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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

FORM 10-Q

                         (Mark One)

[x]   Quarterly Report Pursuant to Section 13 or 15(d) of the
Securities Exchange Act of 1934

For the quarterly period ended September 30, 2002

OR

[   ]   Transition Report Pursuant to Section 13 or 15(d) of the
Securities Exchange Act of 1934

Commission File Number 0-21872

GEN-PROBE INCORPORATED

10210 Genetic Center Drive
San Diego, CA 92121

(858) 410-8000
(Registrant’s Telephone No.)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes    [X]    No [   ]

As of November 12, 2002, there were 23,799,945 shares of the Registrant’s common stock, par value $0.0001 per share, outstanding.

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GEN-PROBE INCORPORATED

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Item 1. Financial Statements

Gen-Probe Incorporated
Consolidated Balance Sheets
(in thousands,
except share and per share data)

    See accompanying notes.

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Gen-Probe Incorporated
Consolidated Statements of Income
(unaudited)
(in thousands, except per share data)

    See accompanying notes.

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Gen-Probe Incorporated
Consolidated Statements of Cash Flows
(unaudited)
(in thousands)

    See accompanying notes.

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Notes to the Consolidated Financial Statements (unaudited)

Note 1 — Basis of Presentation

The accompanying interim financial statements of Gen-Probe Incorporated (“Gen-Probe” or the “Company”) at September 30, 2002, and for the three and nine month periods ended September 30, 2001 and 2002, are unaudited and have been prepared in accordance with accounting principles generally accepted in the United States for interim financial information. Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. In management’s opinion, the unaudited financial statements include all adjustments, consisting only of normal recurring accruals, necessary to state fairly the financial information therein, in accordance with generally accepted accounting principles. Interim results are not necessarily indicative of the results which may be reported for any other interim period or for the year ending December 31, 2002.

You should also read the financial statements and notes in the Company’s Information Statement, included as Exhibit 99.1 to the Registration Statement on Form 10 filed with the SEC on September 5, 2002, which includes audited financial statements and footnotes for the fiscal years ended December 31, 1999, 2000 and 2001.

Note 2 — Reporting Periods

The Company operates and reports on fiscal periods ending on the Friday closest to the end of the month except for year-end, which closes December 31. For ease of presentation, the quarterly reporting periods are deemed to end on March 31, June 30 and September 30. The three month periods ended September 30, 2001 and 2002 each included 13 weeks and the nine month periods ended September 30, 2001 and 2002 each included 39 weeks.

Note 3 — Recent Accounting Pronouncements

In June 2001, the FASB issued SFAS No. 141, “Business Combinations,” and SFAS No. 142, “Goodwill and Other Intangible Assets.”

SFAS No. 141 requires that the purchase method of accounting be used for all business combinations initiated after June 30, 2001. Use of the pooling-of-interests method is no longer permitted. SFAS No. 141 also includes guidance on the initial recognition and measurement of goodwill and other intangible assets acquired in a business combination that is completed after June 30, 2001.

SFAS No. 142 no longer permits the amortization of goodwill and indefinite-lived intangible assets. Instead, these assets must be reviewed annually (or more frequently under certain conditions) for impairment in accordance with this statement. This impairment test uses a fair value approach rather than the undiscounted cash flows approach previously required by SFAS No. 121, “Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of.” Intangible assets that do not have indefinite lives will continue to be amortized over their useful lives and reviewed for impairment in accordance with SFAS No. 121. The Company adopted SFAS No. 142 effective January 1, 2002.

With the adoption of SFAS No. 142, the Company will no longer amortize goodwill, which has been estimated to reduce annual amortization expense and increase the Company’s operating income by approximately $612,000. Goodwill and intangibles with indefinite lives will be assigned to reporting units as determined by the Company for purposes of impairment testing and tested using a two-step approach for impairment annually or whenever there is an impairment indicator.

The Company has performed the first of the required impairment tests of goodwill and indefinite lived intangible assets to determine if a transition impairment charge should be recognized under SFAS 142. The Company has determined that there have been no impairments. In the future, the Company will test for impairment at least annually.

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The following table presents a reconciliation of net income and per share data to what would have been reported had the new rules been in effect during the three month and nine month periods ended September 30, 2001 (in thousands, except per share data):

In August 2001, the FASB issued SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets”, which was adopted by the Company beginning in fiscal 2002. This statement established a number of rules for the recognition, measurement and display of long-lived assets which are impaired and either held for sale or continuing use within the business. In addition, the Statement expanded the definition of a discounted operation to individual reporting units or asset groupings for which identifiable cash flow exists. The adoption of the statement as of January 1, 2002 did not have a significant impact on the Company’s financial statements.

Note 4 — Net Income Per Share

Gen-Probe computes net income per share in accordance with SFAS No. 128, “Earnings Per Share”, and SEC Staff Accounting Bulletin (“SAB”) No. 98. Under the provisions of SFAS No. 128, basic net income per share is computed by dividing the net income for the period by the weighted average number of common shares outstanding during the period. Diluted net income per share is computed by dividing the net income for the period by the weighted average number of common and common equivalent shares outstanding during the period.

Under the provisions of SAB No. 98, common shares issued for nominal consideration, if any, would be included in the per share calculations as if they were outstanding for all periods presented. No common shares have been issued for nominal consideration. The Company has outstanding for all periods 23,799,945 shares of common stock. The Company considers common equivalent shares from the exercise of stock options in the instance where the shares are dilutive to net income of the Company by application of the treasury stock method.

The following table sets forth the computation of basic and diluted shares (in thousands except per share data):

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Note 5 — Comprehensive Income

Components of comprehensive income on an after tax basis where applicable, were as follows (in thousands):

Note 6 — Inventories

Net inventories are comprised of the following (in thousands):

Note 7 — Long Term Debt

In May 1997, the Company issued $14,000,000 of notes payable to a bank and an insurance company. The notes bore interest at 7.68%, with interest only payable through the year 2000, then principal and interest through May 2007.

In September 2002, in connection with the Company’s spin-off from Chugai Pharmaceutical Co. Ltd. (“Chugai”), the Company repaid in full the remaining $10.0 million of principal due on the notes, the accrued interest due and a prepayment premium of approximately $1.2 million. The prepayment premium and the remaining deferred financing fees associated with the notes totaled $1.25 million and were recorded as a $0.75 million extraordinary loss ($1.25 million charge, net of a $0.5 million tax benefit) in the financial statements in the quarter ended September 30, 2002.

The Company has secured a bank line of credit agreement, which expires in July 2004, under which the Company may borrow up to $10,000,000 at the bank’s prime rate, or at LIBOR plus 1%. The line of credit is secured by the assets of the Company other than real property. At September 30, 2002, the Company did not have any amounts outstanding under the line. The line of credit agreement requires the Company to comply with various financial covenants. Financial covenants include requirements as to tangible net worth, liabilities as a percentage of tangible net worth, the ratio of current assets to current liabilities, required minimum levels of earnings before interest, taxes, depreciation and amortization, and the ratio of funded debt to earnings before interest, taxes, depreciation and amortization. The Company was in compliance with all covenants at December 31, 2001 and September 30, 2002.

Note 8 — Stockholders’ Equity

In August 2002, the Company’s Board of Directors authorized a .366153 for 1 stock split. All share information has been retroactively restated to reflect the reverse stock split.

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On September 15, 2002, Chugai spun-off Gen-Probe by distributing all of its 23,799,945 shares of Gen-Probe to the shareholders of Chugai. The common shares distributed were listed on the NASDAQ National Market and began trading on September 16, 2002. The Company has granted options to purchase approximately 2.3 million shares of Gen-Probe common stock, none of which have been exercised. See Note 10, Reorganization and Spin-Off.

On September 16, 2002, the Company adopted a stockholder rights plan. In connection with the rights plan, the Company declared a dividend of one preferred share purchase right for each outstanding share of common stock of the Company outstanding at the close of business on September 26, 2002. Under the terms of the rights plan, the rights would become exercisable on the tenth day following a person or group acquiring 15% or more of Gen-Probe’s common stock, or announcing a tender offer for Gen-Probe’s common stock that would result in the ownership of 15% or more of the Company’s common stock by one person or group. Each right will initially represent the right, under certain circumstances, to purchase 1/100 of a share of newly created Series A Junior Participating Preferred Stock of the Company at an exercise price of $100. The exercise price is subject to adjustment by the Company. The Board of Directors may terminate the rights plan or redeem the rights at the redemption price of $0.01 per right, subject to adjustment, at any time prior to the earlier of September 26, 2012, the expiration date of the rights, or the date of distribution of the rights, as determined under the rights plan. The rights plan has a term of 10 years. The initial distribution of rights is expected to be non-dilutive and non-taxable to stockholders for United States federal income tax purposes.

