SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

(Mark One)

For the Quarterly Period Ended March 31,September 30, 2004

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 daysdays.    Yes  x    No  ¨

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

As of May 7,November 15, 2004, the number of shares of common stock outstanding was 29,044,514.29,070,651.

TRANSGENOMIC INC.

INDEX

PART I FINANCIAL INFORMATION

Item 1. Financial Statements

Transgenomic, Inc. and Subsidiaries

Consolidated Balance Sheets (Unaudited)

(In thousands except share and per share data)

The accompanying notes are an integral part of these financial statements.

Transgenomic, Inc. and Subsidiaries

Consolidated Statements of Operations (Unaudited)

(In thousands except share and per share data)

The accompanying notes are an integral part of these financial statements.

Transgenomic, Inc. and Subsidiaries

Consolidated Statement of Cash Flows (Unaudited)

(In thousands)

The accompanying notes are an integral part of these financial statements.

Transgenomic, Inc. and Subsidiaries

Notes to the Consolidated Financial Statements (Unaudited)

(Columar AmountsIn thousands except share and per share data)

A. CONSOLIDATED FINANCIAL STATEMENTS

The accompanying unaudited 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 accruals) 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 threenine months ended March 31,September 30, 2004 and 2003 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 for the period ended December 31, 2003, that are included in the Company’s Annual Report on Form 10-K.

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.Systems. These contracts cover specific time periods and revenue associated with these contracts is deferred and recognized over the service period.

During the first quarter of fiscal 2004, the Company recognized approximately $196,000 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 second quarter of fiscal 2004.

During the second quarter of 2004, the Company recognized approximately $450,000 of product sales under the bill-and-hold arrangement. 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 third quarter of 2004. As of September 30, 2004, all products under these arrangements had been shipped to the respective customers.

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 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.

Transgenomic, Inc. and Subsidiaries

Notes to the Consolidated Financial Statements (Unaudited)

(In thousands except share and per share data)

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.

B. INVESTMENTS

As of September 30, 2004 and December 31, 2003, the Company had no available-for-sale securities. The amortized cost of available-for-sale securities and their approximate fair values as of March 31, 2004, were as follows:

In January and March 2004, the Company entered into addendums to an existing supply agreement with Geron Corporation. The addendums allowed Geron to pay for products being manufactured by the Company under the addendum with Geron common stock. These shares are being accounted for as available for sale securities. As a result in January 2004, Geron issued 85,885 shares of common stock, valued at $959,000, to the Company as a prepayment for products. On February 12, 2004 the companyCompany sold these shares for $932,000 resulting in a loss of $27,000, which is reflected in the current earnings and cash flow from operations.

In March 2004, Geron issued 33,662 shares of common stock, valued at $289,000, to the Company as a prepayment for products. In April 2004, Geron issued 140,872 shares of common stock, valued at $1,288,000, to the Company as prepayment and payment for products. On July 1, 2004 the company sold these shares for $1,361,328 resulting in a loss of $215,672, which is reflected in the current earnings and cash flow from operations.

In July, 2004, Geron issued 75,247 shares of common stock, valued at $601,371, to the Company as payment and prepayment for products. On July 28, 2004 and July 29, 2004, the Company sold these shares for $474,212 resulting in a loss of $127,159, which is reflected in the current earnings and cash flow from operations.

Included in accounts receivables at September 30, 2004 are amounts due from Geron totaling $1.3 million. In October 2004 these Geron receivables were exchanged for 208,131 shares of Geron common stock. During November 2004, the Company sold these shares for $1.5 million resulting in a gain of $173,000 that will be recognized during the three months ending December 31, 2004.

C. INVENTORIES

At September 30, 2004, and December 31, 2003, inventories consisted of the following:

Transgenomic, Inc. and Subsidiaries

Notes to the Consolidated Financial Statements (Unaudited)

(In thousands except share and per share data) (Continued)

C. INVENTORIESAs of September 30, 2004, the Company had approximately $5.0 million of chemical building block inventory. This inventory primarily includes phosphoramadites and the raw materials to produce phosphoramadites. Based on an analysis of these chemical building blocks as of September 30, 2004 and sales forecast for phosphoramidites, the Company classified $2.7 million of this inventory as a long-term asset under “Intangibles and Other Assets”. The remaining chemical building block inventory of $2.3 million is expected to be sold within twelve months and, accordingly, continues to be classified as current assets.

