cash items. We expect that, as a result of the restructuring, our total operating expenses will be initially decreased by 20% to 25% from 2002 levels. Additional restructuring charges totaling between $500,000 and $700,000 are expected in the first half of 2003.

        Other Income (Expense).    Other income and expense, which consists mainly of net interest income and expense, decreased to income of $437,000 in 2002 from income of $2.4 million in 2001. Interest income for the year was $626,000 as compared to $2.5 million in 2001. Interest expense for the year was $62,000 as compared to $58,000 in 2001. The decrease in interest income is a result of declining interest rates on investments and reductions in our short-term investment balances. We expect interest income to decline in 2003 as short-term interest rates are expected to continue to be low and as we continue to use cash in our operating and investing activities. Additionally, interest expense will increase in 2003 due to the long-term debt obtained by the Company during 2002 and the recently committed line of credit.

        Income Taxes.    No income tax benefit was recorded in 2002 or 2001. No further tax benefits are being recorded due to our cumulative losses in recent years, expected losses in future years and the uncertainty as to whether we will be able to utilize any additional losses as carrybacks. We will continue to assess the recoverability of deferred tax assets and the related valuation allowance. We expect to continue to incur losses and expect to continue to provide valuation allowances against deferred tax assets. To the extent we begin to generate income in future years and it is determined that such valuation allowance is no longer required, the tax benefit of the remaining deferred tax assets will be recognized. Income tax expense in 2002 was $105,000 while in 2001 income tax expense was $24,000. During 2002 the Company recorded current tax expense related to its Japan branch operations and certain state taxes. Our deferred tax assets as of December 31, 2002 were $23.2 million and were offset by a valuation allowance of $23.2 million. Our deferred tax assets as of December 31, 2001 were $14.9 million and were offset by a valuation allowance of $14.9 million. As of December 31, 2002, we had federal net operating loss carryforwards of approximately $60.3 million. We also had federal research and development tax credit carryforwards of approximately $0.9 million. The net operating loss and credit carryforwards will expire at various dates from 2008 through 2022, if not utilized. We also had state income tax loss carryforwards of $22.2 million at December 31, 2002. These carryforwards will also expire at various dates beginning in 2008 if not utilized.

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Years Ended December 31, 2001 and 2000

        Net Sales.    Net sales increased 49% to $38.5 million in 2001 from $25.9 million in 2000. Total revenues from sales of WAVE® Systems increased 25% to $23.5 million in 2001 from $18.8 million in 2000. Consumable product sales and other revenue increased to $15.0 million in 2001 from $4.9 million in 2000. Most of the increase in consumable sales and other revenue came from our Synthetic Nucleic Acid products, obtained through our acquisition of Annovis, Inc. in May 2001, which accounted for approximately 64% of our consumable product sales and other revenue. Additionally, WAVE related consumable products revenue increased approximately 32% to $3.1 million in 2001 from $2.1 million in 2000. Sales of WAVE related consumable products increased as the installed base of WAVE® Systems has increased and as researchers begin to use them more extensively in place of other methods of DNA analysis. Sales of our non-life sciences instrument products were $2.2 million in 2000. There were no sales in 2001 as a result of our divestiture of this product line effective April 1, 2000.

        Cost of Goods Sold.    Cost of goods sold increased 34% to $17.2 million in 2001 from $12.8 million in 2000, representing 45% of net sales in 2001 and 49% of net sales in 2000. Cost of goods sold as a percent of sales improved year over year due to improved margins on our WAVE systems sales offset by the lower margin bulk sales of our Synthetic Nucleic Acid products. Systems sales margins improved due to lower combined material and manufacturing costs for our life science instruments, higher average selling prices per systems and the sale of our lower margin non-life sciences instrument product line in 2000. The average sales price per instrument increased approximately 5% in 2001. The improved margins in systems sales were offset by a lower margin on consumable sales. The consumable sales margin was lower due mainly to bulk sale pricing discounts.

