Back to GetFilings.com

Table of Contents

U.S. SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-K

For the year ended December 31, 2003

OR

Commission file number 0-11303

SYNBIOTICS CORPORATION

(Exact name of registrant as specified in its charter)

Registrant’s telephone number, including area code: (858) 451-3771

Securities registered pursuant to Section 12(b) of the Exchange Act: None

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

Preferred Stock Purchase Rights

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 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  ¨

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and no disclosure will be contained, to the best of the registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  x

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Act).  Yes  ¨  No  x

The aggregate market value of the common stock held by non-affiliates of the registrant as of June 30, 2003 was approximately $2,913,000 based on the closing sale price as reported by the NASD over-the-counter bulletin board. Shares of common stock held by each officer, director and holder of 10% or more of the outstanding common stock, if any, have been excluded in that such persons may be deemed to be affiliates. This determination of affiliate status is not necessarily a conclusive determination for other purposes.

As of March 31, 2004, there were 20,378,479 shares of our common stock outstanding.

Table of Contents

SYNBIOTICS CORPORATION

INDEX

Table of Contents

PART I

Item 1.    Business

General

Synbiotics Corporation is a leading provider of rapid diagnostic and laboratory diagnostic products for the animal health care industry. We are one of a small number of companies that focuses exclusively on animal health and we are a major provider of diagnostic products to the animal health market. Our product portfolio consists of 96 diagnostic test kits and detection devices. Many of our products hold strong positions in their specific markets. In recent years we have been moving to refocus our business on our core diagnostics products.

In 2002, we sold our instrument manufacturing operations, which were located in Rome, New York, and we disposed of our PennHIP^® business, which was located in Malvern, Pennsylvania.

In 2001, we ended our participation in the veterinary vaccines business.

In 2000, we acquired our poultry diagnostic products business, and we disposed of W3COMMERCE, an Internet marketing services subsidiary.

Market and Product Overview

We sell our products globally to veterinary practices, laboratories and poultry producers. We believe that our current and intended future products will offer veterinarians and other professionals an opportunity to improve the quality and expand the scope of animal health care services.

Our most commercially successful products are our canine heartworm diagnostics (representing 24% of our net sales in 2003, and 36%, of our net sales in 2002 and 2001). We estimate that we have approximately a 15% share of the estimated $30 million U.S. canine heartworm diagnostics market. Sales of these products have historically been strongest during the first half of the year when distributors purchase merchandise to sell to veterinarians for the heartworm season.

Marketing

We sell our products in the United States, Canada, Europe, Africa, Oceania, Asia and Latin America. In the United States, we market our line both directly and through independent distributors which, taken together, have approximately 90 outlets, 600 field sales representatives, and 200 telemarketing representatives covering the 25,000 veterinary clinics throughout the country. We also sell directly to laboratories and other centralized facilities. Outside the United States, we sell our small-animal products through distributors, and our food animal products directly to laboratories. We maintain a marketing and sales force, which trains distributor representatives, responds to technical inquiries, promotes products directly to veterinarians, laboratories and poultry producers.

Manufacturing

We manufacture most of our products at our facilities located in San Diego, California and Lyon, France. However, we rely on outside manufacturers for our WITNESS^® canine heartworm, feline leukemia and canine parvovirus diagnostic products, and our SCA 2000^™ instrument products. We manufacture the key biological materials contained in our WITNESS^® canine heartworm, feline leukemia and canine parvovirus diagnostic products.

Until early 2003, we relied on Agen Biomedical Limited as the contract manufacturer of our key Witness^® products. After Agen terminated the supply agreement, we identified a replacement, U.S.-based contract manufacturer and began the re-introduction of these Witness^® products to the market in January 2004.

1

Table of Contents

Patents and Trade Secrets

We believe that our proprietary technology is an important competitive factor in our business, and that protection of our intellectual property rights is a high priority. The basic hybridoma (the cell that produces the monoclonal antibody) technology is in the public domain and is therefore not patentable. However, numerous improvements, variations and applications of hybridoma technology may prove to be patentable. Considering the difficulty of enforcing any patent rights to such improvements, and the rapid advancements in the field, we generally seek, and will continue to seek, to protect our interests by treating our particular variations in the production of monoclonal antibodies as trade secrets. We also pursue, and intend to continue to aggressively pursue, protection for new products, new methodological concepts, and compositions of matter through the use of patents where obtainable. At present, we have been granted 8 U.S. patents. In fact, we are currently involved in patent litigation with Agen to enforce our heartworm detection patent; in 2002 we successfully settled litigation with Heska Corporation pertaining to our heartworm detection patent.

Government Regulation

Most diagnostic test kits for animal health applications marketed in the U.S. require approval by the United States Department of Agriculture (“USDA”). Certain foreign countries in which we market our diagnostic products also require governmental approval for animal diagnostic products. Our instrumentation products are not subject to USDA regulation. Our canine semen freezing products and canine ovulation timing diagnostic products fall within the definition of devices as that term is defined in the Federal Food, Drug, and Cosmetic Act and, therefore, may be subject to regulation by the FDA.

Our manufacturing facilities in San Diego and Lyon, France are licensed by the USDA and adhere to Good Manufacturing Practices (“GMP”) standards. Our French manufacturing facility, which is ISO 9002 certified, is not licensed by any foreign regulatory agency as there is no licensing requirement. The manufacturing facilities of our important suppliers are subject to licensing and regulatory approval in both the United States and Europe.

In addition to the foregoing, our operations may be subject to future legislation and/or rules issued by domestic or foreign governmental agencies with regulatory authority relating to our business.

Competition

We are a major provider of diagnostic products to the animal health market. Most of our competitors are either small divisions of larger human health and chemical companies or smaller companies that sell veterinary products while trying to diversify into the higher profile, and more regulated, human health field. The principal competitor in the industry is IDEXX Laboratories, Inc., a publicly traded company with annual revenues of $476,000,000 (for 2003) that develops, manufactures, and distributes detection and diagnostic products for animal health, food, and environmental testing applications.