At March 31, 2004,The Company periodically evaluates its inventory of chemical building blocks to determine whether they continue to meet quality and December 31, 2003, inventories consisted of the following: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. Cost to purify such product and related yield losses will be expensed as incurred.

D. INTANGIBLE AND OTHER ASSETS

At March 31,September 30, 2004, and December 31, 2003, finite lived intangible assets and other assets consisted of the following:

Amortization expense for intangible assets was $243,000$242,121 and $218,000$205,000 during the three months ended March 31,September 30, 2004, and 2003, respectively. The Company expects amortization expense for intangible assets to be approximately $830,000$345,000 for the remainder of 2004, $1,022,000 in fiscal 2005, $367,000 in fiscal 2006, $377,000 in fiscal 2007, $77,000 in fiscal 2008, and $104,000 in fiscal 2009 and $104,000 in fiscal 2010.

E. GOODWILL

At March 31,September 30, 2004, and December 31, 2003, goodwill by operating segment consisted of the following:

Transgenomic, Inc. and Subsidiaries

Notes to the Consolidated Financial Statements (Unaudited)

(In thousands except share and per share data) (Continued)

During the three months ended March 31, 2004, the Company’s Board of Directors directed management to explore strategic alternatives for the Nucleic Acids operating segment. The ongoing process has included significant due diligence by management, its advisors and prospective independent buyers and other interested parties.

Based upon information obtained through this process during the three months ended June 30, 2004, management determined that it was more likely than not that the assets of the Nucleic Acids business were impaired. Accordingly, the Company engaged an external valuation firm to assist with the completion of a mid-year impairment test. As a result, the Company recorded a non-cash charge of $11,964,387 related to its Nucleic Acids segment during the three months ended June 30, 2004. The charge consisted of $9,864,387 related to the impairment of goodwill and $2,100,000 related to the impairment of property and equipment.

F. STOCKHOLDERS’ EQUITY AND STOCK OPTIONS

Other Comprehensive Income.Results of operations for the Company’s foreign subsidiary are translated using the average exchange rates during the period. Assets and liabilities are translated at the exchange rate in effect on the balance sheet dates. These translation adjustments, along with unrealized gains and losses on available-for-sale securities, are the Company’s only components of other comprehensive income.

Stock Options.During the threenine months ended March 31,September 30, 2004, the Company granted 120,000360,000 options withat an exercise price of between $1.32 to $2.57 per share. The following table summarizes activity under the 1997 Stock Option Plan during the threenine months ended March 31,September 30, 2004.

The weighted average fair value of options granted during the first threenine months of fiscal 2004 was $1.34 per share. 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 in the first threenine months of fiscal 2004: no common stock dividends; risk-free interest rates of 3.84%4.14% to 4.37%4.79%; 85% volatility; and an expected option life of 3 years. At March 31,September 30, 2004, the weighted average remaining contractual life of options outstanding was 6.25.6 years.

G. COMMITMENTS AND CONTINGENCIES

The Company has has been named as a defendant in a lawsuit filed in Spain by a prospective distributor who claims that the Company breached a promise to grant the plaintiff a distributorship for certain of the Company’s products in a specific geographic area in Europe. The plaintiff is seeking monetary relief of approximately $500,000. The Company believes the lawsuit is without merit and intends to vigorously defend this matter.

Transgenomic, Inc. and Subsidiaries

Notes to the Consolidated Financial Statements (Unaudited)

(In thousands except share and per share data)

The Company is subject to a number of other claims of various amounts, which arise out of the normal course of its 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.

H. INCOME TAXES

The Company’s tax expense (benefit) relates to its operations in certain foreign countries and certain states. The tax benefit recorded during the nine months ended September 30, 2004 relates to refunds received in the United Kingdom. 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 threenine months ended March 31,September 30, 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 March 31,September 30, 2004, and December 31, 2003, the Company’s deferred tax assets were offset by a valuation allowance of approximately $32.1$41.4 million and $30.6 million, respectively.

Transgenomic, Inc. and Subsidiaries

Notes to the Consolidated Financial Statements (Unaudited)

(In thousands except share and per share data) (Continued)

H.I. OPERATING SEGMENT AND GEOGRAPHIC INFORMATION

The Company’s operations are managed based upon the nature of the products and services provided. Accordingly, the Company has determined that it operates in two 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 segment operating income (loss). 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 (loss) for the segment. Generally, decisions regarding asset allocation, financing, or other items impacting the Company’s balance sheet are made at the corporate level and, accordingly, balance sheet information is not typically reviewed by operating segment.