        Selling, General and Administrative Expenses.    Selling, general and administrative expenses increased 53% to $21.5 million in 2001 from $14.0 million in 2000. This increase is the result of additional personnel and personnel-related expenses and depreciation. The average selling, general and administrative personnel counts increased 32% to 131 in 2001 from 99 in 2000. This personnel increase was due largely to the acquisition of Annovis. Direct personnel expenses and increased travel and travel related expenses associated with the activities of our expanded staff accounted for approximately 37% of the total increase. Increased rent and depreciation expense associated with investments in offices and equipment supporting our expanded staff accounted for approximately 34% of the total increase. Total selling, general and administrative expenses represented 56% of net sales in 2001 versus 54% of net sales in 2000.

        Research and Development Expenses.    Research and development expenses increased 23% to $9.4 million in 2001 from $7.7 million in 2000. Research and development expenses consist of salaries and related personnel costs of researchers and software developers, material costs for prototypes and test units, legal expenses relating to intellectual property research and application development activities, testing and enhancement of our products, and amortization of intellectual property. We expense our research and development costs in the year in which they are incurred with the exception of certain capitalized software development costs. The increase in these expenses is attributable to increased personnel and personnel related expenses and professional services fees associated with the expanded activities of the staff. The average research and development personnel count increased 27% to 73 in 2001 from 57 in 2000. This increase in personnel was due largely to the acquisition of Annovis. Salaries, payroll taxes and benefits accounted for approximately 49% of the total increase. We supplement the expanded activities of our staff through the engagement of external consultants. Increased professional services fees accounted for approximately 51% of the total increase in research and development expenses. Total research and development expenses represented 30% of net sales in 2000 versus 24% of net sales in 2001.

        Stock Based Compensation.    Stock based compensation expense was $139,000 in 2001 as compared to $861,000 in 2000. Stock based compensation expense was higher in 2000 as we accelerated the vesting of 71,700 options in connection with the sale of our non-life sciences instrument product line. Former

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employees who were associated with our non-life sciences product line held these options. The acceleration resulted in the recording of $600,000 of stock based compensation expense in the first quarter of 2000.

        Gain on Sale of Product Line.    Effective April 1, 2000 we sold the assets related to our non-life sciences instrument product line to enable us to focus our business plan on the genomics segment of the life sciences industry. The assets were sold for a total adjusted purchase price of $5.65 million plus reimbursement by the buyer of approximately $400,000 of expenses paid by us since March 31, 2000 in connection with this product line. At the date of the transaction the gain to be recognized on the sale of the assets was deferred until we received all proceeds from the buyer. All such proceeds were received on December 29, 2000 and a gain on the sale of $784,000, before taxes, was recognized.

        Other Income (Expense).    Other income and expense, which consists mainly of net interest income and expense, increased to income of $2.4 million in 2001 from income of $212,000 in 2000. Interest expense for the year was $58,000 as compared to $1.8 million in 2000. During 2000 we carried a large amount of debt that was either paid or converted into common stock subsequent to our initial public offering in July 2000. As a result of the elimination of debt from our balance sheet we incurred little interest expense in 2001. Interest income for the year was $2.5 million as compared to $2.0 million in 2000. The increase in interest income is a result of the investment of the net proceeds from our initial public offering. Interest income on investments during 2001 was negatively impacted by the significant decline in short-term interest rates

        Income Taxes.    Income tax expense in 2001 was $24,000 as compared to $180,000 in 2000. The expense recorded in 2000 relates to the recognized gain on the sale of the assets related to our non-life sciences product line. Income tax expense in 2001 is related to our sales branch in Japan. Our deferred tax assets as of December 31, 2001 were $14.9 million and were offset by a valuation allowance of $14.9 million. Our deferred tax assets as of December 31, 2000 were $7.6 million and were offset by a valuation allowance of $7.6 million. No tax benefit related to our net operating losses is being recorded due to our cumulative losses in recent years, expected losses in the future and the uncertainty as to whether we will be able to utilize any additional losses as carryforwards. We will continue to assess the recoverability of deferred tax assets and the related valuation allowance. We expect to continue to incur losses and expect to continue to provide valuation allowances against deferred tax assets. To the extent we begin to generate income in the future and it is determined that such valuation allowance is no longer required, the tax benefit of the remaining deferred tax assets will be recognized. As of December 31, 2001, we had federal net operating loss carryforwards of approximately $38.0 million. We also had federal research and development tax credit carryforwards of approximately $0.7 million. The net operating loss and credit carryforwards will expire at various dates from 2008 through 2021, if not utilized. We also had state income tax loss carryforwards of $15.4 million at December 31, 2001. These carryforwards will also expire at various dates beginning in 2008 if not utilized.