The market for animal health care products is extremely competitive. Companies in the animal health care market compete to develop new products, to market and manufacture products efficiently, to implement effective research strategies, and to obtain regulatory approval. Our current competitors include IDEXX Laboratories, a significantly larger company, Heska Corporation, to whom we granted a non-exclusive license of our canine heartworm patent in 2003, and Agen Biomedical Limited., the former contract manufacturer of certain of our WITNESS^® diagnostic products. These companies have greater financial, manufacturing, marketing, and research resources than we do. In addition, IDEXX Laboratories prohibits its distributors from selling competitors’ products, including ours. Further, additional competition could come from new entrants to the animal health care market. We cannot assure you that we will be able to compete successfully in the future or that competition will not harm our business.

Our core canine heartworm diagnostic products can be subject to significant additional competition, affecting both our market share and our average selling price, if we are unable to enforce the United States patent

2

Table of Contents

which underlies our products. We sued Heska for infringing our patent; the suit was settled in 2003 when Heska agreed to pay us a royalty. We are also suing Agen, which entered the U.S. market in 2003, for infringing our patent; in March 2004 we obtained temporary injunctive relief from the United States District Court, barring Agen from continuing its allegedly infringing activities. However, our patent expires in December 2005.

Research and Development

We spent approximately $1,177,000 and $1,380,000 on research and development activities during the years ended December 31, 2003 and 2002, respectively. These figures include both internal research and development and expenditures under contracts for research and development activities with outside parties relating to certain veterinary diagnostic products which utilize licensed technology.

Employees

As of December 31, 2003, we had a total of 94 employees worldwide, 92 of whom were full-time.

Raw Materials

The manufacturing of diagnostics and diagnostic instruments requires raw materials which generally are, and have been, readily available from several sources.

Financial Information About Industry Segments and Financial Information About Foreign and Domestic Operations and Export Sales

See Note 14 to our financials statements in Item 8 of Part II of this Form 10-K.

Item 2.    Properties

We lease two buildings in San Diego, California. The buildings contain approximately 42,000 square feet of space, and house our corporate and sales headquarters, executive offices, U.S. research and development laboratories and manufacturing facilities. We also lease an approximately 25,000 square foot building in Lyon, France which houses Synbiotics Europe’s (“SBIO-E”) corporate and sales headquarters, executive offices, research and development laboratories and manufacturing facilities. In addition, we lease a small research office in College Park, Maryland.

We believe that these facilities are adequate for our current level of operations.

Item 3.    Legal Proceedings

Agen Biomedical Limited v. Synbiotics Corporation—United States District Court for the Southern District of California

On September 2, 2003, Agen Biomedical Limited (“Agen”} filed a lawsuit against us seeking two specific forms of declaratory relief. First, Agen has asked for a declaratory judgment that Agen’s canine heartworm diagnostic test kit does not infringe our U.S. Patent No. 4,789,631 pertaining to heartworm detection technology. Agen also asked for a declaratory judgment that Claim 5 of our U.S. Patent No. 4,789,631 is invalid. We filed a motion to transfer the lawsuit to the United States District Court for the Southern District of California. On November 7, 2003, our motion was granted and the case was transferred.

3

Table of Contents

Synbiotics Corporation v. Agen Biomedical Limited—United States District Court for the Southern District of California

On September 3, 2003, we filed a patent infringement lawsuit against Agen claiming that Agen has infringed our U.S. Patent No. 4,789,631 pertaining to heartworm detection technology. In addition to seeking unspecified damages, we have asked the Court for a declaratory judgment that Agen has willfully infringed Claim 5 of our U.S. Patent No. 4,789,631. We have also asked the Court for a temporary restraining order and a preliminary injunction against Agen, preventing Agen from importing, selling or offering for sale their canine heartworm diagnostic test kit in the United States.

On March 15, 2004, the Court issued a temporary restraining order against Agen, preventing Agen’s canine heartworm diagnostic product from entering the United States market. The Court ordered that Agen, their directors, officers, employees, agents, servants, and all those in active concert or participation with them, are restrained from importing, making, using, selling, or offering for sale, in the United States, any canine heartworm kit containing the DI 16 872.5 monoclonal antibody manufactured or supplied by Agen. The Court ruled earlier that we were likely to succeed on the merits of our claim that Agen’s canine heartworm diagnostic product, STATScreen^TM CHW, which contains our DI 16 872.5 monoclonal antibody, infringed our United States Patent 4,789,631. A preliminary injunction hearing was held on April 15, 2004, and on April 21, 2004, the Court denied our motion and dissolved the temporary restraining order. In conjunction with the temporary restraining order, we were required to post a $250,000 bond; the Court has not yet released the bond.

The lawsuit is currently in the discovery stage, and a trial date is scheduled for June 28, 2004.

Agen Biomedical Limited v. Synbiotics Corporation—San Diego County Superior Court

On March 8, 2004, Agen filed an action against us in the San Diego County Superior Court seeking a declaratory judgment and specific performance requiring us to sell them certain biologicals, including the patented canine heartworm test biologicals, even after the 2003 termination of the supply agreement between Agen and us. A preliminary injunction hearing was held on May 18, 2004; the Court granted Agen’s motion for a preliminary injunction, and ordered us to supply Agen with 2,800 milligrams of biologicals.

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

The Annual Meeting of Shareholders was held on October 2, 2003. The following matters were submitted to a vote, with the results below:

4

Table of Contents

PART II

Item 5.     Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of

Equity Securities

Our common stock is quoted in the NASD over-the-counter bulletin board under the symbol SBIO. Price ranges reported are the high and low sale price information as reported by the NASD over-the-counter bulletin board. Such market quotations reflect inter-dealer prices, without retail mark-up, mark-down or commission. As of March 31, 2004, there were approximately 580 shareholders of record of our common stock.

We have never paid cash dividends on our common stock and do not expect to do so in the foreseeable future. In addition, the terms of our bank loan and of our Series C preferred stock restrict our ability to pay any cash dividends on our common stock.