The BioSystems operating segment generates revenue from the sale of automated instrument systems and associated consumable products and services. This segment’s products are based upon 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 nucleic acid chemistries, separations chemistries and enzymology. Specifically, this segment’s main products are nucleic acid building blocks or phosphoramidites, oligonucleotides, fluorescent markers, dyes and associated reagents and novel chemistry and process development services.

The following is information for net sales and loss from operating income (loss) by segment.

Transgenomic, Inc. and Subsidiaries

Notes to the Consolidated Financial Statements (Unaudited)

(In thousands except share and per share data)

I.J. LINE OF CREDIT AND LONG-TERM DEBT

In December 2003, the Company entered into a new, $7.5 million line of credit facility(the ”Credit Line”) with Laurus Master Fund, Ltd. (“Laurus”). The term of the agreementCredit Line is three years carrying an interest rate of 2.0% over the prime rate or a minimum of 6.0%. Funds available under the line areCredit Line are determined by a borrowing base equal to 90% of eligible accounts receivable balances plus up to $1.0 million related to inventory balances. This line of creditThe Credit Line is secured by most of the Company’s assets. PaymentPrior to amendments to the Credit Line discussed below, payment of interest and principal can,could, under certain circumstances, be made with shares of the Company’s common stock at a fixed conversion price of $2.20 per share. Conversion of this debt to common stock may be made at the election of Laurus or the Company. The Company maycould elect to convert only if its shares trade at a price exceeding $2.42 per share for ten consecutive trading days, and such conversion is further subject to trading volume limitations and a limitation on the total beneficial ownership by Laurus of the Company’s common stock. In connection withUpon entering into the line of credit facility,Credit Line, the Company issued warrants to Laurus to acquire 550,000 shares of itsthe Company’s common stock at an exercise prices that exceedprice exceeding the average trading price of the Company’s common stock over the ten trading days prior to executionthe date of the new linewarrant. As of credit.September 30, 2004, the Company had approximately $7.1 million outstanding on the Credit Line.

In February 2004, the Company entered into a separate $2.75 million convertible note with Laurus (the ”Term Note”). The noteTerm Note carries an interest rate of 2.0% over the prime rate or a minimum of 6.0% and has a term of 3 years. ThePrior to amendments to the Term Note discussed below, the principal and interest on the note mayTerm Note could be converted into common stock of the Company at a fixed conversion price of $2.61 per share. In connection with this agreement,Upon entering the Term Note, the Company issued 125,000 warrants to Laurus to acquire 125,000 shares of its common stock. A portion ofBorrowings under the proceeds from this transactionTerm Note were primarily used to retire the mortgage debt on the Company’s Glasgow facility. The remaining proceedsRemaining borrowings of approximately $750,000 will bewere used to complete the build-out of the Glasgow facility, complete the consolidation ourthe Company’s Glasgow operations into the new facility and provide funds for operations.

Certain features of the line of credit facilityCredit Line and convertable noteTerm Note (collectively, the “Laurus Loans”) require the Company to separately account for the value of certain amounts related to the warrants issued and the conversion feature of the facility.Laurus Loans. Specifically, Emerging Issues Task Force (“EITF”) No. 00-27,Application of Issue No. 98-5 to Certain Convertible Instruments, requires the Company to separately value the warrants issued and the “beneficial conversion premium” related to these agreements.the Laurus Loans. Any borrowings under the line of credit facilityCredit Line may result in additional beneficial conversion premiums. The valuevalues of the warrants and the beneficial conversion premium have been recorded on the balance sheet as a debt discount and an increase to additional paid in capital. The debt discount recorded for these items will be amortized as expense to the income statement over the termterms of the facilityLaurus Loans or as the warrants are exercised or the debt is converted into common stock thereby increasing the effective interest rate on these agreements.the Laurus Loans. In January and February 2004, Laurus exercised its conversion rights on the Credit Line and converted $2.0 million of amounts outstanding on the Credit Line into approximately 910,000 shares of common stock of the Company. In connection with this conversion, the Company accelerated the amortization of approximately $539,000 of the beneficial conversion premium.

