UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

FORM 10-Q

Commission File Number 0-21872

GEN-PROBE INCORPORATED

10210 Genetic Center Drive
San Diego, CA 92121
(Address of principal executive offices)

(858) 410-8000
(Registrant’s telephone number, including area code)

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

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

     As of May 5, 2004, there were 49,192,575 shares of the registrant’s common stock, par value $0.0001 per share, outstanding.

GEN-PROBE INCORPORATED

TABLE OF CONTENTS
FORM 10-Q

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Item 1. Financial Statements

GEN-PROBE INCORPORATED

CONSOLIDATED BALANCE SHEETS
(In thousands, except share and per share data)

See accompanying notes to consolidated financial statements.

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GEN-PROBE INCORPORATED

CONSOLIDATED STATEMENTS OF INCOME
(In thousands, except per share data)

See accompanying notes to consolidated financial statements.

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GEN-PROBE INCORPORATED

CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands)

See accompanying notes to consolidated financial statements.

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Notes to the Consolidated Financial Statements (unaudited)

Note 1 - Basis of presentation

     The accompanying interim consolidated financial statements of Gen-Probe Incorporated (“Gen-Probe” or the “Company”) at March 31, 2004, and for the three month periods ended March 31, 2004 and 2003, are unaudited and have been prepared in accordance with accounting principles generally accepted in the United States for interim financial information. Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. In management’s opinion, the unaudited financial statements include all adjustments, consisting only of normal recurring accruals, necessary to state fairly the financial information therein, in accordance with generally accepted accounting principles. Interim results are not necessarily indicative of the results which may be reported for any other interim period or for the year ending December 31, 2004.

     These unaudited consolidated financial statements and footnotes thereto should be read in conjunction with the audited financial statements and footnotes thereto contained in the Company’s Annual Report on Form 10-K for the year ended December 31, 2003.

Note 2 - Reporting periods

     The Company operates and reports on fiscal periods ending on the Friday closest to the end of the month except for year-end, which closes December 31. For ease of presentation, the quarterly reporting periods are deemed to end on March 31, June 30 and September 30. The three months ended March 31, 2004 included three more business days compared to the same period in the prior year.

Note 3 - Summary of significant accounting policies

Principles of consolidation

     The consolidated financial statements of the Company include the accounts of the Company and its subsidiaries, Gen-Probe Sales and Services, Inc., Gen-Probe Canada, Inc., Gen-Probe UK Limited and Molecular Light Technology Limited and its subsidiaries. All intercompany transactions and balances have been eliminated in consolidation.

Use of estimates

     The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the amounts reported in the consolidated financial statements. These estimates include assessing the collectibility of accounts receivable, valuation of inventories and long-lived assets. Actual results could differ from those estimates.

Foreign currency translation

     The functional currency of the Company’s majority owned subsidiary, Molecular Light Technology Limited and its subsidiaries, is the British pound. Accordingly, all balance sheet accounts of this subsidiary are translated into United States dollars using the exchange rate in effect at the balance sheet date, and revenues and expenses are translated using the average exchange rates in effect during the period. The gains and losses from foreign currency translation of this subsidiary’s financial statements are recorded directly as a separate component of stockholders’ equity under the caption “Accumulated other comprehensive income.”

Reclassifications

     Certain prior year amounts have been reclassified to conform with the current year presentation.

Note 4 - Stock-based compensation

     The Company measures compensation expense for its employee stock-based compensation using the intrinsic value method and provides pro forma disclosures of net income and earnings per common share as if the fair value methods had been applied in measuring compensation expense. Under the intrinsic value method, compensation cost for employee stock awards is recognized as the excess, if any, of the deemed fair value for financial reporting purposes of the Company’s common stock on the date of grant over the amount an employee must pay to acquire the stock.

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     Pro forma information regarding net income is required to be disclosed in interim financial statements by SFAS No. 148, and has been determined as if the Company had accounted for its employee stock options and employee stock purchase plan under the fair value method of SFAS No. 123. The fair value for employee stock options was estimated at the dates of grant using the minimum value option pricing model from the stock option plan inception date in 2000 through September 15, 2002 and the Black-Scholes pricing model for all option grants made subsequent to that date. The following weighted average assumptions were used:

     The fair value of each purchase right issued under the Company’s employee stock purchase plan for the quarter ended March 31, 2004 was estimated on the date of grant using the Black-Scholes pricing model. The Company did not have an employee stock purchase plan during the quarter ended March 31, 2003. The following weighted average assumptions were used:

     Had compensation expense for stock-based compensation plans been determined based on the fair value method prescribed under SFAS No. 123, the Company’s net income and net income per share would have been as follows (in thousands, except per share data):

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     The pro forma effects on net income for the three months ended March 31, 2004 and 2003 are not likely to be representative of the effects on reported net income in future years. In management’s opinion, existing stock option valuation models do not provide a reliable single measure of the fair value of employee stock options that have vesting provisions and are not transferable. In addition, option valuation models require the input of highly subjective assumptions, and changes in such subjective assumptions can materially affect the fair value estimate of employee stock options.