Note 9 — Litigation

The Company is involved in certain lawsuits and legal proceedings which are described in Part II — Other Information, Item 1. Legal Proceedings. While there can be no assurances as to the ultimate outcome of such litigation, management expects that the resolution of these matters will not have a material adverse effect on the Company’s financial position or its ability to conduct business.

On February 26, 2001, the Company commenced an arbitration proceeding against Chiron in connection with the blood screening collaboration. During the fourth quarter of 2001, the Company negotiated a resolution to most of the disputed items, and in January 2002, the Company received $6.9 million in partial settlement of the claims. During the nine months ended September 30, 2002, the Company recognized $2.4 million of the settlement in other income primarily for services provided in prior periods. Additionally, $3.9 million of the settlement was a prepayment for inventory, substantially all of which was recorded in revenues during the first nine months of 2002. The remaining $0.6 million primarily represents the collection of an outstanding receivable.

Note 10 — Reorganization and Spin-off

On December 10, 2001, Chugai announced its intention to spin-off Gen-Probe by distributing all of its shares of Gen-Probe to the shareholders of Chugai, subject to Chugai shareholder approval and Chugai’s merger with Nippon Roche Kabushiki Kaisha, a subsidiary of Roche Phamaholding B.V., and a capital reduction transaction involving the distribution of the Gen-Probe shares. On June 27, 2002, Chugai’s shareholders approved the merger and the capital reduction transaction and on September 15, 2002, Chugai completed the distribution. Prior to the spin-off, Chugai commenced a reorganization that resulted in Gen-Probe becoming a wholly owned subsidiary of Chugai. As part of the reorganization, on July 23, 2002, Gen-Probe Holding Company, Inc. merged into Gen-Probe, making Gen-Probe a wholly owned subsidiary of Chugai. Gen-Probe Holding was a non-operating holding company that at the time of the merger had approximately $75.9 million in cash and owned 37 acres of land, including the site of Gen-Probe’s headquarters.

The merger of Gen-Probe Holding into Gen-Probe was accounted for as a purchase by Gen-Probe and the assets and liabilities were recorded at the historical book value at the merger date. Gen-Probe did not issue additional shares of its common stock in excess of the number of shares previously owned by Gen-Probe Holding to Chugai in consideration for the net assets acquired. Instead, Gen-Probe adjusted all outstanding options to purchase its common stock granted under its 2000 Equity Participation Plan. The number of shares subject to each option were reduced by approximately 17.6% to recognize the contribution of the net assets to Gen-Probe through the merger of Gen-Probe Holding into Gen-Probe. Although the adjustment resulted in a reduction in option holders’ aggregate ownership stake in Gen-Probe relative to Chugai’s ownership stake, the reduction was in proportion to the reduction that would have resulted from the issuance by Gen-Probe of additional shares of Gen-Probe common stock to Chugai in connection with the merger had such shares actually been issued. The results of operations of Gen-Probe Holding are included in the accompanying consolidated financial statements beginning on July 23, 2002.

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The net assets of Gen-Probe Holding acquired are as follows (in thousands):

Gen-Probe’s lease of the land on which its headquarters is located terminated automatically upon the completion of the merger on July 23, 2002 because Gen-Probe now owns the land.

In connection with the merger of Gen-Probe Holding into Gen-Probe, Gen-Probe recorded approximately $3.2 million of deferred tax assets. These deferred tax assets relate principally to financial statement depreciation in excess of that deducted for tax purposes and to research and development tax credits previously held by Chugai Pharma USA, LLC, the successor to Gen-Probe’s sister company Chugai Biopharmaceuticals, Inc. which have been included in the combined tax returns of the Company. These deferred tax assets are being carried forward and may be realized in future periods depending on, among other factors, Gen-Probe’s having sufficient taxable income in the future periods. The deferred tax assets recorded were fully offset by a valuation reserve until these deductions and credits are realized.

The following unaudited pro forma summary presents the consolidated results of operations of the Company, as if the merger had occurred at the beginning of each period presented and does not purport to be indicative of what would have occurred had the merger been made as of that date or of the results which may occur in the future (in thousands):

Item 2. Management’s Discussion And Analysis Of Financial Condition And Results Of Operations

This Quarterly Report contains “forward-looking” statements within the meaning of the Private Securities Litigation Reform Act of 1995 which provides a “safe harbor” for these types of statements. To the extent statements in this Quarterly Report involve, without limitation, our expectations for growth, estimates of future revenue, expenses, profit, cash flow, balance sheet items or any other guidance on future periods, these statements are forward-looking statements. These risks and uncertainties include those included herein under the caption “Risk Factors” in “Item 5. Other Items” and those identified in the Information Statement filed as Exhibit 99.1 to our Registration Statement on Form 10 filed September 5, 2002 with the Securities and Exchange Commission, under the caption “Risk Factors.” We assume no obligation to update any forward-looking statements. The interim financial statements and this Management’s Discussion and Analysis of Financial Condition and Results of Operations should be read in conjunction with the Consolidated Financial Statements and Notes thereto for the year ended December 31, 2001 and the related Management’s Discussion and Analysis of Financial Condition and Result of Operations, both of which are contained in the Information Statement filed as Exhibit 99.1 to our Registration Statement on Form 10 filed September 5, 2002 with the Securities and Exchange Commission.

Overview

We are a global leader in the development, manufacture and marketing of rapid, accurate and cost-effective nucleic acid probe-based products used for the clinical diagnosis of human diseases and for the screening of donated human blood. We have over 17 years of nucleic acid detection research and product development experience, and our products, which are based on our patented nucleic acid testing, or NAT, technology, are used daily in clinical laboratories and blood collection centers in major countries throughout the world.

Revenues

We derive revenues from three primary sources: product sales, collaborative research revenue and royalty and license revenue. The majority of our revenues come from product sales, which consist primarily of sales of both our NAT assays and, to a lesser extent, sales and rentals of the proprietary instruments that serve as the analytical platform for our assays. We recognize as collaborative research revenue payments we receive from Chiron for the products we provide under our collaboration agreements with Chiron prior

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to regulatory approval and the payments we receive from Chiron, Bayer and other collaboration partners, including the National Institutes of Health, or NIH, for research and development activities. Our royalty and license revenues reflect fees paid to us by third parties for the use of our proprietary technology. For the nine months ended September 30, 2002, product sales, collaborative research revenues and royalty and licensing revenues equaled 87%, 10% and 3%, respectively, of our total revenues of $111.4 million.

Product Sales

Historically, our primary source of revenue has been the sale of clinical diagnostic products in the United States. Our primary clinical diagnostic products include our PACE 2, AccuProbe and Amplified Direct Test product lines. We currently manufacture and ship approximately 20 million tests per year for the diagnosis of a wide variety of infectious microorganisms, including those causing sexually transmitted diseases, or STDs, tuberculosis, strep throat, pneumonia and fungal infections. The principal customers for our clinical diagnostics products include large reference laboratories, public health laboratories and hospitals located in North America, Europe and Japan. Sales of our PACE family of assays accounted for approximately 55% of our total revenues for the nine months ended September 30, 2002 and 57% of our total revenues in 2001.

We also recognize product sales from the manufacture and shipment of tests for screening donated blood through our collaboration with Chiron to blood bank facilities located in the countries where our products have obtained governmental approvals. In February 2002, the Food and Drug Administration, or FDA, approved our Biologics License Application, or BLA, for our assay used to screen donated blood for human immunodeficiency virus (type 1), or HIV-1, and hepatitis C virus, or HCV. Accordingly, we began to recognize product sales revenue for tests shipped in the United States in the second quarter of 2002. Outside the United States, the HIV-1/HCV assay has received approval in a number of countries, including France, Germany, Australia, Argentina, Spain, Singapore, Italy, Austria, Switzerland and New Zealand.