Liquidity and Capital Resources

        We have experienced net losses and negative cash flows from operations during the past three years. As a result, we had an accumulated deficit of $49.8 million as of December 31, 2002. As of December 31, 2002 and 2001, we had approximately $9.7 million and $19.6 million, respectively, in cash and cash equivalents. In addition, as of December 31, 2002 and 2001, we had approximately $3.6 million and $23.9 million in short-term investments for total cash and short-term investments of approximately $13.3 million and $43.5 million, respectively.

        During 2002 our major cash expenditures were the funding of our operations that resulted in an operating loss and capital projects. A total of approximately $30.2 million of cash and investments was used with approximately $17.9 million used to fund our operations and $11.5 million for capital projects. Operating activities were funded through existing cash while capital projects were funded through existing cash, a long-term mortgage loan and an operating lease line of credit. Major capital projects during the

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year included facility build-out, expansion and improvement at our two nucleic acid production facilities in Boulder, Colorado and Glasgow, Scotland. The Boulder facility project is designed to bring on line a cGMP (Good Manufacturing Practices) facility for the synthesis of oligonucleotides. This facility began non-GMP production operations during the first quarter of 2003 and is expected to begin cGMP production in the second quarter of 2003. The Glasgow facility project, which produces nucleic acid building blocks, included 2 main objectives, the upgrading of equipment and processes at the current production facility and the opening of a new facility that will include significant capacity expansion along with further equipment and process improvements. The current production facility improvements were completed during the year and the first production line, or pilot line, in the new facility is expected to be completed in the first half of 2003.

        Our operating activities resulted in net outflows of $17.9 million in 2002, $11.1 million in 2001 and $4.7 million in 2000. The operating cash outflows for these periods resulted mainly from our operating losses. Significant investments in research and development and sales and marketing contributed to the operating losses. The operating cash outflows for 2002 are significantly higher than those in the prior year due in large part to increased operating losses and increased inventory balances offset by a reduction in accounts receivable and an increase in accounts payable. Inventory balances increased as raw materials, work in process and finished goods inventory related to our specialty chemicals consumable products were increased as we continue to expand production capabilities and plan for production needs.

        Net cash provided by investing activities was $5.9 million in 2002 as compared to cash used of $9.4 million for 2001 and $22.2 million in 2000. The investing cash flow in 2002 is due primarily to the net transfer of short-term investment funds to cash offset by investment in property, plant and equipment. Cash used in investing activities in 2001 was due primarily to investments in property, plant and equipment and cash used in the acquisition of Annovis, Inc. Cash used in investing activities in 2000 was due primarily to the net transfer of cash to short-term investments and investment in property, plant and equipment. During 2003 we expect to continue to make significant investments in property, plant and equipment. Our capital expenditures budget for 2003 is approximately $8.4 million and includes expenditures for the completion of our facility expansion projects in Glasgow, Scotland, and Boulder, Colorado and for general facility and equipment improvements. Additional expansion projects for the Glasgow and Boulder production facilities may be incurred over the next 2 to 3 years as business demand dictates.

        Net cash provided by financing activities was $1.7 million in 2002, $1.9 million for 2001 and $64.9 million in 2000. The financing cash inflows in 2002 were the result of proceeds from long-term debt and the sale of common stock through the exercise of warrant and options offset by the purchase of treasury stock. The financing cash inflows in 2001 were the result of proceeds from the sale of common stock through the exercise of warrant and options offset by the repayment of acquired company debt. The financing cash inflows in 2000 were the result of our initial public offering offset by the repayment of bank debt and our purchase of treasury stock. Our initial public offering and subsequent sales of common stock for the exercise of warrants and options resulted in cash inflow, net of expenses, of approximately $72.7 million. The repayment of debt resulted in cash outflow of approximately $5.2 million and the purchase of treasury stock resulted in cash outflow of approximately $2.7 million.