Note 5 - Net income per share

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

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

     The following table sets forth the computation of net income per share (in thousands, except per share amounts):

     Dilutive securities include common stock options subject to vesting. Potentially dilutive securities totaling 145,470 and 2,740,694 for the three months ended March 31, 2004 and 2003, respectively, were excluded from the calculation of diluted earnings per share because of their anti-dilutive effect.

Note 6 - Comprehensive income

     Components of comprehensive income, net of income taxes, were as follows (in thousands):

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Note 7 - Inventories

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

Note 8 - Stockholders’ equity

Number of authorized shares of common stock

     On September 5, 2003, the Company’s Board of Directors authorized a two-for-one stock split implemented as a 100% stock dividend, effective September 30, 2003 for holders of record as of September 16, 2003 (the “Stock Split”). As a result of the Stock Split by stock dividend, the number of outstanding shares of the Company’s common stock and the number of shares of the Company’s common stock reserved under its equity compensation plans was doubled. The Board of Directors of the Company has approved and has requested that stockholders’ approve an amendment to the Company’s Amended and Restated Certificate of Incorporation to increase the Company’s authorized number of shares of common stock from 100,000,000 shares to 200,000,000 shares. This increase is subject to approval by the Company’s stockholders’ at the Annual Meeting of Stockholders scheduled to be held on May 28, 2004.

Common stock

     During the three months ended March 31, 2004, 295,529 options to purchase shares of the Company’s common stock were exercised by Gen-Probe employees at a weighted average exercise price of $12.87. The Company also issued 2,085 shares of common stock to members of the Board of Directors as partial consideration for services rendered. The Company recognized expense for these grants to the members of the Board of Directors of $72,512, which was equal to the fair market value on the date of grants. Additionally, employees purchased 56,717 shares of the Company’s common stock at an average purchase price of $26.92 per share pursuant to the Company’s Employee Stock Purchase Plan (“ESPP”).

Note 9 - Litigation

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

Enzo Biochem, Inc.

     In June 1999, the Company was sued by Enzo Biochem, Inc. in the United States District Court for the Southern District of New York. Enzo alleged that the Company and its former affiliates, as well as Becton Dickinson and bioMérieux, have willfully infringed United States patent no. 4,900,659, or the ” ‘659 patent,” through the manufacture and sale of products for the diagnosis of gonorrhea. The Company’s former affiliates and bioMérieux have been dismissed from the case by Enzo. The Company and Becton Dickinson remain as defendants. The Company anticipates that trial in the case may be set for the first quarter of 2005. The Company expects Enzo to assert a damage claim based on a contention that Enzo is entitled to a reasonable royalty on all sales of Gen-Probe products for the detection of Neisseria gonorrhoeae bacteria from June 1993 through trial. Revenues from tests for the detection of Neisseria gonorrhoeae have constituted a significant portion of Gen-Probe’s revenues during the relevant period. The Company believes that the claims of the ‘659 patent are invalid, unenforceable and may not be properly interpreted to cover its products. The Company intends to vigorously defend the lawsuit. However, there can be no assurance that the case will be resolved in the Company’s favor.

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Vysis, Inc.

     In December 1999, the Company initiated litigation in the United States District Court for the Southern District of California against Vysis, now a subsidiary of Abbott Laboratories, seeking a declaratory judgment that the Company’s products were not covered by a Vysis patent that is the subject of a license granted by Vysis in favor of the Company and that the patent is invalid and unenforceable. In August 2002, following a jury trial, the District Court entered judgment in the Company’s favor, finding the Vysis patent invalid and finding that the patent does not cover Gen-Probe’s products. On September 3, 2002, Vysis filed a notice of appeal with the District Court. Further, on October 22, 2002 while Vysis’ appeal was pending, the United States Patent & Trademark Office reissued the Vysis patent with amended claims. On October 22, 2002, the Company filed a second lawsuit in District Court to challenge the validity and scope of the reissued patent. On March 5, 2004, the Court of Appeals vacated the District Court’s August 2002 judgement in favor of the Company and directed the District Court to dismiss the case on the ground of lack of subject matter jurisdiction. On April 2, 2004, the Company timely filed a petition with the Court of Appeals for rehearing and rehearing en banc, which is now pending. There can be no assurances as to the final outcome of this litigation. The Company has at all times maintained the license with Vysis in full force and continued to make royalty payments under the license, pending final resolution of the litigation.