Product sales also include the sales or rental revenue associated with the delivery of our proprietary integrated instrument platforms to customers for performing our NAT assays. We provide multiple instrument rental options to our customers depending on the types and volumes of products purchased. Instruments are manufactured by third-party contractors, but we generally provide technical support and instrument service to maintain these systems in the field. However, Chiron is responsible for placement and servicing of instruments used in connection with our blood screening business and Bayer and other international distributors are responsible for placement and servicing of instruments used in our clinical diagnostics business. Direct sales of our instrument platforms to customers accounted for approximately 3% of our product sales in both the nine months ended September 30, 2002 and twelve months ended December 31, 2001. However we generally retain title to the instruments and recover our instrument costs in connection with the sale of the assay. The costs associated with the instrument are charged to cost of goods sold on a straight-line basis over the estimated life of the instrument, which ranges from three to five years. The costs to maintain these systems in the field are charged to operations as incurred.

Collaborative Research Revenue

We have developed a NAT assay to detect HIV-1 and HCV in donated human blood and have also developed a semi-automated instrument system to conduct the test. These assays and instruments are marketed through our collaboration with Chiron under the Procleix name. The HIV-1/HCV assay and instrumentation were used in clinical trials, under an Investigational New Drug application, or IND, from early 1999 through 2002. In February 2002, the FDA approved the Procleix HIV-1/HCV Assay. Prior to FDA approval, Chiron provided tests to the American Red Cross, America’s Blood Centers, American Independent Blood Centers, the United States military and others for pooled blood sampling under the terms of the IND application. FDA approval of the Procleix HIV-1/HCV Assay has allowed Chiron to implement commercial pricing for sales of the Procleix HIV-1/HCV Assay to U.S. customers, which resulted in a significant increase in the revenues we received from such sales in the third quarter of 2002.

We record net sales of assays to be used for blood screening at amounts equal to the sales of the HIV-1/HCV assay by Chiron to third-parties, less instrument costs, instrument service costs and certain other adjustments specified in our agreement with Chiron, multiplied by our share of the net revenue, which is currently 43%. Our costs related to these products primarily include manufacturing costs and research and development expenses.

Historically, we have recorded revenues related to use of our blood screening products in the United States and other countries in which the products have not received regulatory approval as collaborative research revenue because price restrictions applied to these products prior to FDA license approval in the United States and similar approval in foreign countries. We began deliveries of the commercially approved products to the United States customers in the second quarter of 2002. Accordingly, we began to classify revenues associated with these products as product sales in our financial statements beginning in that period. Collaborative research revenue for the use of our blood screening products for the nine months ended September 30, 2001 and 2002 were $10.3 million and $7.1 million, respectively.

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Under the strategic alliance agreement we entered into with Chiron in June 1998, we have responsibility for research, development and manufacturing of the blood screening products while Chiron has responsibility for marketing, distribution and service of the blood screening products worldwide. We received a $10.0 million up-front license fee from Chiron in connection with the agreement in 1998 and an additional payment of $8.5 million upon achieving an agreed upon contract milestone in 1999. Additional payments of up to $16.5 million will be due to us in the future if we achieve certain other specified milestones relating to the development of what we believe to be the world’s first fully automated high throughput NAT instrument system known as TIGRIS. Our costs to develop and commercialize the blood screening assays and associated instrument products have been substantial and have had a significant impact on our operating results and financial position since 1998. We commenced beta evaluations of the TIGRIS instrument for clinical diagnostic and blood screening applications in the third quarter of 2002 and expect to commence clinical trials by the end of 2003.

On February 26, 2001, we commenced an arbitration proceeding against Chiron in connection with the blood screening collaboration. During the fourth quarter of 2001, we negotiated a resolution to most of the disputed items, and in January 2002, we received $6.9 million in partial settlement of the claims. During the first quarter of 2002, we recognized $2.4 million of the settlement in other income primarily for services provided in prior periods. Additionally, $3.9 million of the settlement was a prepayment for inventory, all of which was recorded into revenues during the first nine months of 2002. The remaining $0.6 million primarily represents the collection of an outstanding receivable. The arbitration proceedings did not result in any disruption in service to our blood screening customers. We are confident that any future disputes that arise between the companies will be resolved equitably through the dispute resolution procedures contained in the collaboration agreement.

In 1996, we were awarded a $7.7 million contract by the National Heart, Lung and Blood Institute, a part of the NIH, to develop NAT assays for screening donor blood for HIV-1 and HCV. Effective January 1998, the contract was modified with the addition of $0.6 million for the development of a semi-automated system for the detection of HIV-1/HCV in pooled plasma. Effective September 1998, the contract was further modified with the addition of $4.3 million for the development of HIV-2 and hepatitis B virus, or HBV, tests. All payments due to us under this reimbursement contract have been received and were recorded as collaborative research revenues as reimbursable costs were incurred.

In January 2000, we began work on a three-year $13.4 million cost sharing contract with the NIH to modify the HIV-1/HCV assay to incorporate HBV detection capability and make it simpler for organ donation centers to test the blood of organ donors. The NIH reimbursed us $7.6 million of this cost, and we and Chiron will share equally the remaining costs to complete the project. Through September 30, 2002, the NIH had reimbursed us all of the contracted cost. We record collaborative research revenues under the reimbursement contract as reimbursable costs are incurred.

In 1998, following the execution of our agreement with Chiron, Chiron assigned the clinical diagnostic portion of the agreement to Bayer. Under the terms of our collaboration with Bayer, we will develop, manufacture and market NAT assays for viral targets and cancer markers in the clinical diagnostic market with Bayer. We record product sales of the assays to Bayer for use in clinical diagnostic applications at agreed upon transfer prices upon shipment to Bayer.

We recognize collaborative research revenue over the term of the agreement as reimbursable costs are incurred. The costs associated with the reported collaborative research revenue are reflected in the statements of operations under the captions “Research and development,” “Marketing and sales” and “General and administrative” based on the nature of the costs. We do not separately track the costs applicable to the blood screening development collaboration with Chiron and therefore are not able to quantify the direct costs associated with the collaborative research revenue. We believe that the costs incurred related to the collaborative research revenue have exceeded the amounts recorded as revenue.

Royalty and License Revenue

We recognize non-refundable up-front license fees over the performance period of the agreement or at the time that we have satisfied all substantive performance obligations. We also receive milestone payments for successful achievement of contractual development activities. Milestone payments are recognized as revenue upon achievement of the milestone only if there are no remaining substantive performance obligations and the amounts are non-refundable.

In May 1997, we entered into collaborative research agreements with bioMérieux, Vitek, Inc., which created a worldwide relationship between bioMérieux and us. The collaboration involved research and development activities, as well as the transfer to bioMérieux, pursuant to separate distribution agreements with bioMérieux S.A., of product distribution rights in international markets, excluding Japan. As part of these agreements, we licensed our NAT technology to bioMérieux to jointly develop NAT assays and adapt and develop instrumentation during a five-year and ten-year term. In return, bioMérieux paid us $6.0 million of license and prepaid royalty fees in 1997 and an additional $6.0 million of license fees in 1998.

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In August 2000, we entered into amended agreements with bioMérieux, Inc. that transitioned the relationship from a collaborative arrangement to a royalty-bearing arrangement that covers semi-automated probe assays and advanced, fully-automated probe assays for the diagnosis of infectious diseases and detection of food pathogens. Under the terms of the amended agreements, bioMérieux will pay us royalty payments based on sales of products incorporating the licensed technology, subject to a minimum annual royalty payment, which began in January of this year with respect to the semi-automated probe assays and will begin in 2006 with respect to the fully automated probe assays, and a reduction in the royalties based on the amount of cumulative royalties that have been paid to us. In addition, we transferred to bioMérieux all information, trade secrets, procedures, methods, data and processes necessary for bioMérieux to assume development of the products that are the subject of the agreement in exchange for the prepaid royalties paid under the original agreement. Accordingly, we recognized $3.0 million in royalty fees related to this agreement in 2000. We currently are amortizing previously received license fees in an amount equal to $1.9 million annually through the period ending December 31, 2002.

Research and Development

In recent years, we have increased our investment in research and development as part of our ongoing efforts to accelerate the development of new products and technologies, particularly our TIGRIS instrument and our HIV-1/HCV assay for screening donated blood, which was approved by the FDA in February 2002. Our research and development expenses consist of expenses associated with the development of proprietary products and instrument platforms as well as expenses related to the co-development of new products and technologies in collaboration with our strategic partners. We expect our research and development expenses as a percentage of revenues to decrease in future periods.

In connection with our research and development efforts, we have various license agreements with unrelated parties, which provide us with rights to develop and market products using certain technology and patent rights maintained by the parties. Terms of the various license agreements require us to pay royalties ranging from 1% to 5% of future sales on products using the technology. These agreements generally provide for a term that commences upon execution of the agreement and continues until expiration of the last patent related to the technology.

