ITEM 1. BUSINESS
THE COMPANY
Cytyc Corporation designs, develops, manufactures and markets a sample preparation system for medical diagnostic applications. The Company's ThinPrep System allows for the automated preparation of cervical cell specimens on microscope slides for use in cervical cancer screening, as well as for the automated preparation of other cell specimens on microscope slides for use in non-gynecological testing applications. On May 20, 1996, the Company received premarket approval ("PMA") from the United States Food and Drug Administration ("FDA") to market the ThinPrep System for cervical cancer screening as a replacement for the conventional Pap smear method. On November 6, 1996, the FDA cleared expanded product labeling for the ThinPrep System to include the claim that the ThinPrep System is significantly more effective in detecting Low Grade Squamous Intraepithelial Lesions ("LGSIL") and more severe lesions than the conventional Pap smear method in a variety of patient populations. The expanded labeling also indicates that the specimen quality using the ThinPrep System is significantly improved over that of the conventional Pap smear method. The Company believes that the ThinPrep System improves accuracy in the detection of cervical cancer and precancerous lesions by making the slide more representative of the patient's clinical condition, improving preservation of the sample, standardizing the presentation of cells on the slide, and reducing the presence of mucus, blood and other obscuring debris. On February 25, 1997, the FDA approved the Company's supplemental PMA application for use of a combination of an endocervical brush and spatula sampling devices, a commonly used method of collecting samples for conventional Pap smears. On September 4, 1997, the FDA approved the Company's supplemental PMA application for the testing for the human papilloma virus ("HPV") directly from a single vial of patient specimen collected in a ThinPrep solution using the Hybrid Capture HPV DNA Assay of Digene Corporation. The Company conducted the full-scale commercial launch of the ThinPrep System for cervical cancer screening in the United States in 1997. See "Business--Marketing and Sales."
CERVICAL CANCER
Cervical cancer is one of the most common cancers among women throughout the world. Cervical cancer is preceded by curable precancerous lesions that progress without symptoms over a period of years until they become invasive, penetrating the cervical epithelium (cellular covering) and entering the bloodstream or lymph system. In order to detect these precancerous lesions, gynecologists in the United States typically recommend annual screening examinations. If detected in the precancerous stage, virtually all cervical cancer cases are preventable. The treatment of cervical cancer after it reaches the invasive stage may require surgery, including a hysterectomy, and chemotherapy or radiation treatment, which are difficult, expensive and may not be successful.
The factors associated with the development of cervical cancer are believed to include early sexual activity, multiple sexual partners, cigarette smoking and immunosuppression. In addition, a number of recent studies have concluded that cervical cancer is strongly correlated to the presence of certain types of HPV. According to these studies, HPV DNA is present in most cases of precancerous lesions and in more than 90% of cases of intraepithelial and invasive cancer. Cervical lesions that are HPV-negative or lacking certain types of HPV are less likely to progress to cervical cancer.
THE PAP SMEAR
Cervical cancer screening has been conducted since the late 1940s using the Pap smear, a test developed by Dr. George Papanicolaou. In the United States, widespread and regular use of the Pap smear as a screening test has contributed to a greater than 70% decrease in mortality from cervical cancer in the past. The Pap smear is currently the most widely-used screening test for the early detection of cancer in the United States.
The Pap Smear Process
The Pap smear process involves the science of cytology, which is the microscopic interpretation of precancerous, malignant and other changes in cells. The conventional Pap smear process begins with the collection of a cervical specimen during a gynecological examination. To obtain a cervical cell sample, a
sampling device, such as either a brush and spatula or a "broom-like" device, is used to scrape cells from the surface of the cervix. The sample is then manually smeared onto a clean microscope slide by the physician who must then spray the slide within a few seconds with a fixative agent to prevent damage to the cell specimen from air drying. The slide is then submitted to a clinical laboratory for manual microscopic examination.
At the laboratory, a cytotechnologist, a medical professional with special training in the examination and interpretation of human cells, conducts a microscopic review of a prepared slide to determine the adequacy of the sample and the presence of abnormal cells. In determining slide adequacy, cytotechnologists classify each slide in one of three categories: (i) satisfactory for evaluation, (ii) satisfactory but limited by ("SBLB") certain characteristics, or (iii) unsatisfactory for evaluation. The percentage of unsatisfactory and SBLB slides varies widely from laboratory to laboratory. In a 1991 study of 600 laboratories, it was reported that up to 20% of slides were classified as unsatisfactory and up to 40% were classified as SBLB. Frequent reasons for unsatisfactory or SBLB classifications include excess blood or mucus that impairs viewing or too few cells per slide.
After determining the adequacy of the slide, the cytotechnologist manually screens each Pap smear slide with a microscope to differentiate diseased or abnormal cells from healthy cells based on size, shape and structural details of the cells and nuclei. Typically, each Pap smear slide is then classified in accordance with The Bethesda System for Reporting Cervical/Vaginal Cytologic Diagnoses ("Bethesda System") into one of the following categories: (i) Negative; (ii) Atypical Squamous Cells of Undetermined Significance/Atypical Glandular Cells of Undetermined Significance ("ASCUS/AGUS"); (iii) Low Grade Squamous Intraepithelial Lesions ("LGSIL"); (iv) High Grade Squamous Intraepithelial Lesion ("HGSIL"); and (v) Carcinoma. Any slide classified as other than negative is considered abnormal and may be precancerous or cancerous. All abnormal slides are referred to a senior cytotechnologist and pathologist for further review and final diagnosis.
Notwithstanding the classifications imposed by the Bethesda System, the subjective nature of the classification of Pap smear specimens results in diagnoses that vary widely among cytotechnologists, pathologists and laboratories. In 1988, to address accuracy and quality control concerns, Congress adopted the Clinical Laboratory Improvement Amendments of 1988 ("CLIA"). CLIA requires cytology laboratories to perform proficiency testing and quality control by testing cytotechnologists in order to assure a minimum level of competence and expertise. In addition, the CLIA regulations currently limit the number of slides screened per day by a cytotechnologist to 100. Certain states have also adopted regulations further limiting the number of slides which can be manually examined per day by a cytotechnologist. As a further quality control measure, the CLIA regulations require that laboratories manually rescreen at least 10% of the slides that are initially classified as negative.
Other methods of rescreening are currently available, including computer imaging technologies that select certain negative slides or portions of negative slides for reexamination by the cytotechnologist. These computer imaging technologies are intended to provide an additional quality control measure to help identify false negative diagnoses.
Follow-Up Treatment of Abnormal Pap Smears
Women with abnormal Pap smears may have to return to their physician's office for a repeat Pap smear or to undergo costly colposcopy and biopsy procedures. A colposcopy involves the physician using a device to visually examine the surface of the cervix, and if necessary, performing a biopsy. Treatment of early-stage non-invasive cervical cancer may be accomplished by procedures to remove the abnormal cells. Once the cancer reaches the invasive stage, the patient's chances for recovery are diminished and more radical treatment is typically required, such as a hysterectomy and chemotherapy or radiation therapy. These procedures may expose the patient to risk and cost and result in significant physical and psychological stress.
PROBLEMS WITH THE CONVENTIONAL PAP SMEAR
In spite of the success of the Pap smear in reducing deaths due to cervical cancer, the test has significant limitations, including inadequacies in sample collection and slide preparation, slide interpretation errors and the
inability to use the specimen for additional diagnostic tests. These limitations result in a substantial number of inaccurate test results, including false negative diagnoses.
False Negative Diagnoses
The limitations of the conventional Pap smear method in sample collection, slide preparation and interpretation result in a substantial number of inaccurate test results in the form of false negative diagnoses. A false negative diagnosis may allow the disease to progress to a later-stage of development before being detected, thereby requiring a more expensive and invasive course of treatment and diminishing the likelihood of successful treatment. Reports of the false negative rate of the Pap test vary widely, between 5% and 55%. Studies suggest that approximately 50% of false negative diagnoses are attributable to inadequacies in sample collection and slide preparation and approximately 50% are attributable to slide interpretation errors.
Inadequacies in Sample Collection and Slide Preparation
There are a variety of difficulties with current methods of cell collection, cell transfer and slide preparation. These difficulties include cell loss, improper fixation of the cells (typically, from air drying), thick and uneven smearing of cells on the slide, and excess blood, mucus and other obscuring debris on the slide. A study published in the American Journal of Clinical Pathology in February 1994 reported that as much as 80% of the sample taken from a patient using the conventional Pap smear method is not transferred to the microscope slide and remains on the discarded collection device. This discarded portion of the sample may contain the abnormal cells necessary for an accurate diagnosis. In addition to the problem of cell transfer, the conventional Pap smear method produces inconsistent and non-uniform slides with extreme variability in quality, making examination difficult. The Company believes that these limitations are responsible for a large percentage of slides being classified as SBLB. These slides are more difficult to interpret and increase the uncertainty of an accurate diagnosis. Consequently, patients are often subjected to the inconvenience and expense of return office visits for repeat testing and to the anxiety resulting from the inconclusive nature of the initial test. The Company believes that these repeat visits and examinations also result in significant costs to the healthcare system.
Slide Interpretation Errors
The process of screening and interpreting a manually prepared Pap smear is complex and tedious. This process requires constant vigilance, as approximately 90% to 95% of all Pap smear diagnoses in the United States are negative. In addition, the process is prone to error as a result of the complexity of properly evaluating and categorizing subtle and minute changes in cellular or nuclear detail. The screening process requires intense visual review through a microscope of a large volume of slides, each of which typically contains 50,000 to 300,000 cervical cells. The small percentage of Pap smears that contain any abnormality may, in turn, contain only a small number of abnormal cells among the vast number of normal cells. Cytotechnologists generally review each slide for approximately five to 10 minutes and may review up to 100 slides per day. All of these factors contribute to the incidence of false negative diagnoses.
Lack of Additional Testing Capability
The conventional Pap smear method does not permit additional or adjunct testing from the original patient sample. The ability to produce multiple slides from a single sample could be used by clinical laboratories for follow- up testing, quality control or proficiency testing. Further, the conventional Pap smear method requires the patient to be called back to the physician's office to provide a second sample if additional testing, such as HPV testing, is desired. The Company believes that the ability to test for HPV directly from the ThinPrep collection vial has the potential for substantial healthcare cost savings through reduced costly management of borderline cervical abnormalities.
THE THINPREP SYSTEM
The Company believes that the ThinPrep System offers a number of benefits which address limitations of the conventional Pap smear method, including improved accuracy in the detection of cervical cancer and precancerous lesions, standardization and simplification of the sample preparation process, the ability to permit
multiple tests to be conducted from a single sample and improved productivity in screening by reducing cytotechnologist fatigue and the time required to examine each slide. In August 1997, Obstetrics & Gynecology, a preeminent, widely read, peer-reviewed journal on women's healthcare issues, published a major study describing the effectiveness of the ThinPrep Pap Test in screening for cervical cancer.
