Back to GetFilings.com

UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Form 10-K

ANNUAL REPORT

For the fiscal year ended December 31, 2001

Commission File No. 000-20931

VENTANA MEDICAL SYSTEMS, INC.

Registrant’s telephone number, including area code:

Securities registered pursuant to Section 12(b) of the Act:

Securities registered pursuant to Section 12(g) of the Act:

      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 þ          No o

      Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein and will not be contained, to the best of registrant’s knowledge, in definitive proxy or other information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  o

      The aggregate value of voting stock held by non-affiliates of the Registrant was approximately $311,139,348 based upon the average of the high and low prices of the Registrant’s Common Stock reported for such date on the Nasdaq National Market. Shares of Common Stock have been excluded in that such persons may be deemed to be affiliates. The determination of affiliate status is not necessarily a conclusive determination for other purposes. As of February 28, 2002, the Registrant had outstanding 16,234,769 shares of Common Stock.

DOCUMENTS INCORPORATED BY REFERENCE

Not applicable

PART I

      This report on Form 10-K may contain projections, estimates and other forward-looking statements that involve a number of risks and uncertainties. For a discussion of factors that may affect the outcome projected in such statements, see “Cautionary Factors That May Affect Future Results,” beginning on page 12. While this outlook represents our current judgment on the future direction of our business, such risks could cause actual results to differ materially from our future performance listed below. We undertake no obligation to release publicly the results of any revisions to these forward-looking statements to reflect events and circumstances arising after the date of this report on Form 10-K.

      For our current and historical financial positions, see “Selected Financial Data,” beginning on page 24.

Item 1.     Description of Business

Summary of Our Business

      Unless the context requires otherwise, all references to we, our or us refer to Ventana Medical Systems, Inc., a corporation originally incorporated in the state of Delaware in 1993 and its six subsidiaries:

	•	Ventana Medical Systems, GmbH
	•	Ventana Medical Systems, Japan K.K.
	•	Ventana Medical Systems, Pty. Ltd.
	•	Ventana Medical Systems, S.A.
	•	BioTek Solutions, Inc.
	•	BioTechnology Tools, Inc.

      We develop, manufacture and market instruments and consumables that are used to automate diagnostic and drug discovery procedures in clinical histology laboratories and drug discovery laboratories worldwide. Our instrument-reagent systems are designed to prepare and to stain patient tissue or cells mounted on a microscope slide for examination by a pathologist. The consumable products we market that are required to operate our instruments include reagents and other accessories. Our systems are designed to provide users with automated high-quality and consistent results with high throughput and significant labor savings. Our clinical products are used by anatomical pathology labs, which are labs that focus on the analysis of human tissue, to assist anatomical pathologists in the diagnosis of cancer and infectious diseases. Most anatomical pathology labs are hospital-based, although some independent reference labs offer histology services. Our drug discovery products are used by research labs at large pharmaceutical and biotechnology companies and medical research centers to assist in the discovery of new drug targets. Our instruments have been placed in the majority of the top fifty U.S. cancer centers, which are recognized as leaders in cancer research and treatment. These include Johns Hopkins Hospital, the Mayo Clinic, Memorial Sloan-Kettering Cancer Center and M.D. Anderson Medical Center.

      The anatomical pathology lab is made up of Histology and Cytology. Histology tests performed on our instruments are used by pathologists and oncologists to assist in the diagnosis of cancer and infectious diseases and to select an appropriate therapy. According to the National Cancer Institute, cancer is the second leading cause of death in the United States. Mortality rates are improved by early detection and the selection of appropriate therapies. Based upon our modeling of the market, we estimate that anatomical pathology labs worldwide purchase in excess of $1.0 billion in instruments and consumables on an annual basis. In addition, the pharmaceutical and biotechnology companies involved in analyzing the human genome and proteome to accelerate new drug discovery also benefit from automating the analysis of human and animal tissue and cells.

Industry Overview

      We target our instrument-reagent systems at two markets: the anatomical pathology lab (Histology and Cytology) and the drug discovery lab. We currently derive the majority of our revenues and profits from

2

     Histology

      Histology is the study of the microscopic structure of tissues. In a histology lab, an anatomical pathologist attempts to identify the causes and consequences of disease in a specific part of the body. An anatomical pathologist uses tools ranging from powerful microscopes to molecular analysis of cell proteins and genes. This is done by examining tissue samples obtained during surgery or through biopsy procedures to identify structural and other changes in cells, tissues and organs. Anatomical pathology examinations are among the most reliable ways to establish: (1) a diagnosis of the type of disease suffered by the patient, (2) a prognosis on the likely progression of the disease and (3) a determination as to which therapies are most likely to be effective in treating the patient.

      All patient tissue samples entering the histology lab move through seven sample preparation and work cells:

	•	Accessioning — Tissue is entered into the hospital information system for medical records and billing purposes.
	•	Grossing — Following accessioning, the gross tissue specimen is examined by a pathologist. Several tissue samples are then cut from the gross specimen for further examination and placed in small plastic cassettes.
	•	Tissue Processing — Cassettes from gross specimens are placed in an instrument called a tissue processor. Tissue processors preserve the tissue through the use of a fixative and infusing the tissue with paraffin so it can be more readily cut or sectioned.
	•	Embedding — Processed tissue is removed from each cassette and embedded in a paraffin block to produce a tissue block of uniform size.
	•	Sectioning — Each tissue block is next transferred to the sectioning area of the lab where very thin sections are cut on a microtome and mounted on a microscope slide.
	•	Hemotoxlyn and Eosin, or H&E, Staining — Each microscope slide is then stained with two basic stains, Hemotoxlyn and Eosin, that help the pathologist identify each cell’s nucleus, cytoplasm and membrane.
	•	Microscopic Examination — Finally, each H&E stained slide is examined by a pathologist using a microscope to determine if the tissue or cells are healthy or diseased. In particular, the pathologist is looking for the presence of microorganisms that could indicate an infectious disease or deformed cells that could indicate the presence of cancer. In cases where an H&E stained slide appears to have abnormalities, the pathologist performing the initial examination of a patient specimen may request that the slide undergo additional testing.

      Additional tests, which may be requested by the pathologist, include immunohistochemistry, special stains or in situ hybridization tests. These tests are significantly more complex than the H&E stains and require special reagents.

	•	Immunohistochemistry, or IHC, stains are used primarily by pathologists and oncologists assisting in the diagnosis of cancer and the determination of different treatment options. IHC staining is used to test for the presence or over expression of the proteins involved in cancer.
	•	Special stains are used primarily to assist in the diagnosis of infectious diseases, although they can also be used to assist in cancer diagnosis. Special stains are chemical dye stains that localize to microorganisms found in tissue and to specific tissue types.
	•	In situ hybridization, or ISH, stains can be used to assist in the diagnosis of infectious diseases or genetic mutations that are usually associated with the presence of cancer.

3

      We currently offer products that are used in tissue processing, IHC staining, special stains staining and ISH staining.

      Tissue Processing. In developed nations, all histology labs have at least one automated tissue processor instrument and most labs have two or more. In less developed countries, tissue processing is still performed manually in most labs. Tissue processors consume a substantial quantity of reagents (fixatives, alcohol, xylene, paraffin), however we do not participate in this reagent market.

      IHC Staining. We estimate that there are in excess of 30 million slides stained with IHC annually on a worldwide basis. The majority of these slides are stained in the approximately 6,000 hospital-based histology labs. However, in North America and Japan some hospitals send their IHC slides to regional reference labs for staining rather than performing the work themselves. We estimate that the number of IHC slides processed all across labs in the U.S. is growing about 6% – 8% annually due to:

	•	the increasing acceptance of the value of the technology by pathologists and oncologists;
	•	the increasing incidence of cancer as the population ages increases histology producing surgical cases;
	•	the emergence of new stains that may influence therapy choices;
	•	a shrinking qualified labor pool; and
	•	the shifting of the market from manual to automated IHC slide processing.