Critical Accounting Policies and Estimates

Our discussion and analysis of our financial condition and results of operations is based on our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses and related disclosure of contingent assets and liabilities. On an ongoing basis, we evaluate our estimates, including those related to revenue recognition, the collectibility of accounts receivable, valuation of inventories, long-lived assets including patent costs and capitalized software and income taxes. We base our estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities. Actual results may differ from these estimates under different assumptions or conditions.

We believe the following critical accounting policies affect the significant judgments and estimates used in the preparation of our consolidated financial statements.

Revenue Recognition

We recognize revenue from product sales when the product is shipped and title and risk of loss has passed and when collection of the resulting receivable is reasonably assured. We record revenue from product sales on our blood screening products shipped to countries where regulatory approval has been received based on a contracted transfer price with our third-party collaboration partner, Chiron. Blood screening product sales are then adjusted monthly upon payment by Chiron to us of amounts reflecting our ultimate share of net revenue from sales by Chiron to the end user less the transfer price revenues previously paid.

Historically, we have recorded revenues related to use of our blood screening products in the United States and other countries in which the products have not received regulatory approval as collaborative research revenue because price restrictions applied to these products prior to FDA approval in the United States and in certain foreign countries. As commercial pricing is implemented in the United States, we will classify domestic sales of these products as product sales in our financial statements. Chiron began to implement commercial pricing in the United States for the blood screening products in the second quarter of 2002. Commercially approved products that we began shipping in the second quarter of 2002 are recorded as product sales based on the contracted transfer price with Chiron. Based on the terms of our agreement with Chiron, our ultimate share of the net revenue from sales to the end user will not be known until reported by Chiron to us. Blood screening product sales are adjusted upon payment by Chiron to us of amounts reflecting our ultimate share of net revenue from sales by Chiron of these products.

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Product sales also include the sales or rental value associated with the delivery of our proprietary integrated instrument platforms performing our NAT assays. Historically, we have provided our instrumentation to laboratories and hospitals without requiring them to purchase the equipment or enter into an equipment lease. Instead, we recover the cost of providing the instrumentation in the amounts we charge for our diagnostic assays. We recently have begun to implement multi-year sales contracts that have an equipment factor set forth in them. The costs associated with the instrument are charged to costs of goods sold on a straight-line basis over the estimated life of the instrument, which ranges from three to five years. The costs to maintain these systems in the field are charged to operations as incurred.

We also recognize collaborative research revenue over the term of various collaboration agreements as negotiated monthly contractual payments are earned or we incur reimbursable costs related to the agreement. Negotiated monthly contracted amounts are earned in relative proportion to the performance required under the contracts. Non-refundable license fees are recognized over the related performance period or at the time that we have satisfied all performance obligations related to the agreement. Milestone payments related to a particular milestone are recognized as revenue upon the achievement of specified milestones when (1) we have earned the milestone payment, (2) the milestone is substantive in nature and the achievement of the milestone was not reasonably assured at the inception of the agreement and (3) the fees are non-refundable. Any amounts received prior to satisfying our revenue recognition criteria are recorded as deferred revenue in our balance sheet.

We recognize royalty revenue related to the manufacture, sale or use of our products or technologies under license agreements with third parties. For those arrangements where royalties are reasonably estimable, we recognize revenue based on estimates of royalties earned during the applicable period and adjust for differences between the estimated and actual royalties in the following period. Historically, these adjustments have not been material. For those arrangements where royalties are not reasonably estimable, we recognize revenue upon receipt of royalty statements from the licensee.

Collectibility of Accounts Receivable

We maintain an allowance for doubtful accounts for estimated losses resulting from the inability of our customers to make required payments. Credit losses historically have been minimal and within management’s expectations. If the financial condition of our customers were to deteriorate, resulting in an impairment of their ability to make payments, additional allowances would be required.

Valuation of Inventories

We record valuation adjustments to our inventory balances for estimated excess and obsolete inventory equal to the difference between the cost of such inventory and the estimated market value based upon assumptions about future product demand and the shelf-life and expiration dates for finished goods and materials used in the manufacturing process. We operate in an environment that is regulated by the FDA and other governmental agencies that may place restrictions on our ability to sell our products into the marketplace if certain compliance requirements are not met. We have made assumptions that are reflected in arriving at our net inventory value based on the information currently available to us. If future product demand, regulatory constraints or other market conditions are less favorable than those projected by management, additional inventory valuation reserves may be required.

We also manufacture products to conduct developmental evaluations and clinical trials and to validate our manufacturing practices prior to receiving commercial approval for sale of our products. In these circumstances, uncertainty exists regarding the saleability of these products until the FDA or the other governing bodies commercially approve them. Accordingly, we provide valuation allowances for these items in inventory and charge those amounts to research and development. In cases where we manufacture products that are sold into approved markets and also maintained for further development evaluations for other markets, we may also provide valuation allowances for this inventory due to the historical uncertainties associated with regulated product introductions.

Patent Costs

We capitalize the costs incurred to file patent applications. We amortize these costs over the lesser of the remaining useful life of the related technology or eight years. At September 30, 2002, capitalized patent costs totaled approximately $2.4 million, net of accumulated amortization. We expense all costs related to abandoned patent applications. Historically, our expense related to abandoned patent costs has not been material but, if we elect to abandon any of our currently issued or unissued patents, the related expense could be material to our operations in the period of abandonment.

Capitalized Software Costs

We capitalize costs incurred in the development of computer software related to products under development after establishment of technological feasibility. These capitalized costs are recorded at the lower of unamortized cost or net realizable value and will be amortized over the estimated life of the related product beginning when the product is available for sale. At September 30, 2002,

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capitalized software development costs related to our TIGRIS instrument totaled $22.1 million. We commenced beta evaluations of this instrument in the third quarter of 2002 and expect to commence clinical trials by the end of 2003. If we are not able to successfully deliver this instrument to the marketplace and attain customer acceptance, the asset could be impaired and an adjustment to the carrying value of this asset would be considered by management at that time.

Income Taxes

We historically have been included in the consolidated federal and in various combined state income tax returns of our former parent company,Gen-Probe Holding Company, Inc. (formerly known as Chugai Pharma U.S.A., Inc.). Pursuant to a tax sharing agreement with Gen-Probe Holding Company, we generally have been allocated an amount of the consolidated tax liability equal to the tax that would have been applicable if computed separately. At September 30, 2002, we had net deferred tax assets of $4.2 million that are more likely than not to be realized, and therefore, no valuation allowance is deemed necessary. The deferred tax assets relate to research and investment credits taken in our tax returns, timing differences arising from the recording of deferred revenue and certain reserves and accruals. These amounts are offset by capitalized costs expensed for tax purposes and other items. In the event that we were to determine that we would not be able to realize all or part of our deferred tax assets in the future, an adjustment to reduce the deferred tax asset would be made in the period such determination was made.

Results of Operations

The following table sets forth operating data as a percentage of total revenues on a comparable basis for the three and nine month periods ended September 30, 2001 and 2002, respectively:

Three Months Ended September 30, 2002 Compared to Three Months Ended September 30, 2001

Product Sales. Product sales increased $15.9 million, or 63.9%, to $40.9 million in the three months ended September 30, 2002 from $25.0 million in the three months ended September 30, 2001. The increase was primarily a result of a $13.5 million increase in commercial sales of blood screening products, both in the United States and international markets. Blood screening product sales represented $14.7 million, or 35.9%, of product sales in the third quarter of 2002 as compared to $1.2 million, or 4.8%, of product sales in the third quarter of 2001.

In February 2002, the FDA approved our HIV-1/HCV assay for screening donated human blood. Chiron began implementing commercial pricing for the sale of these products in the United States in the second quarter of 2002. Revenues from the sale of these products are now classified as product sales in our financial statements. Previously we recorded revenues related to use of our blood

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screening products in the United States and other countries in which the products had not received regulatory approval as collaborative research revenues.

Although we do not expect testing volumes to change significantly as a result of FDA approval, we will realize increased net revenues from the sale of the approved blood screening product in the United States as compared to the revenues received prior to FDA approval as a result of the implementation of commercial pricing. However, under our collaboration agreement with Chiron, Chiron has responsibility for marketing, sales, distribution and service of the blood screening systems, which includes the assay and the related instrumentation. Accordingly, our revenues are dependent on Chiron’s success in establishing commercial pricing with its customers and the time that it will take to do so. Prior to the implementation of commercial pricing, we received compensation for sales of the blood screening product from Chiron through monthly firm support commitment payments of approximately $1.5 million, provided that the number of tests we shipped fell within a range provided in agreements with Chiron and the blood screening customers. As a result of the implementation of commercial pricing, we record revenue that we derive from our relationship with Chiron at an agreed upon transfer price when the product is shipped and title and risk of loss has passed and when collection of the resulting receivable is reasonably assured. We record additional revenue on these sales based on our ultimate share of the net revenue from sales to end users of the blood screening products as Chiron reports these sales to us. Chiron is required to report its sales to us within 45 days after the end of each month in which we ship blood screening products to Chiron.