The ThinPrep System, which was cleared for marketing as a replacement for the conventional Pap smear method for cervical cancer screening by the FDA on May 20, 1996, consists of the ThinPrep 2000 Processor and related disposable reagents, filters and other supplies. The ThinPrep System is designed to reduce the incidence of false negative diagnoses, improve slide quality, reduce inconclusive SBLBs and enable a single sample to be used for additional diagnostic testing. On November 6, 1996, the FDA cleared expanded product labeling for the ThinPrep System to include the claim that the ThinPrep System is significantly more effective in detecting LGSIL and more severe lesions than the conventional Pap smear method in a variety of patient populations. This expanded labeling also indicates that the specimen quality using the ThinPrep System is significantly improved over that of the conventional Pap smear method. In February 1997, the Company received FDA approval of the Company's supplemental PMA application for the use of a combination of an endocervical brush and spatula sampling devices, a commonly used method of collecting samples for conventional Pap smears. In September 1997, the FDA approved the Company's supplemental PMA application for the testing for HPV directly from a single vial of patient specimen collected in a ThinPrep solution using the Hybrid Capture HPV DNA Assay of Digene Corporation.
The ThinPrep process begins with the patient's cervical sample being taken by the physician using a cervical sampling device which, rather than being smeared on a microscope slide, is rinsed in a vial filled with the Company's proprietary PreservCyt Solution. This enables virtually all of the patient's cell sample to be preserved before the cells can be damaged by air drying. The ThinPrep specimen vial is then labeled and sent to a laboratory equipped with a ThinPrep 2000 Processor for slide preparation and screening.
At the laboratory, the ThinPrep specimen vial is inserted into a ThinPrep 2000 Processor, a proprietary sample preparation device which automates the process of preparing cervical specimens. Once the vial is inserted into the ThinPrep 2000 Processor, a gentle dispersion step breaks up blood, mucus, non- diagnostic debris and large sheets of cells and homogenizes the cell population. The cells are then automatically collected on the Company's proprietary TransCyt Filter, which incorporates an eight micron membrane specifically designed to collect abnormal and cancerous cells. The ThinPrep 2000 Processor constantly monitors the rate of flow through the TransCyt Filter during the collection process in order to prevent the cellular presentation from being too scant or too dense. A thin layer of cells is then transferred to a glass slide in a 20 mm-diameter circle and the slide is automatically deposited into a preservative solution. The ThinPrep 2000 Processor allows for the processing of approximately 20 to 25 patient samples per hour.
The Company's proprietary reagents and supplies include PreservCyt Solution to collect and transport cervical samples to the laboratory for optimal cell preservation and TransCyt Filters to collect cells and remove non-diagnostic debris and mucus. The Company also sells ThinPrep Microscope Slides, high- quality microscope slides manufactured to the Company's specifications, which improve cell adhesion to the slide.
CLINICAL TRIAL RESULTS
In October 1995, the Company completed the clinical trial used to support its PMA application, which was a blinded study performed at six clinical sites in the United States, including three screening centers and three hospital sites. The study was designed to rigorously compare the effectiveness of the ThinPrep System to the conventional Pap smear method for the detection of precancerous lesions of the cervix. Specimen adequacy was also compared.
Combining the results of all six sites and 6,747 patients, the ThinPrep System demonstrated a statistically significant 18% improvement in the detection of disease (LGSIL or higher classification) as compared to the conventional Pap smear. The results from the three screening centers indicated a 65% improvement in the
detection of disease, while in the three hospital sites in which patients had historically exhibited high prevalence rates of cervical abnormalities, the ThinPrep method demonstrated a 6% improvement. Based on the clinical trial results, the FDA cleared expanded product labeling for the ThinPrep System to include that the ThinPrep System is significantly more effective in detecting LGSIL and more severe lesions than the conventional Pap smear method in a variety of patient populations.
Slides from each patient were also evaluated for specimen adequacy. Combining the results of all six sites, the ThinPrep System reduced the SBLB classification rate of specimen adequacy by 29%, a statistically significant reduction. The Company believes, based on data submitted with its PMA application, that the ThinPrep System may reduce SBLB classifications by as much as 50% if the immersion of the sampling device in the PreservCyt Solution occurs directly after the sample is taken rather than after the preparation of a conventional Pap smear slide. The direct immersion procedure reflects the intended use of the ThinPrep System in clinical practice. Based on the clinical trial results, the FDA cleared expanded product labeling for the ThinPrep System to include that the specimen quality using the ThinPrep System is significantly improved over that of the conventional Pap smear method.
NON-GYNECOLOGICAL CYTOLOGY
In May 1991, the Company began commercial shipments of the ThinPrep Processor to cytology laboratories in the United States for use in non- gynecological testing applications. Non-gynecological specimens include sputum; voided and catheterized urine; body fluids such as peritoneal fluid, ascites fluid, or cerebrospinal fluid; brushing of respiratory or gastrointestinal tracts; and fine needle aspiration specimens obtained from a variety of sources such as the breast, thyroid, lung or liver. These samples are evaluated in patients in whom malignancy is strongly suspected or as follow-up information in patients previously diagnosed and treated for cancer.
MARKETING AND SALES
The Company's marketing and sales strategy is to achieve broad market acceptance of the ThinPrep System for cervical cancer screening. A critical element of its strategy is to utilize the results of the Company's 1995 clinical trial and expanded FDA labeling to demonstrate the safety and efficacy of the ThinPrep System to healthcare providers, third-party payors and clinical laboratories. The Company believes that coordination of the activity of these three market segments is necessary to achieve the desired level of market penetration of the ThinPrep System. In 1997, the Company implemented a full-scale commercial launch of the ThinPrep System in the United States with its direct marketing and sales force organization, complemented by the initiation of strategic marketing relationships with third parties.
The Company continues to expand its direct marketing and sales organization in the United States, supported by customer and technical service representatives. The Company's direct marketing and sales organization focuses on the clinical and economic benefits of the ThinPrep System for healthcare providers, third-party payors and clinical laboratories. The Company designs its marketing programs to establish and reinforce the recognition of its corporate and product names through investments in medical advertising, direct mail, focused medical educational symposia, trade shows and other promotional activities. The Company has also initiated an education and training program which will be offered to accredited cytology schools across the United States.
In addition to its direct sales efforts, the Company has built strategic marketing relationships with third parties, including Mead Johnson, a division of Bristol-Myers Squibb Company. The Company has entered into an agreement with Mead Johnson Nutritionals ("MJN") to build a joint sales force of approximately 500 sales representatives to co-promote the ThinPrep Pap Test directly to over 15,000 obstetricians and gynecologists throughout the United States. The Company has also entered into agreements with large clinical laboratory companies with a network of laboratories across the United States. The clinical laboratory companies have worked with the Company on marketing and sales programs, which generally involve joint marketing geared toward promoting the Company's products to physicians and third-party payors.
Following the initial market launch of the ThinPrep product in the United States, the Company has more recently expanded its marketing and sales efforts beyond the United States to Europe and Australia. The Company has established subsidiaries in Switzerland and Australia in 1997, and most recently in France and Italy, to handle sales, service, training and distribution to clinical laboratories. The Company's strategy is to establish a worldwide selling channel appropriate for developing an international customer-base, taking into consideration factors such as government regulations, screening cycles and clinical practices of the particular country or region. The Company is also evaluating the use of direct and indirect international sales channels, including contract sales organizations, distributors and marketing partners.
Due to limited market awareness of the ThinPrep System, the Company believes that both domestic and international sales efforts will continue to involve a lengthy process, requiring the Company to educate healthcare providers and third-party payors regarding the clinical benefits and cost-effectiveness of the ThinPrep System. The Company's success and growth will depend on market acceptance of the ThinPrep System among healthcare providers, third-party payors and clinical laboratories. The Company will continue to sell the ThinPrep 2000 Processor to customers and charge separately for related disposable reagents, filters and supplies. In the past, the Company has offered discounts to stimulate demand for the ThinPrep System and may elect to do so in the future, which discounts could have a material adverse effect on the Company's business, financial condition and results of operations.
In order to effectively market the ThinPrep System for cervical cancer screening, the Company will need to continue to increase its marketing and sales capabilities. No assurance can be given that the Company's direct sales force or strategic marketing relationships will succeed in promoting the ThinPrep System to healthcare providers, third-party payors or clinical laboratories, or that additional marketing and sales channels will be successfully established. While the Company is currently evaluating marketing and sales channels abroad, including contract sales organizations, distributors and marketing partners, the Company has established very limited foreign sales channels. There can be no assurance that the Company will be able to recruit and retain skilled marketing, sales, service or support personnel or foreign distributors, or that the Company's marketing and sales efforts will be successful. Failure to successfully expand its marketing and sales capabilities in the United States or establish its international marketing and sales organization internationally would have a material adverse effect on the Company's business, financial condition and results of operations. The Company's marketing success in the United States and abroad will depend on whether it can obtain required regulatory approvals, successfully demonstrate the cost-effectiveness of the ThinPrep System, further develop its direct sales capability and establish arrangements with contract sales organizations, distributors and marketing partners. Failure by the Company to successfully market its products would have a material adverse effect on the Company's business, financial condition and results of operations.
RESEARCH AND DEVELOPMENT
The Company's research and development strategy is to continue to develop innovative medical diagnostic applications of the ThinPrep technology and to continue to enhance the ThinPrep System. The Company has established a program to further enhance and automate the ThinPrep Processor. The Company's next generation instrument, the ThinPrep 3000 Processor, is being designed to provide batch processing and walk-away capability by increasing capacity to 80 sample vials and more fully-automating the slide preparation process. The Company expects to conduct clinical trials using the automated ThinPrep 3000 Processor in 1998. Although the Company anticipates that the ThinPrep 3000 Processor will be commercially available during early 1999, there can be no assurance that the ThinPrep 3000 will be successfully developed, receive necessary regulatory approvals, or be successfully commercialized.
The Company is also evaluating additional diagnostic applications of its ThinPrep technology in testing for the presence of other types of cancers and sexually transmitted diseases. The Company has not yet determined which of these applications, if any, it will seek to develop and commercialize. There can be no assurance that the Company will be successful in developing or marketing additional applications. Furthermore, any additional
applications will require submission of a PMA application or PMA supplement prior to the marketing of such applications. There can be no assurance that the FDA would approve such submissions on a timely basis, if at all.
In addition, the Company is evaluating the use of certain automated rescreening methods in conjunction with the ThinPrep System. Such systems use imaging technology to identify slides as more likely to contain cellular abnormalities. On November 8, 1996, the Company and Neopath, Inc. ("Neopath") announced the completion of a joint study of the feasibility of screening cervical specimens using the ThinPrep System in conjunction with Neopath's AutoPap QC. Additional development work would be required prior to application to the FDA for the use of such systems in combination. There can be no assurance that either company will conduct further development work with respect to this study or that the Company will be able to integrate successfully the ThinPrep technology with any automated rescreening technology. The Company is also developing imaging technology, which is also subject to regulatory approvals. There can be no assurance that the Company will obtain necessary regulatory approvals or successfully develop such imaging technology.
The Company's expenditures for research and development (which includes clinical trials, regulatory affairs and engineering) were approximately $3.9 million, $4.7 million, and $6.0 million for the years ended December 31, 1995, 1996 and 1997, respectively.
THIRD-PARTY REIMBURSEMENT
The Company intends to focus on obtaining coverage and reimbursement from major national and regional managed care organizations and insurance carriers throughout the United States. Most of the third-party payor organizations independently evaluate new diagnostic procedures by reviewing the published literature and the Medicare coverage and reimbursement policy on the specific diagnostic procedure. To assist the third-party payors in their respective evaluations of the ThinPrep System, the Company provides scientific and clinical data to support its claims of the safety and efficacy of the ThinPrep System. The Company believes that the ThinPrep System will allow for earlier detection of LGSIL and more severe lesions and result in less aggressive and costly treatment procedures. In addition, the Company expects that the ThinPrep System will significantly improve specimen adequacy, thereby reducing repeat office visits and test procedures and thus overall healthcare management costs. The Company will focus on earlier disease detection and cost savings benefits in establishing reimbursement for the ThinPrep method for cervical cancer screening.
