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COMBIMATRIX CORP - 10-Q - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS(Edgar Glimpses Via Acquire Media NewsEdge) Cautionary Statement You should read the following discussion and analysis in conjunction with the consolidated financial statements and related notes thereto contained in Part I, Item 1 of this report. The information contained in this Quarterly Report on Form 10-Q is not a complete description of our businesses or the risks associated with an investment in our common stock. We urge you to carefully review and consider the various disclosures made by us in this report and in our other reports filed with the U.S. Securities and Exchange Commission, or "SEC," including our Annual Report on Form 10-K for the year ended December 31, 2010, filed with the SEC on March 22, 2011. This report contains forward-looking statements within the meaning of the "safe harbor" provisions of the Private Securities Litigation Reform Act of 1995. All statements, other than statements of historical fact included in this report, are forward-looking statements. Reference is made in particular to the description of our plans and objectives for future operations, assumptions underlying such plans and objectives, and other forward-looking statements included in this report. Such statements may be identified by the use of forward-looking terminology such as "may," "will," "should," "would," "could," "expect," "believe," "estimate," "anticipate," "intend," "plan," "predict," "seek," "potential," "continue," "focus," "ongoing," or similar terms, variations of such terms or the negative of such terms, and include, but are not limited to, statements regarding projected results of operations, capital expenditures, earnings, management's future strategic plans, product development, litigation, regulatory matters, market acceptance and performance of our products and services, the success and effectiveness of our technologies, planned clinical trials by our minority-owned subsidiary, our ability to retain and hire key personnel, the competitive nature of and anticipated growth in our markets, market position of our products and services, marketing efforts and partnerships, liquidity and capital resources, our accounting estimates, and our assumptions and judgments. Such statements are based on management's current expectations, estimates and projections about our industry, management's beliefs, and certain assumptions made by us, all of which are subject to change. These forward looking statements are not guarantees of future results and are subject to a number of risks, uncertainties and assumptions that are difficult to predict and that could cause actual results to differ materially and adversely from those described in the forward-looking statements. The risks and uncertainties referred to above include, but are not limited to, our ability to obtain additional financing for working capital on acceptable terms and in a timely manner; our ability to successfully implement our strategic and operational restructuring plan; our ability to successfully increase the volume of our existing tests, expand the number of tests offered by our laboratory, increase the number of customers and partners and improve reimbursement for our testing; our ability to continue as a going concern; changes in consumer demand; our ability to attract and retain a qualified sales force and key technical personnel; our ability to successfully develop products; our ability to successfully introduce new technologies and services; rapid technological change in our markets; supply availability; the outcome of existing litigation; our ability to bill and obtain reimbursement for highly specialized tests; our ability to comply with regulations to which our business is subject; legislative, regulatory and competitive developments in markets in which we and our subsidiaries operate; our limited market capitalization; future economic conditions; other circumstances affecting anticipated revenues and costs; and other factors as more fully disclosed in our discussion of risk factors in Item 1A of Part II of this report and in the "Risk Factors" described in our Annual Report on Form 10-K for the year ended December 31, 2010 filed with the SEC on March 22, 2011. Additional factors that could cause such results to differ materially from those described in the forward-looking statements are set forth in connection with the forward-looking statements. These forward-looking statements speak only as of the date of this report and we expressly disclaim any obligation or undertaking to release publicly any updates or revisions to any forward-looking statements contained herein to reflect any change in our expectations with regard thereto or any change in events, conditions or circumstances on which any such statement is based, except as required by law. General We are a molecular diagnostics company that operates primarily in the field of genetic analysis and molecular diagnostics through our wholly owned subsidiary, CombiMatrix Diagnostics ("CMDX"), located in Irvine, California. CMDX operates as a diagnostics reference laboratory that provides DNA-based clinical diagnostic testing services to physicians, hospitals and other laboratories in two primary areas: (i) prenatal and postnatal developmental disorders; and (ii) oncology. CMDX provides its services through the use of array-comparative genomic hybridization ("aCGH"), which enables the analysis of genetic anomalies. Our mission is to empower physicians to positively impact patient care through the delivery of innovative DNA-based clinical services. 