We expect competitive pressures related to our STD and blood screening products to continue into the foreseeable future, primarily as the result of the introduction of competing products into the market and continuing pricing pressure, particularly with our STD products.

Collaborative Research Revenue. Collaborative research revenue decreased $5.9 million, or 88.0%, to $0.8 million in the three months ended September 30, 2002 from $6.7 million in the three months ended September 30, 2001. The decrease was primarily the result of a $4.4 million decrease in firm support commitment payments recorded in the third quarter of 2002 in connection with tests provided to United States customers through our collaboration with Chiron for pooled blood sampling under the terms of the IND application. These revenues represented $4.5 million in the third quarter of 2001. We do not expect additional revenue from shipments of blood screening products pursuant to the IND application in future periods. In addition, there was a $0.9 million decrease in contract revenues from the NIH for the organ donor program, reflecting the completion of this program in the third quarter of 2002.

Collaborative research revenue tends to fluctuate based on the amount of research services performed, the status of projects under collaboration and the achievement of milestones. Due to the nature of our collaborative research revenues, results in any one period are not necessarily indicative of results to be achieved in the future. Our ability to generate additional collaborative research revenues may depend, in part, on our ability to initiate and maintain relationships with potential and current collaborative partners. There can be no assurance that such relationships will be established or that current collaborative research revenue will not decline.

Royalty and License Revenue. Royalty and license revenue decreased $1.8 million, or 62.7%, to $1.1 million in the three months ended September 30, 2002 from $2.9 million in the three months ended September 30, 2001. The decrease was primarily the result of the receipt in the third quarter of 2001 of $2.0 million in license and royalty fees from Chugai Diagnostics Science Co., Ltd. for the licensing of rights to certain patented property and royalties.

Royalty and license revenue may fluctuate based on the nature of the related agreements and the timing of receipt of license fees. Results in any one period are not necessarily indicative of results to be achieved in the future. In addition, our ability to generate additional royalty and license revenues may depend, in part, on our ability to market and capitalize on our technologies. There can be no assurance that we will be able to do so or that future royalty and license revenue will not decline.

Cost of Product Sales. Cost of product sales increased $5.0 million to $14.6 million, or 35.7% of product sales revenues, in the three months ended September 30, 2002 from $9.6 million, or 38.4% of product sales revenues, in the three months ended September 30, 2001. The increase in cost of sales was primarily attributable to increased sales volume in the three months ended September 30, 2002 and from recording a greater portion of the costs associated with the operation of our blood screening manufacturing facility to cost of product sales in the three months ended September 30, 2002 compared to the three months ended September 30, 2001. A substantial portion of the costs associated with the blood screening product manufacturing facility were classified as research and development expenses prior to receiving FDA approval for the product in the United States. The amount included in research and development expense in the third quarter of 2001 was $2.4 million which includes costs associated with the blood screening product manufacturing facility as well as scrap charges associated with the production of developmental lots for the assay. Cost of product sales decreased as a percentage of product sales in the quarter ended September 30, 2002 compared to the quarter ended September 30, 2001 as a result of an increased level of production being spread over a relatively high proportion of fixed manufacturing costs. The resulting gross profit margin on product sales increased to 64.3% in the three months ended September 30, 2002 from 61.6% for the three months ended September 30, 2001.

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In 1999, we completed the leasehold improvements on a manufacturing facility designed primarily for the manufacture of our blood screening products. This facility contains advanced equipment, technology and controls that are intended to enable us to meet stringent FDA regulations applicable to blood screening products. This facility has operated well below capacity and will continue to operate below capacity for the foreseeable future. This excess capacity, as well as excess capacity at our manufacturing facility at our headquarters, provides us with significant opportunities to expand the manufacturing of both our own products and potentially the products of other companies on a contract basis. The costs related to the operation of our blood screening manufacturing facility, together with other manufacturing costs for the production of assays that were delivered under the terms of our IND application prior to FDA approval of our blood screening products, were classified as research and development expenses prior to FDA approval of our blood screening products. In addition to the above mentioned costs, we manufactured significant quantities of raw materials, development lots and clinical trial lots of product prior to receiving FDA approval for commercial sale. During the blood screening development process for the United States market, we also manufactured and delivered an equivalent product for sale in international markets where governmental approvals were obtained. However, due to the relatively low initial sales volumes for this product, we continued to charge the costs of manufacturing blood screening products to research and development expense, except for an amount equal to the product sales revenues recorded for international commercial sales, which was charged to cost of product sales and approximates the costs applicable to those product sales. Amounts included in cost of product sales related to such costs were approximately $1.2 million for the three months ended September 30, 2001, and $3.0 million for the nine months ended September 30, 2001. Beginning in the latter part of the first quarter of 2002 the sales volume for the approved products shipped equaled or exceeded the estimated cost applicable to those product sales, and we ceased the allocation of the costs of manufacturing blood screening products to research and development expense. Amounts included in research and development related to such costs were approximately $0 and $2.4 million, for the three months ended September 30, 2002 and September 30, 2001, respectively.

As a result of the implementation of commercial pricing for our blood screening products in the United States, we have classified these costs as costs of product sales rather than the research and development expenses. Accordingly, we expect that our blood screening products will realize a lower gross profit margin rates than our clinical diagnostics products during the early stages of commercialization and for the foreseeable future, as relatively high fixed costs for producing these products in the specialized manufacturing facility are absorbed over the expected sales volume for blood screening products. After that time, we expect the gross margin rates on our blood screening products to continue to be lower than those on our clinical diagnostic products. However, because Chiron bears responsibility for marketing and sales of these products, the marketing, sales and distribution expenses we incur associated with our blood screening products are significantly lower than for our clinical diagnostic products. We also anticipate that requirements for individual donor testing, if and when implemented, may result in lower gross margin rates. We are not able to accurately predict the extent to which our gross margin percentages may be negatively affected as a result of individual donor testing because we do not know the ultimate selling price that Chiron would charge to the end user if individual donor testing were implemented.

Gross profit margin percentages may fluctuate significantly in future periods based on changes in production volumes, competitive pricing pressures, allowances for scrap or obsolete materials, additional costs related to initial production quantities of new products after achieving FDA approval and contractual adjustments, such as instrument costs, instrument service cost and certain other adjustments made by Chiron to arrive at the net sales value of blood screening products.

Research and Development. Research and development expenses decreased $2.3 million to $9.9 million, or 23.1% of total revenues, in the three months ended September 30, 2002 from $12.2 million, or 35.2% of total revenues, in the three months ended September 30, 2001. The decrease was primarily the result of a $2.4 million decrease in the recorded amount of manufacturing costs for blood screening assays as research and development expenses as a result of FDA approval of our blood screening products in February 2002, partially offset by a $0.1 million increase in other research and development costs. Manufacturing costs for blood screening assays included in research and development were approximately $0 and $2.4 million, respectively, during the three months ended September 30, 2002 and 2001, respectively.

Marketing and Sales. Marketing and sales expenses increased $0.1 million to $4.3 million, or 10.0% of total revenues, in the three months ended September 30, 2002 from $4.2 million, or 12.2% of total revenues, in the three months ended September 30, 2001. The increase was primarily related to a $0.3 million increase in personnel costs in our marketing and sales force to support anticipated increases in sales for our clinical diagnostic products, partially offset by $0.2 million in lower professional fees.

General and Administrative. General and administrative expenses increased $1.7 million to $5.9 million, or 13.7% of total revenues, in the three months ended September 30, 2002 from $4.2 million, or 12.1% of total revenues, in the three months ended September 30, 2001. The increase was primarily the result of a $1.0 million increase in spending for professional fees primarily related to our spin-off from Chugai Pharmaceutical, $0.2 million for printing and public relations expenses primarily relating to the registration of our shares under the Securities Exchange Act of 1934 in connection with the spin-off, a $0.2 million increase in salaries and benefits resulting from higher staffing levels and a $0.3 million increase in other general and administrative expenses.