      We estimate that approximately 50% of the IHC slides processed in North America and Europe are stained on automated instruments. Most of the rest of the world is using manual staining, a substantial growth opportunity as these users convert to automated systems.

      IHC instruments require reagents and accessories to operate. We supply a full line of these consumables for use with our instruments. Our experience in the industry suggests that we are the worldwide market leader in supplying automated IHC staining systems.

      Special Stains Staining. We estimate that the special stains market is slightly smaller than the worldwide IHC market and growing rapidly. There is an opportunity to place instruments with virtually every hospital-based histology lab as special stains slides are rarely sent to reference labs. Currently, nearly all special stains slides are processed manually; we believe that a major segment of the market will switch toward automated slide processing over the next 5–10 years.

      ISH Staining. The clinical market for ISH staining is currently very small due to the difficulty of performing ISH stains manually and the small number of assays accepted for clinical use. We expect automation to grow the clinical market significantly. Currently, the principal clinical tests are used to detect cancer and infectious diseases, primarily viruses, in tissue. We believe ISH tests for genetic mutations will become important clinical tests.

      Her-2/neu testing. Her-2 is tested either by protein overexpression or gene amplification. Whether in biopsied tissue or in cytological fluid collected by ductal lavage, Her-2/neu FISH testing is critical in determining the correct therapy for a patient. We are the only company to offer a complete, fully automated Her-2 triage method which incorporates both an FDA approved protein assay, Pathway, and a HER-2 FISH assay, INFORM Her-2/neu.

     Cytology

      Cytology is the microscopic study of cell samples from various human body sites for the detection, diagnosis, and management of human disease. In cytology labs, cytopathologists seek to identify cells, which are either living (phase microscopy) or dead (fixed) and prepared for viewing (embedded, sectioned, and stained) on microscopes. The cytotechnologist microscopically examines the morphologic features of the cells, which are gathered by brush, lavage, scraping or aspirate, relates these findings to the patient’s clinical history, and renders a cytological diagnosis. The pathologist then reviews all the findings and reports out abnormal cases and all non-gynecologic cases. The cytopathologist’s finding is used to aid the clinician with patient

4

      Tests, which can assist the pathologist in assessing patient samples, include special stains, immunohistochemistry or in situ hybridization.

      The U.S. Department of Health and Human Services estimates that approximately 26.5 million of the 53 million sexually active women are infected with Human Papillomavirus (HPV) with 1.75 million displaying evidence of infection. Although most HPV is categorized as low patient risk and does not progress to cancer, more than 25% (883,000 cases) of all HPV cases are high risk, which is responsible for more than 95% of all cervical cancer cases. Our INFORM HPV in situ assays for liquid-based cytological specimens and tissue specimens are used to determine if a patient is HPV positive and if the infection is a high or low risk viral type. These tests are fully automated on the BenchMark slide staining system.

     Drug Research

      The research market for new drugs comprises over 500,000 researchers worldwide located in labs operated by traditional pharmaceutical companies, biopharmaceutical companies, governments and medical research centers. In these labs, research is being conducted to determine the causes of disease and the specific drugs to treat disease. Both genomics, the study of genes and their function, and proteomics, the study of proteins and their function, seek to accelerate the drug discovery process by understanding the molecular mechanisms of disease. The genomic and proteomic revolutions are providing researchers with a dramatic increase in the number of potential drug targets. For example, researchers are now able to conduct screens against compound collections and compound libraries for specific proteins.

      Genomics has created opportunities to fundamentally alter the field of human medicine through the discovery of new biological targets for drugs and an improved ability to diagnose and manage disease. Interest in understanding the relationships between genes and disease has generated a worldwide effort to identify and sequence the genes of many organisms, including the approximately three-billion nucleotide pairs and the estimated 30,000 genes within the human genome. Once researchers identify the genes and their nucleotide sequences, we anticipate that many years of additional research will be required to gain an understanding of the specific function of each of these genes and their role in disease.

      Proteomics is the analysis of proteins encoded by active genes — the direct cause of disease in the body. It is believed that there are many more proteins in the human body than genes. The human proteome is years away from being decoded, but this task will be simplified, as the functions of the estimated 30,000 human genes are uncovered. We believe proteomics will likely increase in importance in worldwide drug discovery labs.

Business Strategy

      Our objectives are to: (1) expand our worldwide leadership position in automating anatomical pathology labs and (2) leverage the core technologies we have developed for the anatomical pathology lab into drug discovery labs. Our business strategies to achieve these objectives are as follows:

	•	Provide high-quality, innovative and flexible automation systems for tissue analysis. Our position as a leader in the histology lab automation market has been built on innovative automated instrument-reagent systems. These systems have been designed as broad enabling platforms that permit customers to easily expand their test menu and provide superior patient care with higher quality, consistent and timely tissue staining. Labs also benefit by increasing output and reducing labor costs through automation and walk-away convenience.

5

	•	Provide high throughput, value-added testing systems for drug discovery applications. We believe the same strategies that we are using in the anatomical pathology market can be applied to the drug discovery marketplace through our product introductions.
	•	Maximize domestic and worldwide placement of automated systems in anatomical pathology and drug discovery laboratories. Automating manual work cells provides a competitive advantage by establishing a large base of instruments that other market entrants must overcome. We believe that our worldwide installed base of IHC, special stains and ISH instruments is larger than the instrument base of all of our competitors combined. The size and quality of our direct sales coverage permits us to maximize instrument placements and revenue stream per placement.
	•	Ensure a steady sales stream of consumables for use in these instruments. Each IHC, special stains and ISH instrument placed provides a recurring revenue stream from reagents and other consumable supplies. Our strategy is to increase this revenue stream by automating manual lab activities and selling all the reagents required. In addition, we intend to continue expanding our menu of automated tests, thereby increasing the consumable revenue from each instrument placement. Typically, our instruments are closed systems that can only be operated with Ventana-produced consumables.
	•	Continue on-going technological development and improvement of our instrumentation and reagents. Unlike most of our competitors who rely on outside design firms for the creation of their instrumentation, we design our products internally. We are designing new instrumentation, enhancing existing instruments and developing reagents for current and future customer applications. Our engineering, marketing and reagent research and development organizations work closely with their manufacturing counterparts on all new products to ensure cost effective production. These designs are protected with an aggressive intellectual property strategy.

History of the Company

      In 1985, Ventana Medical Systems was incorporated in California by a pathologist at the University of Arizona Medical Center interested in the automation of IHC staining. After obtaining venture capital funding, we launched our first instrument-reagent system in 1991 before reincorporating in Delaware in 1993. We have since launched numerous new products using internally developed and acquired technologies.

Our Products

      Our product offerings are summarized as follows:

     Tissue Processors

      Our Renaissance tissue processor is a batch instrument that processes up to 350 specimens in a single run. This enclosed system has features that dramatically improve the quality of prepared tissue.

     Staining Systems and Associated Reagents

      The principal benefits of automated cellular and tissue analysis using our integrated systems, compared with manual methods, are as follows:

	•	improved reliability, reproducibility and consistency of test results;
	•	faster turnaround time for test results;
	•	increased test throughput for the testing;
	•	reduced dependence on skilled technicians;
	•	ability to obtain maximum clinical information from minimally-sized biopsies;
	•	ability to document processing protocols; and
	•	standardization of slide preparation among institutions.

6

      In addition to the critical clinical and operational advantages, our automated approach has shown significant cost savings and advantages over manual methods.

      IHC Staining. Our first product launch in 1991 was an instrument-reagent system to automate IHC staining. Prior to the introduction of this system, all IHC staining was performed manually or with low-levels of automation. In early 1996, we acquired BioTek Solutions, Inc. and now enjoy a strong market share position in the worldwide-automated IHC staining market.

      We market three IHC instrument systems with a full line of complementary reagents and accessories. Our line of IHC products includes batch-processing and patient-priority systems targeted to hospital clinical and reference labs.