In February 2004, Laurus waived the borrowing base limitation on the Company’s line of credit,Credit Line, thereby making the full $7.5 million facility available to the Company regardless of the available collateral. The waiver will expire on December 19, 2004. As of MarchOn August 31, 2004, Laurus agreed to extend the borrowing base waiver on the Credit Line through March 19, 2005. In addition, Laurus

Transgenomic, Inc. and Subsidiaries

Notes to the Consolidated Financial Statements (Unaudited)

(In thousands except share and per share data)

deferred certain payments due under the Term Note and reduced 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 had approximately $4.4 million outstandinglowered the conversion price on this lineeach of credit facility. In Januarythe Laurus Loans to $1.00 per share and Februaryissued 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 exercised its conversion rightsmodifications 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 $2.9 million at August 31, 2004 reflecting the difference between (i) the recorded amount of debt, net of related discounts, of $7.4 million and (ii) the fair value of the new debt instrument of $10.3 million plus the fair value of the new warrants of $120,000. The difference between the fair value of the new debt of $10.3 million and the face value of the debt of $8.6 million represents a premium, which will be reflected as a reduction of interest expense over the life of the new debt.

Prospectively, draws on the lineCredit Line may result in beneficial conversion charges to the extent the price of credit and converted $2.0 million of amounts outstandingthe Company’s common stock exceeds the conversion price on the lineday of the draw. Such beneficial charges will be amortized as expense to the income statement during the period the draw remains outstanding or up to the point the debt is converted into approximately 910,000 shares of common stock ofthereby increasing the Company. In connection witheffective interest rate on the conversion of $2.0 million of debt incurred under the line of credit facility in January and February 2004, the Company has accelerated the amortization of approximately $460,000 of the beneficial conversion premium.Credit Line.

The following table details the components of the Company’s line of creditCredit Line, Term Loan and long-termother debt as of March 31,September 30, 2004 and December 31, 2003.

J.K. CORPORATE RESTRUCTURING

The Company has historically experienced net losses and negative cash flows from operations. As a result, during the fourth quarter of fiscal 2002, management formulated a restructuring plan designed to reduce expenses thereby better aligning the Company’s expense structure with current business prospects. The plan included employee terminations, office closures, and termination of collaborations and write-offs of abandoned intellectual property. A significant portion of the plan was executed in the fourth quarter of 2002 resulting in the recording of $3.3 million in restructuring charges. The Company had accrued expenses and other liabilities associated with the restructuring activities of approximately $136,000$3,365 and $227,000 at March 31,September 30, 2004, and December 31, 2003, respectively. The accrued expenses at March 31,September 30, 2004, were related to lease payments associated with office closures.

Transgenomic, Inc. and Subsidiaries

Notes to the Consolidated Financial Statements (Unaudited)

(In thousands except share and per share data)

L. SUBSEQUENT EVENTS

Sale of Specialty Oligonucleotides Facility. On November 11, 2004, the Company sold the assets associated with its specialty oligonucleotides manufacturing facility in Boulder, Colorado to a subsidiary of Eyetech Pharmaceuticals, Inc. (“Eyetech”). The sale price was $3.0 million in cash plus the assumption of the lease on the Boulder facility and certain equipment leases with a gross value of $2.3 million. Substantially all of the 27 employees at the Boulder facility became Eyetech employees. Net proceeds from the sale (after transaction expenses and fees paid to the Company’s investment advisors) equaled approximately $2.7 million, subject to a holdback of $300,000 that will be held in escrow for 90 days for liabilities for representations and warranties and to pay the costs of moving certain acquired assets to the Boulder facility. The net proceeds will be used primarily for general working capital purposes and to repay a portion of the Credit Line. The sale will be recognized during the quarter ending December 31, 2004 and is not expected to a significant effect on earnings during that quarter.

Restructuring Plan. On November 13, 2004, the Board of Directors approved a restructuring plan designed to refocus the Company on its BioSystems business segment and to align the Company’s cost structure with anticipated revenues. The plan (which is incremental to the sale of the Boulder facility previously summarized) includes a workforce reduction of approximately 60 positions and the closure of two domestic research and development facilities associated with the Company’s nucleic acids operation segment and two European field offices. The majority of workforce reductions will be completed by the end of November 2004. The plan is expected to yield annualized savings of $6.0 to $8.0 million once the cost reductions are fully implemented in the first quarter 2005. In conjunction with the plan, the Company expects to incur a charge of between $1.5 million to $1.8 million during the quarter ending December 31, 2004, related primarily to severance, benefits and facility closures.

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations.

The following discussion should be read in conjunction with our consolidated financial statements and notes included elsewhere in this filing.

Overview

We provide innovative products and services for the synthesis, purification and analysis of nucleic acids. We develop, assemble, manufacture and market our 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. 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, biochemical reagents and services to those entities engaged in basic biomedical research and the development of diagnostics and therapeutic agents.