Item 6.    Selected Financial Data

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

The information contained in this Management’s Discussion and Analysis of Financial Condition and Results of Operations and elsewhere in this Annual Report on Form 10-K contains both historical financial information and forward-looking statements. Forward-looking statements are characterized by words such as

5

Table of Contents

“intend”, “plan”, “believe”, “will”, “would”, etc. Historical financial information may not be indicative of future financial performance. In fact, future financial performance may be materially different than the historical financial information presented herein. Moreover, the forward-looking statements about future business or future results of operations are subject to significant uncertainties and risks, including those detailed under the caption “Certain Risk Factors”, which could cause actual future results to differ materially from what is suggested by the forward-looking information.

Results of Operations

Year Ended December 31, 2003 Compared to Year Ended December 31, 2002

Our net sales for 2003 decreased by $2,557,000 or 12% from 2002. The decrease reflects a decrease in our diagnostic product sales of $2,858,000 offset by an increase in our instrument product sales of $301,000. Sales of our diagnostic products decreased due to the termination by Agen of our supply agreement under which Agen supplied us with certain of our Witness^® diagnostic products, as discussed below, leaving us with no inventory of these products for over half the year. Our instrument product sales increased primarily due to increased placements of our SCA 2000^™ blood coagulation timing instrument, and the resulting sales of the related consumables.

In April 2003, we were notified by Agen that Agen was terminating its supply agreement with us due to late payment of invoices for test kits. Agen contract manufactured certain of our Witness^® in-clinic diagnostic products including canine heartworm, feline leukemia, feline heartworm and canine parvovirus, using key biological components which we manufacture at our facilities and had provided to Agen. These Witness^® products represented $4,345,000 and $8,069,000 of our net sales during 2003 and 2002, respectively. We have notified Agen that Agen did not have the right to terminate the Agreement, and that it acted wrongfully in terminating the Agreement.

We identified a U.S.-based alternate contract manufacturer of the same Witness^® products previously manufactured for us by Agen. We licensed the alternate-source Witness^® canine heartworm product with the USDA, and we began selling this product in January 2004. We also anticipate having the alternate-source Witness^® feline leukemia and canine parvovirus products available for sale late in the second quarter of 2004. In addition to the material impact during 2003, we also believe that our results of operations and financial condition could be materially adversely affected in 2004 and beyond if we are unable to successfully reintroduce the alternate-source products into the market.

Agen has introduced into the U.S. market a canine heartworm diagnostic product which is essentially identical to our Witness^® canine heartworm diagnostic test kit, including biological components which incorporate our patented technology. In September 2003, we filed a patent infringement lawsuit against Agen claiming that Agen has willfully infringed our U.S. Patent No. 4,789,631 pertaining to heartworm detection technology. In addition to seeking damages, we are asking for an injunction against Agen, preventing Agen from importing, selling or offering for sale their canine heartworm diagnostic test kit in the United States.

On March 15, 2004, the Court issued a temporary restraining order against Agen, preventing Agen’s canine heartworm diagnostic product from entering the United States market. The Court ordered that Agen, their directors, officers, employees, agents, servants, and all those in active concert or participation with them, are restrained from importing, making, using, selling, or offering for sale, in the United States, any canine heartworm kit containing the DI 16 872.5 monoclonal antibody manufactured or supplied by Agen. The Court ruled earlier that we were likely to succeed on the merits of our claim that Agen’s canine heartworm diagnostic product, STATScreen^TM CHW, which contains our DI 16 872.5 monoclonal antibody, infringed our United States Patent 4,789,631. A preliminary injunction hearing was held on April 15, 2004, and on April 21, 2004, the Court denied our motion and dissolved the temporary restraining order. In conjunction with the temporary restraining order, we were required to post a $250,000 bond; the Court has not yet released the bond. The lawsuit is currently in the discovery stage, and a trial date is scheduled for June 28, 2004.

6

Table of Contents

Should Agen prevail at trial, our future sales of canine heartworm diagnostics products in general, our Witness^® line of products, and especially our Witness^® canine heartworm diagnostic product, may be materially adversely affected due to market competition from Agen’s product. We believe that our first quarter 2004 sales and margins were penalized by competition from Agen’s products.

Not only has Agen increased the competition in the canine heartworm market, they have also significantly eroded the average selling price of the product in the marketplace. We do not believe that this erosion will be easily reversed, especially after our patent expires in 2005.

We recognize revenue from product sales when title and risk of loss transfer to our customer, which is generally upon shipment. Amounts we charge to our customers for shipping and handling are included in our net sales. We provide promotional discounts and rebates to certain of our distributors. Based upon the structure of these rebate programs and our past history, we are able to accurately estimate the amount of rebates at the time of sale. These rebates are recorded as a reduction of our net sales. We recognize license fee revenue ratably over the license term when we have further performance obligations to our licensee. In the event that we have no further performance obligations to our licensee, we recognize license fee revenue upon receipt.

Our cost of sales as a percentage of our net sales was 49% during 2003 and 2002. The preservation of margin despite reduced sales was heartening, because a significant portion of our internal manufacturing costs are fixed. Among our major products, our DiroCHEK^® canine heartworm diagnostic products are manufactured at our facilities, whereas our WITNESS^® in-clinic canine heartworm, feline leukemia, and canine parvovirus diagnostic products and our SCA 2000^™ instrument products are manufactured by third parties. We manufacture the key biological materials contained in our WITNESS^® canine heartworm, feline leukemia and canine parvovirus diagnostic products. In addition to affecting our gross margins, outsourcing of manufacturing renders us relatively more dependent on the third-party manufacturers. Agen, the previous contract manufacturer of certain of our Witness^® products, ceased to supply us with those products In April 2003. We identified a U.S.-based alternate contract manufacturer of the same Witness^® products previously contract manufactured for us by Agen, and the cost of these products to us is lower than the cost of those contract manufactured for us by Agen. In 2003 we also incurred costs to re-license these products with the USDA.

Our research and development expenses decreased by $203,000 or 15% during the year ended December 31, 2003 as compared to the year ended December 31, 2002. The decreases are a result of a cost reduction program that was implemented at the end of the third quarter of 2002, offset by costs incurred 2003 related to the re-launching of our Witness^® canine heartworm product. Our research and development expenses as a percentage of our net sales were 6% during 2003 and 2002.