        As of December 31, 2002, we did not have any significant contractual purchase obligations. We are party to a number of lease agreements mainly for office, research and development and production facilities. Such lease agreements expire at various dates through 2007. At December 31, 2002, the future minimum lease payments required under noncancellable lease provisions are approximately $2.9 million in 2003; $2.6 million in 2004; $2.2 million in 2005; $1.4 million in 2006; and a total of approximately $700,000 in rental payments for the year 2007.

        In March 2003 the Company entered into a loan commitment agreement with a financial institution for up to a $5.0 million secured line of credit. Collateral for the line consists of qualified accounts receivable balances. Funds available under the line are equal to 80% of eligible accounts receivable

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balances. Management expects to finalize the line of credit agreement in the second quarter of 2003. The proposed term of the agreement is 1 year carrying a variable interest rate of 2.25% over prime.

        We expect to devote substantial capital resources to continue our research and development efforts, to expand our marketing and sales and customer support activities, and for other general corporate activities. Our capital requirements for operations depend on a number of factors, including the level of our research and development activities, market acceptance of our products and services, the resources we devote to developing and supporting our products and services, normal capital expenditures and other factors. The restructuring plan developed in 2002 is expected to reduce our operating expenses and thereby reduce the cash needed to fund our operations until such time as we become cash flow positive. Capital expenditures for production expansion projects have been planned in phases. It is our intention to initiate the phased expansions when we have identified specific business opportunities that would require such expansion. We may elect to advance these phases ahead of the business opportunities if we can obtain additional financing on favorable terms. We are currently investigating various financing vehicles for these projects.

        In fiscal year 2003, current financial and cash flow projections indicate that we expect to use approximately $14.0 million in cash to fund further operating losses and our capital expenditures budget of approximately $8.4 million. The current capital expenditures budget mainly relates to the completion of the current projects in Boulder and Glasgow during the first half of 2003. We expect to meet this total cash need from existing cash as of December 31, 2002 of $13.3 million, additional cash generated from operations during 2003 and funds available to us under our new $5.0 million credit facility expected to be available during the second quarter of 2003. Current financial and cash flow projections indicate that operating cash is expected to turn positive during the fourth quarter of 2003. These projections may or may not be realized based upon actual operating results and project requirements, thus, during or after this period, if our existing cash and short-term investments, cash generated by operations and available borrowings under credit agreements is insufficient to satisfy our liquidity requirement, we may need to sell additional equity or debt securities, or obtain additional credit arrangements. We are currently pursuing additional financing of up to $5.0 million beyond the committed line of credit. We feel that such additional financing will be secured in 2003. However, we cannot assure you that any financing arrangement will be available in amounts or on terms acceptable to us.

Impact of Inflation

        We do not believe that price inflation had a material adverse effect on our financial condition or results of operations during the periods presented.

Recent Account Pronouncements

        Effective January 1, 2002, we adopted Statement of Financial Accounting Standard (SFAS) No. 142,Goodwill and Other Intangible Assets. SFAS No. 142 establishes new guidelines for accounting for goodwill and other intangible assets and provides that goodwill and other intangible assets with indefinite lives will not be amortized, but will be evaluated for impairment annually. The provisions of SFAS No. 142 require the completion of a transitional impairment test within six months of adoption, with any impairment treated as a cumulative effect of a change in accounting principle. The Company has performed the transitional goodwill impairment test during the second quarter of 2002 and determined that no impairment exists at the time of adoption of SFAS No. 142. The Company also completed its annual impairment test during the fourth quarter of 2002 and determined that no impairment existed at the time of the annual test.

        In August 2001, the Financial Accounting Standards Board (FASB) issued SFAS No. 143,Accounting For Asset Retirement Obligations. SFAS No. 143 requires the Company to record the fair value of a liability for an asset retirement obligation in the period in which it is incurred and is effective for the Company's

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fiscal year beginning January 1, 2003. Management is in the process of evaluating the impact, if any, this standard will have on the Company's consolidated financial statements.