15 -------------------------------------------------------------------------------- Table of Contents Prior to 2010, we were primarily focused on developing proprietary DNA array-based tools and instruments for the genetic research community, under the brand formerly known as "CustomArray," as well as providing molecular diagnostics services through CMDX. On April 19, 2010, we announced a strategic and operational restructuring plan (the "Restructuring Plan") intended to significantly reduce operating costs, increase the focus on our diagnostic services business and transition senior management. As part of the Restructuring Plan, we closed our CustomArray business and facilities located in Mukilteo, Washington and relocated our corporate headquarters to Irvine, California. Since the restructuring, our strategic focus is on commercializing our diagnostics services business by increasing the volume of our existing tests, expanding the number of tests offered by our laboratory, increasing the number of customers and partners, and improving reimbursement for our testing. We also initiated a search for a new President and Chief Executive Officer, which was completed on August 11, 2010 with the hiring of R. Judd Jessup. Concurrent with Mr. Jessup's appointment, Mark McGowan, our Chairman of the Board of Directors, discontinued serving as interim President and CEO, a role which he had assumed as a result of Dr. Amit Kumar's resignation from that role on June 30, 2010. Dr. Kumar was our President and CEO from September 2001 to June 30, 2010 and he continues to serve on our Board of Directors. As a result of executing the Restructuring Plan, the financial results of our CustomArray business have been classified as discontinued operations in the consolidated statements of operations for all periods presented. See Note 3 to our consolidated financial statements for additional information regarding discontinued operations. Unless otherwise noted, amounts and disclosures throughout this report relate to our continuing operations. We also own a one-third minority interest in Leuchemix, Inc. ("Leuchemix"), a private drug development company focused on developing a series of compounds to address a number of oncology-related diseases. Overview For the three and six months ended June 30, 2011, our operating activities included the recognition of $1.2 million and $2.1 million in diagnostic test services revenues, respectively, which increased from the comparable periods in 2010 due primarily to increased volumes of tests performed as well as an overall increase in our customer base as a result of increased sales and marketing efforts. Operating expenses decreased as the 2010 periods included a one-time goodwill impairment charge that was not repeated in 2011 and also from reduced research and development costs as we continue to focus our efforts on commercialization of our suite of diagnostic test service offerings. Net loss decreased from prior periods primarily due to the 2010 goodwill impairment charge not being repeated in 2011 and also from increased revenues. In April 2011, we completed a private placement transaction (the "Private Placement") with accredited investors in which we sold $6.76 million of newly-issued shares of our common stock and common stock purchase warrants. Under the terms of the Private Placement, we sold 3.08 million units for $2.193125 per unit. Each unit consisted of one share of common stock and one warrant to purchase 0.425 shares of common stock at an exercise price of $2.14 per share. Critical Accounting Estimates Our unaudited interim financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America. Preparation of these statements requires management to make judgments and estimates. Some accounting policies have a significant impact on amounts reported in these financial statements. A summary of significant accounting policies and a description of accounting policies that are considered critical may be found in our Annual Report on Form 10-K for the year ended December 31, 2010, filed with the SEC on March 22, 2011, in the Notes to the Consolidated Financial Statements and the Critical Accounting Estimates sections. In addition, refer to Note 2 to the consolidated interim financial statements included in Part I, Item 1 of this report. Comparison of the Results of Operations for the Three and Six Months Ended June 30, 2011 and 2010 Revenues and Cost of Revenues (dollars in thousands): Three Months Ended Six Months Ended June 30, Change June 30, Change 2011 2010 $ % 2011 2010 $ % Services $ 1,209 $ 796 $ 413 52% $ 2,122 $ 1,568 $ 554 35% Products - 120 (120 ) (100%) - 168 (168 ) (100%) Cost of products and services (693 ) (393 ) (300 ) (76%) (1,323 ) (715 ) (608 ) (85%) 16 -------------------------------------------------------------------------------- Table of Contents Services. Services revenues are generated from providing DNA-based genomic testing services primarily in the areas of prenatal and postnatal development disorders in children and, to a lesser extent, in oncology. Service