      The TechMate 500 batch-processing instrument has a 120-slide capacity and is designed for large volume, single application testing, applicable to large and moderate-size reference and research labs. We manufacture and market reagents for use with our TechMate systems.

      Our NexES IHC staining system continues to be a key tool in supporting the automation of mid-sized and smaller volume customer accounts in IHC.

      Our premier IHC system, the BenchMark, launched in late 2000, has revolutionized the industry. It automates all the steps in the IHC workcell with its baking through staining (BTS) technology. This automation saves up to 90 minutes of manual work required prior to an IHC run and allows walk-away convenience. Additionally, this system will perform IHC and, more complex, ISH stains. The BenchMark uses a barcode system and is designed to run multiple tests on a single biopsy with rapid turnaround time and without manual intervention. The barcode, affixed to each slide, identifies the slide and testing procedures to be performed. The BenchMark scans the slide, dispenses the reagents and processes each slide with the unique steps. Our software controls all aspects of the test procedures. The dispensing, incubating (i.e. temperature and time control) and washing performed using proprietary chemical/mechanical methods are critical to obtaining precise, sensitive and rapid test results. This makes the system reliable and easy to use, reducing the slide processing time to less than two hours.

      The BenchMark has a modular design using an external personal computer operating in a Windows environment. Each module holds up to 20 slides in the reaction chamber and 25 reagents on its reagent carousel. The modular design of the BenchMark permits the linkage of up to eight BenchMark IHC/ ISH or NexES Special Stains modules, creating the capacity to process up to 160 slides. Therefore, the BenchMark offers customers flexibility in meeting their test volume requirements.

      We manufacture and market an extensive line of primary antibodies and detection chemistries for use on our IHC systems. In combination, these reagents detect antigens of interest in tissue samples. We produce bulk reagents, used to condition tissue and cells prior to staining, and dispenser administered reagents, used as primary antibodies and detection chemistries. Each of these reagent products is required for an IHC test. Customers with patient-priority systems must use our detection chemistries on all tests, but they have the option of purchasing primary antibodies from other sources. Customers with our batch-processing systems can purchase both primary antibodies and detection chemistries from other sources, however the majority purchase Ventana-produced reagents.

      As we place additional BenchMark systems, the reagents used to prepare tissue prior to the application of a primary antibody will be an important source of revenue. The detection chemistries, primary antibodies and other reagents have been developed using proprietary formulations that, when combined, optimize the results of tests performed. These kits generate the visual signal in an IHC reaction at the site where a primary antibody is bound to a specific antigen or molecule in the cell or tissue.

      Additionally, we offer a line of consumable ancillary products necessary for processing slides. These include buffers, for optimizing the IHC reaction, and counterstains, for staining cell nuclei, used with both patient-priority and batch-processing instruments.

7

      Special Stains. In late 1998, we offered histology labs the first automated system for special stains testing with the launch of our second instrument-reagent system. We believe our Special Stains system is the market leader in this product segment.

      The Special Stains module can be operated with the same control computer that operates our NexES IHC and BenchMark modules, with up to eight complete modules operated on a system. This flexibility enables customers to design a combination special stains/ IHC system that meets their specific needs and provides flexibility for future lab growth. Presently, our fourteen special stains kits account for 90% of all special stains testing performed in histology labs. We plan to expand our test menu so that our system can meet the special staining needs of more than 95% of most laboratories. All of our kits are developed using proprietary protocols.

      ISH Staining. The launch of our GenII system in 1995 was our entry into the ISH staining market. The instrument was sold primarily into the drug discovery market, although some were placed into clinical histology labs. Our BenchMark IHC system also has ISH capability, and we plan to leverage this capability with an expanded menu of clinical ISH tests.

      In December 1999, we launched the Discovery system for ISH and IHC staining in drug discovery labs. This system can function as a high throughput processor of DNA microarrays, RNA microarrays and tissue stains used to validate drug leads. We anticipate this system will be sold primarily to drug research companies.

      Like the BenchMark system, the Discovery system incorporates a number of important technological advances over our earlier NexES IHC and Special Stains systems. In contrast to the NexES IHC and Special Stains modules that heat the entire reaction chamber to a pre-set temperature and maintain that temperature during the entire processing cycle, the Discovery system can accurately control the reaction temperature for each slide. Individual slide heaters permit an optimal protocol for each test and allow for the denaturing of DNA, a critical step for detecting genetic abnormalities. We have filed patents to protect inventions incorporated into the Discovery system.

      Our Discovery system is currently being used and tested for use in the following drug discovery applications: message expression analysis in tissue sections, protein expression analysis in tissue and the hybridization of DNA and RNA microarrays.

Research and Development

      The research and development group is divided into two teams: (1) instrumentation development and (2) staining protocol and reagents. Our efforts are focused on innovative combined instrument-reagent systems, as well as enhancements to existing instruments. In addition, we are developing reagents for current and future customer applications.

      Our staff of 82 employees performs the majority of our research and development activities. These efforts are supplemented by consulting services and assistance from scientific advisors. We spent $14.9 million in 2001, $11.1 million in 2000 and $7.1 million in 1999 on research and development.

     Instrumentation Development Projects

      Our instrumentation development is focused on product improvement and new product development. The modular platform used by our NexES IHC system enabled us to rapidly develop new products, such as the NexES Special Stains system, the Discovery system and the BenchMark system. This modular development strategy will continue as we explore new opportunities in instrument systems, adding value to our customer and automating manual lab processes.

8

     Reagent Development Projects

      Our reagent development is divided into five principal areas:

	•	new antibody development;
	•	detection chemistries;
	•	Special Stain chemistries;
	•	ISH clinical chemistries for BenchMark; and
	•	ISH and IHC applications for the Discovery.

      We continue to monitor third-party development of new primary antibodies used to identify abnormal levels of patient expression and assist pathologists in recommending treatment. We will license or purchase these antibodies as appropriate. New detection chemistries with improved sensitivity and specificity continue to be developed through our research efforts and reagent development for our systems is on going.

Customers

      Our customers consist of hospital-based histology labs, independent reference labs and drug discovery of large pharmaceutical companies, biotechnology companies, government labs and medical research centers. None of our customers accounted for more than 5% of our consolidated revenues in 2001, 2000 or 1999.

Patents and Proprietary Rights

      It is our internal strategy to patent key technologies in the automation of and chemistry of analyzing cells and tissues on microscope slides. Presently, we own thirty-four active United States patents and numerous corresponding foreign patents, and have filed patent applications in the U.S. and abroad to cover our existing and future products. Two U.S. patents were issued in 2001. These two new patents complement our access to key technology through exclusive and nonexclusive licenses, manufacturing supply contracts and research support agreements. The expiration dates of our issued United States patents range from September 2005 to February 2018.

      Our patent portfolio is divided into two segments: instruments and reagents.

      Instrument patents and applications include:

	•	three U.S. patents directed to the Liquid Cover Slip technology;
	•	the suite of patents related to the TechMate instrument that covers all aspects of the instrument including the algorithm for the interleaving of steps of a run;
	•	three separate U.S. patents on reagent dispenser designs;
	•	five patents on apparatus for automated IHC tissue staining; and
	•	one patent on independently heatable slide staining apparatus.

      Reagent patents and applications include:

	•	tissue fixatives;
	•	hybridization methods and compositions;
	•	IHC staining methods and reagents;
	•	biotin/avidin formulations and methods; and
	•	compositions and image based methods for manual and automated assessment of various types of cancer including breast, leukemia and prostate.

9

Sales and Marketing

      Our sales and marketing strategy is to provide superior levels of customer service. In our major markets, including North America, Japan and Europe, we achieve this goal by selling our products directly to our customers and controlling our telephone and field service forces. Our direct sales force, believed to be the world’s largest covering histology labs, is organized by region in North America, with the exception of national and key accounts, and by country internationally. In smaller markets, we rely on strategic distributors to sell and service our products. Our efforts have led to high levels of customer satisfaction and rapid response to customer feedback.