Our selling and marketing expenses decreased $228,000 or 5% during 2003 as compared to 2002. The decreases are a result of a cost reduction program, including reductions in headcount, that were implemented at the end of the third quarter of 2002. Our selling and marketing expenses as a percentage of our net sales were 22% and 20% during 2003 and 2002, respectively.

Our general and administrative expenses decreased by $5,283,000 or 60% during 2003 as compared to 2002. The decrease during 2003 was primarily attributable to the non-recurrence of $3,682,000 of retention bonuses that became payable in the first quarter of 2002. The decrease was also attributable to a cost reduction program, including reductions in headcount, that was implemented at the end of the third quarter of 2002, and favorable effects of foreign currency exchange rates on our intercompany balances. Our general and administrative expenses as a percentage of our net sales were 19% and 41% during 2003 and 2002, respectively. Excluding the first quarter 2002 bonus expense our general and administrative expenses would have been $5,090,000 or 24% of our net sales during 2002.

As previously mentioned, we are currently involved in patent litigation with Agen. As a result, we have incurred, and we will be incurring, material litigation expenses.

7

Table of Contents

In November 1998, we filed a lawsuit against Heska Corporation alleging that Heska infringed our U.S. Patent No. 4,789,631 relating to heartworm diagnostic technology. In March 2003, we entered into settlement and license agreements with Heska which resolved all outstanding claims in the lawsuit. As part of those agreements, each party has licensed certain intellectual property rights from the other party, including Heska licensing from us the patent relating to the heartworm diagnostic technology. In addition, we received $250,000 in April 2003, we will receive $265,000 in 24 monthly installments of $11,000 beginning in January 2004 and we receive royalty payments on sales of licensed canine heartworm diagnostic products beginning April 2003. As a result, we recorded a one-time credit to operating expenses totaling $515,000 during 2003. We recognized royalty income related to this license totaling $277,000 during 2003.

Our net interest expense decreased by $177,000 or 26% during 2003 as compared to 2002. The decrease was due to decreases in the prime rate, and to decreases in the outstanding principal balances of our bank debt.

We recognized a benefit from income taxes of $2,000 during 2003 as compared to a provision for income taxes of $7,000 during 2002. We are limited in the utilization of certain of our Federal and state net operating loss carryforwards. As a result of this limitation, $15,351,000 of our Federal net operating loss carryforwards, and $969,000 of our state net operating loss carryforwards, may expire before they can be utilized. In addition, California placed a moratorium on the utilization of net operating loss carryforwards for 2003.

In the first quarter of 2002, we adopted Statement of Financial Accounting Standards No. 142 (“FAS 142”), “Goodwill and Other Intangible Assets”. In connection with the adoption of FAS 142, we performed a transitional goodwill impairment assessment. As a result of this impairment assessment, we recorded an impairment of $7,649,000, net of income tax benefit of $106,000, which is classified as a cumulative effect of a change in accounting principle in the first quarter of 2002. FAS 142 requires that we perform subsequent impairment assessments on an annual basis, or on an interim basis if events occur that may cause an impairment of our goodwill and other intangible assets. In 2002, as a result of the annual assessment based upon the market price of the our common stock on December 31, 2002, we recorded an additional impairment loss of $2,877,000. Based upon the market price of the Company’s common stock on December 31, 2003, there was no impairment loss resulting from the annual impairment assessment in 2003.

Year Ended December 31, 2002 Compared to Year Ended December 31, 2001

Our net sales for 2002 decreased by $4,143,000 or 16% from 2001. The decrease reflects a decrease in our diagnostic product sales of $4,012,000 primarily related to canine heartworm diagnostic products. Sales of our diagnostic products decreased due to the loss of one of our larger distributors in January 2002 who accounted for $1,617,000 of our sales in 2001, an additional $599,000 related to the fourth quarter 2001 transfer of our Japanese diagnostic business to a third party as part of a license agreement, and increased competition in the canine heartworm market. The increased competition in the canine heartworm market resulted from IDEXX Laboratories’ combination in-clinic diagnostic test. In addition, our sales in France for the year fell by $635,000 or 26% due primarily to the French authorities’ decisions to no longer require cattle to be tested annually for tuberculosis.

Our license fee revenue for 2002 decreased by $719,000 or 71% from 2001. The decrease is due to the recognition, in June 2001, of the remainder of deferred license fee revenue upon the termination of a vaccine supply agreement with Merial.

We recognize revenue from product sales when title and risk of loss transfer to our customer, which is generally upon shipment. Amounts we charge to our customers for shipping and handling are included in our net sales. We provide promotional discounts and rebates to certain of our distributors. Based upon the structure of these rebate programs and our past history, we are able to accurately estimate the amount of rebates at the time of sale. These rebates are recorded as a reduction of our net sales. We recognize license fee revenue ratably over the license term when we have further performance obligations to our licensee. In the event that we have no further performance obligations to our licensee, we recognize license fee revenue upon receipt.

8

Table of Contents

Our cost of sales as a percentage of our net sales was 49% during 2002 compared to 45% during 2001. The lower gross margins are a direct result of the decrease in our sales during 2002, and the fact that a significant portion of our manufacturing costs are fixed.

Among our major products, our DiroCHEK^® canine heartworm diagnostic products are manufactured at our facilities, whereas our WITNESS^® canine heartworm and feline leukemia diagnostic products and the SCA 2000^™ products are manufactured by third parties. Our poultry diagnostic products were manufactured for us by a third party during 2001. In addition to affecting our gross margins, outsourcing of manufacturing renders us relatively more dependent on the third-party manufacturers.

We completed the transfer of the manufacturing of our poultry diagnostic products from our supplier to our manufacturing facilities in San Diego during the first quarter of 2002, although some of the lower-volume products were still awaiting licensure by the USDA. We believe that our gross margins on these products will improve as we will have more products to absorb our fixed manufacturing costs.