The Company’s operations are managed based upon the nature of the products and services provided. Accordingly, the Company has determined that it operates in two 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 segment’s products are based upon separations chemistries and enzymology. Specifically, this segment’s main products are the WAVE System, related bioconsumables and research services. Since the WAVE System product introduction in 1997, we have sold over 1,000 instruments to customers in over 30 countries.

The Nucleic Acids operating segment generates revenue fromhas been engaged in the salemanufacture of products and services based upon nucleic acid chemistries, separations chemistries and enzymology. Specifically, this segment’s main products are nucleic acid building blocks or phosphoramidites, oligonucleotides, fluorescent markers, dyes and associated reagents and novel chemistry and process development services. This operating segment has historically operated at a loss and the Company has been exploring strategic alternatives regarding this operating segment during 2004. On November 11, 2004, we sold the assets associated with our specialty oligonucleotide manufacturing facility in Boulder, Colorado to a subsidiary of Eyetech Pharmaceuticals, Inc. As a result, we no longer manufacture and sell oligonucleotides.

Executive Summary and Operating Strategy

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 March 31,September 30, 2004, we had an accumulated deficit of $76.6$100.2 million. WeOur liquidity and working capital positions deteriorated during the quarter predominately due to operating losses. These operating losses were funded primarily by borrowings under our credit facility and reductions in accounts receivables.

While we expect to continue to incur substantial research and development and selling, general and administrative costs.costs, we have implemented an operating strategy which is designed to refocus on the BioSystems segment of our business and to align our cost structure with projected revenues. We have initiated the following steps to accomplish this objective.

Executive SummaryStrategic Alternatives For Our Nucleic Acids Operating Segment. Our Nucleic Acids operating segment has historically operated at a loss and produced negative cash flow. While we believe the long-term prospects for this business segment are favorable, the projected levels of near-term revenues from this segment are not expected to generate either positive cash flows or profits from operations. After considering, among other factors, the historical financial results of this division and the near-term outlook for the nucleic acids industry, our

Board of Directors directed management to explore strategic alternatives for this operating segment, including the possible sale of one or both of the facilities in Glasgow, Scotland and Boulder, Colorado. On November 11, 2004, the Company sold the assets associated with its specialty oligonucleotide manufacturing facility in Boulder, Colorado to a subsidiary of Eyetech Pharmaceuticals, Inc. (“Eyetech”). The sale price was $3.0 million in cash plus the assumption of the lease on the Boulder facility and certain equipment leases with a gross value of $2.3 million. Substantially all of the 27 employees at the Boulder facility became Eyetech employees. Net proceeds from the sale (after transaction expenses and fees paid to our investment advisors) equaled approximately $2.7 million, subject to a holdback of $300,000 that will be held in escrow for 90 days for liabilities for representations and warranties and to pay the costs of moving certain acquired assets to the Boulder facility. The net proceeds will be used primarily for general working capital purposes and to repay portion of our credit line. We have also taken steps to downsize our remaining nucleic acids facility in Glasgow, Scotland as part of the restructuring plan described below.

Restructuring Plan. On November 13, 2004, the Board of Directors approved a restructuring plan designed to refocus the Company on its BioSystems business segment and to align the Company’s cost structure with anticipated revenues. The plan (which is incremental to the sale of the Boulder facility previously summarized) includes a workforce reduction of approximately 60 positions and the closure of two domestic research and development facilities associated with our nucleic acids operating segment and two European field offices. The majority of workforce reductions will be completed by the end of November 2004. The plan is expected to yield annualized savings of $6.0 to $8.0 million once the cost reductions are fully implemented in the first quarter 2005. In conjunction with the plan, the Company expects to incur a charge of between $1.5 million to $1.8 million during the quarter ending December 31, 2004 related primarily to severance, benefits and facility closures. Additionally, we have adopted processes to improve the collection of accounts receivables, especially with respect to sales in European markets which historically have longer payment cycles. Finally, we have taken steps to more appropriately align the timing of our inventory acquisitions with anticipated sales.

Together, the sale of our oligonucleotide manufacturing facility and the November 13, 2004 restructuring plan, is expected to result in $10.0 to $12.0 million in annual cost savings.