revenues increased primarily due to volume increases of our genomic tests. Billable test volumes were 1,201 and 2,159 for the three and six months ended June 30, 2011, respectively, compared to 773 and 1,400 for the comparable periods in 2010. For the six months ended June 30, 2011 and 2010, our average revenue per test was approximately $983 and $1,119, respectively. This decrease was due primarily to a change in mix of tests performed for customers with governmental third-party insurance coverage including Medicare and various state Medicaid programs, which tend to have lower reimbursement per test than do commercial insurance or direct-bill customers. Services revenues also includes adjustments relating to our revenue recognition policy of periodically adjusting our estimate for contractual allowances for revenues from non-contracted payors as well as from receiving cash payments in excess of amounts previously recognized for service revenues. For the three and six months ended June 30, 2011 and 2010, net positive revenue adjustments were $150,000, $181,000, $53,000 and $282,000, respectively. Products. Product revenues have historically been generated exclusively from selling bacterial artificial chromosome, or "BAC," CGH arrays and related reagents to a single distributor located in Taiwan. During the third quarter of 2010, we were notified by our distributor that its customers were considering other BAC CGH array providers and as a result, it was likely that our revenues from product sales would decrease in future periods. As a result, we did not sell any BAC arrays during the first half of 2011 and do not expect to sell arrays in the future. Cost of Products and Services. Cost of products and services include direct materials such as array and laboratory costs, direct laboratory labor (wages and benefits), allocation of overhead and stock-compensation expenses. These costs increased during the periods presented in 2011 as compared to 2010 due to volume increases as well as due to increases in material and supply costs for certain of our aCGH arrays as we were validating other microarray platforms for our suite of diagnostic tests. For the three and six months ended June 30, 2011 and 2010, cost of products and services included $16,000, $32,000 $14,000 and $27,000, respectively, of non-cash stock compensation expense. See Note 2 to our consolidated interim financial statements included elsewhere in this report for a detailed description of the amounts of non-cash stock compensation expense recognized for the periods presented. Operating Expenses (dollars in thousands): Three Months Ended Six Months Ended June 30, Change June 30, Change 2011 2010 $ % 2011 2010 $ % Research and development $ 321 $ 725 $ (404 ) (56%) $ 660 $ 1,498 $ (838 ) (56%) Sales and marketing 671 491 180 37% 1,228 998 230 23% General and administrative 1,369 1,665 (296 ) (18%) 2,695 3,143 (448 ) (14%) Goodwill impairment - 16,918 (16,918 ) - - 16,918 (16,918 ) - Research and Development. These expenses include labor and laboratory supply costs associated with investigating new tests, but primarily consist of development costs to maintain and improve our existing suite of diagnostic tests offered. Prior to launching a new test or modifying an existing test, appropriate clinical trials and extensive laboratory validations, consistent with the various regulations that govern our industry, must be performed. These costs are classified as research and development for all periods presented. The decrease in research and development expenses was due primarily to greater allocation of laboratory resources on production and commercial efforts during the first half of 2011 compared to the first half of 2010. In addition, for the three and six months ended June 30, 2011 and 2010, research and development expenses included $18,000, $37,000, $46,000 and $94,000, respectively, of non-cash stock compensation expense. The decreases from prior periods were due primarily to prior stock option awards granted to our employees that were or became fully vested during the current periods. See Note 2 to our consolidated interim financial statements included elsewhere in this report for a detailed description of the amounts of non-cash stock compensation expense recognized for the periods presented. Sales and Marketing. These expenses include salaries and wages associated with our sales force and marketing resources, sales commissions and other expenses associated with promotional and advertising efforts. The increase in sales and marketing expenses was due to greater emphasis during the first half of 2011 on our sales and marketing efforts in order to expand and increase market awareness and penetration of our suite of molecular diagnostic tests. In addition, for the three and six months ended June 30, 2011 and 2010, sales and marketing expenses included $17,000, $34,000, $36,000 and $74,000, respectively, of non-cash stock compensation expense. The decreases from prior periods were due primarily to prior stock option awards granted to our employees that were or became fully vested during the current periods. See Note 2 to our consolidated interim financial statements included elsewhere in this report for a detailed description of the amounts of non-cash stock compensation expense recognized for the periods presented. 