Our research and development expenses decreased by $224,000 or 14% during 2002 as compared to 2001. This was due primarily to the decrease in research activities performed for us by third parties, and decreases in patent legal expense. Our research and development expenses as a percentage of our net sales were 6% during 2002 and 2001.

Our selling and marketing expenses decreased by $1,306,000 or 23% during 2002 as compared to 2001. This was due to a concerted effort to reduce selling and marketing expenses. Our selling and marketing expenses as a percentage of our net sales were 20% and 22% during 2002 and 2001, respectively.

Our general and administrative expenses increased by $2,526,000 or 40% during 2002 as compared to 2001. The increase is primarily due to $3,682,000 of retention bonuses that became payable upon the consummation of the January 2002 Redwood preferred stock investment transaction, the severance costs related to the July 2002 termination of the President of SBIO-E and the severance costs related to the September 2002 resignations of our Chief Executive Officer and Chief Financial Officer, and offset by the fact that goodwill is no longer amortized. Our general and administrative expenses as a percentage of our net sales were 41% and 24% during 2002 and 2001, respectively. Excluding the first quarter 2002 bonus expense and the goodwill amortization during 2001, our general and administrative expenses would have been $5,090,000 and $4,801,000 during 2002 and 2001, respectively, or 24% and 19% of our net sales during 2002 and 2001, respectively.

Our net interest expense decreased by $268,000 or 29% during 2002 as compared to 2001. This was due to the decrease in the prime rate during 2002 and 2001, and decreases in the outstanding principal balance of our bank loan.

We recognized a provision for income taxes of $7,000 during 2002 as compared to a provision for income taxes of $10,000 during 2001. The change in our ownership resulting from the January 2002 Redwood transaction limits the utilization of both Federal and state net operating loss carryforwards to $59,000 per year. As a result of this limitation, $15,999,000 of our Federal net operating loss carryforwards, and $969,000 of our state net operating loss carryforwards, may expire before they can be utilized.

At the end of the third quarter of 2002, we began implementing a cost reduction program, which included a reduction in our headcount.

We disposed of two unprofitable business lines in 2002. In August 2002, we sold our instrument manufacturing operations, located in Rome, New York, to Danam Acquisition Corp., located in Dallas, Texas, in exchange for a $500,000 note receivable. The note is payable, beginning in September 2002, in 60 monthly principal payments of $8,000 plus interest at 5%, is secured by the assets of the disposed operations (all of which we had been previously written off), and is guaranteed by Drew Scientific Group PLC (the parent of Danam Acquisition Corp.) In November 2002, we terminated the license agreement for our PennHIP^® operations,

9

Table of Contents

located in Malvern, Pennsylvania, and transferred all of the assets related to the PennHIP^® operations to the University of Pennsylvania. No consideration was received for the transferred assets. We recorded the $500,000 sale price for the instrument manufacturing operations in, and we have restated prior amounts related to the disposed operations as, discontinued operations. See Note 4 to our consolidated financial statements in Item 8 for a reconciliation of the restated amounts for the year ended December 31, 2001.

As of January 1, 2002, we adopted Statement of Financial Accounting Standards No. 142 (“FAS 142”), “Goodwill and Other Intangible Assets”. FAS 142 changed the accounting for goodwill from an amortization method to an impairment-only approach. Under FAS 142, goodwill is tested annually and whenever events or circumstances occur indicating that goodwill might be impaired. Upon adoption of FAS 142, amortization of goodwill recorded for business combinations consummated prior to July 1, 2001 ceased. In connection with the adoption of FAS 142, we performed a transitional goodwill impairment assessment. As a result of this impairment assessment, we recorded an impairment of $7,756,000 which is classified as a cumulative effect of a change in accounting principle in the first quarter of 2002. We perform subsequent impairment assessments, at a minimum, in the fourth quarter of each year; and subsequent impairments, if any, are classified as an operating expense. Our measurement of fair value upon adoption of FAS 142 was based upon a “fairness opinion” prepared by an independent investment advisor in conjunction with the Redwood transaction. Our measurement of fair value for subsequent impairment assessments is the market price of our common stock on the date the assessment is performed. As a result of decreases in the market price of our common stock during 2002, we recorded an impairment loss of $2,877,000 in the fourth quarter of 2002.

As of January 1, 2002, we adopted Statement of Financial Accounting Standards No. 144 “Accounting for the Impairment or Disposal of Long-Lived Assets” (“FAS 144”). FAS 144 supersedes FAS 121 “Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of”. FAS 144 applies to all long-lived assets (including discontinued operations) and consequently amends Accounting Principles Board Opinion No. 30 (“APB 30”), “Reporting Results of Operations - Reporting the Effects of Disposal of a Segment of a Business”. FAS 144 develops one accounting model for long-lived assets that are to be disposed of by sale. FAS 144 requires that long-lived assets that are to be disposed of by sale be measured at the lower of book value or fair value less cost to sell. Additionally, FAS 144 expands the scope of discontinued operations to include all components of an entity with operations that (1) can be distinguished from the rest of the entity and (2) will be eliminated from the ongoing operations of the entity in a disposal transaction. The adoption of FAS 144 did not have a material impact on our financial position or results of operations.

Financial Condition and Liquidity

The following table summarizes the future cash payments related to our contractual obligations (other than trade payables) as of December 31, 2003 (amounts are in thousands):

Our bank loan came due in January 2004; we did not pay it when it came due, and as of March 31, 2004, we had an outstanding principal balance on the note of $4,700,000. We will have to extend or restructure the note with the bank or refinance it with another lending source. The bank had informally reduced the monthly principal payments to $30,000 for the payments due February 1, 2004, and March 1, 2004. On March 29, 2004, we entered into a forbearance agreement with the bank whereby the bank agreed not to exercise any of its rights under the credit agreement through May 5, 2004, and agreed to formally reduce the monthly principal payments to $30,000 for the payments due April 1, 2004, and May 1, 2004; the forbearance agreement has now expired. We believe we will be able to restructure or refinance the bank debt and it is absolutely essential to us that we do so. However, no assurance can be given that we will be successful in this effort to restructure or refinance the bank debt. Our bank has given us no commitment that it will formally extend or refinance the loan.