Revisions to Credit Facilities. We have entered into a $7.5 million line of credit (the ”Credit Line”) and a separate $2.75 million convertible note with Laurus (the ”Term Note”) with Laurus Master Fund, Ltd. (“Laurus”) (collectively, the “Laurus Loans”). In February 2004, Laurus waived the borrowing base limitation on the Credit Line, thereby making the full $7.5 million facility available to the Company regardless of the available collateral. On August 31, 2004, Laurus agreed to extend the borrowing base waiver on the Credit Line through March 19, 2005. In addition, Laurus has deferred certain payments due under the Term Note and reduced 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, we 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 following is a summaryrevisions to the Laurus Loans agreements, along with the anticipated liquidity benefits resulting from the sale of significant items or events that have had an effect on the Company’s financial position, resultsBoulder facility and implementation of operations, and liquidity during the quarter:

Results of Operations Three Months Ending March 31,September 30, 2004 and 2003

Three Months Ended March 31, 2004 and 2003

Net Sales. SalesNet sales during the third quarter of 2004 increased 9% from the third quarter of 2003, as a result of 10% reduction in sales in our BioSystems operating segment decreasedoffset by 85% increase in sales in our Nucleic Acids operating segment.

The decrease in BioSystems sales resulted from a 27% decline in revenues from the first quartersales of 2004 compared to the first quarter 2003. Bioinstruments revenues were significantly lower than 2003bioinstruments. This reduction was partially offset by increaseda 99% increase from discovery services and a 15% increase in bioconsumables. Net sales in our Discovery Services. The decline in systems sales is mainlyof software upgrades, service contracts and consumable products continued to increase due to continued low sales volumes to our North American customer base.a larger installed base of WAVE Systems. Increased discovery services revenue is attributable to oura focus on providing genetic variation discovery and analysis services to our pharmaceutical base of customers. We believe that our genetic variation discovery and analysis services provide us a significant opportunity to expand revenues in the future. In December 2003, we announced a discovery services agreement with Novartis Pharmaceuticals Corp. supporting the clinical development of oncology therapeuticstherapeutics. We believe that genetic variation discovery and believe this providesanalysis services provide us a good model ofsignificant opportunity to expand revenues in the opportunity for our services offering. Bioconsumable product sales strengthened from increased WAVE related consumable usage as the installed base of WAVE Systems has increased resulting in increased consumable usage.

Sales in our Nucleic Acid operating segment continued to decreasedincreased by 85% in the firstthird quarter of 2004 duecompared to the third quarter of 2003 as a declineresult of a substantial increase in demand forsales of our chemical building block products.products, primarily to Geron Corporation. Sales of oligonucleotide products remained flat during the period. These products are used by our biopharmaceutical and pharmaceutical customers as raw materials in DNA based drug candidates. The decrease incandidates and demand is largely attributable toaffected by the timing of completion and/or failure of Phase III clinical trials by certain of our large customers. We look for demand for these products to rebound slightly during the balance of 2004 as other customer products move through the clinical trial phases. This decrease in demand for DNA building blocks in the first quarter of 2004 was partially offset by sales of oligonucleotides generated by our start-up manufacturing facility in Boulder, Colorado. Part of our business strategy has been 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 on the success of the biopharmaceutical and pharmaceutical companies diagnostic and therapeutic products.drug candidates. As a result of the sale of our Boulder, Colorado facility in November 2004, we may see large variations in revenue flows for these products.no longer manufacture or sell oligonucleotides.

Cost of Goods Sold. Cost of goods sold remained relatively flat year to year despite the declineincrease in our revenues. Fixed costs associated with excess manufacturing capacity in our Nucleic Acids business unit and a lower number of high margin Wave systemsWAVE Systems sold kept our cost of goods sold comparable to the firstthird quarter of 2003. The BioSystems business unit cost of goods sold as a percentage of sales increased year over year but remained within historical ranges at approximately 44%45% to 50%. We expect that our BiosystemsBioSystems margins will fluctuate within historical ranges based upon the sales mix of systems, consumables and services. Currently our Nucleic Acid products are sold at lower margins compared to our BiosystemsBioSystems products. The margins in our Nucleic Acids business unit have been negatively impacted by higher manufacturing costs and excess capacity due largely to our plant expansion efforts in Glasgow, Scotland and Boulder, Colorado. We

As a result of the sale of our Boulder, Colorado facility and the restructuring plan implemented in November 2004, we anticipate that our cost of goods sold for our Nucleic Acid products will remain under pressurebe significantly improved. However, until demand for our Nucleic Acid products increase we will continue to have excess manufacturing capacity and lower than expected margins.