      To augment our clinical histology tactical marketing and sales organizations, we have established similar operations to cover our drug discovery line of business. These sales forces in North America, Japan and Europe will primarily promote our Discovery systems and related consumables.

      Our worldwide marketing team is responsible for identifying new product opportunities, working with R&D on product development and driving worldwide revenues through marketing support. In 2001, we established a cytology group to drive market penetration of our INFORM HPV ASR product and to develop a branded presence in the women’s health field.

Competition

      We face an array of competitors in the anatomical pathology lab and drug discovery markets. In many market segments, our competitors have greater experience and name recognition, yet we have been able to successfully introduce our products. Competition is intense and based on product performance, product price, the company product line and after-sales service.

     Tissue Processor

      In the tissue processing market, our principal competitor is Sakura Fine Technical Co., Ltd., a privately held Japanese company with extensive brand recognition. Other competitors in the industry include Leica Microsystems Group, a German-based competitor, and Thermo BioAnalysis Group, a publicly traded U.S. company owning Shandon Lipshaw, a competitor in lab equipment.

     Histology

      As the market share leader in automated IHC staining, we have historically placed more new instruments annually than all our competitors combined. Nevertheless, we face strong competition from the manual method of performing IHC tests and from competitors marketing instrument-reagent IHC staining systems. A number of histology labs in the U.S. and the majority outside the U.S. continue to manually perform IHC slide staining. Significant barriers exist to automation in countries where insurance or governmental healthcare reimbursement for IHC tests is low. Additionally, labs in which pathologists prefer manually stained slides remain reluctant to automate their processes.

      Currently, direct competition comes from four competitors selling instrument-reagent IHC staining systems. These competitors are Dako, a privately held Danish company that dominates the market for manual IHC reagents; BioGenex Laboratories, Inc., a privately held U.S. company marketing instruments with a reagent stream; LabVision Corporation, a subsidiary of the publicly traded company, Apogent Technologies, Inc., that supplies Dako with instruments, and markets its instruments through distributors and direct salesforce; and Diagnostics Products Corp. that markets high volume IHC staining systems in Europe.

      Two automated special stains systems compete with our Special Stains module. CytoLogix Corp., a venture-backed U.S. company, markets the Artisan Staining System. BioGenex also markets special stains systems known as Optimax. We believe our initial success in the special stains market will attract additional competitors.

10

     Cytology

      The current HPV cytology market is dominated by Digene Corporation with their FDA approved, Hybrid Capture II liquid based prep assay holding more than 95% of the HPV testing market.

     Drug Discovery

      In drug discovery applications, we are focused on the study of the hybridization of nucleic acid microarrays and messenger RNA expression. Our competitors in nucleic acid microarray hybridization include Genomic Solutions, Inc. and Molecular Dynamics, a subsidiary of the publicly traded company, Amersham Pharmacia Biotech. Currently, we do not face competition providing automated systems for messenger RNA expression studies. In Discovery IHC staining, competition includes our clinical IHC competitors, Dako and BioGenex.

Manufacturing

      Our instrument and reagent manufacturing are maintained in a single facility located in Tucson, Arizona. We manufacture all of our instruments with the exception of the TechMate 500 system. This product is produced by a third-party manufacturer and accounts for a small portion of our sales.

      Medical device manufacturing operations are required to follow the FDA Quality Systems Regulations. These regulations subject our facilities to inspections, verifying the compliance of requirements and requiring the maintenance of documentation and controls for our manufacturing and quality measures. We intend to implement manufacturing policies and procedures enabling receipt of ISO certification — global standards for the design of the manufacturing and quality assurance processes.

Contracts

      Instruments are placed through direct sales, non-recourse leases, instrument rentals and our Performance Evaluation Period (PEP) program. The PEP program allows customers to evaluate an instrument for up to six months, provided the customer enters an agreement to purchase Ventana-produced consumables to operate the instrument. At the end of the evaluation period, the customer must purchase, rent or return the system.

Employees

      As of December 31, 2001, we had 543 full-time employees, including our 10 officers.

11

Cautionary Factors That May Affect Future Results

12

13

		their patients. Third-party payors may deny reimbursement to our customers if they determine that a prescribed device or diagnostic test has not received appropriate FDA or other governmental regulatory clearances or approvals, is not used in accordance with cost-effective treatment methods as determined by the payor, or is experimental, unnecessary or inappropriate. The success of our products may depend on the extent that appropriate reimbursement levels for the costs of such products and related treatment are obtained by our customers from government authorities, private health insurers and other organizations, such as health maintenance organizations, or HMOs.
		Third-party payors are increasingly challenging the prices charged for medical products and services. The trend towards managed health care in the United States and the concurrent growth of organizations such as HMOs could significantly influence the purchase of health care services and products.
		Cost containment measures that health care payors are instituting and the impact of any health care reform could have a material adverse effect on the levels of reimbursement our customers receive from third-party payors.
A reduction in government funding to research centers would reduce their ability to purchase our products		Some of our products are sold to universities, research laboratories, private foundations and other institutions where funding is dependent upon grants from government agencies, such as the National Institutes of Health. Research funding by the government could be significantly reduced. Any such reduction may materially affect the ability of many of our research customers to purchase our products.
Future operating results may fluctuate depending on:		Our operating results may fluctuate depending on sales of instruments and sales of reagents. If actual earnings in a given quarter are less than analyst estimates, our stock price could be adversely affected.
— how many instruments we sell and under what terms they are sold		The initial placement of an instrument is subject to a longer, less consistent sales cycle than the sale of reagents. Instruments are typically sold in the latter part of a quarter and in the fourth quarter of the year due to the buying patterns of our customers. The degree of fluctuation will depend on the timing, level and mix of instruments placed through direct sales, PEP programs and rentals. Our future operating results are likely to fluctuate from period to period because instrument sales are likely to remain an important part of revenues in the near future.
— changes in our sales force		Our sales force is responsible for customer sales, placement, and support. If we fail to replace members of our sales force in a timely manner or if we fail to train our sales force adequately with regards to our products and services, it may adversely affect sales of instruments and reagents.
— how much reagent our customers use		Additionally, average daily reagent use by customers may fluctuate, contributing to future fluctuations in revenues.

14

15

16

		any clearance or approval will be granted or that FDA review will not involve delays that would harm our ability to market and sell our products.
		Further, clearances or approvals may be conditional and place substantial restrictions on the marketing of the product. We also cannot assure that the FDA will not require additional data, require further clinical studies or obtain a PMA, and incur further cost and delay in product introduction.
— although our IHC and ISH products have not needed 510(k) approval, some of our future products may		With respect to automated IHC testing functions, our instruments have been categorized by the FDA as automated cell staining devices and have been exempted from the 510(k) notification process. To date, ISH tests have not received FDA approval or clearance and, therefore, use of the Discovery for ISH tests will be restricted to research applications. New instrument products could require future 510(k) clearances.
— some of our antibody products may require PMA approval if marketed in a particular way		Antibodies we may wish to market, with labeling indicating they can be used in the diagnosis of particular diseases, may require PMA approval. In addition, the FDA has proposed that some antibody products may be subjected to a costly pre-filing certification process. Certain products are currently sold for research use and are labeled accordingly.
— if we do not comply with regulatory requirements, or we fail to get approval for our products, our results of operations would suffer		If we do not comply with applicable regulatory requirements, we could be subject to, among other consequences, fines, injunctions, civil penalties, suspensions or loss of regulatory approvals, recalls or seizures of products, operating restrictions and criminal prosecutions. In particular, the FDA enforces regulations prohibiting the marketing of products for non-indicated uses. In addition, governmental regulations may be established that could prevent or delay regulatory approval of our products. Delays in or failure to receive approval of products we plan to introduce, loss of, or additional restrictions on or limitations relating to previously received approvals, other regulatory action against us, or changes in the applicable regulatory climate could cause our results of operations to suffer.
— we and our customers are inspected for compliance with FDA regulations		We are required to register as a medical device manufacturer with the FDA and are inspected on a routine basis for regulatory compliance. Our clinical laboratory customers are subject to CLIA, intended to ensure the quality and reliability of medical testing.
— other laws and regulations may adversely affect our operations		In addition to these regulations, we are subject to numerous federal, state and local laws and regulations relating to such matters as safe working conditions and environmental matters. We cannot assure that these laws will not adversely affect results of operations in the future.
There are risks associated with the acquisition of businesses, products or technologies		We may make additional acquisitions of complementary businesses, products or technologies in the future.