10

Table of Contents

Our loan has been handled by the bank’s workout department since 2001. We have, however, with the exception of the January 25, 2004, balloon payment, always made our monthly payments of principal and interest, which we hope will weigh in our favor. In each of the past three years we have repaid approximately $1,200,000 of principal on the note.

We have positive cash flow from operations. Nonetheless, we may require additional financing in the future, even if our bank loan situation is resolved. There can be no assurance that such financing would be available to us on favorable terms, or at all. Because our stock price is low, any equity financing would significantly dilute current shareholders.

Our operations are seasonal due to the sales of our canine heartworm diagnostic products. Our sales and profits tend to be concentrated in the first half of the year, as our distributors prepare for the heartworm season by purchasing diagnostic products for resale to veterinarians. The operations of SBIO-E have reduced our seasonality as sales of their large animal diagnostic products tend to occur evenly throughout the year. In addition, sales of our SCA 2000^™ instruments and supplies and our poultry diagnostic products reduce our seasonality.

Certain Risk Factors

Our future operating results are subject to a number of factors, including:

In addition to the necessity of extending or refinancing our bank loan which matured in January 2004, we may need additional capital in the future

Our bank loan came due in January 2004; we did not pay it when it came due, and as of March 31, 2004, we had an outstanding principal balance on the note of $4,700,000. We will have to restructure the note with the bank or refinance it with another lending source. The bank had informally reduced the monthly principal payments to $30,000 for the payments due February 1, 2004, and March 1, 2004. On March 29, 2004, we entered into a forbearance agreement with the bank whereby the bank agreed not to exercise any of its rights under the credit agreement through May 5, 2004, and agreed to formally reduce the monthly principal payments to $30,000 for the payments due April 1, 2004, and May 1, 2004; the forbearance agreement has now expired. We believe we will be able to restructure or refinance the bank debt. However, no assurance can be given that we will be successful in this effort to restructure or refinance the bank debt. We may also need to raise additional funds if our estimates of revenues, working capital and/or capital expenditure requirements change or prove inaccurate or in order for us to respond to unforeseen technological or marketing hurdles or to take advantage of unanticipated opportunities.

Further, our future capital requirements will depend on many factors beyond our control or ability to accurately estimate, including continued scientific progress in our product development programs, the cost of manufacturing scale-up, the costs involved in preparing, filing, prosecuting, maintaining and enforcing patent claims, the cost involved in patent infringement litigation, competing technological and market developments, and the cost of establishing effective sales and marketing arrangements. Such funds may not be available at the time or times needed, or available on terms acceptable to us. If adequate funds are not available, or are not available on acceptable terms, we may not be able to take advantage of market opportunities, to develop new products, or to otherwise respond to competitive pressures. This inability could materially harm our business.

If we are unable to successfully reintroduce to the market the Witness^® products which were previously manufactured by Agen, it could also hinder our ability to restructure or refinance our bank loan, or obtain any other necessary additional capital.

We may be unable to successfully reintroduce our key Witness^® products

Agen was the contract manufacturer of certain of our Witness^® in-clinic diagnostic products, representing 38% of our 2002 net sales. Agen ceased supplying these products in April 2003. We have licensed the alternate-

11

Table of Contents

source Witness^® canine heartworm product with the USDA (now to be supplied by another contract manufacturer), and we began selling this product in January 2004. We also anticipate having the alternate-source Witness^® feline leukemia and canine parvovirus products available for sale late in the second quarter of 2004. In addition to the risks that the alternate-source products will be delayed, will experience quality issues, cannot be supplied reliably, etc., we cannot ensure that after our products have been off the market for several months we will necessarily be able to regain our previous market share and our previous price points.

The market in which we operate is intensely competitive, even with regard to our key canine heartworm diagnostic products, and many of our competitors are larger and more established, and we are facing unfair competition from Agen in this market

The market for animal health care products is extremely competitive. Companies in the animal health care market compete to develop new products, to market and manufacture products efficiently, to implement effective research strategies, and to obtain regulatory approval. Our current competitors include IDEXX Laboratories, a significantly larger company, Heska Corporation and Agen. These companies may have greater financial, manufacturing, marketing, and research resources than we do. In addition, IDEXX Laboratories prohibits its distributors from selling competitors’ products, including ours. Further, additional competition could come from new entrants to the animal health care market. We cannot assure you that we will be able to compete successfully in the future or that competition will not harm our business.

Our canine heartworm diagnostic products constituted 24% of our sales for the year ended December 31, 2003. In addition to our historic competition with IDEXX Laboratories, the sales leader in this product category, our sales have been substantially affected since 1999 by a heartworm product from Heska. Agen has entered this market too (with, we believe, a product which infringes our heartworm patent). Additional competition, including erosion of the average selling price, from Agen in this key market with this product has seriously damaged us. Even if we prevail against Agen in our patent litigation, we could face renewed competition from Agen or other new competitors when our U.S. heartworm patent expires in December 2005.

As previously mentioned, as a result of Agen ceasing to contract manufacture our Witness^® products we believe that our sales could be materially adversely affected in 2004 and beyond if we are unable to successfully reintroduce the alternate-source products into the market. The Witness^® products previously contract manufactured by Agen represented 38% of our net sales for the year ending December 31, 2002. There can be no assurances that we will be able to achieve our previous sales levels of these in-clinic products.

We have a history of losses and an accumulated deficit

Although we were profitable in 2003 and 2001, we did not achieve profitability for the year ended December 31, 2002, and we have had a history of annual losses. We have incurred a consolidated accumulated deficit of $45,146,000 at December 31, 2003. We may not achieve annual profitability again, and if we are profitable in the future there can be no assurance that profitability can be sustained.