Bayer Corporation

     In November 2002, the Company filed a demand for arbitration against Bayer Corporation, or Bayer, in the Judicial Arbitration & Mediation Services, Inc., or JAMS, office in San Diego, California related to the Company’s collaboration with Bayer for nucleic acid diagnostic tests for viral organisms. Under the terms of the collaboration agreement, Bayer acquired the exclusive right to distribute nucleic acid diagnostic tests designed and developed by Gen-Probe for the detection of HIV, hepatitis viruses and other specified viruses, subject to certain conditions. Gen-Probe’s demand for arbitration states that Bayer has failed to fulfill the conditions required to maintain exclusive distribution rights. The arbitration demand seeks confirmation that the agreement grants Gen-Probe, in the present circumstances, a co-exclusive right to directly distribute the viral diagnostic tests that are the subject of the agreement. Gen-Probe’s arbitration demand also seeks money damages due to Bayer’s failure to use commercially reasonable efforts to promote, market and sell viral diagnostic assays developed by Gen-Probe. In November 2003, Bayer filed a counterclaim for money damages based on alleged delays in the development of the TIGRIS system, alleged delays in the development of certain assays, and other claims. The matter has been set for hearing beginning September 13, 2004. There can be no assurances as to the final outcome of the arbitration.

     In February 2004, the Company filed a patent infringement action in the United States District Court for the Southern District of California, alleging that Bayer’s bDNA nucleic acid tests for HIV and HCV infringe Gen-Probe’s U.S. patent no. 5,955,261, entitled “Method for Detecting the Presence of Group-Specific Viral mRNA in a Sample.” Bayer’s bDNA tests are not covered by the collaboration agreement between the companies. The complaint seeks money damages and injunctive relief. Bayer has not yet responded to the complaint. There can be no assurances as to the final outcome of the litigation.

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

     This report contains “forward-looking” statements within the meaning of the Private Securities Litigation Reform Act of 1995, which provides a “safe harbor” for these types of statements. To the extent statements in this report involve, without limitation, our expectations for growth, estimates of future revenue, expenses, profit, cash flow, balance sheet items or any other guidance on future periods, these statements are forward-looking statements. Forward-looking statements are not guarantees of performance. They involve known and unknown risks, uncertainties and assumptions that may cause actual results, levels of activity, performance or achievements to differ materially from any results, level of activity, performance or achievements expressed or implied by any forward-looking statement. We assume no obligation to update any forward-looking statements.

     The following information should be read in conjunction with our March 31, 2004 consolidated financial statements and related notes thereto and with our consolidated financial statements and notes thereto for the year ended December 31, 2003 and the related “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” contained in our Annual Report on Form 10-K for the year ended December 31, 2003. We also urge you to review and consider our disclosures describing various risks that may affect our business, which are set forth under the heading “Risk Factors” in this report and in our Annual Report on Form 10-K for the year ended December 31, 2003.

Overview

     We are a global leader in the development, manufacture and marketing of rapid, accurate and cost-effective nucleic acid probe-based products used for the clinical diagnosis of human diseases and for the screening of donated human blood. We have over 21 years of nucleic acid detection research and product development experience, and our products, which are based on our patented nucleic acid testing, or NAT, technology, are used daily in clinical laboratories and blood collection centers in major countries

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throughout the world.

     In September 2002, our common stock began trading on the Nasdaq National Market immediately after our former parent company, Chugai Pharmaceutical Co., Ltd. distributed all of its shares of our common stock to its shareholders. Since our spin-off into an independent, publicly traded company, we have achieved strong growth in both revenues and earnings due principally to the success of our blood screening products which are used to detect the presence of human immunodeficiency virus (type 1), or HIV-1, and hepatitis C virus, or HCV. Under our collaboration agreement with Chiron Corporation, or Chiron, we are responsible for the research, development, regulatory process and manufacturing of our blood screening products while Chiron is responsible for marketing, sales, distribution and service.