17

18

		Regulations and other standards prescribed by various federal, state and local regulatory agencies in the United States and other countries.
— our quality problems arising from internal manufacturing issues or third party supplier failures		We cannot assure that manufacturing and quality problems will not arise as we increase our manufacturing operations or that scale-up can be achieved in a timely manner or at a commercially reasonable cost. Manufacturing or quality problems, or difficulties in the manufacturing scale-up could affect our operating results.
We depend on key suppliers to provide some of the components and raw materials for our reagents; if that supply is interrupted, our results of operations could suffer		Our reagent products are formulated from chemical and biological materials using proprietary technology, and standard processing techniques. We purchase components and raw materials used to make our reagent products from single-source vendors. We cannot assure that the materials or reagents needed, will be available in commercial quantities or at acceptable prices. Any supply interruption or yield problems encountered in the use of materials from these vendors could have a material adverse effect on our ability to manufacture our products. Developing an alternative or additional suppliers could be time consuming and expensive.
We rely on others to make certain custom parts for our instruments; if these parts are not supplied or delivered on time, our results of operations would suffer		A number of components used to manufacture instruments are made on a custom basis to our specifications and are available from a limited number of sources. If the supply of materials or components from any of these vendors were delayed or interrupted for any reason, or if the quality or reliability of the materials or components is not adequate for use in our instruments, our ability to make instruments in a timely fashion could be impaired and our results of operations would suffer.
Some of our manufacturing processes involve the use of environmentally hazardous materials		Our manufacturing processes, primarily those involved in producing some of our reagent products, require the use of potentially hazardous and carcinogenic chemicals. We are required to comply with applicable federal, state and local laws regarding the use, storage and disposal of these materials.
— if it is found that we or our third party disposal service has violated any environmental laws, we could incur substantial liability		We currently use third-party disposal services to remove and dispose of the hazardous materials. Despite our policy of being vigilant with regard to monitoring these third parties, we could inadvertently violate environmental laws and also encounter claims from individuals, governmental authorities or others in connection with the disposal and handling of these hazardous materials. We could be required to incur additional expenditures for hazardous materials management or environmental compliance. The costs associated with environmental claims, violations of environmental laws or regulations, hazardous materials management and compliance with environmental laws could cause our results of operations to suffer.
We cannot assure that we will be able to fund our future capital requirements through internal sources, our existing line of credit or from other sources		We anticipate that our existing capital resources and borrowing capacity will be adequate to satisfy our capital requirements for the next 12 months. Our future capital requirements will depend on many factors including:
		• the extent that our products gain market acceptance;

19

Item 2.     Properties

      Currently, our U.S. research laboratories, instrument and reagent manufacturing facilities and administrative offices are located in approximately 182,400 square feet of owned space in Tucson, Arizona and 5,766 square feet of leased space in Chicago, Illinois. The lease for the Chicago facility expires on September 15, 2008. In the third quarter of 2001, we moved our instrument manufacturing into a new facility in Tucson. In the fourth quarter 2001, we moved reagent manufacturing, our U.S. research laboratories and our administration offices into the same facility. In August 2001, we purchased an additional 19 acres of vacant land adjacent to our Tucson facility to support future expansion.

      Currently, we own a 39,000 square foot office building for our European operations in Strasbourg, France. This building was acquired in June 2000 and financed through a sale/leaseback.

      Our Japanese operations are located in 3,000 square feet of leased office space in Tokyo. We moved into this space in July 2000 and signed a 2-year lease that expires in July 2002.

Item 3.     Legal Proceedings

      In January 1997, four individuals who are former BioTek noteholders who held in the aggregate approximately $1.1 million in principal amount of BioTek notes filed an action, TSE, ET AL. v. VENTANA MEDICAL SYSTEMS, INC., ET AL. No. 97-37, against the Company and certain of its directors and stockholders in the United States District Court for the District of Delaware. The complaint alleged, among other things, that the company violated federal and California securities laws and engaged in common law fraud in connection with the BioTek shareholders’ consent to the February 1996 merger of BioTek into Ventana and the related conversion of BioTek notes into Ventana notes. Plaintiffs seek compensatory damages in excess of the principal amount of their BioTek notes, as well as punitive damages, and fees and costs.

      On April 25, 1997, plaintiffs filed an Amended Complaint. The Amended Complaint made the same allegations as the original Complaint and added a claim under North Carolina securities laws. On December 16, 1997, we filed a motion to dismiss plaintiffs’ Amended Complaint. On September 23, 1998, the Court issued its Order granting in part and denying in part our motion to dismiss. The Court dismissed plaintiffs’ claims based upon the North Carolina securities laws and California’s insider-trading statute. Plaintiffs’ surviving claims included violations of federal and California securities laws, common law fraud and breach of fiduciary duty. On June 5, 2000, we filed a motion for summary judgment on all of plaintiffs’ remaining claims. On November 22, 2000, the Court issued an Order granting our motion for summary

20

      On June 15, 1999, we filed a proof of claim against Oncor, Inc. in an action pending in the United States Bankruptcy Court for the District of Delaware titled IN RE ONCOR, INC., No. 9-437 (JJF). Our claims arise out of an Asset Purchase Agreement dated November 23, 1998 and related documents wherein we acquired Oncor’s unincorporated In Situ Hybridization Technology Division and rights related thereto. In February 2000, we filed an amended proof of claim alleging, inter alia, that Oncor breached the terms of the Asset Purchase Agreement by purporting to transfer or assign to us Oncor’s rights under a license agreement, which were not transferable or assignable under the circumstances then existing. The amended proof of claim seeks damages of no less than approximately $7.3 million. On August 17, 2000, Oncor filed an Omnibus Objection to Claims, which included our claims. However, the Omnibus Objection did not set forth any specific allegations with respect to our claims. On July 20, 2001, we filed our response to the Omnibus Objection reasserting our original claim and discovery has commenced. We continue to believe our claims are meritorious and that we will prevail, however, the results of the proceedings are uncertain and there can be no assurance to that effect.

      On December 9, 1999, we filed an action, VENTANA MEDICAL SYSTEMS, INC. v. CYTOLOGIX CORP., No. CIV99-606 TUC FRZ, alleging patent infringement seeking monetary damages and injunctive relief in the United States District Court in Tucson. The original complaint was amended March 21, 2000 by the addition of another patent to the litigation. We believe our claims are meritorious and that we will prevail, however, results of the proceedings are uncertain and there can be no assurance to that effect.

      CytoLogix Corp. has filed three separate actions against us in various courts. The first action is CYTOLOGIX v. VENTANA, Case No. 00-12231 REK, filed Oct. 27, 2000 in federal district court in Boston. The complaint claims, under state-law based unfair competition law, that Ventana misappropriated CytoLogix’s trade secrets related to individual slide heating and incorporated such secrets into our Discovery and BenchMark instruments. CytoLogix seeks assignment of our patent applications relating to individual slide heating claiming the idea, treble damages (unspecified amount) and an injunction against our further sales of Discovery and BenchMark instruments. Cytologix filed a motion to amend their complaint to add the related claims of attempted monopolization and monopolization under the Sherman Act, and various Lanham Act violations. We believe that we have meritorious defenses to the claims in this action and that resolution of this matter will not have a material adverse effect on our business, financial condition or results of operation; however, the results of the proceeding are uncertain and there can be no assurance to that effect. Trial is scheduled to begin on July 15, 2002.