We rely on third party distributors for a substantial portion of our sales

We have historically depended upon distributors for a large portion of our sales, and we may not have the ability to establish and maintain an adequate independent sales and marketing capability in any or all of our targeted markets. Distributor agreements render our sales exposed to the efforts of third parties who are not employees of Synbiotics and over whom we have no control. Their failure to generate significant sales of our products could materially harm our business. Reduction by these distributors of the quantity of our products which they distribute would materially harm our business. Also, the distributors are not bound to us by long-term agreements, and a decision by any major distributor to stop doing business with us could materially hurt our revenues. IDEXX Laboratories’ prohibition against its distributors carrying competitors’ products, including ours, has made, and could continue to make, some distributors unavailable to us. In the past, we have lost major distributors to IDEXX Laboratories.

12

Table of Contents

We depend on key executives and personnel, but we have experienced executive turnover

Our future success will depend, to a significant extent, on the ability of our management to operate effectively, both individually and as a group. Competition for qualified personnel in the animal health care products industry is intense, and we may not be successful in attracting and retaining such personnel. There are only a limited number of persons with the requisite skills to serve in those positions and it may become increasingly difficult to hire such persons. The loss of the services of any of our key personnel or the inability to attract or retain qualified personnel could harm our business. At the end of the third quarter of 2002, our chief executive officer and our chief financial officer both resigned. We replaced our chief financial officer by promoting our corporate controller, and we hired Paul Hays, our new president, at the end of December 2002. In May 2003, we hired Kent Luther, our new vice president of sales and marketing, to replace our former vice president who resigned in April 2003.

We depend on third party manufacturers, and may experience problems in obtaining supplies of our key products

We contract for the manufacture of some of our products, including our Witness^® in-clinic canine heartworm, feline leukemia, and canine parvovirus diagnostic products and our SCA 2000^™ instrument products. We also expect that some of our anticipated new products will be manufactured by third parties. In addition, some of the products manufactured for us by third parties are licensed to us by their manufacturers. There are a number of risks associated with our dependence on third-party manufacturers including:

If our third party manufacturers fail to supply us with an adequate number of finished products, our business would be significantly harmed. We have no long-term contracts or arrangements with any of our vendors that guarantee product availability, the continuation of particular payment terms or the extension of credit limits.

If we encounter delays or difficulties in our relationships with our manufacturers, the resulting problems could have a material adverse effect on us.

As mentioned above, Agen, the previous contract manufacturer of certain of our Witness^® in-clinic products, ceased to supply us with those products, and entered the market with competing products.

We rely on new and recent products

We rely to a significant extent on new and recently developed products, and expect that we will need to continue to introduce new products to be successful in the future. There can be no assurance that we will obtain and maintain market acceptance of our products. There can be no assurance that future products, including our alternate-source in-clinic diagnostic products, will meet applicable regulatory standards, be capable of being produced in commercial quantities at acceptable cost or be successfully commercialized.

13

Table of Contents

There can be no assurance that new products can be manufactured at a cost or in quantities necessary to make them commercially viable. If we are unable to produce internally, or to contract for, a sufficient supply of our new products on acceptable terms, or if we should encounter delays or difficulties in our relationships with manufacturers, the introduction of new products would be delayed, which could have a material adverse effect on our business.

Our canine heartworm business is seasonal

Our operations are seasonal due to the timing of sales of our canine heartworm diagnostic products. Our sales and profits tend to be concentrated in the first half of the year as our distributors prepare for the heartworm season by purchasing diagnostic products for resale to veterinarians. One effect of this is a need to devote large amounts of cash to building canine heartworm diagnostic products inventory in preparation for the canine heartworm selling season at a time when our working capital is relatively low.

Any failure to adequately establish or protect our proprietary rights may adversely affect us

We rely on a combination of patent, copyright, and trademark laws, trade secrets, and confidentiality and other contractual provisions to protect our proprietary rights. These measures afford only limited protection. We currently have 13 issued U.S. patents and one pending patent application. Our means of protecting our proprietary rights in the U.S. or abroad may not be adequate and competitors may independently develop similar technologies. Our future success will depend in part on our ability to protect our proprietary rights and the technologies used in our principal products. Despite our efforts to protect our proprietary rights, unauthorized parties may attempt to copy aspects of our products or to obtain and use trade secrets or other information that we regard as proprietary. In addition, the laws of some foreign countries do not protect our proprietary rights as fully as do the laws of the United States. Issued patents may not preserve our proprietary position. Even if they do, competitors or others may develop technologies similar to or superior to our own. If we do not enforce and protect our intellectual property, our business will be harmed. From time to time, third parties, including our competitors, have asserted patent, copyright, and other intellectual property rights to technologies that are important to us. We expect that we will increasingly be subject to infringement claims as the number of products and competitors in the animal health care market increases.

The results of any litigated matter are inherently uncertain. In the event of an adverse result in any litigation with third parties that could arise in the future, we could be required to:

Licenses may not be available from any third party that asserts intellectual property claims against us on commercially reasonable terms, or at all.

Also, litigation is costly regardless of its outcome and can require significant management attention.

Agen has introduced into the U.S. market a canine heartworm diagnostic product which is essentially identical to our Witness^® canine heartworm diagnostic test kit, including our patented biological components. In September 2003, we filed a patent infringement lawsuit against Agen claiming that Agen has willfully infringed our U.S. Patent No. 4,789,631 pertaining to heartworm detection technology. In addition to seeking damages, we are asking for an injunction against Agen, preventing Agen from importing, selling or offering for sale their canine heartworm diagnostic test kit in the United States. On March 15, 2004, the Court issued a temporary restraining order against Agen, preventing Agen’s canine heartworm diagnostic product from entering the United States market. The Court ordered that Agen, their directors, officers, employees, agents, servants, and all those in

14

Table of Contents

active concert or participation with them, are restrained from importing, making, using, selling, or offering for sale, in the United States, any canine heartworm kit containing the DI 16 872.5 monoclonal antibody manufactured or supplied by Agen. The Court ruled earlier that we were likely to succeed on the merits of our claim that Agen’s canine heartworm diagnostic product, STATScreen^TM CHW, which contains our DI 16 872.5 monoclonal antibody, infringed our United States Patent 4,789,631. A preliminary injunction hearing was held on April 15, 2004, and on April 21, 2004, the Court denied our motion and dissolved the temporary restraining order. In conjunction with the temporary restraining order, we were required to post a $250,000 bond; the Court has not yet released the bond. The lawsuit is currently in the discovery stage, and a trial date is scheduled for June 28, 2004.