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Amortization of Intangible Assets. Amortization of intangible assets decreased $0.1 million to $0.1 million in the three months ended September 30, 2002 from $0.2 million in the three months ended September 30, 2001. The amortization is associated with Gen-Probe Holding’s purchase of us in 1989. The amount amortized each period has decreased as a result of our implementation of SFAS 142 as discussed below.

In June 2001, the Financial Accounting Standards Board issued Statement of Financial Accounting Statement, or SFAS, No. 141, “Business Combinations” and No. 142, “Goodwill and Other Intangible Assets.” SFAS No. 142 no longer permits the amortization of goodwill and indefinite-lived intangible assets. Instead, these assets must be reviewed annually, or more frequently under certain conditions, for impairment. We adopted SFAS No. 142 effective January 1, 2002 and were required to reassess the intangible assets, including goodwill and purchased intangibles, previously recorded in connection with previous purchase acquisitions. Following the first required impairment tests, we determined that there have been no impairments. In 2002, we will no longer amortize goodwill, which will reduce our annual amortization expenses and, therefore, increase our operating income by approximately $0.6 million per year.

Total Other Expenses, Net. Other expenses primarily consist of investment and interest income offset by interest expense on borrowing and other items. The net other expenses increased $0.1 million to $0.3 million for the three months ended September 30, 2002 from the net expense of $0.2 million for the three months ended September 30, 2001. The net increase in other expenses is primarily due to a $0.4 million litigation settlement, partially offset by $0.2 million higher interest earned and $0.1 in reduced interest expense.

Income Tax Expense (Benefit). Income taxes amounted to $2.6 million for the three months ended September 30, 2002 compared to a $0.1 million benefit for taxes for the three months ended September 30, 2001. The tax benefit recorded for the three months ended September 30, 2001 was affected by revisions to the anticipated full year 2001 tax provision that had the effect of increasing net income by approximately $1.6 million in the quarter.

Extraordinary Loss. In September 2002, in connection with the spin-off, the Company repaid in full the remaining $10.0 million of principal and accrued interest due on the notes due to a bank and an insurance company. The early payoff required a prepayment premium in the amount of $1.2 million. The prepayment premium and the remaining deferred financing fees associated with the notes totaled $1.25 million and were recorded as a $0.75 million extraordinary loss (net of a tax benefit of $0.5 million) in the quarter ended September 30, 2002.

Nine Months Ended September 30, 2002 Compared to Nine Months Ended September 30, 2001

Product Sales. Product sales increased $20.1 million, or 25.9%, to $97.6 million in the nine months ended September 30, 2002 from $77.5 million in the nine months ended September 30, 2001. The increase was primarily a result of a $18.6 million increase in commercial sales of blood screening products, both in the United States and international markets. Blood screening product sales represented $21.6 million or 22.1% of product sales for the nine month period ended September 30, 2002 as compared to $3.0 million or 3.9% of product sales in the nine month period ended September 30, 2001.

Collaborative Research Revenue. Collaborative research revenue decreased $3.9 million, or 26.3%, to $10.9 million in the nine months ended September 30, 2002 from $14.8 million in the nine months ended September 30, 2001. The decrease was primarily the result of a $3.2 million decrease in firm support commitment payments recorded in the nine months ended September 30, 2002 in connection with tests provided to United States customers through our collaboration with Chiron for pooled blood sampling under the terms of the IND application. These revenues represented $7.1 million in the nine month period ended September 30, 2002. In addition, contract revenues from our collaboration with Bayer for the organ donor program decreased by $0.5 million.

Chiron amended its agreements for supplying our blood screening products to United States blood banks, effective in the second quarter of 2001, which resulted in increases in the payments received from our collaboration with Chiron beginning in the latter part of the second quarter of 2001.

Royalty and License Revenue. Royalty and license revenue decreased $1.4 million, or 32.5%, to $3.0 million in the nine months ended September 30, 2002 from $4.4 million in the nine months ended September 30, 2001. The decrease was primarily the result of the receipt in the third quarter of 2001 of $2.0 million in license and royalty fees from Chugai Diagnostics Science Co., Ltd. for the licensing of rights to certain patented property and royalties, as compared to $0.3 million of such royalties received in 2002. This was partially offset by a $0.4 million increase in royalty revenues received from bioMerieux in exchange for distribution rights for our nucleic acid probe-related technology in international markets, excluding Japan.

Cost of Product Sales. Cost of product sales increased $10.0 million to $38.5 million, or 39.4% of product sales revenues, in the nine months ended September 30, 2002 from $28.4 million, or 36.7% of product sales revenues, in the nine months ended September 30, 2001. The increase in cost of sales was primarily attributable to increased sales volume in the nine months ended September 30, 2002

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and from recording a greater portion of the costs associated with the operation of our blood screening manufacturing facility to cost of product sales in the nine months ended September 30, 2002 compared to the nine months ended September 30, 2001. A substantial portion of the costs associated with the blood screening manufacturing facility were classified as research and development expense prior to receiving commercial approval for the product in the United States. The amount included in research and development expense in the nine month period ended September 30, 2001 was $11.3 million, which includes costs associated with the blood screening manufacturing facility as well as scrap charges associated with the production of developmental lots for the assay. The amount included in research and development expenses in the nine month period ended September 30, 2002 was $1.6 million. As a result, cost of product sales increased as a percentage of product sales in the nine months ended September 30, 2002 compared to the nine months ended September 30, 2001. The gross profit margin on product sales decreased to 60.6% in the nine months ended September 30, 2002 from 63.3% for the nine months ended September 30, 2001.

Research and Development. Research and development expenses decreased $7.4 million to $33.1 million, or 29.7% of total revenues, in the nine months ended September 30, 2002 from $40.5 million, or 42.0% of total revenues, in the nine months ended September 30, 2001. The decrease was primarily the result of a $9.8 million decrease in the recorded amount of manufacturing costs for blood screening assays as research and development expenses as a result of FDA approval of our blood screening product in February 2002, partially offset by a $1.5 million increase in outside development costs for the TIGRIS instrument program, a $1.4 million increase in personnel costs and $0.5 million decrease in spending for other research and development costs. Manufacturing costs for blood screening assays included in research and development were approximately $1.6 million and $11.4 million, respectively, during the nine months ended September 30, 2002 and 2001, respectively.

Marketing and Sales. Marketing and sales expenses increased $0.5 million to $12.7 million, or 11.4% of total revenues, in the nine months ended September 30, 2002 from $12.2 million, or 12.6% of total revenues, in the nine months ended September 30, 2001. The increase was primarily related to a $0.9 increase in personnel costs in our marketing and sales force to support anticipated increases in sales for our clinical diagnostic products, partially offset by decreases of $0.3 million in professional fees and $0.1 million in other marketing and sales expenses.

General and Administrative. General and administrative expenses increased $5.5 million to $17.9 million, or 16.1% of total revenues, in the nine months ended September 30, 2002 from $12.4 million, or 12.9% of total revenues, in the nine months ended September 30, 2001. The increase was the result of a $2.6 million increase in spending for legal and other professional fees primarily related to our spin-off from Chugai Pharmaceutical, $1.1 million in patent related expenses, $0.6 million for printing and public relations expenses primarily relating to the registration of our shares under the Exchange Act , a $0.6 million increase in salaries and benefits resulting from higher staffing levels and a $0.6 million increase in other general and administrative expenses.

Amortization of Intangible Assets. Amortization of intangible assets decreased $0.4 million to $0.3 million in the nine months ended September 30, 2002 from $0.7 million in the nine months ended September 30, 2001. The amortization is associated with Gen-Probe Holding’s purchase of us in 1989. The amount amortized each period has decreased as a result of our implementation of SFAS 142 as described above.

Total Other Expenses, Net. Other expenses primarily consist of investment and interest income offset by interest expense on borrowing and other items. The net other income of $3.1 million for the nine months ended September 30, 2002 increased by $3.5 million over the net expense of $0.4 million for the nine months ended September 30, 2001. The increase in net other income for the nine months ended September 30, 2002 is primarily due to the receipt in cash and recognition of income from settlements of outstanding contractual issues with Chiron for $2.4 million and from a former vendor in the amount of $1.2 million.

Income Tax Expense (Benefit). The expense for income taxes amounted to $3.2 million for the nine months ended September 30, 2002 compared to a $1.2 million benefit for the nine months ended September 30, 2001. This tax expense increase was attributable to the pre-tax income of $12.0 million for the nine months ended September 30, 2002 compared to the $2.0 million pre-tax loss for the nine months ended September 30, 2001.