      The second is CYTOLOGIX v. VENTANA, Case No. 4 Ni 54/00 (EU) (Nullity suit), filed November 9, 2000 in the German Federal Patent Court, Munich, Germany. In a decision at the oral hearing March 20, 2002, the German Federal Patent Court ruled that our German patent no. DE 69117052.5, which covers various aspects of our previous generation GEN II automated slide staining system, is invalid. The technology addressed by the German patent is unrelated to the technologies involved in any of the other patent litigations, including the individual slide heating technology that is the subject of the Boston-based patent litigation. The decision affects our ability to enforce this patent in Germany subject to an appeal and final decision on validity.

      The third action is CYTOLOGIX v. VENTANA, Case No. 01-10178 REK, filed January 30, 2001 in the U.S. District Court, Eastern District of Massachusetts. This complaint claims that we infringed on CytoLogix’s patent No. 6,180,061, entitled “Moving Platform Slide Stainer with Heating Elements,” and was later amended to add U.S. Patent No. 6,183,693, issued Feb. 7, 2001, entitled “Random Access Slide Stainer with Independent Slide Heating Regulation,” both assigned to CytoLogix Corporation. CytoLogix seeks assignment of our patent applications claiming the independent slide heater idea, treble damages (unspecified amount) and an injunction against our further sales of Discovery and BenchMark instruments. Cytologix filed a motion amending their complaint to add the related claims of attempted monopolization and monopolization under the Sherman Act, and various Lanham Act violations. We believe that we have meritorious defenses to

21

      On November 19, 2001 a patent infringement claim was filed against us titled DIGENE CORPORATION v. VENTANA MEDICAL SYSTEMS, INC., (Case No. 01-752) in Delaware Federal District Court. This complaint alleges that we infringed two US patents held by Digene, U.S. 4,849,331 and 4,849,332 by our INFORM™ HPV High-risk and Low-risk probe products. We filed an answer denying the allegations on Feb. 4, 2002. Digene seeks, among other remedies, an injunction against the sale of our INFORM products. This litigation is in a very early stage. However, we believe that we have meritorious defenses to the infringement claims of Digene and we intend to defend ourselves vigorously, however we cannot assure you that we will prevail on either claim.

      On March 8, 2002, Ventana filed a new patent infringement action against Cytologix in Arizona Federal District Court, Case No. (CIV02-117TUCRCC), alleging infringement of U.S. Patent No. 6,352,861 (“Automated Biological Reaction Apparatus”) by the making, using and selling of the ARTISAN™ automated staining system. The suit seeks injunction relief including a temporary restraining order or a preliminary injunction against the continued making, using and selling of the instrument. We believe our claims are meritorious and that we will prevail, however, results of the proceedings are uncertain and there can be no assurance to that effect.

      With respect to each of the matters above, management’s estimate of the potential loss, if any, is set forth therein unless such an estimate is not possible. It is the opinion of management the ultimate resolution of these contingencies will not have material adverse effect on our financial condition, results of operations or cash flows.

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

      We did not submit any matter for a vote by our shareholders, through the solicitation of proxies or otherwise, during the fourth quarter of the fiscal year covered by this report.

22

PART II

Item 5.     Market for Registrant’s Common Equity and Related Stockholder Matters.

      Our common stock is listed on the NASDAQ National Market. The closing price of our common stock on December 31, 2001 was $22.62. The following table shows the high and low bid prices in dollars per share for the last two years as reported by NASDAQ. These prices may not be the prices that you would pay to purchase a share of our common stock during the periods shown.

      As of December 31, 2001, we had approximately 4,790 beneficial holders of our common stock.

Dividend Policy

      Holders of our common stock are entitled to receive dividends only when declared by our Board of Directors. Our line of credit with Bank of America forbids us from declaring dividends on any of our equity securities. To date dividends have never been declared or paid and we do not plan to make any dividend payments in the future. Instead we will reinvest in the expansion and development of our business. If the Board of Directors decides to declare a dividend in the future, the decision will be based on our earnings, financial condition, cash requirements and any other factors they deem relevant.

23

Item 6.     Selected Financial Data

Selected Consolidated Financial Data

(1)	See Note 1 to the Consolidated Financial Statements in Form 10-K attached for information regarding the change in the accounting for revenue recognition in accordance with Staff Accounting Bulletin (SAB) No. 101.

24

      The following tables contain summary unaudited quarterly consolidated statements of operations for the four quarters ended December 31, 2001 and the four quarters ended December 31, 2000. We have prepared the quarterly consolidated statements of operations data on the same basis as the Consolidated Statements of Operations beginning on page F-3. Our results of operations have varied and may continue to fluctuate significantly from quarter to quarter. Results of operations in any period should not be considered indicative of the results to be expected for any future period.

Summary Quarterly

25

(1)

During the fourth quarter of 2000, the Company changed its method of accounting for revenue recognition in accordance with Staff Accounting Bulletin No. 101, Revenue Recognition in Financial Statements. Pursuant to Financial Accounting Statement No. 3, Reporting Financial Changes in Interim Financial Statements, effective January 1, 2000, the Company recorded the cumulative effect of the accounting change and accordingly, the quarterly information for the first three quarters of 2000, which had been previously reported, have been restated. No restatement of 1999 is required under the implementation guidance of Staff Accounting Bulletin No. 101.

26

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

Introduction

      In Management’s Discussion and Analysis we explain our general financial condition and the results of operations including:

	•	what factors affect our business;
	•	what our earnings and costs were in 2001 and 2000;
	•	why those earnings and costs were different from the year before;
	•	where our earnings came from;
	•	how all of this affects our overall financial condition; and
	•	what our research and development expenditures were in 2001 and 2000 and what we expect to spend in the near future.

Forward-Looking Statements

      Some statements contained in this Annual Report, including, without limitation, statements containing the words “believes,” “anticipates,” “estimates,” “expects,” and words of similar import, constitute “forward-looking statements.” You should not place undue reliance on these forward-looking statements. Our actual results could differ materially from those anticipated in these forward-looking statements for many reasons, including the risks faced by us described in the Cautionary Factors section beginning on page 12, among others and those included in other documents we file with the SEC.

Critical Accounting Policies and Estimates

      Our discussion and analysis of financial condition and results of operations are based upon 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 liabilities. On an on-going basis, we evaluate our estimates, including those related to bad debts, inventories, investments, intangible assets, income taxes, warranty obligations and contingencies and litigation. 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 that are not readily apparent from other resources. Actual results may differ from these estimates under different assumptions or conditions.

      We have adopted the following critical accounting policies used in the preparation of our consolidated financial statements.

     Revenue Recognition

      Revenue from instrument sales made directly to the end user is generally recognized upon completion of installation. However, if the end user already has the identical instrument installed at the same location we recognize the revenue from that sale upon shipment. Revenue from reagents is recognized upon shipment. Service contract revenue is deferred and recognized ratably over the service period obligations, which are typically one to three years. Out-of-warranty work is recognized as services are rendered.

      A portion of our instrument revenue is from sales made to distributors under agreements that require them to assume responsibility for product installation without recourse to us. Revenue for instruments sold under these agreements is recognized upon shipment to the distributor. There are certain foreign distributors for which revenue is not recognized until the instrument is installed and accepted by the end user.

27

     Bad Debt

      We maintain allowances for doubtful accounts for estimated losses resulting from the inability of our customers to make required payments. If the financial condition of our customers were to deteriorate, resulting in an impairment of their ability to make payments, additional allowances may be required.

     Inventory

      We write down our inventory for estimated obsolescence or unmarketable inventory equal to the difference between the cost of the inventory and the estimated market value based upon assumptions about future demand and market conditions. If actual future demand or market conditions are less favorable than those projected by management, additional inventory write-downs may be required.