Selling, General and Administrative Expenses. Selling, general and administrative expenses increased slightly as a result of increased costs in our Glasgow, Scotland facility offset by reductions in personnel and personnel related expenses and travel costs attributed to the decrease, offset by foreign currency increases.

Research and Development Expenses. Research and development expenses decreased as a result of our focus on expense control. Reductions in personnel, personnel related expenses and outside services all contributed to the decrease. We expense our research and development costs in the year in which they are incurred.

Other Income (Expense). Other income (expense) includes of interest and investment income, interest expense and loss on debt extinguishment.

Interest and investment income (loss) totaled $(345,000) in the third quarter of 2004 compared to $2,000 during the same period of 2003. The decrease related primarily to losses realized on the sale of Geron stock. As described in Note B to the consolidated financial statements, Geron has paid us for products with Geron common stock that we have accounted for as available for sale securities.

Interest expense was $378,000 in the third quarter of 2004 compared to $98,000 for the same period of 2003. The increase related to a significantly higher debt burden and a slightly higher cost of funds.

Loss on debt extinguishment totaled $2.9 million in the third quarter of 2004. As described in Note J to the consolidated financial statements, certain August 31, 2004 modifications to our Laurus facilities 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 $2.9 million at August 31, 2003 reflecting the difference between (i) the recorded amount of debt, net of related discounts, of $7.4 million and (ii) the fair value of the new debt instrument of $10.3 million plus the fair value of the new warrants of $120,000. The difference between the fair value of the new debt of $10.3 million and the face value of the debt of $8.6 million represents a premium, which will be reflected as a reduction of interest expense over the life of the new debt.

Income Tax Expense. The Company’s tax expense (benefit) relates to its operations in certain foreign countries and certain states. The tax benefit recorded in the third quarter of 2004 relates to refunds received in the United Kingdom. No further tax benefits are being recorded due to 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 taxable 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.

Results of Operations Nine Months Ending September 30, 2004 and 2003

Net Sales. Net sales during the nine months ended September 30, 2004 increased 1% from the same period of 2003, as a result of a 27% increase in sales in our Nucleic Acids operating segment offset by a 6% reduction in sales in our BioSystems operating segment.

Sales in our Nucleic Acid operating segment increased by 27% in the nine months ended September 30, 2004 compared to the same period of 2003 as a result of increases in sales of our chemical building block products, primarily to Geron Corporation and substantial increases in sales of oligonucleotides. These products are used by our biopharmaceutical and pharmaceutical customers as raw materials in DNA based drug candidates and demand is affected by the timing of completion and/or failure clinical trials for these drug candidates. As a result of the sale of our Boulder, Colorado facility in November 2004, we will no longer manufacture or sell oligonucleotides.

The decrease in BioSystems sales resulted from a 16% decrease in bioinstrument and discovery services sales offset by a 21% increase in bioconsumable sales. This resulted from a 24% decline in revenues from the sales of bioinstruments. This reduction was partially offset by a 309% increase from discovery services and a 21% increase in bioconsumables. Net sales of software upgrades, service contracts and consumable products continued to increase due to a larger installed base of WAVE Systems. Increased discovery services revenue is attributable to a focus on providing genetic variation discovery and analysis services to our pharmaceutical base of customers. In December 2003, we announced a discovery services agreement with Novartis Pharmaceuticals Corp. supporting the clinical development of oncology therapeutics. We believe that genetic variation discovery and analysis services provide us a significant opportunity to expand revenues in the future.

Cost of Goods Sold. Cost of goods sold remained relatively flat year to year despite the increases in our revenues. Fixed costs associated with excess manufacturing capacity during 2004. Overall we anticipate thatin our Nucleic Acids business unit and a lower number of high margin WAVE Systems sold kept our cost of goods sold comparable to the prior period. The BioSystems business unit cost of goods sold as a percentage of sales increased year over year but remained within historical ranges at 45% to 50%. We expect that our BioSystems margins will fluctuate within historical ranges based upon the sales mix of systems, consumables and services. Currently our Nucleic Acid products are sold at lower margins compared to our BioSystems products. The margins in our Nucleic Acids business unit have been negatively impacted by higher manufacturing costs and excess capacity due largely to our plant expansion efforts in Glasgow, Scotland and Boulder, Colorado.