     During the three months ended March 31, 2004, we achieved strong financial results, with earnings per share, total revenues and product sales all establishing new records. Net income for the current period was $19.7 million ($0.39 per diluted share), compared to $8.7 million ($0.18 per diluted share) in the same period of the prior year, an increase of 117% per diluted share. Total revenues for the current period were $76.5 million, compared to $46.2 million in the same period of the prior year, an increase of 66%. Product sales for the current period were $55.0 million, compared to $43.6 million in the same period of the prior year, an increase of 26%. During the current period, net income and total revenues included a contract milestone with Chiron and a license fee earned in connection with our cross-licensing agreement with Tosoh Corporation, or Tosoh. These amounts added approximately $0.17 to diluted earnings per share and $13.5 million to revenues.

Recent Events

     In December 2003, we signed a cross-licensing agreement with Tosoh, effective January 1, 2004, for certain NAT technologies in clinical diagnostics and other related fields. Under the agreement, we earned $7.0 million during the three months ended March 31, 2004.

     In January 2004, we began United States clinical trials of the Procleix Ultrio assay on the fully automated, high-throughput TIGRIS instrument system, triggering a $6.5 million contract milestone with Chiron that we recognized during the three months ended March 31, 2004. During January, the Procleix Ultrio assay received its Community European, or CE, mark, clearing the way for Chiron to launch the product in the European Economic Area.

Revenues

     We derive revenues from three primary sources: product sales, collaborative research revenue and royalty and license revenue. The majority of our revenues come from product sales, which consist primarily of sales of our NAT assays tested on the proprietary instruments that serve as the analytical platform for our assays. We recognize as collaborative research revenue payments we receive from Chiron for the products we provided under our collaboration agreements with Chiron prior to their regulatory approval and the payments we receive from Chiron, Bayer Corporation, or Bayer, and other collaboration partners, including the National Institutes of Health, or NIH, for research and development activities. Our royalty and license revenues reflect fees paid to us by third parties for the use of our proprietary technology. For the three months ended March 31, 2004, product sales, collaborative research revenues and royalty and license revenues equaled 72%, 9% and 19%, respectively, of our total revenues of $76.5 million. For the same period in the prior year, product sales, collaborative research revenues and royalty and license revenues equaled 95%, 4% and 1%, respectively, of our total revenues of $46.2 million.

Product sales

     Our primary source of revenue continues to be the sale of clinical diagnostic products in the United States, which primarily include our PACE 2, AccuProbe, Amplified Mycobacterium Tuberculosis Direct Test, and APTIMA Combo 2 product lines. During the first quarter of 2004, we shipped approximately 5.8 million tests for the diagnosis of a wide variety of infectious microorganisms, including those causing sexually transmitted diseases, or STDs, tuberculosis, strep throat, pneumonia and fungal infections. The principal customers for our clinical diagnostics products include large reference laboratories, public health laboratories and hospitals located in North America, Europe and Japan.

     Since 1999, we have supplied NAT assays for use in screening blood donations intended for transfusion. Our first blood screening assay detects HIV-1 and HCV in donated human blood. Our blood screening assays and instruments are marketed through our collaboration with Chiron under the Procleix trademark. We recognize product sales from the manufacture and shipment of tests for screening donated blood through our collaboration with Chiron to blood bank facilities located in the countries where our products have obtained governmental approvals. Blood screening product sales are then adjusted monthly upon payment by Chiron to us of amounts reflecting our ultimate share of net revenue from sales by Chiron to the end user, less the transfer price revenues previously paid. Net sales are ultimately equal to the sales of the assays by Chiron to third-parties, less freight, duty and certain other adjustments

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specified in our agreement with Chiron, multiplied by our share of the net revenue, which was 43.0% with respect to sales of assays that include a test for HCV beginning the second quarter of 2002 upon implementation of commercial pricing, through April 6, 2003, after which our share of net revenues from sales of assays that include a test for HCV was adjusted to 47.5%. Effective January 1, 2004, our share of net revenues from commercial sales of assays that include a test for HCV was permanently changed to 45.75% under our agreement with Chiron. With respect to commercial sales of blood screening assays under our collaboration with Chiron that do not include a test for HCV, such as possible future commercial tests for West Nile virus, or WNV, we will continue to receive reimbursement for our manufacturing costs plus 50% of net revenues. Our costs related to these products primarily include manufacturing costs.

Collaborative research revenue

     We have developed a NAT assay to detect HIV-1 and HCV in donated human blood and have also developed a semi-automated instrument system to conduct the test. These assays and instruments are marketed through our collaboration with Chiron under the Procleix name. In February 2002, the FDA approved the Procleix HIV-1/HCV assays.