The tax expense benefit for each year gives consideration to research and development tax credits available to the Company.

Extraordinary Loss. In September 2002, in connection with the spin-off, the Company repaid in full the remaining $10.0 million of principal and accrued interest due on the notes due to a bank and an insurance company. The early payoff required a prepayment premium in the amount of $1.2 million. The prepayment premium and the remaining deferred financing fees associated with the notes totaled $1.25 million and were recorded as a $0.75 million extraordinary loss (net of a tax benefit of $0.5 million) in the quarter ended September 30, 2002.

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Liquidity and Capital Resources

Historically, we have financed our operations through revenues from operations, cash received from collaborative research agreements, royalty and license fees and the private placement of debt. At September 30, 2002, we had $91.9 million of cash and cash equivalents.

For the nine months ended September 30, 2002, net cash provided by operating activities was $22.6 million compared to $9.8 million for the nine months ended September 30, 2001. For the nine months ended September 30, 2002, net cash from operating activities of $22.6 million was the result of net income of $8.1 million plus depreciation and amortization expenses of $13.2 and $4.5 million in cash from accounts receivable. These were partially offset by $2.9 million in deferred revenue and $2.0 million for inventory purchases. In addition, there was a $1.7 million increase in cash from changes in other assets and liabilities.

We recorded $9.5 million for the purchase of capital equipment in the nine months ended September 30, 2002. Our expenditures for capital additions vary based on the stage of certain development projects and may increase in the future related to the timing of development of new product opportunities and to support expansion of our facilities in connection with those opportunities. We anticipate that we will incur approximately $12 million for capital additions during the full year 2002, primarily for research and development activities. We anticipate 2003 capital expenditures will exceed 2002 levels, primarily for research and development activities including clinical trials for TIGRIS. However, the average age of our property, plant and equipment is approximately three to four years, which gives us flexibility in planning capital expenditures.

In September 2002, in connection with the spin-off, we repaid in full the remaining $10.0 million of principal due on the notes, the accrued interest due and a prepayment premium of approximately $1.2 million. The prepayment premium and the remaining deferred financing fees associated with the notes totaled $1.25 million and was recorded as a $0.75 million extraordinary loss ($1.25 million charge, net of a $0.5 million tax benefit) in the financial statements in the quarter ended September 30, 2002.

We have a secured bank line of credit agreement with Wells Fargo Bank, N.A., which expires in July 2004, under which we may borrow up to $10.0 million, subject to a “borrowing base formula,” at the bank’s prime rate, or at LIBOR plus 1.0%. The line of credit is secured by our assets with the exception of real property. We have not taken advances against the line of credit since inception. The line of credit agreement requires us to comply with various financial and restrictive covenants. Financial covenants include requirements as to tangible net worth, liabilities as a percentage of tangible net worth, the ratio of current assets to current liabilities, required minimum levels of earnings before interest, taxes, depreciation and amortization, the ratio of funded debt to earnings before interest, taxes, depreciation and amortization, and maximum levels of pre-tax and after tax losses. At December 31, 2001 and September 30, 2002, we were in compliance with all covenants.

On December 10, 2001, Chugai Pharmaceutical announced its intention to distribute all of the shares of our common stock that it holds to its shareholders, and on June 27, 2002 Chugai Pharmaceutical’s shareholders approved this transaction. In connection with the transaction, in March 2002, Gen-Probe Holding Company, Inc., our former direct parent company, commenced a reorganization that resulted in our becoming a wholly owned subsidiary of Chugai Pharmaceutical. The reorganization involved the sale or transfer by Gen-Probe Holding of certain assets, including its ownership interest in Chugai Pharma USA, LLC, the successor to our former sister company Chugai Biopharmaceuticals, Inc., to other Chugai Pharmaceutical subsidiaries. On July 23, 2002, Gen-Probe Holding merged into us. At the time of the merger, Gen-Probe Holding held $75.9 million of cash, 37 acres of land, which includes the site of our headquarters building, valued at approximately $30 million and net other assets of $ 1.5 million.

On September 15, 2002, the distribution of all shares of our common stock to the shareholders of Chugai Pharmaceutical was completed, finalizing the spin-off and making Gen-Probe an independent, public company.

Contractual Obligations and Commercial Commitments

Our contractual obligations due to note holders and lessors for properties that we lease, as well as other amounts due for purchase and capital commitments as of December 31, 2001, were as follows:

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(2)		We lease facilities under operating leases as of December 31, 2001. Future minimum lease payments are included in the schedule.
(3)		We paid rent of $525,000 to our former parent company Gen-Probe Holding Company, Inc. pursuant to a ground lease for the site of our headquarters facility. This lease terminated upon the merger of Gen-Probe Holding into us on July 23, 2002.
(4)		Does not include amounts relating to our obligations under our collaboration with Chiron. With respect to our collaboration with Chiron, both parties have obligations to each other. We are obligated to manufacture and supply our blood screening assay to Chiron, and Chiron is obligated to purchase all of the quantities of this assay specified on a 90-day demand forecast, due 90 days prior to the date Chiron intends to take delivery, and certain quantities specified on a rolling 12-month forecast.

In connection with the joint development of the HIV-1/HCV assay, and as a condition for Chiron’s agreement to pay for most of the clinical trial costs related to approval of that assay, we agreed to pay the costs related to the clinical trial for the next joint development project with Chiron. Our obligation is limited to the cost incurred for the previous joint clinical trial, which approximates $4.1 million.

Our primary short-term needs for capital, which are subject to change, are for continued research and development of new products, costs related to commercialization of the blood screening products and development of our automated instrumentation solution, TIGRIS. Certain research and development costs are funded under collaboration agreements with partners or agencies of the United States government. We anticipate additional funds from these sources as reimbursable costs are incurred but there can be no assurance that these funds will materialize or that these relationships will continue.

We believe that our available cash balances, anticipated cash flows from operations and available line of credit will be sufficient to satisfy our operating needs for at least the next twelve months. However, we operate in a rapidly evolving and often unpredictable business environment that may change the timing or amount of expected future cash receipts and expenditures. Accordingly, there can be no assurance that we may not be required to raise additional funds through the sale of equity or debt securities or from additional credit facilities. Additional capital, if needed, may not be available on satisfactory terms, if at all. Furthermore, additional debt financing may contain more restrictive covenants than our existing debt.

Item 3. Quantitative and Qualitative Disclosures about Market Risk

In September of 2002, we repaid the remaining principal on the fixed rate financing of our headquarters building. We believe that our exposure to market risk relating to interest rate risk is not material. We are exposed to foreign exchange risk for expenditures in certain foreign countries, but the total receivables and payables denominated in foreign currencies at September 30, 2002 were not material. We believe that our business operations are not exposed to market risk relating to commodity price risk or equity price risk.

Item 4. Controls And Procedures

We maintain disclosure controls and procedures that are designed to ensure that information required to be disclosed in our Exchange Act reports is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms, and that such information is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure. In designing and evaluating the disclosure controls and procedures, management recognized that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives, and management necessarily was required to apply its judgment in evaluating the cost-benefit relationship of possible controls and procedures.

Within 90 days prior to the date of this report, we carried out an evaluation, under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures. Based on the foregoing, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures were effective.

There have been no significant changes in our internal controls or in other factors that could significantly affect the internal controls subsequent to the date we completed our evaluation.

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PART II — OTHER INFORMATION

Item 1. Legal Proceedings

We are a party to the following litigation and are currently participating in other litigation in the ordinary course of business. We intend to vigorously defend our interests in these matters. We expect that the resolution of these matters will not have a material adverse effect on our business, financial condition or results of operations. However, due to the uncertainties inherent in litigation, no assurance can be given as to the outcome of these proceedings. If any of these matters were resolved in a manner unfavorable to us, our business, financial condition and results of operations would be harmed.

Enzo Biochem, Inc.