As a result of the sale of our Boulder, Colorado facility and the restructuring plan implemented in November 2004, we anticipate that our cost of goods sold for our Nucleic Acid products will be consistent with 2003 or slightly lower as we are hopeful thatsignificantly improved. However, until demand for our Nucleic Acid products increase we will rebound slightly. Margin improvement will depend largely on the return of product demand thereby more fully utilizing ourcontinue to have excess manufacturing capacity and spreading fixed costs across a larger revenue base.lower margins.

Selling, General and Administrative Expenses. Selling, general and administrative expenses decreased slightly as a result of our focus on expense control. Reductions in personnel and personnel related expenses and travel costs attributed to the decrease, offset by foreign currency increases. We will remain focused on controlling and reducing expenses during 2004.

Research and Development Expenses. Research and development expenses decreased as a result of our restructuring activities and focus on expense control. Approximately 60% of the total decrease wasReductions in personnel, and personnel related expenses as we have reduced our employee headcount. Additionally, reductions inand outside services and supplies were realized. We will remain focused on controlling and reducing expenses during 2004.all contributed to the decrease. We expense our research and development costs in the year in which they are incurred.

Impairment Charges.During the three months ended March 31, 2004, our Board of Directors directed us to explore strategic alternatives for the Nucleic Acids operating segment. The ongoing process has included significant due diligence by us, our advisors and prospective independent buyers and other interested parties.

Based upon information obtained through this process during the three months ended June 30, 2004, we determined that it was more likely than not that the assets of the Nucleic Acids business were impaired. Accordingly, we engaged an external valuation firm to assist with the completion of a mid-year impairment test. As a result, we recorded a non-cash charge of $12.0 million related to its Nucleic Acids segment during the three months ended June 30, 2004. The charge consisted of $9.9 million related to the impairment of goodwill and $2.1 million related to the impairment of property and equipment.

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. We continued to execute the plan during the first quarter of 2003 resulting in the additional charges recorded in 2003. These charges consisted of mainly employee severance costs and office closings. We didhave not incur furtherincurred any significant restructuring charges in the first quarter ofnine months ended September 30, 2004.

Other Income Taxes.(Expense). Other income (expense) includes of interest and investment income, interest expense and loss on debt extinguishment.

Interest and investment income (loss) totaled $(371,000) in the nine months ended September 30, 2004 compared to $48,000 during the same period of 2003. The decrease related primarily to losses realized on the sale of Geron stock. As described in Note B to the consolidated financial statements, Geron has paid us for products with Geron common stock that we have accounted for as available for sale securities.

Interest expense was $1.3 million in the nine months ended September 30, 2004 compared to $191,000 for the same period of 2003. The increase related to a significantly higher debt burden and a slightly higher cost of funds.

Loss on debt extinguishment totaled $2.9 million in the nine months ended September 30, 2004. As described in Note J to the consolidated financial statements, certain August 31, 2004 modifications to our Laurus facilities 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 $2.9 million at August 31, 2004 reflecting the difference between (i) the recorded amount of debt, net of related discounts, of $7.4 million and (ii) the fair value of the new debt instrument of $10.3 million plus the fair value of the new warrants of $120,000. The difference between the fair value of the new debt of $10.3 million and the face value of the debt of $8.6 million represents a premium, which will be reflected as a reduction of interest expense over the life of the new debt.

Income Tax Expense. The Company’s tax expense (benefit) relates to its operations in certain foreign countries and certain states. The tax benefit recorded in the first quarter ofnine months ended September 30, 2004 relates to refunds received in the United Kingdom. No further tax benefits are being recorded due to our cumulative losses expected losses 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 taxable 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. Our deferred tax assets as of March 31, 2004 were $32.1 million and were offset by a valuation allowance of $32.1 million.

Liquidity and Capital Resources

Overview

The Company’s liquidity position continued to be difficult during the first quarter of 2004 due primarily to continued losses and increases in working capital components. We have been and will continue to be focused on improving accounts receivables collections and reducing inventory levels. As of March 31,September 30, 2004, and December 31, 2003 we had approximately $2.2$1.1 million and $1.2 million, respectively, in cash and cash equivalents. In addition, as of March 31,At November 15, 2004, we had $316,000 in short-term investments and no short-term investments as of December 31, 2003, for total cash and short-term investmentscash equivalents of approximately $2.5 million$500,000 plus an additional $2.8 available under our Credit Line. The increase in cash and $1.2 million, respectively.

The following table summarizescash equivalents from September 30, 2004, relates primarily to the sale of our short-term liquidity and sources and uses of cash, as of March 31, 2004 and December 31, 2003 and for the periods ended March 31, 2004 and 2003:Boulder, Colorado facility.