     In March 2003, we signed a definitive agreement with Chiron for the development and commercialization of the Procleix Ultrio assay. For the three month periods ended March 31, 2004 and 2003, we recognized $0.5 million and $1.3 million in reimbursements for expenses incurred related to the development of this assay. In January 2004, we commenced clinical trials of the Procleix Ultrio assay in the United States on our TIGRIS instrument. We have also developed a NAT assay to detect WNV, which is currently being used in clinical trials under an Investigational New Drug, or IND, application. We expect to receive further reimbursement for certain costs incurred during the development of the Procleix Ultrio and WNV assays from Chiron and separately from the National Heart, Lung, and Blood Institute, a part of the NIH.

     We have recorded revenues related to use of our blood screening products in the United States and other countries in which the products have not received regulatory approval as collaborative research revenue because price restrictions applied to these products prior to Food and Drug Administration, or FDA, license approval in the United States and similar approval in foreign countries. For the three months ended March 31, 2004, we recognized $4.5 million in collaborative research revenue through our collaboration with Chiron from deliveries of WNV tests on a “cost recovery” basis. We expect to continue recognizing these sales as collaborative research revenue until such time as FDA approval has been received, although there is no guarantee we ultimately will receive FDA approval.

     Since 1996, we have been awarded contracts aggregating approximately $28.2 million by the NIH to develop NAT assays for screening donated blood for HIV-1, HCV, hepatitis B virus, or HBV, and WNV. To date, all payments due to us under these reimbursement contracts have been received and have been recorded as collaborative research revenues as reimbursable costs were incurred. As of March 31, 2004, the Company had approximately $1.4 million in reimbursements remaining under this contract, which will continue to be realized as expenses are incurred.

     In 1998, following the execution of our agreement with Chiron, Chiron assigned the clinical diagnostic portion of the agreement to Bayer. Under the terms of our collaboration with Bayer, we agreed to develop, manufacture and market NAT assays for viral targets and cancer markers in the clinical diagnostic market with Bayer. We record product sales of the assays to Bayer for use in clinical diagnostic applications at agreed upon transfer prices upon shipment to Bayer. The on-going arbitration proceeding relating to our collaboration with Bayer, as well as a lawsuit filed against Bayer in February of this year, is described under Item 1 (Note 9) of this report.

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

Royalty and license revenue

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

     In May 1997, we entered into a worldwide collaboration with bioMérieux Vitek, Inc. In August 2000, we entered into amended agreements with bioMérieux, Inc. that transitioned the relationship from a collaborative arrangement to a royalty-bearing arrangement that covers semi-automated probe assays and advanced, fully-automated probe assays for the diagnosis of infectious diseases and detection of food pathogens. Under the terms of the amended agreements, bioMérieux pays us royalties based on sales of products incorporating the licensed technologies, subject to a minimum annual royalty payment, which began in January 2002 with respect to

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the semi-automated probe assays and are scheduled to begin in 2006 with respect to the fully automated probe assays. In addition, we transferred to bioMérieux all information, trade secrets, procedures, methods, data and processes necessary for bioMérieux to assume development of the products that are the subject of the agreement in exchange for the prepaid royalties paid under the original agreement. We recognized $0.3 million and $0.2 million in minimum annual royalties during the three month periods ended March 31, 2004 and 2003, respectively, in connection with this license agreement.

     In December 2003, we entered into an agreement with Tosoh to cross-license intellectual property covering certain NAT technologies. The licenses, which are effective January 1, 2004, cover products in clinical diagnostics and other related fields. Under the agreement, Tosoh will receive non-exclusive rights to our proprietary Transcription-Mediated Amplification, or TMA, and rRNA technologies in exchange for two payments totaling $7.0 million, which was recognized as revenue in the three months ended March 31, 2004. Additionally, Tosoh will pay us royalties on worldwide sales of any future products that employ our technologies licensed by Tosoh. We will gain access, in exchange for royalties, to Tosoh’s patented Transcription Reverse-Transcription Concerted, or TRC, amplification and Intercalation Activating Fluorescence, or INAF, detection technologies for use with our real time TMA technology.

     Under the strategic alliance agreement we entered into with Chiron in June 1998, we have responsibility for research, development and manufacturing of the blood screening products covered by the agreement, while Chiron has responsibility for marketing, distribution and service of the blood screening products worldwide. During the three months ended March 31, 2004, the Company recognized as royalty and license revenue, a $6.5 million milestone payment, as the Company began clinical trial tests of the Procleix Ultrio assay on the TIGRIS instrument in the United States. Additional payments of up to $10.0 million are due to us in the future under the agreement if we achieve certain other specified milestones relating to the development of the TIGRIS instrument. There is no guarantee we will receive any additional milestone payments under this agreement.

Cost of product sales

     Cost of product sales includes direct material, direct labor, and manufacturing overhead associated with the production of inventory on a standard cost basis. Indirect cost elements, which include manufacturing variances, purchase price variances, and allowances for scrap, etc., are also included as a component of cost of product sales, as well as certain related expenses, such as royalties, warranty, and instrument amortization.

     In addition, we manufacture significant quantities of raw materials, development lots, and clinical trial lots of product prior to receiving FDA approval for commercial sale. During the three month periods ended March 31, 2004 and 2003, our manufacturing facilities produced development lots for WNV and Procleix Ultrio assays. The costs associated with these development lots are classified as research and development expense.

     During the three months ended March 31, 2004 and all of 2003, our blood screening manufacturing facility operated below its capacity and will continue to operate below its capacity for the foreseeable future. A portion of this available capacity was utilized for research and development activities, as new product offerings are being identified for commercialization. The costs associated with this excess capacity are included as a component of inventory and cost of product sales, except to the extent that available capacity was utilized in the production of pre-commercial development lots. Certain operating costs of our blood screening facility, together with other manufacturing costs for the production of assays that are delivered under the terms of an IND application are classified as research and development expense prior to FDA approval.

Research and development

     We continue to invest significantly in research and development as part of our ongoing efforts to accelerate the development of new products and technologies, particularly our TIGRIS instrument and our Procleix Ultrio and WNV assays for screening donated blood. Our research and development expenses consist of expenses associated with the development of proprietary products and instrument platforms, as well as expenses related to the co-development of new products and technologies in collaboration with our strategic partners. Research and development costs in total are expected to increase in the future due to new product development, clinical trial costs and clinical manufacturing costs; however, we expect our research and development expenses as a percentage of total revenues to decline in future years. The timing of clinical trials and development manufacturing costs is variable and is affected by product development activities and the regulatory process.

     In connection with our research and development efforts, we have various license agreements, which provide us with rights to develop and market products using certain technologies and patent rights maintained by third parties. These agreements generally provide for a term that commences upon execution of the agreement and continues until expiration of the last patent related to the technologies covered by the license.

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     Research and development costs include the costs of raw materials, development lots and clinical trial lots of products that we manufacture. These costs are dependent on the status of projects under development and may vary substantially between quarterly or annual reporting periods. During the remainder of 2004, we expect to incur additional incremental costs associated with the manufacture of developmental lots and clinical trial lots for our blood screening products and with the TIGRIS instrument. Collaborative research revenues, if any, associated with these types of incurred costs have typically been realized in a period later than when incurred.

Critical accounting policies and estimates

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

     We believe there have been no significant changes during the three months ended March 31, 2004 to the items that we disclosed as our critical accounting policies and estimates in Management’s Discussion and Analysis of Financial Condition and Results of Operations in our Annual Report on Form 10-K for the year ended December 31, 2003, except for the item(s) discussed below.

Capitalized software costs

     We capitalize costs incurred in the development of computer software related to products under development after establishment of technological feasibility. These capitalized costs are recorded at the lower of unamortized cost or net realizable value and will be amortized over the estimated life of the related product beginning when the product is available for sale. At March 31, 2004, capitalized software development costs related to our TIGRIS instrument totaled $25.1 million. We completed beta evaluations of this instrument for clinical diagnostic applications and undertook initial beta trials for blood screening applications in the third quarter of 2002 and we completed a clinical trial for a diagnostic application in June 2003. In December 2003, we received approval from the FDA for testing certain STDs on the TIGRIS instrument. We initiated clinical trials of our Procleix Ultrio assay on the TIGRIS instrument for a blood screening application in January 2004. If we are not able to successfully deliver this instrument to the marketplace and attain customer acceptance, the asset could be impaired and an adjustment to the carrying value of this asset would be considered by management at that time. In accordance with Statement of Financial Accounting Standards (“SFAS”) No. 86, “Accounting for the Costs of Computer Software to Be Sold, Leased, or Otherwise Marketed, we plan to begin amortizing the capitalized software costs on a straight-line basis over 120 months during the seco