In the United States, the current rate of reimbursement to laboratories from managed care organizations and other third-party payors to screen conventional Pap smears ranges from approximately $6.00 to $36.00 per test, with $17.00 as the most common rate of reimbursement. The Company believes that the cost per ThinPrep Pap Test, plus a laboratory mark-up, will be billed to third-party payors and result in a higher cost than the current charge for conventional Pap tests.
Successful sales of the ThinPrep System for cervical cancer screening in the United States and other countries will depend on the availability of reimbursement from third-party payors such as private insurance plans, managed care organizations, and Medicare and Medicaid. Although United HealthCare has announced that it will expand its healthcare coverage to include the ThinPrep Pap Test, the applicable rate of reimbursement is negotiated between United HealthCare or its various plans and the specific clinical laboratories servicing such plans. In February 1997, Blue Cross Blue Shield of Massachusetts announced that it would expand its healthcare coverage to include the ThinPrep Pap Test and since that announcement, fifteen additional Blue Cross and Blue Shield plans across the United States have added the ThinPrep Pap Test to their list of covered benefits. In 1997, the United States Healthcare Financing Administration ("USHCFA") determined that Medicare would cover the ThinPrep Pap Test. Because the ThinPrep Pap Test is a new test, the USHCFA did not assign a reimbursement level for the procedure, but instead allows Medicare intermediaries at the state level to "gap fill" or reimburse for the procedure based on the laboratory billing they receive. Although a number of managed care organizations have added the ThinPrep Pap Test to their coverage, there can be no assurance that third-party payors will provide or continue to provide such coverage, that reimbursement levels will be adequate or that healthcare providers or clinical laboratories will use the ThinPrep System for cervical cancer screening in lieu of the
conventional Pap smear method. There is significant uncertainty concerning third-party reimbursement for the use of any medical device incorporating new technology. In February 1998, the BlueCross BlueShield Association's Technology Evaluation Center announced results of a recent review of three new cervical cancer screening technologies, including the ThinPrep Pap Test, with respect to cost-effectiveness. Although the review concluded that such technologies offered only modest improvement, the Company believes that the study did not consider certain cost advantages inherent in using the ThinPrep System. The study's conclusions are not binding and do not represent a national coverage or reimbursement decision by the Blue Cross and Blue Shield organizations. Although the Company believes that to date the review has not caused any change in the decision of Blue Cross and Blue Shield plans currently reimbursing laboratories for the ThinPrep Pap Test, there can be no assurance that the review will not lead to adverse reimbursement decisions by Blue Cross, Blue Shield plans or others. Reimbursement by a third-party payor depends on a number of factors, including the level of demand by healthcare providers and the payor's determination that the use of the ThinPrep System represents a clinical advance compared to current technology and is safe and effective, medically necessary, appropriate for specific patient populations and cost-effective. Since reimbursement approval is required from each payor individually, seeking such approvals is a time-consuming and costly process which requires the Company to provide scientific and clinical data to support the use of the ThinPrep System to each payor separately. There can be no assurance that third-party reimbursement will be or remain available for the ThinPrep System or any other products that may be developed by the Company, or that such third-party reimbursement will be adequate.
A key component in the reimbursement decision by most private insurers and the United States Health Care Financing Administration, which administers Medicare, is the assignment of a CPT code which is used in the submission of claims to insurers for reimbursement for medical services. CPT codes are assigned, maintained and revised by the CPT Editorial Board administered by the American Medical Association. In 1997, the CPT Editorial Board assigned a new CPT code number 88142 effective as of January 1, 1998, specifically for liquid-based monolayer cervical cell specimen preparation.
The Company has limited experience in obtaining reimbursement for its products in the United States or other countries. In addition, third-party payors are routinely limiting reimbursement and coverage for medical devices and in many instances are exerting significant pressure on medical suppliers to lower their prices. Lack of or inadequate reimbursement by government and other third-party payors for the Company's products would have a material adverse effect on the Company's business, financial condition and results of operations. Further, outside of the United States healthcare reimbursement systems vary from country to country, and there can be no assurance that third-party reimbursement will be made available at an adequate level, if at all, for the ThinPrep System under any other reimbursement system.
MANUFACTURING
The Company manufactures its ThinPrep 2000 Processors and filters and purchases related disposable reagents and supplies from third parties. In November, 1997, the Company leased additional space at its current facility and currently has a lease for a total of approximately 97,000 square feet. The Company believes that its existing manufacturing equipment is adequate to meet the full-scale production demands for the ThinPrep System for cervical cancer screening.
In 1997, the Company installed new custom-built automated manufacturing equipment, which incorporates new materials handling procedures that increased production capacity. The Company is committed to expand its manufacturing capacity by ordering approximately $2.0 million of additional custom-built automated equipment, which is expected to be installed in late 1998.
The Company's manufacturing process is subject to pervasive and continuing regulation by the FDA, including the FDA's Good Manufacturing Practices ("GMP") requirements. Failure to comply with such regulations would materially impair the Company's ability to achieve or maintain commercial-scale production. Further, any failure of the Company's custom-built equipment to perform to the Company's specifications could impair the Company's ability to produce adequate quantities of ThinPrep supplies. Further, the Company has
limited manufacturing experience with the ThinPrep System and, accordingly, there can be no assurance that the Company's ThinPrep System for cervical cancer screening will perform adequately in the field when subjected to use under a variety of conditions. As a result, the Company may be subject to total or partial suspension of production, withdrawal of approval, and recall or seizure of products by the FDA in the event of product malfunction or failure.
In October 1997, the Company obtained ISO 9001 registration, an international quality standard. The Company has also met the applicable requirements to use the "CE" mark for its ThinPrep System. There can be no assurance that the Company will be able to maintain compliance with ISO 9001 or CE mark requirements. Failure to maintain compliance with the applicable manufacturing requirements of various regulatory agencies would have a material adverse effect on the Company's business, financial condition and results of operations.
Certain key components of the Company's ThinPrep System are currently provided to the Company by single sources. In the event that the Company is unable to obtain sufficient quantities of such components on commercially reasonable terms, or in a timely manner, the Company would not be able to manufacture its products on a timely and cost-competitive basis, which would have a material adverse effect on the Company's business, financial condition and results of operations. The Company must obtain approval of a PMA supplement in order to change suppliers or obtain new suppliers.
GOVERNMENT REGULATION
The manufacture and sale of medical diagnostic devices intended for commercial use are subject to extensive governmental regulation in the United States and in other countries. The Company's existing products, including the ThinPrep System, are regulated in the United States as medical devices by the FDA under the Federal Food, Drug, and Cosmetic Act ("FDC Act") and generally require premarket clearance or PMA approval prior to commercial distribution. In addition, certain material changes or modifications to medical devices also are subject to the FDA review and clearance or approval. Pursuant to the FDC Act, the FDA regulates the research, testing, manufacture, safety, labeling, storage, record keeping, advertising, distribution and production of medical devices in the United States. Noncompliance with applicable requirements can result in failure of the government to grant premarket approval for devices, withdrawal of clearances or approvals, total or partial suspension of production, fines, injunctions, civil penalties, recall or seizure of products, and criminal prosecution.
The regulatory approval process can be expensive, lengthy and uncertain. There can be no assurance that the Company will be able to obtain necessary regulatory approvals for any proposed future products or modifications of existing products. The failure to obtain approvals, loss of previously received approvals, or failure to comply with existing or future regulatory requirements, would have a material adverse effect on the Company's business, financial condition and results of operations.
The FDA's regulations require agency approval of a PMA supplement for certain changes if they affect the safety and effectiveness of the device, including, but not limited to, new indications for use; labeling changes; the use of a different facility or establishment to manufacture, process, or package the device; changes in manufacturing facilities, methods, or quality control systems; and changes in performance or design specifications.
The ThinPrep System for cervical cancer screening received PMA approval in May 1996. The Company anticipates that other proposed uses for the ThinPrep System will require approval of a PMA supplement or a new PMA application. There can be no assurance that such approvals will be obtained on a timely basis, or at all.
In July 1997, several petitions were filed requesting that the FDA review the PMA approval granted to the ThinPrep System. The petitions were filed pursuant to a provision of the FDC Act permitting any interested party to initiate a process by which the FDA may review an approval order and may issue an order affirming, reversing or modifying the approval. To the Company's knowledge, the FDA has conducted a review pursuant
to this provision only twice since the enactment of the Medical Device Amendments of 1976. The Company responded to the petitions by submitting comments in December 1997 arguing that the FDA should deny them. No assurance can be given that the FDA will not conduct a review of the PMA approval granted with respect to the ThinPrep System, nor can assurance be given that the FDA will not, after such review, issue an order reversing or unfavorably modifying the original PMA approval. Any such action by the FDA would have a material adverse effect on the Company.
The ThinPrep System is, and any other products manufactured or distributed by the Company pursuant to an approved PMA application and supplements will be, subject to pervasive and continuing regulation by the FDA, including record-keeping requirements, reporting of adverse experience with the use of the device, postmarket surveillance, postmarket registry and other actions as deemed necessary by the FDA. The Company is subject to FDA inspection for compliance with regulatory requirements. Product labeling and promotional activities are also subject to scrutiny by the FDA and, in certain instances, by the Federal Trade Commission. Products may only be promoted by the Company and any of its distributors for their approved indications. No assurance can be given that modifications to the labeling which may be required by the FDA in the future will not adversely affect the Company's ability to market or sell the ThinPrep Processor.
The Company also is subject to numerous federal, state and local laws relating to such matters as safe working conditions, manufacturing practices, environmental protection, fire hazard control and disposal of hazardous or potentially hazardous substances. There can be no assurance that the Company will not be required to incur significant costs to comply with such laws and regulations in the future, or that such laws or regulations will not have a material adverse effect upon the Company's business, financial condition and results of operations.
Sales of medical devices outside of the United States are subject to foreign regulatory requirements that vary widely from country to country. The time required to obtain approval by a foreign country may be longer or shorter than that required for FDA approval, and the requirements may differ. No assurance can be given that such foreign regulatory approvals will be granted on a timely basis, or at all. In addition, there can be no assurance that the Company will meet the FDA's export requirements or receive FDA export approval when such approval is necessary, or that countries to which the devices are to be exported will approve the devices for import. Failure of the Company to meet the FDA's export requirements or obtain FDA export approval when required to do so, or to obtain approval for import, could have a material adverse effect on the Company's business, financial condition and results of operations.
In February 1997, the Company received FDA approval of the Company's PMA supplement for the ThinPrep System using a combination of an endocervical brush and spatula sampling devices, which is a commonly used method of collecting samples for conventional Pap smears.
In April 1997, the Company received the FDA's approval of a PMA supplement of certain manufacturing process and material changes (and other related changes to the device, including a software modification).
In September 1997, the FDA approved the Company's supplemental PMA application for the testing for HPV directly from a single vial of patient specimen collected in a ThinPrep solution using the Hybrid Capture HPV DNA Assay of Digene Corporation.