        In July 2002, the FASB issued SFAS No. 146,Accounting for Costs Associated with Exit or Disposal Activities. SFAS No. 146 addresses the accounting and reporting related to exit or disposal activities and is effective for the Company beginning January 1, 2003. The Company believes the adoption of this standard will not have a significant impact on the financial statements of the Company.

        In November 2002, the FASB issued FASB Interpretation (FIN) No. 45,Guarantor's Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others. FIN No. 45 clarifies that a guarantor is required to recognize, at the inception of a guarantee, a liability for the fair value of the obligation undertaken in issuing certain guarantees. FIN No. 45 also expands the disclosures to be made by a guarantor in its financial statements about its obligations under certain guarantees that it has issued. The recognition provisions are applicable on a prospective basis to guarantees issued or modified after December 31, 2002. Management believes that FIN No. 45 will not have a significant impact on the Company's Consolidated Financial Statements.

Foreign Currency Rate Fluctuations

        Historically, approximately 50% of our net sales have been to customers in the United States. While we do sell products in many foreign countries, most of these sales are completed by our wholly-owned subsidiaries, Transgenomic, LTD., or Cruachem, LTD., and are made in their operating currency British pounds sterling, or the Euro. Results of operations for the Company's foreign subsidiary are translated using the average exchange rate during the period. Assets and liabilities are translated at the exchange rate in effect on the balance sheet dates. To further limit our exposure to exchange rate risk all sales quotes issued by Transgenomic, Ltd. are based upon the United States dollar pricing converted at prevailing exchange rates at the time of the quote. Additionally, such quotes will have short expiration dates. As a result, although we are subject to exchange rate risk, management feels we do not have a material exposure to foreign currency rate fluctuations at this time.

Item 7A.    Quantitative and Qualitative Disclosures About Market Risk.

        The primary objective of our investment activities is to preserve principal while at the same time maximizing the income we receive from our investments without significantly increasing risk. Some of the securities that we invest in may have market risk. This means that a change in prevailing interest rates may cause the market value of the investment to fluctuate. For example, if we hold a security that was issued with a fixed interest rate at the then-prevailing rate and the prevailing interest rate later rises, the market value of our investment will probably decline. To minimize this risk in the future, we intend to maintain our portfolio of cash equivalents and short-term investments in a variety of securities, including commercial paper, money market funds, government and non-government debt securities. The average duration of all of our investments in 2002 was less than one year. Due to the short-term nature of these investments, we believe we have no material exposure to interest rate risk arising from our investments. Therefore, no quantitative tabular disclosure is presented. We recently committed to a secured line of credit that carries a variable interest rate. This line of credit will expose us to interest rate risk in 2003.

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Item 8.    Financial Statements and Supplementary Data.

INDEPENDENT AUDITORS' REPORT

Board of Directors
Transgenomic, Inc.
Omaha, Nebraska

        We have audited the accompanying consolidated balance sheets of Transgenomic, Inc. and subsidiaries (the Company) as of December 31, 2002 and 2001 and the related consolidated statements of operations, stockholders' equity (deficit) and cash flows for each of the three years in the period ended December 31, 2002. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits.

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

        In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of Transgenomic, Inc. and subsidiaries as of December 31, 2002 and 2001, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2002 in conformity with accounting principles generally accepted in the United States of America.

        As discussed in Note A, in 2002 the Company changed its method of accounting for goodwill and other intangible assets in connection with the adoption of Statement of Financial Accounting Standards No. 142,Goodwill and Other Intangible Assets. Also, as discussed in Note Q, on March 31, 2003, the Company received a commitment letter for a new revolving credit agreement.

/s/ DELOITTE & TOUCHE LLP

Deloitte & Touche LLP
Omaha, Nebraska
February 4, 2003 (March 31, 2003 as to the second paragraph of Note Q)

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TRANSGENOMIC, INC. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

As of December 31, 2002 and 2001

(In thousands except share and per share data)

See notes to consolidated financial statements.