     Goodwill and Intangible Asset Impairment

      In assessing the recoverability of the goodwill and other intangibles we must make assumptions regarding estimated future cash flows and other factors to determine the fair value of the respective assets. If these estimates or their related assumptions change in the future, we may be required to record impairment charges for these assets not previously recorded. On January 1, 2002, we adopted Statement of Financial Accounting Standards No. 142, Goodwill and Other Intangible Assets which require us to analyze our goodwill for impairment issues during the first six months of fiscal 2002 and then on a periodic basis thereafter. During the year ended December 31, 2001, we did not record any impairment losses related to goodwill and other intangible assets.

     Capitalized Software

      We capitalize certain internal expenses related to developing computer software used in the instruments we sell. Costs incurred prior to the establishment of technological feasibility are charged to research and development expense. The R&D group considers technological feasibility to have been established for a product when all of the following conditions have been met: a) the detail program design has been completed and it has been determined that the necessary skills, hardware and software technology are available to produce the product, b) the detail program design has been traced to product specifications and c) all high-risk development issues have been resolved through coding and testing. Upon general release to customers of the product in which the software is included, capitalization ceases and such costs are amortized using the straight-line method over an estimated life of 5 years. The determination of whether or not these capitalized costs are impaired involves significant judgment. Changes in strategy and/or market conditions could significantly impact these judgments and require adjustments to recorded asset balances.

     Warranties

      We generally provide a warranty for the first year of use on all instruments sold. We provide for the estimated cost of instrument warranties at the time revenue is recognized. While we are committed to quality, our warranty obligation is affected by product failure rates, material usage and service delivery costs incurred in correcting a product failure. Should actual product failure rates, material usage or service delivery costs differ from our estimates, revisions to the estimated warranty liability may be required.

     Investments in Equity Securities

      We hold preferred stock and a warrant in a small cap public company having operations or technology in areas within or adjacent to our strategic focus, and whose share price is highly volatile. We would assess the estimated fair value of such investments based upon a periodic evaluation of the investees operating results and financial condition. We would incur an investment impairment charge when we believe an investment has experienced a decline in value that is other than temporary. Future adverse changes in market conditions or poor operating results of underlying investments could result in losses or an inability to recover the carrying value of the investments that may not be reflected in an investment’s current carrying value, thereby possibly requiring an impairment charge in the future.

28

     Deferred Tax Assets

      We record a valuation allowance to reduce our deferred tax assets to the amount that we believe is more likely than not to be realized. We have considered future taxable income in assessing the need for the valuation allowance. In the event we determine that we would not be able to realize all or part of our net deferred tax assets in the future, an adjustment to the deferred tax assets would be charged to income in the period such determination was made. Likewise, should we determine that we would be able to realize our deferred tax assets in the future in excess of our net recorded amount, an adjustment to the deferred tax assets would increase income in the period such determination was made.

     Legal Contingencies

      We are currently involved in certain legal proceedings. We do not believe these proceedings will have a material adverse effect on our consolidated financial position. It is possible, however, that future results of operations for any particular quarterly or annual period could be materially affected by changes in our assumptions, or the effectiveness of our strategies, related to these proceedings.

Results of Operations

     Comparison of 2001 and 2000

      Net sales increased to $87.8 million in 2001 from $71.1 million in 2000. Net revenues for reagents and other increased by 24% from 2000 to 2001. Net revenues for instruments increased by 22% from 2000. The increase for reagents was primarily due to the growth in the underlying installed base and the launch of new reagent systems. Increased instrument revenue from 2000 to 2001 was primarily due to continued market acceptance of the BenchMark system, launched in late 2000, and strong performance from our IHC and Special Stains instruments.

      Our total gross margin percentage increased to 69% in 2001, up from 49% in 2000. The gross margin in 2000 was impacted by charges totaling $11.8 million. Absent these charges, gross margin percentage increased 4% primarily due to the higher margin reagent and other sales mix as a percentage of sales.

      Research and development spending increased $3.8 million in 2001, or 34% from 2000, primarily due to increased spending on product development programs, including the development of chemistry applications for DNA microarrays and messenger RNA tissue testing.

      Selling, general and administrative (“SG&A”) expenses decreased $1.0 million, or (2%), in 2001 compared to 2000, primarily due to charges of $5.7 million recorded in 2000 associated with the discontinuation of various products and with the revaluation of field instruments brought about with the launch of the BenchMark instrument. Absent this charge, SG&A increased by $4.7 million, or 12%, as we continued to invest in key areas including our direct sales force, product strategy and customer support, to position ourselves for future market opportunities.

      Amortization of goodwill and other acquisition-related intangibles increased $0.1 million, or 7%, in 2001 compared to 2000. The increase for the period was primarily due to a full year’s impact of the 2000 acquisition of Quantitative Diagnostic Laboratories, Inc. We recorded approximately $1.6 million in amortization of our intangible assets during 2001 and are currently determining the portion that will not be subject to future amortization under SFAS 142. The provisions of these standards are not expected to have a significant effect on our financial position or operating results.

      Interest and other, net decreased $0.5 million, or 39%, in 2001 compared to 2000. The decrease is primarily due to lower average investment balances in 2001 compared to 2000 as well as lower market rates of return as interest rates fell throughout 2001. The lower balances were primarily the result of the 2001 investment in the Company’s new facility in Tucson, Arizona.

29

      Fiscal 2000 results were negatively impacted by $22.5 million in write-offs and accruals relating to several different issues. The following table summarizes the 2001 reserve activity:

      The $1.6 million revision to the estimate was due to the favorable resolution of outstanding accounts receivable balances related to the reagent dispenser quality issue and were reflected in the 2001 financial statements as a reduction in SG&A expenses. However, an additional $0.8 million charge was recorded as a charge to SG&A expenses during the year due to our uncertainty of how the worldwide recession will impact our customer base and their ability to pay.

      The deferred tax assets and valuation allowance decreased by $0.5 million during 2001. The decrease relates primarily to expiring state net operating loss carry forwards and reversal of temporary differences. No additional valuation allowance was considered necessary for the deferred tax assets of $8.8 million as management believes that it is more likely than not such assets will be recovered.

      At December 31, 2001, we have net operating loss carry forwards for state and federal income tax purposes of approximately $11.2 million and $18.7 million, respectively. These state and federal carry forwards will begin to expire in 2005 and 2007, respectively, if not previously utilized. Approximately $0.6 million of state net operating loss carry forwards expired unused in 2001. We also have research and development tax credit carry forwards of approximately $1.9 million that begin to expire in 2005, if not previously utilized. Utilization of our net operating loss carry forwards will be subject to limitations due to the “change in ownership” provisions of the Internal Revenue Code of 1996, as amended, as a result of our prior issuances of equity securities. These carry forwards, therefore, may expire prior to being fully utilized. Future financings may cause additional changes in ownership and further limitations on the use of federal net operating loss carry forwards. In addition, we have certain foreign net operating loss carry forwards approximating $7.4 million. We will continue to closely monitor operating results and analyze our ability to recover these deferred assets in the very near term.

     Comparison of 2000 and 1999

      Net sales increased to $71.1 million in 2000 from $69.4 million in 1999. Our revenue growth of 2% was impacted by reagent dispenser quality issues experienced in the second and third quarters of 2000. We also changed our method of revenue recognition for products that require installation at the customer’s site in accordance with Staff Accounting Bulletin (SAB) No. 101 Revenue Recognition in Financial Statements. The change in revenue recognition method had a favorable effect of $0.6 million on net sales for 2000. The cumulative effect of the accounting change resulted in a charge to operations of $2.2 million (net of an income tax benefit of $1.4 million), which is included in operations for the year ended December 31, 2000.