The laboratories that would purchase the ThinPrep System are subject to extensive regulation under the Clinical Laboratory Improvement Amendments of 1988 (CLIA), which requires laboratories to meet specified standards in the areas of personnel qualifications, administration, participation in proficiency testing, patient test management, quality control, quality assurance and inspections. The Company believes that the device operates in a manner that will allow laboratories purchasing the device to comply with CLIA requirements. However, there can be no assurance that interpretations of current CLIA regulations or future changes in CLIA regulations would not make compliance by the laboratory difficult or impossible and therefore have an adverse effect on sales of the ThinPrep System.
PATENTS, TRADEMARKS, COPYRIGHTS, LICENSES AND PROPRIETARY RIGHTS
The Company relies on a combination of patents, trademarks, trade secrets, copyrights and confidentiality agreements to protect its proprietary technology, rights and know-how. The Company pursues patent protection
in the United States and files corresponding patent applications in certain foreign jurisdictions. The Company holds ten issued United States patents, two pending United States patent applications, and corresponding foreign patents or patent applications relating to various aspects of its ThinPrep technology. There can be no assurance, however, that pending patent applications will ultimately issue as patents or that the claims allowed in any of the Company's existing or future patents will provide competitive advantages for the Company's products or will not be successfully challenged or circumvented by competitors. Under current law, patent applications in the United States are maintained in secrecy until patents are issued and patent applications in foreign countries are maintained in secrecy for a period after filing. The right to a patent in the United States is attributable to the first to invent, not the first to file a patent application. The Company cannot be sure that its products or technologies do not infringe patents that may be granted in the future pursuant to pending patent applications or that its products do not infringe any patents or proprietary rights of third parties. In the event that any relevant claims of third-party patents are upheld as valid and enforceable, the Company could be prevented from selling its products or could be required to obtain licenses from the owners of such patents or be required to redesign its products to avoid infringement. There can be no assurance that such licenses would be available or, if available, would be on terms acceptable to the Company or that the Company would be successful in any attempts to redesign its products or processes to avoid infringement. The Company's failure to obtain these licenses or to redesign its products would have a material adverse effect on the Company's business, financial condition and results of operations. There can be no assurance that the obligations of employees of the Company and third parties with whom the Company has entered into confidentiality agreements to maintain the confidentiality of such trade secrets and proprietary information will effectively prevent disclosure of the Company's confidential information or provide meaningful protection for the Company's confidential information if there is unauthorized use or disclosure, or that the Company's trade secrets or proprietary information will not be independently developed by the Company's competitors. In addition, the Company is the exclusive licensee of certain patented technology from DEKA for use in the field of cytology related to the fluid pumping system used in the ThinPrep System. The Company is obligated to pay royalties equal to 1% of net sales of the ThinPrep Processor, filter cylinder disposable products which are used in the ThinPrep System, and improvements made by the Company relating to such items. The license provides that it may be terminated (1) by mutual written consent of both parties or (ii) by DEKA on written notice to the Company in the event that the license is assigned without the consent of DEKA. Failure by the Company to maintain rights to such technology could have a material adverse effect on the Company's business, financial condition and results of operations. The Company also holds unregistered rights to copyrights on documentation and operating software developed by it for the ThinPrep System. There can be no assurance that any copyrights owned by the Company will provide competitive advantages for the Company's products or will not be challenged or circumvented by its competitors. Litigation may be necessary to defend against claims of infringement, to enforce patents and copyrights of the Company, or to protect trade secrets and could result in substantial cost to, and diversion of effort by, the Company. There can be no assurance that the Company would prevail in any such litigation. In addition, the laws of some foreign countries do not protect the Company's proprietary rights to the same extent as do the laws of the United States.
COMPETITION
The Company faces direct competition from a number of publicly-traded and privately-held companies, including other manufacturers of thin layer slide preparation systems. Many of the Company's existing and potential competitors have substantially greater financial, marketing, sales, distribution and technical resources than the Company, and more experience in research and development, clinical trials, regulatory matters, manufacturing and marketing. In addition, many of these companies may have established third-party reimbursement for their products. Several established medical device manufacturers produce thin layer slide preparation systems for use in non- gynecological testing applications, at least one of which has achieved brand- name recognition and significant penetration in the non-gynecological cytology market. The Company is aware that another potential competitor, AutoCyte, Inc., has submitted a PMA for a system for the production and automated analysis of thin-layer slides, a potential alternative to the conventional Pap smear and the ThinPrep Pap Test. In addition, Neopath, Inc. is seeking FDA approval of its AutoPap QC product, an automated computer-aided imaging system, as a primary screening method. On January 28, 1998, the FDA's Hematology and
Pathology Devices panel unanimously recommended that the FDA approve the AutoPap QC for primary screening. The FDA typically accords substantial weight to a panel's recommendation but is not bound by it. The development, FDA approval and commercial marketing of such systems for cervical cancer screening could have a material adverse effect on the Company's business, financial condition and results of operations. In addition to direct competition, the Company faces indirect competition from companies which currently market imaging systems to reexamine or rescreen conventional Pap smears previously diagnosed as negative. The Company believes that these rescreening systems, as currently sold, could not be used with the ThinPrep System, and, therefore, if either of such systems is installed at or used by hospitals and reference laboratories, the Company's ability to market its products to such hospitals and laboratories could be materially adversely affected. In addition, if any company receives FDA approval of an imaging system as a primary screening system to replace some or all of the manual screening of conventional Pap smears, marketing of these systems for such purpose could have a material adverse effect on the Company's business, financial condition and results of operations. The medical device industry is characterized by rapid product development and technological advances. The Company's products could be rendered obsolete or uneconomical by the introduction and market acceptance of competing products, by technological advances of the Company's current or potential competitors or by other approaches. The Company competes on the basis of a number of factors, including manufacturing efficiency, marketing and sales capabilities and customer service and support, areas in which the Company currently has limited experience. There can be no assurance that the Company will be able to compete successfully against current or future competitors or that competition, including the development and commercialization of new products and technology, will not have a material adverse effect on the Company's business, financial condition or results of operations.
EMPLOYEES
As of December 31, 1997, the Company employed 209 persons. The Company is not subject to any collective bargaining agreements, has never experienced a work stoppage and considers its relations with its employees to be good.
ITEM 2.
ITEM 2. PROPERTIES
The Company's executive offices and manufacturing operations are located in Boxborough, Massachusetts in a leased facility consisting of approximately 97,000 square feet. The lease of this facility has a term of seven years beginning November 1997, with an option to extend the term for an additional five years. The Company believes this facility will satisfy its principal facilities requirements for the foreseeable future.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
On April 15, 1997, the Company commenced a lawsuit against Neuromedical Systems, Inc. ("NSI"), The PIE Mutual Insurance Company ("PIE"), Cytology West, Inc. ("CWI") and other parties in the United States District Court in Massachusetts (Civil Action No. 97-10740). The action was voluntarily dismissed without prejudice as to certain defendants, and dismissed as to the remaining defendants following the court's determination that personal jurisdiction was lacking.
The Company refiled its suit against NSI and two of its officers in the United States District Court for the Southern District of New York on June 24, 1997 (Civil Action No. 97 CIV 4642). The lawsuit includes claims of false and misleading advertising, unfair and deceptive trade practices, unfair competition, misappropriation of trade secrets, tortious interference with the Company's business relationships and defamation. In addition to seeking preliminary and permanent injunctions to stop NSI and its officers from such conduct, the Company seeks damages, including treble damages. On July 30, 1997, NSI moved to dismiss the Company's complaint. On September 5, 1997, the Court denied NSI's motion to dismiss. On September 19, 1997, the defendants filed answers and affirmative defenses to the Company's claims, denying liability, and on October 3, 1997, NSI filed counterclaims against the Company for false and misleading advertising, unfair competition and defamation. On November 12, 1997, the Company moved to dismiss NSI's counterclaims, and that motion is currently pending. The case is in the early stages of discovery. While the outcome of the action cannot be determined, the Company believes that the counterclaims are without merit, and intends to defend against them vigorously.
The Company also refiled its suit against PIE and its medical director in the United States District Court for the Northern District of Ohio, Eastern Division on July 3, 1997 (Civil Action No. 1:97 CV 1779). The complaint alleges false and misleading description and representation, unfair and deceptive trade practices, interference with advantageous relationships, defamation and commercial disparagement. The Company is seeking injunctive relief as well as damages, including treble damages. On September 2, 1997, the defendants filed an answer and affirmative defenses to the Company's claims, denying liability.
On May 14, 1997, CWI, a defendant in the Company's original lawsuit in Massachusetts, filed suit against the Company in the United States District Court for the District of Nevada (Civil Action, No. CV-S-97-00594-LDG (LRL)), alleging false description, false representation and unfair competition. On June 27, 1997, the Company filed a motion to dismiss the complaint. The Court has not rendered a decision on the Company's motion. On August 6, 1997, the Company filed counterclaims against CWI and third party claims against its President, including claims for false and misleading description and representation, unfair competition, interference with advantageous relationships, defamation, commercial disparagement and abuse of process. On August 26, 1997, CWI and its President filed an answer and affirmative defenses to the Company's counterclaims, denying liability. On January 23, 1998, the Company voluntarily withdrew its claim for abuse of process. While the outcome of the action cannot be determined the Company believes the claims against the Company are without merit, and intends to defend against those claims vigorously.
Each of the above pending actions are in the early stages of discovery and, accordingly, the Company is unable to determine the extent of its liability, if any, or the likelihood of prevailing in such actions.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
There were no matters submitted to a vote of security holders of the Company during the fourth quarter of the fiscal year ended December 31, 1997.
PART II
ITEM 5.
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED SECURITY HOLDER MATTERS
The Company's Common Stock is traded on the Nasdaq National Market under the symbol "CYTC." The following table sets forth, for the calendar periods indicated since the Company's initial public offering in March 1996, the range of high and low sales prices for the Common Stock of the Company on the Nasdaq National Market. These prices do not include retail mark-up, mark-down or commissions and may not represent actual transactions.
On March 23, 1998, the last reported sales price of the Common Stock on the Nasdaq National Market was $24 13/16 per share. As of March 23, 1998, there were approximately 275 holders of record of the Common Stock.
For the year ended December 31, 1997, no shares of Common Stock have been sold which were not registered under the Securities Act.
The Company has never declared or paid cash dividends. The Company currently intends to retain any earnings for use in its business and does not anticipate paying any cash dividends on its capital stock in the foreseeable future.
ITEM 6.
ITEM 6. SELECTED CONSOLIDATED FINANCIAL DATA
The selected consolidated financial data set forth below for each of the years ended December 31, 1995, 1996 and 1997 and at December 31, 1996 and 1997 are derived from consolidated financial statements of the Company audited by Arthur Andersen LLP, independent public accountants, which are included elsewhere herein. The consolidated selected financial data for the years ended December 31, 1993 and 1994 and at December 31, 1993, 1994 and 1995 are derived from consolidated financial statements of the Company audited by Arthur Andersen LLP which are not included herein. The selected consolidated financial data set forth below should be read in conjunction with the Consolidated Financial Statements and related Notes thereto and with Management's Discussion and Analysis of Financial Condition and Results of Operations included as Items 7 and 8 in this Form 10-K.
- -------- (1) See Note 2 of Notes to Consolidated Financial Statements for an explanation of the computation of Basic, Diluted and Pro forma diluted per share data.