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TRANSGENOMIC, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF OPERATIONS

Years Ended December 31, 2002, 2001 and 2000

(in thousands except share and per share data)

See notes to consolidated financial statements.

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TRANSGENOMIC, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (DEFICIT)

Years Ended December 31, 2002, 2001 and 2000

(in thousands except share data)

See notes to consolidated financial statements.

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TRANSGENOMIC INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

Years Ended December 31, 2002, 2001 and 2000

(In thousands)

See notes to consolidated financial statements.

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TRANSGENOMIC, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Years Ended December 31, 2002, 2001 and 2000

(Tabular amounts in thousands except share and per share data)

A.    SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Business Description.

        Transgenomic, Inc., a Delaware corporation, and its subsidiaries (the "Company") provide innovative products and services for the synthesis, purification and analysis of nucleic acids. The Company's products and services include automated instrument systems, associated consumables, nucleic acid chemical building blocks, nucleic acid synthesis products, novel chemistry development for nucleic acids, process development services and genetic variation discovery services. The Company develops, assembles, manufactures and markets it's products and services to the life sciences industry to be used in research focused on molecular genetics of humans and other organisms. Such research could lead to development of new diagnostics and therapeutics. The Company's business plan is to participate in the value chain associated with these activities by providing key technology, tools, consumables, biochemical reagents and services to those entities engaged in basic biomedical research and the development of diagnostics and therapeutic agents.

        Prior to 2002 the Company was managed and operated on a fully integrated basis in one operating segment. During 2002, management determined it was appropriate to evaluate the Company's operations based upon the nature of the products and services provided. Accordingly, the Company has determined that it operates in two reportable segments, BioSystems and Nucleic Acids. The BioSystems operating segment generates revenue from the sale of automated instrument systems and associated consumable products and services. The Nucleic Acids operating segment generates revenue from the sale of nucleic acid-based products and services.

        The Company markets and sells these products primarily through a direct sales and support group in North America and Europe and through a network of distributors in the Pacific Rim and other international markets. These sales efforts are directed from the Company headquarters in Omaha, Nebraska and through a series of sales and support offices strategically located throughout the United States, Europe and Japan.

Principles of Consolidation.

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

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.

Short Term Investments.

        The Company classifies all of its short-term investments with maturities at acquisition of greater than three months as available for sale securities. Such short term investments consist primarily of United States government and federal agency securities, corporate commercial paper and corporate debt which are stated at market value, with unrealized gains and losses on such securities reflected, net of tax, as other comprehensive income in stockholders' equity. Realized gains and losses on short term investments are

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included in earnings and are derived using the specific identification method for determining the cost of securities. It is the Company's intent to maintain a liquid portfolio to take advantage of investment opportunities; therefore, all securities are considered to be available for sale and are classified as current assets.

Accounts Receivable.

        Accounts receivable are shown net of allowance for doubtful accounts of $450,000 and $213,000 in 2002 and 2001, respectively. Payment terms generally are 30 or 60 days. The Company has also provided extended payment terms of up to 90 days to some of its customers.

Inventories.

        Inventories are stated at the lower of cost or market. Cost is computed using standard costs for finished goods and average or latest actual cost for raw materials and work in process.

Property and Equipment.

        Property and equipment are carried at cost. Depreciation and amortization are computed by the straight-line and accelerated methods over the estimated useful lives of the related assets as follows:

Goodwill.

        Effective January 1, 2002, the Company adopted Statement of Financial Accounting Standard (SFAS) No. 142,Goodwill and Other Intangible Assets. SFAS No. 142 establishes new guidelines for accounting for goodwill and other intangible assets and provides that goodwill and other intangible assets with indefinite lives will not be amortized, but will be evaluated for impairment annually. The provisions of SFAS No. 142 require the completion of a transitional impairment test within six months of adoption, with any impairment treated as a cumulative effect of a change in accounting principle. The Company has performed the transitional goodwill impairment test during the second quarter of 2002 and determined that no impairment exists at the time of adoption of SFAS No. 142. The Company also completed its annual impairment test during the fourth quarter of 2002 and determined that no impairment existed at the time of the annual test.