In September 2003, Agen filed a lawsuit against us, in the U.S. District Court for the Northern District of California, asking for a declaratory judgment that Agen’s canine heartworm diagnostic test kit does not infringe our U.S. Patent No. 4,789,631 pertaining to heartworm detection technology, and also asking for a declaratory judgment that Claim 5 of our U.S. Patent No. 4,789,631 is invalid. We filed a motion to transfer the lawsuit to the U.S. District Court for the Southern District of California. On November 7, 2003, our motion was granted and the case was transferred.

Should Agen prevail in either of these lawsuits, our future sales of canine heartworm diagnostics products in general, and especially our Witness^® canine heartworm diagnostic product, may be materially adversely affected due to market competition from Agen’s product. Additionally, we will be incurring material litigation expenses.

Also, because our patents and patent applications cover novel diagnostic approaches:

Because of this, our patent position could be vulnerable and our business could be materially harmed. In any event, our important United States canine heartworm diagnosis patent will expire in December 2005.

The U.S. patent application system also exposes us to risks. In the United States, the first party to make a discovery is granted the right to patent it and patent applications are generally maintained in secrecy for 18 months. For these reasons, we can never know if we are the first to discover particular technologies. Therefore, we can never be certain that our technologies will be patented and we could become involved in lengthy, expensive, and distracting disputes concerning whether we were the first to make the disputed discovery. Any of these events would materially harm our business.

Our business is regulated by the United States and various foreign governments

Our business is subject to substantial regulation by the United States government, most notably the United States Department of Agriculture, and the French government. In addition, our operations may be subject to future legislation and/or rules issued by domestic or foreign governmental agencies with regulatory authority relating to our business. There can be no assurance that we will continue to be in compliance with any of these regulations.

For marketing outside the United States, we and our suppliers are subject to foreign regulatory requirements, which vary widely from country to country. There can be no assurance that we and our suppliers will meet and sustain compliance with any such requirements.

We use hazardous materials

Our business requires that we store and use hazardous materials and chemicals. Although we believe that our procedures for storing, handling, and disposing of these materials comply with the standards prescribed by local, state, and federal regulations, the risk of accidental contamination or injury from these materials cannot be

15

Table of Contents

completely eliminated. If any of these materials were mishandled, or if an accident with them occurred, the consequences could be extremely damaging and we could be held liable for them. Our liability for such an event would materially harm our business and could exceed all of our available resources for satisfying it.

Item 7A.    Quantitative and Qualitative Disclosures About Market Risk

Our market risk consists primarily of the potential for changes in interest rates and foreign currency exchange rates.

Interest Rate Risk

The fair value of our interest bearing debt at December 31, 2003 was $4,804,000, which has a variable interest rate based on the prime rate.

A change in interest rates of five percentage points would have a material impact on our financial condition, results of operations and cash flows as it relates to our variable rate debt. In addition, if interest rates increased by five percentage points our ability to refinance our bank debt would be seriously compromised.

Foreign Currency Exchange Rate Risk

Our foreign currency exchange rate risk relates to the operations of SBIO-E as it transacts business in Euros, its local currency. However, this risk is limited to our intercompany receivable from SBIO-E and the conversion of its financial statements into the U.S. dollar for consolidation. There is no foreign currency exchange rate risk related to SBIO-E’s transactions outside of the European Union as those transactions are denominated in Euros and, to a lesser extent, U.S. dollars. Similarly, all of the foreign transactions of our U.S. operations are denominated in U.S. dollars. We do not hedge our cash flows on intercompany transactions, nor do we hold any other derivative securities or hedging instruments based on currency exchange rates. As a result, the effects of a 5% change in exchange rates would have a material impact on our financial condition, results of operations and cash flows, but only to the extent that it relates to the conversion of SBIO-E’s financial statements, including its intercompany payable, into the U.S. dollar for consolidation. For the year ended December 31, 2003, 40% of our net sales were net sales of SBIO-E.

16

Table of Contents

Item 8.    Financial Statements and Supplementary Data

Index to Financial Statements

All other schedules are omitted because they are not applicable or the required information is included in the consolidated financial statements and notes thereto.

17

Table of Contents

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

To the Board of Directors

and Shareholders of

Synbiotics Corporation

We have audited the consolidated financial statements listed in the accompanying index of Synbiotics Corporation and its subsidiary as of December 31, 2003 and 2002, and for each of the years in the three year period ended December 31, 2003. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Synbiotics Corporation and its subsidiary as of December 31, 2003 and 2002, and the consolidated results of their operations and their cash flows for each of the years in the three year period ended December 31, 2003 in conformity with accounting principles generally accepted in the United States of America.

The accompanying consolidated financial statements have been prepared assuming the Company will continue as a going concern. As discussed in Note 2 to the consolidated financial statements, the Company has an accumulated deficit of $45,146,000, and has a note payable of $4,804,000 which was payable in full on January 25, 2004, and was not paid in full. These factors, among others, raise substantial doubt about its ability to continue as a going concern. Management’s plans in regards to these matters are also described in Note 2. The consolidated financial statements do not include any adjustments that might result from the outcome of this uncertainty.

LEVITZ, ZACKS & CICERIC

Certified Public Accountants

San Diego, California

May 17, 2004

18

Table of Contents

SYNBIOTICS CORPORATION

CONSOLIDATED BALANCE SHEET

See accompanying notes to consolidated financial statements.

19

Table of Contents

SYNBIOTICS CORPORATION

CONSOLIDATED STATEMENT OF OPERATIONS AND COMPREHENSIVE INCOME (LOSS)

See accompanying notes to consolidated financial statements.

20

Table of Contents

SYNBIOTICS CORPORATION

CONSOLIDATED STATEMENT OF CASH FLOWS

See accompanying notes to consolidated financial statements.

21

Table of Contents

SYNBIOTICS CORPORATION

CONSOLIDATED STATEMENT OF SHAREHOLDERS’ EQUITY