ITEM 7.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
OVERVIEW
The Company designs, develops, manufactures and markets a sample preparation system for medical diagnostic applications. The ThinPrep System consists of the Thin Prep 2000 Processor, and related disposable reagents, filters and other supplies. The Company has marketed the ThinPrep System for use in non- gynecological testing applications since 1991. On May 20, 1996, the Company received PMA approval from the FDA to market the ThinPrep System for cervical cancer screening as a replacement for the conventional Pap smear method. On November 6, 1996, the FDA cleared expanded product labeling for the ThinPrep System to include the claim that the ThinPrep System is significantly more effective in detecting LGSIL and more severe lesions than the conventional Pap smear method in a variety of patient populations. The expanded labeling also indicates that the specimen quality using the ThinPrep System is significantly improved over that of the conventional Pap smear method. On February 25, 1997, the FDA approved the Company's supplemental PMA application for use of a combination of an endocervical brush and spatula sampling devices, which is a commonly used method of collecting samples for conventional Pap smears. On September 4, 1997, the FDA approved the Company's supplemental PMA application for the testing for HPV directly from a single vial of patient specimen collected in a ThinPrep solution using the Hybrid Capture HPV DNA Assay of Digene Corporation. The Company conducted the full-scale commercial launch of the ThinPrep System for cervical cancer screening in the United States in 1997.
Since inception, the Company has incurred substantial losses, principally from expenses associated with obtaining FDA approval of the Company's ThinPrep System for cervical cancer screening, engineering and development efforts related to the ThinPrep System, expansion of the Company's manufacturing facilities, and the establishment of a marketing and sales organization. The Company expects such losses to continue for the foreseeable future as it expands its domestic and establishes its international marketing and sales activities, continues its product development efforts, and commences full- scale manufacturing of the ThinPrep System for cervical cancer screening. The operating results of the Company have fluctuated significantly in the past on an annual and a quarterly basis. The Company expects that its operating results will fluctuate significantly from quarter to quarter in the future and will depend on a number of factors, including the extent to which the Company's products gain market acceptance, the rate and size of expenditures incurred as the Company expands its domestic and establishes its international sales and distribution networks, the timing of any approvals of the ThinPrep System for reimbursement by third-party payors, and other factors, many of which are outside the Company's control.
The Company occupies a 97,000 square foot facility in Boxborough, Massachusetts. The Company has installed new custom-built automated equipment for the high-volume manufacture of disposable filters for use in connection with the ThinPrep System.
The Company believes that in the United States, the current rate of reimbursement of laboratories from managed care organizations and other third- party payors to screen conventional Pap smears ranges from approximately $6.00 to $36.00 per test, with $17.00 as the most common rate of reimbursement.
The Company believes that the cost per ThinPrep Pap Test, plus a laboratory mark-up, will be billed to third-party payors and result in a higher cost than the current charge for conventional Pap tests. In the past, the Company has offered discounts to stimulate demand for the ThinPrep System and may elect to do so in the future, which discounts could have a material adverse effect on the Company's business, financial condition and results of operations.
The Company believes that its expanded FDA labeling supported by clinical field and trial results may assist in the establishment of increased reimbursement for the ThinPrep Pap Test. Although United HealthCare has announced that it will expand its healthcare coverage to include the ThinPrep Pap Test, the applicable rate of reimbursement is negotiated between United HealthCare or its various plans and the specific clinical laboratories servicing such plans. In February 1997, Blue Cross Blue Shield of Massachusetts announced that it would expand its healthcare coverage to include the ThinPrep Pap Test and since that announcement, fifteen additional Blue Cross and Blue Shield plans across the United States have added the ThinPrep Pap Test to their list of covered benefits. In 1997, the United States Health Care Financing Administration ("USHCFA") determined that Medicare would cover the ThinPrep Pap Test. Because the ThinPrep Pap Test is a new test, the USHCFA did not assign a reimbursement level for the procedure, but instead allows Medicare intermediaries at the state level to "gap fill" or reimburse for the procedure based on the laboratory billing they receive. Although a number of managed care organizations have added the ThinPrep Pap Test to their coverage, there can be no assurance that third-party payors will provide or continue to provide such coverage, that reimbursement levels will be adequate or that healthcare providers or clinical laboratories will use the ThinPrep System for cervical cancer screening in lieu of the conventional Pap smear method.
The Company will continue to increase the amount of expenditures for marketing, sales and customer support activities of the ThinPrep System for cervical cancer screening. There can be no assurance, however, that such investments will result in increased net sales or that the Company's direct sales force will succeed in promoting the ThinPrep System to healthcare providers, third-party payors or clinical laboratories, or that additional marketing and sales channels will be successfully established. During 1997, the Company entered into a number of agreements in connection with its marketing and sales activities, including a co-promotion agreement with Mead Johnson & Company, a division of Bristol-Myers Squibb, to promote the ThinPrep Pap Test to obstetricians in the United States, and an agreement with Quest Diagnostics Incorporated to provide ThinPrep Pap Testing at its clinical laboratories in the United States. The Quest Diagnostics agreement is exclusive in that Quest will only provide other liquid-based mono or thin layer sample preparation technologies if FDA labeling claims for such products exceed the FDA labeling claims of the ThinPrep System and will only provide computer aided rescreening upon customer initiated request. Quest Diagnostics and the Company agreed to coordinate their efforts in planning and marketing the ThinPrep Pap Test to medical professionals and third party payors. There can be no assurance that such marketing, sales and customer support activities will result in increased net sales, that the agreements with Mead Johnson & Company, Quest Diagnostics Incorporated or other third parties will be successful, that the Company's direct sales force will succeed in promoting the ThinPrep System to health care providers, third-party payors or clinical laboratories, or that additional marketing and sales channels will be successfully established.
The Company will continue to increase its expenditures for research and development to fund development of follow-on products and additional applications of ThinPrep technology. The Company will also continue to increase the amount of expenditures for administrative activities, principally for the employment of additional administrative personnel, increases in professional fees and the incremental costs associated with being a publicly- held company.
The Company is the exclusive licensee of certain patented technology used in the ThinPrep System. In consideration for this license, the Company has agreed to pay a royalty equal to 1% of net sales of the ThinPrep Processor, filter cylinder disposable products that are used with the ThinPrep System, and improvements made by the Company relating to such items. Royalty payments, in connection with this license for the years ended 1995, 1996 and 1997 were $19,000, $53,000 and $135,000, respectively.
RESULTS OF OPERATIONS
Years Ended December 31, 1997 and December 31, 1996
Net sales increased to $26.3 million in 1997 from $8.2 million in 1996, an increase of 221.4%. This increase in sales was primarily due to an increase in the number of ThinPrep Processors sold, sales of the Company's ThinPrep Pap Test for cervical cancer screening, and additional sales of related reagents, filters and other supplies for non-gynecological testing. Gross profit increased to $18.3 million in 1997 from $3.8 million in 1996, an increase of 377.1%, and the gross margin increased to 69.6% in 1997 from 46.9% in 1996. Management attributes the increase in gross margin in 1997 primarily to the introduction and sales of the ThinPrep Pap Test beginning in the later part of 1996, the subsequent change in product mix, and increased sale prices for non-gynecological tests and ThinPrep 2000 Processors.
Total operating expenses increased to $45.6 million in 1997 from $17.9 million in 1996, an increase of 154.2%. Research and development costs increased to $6.0 million in 1997 from $4.7 million in 1996, an increase of 29.0%, as a result of employment of additional research and development personnel and engineering consulting expenses. Sales, marketing and customer support increased to $31.8 million in 1997 from $9.9 million in 1996, an increase of 220.2%. The increase in sales, marketing and customer support costs reflects the employment of additional sales and customer support personnel, increased commission expenses, expenses associated with the Mead Johnson co-promotion agreement, and additional marketing consulting costs related to the commercial launch of the ThinPrep Pap Test. General and administrative costs increased to $7.7 million in 1997 from $3.3 million in 1996, an increase of 133.7%, due to the employment of additional administrative personnel, increased business insurance costs, and legal expenses. Net interest income increased to $5.1 million in 1997 from $2.2 million in 1996, an increase of 138.3%, due to an increase in the average cash balance available for investment.
Years Ended December 31, 1996 and December 31, 1995
Net sales increased to $8.2 million in 1996 from $4.3 million in 1995, an increase of 91.9%. This increase in sales was primarily due to an increase in the number of ThinPrep Processors sold, initial sales of the Company's new ThinPrep Pap Test for cervical cancer screening, and additional sales of related reagents, filters and other supplies for non-gynecological testing. Gross profit increased to $3.8 million in 1996 from $1.9 million in 1995, an increase of 106.7%, and the gross margin increased to 46.9% in 1996 from 43.5% in 1995. Management attributes the increase in gross margin in 1996 to the introduction of the ThinPrep Pap Test during the later part of 1996 and increased sale prices for non-gynecological tests and ThinPrep 2000 Processors, offset partially by the lower unit margin for unit sales to existing customers upgrading to the ThinPrep 2000 Processor.
Total operating expenses increased to $17.9 million in 1996 from $8.0 million in 1995, an increase of 123.4%. Research and development costs increased to $4.7 million in 1996 from $3.9 million in 1995, an increase of 20.0%, as a result of employment of additional research and development personnel and engineering consulting expenses. Sales, marketing and customer support increased to $9.9 million in 1996 from $2.6 million in 1995, an increase of 284.1%. The increase in sales, marketing and customer support costs reflects the employment of additional sales and customer support personnel, increased commission expenses, increased customer training costs and additional marketing consulting costs related to the commercial launch of the ThinPrep Pap Test. General and administrative costs increased to $3.3 million in 1996 from $1.5 million in 1995, an increase of 116.3% due to the employment of additional administrative personnel, increased business insurance costs and expenses associated with being a publicly-held company. Net interest income increased to $2.2 million in 1996 from $262,000 in 1995, an increase of 729.8%, due to an increase in the average cash balance available for investment.
LIQUIDITY AND CAPITAL RESOURCES
Since inception, the Company's expenses have significantly exceeded its revenue, resulting in an accumulated deficit of $69.2 million as of December 31, 1997. The Company has funded its operations primarily through the private placement and public sale of equity securities aggregating $165.4 million, net of offering expenses. At December 31, 1997, the Company had cash, cash equivalents and short-term investments of $85.4 million. Cash, cash equivalents and short-term investments increased during 1997 primarily due to the issuance of 3,197,500 shares of Common Stock in connection with the Company's second public offering for aggregate net proceeds of approximately $70.6 million. Cash used in the Company's operations was $7.0 million, $13.7 million and $22.0 million for 1995, 1996 and 1997 respectively. The increase in cash used in operations in 1997 was primarily due to a significant loss from operations of $27.2 million, which included the expansion of the Company's marketing, sales and customer support organizations, offset by an increase in current liabilities.
The Company's capital expenditures for the years ended 1995, 1996 and 1997 were $663,000, $4.8 million, and $1.7 million respectively. The decrease in capital expenditures in 1997 was due primarily to reduced purchases for customized manufacturing equipment and leasehold improvements for the Company's new facility. Additionally, as of December 31, 1997, the Company had commitments for customized manufacturing equipment of approximately $2.0 million.