Impairment of Long-Lived Assets.

        The Company assesses the recoverability of long-lived assets held for use, including certain intangible assets and goodwill, whenever events or changes in circumstances indicate that the carrying amount of an

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asset may not be recoverable. In such cases, if the sum of the expected cash flows (undiscounted and without interest) resulting from the use of the asset is less than the carrying amount, an impairment loss is recognized based on the difference between the carrying amount and the fair value of the assets.

Other Assets.

        Other assets include patents, intellectual property, goodwill and capitalized software development costs. The Company capitalizes the external and in-house legal costs and filing fees associated with obtaining patents on its new discoveries and amortizes these costs using the straight-line method over the shorter of the legal life of the patent or its economic life, generally 17 years, beginning on the date the patent is issued. Intellectual property, which is purchased technology, is recorded at cost and is amortized over its estimated useful life of between 5 and 10 years.

Software Development Costs.

        The Company capitalizes software development costs for products offered for sale in accordance with Statement of Financial Accounting Standard No. 86,Accounting for the Costs of Computer Software to be Sold, Leased or Otherwise Marketed. This Standard allows for the capitalization of certain development costs once a software product has reached technological feasibility. Capitalized costs are included in Other Assets, net of amortization. Such capitalized costs are amortized over the estimated useful life of the software product, generally 3 to 5 years, beginning when a product is released for sale.

        The Company capitalizes internal use software development costs in accordance with Statement of Position No. 98-1,Accounting for the Costs of Computer Software Developed or Obtained for Internal Use. Capitalized internal use software development costs are amortized on an accelerated basis over three years. For the years ended December 31, 2002 and 2001, capitalized internal software costs included in property, plant and equipment, net of accumulated amortization, totaled $461,000 and $1,000,000, respectively.

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 deemed fair market value of the Company's common stock at the date of grant over the stock option exercise price. Stock option grants to nonemployees are accounted for using the fair value method of accounting in accordance with Statement of Financial Accounting Standards (SFAS) No. 123,Accounting for Stock-Based Compensation using the Black-Scholes model.

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        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,Accounting for Stock-Based Compensation, to stock based employee compensation.

Unearned Compensation.

        Unearned compensation represents the unamortized difference between the option exercise price and the deemed fair market value of the Company's common stock at the option grant date, for options issued under the Company's Stock Option Plan (Note I). The unearned compensation is charged to operations over the vesting period of the respective options.

Income Taxes.

        Deferred tax assets and liabilities are determined based on the differences between the financial reporting and tax basis of assets and liabilities at each balance sheet date using tax rates expected to be in effect in the year the differences are expected to reverse. Deferred tax assets are reduced by a valuation allowance to the extent that it is unlikely they will be realized.

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 December 31, 2002 and 2001 deferred revenue, mainly associated with our service contracts, included on the Company's balance sheet was approximately $1.2 million.

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Research and Development.

        Research and development costs are charged to expense when incurred with the exception of certain software development costs that are capitalized.

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. Foreign currency transaction adjustments decreased net loss approximately $1.0 million in 2002. Foreign currency transaction adjustments in 2001 and 2000 were not significant.

Comprehensive Income.

        Comprehensive income for all periods presented consists of net income, foreign currency translation adjustments and unrealized gains or losses on available for sale investments. The Company deems its foreign investments to be permanent in nature and does not provide for taxes on currency translation adjustments arising from converting its investments in a foreign currency to U.S. dollars. There were no reclassification adjustments to be reported in the periods presented.

Fair Value of Financial Instruments.

        The carrying amount of the Company's cash and cash equivalents, receivables, accounts payable and accrued expenses approximate fair value because of the short maturity of those instruments. The Company derives the fair value of its short-term investments based on quoted market prices. The carrying value of long-term debt approximates fair value based upon existing interest rates available to the Company for similar debt.

Earnings Per Share.

        Basic earnings per share are calculated based on the weighted-average number of common shares outstanding during each period. Diluted earnings per share include shares issuable upon exercise of outstanding stock options and warrants or conversion of convertible notes, where dilutive. Potentially dilutive securities have been excluded from the computation of diluted earnings per share as they have an antidilutive effect due to the Company's net loss.