17 -------------------------------------------------------------------------------- Table of Contents General and Administrative. These expenses include compensation and benefit costs of our administrative staff, information technology, executive management, human resources and accounting personnel, as well as facilities-related costs, insurance, legal, audit and other professional services. The overall decrease was due primarily to an asset impairment charge of $181,000 recognized during the three months ended June 30, 2010 related to a cost-basis investment held by us, which was not repeated or incurred during the 2011 periods, as well as from decreased salaries and wages expenses from reduced executive staffing. These decreases were partially offset by higher outside legal costs primarily related to ongoing litigation. Also contributing to the decreases were lower stock-based compensation expenses, which were $318,000, $607,000, $486,000 and $957,000 for the three and six months ended June 30, 2011 and 2010, respectively. The decreases from prior periods were due primarily to prior stock option awards granted to our employees that were or became fully vested during the current periods. See Note 2 to our consolidated interim financial statements included elsewhere in this report for a detailed description of the amounts of non-cash stock compensation expense recognized for the periods presented. Goodwill Impairment. The decline in our market capitalization during the second quarter of 2010 (as indicated by the trading of our common stock on Nasdaq) was considered by management to be a potential goodwill impairment triggering event. As a result, we performed a business valuation using a market-based approach and determined that all of our $16.9 million in goodwill was impaired. Other Non-Operating Items (dollars in thousands): Three Months Ended Six Months Ended June 30, Change June 30, Change 2011 2010 $ % 2011 2010 $ % Litigation settlement gain $ - $ - $ - - $ - $ 19,385 $ (19,385 ) - Loss from early extinguishment of debt - - - - - (572 ) 572 - Interest expense (4 ) (5 ) 1 20% (9 ) (353 ) 344 97% Derivatives gains - - - - - 605 (605 ) 100% Litigation Settlement Gain. In February 2010, we received gross proceeds of $25 million from entering into a settlement agreement with National Union. Contingent attorneys' costs and expenses relating to the settlement were $5.6 million. Thus, the net amount of the settlement gain recognized was $19.4 million during the three months ended March 31, 2010. There were no such events in the first half of 2011. Loss from Early Extinguishment of Debt. In March 2010, we fully retired our secured convertible debenture (the "Debenture"). As a result, the remaining, unamortized debt discount of $572,000 was written off as a non-operating loss from early extinguishment of debt in the six months ended June 30, 2010. There were no such events in the first half of 2011. Interest Expense. Prior to March 2010, interest expense was primarily comprised of interest charges associated with the Debenture, which accrued interest at an annual rate of 10% on the outstanding principal balance. Interest expense also included amortization of debt discount originally recognized from issuance of the Debenture and related warrants using the effective interest method. Interest expense decreased as a result of retiring the Debenture in March 2010. Remaining interest charges are from capital leases for certain laboratory equipment. Derivative Gains. These gains represent the net gain recognized from mark-to-model adjustments to the embedded derivatives associated with the Debenture that were outstanding during the first quarter of 2010. In accordance with U.S. generally accepted accounting principles, the conversion feature, cash redemption option, potential acceleration of maturity of the Debenture and potential adjustments to the conversion price all represented embedded derivatives of the Debenture that were recorded separately at fair value as other liabilities, with the corresponding fair value adjustments reflected as non-operating charges or gains, depending upon the results of the mark-to-model valuation adjustments. The fair value of the embedded derivatives was determined using the convertible bond model, discounted cash flows and binomial lattice models. In March 2010, the Debenture was retired. As a result, the remaining derivatives liability of $605,000 was written off as a non-operating gain in the six months ended June 30, 2010. There were no such events in the first half of 2011. 18 -------------------------------------------------------------------------------- Table of Contents Discontinued Operations (dollars in thousands): Three Months Ended Six Months Ended June 30, Change June 30, Change 2011 2010 $ % 2011 2010 $ % Income (loss) from discontinued operations $ 205 $ (5,442 ) $ 5,647 (104%) $ 236 $ (6,856 ) $ 7,092 (103%) On April 19, 2010, we announced a Restructuring Plan intended to focus our Company on our diagnostic services business while shutting down our CustomArray business. Related restructuring and impairment charges were $0, $0, $4.7 million and $4.7 million, net of surplus sales of property and equipment, for the three and six months ended June 30, 2011 and 2010, respectively. The operations of our former CustomArray business are classified as discontinued operations for all periods