Accounts receivable increased $7.8 million to approximately $10.5 million during 1997 as a result of increased sales volume. Inventories increased approximately $1.8 million to $3.2 million from December 31, 1996 to December 31, 1997 due primarily to the Company's planned sales increase of ThinPrep Pap Tests, ThinPrep 2000 Processors and reagents, filters and other supplies for non-gynecological testing in 1998. Stockholders' equity increased approximately $49.5 million from December 31, 1996 to December 31, 1997 primarily due to the sale of 3,197,500 shares of Common Stock in connection with the Company's second public offering in February 1997, which was offset by the net loss of $22.1 million.
The Company's future liquidity and capital requirements will depend upon numerous factors, including the resources required to further develop its marketing and sales capabilities, both domestic and international, and the extent to which such activities generate market acceptance and demand for the ThinPrep System for cervical cancer screening. The Company's capital requirements will also depend upon the progress of the Company's research and development programs including clinical trials, the receipt of and the time required to obtain regulatory clearances and approvals, and the resources the Company devotes to developing, manufacturing and marketing its products. In addition, the Company's capital requirements will depend on the extent of potential liabilities, if any, and costs associated with, existing or future litigation. See "Legal Proceedings." There can be no assurance that the Company will not require additional financing or will not in the future seek to raise additional funds through bank facilities, debt or equity offerings or other sources of capital. Additional funding may not be available when needed or on terms acceptable to the Company, which would have a material adverse effect on the Company's business, financial condition and results of operations.
CERTAIN FACTORS WHICH MAY AFFECT FUTURE RESULTS
The Company does not provide financial performance forecasts. The forward looking statements in this Form 10-K are made under the safe harbor provisions of Section 21E of the Securities Exchange Act of 1934, as amended. The Company's operating results and financial condition have varied and may in the future vary significantly depending on a number of factors. Statements in this Form 10-K which are not strictly historical statements, including, without limitation, statements regarding management's plans and objectives for future operations, domestic and international marketing and sales plans, product plans and performance, potential savings to the healthcare system, management's assessment of market factors, as well as statements regarding the strategy and plans of the Company, constitute forward-looking statements that involve risks and uncertainties. The following factors, among others, could cause actual results to differ materially from those contained in forward- looking statements made in this report and presented elsewhere by management from time to time. Such
factors, among others, may have a material adverse effect upon the Company's business, results of operations and financial conditions.
The following discussion of the Company's risk factors should be read in conjunction with the consolidated financial statements and related notes included herein. Because of these and other factors, past financial performance should not be considered an indication of future performance.
Dependence on Single Product. Substantially all of the Company's revenues to date have been derived from sales of its ThinPrep 2000 Processor and predecessor instruments, and related reagents, filters and other supplies, for use in gynecological and non-gynecological testing applications. The Company's inability to successfully commercialize the ThinPrep System for cervical cancer screening or to obtain adequate third-party reimbursement coverage, among other factors, would have a material adverse effect on the Company's business, financial condition and results of operations.
Uncertainty of Market Acceptance and Additional Cost. The Company's success and growth will depend on market acceptance of the ThinPrep System for cervical cancer screening by healthcare providers, third-party payors and clinical laboratories. The laboratory cost of using the ThinPrep System for cervical cancer screening is higher than that of a conventional Pap smear. Due in part to increased competitive pressures in the healthcare industry to reduce costs, the Company's ability to gain market acceptance of the ThinPrep System for cervical cancer screening will depend on the Company's ability to demonstrate that the higher cost of using the ThinPrep System will be offset by a reduction in costs often associated with conventional Pap smears, including inaccurate diagnoses and the need for repeat Pap tests.
Limited Marketing and Sales Experience. Although the Company received clearance from the FDA to market its ThinPrep System for cervical cancer screening on May 20, 1996, the Company initiated full-scale marketing and sales efforts for the ThinPrep System in United States beginning only in the first quarter of 1997. The Company depends on strategic marketing relationships with Mead Johnson and large clinical laboratories to effect commercial-scale marketing in the United States. There can be no assurance that such relationships will succeed in promoting the ThinPrep System in the United States. The Company has limited experience in selling the ThinPrep System for cervical cancer screening, and no assurance can be given that its direct marketing and sales organization will succeed in promoting the ThinPrep System in the United States or internationally.
Dependence on Third-Party Reimbursement. Successful sales of the ThinPrep System for cervical cancer screening in the United States and other countries will depend on the availability of adequate reimbursement from third-party payors such as private insurance plans, managed care organizations, and Medicare and Medicaid. Although United HealthCare has announced that it will expand its healthcare coverage to include the ThinPrep Pap Test, the applicable rate of reimbursement is negotiated between United HealthCare or its various plans and the specific clinical laboratories servicing such plans. In February 1997, Blue Cross Blue Shield of Massachusetts announced that it would expand its healthcare coverage to include the ThinPrep Pap Test and since that announcement, fifteen additional Blue Cross and Blue Shield plans across the United States have added the ThinPrep Pap Test to their list of covered benefits. Although a number of managed care organizations have added the ThinPrep Pap Test to their coverage, there can be no assurance that reimbursement will be available, reimbursement levels will be adequate or that healthcare providers or clinical laboratories will use the ThinPrep System for cervical cancer screening in lieu of the conventional Pap smear method. In February 1998, the BlueCross BlueShield Association's Technology Evaluation Center announced results of a recent review of three new cervical cancer screening technologies, including the ThinPrep Pap Test, with respect to cost- effectiveness. Although the review concluded that such technologies offered only modest improvement, the Company believes that the study did not consider certain cost advantages inherent in using the ThinPrep System. The study's conclusions are not binding and do not represent a national coverage or reimbursement decision by the Blue Cross and Blue Shield organizations. Although the Company believes that to date the review has not caused any change in the decision of Blue Cross and Blue Shield plans currently reimbursing laboratories for the ThinPrep Pap Test, there can be no assurance that the review will not lead to adverse reimbursement decisions by Blue Cross, Blue Shield plans or others. There is significant uncertainty concerning third-party reimbursement for the use of any medical device incorporating new technology.
Limited Number of Customers and Lengthy Sales Process. Due in part to a recent trend toward consolidation of clinical laboratories, the Company expects that the number of potential domestic customers for its products will decrease. Due to the relative size of the largest United States laboratories, it is likely that a significant portion of ThinPrep System sales will be concentrated among a relatively small number of large clinical laboratories. Further, in order to generate demand for the ThinPrep Pap Test among clinical laboratories, the Company will be required to educate physicians and healthcare providers regarding the clinical benefits and cost-effectiveness of the ThinPrep System as well as to demonstrate to such parties that adequate levels of reimbursement will be available for the ThinPrep Pap Test, a process which the Company believes will require a lengthy sales effort.
Limited Operating History; Uncertainty of Profitability. The Company has a limited operating history and, to date, has focused on product development, clinical trials, obtaining regulatory approvals, the expansion of manufacturing facilities and the establishment of marketing and sales capabilities for its ThinPrep System for cervical cancer screening in the United States and abroad. The Company has limited experience in marketing and selling the ThinPrep System for cervical cancer screening. The Company's future revenues and profitability are critically dependent on the Company's ability to successfully market and sell the ThinPrep System for cervical cancer screening.
Risks Associated with Commercialization. In connection with the full-scale commercialization of the ThinPrep System for cervical cancer screening, the Company has significantly expanded its facilities and intends to continue to significantly increase the number of its marketing and sales, engineering, and financial personnel, and enhance or replace its management information systems. Such activities are likely to place significant strain on the Company's management, operations and systems.
Intense Competition. The Company faces direct competition from a number of publicly-traded and privately-held companies, including at least one other manufacturer of a thin layer slide preparation system which is seeking approval of its PMA application. In addition, Neopath, Inc. is seeking FDA approval of its AutoPap QC product, an automated computer-aided imaging system, as a primary screening method. On January 28, 1998, the FDA's Hematology and Pathology Devices Panel unanimously recommended that the FDA approve the AutoPap QC for primary screening. The FDA typically accords substantial weight to a panel's recommendation but is not bound by it. The development, FDA approval and commercial marketing of such systems for cervical cancer screening could have a material adverse effect on the Company's business, financial condition and results of operations. Many of the Company's existing and potential competitors have substantially greater financial, marketing, sales, distribution and technical resources than the Company, and more experience in research and development, clinical trials, regulatory matters, manufacturing and marketing.
History of Losses. The Company has incurred substantial losses since inception. The Company expects such losses to continue for the foreseeable future due to expansion of its sales and marketing activities, both domestic and international, its product development efforts, and commencement of full- scale commercial manufacturing.
Potential Fluctuations in Future Quarterly Results. The Company expects that its operating results will fluctuate significantly from quarter to quarter in the future and will depend on a number of factors, many of which are outside the Company's control. These factors include: the extent to which the Company's products gain market acceptance; the rate and size of expenditures incurred as the Company expands its domestic and establishes its international sales and distribution networks; the timing of any approvals of the ThinPrep System for reimbursement by third-party payors; the timing and size of sales; the likelihood and timing of FDA approval of PMA supplements related to the ThinPrep System; the timing and size of expenditures incurred in the research and development of new products; and the introduction and market acceptance of competing products or technologies.
Extensive Government Regulation. The manufacture and sale of medical diagnostic devices are subject to extensive government regulation in the United States and in other countries. The process of obtaining FDA and
other required regulatory approvals can be time-consuming, expensive and uncertain, frequently requiring several years from the commencement of clinical trials to the receipt of regulatory approval. After approval, the Company and its medical products remain subject to pervasive regulation and FDA inspection for compliance with regulatory requirements. In July 1997, several petitions were filed requesting that the FDA review the PMA approval granted to the ThinPrep System. The petitions were filed pursuant to a provision of the FDC Act permitting any interested party to initiate a process by which the FDA may review an approval order and may issue an order affirming, reversing or modifying the approval. To the Company's knowledge, the FDA has conducted a review pursuant to this provision only twice since the enactment of the Medical Device Amendments of 1976. The Company responded to the petitions by submitting comments in December 1997 arguing that the FDA should deny them. No assurance can be given that the FDA will not conduct a review of the PMA approval granted to the ThinPrep System, nor can assurance be given that the FDA will not, after such review, issue an order reversing or unfavorably modifying the original PMA approval. Any such action by the FDA would have a material adverse effect on the Company.
International Sales and Operations Risks. The Company has commenced sale of its ThinPrep System and intends to sell any future products to customers both in the United States and internationally. While the Company is evaluating marketing and sales channels abroad, including contract sales organizations, distributors and marketing partners, the Company currently has very limited foreign sales channels in place at this time. There can be no assurance that the Company will successfully develop international sales capabilities or that, if the Company establishes such capabilities, the Company will be successful in obtaining reimbursement or any regulatory approvals required in foreign countries.
Uncertainty of Additional Applications. The Company intends to continue to evaluate additional diagnostic applications of its ThinPrep technology in testing for the presence of other types of cancers and sexually transmitted diseases. The Company has not yet determined which of these applications, if any, it will seek to develop and commercialize.
Dependence on Key Personnel. The Company is highly dependent on the principal members of its management and scientific staff, the loss of whose services might impede achievement of its research and development or strategic objectives. The Company's success will depend on its ability to retain key employees and to attract additional qualified employees.