In June 1999, we were sued by Enzo Biochem, Inc. in the United States District Court for the Southern District of New York. Enzo alleges that we, our former affiliates, Becton Dickinson, and bioMérieux infringed United States patent no. 4,900,659 through the manufacture and sale of products for the detection of gonorrhea. On January 24, 2001, the district court granted our motion for summary judgment, finding that the ‘659 patent is invalid. Enzo appealed the judgment to the Federal Circuit Court of Appeals. On July 15, 2002, a panel of the Federal Circuit Court, after having previously affirmed the district court’s summary judgment decision, granted Enzo’s petition for rehearing and, without hearing further argument, reversed the district court’s order granting summary judgment and remanded the case to the district court for further proceedings. We anticipate that trial in the case will be set for the fourth quarter of 2003 or the first quarter of 2004. We expect Enzo to assert a damage claim based on a contention that Enzo is entitled to a reasonable royalty on all sales of Gen-Probe products for the detection of Neisseria gonorrhoeae bacteria from June 1993 through trial. Sales of such tests have constituted a significant portion of Gen-Probe’s revenues during the relevant period. We believe that the claims of the ‘659 patent are invalid, unenforceable and may not be properly interpreted to cover our products. We intend to vigorously defend the lawsuit. However, there can be no assurance that the case will be resolved in our favor.

Hoffman-La Roche Inc.

On May 18, 1999, we filed a declaratory relief action in Italy against Roche, seeking to have the Italian portion of European patent no. 0505012 declared invalid and seeking a cross-border declaration that the claims of the ‘012 patent are not infringed by our TMA method. We also opposed the patent in the Opposition Division of the European Patent Office. The ‘012 patent claims invention of certain nucleic acid amplification technology that could arguably be asserted to cover technology incorporated into our amplified NAT assays. At a hearing before the EPO Opposition Division on February 15, 2001, Roche agreed to amend certain claims of the patent to limit those claims to Roche’s polymerase chain reaction method of amplification and the Opposition Division thereafter denied our objection to the amended claims. On May 23, 2003, we filed an appeal to the Technical Board of Appeal. Additionally, we intend to continue to prosecute the Italian lawsuit seeking a declaration that the ‘012 patent is not valid and does not cover our TMA methods. Roche owns several United States patents claiming subject matter related to that of the ‘012 patent. While we believe that the relevant claims of these United States patents are invalid and may not be properly interpreted to cover our products, there can be no assurance that Roche will not attempt to assert these patents against our amplified products.

Vysis, Inc.

In December 1999, we initiated litigation against Vysis, now a subsidiary of Abbott Laboratories, seeking a declaratory judgment that our products were not covered by a Vysis patent that is the subject of our license with them and that the patent is invalid and unenforceable. In August 2002, following a jury trial, the district court entered judgment in our favor, finding the Vysis patent invalid and finding that the patent does not cover Gen-Probe’s products. Vysis has filed a notice of appeal. Further, on October 22, 2002 the United States Patent & Trademark Office reissued the Vysis patent with amended claims. On October 22, 2002, we filed a lawsuit to challenge the validity and scope of the reissued patent. We believe that Vysis will contend that the August 2002 judgment concerning the original patent is not determinative of the validity and scope of the reissued patent. Pending further proceedings, we have continued to make royalty payments under our license with Vysis pending final resolution of the litigation. There can be no assurances as to the final outcome of the litigation.

Item 4. Submission of Matters to a Vote of Security Holders

On August 13, 2002, Chugai Pharmaceutical, our sole stockholder prior to the distribution, acted by written consent to approve the following:

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a .366153-for-one reverse stock split of our common stock, which resulted in the number of our outstanding shares of common stock being reduced from 65,000,000 to 23,799,945.

On August 15, 2002, Chugai Pharmaceutical acted by written consent to approve the following:

	•		our amended and restated certificate of incorporation;
	•		our amended and restated bylaws; and
	•		the form of indemnification agreement to be entered into between us and our officers and directors, including future officers and directors.

Item 5. Other Items

Risk Factors

The following information sets forth factors that could cause our actual results to differ materially from those contained in forward-looking statements we have made in this Quarterly Report and those we may make from time to time. For a more detailed discussion of the factors that could cause actual results to differ, see the section under the caption “Risk Factors” in our Information Statement filed as Exhibit 99.1 to our Registration Statement on Form 10 filed September 5, 2002.

We expect to continue to incur significant research and development expenses, which may make it difficult for us to maintain profitability.

In recent years, we have incurred significant costs in connection with the development of our blood screening products and the TIGRIS instrument. We expect our expense levels to remain high in connection with our research and development as we continue to expand our product offerings. As a result, we will need to continue to generate significant revenues to maintain profitability. We may not be able to generate such revenues and may not maintain profitability in the future. Our failure to maintain profitability in the future could cause the market price of our common stock to decline.

We could incur significant liability if we are acquired or engage in a transaction involving our stock and Chugai Pharmaceutical’s Japanese tax liabilities are greater than the amount specified in the separation and distribution agreement.

In connection with the distribution of all of the outstanding shares of our common stock held by Chugai Pharmaceutical Co., Ltd. to holders of its common stock, Chugai Pharmaceutical will be subject to Japanese tax liabilities, the amount of which is dependent upon the fair market value of our stock. While Chugai Pharmaceutical has used its reasonable efforts to estimate the total amount of such Japanese tax liability, the process and methodology by which the Japanese taxing authority will make its determination of the value of our stock and the amount of tax for which Chugai Pharmaceutical is liable with respect to the distribution is uncertain, and Chugai Pharmaceutical’s actual tax liability may exceed such estimated amount. As a result, in the separation and distribution agreement between Chugai Pharmaceutical and us, we have agreed to indemnify Chugai Pharmaceutical in the event that, within 15 months following the distribution, we sell all or substantially all of our assets, a person or group acquires beneficial ownership of 50% or more of our voting stock, we are a party to a merger, or we issue common stock or other equity securities other than issuances of equity securities for cash consideration at a price not in excess of the market price of our common stock immediately prior to such issuance or pursuant to an employee benefit or incentive plan and Chugai Pharmaceutical’s Japanese tax liabilities are greater than the amount specified in the separation and distribution agreement. This potential obligation to indemnify Chugai Pharmaceutical could discourage, delay or prevent a change of control.

Because our quarterly revenue and operating results may vary significantly in future periods, our stock price may decline.

Our operating results have fluctuated in the past and are likely to continue to do so in the future. Our revenues are unpredictable and may fluctuate due to changes in demand for our products, the timing of the execution of customer contracts and the initiation or termination of corporate collaboration agreements. A significant portion of our costs are fixed, due in part to significant selling, research and development and manufacturing costs. Thus, small declines in revenue could disproportionately affect operating results in a quarter and the price of our common stock may fall. Moreover, a variety of factors may affect our ability to make accurate forecasts regarding our operating results. For example, our blood screening products and some of our clinical diagnostic products, such as APTIMA Combo 2, have a limited sales history, which limits our ability to project future sales accurately. In addition, we base our internal projections of our international sales on projections prepared by our distributors of these products. Because of these

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factors, our operating results in one or more future quarters may fail to meet the expectations of securities analysts or investors, which could cause our stock price to decline.

We are dependent in the near term on sales of our PACE family of assays. A significant reduction in sales of our PACE assays, without a corresponding increase in sales of our APTIMA Combo 2 assay, would cause our revenues to decline and could materially harm our business.

Sales of our PACE family of assays accounted for approximately 55% of our total revenues for the nine months ended September 30, 2002 and 57% of our total revenues in 2001. We expect our revenue and profitability to substantially depend for the foreseeable future on sales of our PACE assays. We believe that sales of our PACE assays may decline because several of our competitors have introduced products using amplified technologies that target the same infectious organisms as our PACE assays. Our continued growth will depend on our ability to:

	•		successfully commercialize newly developed products, including those that incorporate amplified technologies, such as our APTIMA Combo 2 assay,
	•		develop and commercialize additional products, and
	•		gain additional acceptance of our PACE assays in new market segments, including international markets.

A significant decrease in the demand for our PACE assays, without a corresponding increase in sales of our APTIMA Combo 2 assay, would cause our revenues to decline and could materially harm our business.

If large reference laboratories, public health laboratories and hospitals do not adopt and use our new clinical diagnostic products, including our APTIMA Combo 2 assay, we may not be able to expand or maintain our share of the clinical diagnostic market.

The products that we develop, including our new APTIMA Combo 2 assay that utilizes amplified technology, may not achieve market acceptance. The market acceptance of our products will depend on a number of factors, including but not limited to:

	•		their advantages over competing products, including effectiveness and ease of use,
	•		pricing, and
	•		the reimbursement policies of government and third-party payors.

If our new products do not obtain market acceptance, we may not be able to maintain or expand our share of the clinical diagnostics market, including the market for the diagnosis of the infectious diseases addressed by our PACE assays, causing our sales to be reduced.

If we are unable to complete development of our TIGRIS instrument in a timely manner, we may be unable to retain our existing customers and attract new customers.