presented. The decrease in the loss from discontinued operations is due to shutting down our Mukilteo facilities and terminating all staff at that location during the second, third and fourth quarters of 2010, resulting in minimal operating expenses associated with the CustomArray business for the first half of 2011 compared to a full period's worth of operations in the three and six months ended June 30, 2010. Income from final billings on former Department of Defense contracts occurred and was recognized during the first half of 2011. Inflation Inflation has not had a significant impact on our business, results of operations or financial condition. Liquidity and Capital Resources At June 30, 2011, cash and cash equivalents totaled $10.0 million, compared to $6.6 million at December 31, 2010. Cash is held primarily in general checking accounts as well as in money market mutual funds backed by U.S. government securities. Working capital at June 30, 2011 was $11.2 million, compared to $7.5 million at December 31, 2010. The change in working capital was due primarily to the impact of net cash flow activities as discussed below. The net change in cash and cash equivalents for the periods presented was comprised of the following (in thousands): Six Months Ended June 30, 2011 2010 Change Net cash provided by (used in): Operating activities $ (3,121 ) $ 13,281 $ (16,402 ) Investing activities (50 ) (73 ) 23 Financing activities 6,603 (8,436 ) 15,039 Increase cash and cash equivalents $ 3,432 $ 4,772 $ (1,340 ) Operating Activities. The overall net decrease in cash provided by operating activities was due primarily to the net litigation settlement proceeds from National Union of $19.4 million received in February 2010. Excluding the impact of this one-time event, cash flows from operating activities improved due primarily to reduced operating cash burn from shutting down the CustomArray business unit as part of the Restructuring Plan. Investing Activities. The decrease in net cash flows used in investing activities was due to a decrease in capital expenditures. Financing Activities. The increase in net cash flows from financing activities was due primarily to the $6.64 million of net proceeds received from the Private Placement during the period ended June 30, 2011. Also, we repaid the Debenture totaling $8.4 million in the first quarter of 2010. 19 -------------------------------------------------------------------------------- Table of Contents Future Liquidity. We have a history of incurring net losses and net operating cash flow deficits. We are also deploying new technologies and continue to develop commercial products and services. We believe that our cash and cash equivalent balances, anticipated cash flows from operations, anticipated operating cash savings from our Restructuring Plan, cash proceeds from the Private Placement and other possible sources of funding from the capital markets will be sufficient to meet our cash requirements into the fourth quarter of 2012. In order for us to continue as a going concern beyond this point and ultimately to achieve profitability, we may be required to obtain capital from external sources, increase revenues and reduce operating costs. However, there can be no assurance that our operations will become profitable or that external sources of financing, including the issuance of debt and/or equity securities, will be available at times and at terms acceptable to us, or at all. The issuance of additional equity or convertible debt securities will also cause dilution to our shareholders. If external financing sources are not available or are inadequate to fund our operations, we will be required to reduce operating costs, including research projects and personnel, which could jeopardize our future strategic initiatives and business plans. See Note 1 to the consolidated financial statements included elsewhere in this report for additional discussion of these matters. Capital Requirements. We may also encounter unforeseen difficulties that may deplete our capital resources more rapidly than anticipated. As a result, we may be required to seek additional funding through equity, debt or other external financing, and there can be no assurance that additional funding will be available on favorable terms, in a timely fashion or at all. At this time, we have no significant commitments for capital expenditures in 2011 or beyond. However, our long-term capital requirements could be substantial and the adequacy of available funds will depend upon many factors, including: † the costs of commercialization activities, including sales and marketing costs and capital equipment; † † competing technological developments; † † the creation and formation of strategic partnerships; † † the costs associated with leasing and improving our Irvine, California facility; and † † other factors that may not be within our control. Off-Balance Sheet Arrangements As of June 30, 2011, we did not have any significant off-balance sheet arrangements, as defined in Item 303(a)(4)(ii) of Regulation S-K promulgated by the SEC. However, we have entered into an operating lease for our laboratory space and corporate offices, totaling approximately 13,000 square feet. Recent Accounting Pronouncements Refer to Note 2 to our consolidated interim financial statements included in Part I, Item 1 of this report. |