      Gross margin of 49% in 2000 was impacted by second quarter 2000 charges totaling $11.8 million associated with reagent dispenser quality issues, planned relocation of our Gaithersburg, Maryland production facility, exiting the electron microscopy product line and write-down of older generation staining instruments

30

      Fiscal 2000 results were negatively impacted by $22.5 million in write-offs and accruals relating to several different issues. The following table summarizes details of the impairment charges and other expenses:

      Charges of $5.4 million were related to quality problems with our dispensers and reagents used with the majority of our staining instruments. As a result, charges were taken to write-off inventory and set up reserves to cover product replacements, returns, and warranty matters.

      A charge of $4.6 million was recorded to account for our decision to exit our electron microscopy (EM) product line. Charges were taken to write-down all EM inventory and field instruments to their net realizable value. In addition, goodwill recognized in the BTTI acquisition was written down $1.4 million to reflect the impact of product discontinuance.

      Charges of $8.6 million were recorded in recognition of the decreased value of certain instrument inventory, fixed assets and intangible assets given the launch of our new BenchMark advanced staining system in 2000. In addition, intangible assets associated with the Company’s 1996 acquisition of BioTek Solutions, Inc. were written down $3.1 million to reflect the impact of product discontinuation. The TechMate IHC staining system product line acquired in the BioTek transaction was among those whose value was impacted by the launch of BenchMark.

      We also recognized charges of $2.6 million relating to closure of our production facility in Gaithersburg, Maryland. The Gaithersburg facility was acquired in late 1998 with the acquisition of all the oncology assets of Oncor, Inc.

      Other charges recognized in 2000 totaled $1.4 million, which included expenses related to contracted research and development being handled by an outside company.

      Research and development expenses increased by $4 million in 2000 versus 1999, to 16% of net sales from 10% in 1999. The spending increase reflects our ongoing research and development efforts in a variety of areas such as the launch of the BenchMark advanced IHC and ISH Staining System, the US launch of our Discovery system, the December 2000 launch of our Pathway test for breast cancer patients and further expansion of our Special Stains reagent menu.

      Selling, general and administrative expenses increased by $11.4 million in fiscal 2000 over fiscal 1999 and increased as a percent of net sales to 62% in 2000 from 47% in 1999. The spending increase is attributed primarily to the charges recorded in the second quarter of 2000 associated with various product discontinuations and revaluations of field instruments given the launch of BenchMark.

31

      Impairment charges of $4.5 million were recognized in 2000 in conjunction with the write down of intangibles associated with the BioTechnology Tools and BioTek acquisitions. The charges reflect the impact of various product discontinuations on expected future cash flows.

      Amortization expense increased to $1.5 million in 2000 from $1.1 million in 1999. Intangible assets increased in 2000 through the acquisition of QDL Laboratories and a payment made to Vysis on a license to market certain consumables.

      Interest and other income, net, was income of $1.3 million in 2000 versus an expense of $0.4 million in 1999. The interest income was attributed to the investment of proceeds from the private placement of 1,250,000 shares of common stock in 2000.

      No additional income tax benefit was recognized in 2000 related to the deferred tax asset that arose relative to the increase in the net operating loss carry forward and other future tax deductible items as it could not be readily determined whether such assets will be recoverable in the near term. Our valuation allowance increased by $8.3 million in 2000 to $10.7 million at December 31, 2000.

      The majority of our deferred tax assets relate to net operating loss carryforwards. At December 31, 2000, we had $21 million and $18 million in federal and state net operating loss carryforwards for income tax purposes, respectively. The state and federal net operating loss carryforwards will begin to expire in 2005 and 2007, respectively, if not previously utilized. In addition, we had certain foreign net operating loss carryforwards of $6.9 million and research and development credits of $1 million.

      As a result of the above, our net loss for 2000 was $27.3 million, which included $22.5 million in impairment charges and other expenses recognized in the second quarter of 2000 and included the adverse impact of $2.2 million related to the change in accounting principle for the adoption of SAB No. 101.

Liquidity and Capital Resources

      Cash and cash equivalents were $12.3 million at December 31, 2001, a decrease of $26.2 million from December 31, 2000. Spending against cash reserves was attributable to our ongoing investment in the growth of the business including working capital, the construction of our new facility in Tucson, Arizona, substantially completed in November 2001 and partially offset by cash generated from the exercise of employee stock options and warrants.

      Net cash used in our operating activities was $5.3 million in 2001 compared to net cash provided by our operating activities of $2.2 million in fiscal year 2000. The decrease is primarily attributable to changes in working capital. During 2001 cash used in operating activities differed from net income as a result of increased working capital balances exceeding depreciation and amortization expense.

      Net cash used in investing activities in 2001 and 2000 was $25.7 million and $19.3 million, respectively. This is primarily attributable to spending on the construction of our new facility in Tucson, Arizona, substantially completed in November 2001, and our transaction with Molecular Diagnostics, Inc.

      Net cash provided by financing activities in 2001 and 2000 was $4.8 million and $54.3 million, respectively. Financing activities in fiscal year 2001 consisted primarily of $5.7 million in proceeds from the issuance of common stock due to the exercise of warrants, stock options and employee stock purchases. This was partially offset by payments of $0.9 million on long-term debt. Financing activities in fiscal year 2000 consisted primarily of proceeds from our private equity placement of 1.25 million shares of common stock, issuance of common stock from stock option exercises and financing of our new European facility located in Strasbourg, France.

      We believe that our current cash and cash equivalents, line of credit and cash generated from operations will satisfy funding requirements including working capital and capital expenditure for the next twelve months.

32

Foreign Currency Risk

      The value of the U.S. Dollar affects our financial results. Changes in exchange rates may positively or negatively affect our revenues, gross margins, operating expenses and shareholders’ equity as expressed in U.S. Dollars. We have determined that hedging of non-U.S. Dollar net monetary assets is not cost effective and instead attempt to minimize currency exposure risk through working capital management. There can be no assurance that such an approach will be successful, especially if a significant and sudden decline occurs in the value of local currencies. We conduct a growing portion of our business in the Euro, the Japanese Yen and the Australian Dollar.

New Pronouncements

      In June 2001, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 141 (SFAS 141), Business Combinations and No. 142 (SFAS 142), Goodwill and Other Intangible Assets, effective for fiscal years beginning after December 15, 2001. Under the new rules, goodwill and intangible assets deemed to have indefinite lives will no longer be amortized, but will be subject to annual impairment tests in accordance with the statements. Other intangible assets will continue to be amortized over their useful lives. For fiscal 2001, the amortization provisions of SFAS 142 apply to goodwill and other intangible assets acquired after June 30, 2001. For fiscal 2002, the provision will apply to all goodwill and other intangible assets. We will adopt the new rules on accounting for goodwill and other intangible assets beginning in the first quarter of fiscal 2002, including the required impairment tests. We recorded approximately $1.6 million in amortization of its intangible assets during 2001 that is being evaluated by management to determine which portion will be subject to no future amortization under SFAS 142. The provisions of these standards are not expected to have a significant effect on our financial position or operating results.

      In August 2001, FASB issued SFAS No. 144 (SFAS 144), Accounting for the Impairment or Disposal of Long-Lived Assets that is applicable to financial statements issued for fiscal years beginning after December 15, 2001. The FASB’s new rule on asset impairment supersedes SFAS No. 121 (SFAS 121), Accounting for the Impairment or Disposal of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of and portions of APB Opinion 30, Reporting the Results of Operations for a Disposal of a Segment of a Business. This Standard provides a single accounting model for long-lived assets to be disposed of and significantly changes the criteria that would have to be met to classify an asset as held-for-sale. Classification as held-for-sale is an important distinction since such assets are not depreciated and are stated at the lower of fair value and carrying amount. The Standard also required expected future operating losses from discontinued operations to be displayed in the period(s) in which the losses are incurred, rather than as of the measurement date as presently required. The provisions of this Standard are not expected to have a significant effect on our financial position or operating results.