Dependence on Patents, Copyrights, Licenses and Proprietary Rights; Risk of Third-Party Claims of Infringement. The Company relies on a combination of patents, trade secrets, copyrights and confidentiality agreements to protect its proprietary technology, rights and know-how. In addition, the Company is the exclusive licensee of certain patented technology for use in the field of cytology related to the fluid pumping system used in the ThinPrep System. Failure by the Company to protect, defend and maintain such intellectual property rights, or a third party claim of infringement, could have a material adverse effect on the Company's business, financial condition and results of operations.
Dependence on Single Source Suppliers. Certain key components of the ThinPrep System, including its proprietary filter, are currently provided to the Company by single sources. In the event that the Company is unable to obtain sufficient quantities of such components on commercially reasonable terms, or in a timely manner, the Company would not be able to manufacture its products on a timely and cost-competitive basis, which would have a material adverse effect on the Company's business, financial condition and results of operations.
Year 2000 Compliance. The Company has taken actions to understand the nature and extent of work required to make its products, systems and infrastructure Year 2000 compliant. The Company uses a number of computer software programs and operating systems in its internal operations, including applications used in manufacturing, product development, financial business systems and various administrative functions. To the extent that these software applications contain source code that is unable to appropriately interpret the upcoming year "2000," some level of modification or possibly replacement of such source code or applications will be
necessary. While these efforts will involve some additional costs, the Company believes, based on available information, that it will be able to manage its total Year 2000 transition without any material adverse effect on its business, financial condition or operating results.
Impact of Ongoing Litigation. The Company is currently involved in ongoing commercial litigation. Any such litigation, regardless of the outcome, could result in substantial cost to the Company and divert management's attention from the Company's operations.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
The information required by this item may be found on pages through of this Form 10-K.
ITEM 9.
ITEM 9. DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
There have been no changes in or disagreements with accountants on accounting or financial disclosure matters in the last two fiscal years.
PART III
ITEM 10.
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
The information required under this item may be found under the sections captioned "Election of Directors," "Occupations of Directors and Executive Officers" and "Section 16(a) Beneficial Ownership Reporting Compliance" in the Company's Proxy Statement (the "1998 Proxy Statement"), which will be filed with the Securities and Exchange Commission not later than 120 days after the close of the Company's fiscal year ended December 31, 1997, and is incorporated herein by reference.
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION
The information required under this item may be found under the section captioned "Compensation and Other Information concerning Directors and Officers" in the 1998 Proxy Statement, and is incorporated herein by reference.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
The information required under this item may be found under the section captioned "Securities Ownership of Certain Beneficial Owners and Management" in the 1998 Proxy Statement, and is incorporated herein by reference.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
The information required under this item may be found under the caption "Certain Relationships and Related Transactions" in the 1998 Proxy Statement, and is incorporated herein by reference.
PART IV
ITEM 14.
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K
(a)(1) Consolidated Financial Statements.
For a list of the consolidated financial information included herein, see Index on page.
(a)(2) Financial Statement Schedules.
Schedules not listed above have been omitted because the information required to be set forth therein is not applicable or is shown in the accompanying Consolidated Financial Statements or notes thereto.
(a)(3) List of Exhibits.
The following exhibits are filed as part of and incorporated by reference into, this Annual Report on Form 10-K:
- -------- (1) Incorporated herein by reference to the exhibits to the Company's Registration Statement on Form S-1 (File No. 333-00300). (2) Incorporated by reference to the exhibits to the Company's Registration Statement on Form S-1 (File No. 333-19367). (3) Incorporated herein by reference to Exhibit 4.1 to the Company's Current Report on Form 8-K, filed August 29, 1997 (File No. 000-27558). (4) Incorporated herein by reference to Exhibit 10.1 to the Company's Quarterly Report on Form 10-Q, filed August 8, 1997. *Indicates a management contract or any compensatory plan, contract or arrangement **Filed herewith. *** Such report, except for those portions thereof which are expressly incorporated by reference herein, is furnished for the information of the Commission and is not to be deemed "filed" as part of this Annual Report on Form 10-K.
# Confidential treatment granted as to certain portions. + Confidential treatment requested as to omitted portions pursuant to Rule 24b-2 promulgated under the Securities Exchange Act of 1934, as amended.
(b) Reports On Form 8-K
There were no reports on Form 8-K filed by the Company for the quarter ended December 31, 1997
(c) Exhibits
The Company hereby files as part of this Annual Report on Form 10-K the exhibits listed in Item 14(a)(3) set forth above. Exhibits which are incorporated herein by reference may be inspected and copied at the public reference facilities maintained by the SEC at Room 1024, Washington, D.C. 20549, and at the SEC's regional offices located at Seven World Trade Center, Suite 1300, New York, New York 10048, and at Citicorp Center, 500 West Madison Street, Suite 1400, Chicago, Illinois 60611-2511. Copies of such material may be obtained by mail from the Public Reference Section of the SEC at Judiciary Plaza, 450 Fifth Street, N.W., Washington, D.C. 20549, at prescribed rates. The SEC also maintains a Website that contains reports, proxy and information statements and other information regarding registrants that file electronically with the SEC at the address "http://www.sec.gov"
SIGNATURES
PURSUANT TO THE REQUIREMENTS OF SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934, THE REGISTRANT HAS DULY CAUSED THIS REPORT TO BE SIGNED ON ITS BEHALF BY THE UNDERSIGNED, THEREUNTO DULY AUTHORIZED.
Cytyc Corporation
Date: March 30, 1998
/s/ Patrick J. Sullivan By: _________________________________ PRESIDENT AND CHIEF EXECUTIVE OFFICER
POWER OF ATTORNEY AND SIGNATURES
We, the undersigned officers and directors of Cytyc Corporation, hereby severally constitute and appoint Patrick J. Sullivan and Joseph W. Kelly, and each of them singly, our true and lawful attorneys, with full power to both of them and each of them singly, to sign for us and in our names in the capacities indicated below, any amendments to this Report on Form 10-K, and generally to do all things in our names and on our behalf in such capacities to enable Cytyc Corporation to comply with the provisions of the Securities Exchange Act of 1934, as amended, and all the requirements of the Securities and Exchange Commission.
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant, in the capacities and on the dates indicated.
CYTYC CORPORATION
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS
To the Stockholders and Board of Directors of Cytyc Corporation:
We have audited the accompanying consolidated balance sheets of Cytyc Corporation (a Delaware corporation) and subsidiaries as of December 31, 1996 and 1997, 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, 1997. These consolidated 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 generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Cytyc Corporation and subsidiaries as of December 31, 1996 and 1997 and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1997, in conformity with generally accepted accounting principles.
Arthur Andersen LLP
Boston, Massachusetts January 26, 1998
CYTYC CORPORATION
CONSOLIDATED BALANCE SHEETS (IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA)
The accompanying notes are an integral part of these consolidated financial statements.
CYTYC CORPORATION
CONSOLIDATED STATEMENTS OF OPERATIONS (IN THOUSANDS, EXCEPT PER SHARE DATA)
The accompanying notes are an integral part of these consolidated financial statements.
CYTYC CORPORATION
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (DEFICIT) (IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA)
The accompanying notes are an integral part of these consolidated financial statements
CYTYC CORPORATION
CONSOLIDATED STATEMENTS OF CASH FLOWS (IN THOUSANDS)
The accompanying notes are an integral part of these consolidated financial statements.
CYTYC CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(1) THE COMPANY
Cytyc Corporation and subsidiaries (the Company) design, develop, manufacture and market sample preparation systems for medical diagnostic applications. The Company's principal product, the ThinPrep System, is an automated system for the preparation of non-gynecological samples and cervical specimens on microscope slides.
In 1991, the Company commenced commercial sales of ThinPrep Processors, reagents, filters and related supplies for non-gynecological diagnostic applications to clinical laboratories and hospitals. On May 20, 1996, the Company received clearance from the U.S. Food and Drug Administration to market the ThinPrep System for cervical cancer screening.
To date, revenue from sales of products have not generated sufficient cash to support the Company's operations. Since inception, the Company has incurred substantial losses, principally from expenses associated with obtaining FDA approval of the ThinPrep System, engineering and development efforts related to the ThinPrep System and the establishment of a sales and administrative organization. The Company has funded its operations primarily through the private placement and public sale of equity securities, which resulted in $163.9 million of net proceeds through 1997. The Company continues to be subject to certain risks common to medical device companies in similar stages of development, including dependence on a single product, extensive government regulation, uncertainty of market acceptance, limited manufacturing, marketing and sales experience and uncertainty of future profitability.
(2) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
The accompanying consolidated financial statements reflect the application of certain significant accounting policies, as discussed below and elsewhere in the notes to consolidated financial statements. The preparation of these consolidated financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosures of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting period. Actual results could differ from those estimates.
(a) Principles of Consolidation
The accompanying consolidated financial statements include the accounts of the Company and its wholly owned subsidiaries, Cytyc SARL (a Swiss corporation) (including its wholly-owned subsidiaries Cytyc Italia s.r.l. and Cytyc France s.a.r.l.), Cytyc (Australia) PTY LTD (an Australian Corporation) and Cytyc Securities Corporation (a Massachusetts securities corporation). All material intercompany transactions and balances have been eliminated in consolidation.
(b) Revenue Recognition
The Company recognizes product revenue upon shipment, when customer acceptance is assured and collection of the resulting receivable is probable. Deferred revenue represents amounts relating to deferred interest recorded in connection with sales type finance leases with customers, and amounts related to product billed but not shipped.
(c) Cash and Cash Equivalents
Cash equivalents consist of money market mutual funds, commercial paper and U.S. Government securities with original maturities of three months or less.
CYTYC CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
(d) Short-term Investments
The Company follows the provisions of Statement of Financial Accounting Standards ("SFAS") No. 115, Accounting for Certain Investments in Debt and Equity Securities.
Short-term investments consist of U.S. Government securities with original maturities between three and twelve months. The Company classifies these short-term investments as held-to-maturity, and accordingly, they are carried at amortized cost, which approximates market. Aggregate fair value, amortized cost and average maturity for marketable securities held at December 31, 1997 and 1996 are as follows:
(e) Concentration of Credit Risk
Financial instruments that potentially subject the Company to concentrations of credit risk are principally cash, cash equivalents, short-term investments and accounts receivable. The Company places its investments in rated financial institutions. Concentration of credit risk with respect to accounts receivable is limited to certain customers to whom the Company makes substantial sales. To reduce risk, the Company routinely assesses the financial strength of its customers and, as a consequence, believes that its accounts receivable credit risk exposure is limited. The Company maintains an allowance for potential credit losses but historically has not experienced any significant credit losses related to an individual customer or groups of customers in any particular industry or geographic area.
(f) Inventories
Inventories are stated at the lower of cost (first-in, first-out) or market.
(g) Depreciation and Amortization
The Company provides for depreciation and amortization by charges to operations, on a straight-line basis, in amounts estimated to allocate the cost of the assets over their estimated useful lives as follows:
(h) Other Assets
Other assets consist of long-term lease receivables from the sale of ThinPrep Processors, long-term deposits and the cost of obtaining patents. Through 1996, patent costs were amortized over their estimated useful lives on a straight-line basis. The Company chose to fully amortize these costs in 1997.
CYTYC CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
(i) Research and Development Costs
The Company charges research and development costs to operations as incurred.
(j) Net Loss Per Common Share
The Company adopted SFAS No. 128, Earnings Per Share, effective December 15, 1997. SFAS No. 128 establishes standards for computing and presenting earnings per share and applies to entities with publicly held common stock or potential common stock. The Company has applied the provisions of SFAS No. 128 retroactively to all periods presented. In accordance with Staff Accounting Bulletin (SAB) No. 98, the Company has determined that there were no nominal issuances of common stock or potential common stock in the period prior to the Company's initial public offering (IPO). Diluted weighted average shares outstanding for 1995, 1996 and 1997 exclude the potential common shares from stock options and convertible preferred stock outstanding because to do so would have been antidilutive for the years presented. Pro forma diluted net loss per common and potential common share assumes that all series of convertible preferred stock had been converted to common stock as of the original issuance dates. Calculations of basic, diluted and pro forma diluted net loss per common share and potential common share are as follows:
(k) Postretirement and Postemployment Benefits
The Company has no obligations for postretirement or postemployment benefits.
(l) New Accounting Standards
In June 1997, the Financial Accounting Standards Board (FASB) issued SFAS No.130, Reporting Comprehensive Income. SFAS No. 130 requires disclosure of all components of comprehensive income on an annual and interim basis. Comprehensive income is defined as the change in equity of a business enterprise during a period from transactions and other events and circumstances from nonowner sources. SFAS No. 130 is effective for fiscal years beginning after December 15, 1997.
In July 1997, the FASB issued SFAS No. 131 Disclosures About Segments of an Enterprise and Related Information. SFAS No. 131 requires certain financial and supplemental information to be disclosed on an annual and interim basis for each reportable segment of an enterprise. SFAS No. 131 is effective for fiscal years beginning after December 15, 1997.
CYTYC CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
(3) ALLOWANCE FOR DOUBTFUL ACCOUNTS
A summary of the allowance for doubtful accounts activity is as follows:
(4) INVENTORIES
Inventories consist of the following:
(5) PROPERTY AND EQUIPMENT
Property and equipment is stated at cost and consists of the following:
CYTYC CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
(6) ACCRUED EXPENSES
Accrued expenses consist of the following:
(7) INCOME TAXES
The Company records a deferred tax asset or liability based on the difference between the financial statement and tax bases of assets and liabilities, as measured by the enacted tax rates assumed to be in effect when these differences reverse.
As of December 31, 1997, the Company has available net operating loss carryforwards for federal tax purposes of approximately $60,000,000 and research and development credit carryforwards of approximately $969,000 to reduce future income taxes, if any. In addition, the Company has net operating loss carryforwards for state tax purposes of approximately $54,000,000 and other credit carryforwards of $897,000. These carryforwards expire at various dates from 2002 to 2017, and are subject to review and possible adjustment by the Internal Revenue Service.
The Internal Revenue Code ("IRC") contains provisions that may limit the amount of net federal operating loss and credit carryforwards that the Company may utilize in any one year in the event of certain cumulative changes in ownership over a three-year period. In the event the Company has had a change of ownership, as defined in IRC Section 382, utilization of the carryforwards may be restricted.
The approximate income tax effect of each type of temporary difference and carryforward is as follows:
Due to the uncertainty surrounding the realization of the deferred tax asset, the Company has provided a full valuation allowance against this amount.
CYTYC CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
(8) STOCKHOLDERS' EQUITY
(a) Common Stock Reserved
As of December 31, 1997, the Company has reserved 2,440,260 shares of Common Stock for issuance as follows:
(b) Preferred Stock
The Board of Directors and stockholders authorized 5,000,000 shares of $.01 par value Preferred Stock. The Board of Directors has the authority to issue such shares in one or more series and to fix the relative rights and preferences without further vote or action by the stockholders. The Board of Directors has no present plans to issue any shares of Preferred Stock.
(c) Stockholders' Rights Plan
On August 6, 1997 the Board of Directors declared a dividend of one Preferred Stock purchase right for each outstanding share of the Company's Common Stock to stockholders of record at the close of business on September 5, 1997. Each right entitles the holder to purchase from the Company a unit consisting of one one-hundredth of a share of Series A Junior Participating Preferred Stock, $.01 par value, at a purchase price of $110 per Unit, subject to adjustment.
(9) STOCK OPTION PLANS AND WARRANT
(a) 1995 Stock Option Plan
During 1995, the Board of Directors and stockholders approved, effective upon the closing of the initial public offering of the Company's Common Stock described in Note (10), the 1995 Stock Option Plan. The aggregate number of shares of Common Stock that may be issued pursuant to this Plan is 1,000,000 plus, effective as of January 1, 1997 and each year thereafter, the excess, if any, of (i) five percent of the total number of shares of Common Stock issued and outstanding as of December 31 of the preceding year or then reserved for issuance upon the exercise or conversion of outstanding options, warrants or convertible securities, over (ii) the number of shares then remaining reserved and available for grant under the 1995 Plan, subject to certain adjustments, provided, however, that in no event shall more than 2,000,000 shares of Common Stock be issued pursuant to incentive stock options under the 1995 Plan. At January 1, 1998, 454,115 additional shares were made available for grant under this provision.
(b) 1989 Stock Option Plan
As of December 31, 1997, options to purchase 915,726 shares of common were outstanding under the 1989 Stock Plan. Upon the closing of the initial public offering of the Company's Common Stock described in Note (10), no further grants may be issued under the 1989 Stock Option Plan.
(c) 1995 Director Option Plan
The Board of Directors and stockholders approved the 1995 Non-Employee Director Stock Option Plan pursuant to which options to purchase up to 250,000 shares of Common Stock were authorized for future issuance. In January 1996, the Company granted options to purchase 105,000 shares of Common Stock to seven directors under this plan at an exercise price equal to $16.00 per share.
CYTYC CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
At December 31, 1997, the Company had 598,823 options available for future grants under the 1995 Stock Option Plan and the 1995 Director Option Plan. In October 1997, the Company approved for grant 3,500 shares of Common Stock to seven directors under the 1995 Director Option Plan at a market value of approximately $87,500. Also in October 1997, the Company approved for grant 3,500 shares of Common Stock to seven directors (500 shares each, vesting equally each month during 1998).
The following schedule summarizes the activity under the Company's stock option plans for the three years ended December 31, 1997.
In October 1995, the FASB issued SFAS No. 123, which requires the measurement of the fair value of stock-based compensation to be included in the statement of operations or disclosed in the notes to the financial statements. The Company has determined that it will continue to account for stock-based compensation for employees under Accounting Principles Board Opinion No. 25 and elect the disclosure-only alternative under SFAS No. 123 for stock-based compensation awarded in 1995, 1996 and 1997 using the Black- Scholes option pricing model prescribed by SFAS No. 123. The underlying assumptions used are as follows:
CYTYC CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
Had compensation cost for the Company's stock option plans and Employee stock purchase plan been determined consistent with SFAS No. 123, pro forma net loss and net loss per share would have been:
Because the method prescribed by SFAS No. 123 has not been applied to options granted prior to January 1, 1995, the resulting pro forma compensation cost may not be representative of that to be expected in future years.
(d) 1995 Employee Stock Purchase Plan
During 1995, the Board of Directors and stockholders approved, effective upon the closing of the initial public offering of the Company's Common Stock described in Note (10), the 1995 Employee Stock Purchase Plan pursuant to which 140,000 shares of Common Stock could be issued. Purchase price is determined by taking the lesser of 85% of the closing price on the first or last day of the period. During 1997, 11,173 shares of common stock were issued at the purchase prices of $22.53 and $21.14 per share. As of December 31, 1997, 122,805 shares were available for future issuance under the 1995 Employee Stock Purchase Plan.
(e) Warrant
In June 1994, the Company issued to a stockholder a warrant to purchase shares of Common Stock at an exercise price equal to the fair market value of Common Stock at the time of vesting but not less than $5.00 per share. The warrant expires ten years from the date of issuance. Vesting of the warrant was contingent upon achievement of certain performance objectives in connection with a purchasing agreement between the Company and the stockholder, which was canceled on July 22, 1996. At December 31, 1997, such warrant was exercisable to purchase 2,000 shares of Common Stock at an exercise price of $10.00 per share.
(10) PUBLIC STOCK OFFERINGS
On March 8, 1996, the Company sold through an underwritten initial public offering, 3,000,000 shares of its Common Stock at $16.00 per share. Upon the closing of the Company's initial public offering, all outstanding shares of the Convertible Preferred Stock were converted into 9,778,326 shares of Common Stock. On April 4, 1996, the Underwriters of the Company's initial public offering exercised their over-allotment option in full to purchase an additional 450,000 shares of the Company's Common Stock at $16.00 per share.
On February 6, 1997, the Company sold through an underwritten follow-on offering 2,650,000 shares of Common Stock at $ 23.50 per share, while existing shareholders sold 1,000,000 shares of common stock. On February 20, 1997, the Underwriters of the follow-on public offering exercised their over-allotment option in full to purchase an additional 547,500 shares of the Company's Common Stock at $ 23.50 per share.
CYTYC CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
(11) COMMITMENTS AND CONTINGENCIES
(a) Lease Commitments
The Company rents a manufacturing and administrative facility under an operating lease expiring in February 2005.
At December 31, 1997, future minimum annual lease payments under this lease are as follows:
Rent expense under operating leases totaled approximately $270,000, $513,000 and $709,000 in 1995, 1996 and 1997 respectively.
(b) Litigation
The Company is involved in various commercial lawsuits involving Neuromedical Systems, Inc. and others. As of December 31, 1997, there were several pending actions that are in the early stages of discovery and, accordingly, the Company is unable to determine the extent of its liability, if any, or the likelihood of prevailing in such actions.
(c) Royalties
The Company is the exclusive licensee of certain patented technology used in the ThinPrep System. In consideration for this license, the Company has agreed to pay a royalty equal to 1% of net sales of the ThinPrep Processor, filter cylinder disposable products that are used with the ThinPrep System, and improvements made by the Company relating to such items. Royalty payments, in connection with this license, for the years ended December 31, 1995, 1996 and 1997 were $19,000, $53,000 and $135,000 respectively.
At December 31, 1997, the Company has commitments for the purchase of capital equipment costing approximately $2,023,000.
CYTYC CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
(12) EMPLOYEE BENEFIT PLAN
The Company maintains an employee benefit plan under Section 401(k) of the Internal Revenue Code. The Plan allows for employees to defer a portion of their salary up to the maximum allowed under IRS rules. The Company made contributions to the Plan during 1997 totaling $89,635.
CYTYC CORPORATION
INDEX TO EXHIBITS FILED WITH FORM 10-K YEAR ENDED DECEMBER 31, 1997
- -------- (1) Incorporated herein by reference to the exhibits to the Company's Registration Statement on Form S-1 (File No. 333-00300). (2) Incorporated by reference to the exhibits to the Company's Registration Statement on Form S-1 (File No. 333-19367). (3) Incorporated herein by reference to Exhibit 4.1 to the Company's Current Report on Form 8-K, filed August 29, 1997 (File No. 000-27558). (4) Incorporated herein by reference to Exhibit 10.1 to the Company's Quarterly Report on Form 10-Q, filed August 8, 1997. * Indicates a management contract or any compensatory plan, contract or arrangement ** Filed herewith. *** Such report, except for those portions thereof which are expressly incorporated by reference herein, is furnished for the information of the Commission and is not to be deemed "filed" as part of this Annual Report on Form 10-K. # Confidential treatment granted as to certain portions. + Confidential treatment requested as to omitted portions pursuant to Rule 24b-2 promulgated under the Securities Exchange Act of 1934, as amended.