Recently Issued Accounting Pronouncements.

        In August 2001, the Financial Accounting Standards Board (FASB) issued SFAS No. 143,Accounting For Asset Retirement Obligations. SFAS No. 143 requires the Company to record the fair value of a liability for an asset retirement obligation in the period in which it is incurred and is effective for the Company's fiscal year beginning January 1, 2003. Management is in the process of evaluating the impact, if any, this standard will have on the Company's consolidated financial statements.

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        In July 2002, the FASB issued SFAS No. 146, "Accounting for Costs Associated with Exit or Disposal Activities". SFAS No. 146 addresses the accounting and reporting related to exit or disposal activities and is effective for the Company beginning January 1, 2003. The Company believes the adoption of this standard will not have a significant impact on the financial statements of the Company.

        In November 2002, the FASB issued FASB Interpretation (FIN) No. 45,Guarantor's Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others. FIN No. 45 clarifies that a guarantor is required to recognize, at the inception of a guarantee, a liability for the fair value of the obligation undertaken in issuing certain guarantees. FIN No. 45 also expands the disclosures to be made by a guarantor in its financial statements about its obligations under certain guarantees that it has issued. The recognition provisions are applicable on a prospective basis to guarantees issued or modified after December 31, 2002. Management believes that FIN No. 45 will not have a significant impact on the Company's Consolidated Financial Statements.

Use of Estimates.

        The preparation of consolidated financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.

Reclassifications.

        Certain reclassifications may have been made to the 2000 and 2001 financial statements to conform to the 2002 presentation.

B.    SHORT TERM INVESTMENTS

        The amortized cost of available-for-sale securities and their approximate fair values were as follows:

        Maturities of short-term investments are due within one year.

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C.    INVENTORIES

        At December 31, 2002 and 2001, inventories consist of the following:

D.    OTHER ASSETS

        At December 31, 2002 and 2001, finite lived intangible assets and other assets consist of the following:

        Amortization expense for intangible assets was $150,000 during 2002. The Company expects amortization expense for intangible assets to be approximately $900,000 in fiscal 2003, $900,000 in fiscal 2004, $850,000 in fiscal 2005, and $200,000 in fiscal 2006 and 2007.

E.    GOODWILL

        At December 31, 2002 and 2001, goodwill by operating segment consisted of the following:

        Annual testing of goodwill for impairment was completed in the fourth quarter, after the annual forecasting process. The Company has determined that no impairment existed at the time of the annual test. The fair value of operating segments was estimated using a discounted cash flow model.

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        A reconciliation of previously reported net loss and loss per share to the amounts adjusted for the exclusion of goodwill amortization follows:

F.    COMMITMENTS AND CONTINGENCIES

        The Company leases certain equipment, vehicles and operating facilities. The Company's leases related to its operating facilities currently expire on various dates through 2007. At December 31, 2002, the future minimum lease payments required under non-cancellable lease provisions are approximately $2.9 million in 2003; $2.6 million in 2004; $2.2 million in 2005; $1.4 million in 2006; $700,000 in 2007; and no rental payments for the year 2008. Rent expense related to all operating leases for the years ended December 31, 2002, 2001 and 2000 was approximately $2.3 million, $1.7 million and $1.0 million, respectively.

        During 2002, Cruachem Ltd., wholly owned subsidiary of the Company, entered into a long-term mortgage loan with The Royal Bank of Scotland. The principal amount of the loan was £1.0 million, or approximately $1.5 million. Principal and interest are payable in quarterly installments. The loan carries a 15 year term and a fixed annual interest rate of 6.77%. Security for this loan is the Company's 45,000 square foot manufacturing facility located in Glasgow, Scotland. The loan carries certain financial and non-financial covenants that must be met by Cruachem Ltd. that includes a minimum net cash flow requirement. The net book value of the facility was approximately $1.9 million at December 31, 2002.

        The Company is not a party to any material legal proceedings.

G.    INCOME TAXES

        Loss before income taxes consists of the following:

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        The income tax provision consists of the following: