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  • 10-K (Jan 6, 2011)

 
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Affymetrix 10-K 2006

 

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549


FORM 10-K

(Mark One)

x                               ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

FOR THE FISCAL YEAR ENDED DECEMBER 31, 2005

OR

o                                  TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 (NO FEE REQUIRED)

FOR THE TRANSITION PERIOD FROM              TO             

COMMISSION FILE NUMBER 0-28218


AFFYMETRIX, INC.

(Exact name of registrant as specified in its charter)

DELAWARE

 

77-0319159

(State or other jurisdiction of
incorporation or organization)

 

(IRS Employer
Identification Number)

3420 CENTRAL EXPRESSWAY
SANTA CLARA, CALIFORNIA

 

95051

(Address of principal executive offices)

 

(Zip Code)

 

(408) 731-5000

(Registrant’s telephone number, including area code)

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

None

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

Common Stock, $0.01

Preferred Stock Purchase Rights


Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes x  No o

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes o  No x

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 o

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or 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 if the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b(2) of the Exchange Act. (Check one).

Large accelerated filer x

 

Accelerated filer o

 

Non-accelerated filer o

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o  No ý

The aggregate market value of the registrant’s common stock held by non-affiliates of the registrant at June 30, 2005, based on the closing price of such stock on the Nasdaq National Market on such date, was approximately $1.44 billion. The number of shares of the registrant’s Common Stock, $0.01 par value, outstanding on March 2, 2006, was 67,398,440.

DOCUMENTS INCORPORATED BY REFERENCE

Certain sections of the Proxy Statement to be filed in connection with the 2006 Annual Meeting of Stockholders are incorporated by reference into Part III of this Form 10-K where indicated.

 




AFFYMETRIX, INC.

FORM 10-K
DECEMBER 31, 2005

TABLE OF CONTENTS

Item No.

 

 

 

Page

 

 

 

PART I

 

 

 

1.

 

Business

 

3

 

1A.

 

Risk Factors

 

24

 

1B.

 

Unresolved Staff Comments

 

34

 

2.

 

Properties

 

34

 

3.

 

Legal Proceedings

 

34

 

4.

 

Submission of Matters to a Vote of Security Holders

 

36

 

 

 

PART II

 

 

 

5.

 

Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Repurchases of Equity Securities

 

37

 

6.

 

Selected Financial Data

 

38

 

7.

 

Management’s Discussion and Analysis of Financial Condition and Results of Operations 

 

39

 

7A.

 

Quantitative and Qualitative Disclosures About Market Risk

 

54

 

8.

 

Financial Statements and Supplementary Data

 

56

 

9.

 

Changes in and Disagreements with Accountants on Accounting and Financial Disclosure 

 

95

 

9A.

 

Controls and Procedures

 

95

 

9B.

 

Other Information

 

97

 

 

 

PART III

 

 

 

10.

 

Directors and Executive Officers of the Registrant

 

97

 

11.

 

Executive Compensation

 

97

 

12.

 

Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters

 

97

 

13.

 

Certain Relationships and Related Transactions

 

97

 

14.

 

Principal Accounting Fees and Services

 

97

 

 

 

PART IV

 

 

 

15.

 

Exhibits and Financial Statement Schedules

 

98

 

 

 

Signatures

 

103

 

 

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PART I

ITEM 1.                BUSINESS

Forward-Looking Statements

All statements in this Annual Report on Form 10-K that are not historical are “forward-looking statements” within the meaning of the federal securities laws, including statements regarding our “expectations,” “beliefs,” “hopes,” “intentions,” “strategies” or the like. Such statements are based on our current expectations and are subject to a number of factors and uncertainties that could cause actual results to differ materially from those described in the forward-looking statements. We caution investors that there can be no assurance that actual results or business conditions will not differ materially from those projected or suggested in such forward-looking statements as a result of various factors, including, but not limited to, the risk factors discussed in “Risk Factors” contained in Item 1A of this report and elsewhere in this report. We expressly disclaim any obligation or undertaking to release publicly any updates or revisions to any forward-looking statements contained herein to reflect any change in our expectations with regard thereto or any change in events, conditions, or circumstances on which any such statements are based.

Narrative Description of Business

Overview

We are engaged in the development, manufacture, sale and service of consumables and systems for genetic analysis in the life sciences and clinical healthcare and are recognized as a market leader in creating breakthrough tools that are advancing our understanding of the molecular basis of life. The markets for our products currently include all aspects of molecular biology research in the life sciences, including basic human disease research, genetic analysis, pharmaceutical drug discovery and development, pharmacogenomics (research relating to how a person’s genes affect the body’s response to drug treatments), toxicogenomics (research relating to the measurement of gene expression as a predictor of toxicity) and molecular diagnostics. Additional markets are emerging in agricultural research, plant breeding, food testing, pathogen identification and consumer genetics. Our integrated GeneChip® microarray platform includes: disposable DNA probe arrays (chips) consisting of nucleic acid sequences set out in an ordered, high density pattern, certain reagents for use with the probe arrays, a scanner and other instruments used to process the probe arrays, and software to analyze and manage genomic or genetic information obtained from the probe arrays. Related microarray technology also offered by us includes licenses for fabricating, scanning, collecting and analyzing results from complementary technologies.

Our business strategy is to capitalize on our leadership position in the DNA microarray field by marketing our GeneChip® technologies to customers based on two central applications: gene expression monitoring and DNA variation detection. Due to the novel, massively parallel approach to studying biological systems that GeneChip® technology enables, numerous discoveries across many disciplines have already been made, as evidenced by the over 4,000 peer-reviewed publications released that have cited GeneChip® technology. The molecular diagnostic application of GeneChip® technologies for diagnosing and guiding treatment of disease is an emerging market opportunity in health management that seeks to improve the effectiveness of health care by collecting information about DNA variation and RNA expression in patients at various times from screening and diagnosis through prognosis and throughout therapeutic monitoring. We currently sell our products directly to pharmaceutical, biotechnology, agrichemical, diagnostics and consumer products companies as well as academic research centers, government research laboratories, private foundation laboratories and clinical reference laboratories in North America and Europe. We also sell our products through life science supply specialists acting as authorized distributors in Latin America, India, the Middle East and Asia Pacific regions, including China.

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In March 1992, Affymetrix, Inc. was incorporated in California as a wholly-owned subsidiary of Affymax N.V. (Affymax) and we have continued our business and operations as Affymetrix. We completed our initial public offering in June 1996 and in September 1998 we reincorporated as a Delaware corporation. Our headquarters and principal research and development facilities are located in Santa Clara, California, and we maintain facilities in West Sacramento, California (probe array manufacturing), Sunnyvale, California (sales, marketing, administration, and array research and development), Emeryville, California (bioinformatics and software development), South San Francisco, California (manufacturing and research and development), Bedford, Massachusetts (instrument development and manufacturing), and additional sales offices in the United Kingdom, Singapore and Japan.

Acquisition

On October 21, 2005, Affymetrix acquired 100% of the outstanding shares of ParAllele BioScience, Inc. (“ParAllele”), a provider of comprehensive genetic discovery solutions to the life science research, pharmaceutical and diagnostic sectors. ParAllele’s products and services utilize a unique approach that leverages novel biochemical processes rather than complex instrumentation to discover and analyze minute variations in the human genome. Affymetrix expects the acquisition to accelerate the development and commercialization of new products and create greater opportunities for market penetration and revenue generation as well as increase Affymetrix’ core assay development capabilities.

Scientific Background and Technology

Introduction to the Genome and its Opportunity

The genetic content of an organism is known as its “genome.” All known genomes are composed of either deoxyribonucleic acid (DNA) or ribonucleic acid (RNA). The instructions required for every living cell to develop its characteristic form and function are believed to be represented within discrete regions of the DNA or RNA known as genes. The instructions contained within genes are embodied in the specific sequences of the four nucleotide bases—adenine-A, cytosine-C, guanine-G and thymine-T (uracil-U replaces T in RNA)—that are the chemical building blocks of DNA and RNA. In protein coding genes, the sequence of these building blocks forms a code which instructs the cell to build a protein, comprised of a string of amino acids, ordered in a way which matches the sequence code of the gene. These proteins are an example of a “hard copy” output of the genetic code and contribute to the structure, biochemical functions and communication mechanisms of the cell in which they are formed.

The DNA molecule possesses a chemical structure which consists of a combination of two DNA strands with hydrogen bonds between nucleotide bases on one strand to complementary nucleotide bases on the other strand. Only certain pairs of the bases can form these complementary bonds: C pairs with G, and A pairs with T. Therefore, a single DNA strand containing bases in the sequence CGTACGGAT can form a bond with a DNA strand containing bases in the sequence GCATGCCTA. Such paired DNA strands are said to be “complementary” and can form a double helix structure in a process called “hybridization.” Our GeneChip® technology uses the principle of hybridization to recognize the presence of specific gene sequences and to analyze genetic information.

Genes are segments of DNA that serve as information packets of the genome. In general, a gene’s functional information is made available to a cell through the process of transcription or “gene expression,” whereby the sequence is copied into an RNA molecule. Protein coding genes may span thousands to hundreds of thousands, or even millions, of nucleotide bases since the non-coding regions of a gene (called “introns”) and the coding regions of a gene (called “exons”) are usually distributed within neighboring genomic sequences that are not translated into proteins or used, or to the extent currently understood, as a functional part of the gene. The number of distinct protein coding genes in the human genome is estimated to be between 25,000 to 30,000. The number of functional non-coding sequences is the focus of current research interest. Though currently unknown, the number of functional non-coding

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sequences is estimated to be significantly larger than the number of protein coding genes in the human genome.

A primary goal in life sciences research and modern molecular medicine is to unravel the complexities of the genome. This has generated a worldwide effort to identify and sequence the genomes of many organisms. In the human genome, this effort includes more than three billion nucleotide pairs. In recent years, the effort led by the Human Genome Project and related academic, government and industry research projects resulted in a first near complete draft of the human genome sequence. It is anticipated that many years of research will be required to gain a better understanding of the complexities of the genome, and its characteristics in normal and diseased conditions. We believe that this will lead to a new healthcare paradigm where disease is understood at the molecular level, allowing patients to be diagnosed according to genetic information and then treated with drugs designed to work on specific molecular targets. Ultimately, in addition to diagnosis and treatment, prevention and cure of disease might also be possible based on genetic information.

While scientists are learning more and more about the functions of genes and their variability, there is a great deal more to discover. We believe that the efforts of science to understand the complexities of gene expression, the interaction of genes with our environment and the role of genes in disease and health will continue to provide growth opportunities for our existing gene expression and DNA analysis products, and will continue to create new opportunities in clinical medicine. Toward this end we have partnered with the National Cancer Institute to assemble the first complete map of the human transcriptome (a catalog of all of the RNA transcripts made by the genome). This ongoing effort has already led to the discovery of many novel protein coding and non-protein coding sequences that we expect to include in future products. This effort is also prompting continued development of our sample preparation, array, instrumentation and data analysis technologies.

Genetic Variability and Disease

For the most part, each cell in a complex organism contains a complete copy of the genome. In a population of organisms, individuals vary from one another because of differences in gene sequences which are inherited from each parent and sometimes through the introduction of sequence changes due to environmental damage or biological errors in processes like gene replication. In some cases these variations, or polymorphisms, have little detectable effect on the biology of the organism, while in other cases they may result in an altered biological response to the environment which could thereby lead to disease. By screening for these polymorphisms, researchers seek to identify those that might be implicated in specific diseases. Sometimes it is not a single variation, but the combination of these sequence differences that leads to a diseased state. For this reason, researchers look at the patterns of these polymorphisms in a large number of healthy and affected organisms in order to correlate specific gene polymorphisms with specific diseases.

Another major mechanism by which the fate and function of cells is regulated is the timing and level of gene expression, which can reflect the interface between genes and the environment. Although most cells contain an organism’s full set of genes, each cell expresses only a fraction of this set of genes in different quantities and at different times. The expression patterns of genes can be correlated with many human diseases such as cancer, as well as with the effectiveness of treatment in specific patient populations for which new therapies can be developed. By identifying genes that are differentially expressed in particular diseases or patient populations, novel molecular targets and treatments may be identified and validated. In addition, gene expression signatures may be identified that allow the selection of optimal treatment for a single individual.

In order to understand the impact of genomics on health, disease and other aspects of the human condition, scientists must compare both the sequence variation and the gene expression patterns of healthy and diseased individuals, tissues and cells. We believe that our GeneChip® platform not only enables

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scientists to attain ambitious goals, from identifying genetic variations associated with disease to discovering new drug targets, but also simplifies, accelerates and reduces the cost of understanding this genetic information.

GeneChip® Probe Array Technology

Our GeneChip® technology leverages semiconductor-based photolithographic fabrication techniques, which enables us to synthesize a large variety of predetermined DNA sequences simultaneously in predetermined locations on a small glass chip called a “probe array.” Photolithography is a technique which uses light to create exposure patterns on the glass chip and direct chemical reactions. The process begins by coating the chip with light-sensitive chemical compounds that prevent chemical coupling. These light-sensitive compounds are called “protecting groups.” Lithographic masks, which consist of predetermined transparent patterns etched into a glass plate that either block or transmit light, are used to selectively illuminate the glass surface of the chip. Only those areas exposed to light are deprotected, and thus activated for chemical coupling through removal of the light-sensitive protecting groups. The entire surface is then flooded with a solution containing the first in a series of DNA building blocks (A, C, G or T). Coupling only occurs in those regions that have been deprotected through illumination. The new DNA building block also bears a light-sensitive protecting group so that the cycle can be repeated.

This process of exposure to light and subsequent chemical coupling can be repeated many times on the same chip in order to generate a complex array of DNA sequences of defined length. The intricate illumination patterns allow us to build high-density arrays of many diverse DNA sequences in a small area. Unlike conventional synthesis techniques, which generally use a linear process to create compounds, our synthesis technique is combinatorial, in that the number of different compounds synthesized grows exponentially with the number of cycles in the synthesis. Currently available commercial arrays contain over 6.0 million unique sequences. Each unique sequence is 25 nucleotides in length and is represented millions of times within a specified area of the probe array. Just as in the semiconductor industry, we manufacture probe arrays in a wafer format. Each wafer is approximately five inches square and can contain over 300 million unique probe sequences based on current technology. Whole wafers have been used by a related party of Affymetrix, Perlegen Sciences, Inc., in its work to resequence multiple samples of the human genome. For our commercial array products, we can manufacture a large number of identical or different DNA probe arrays on a glass wafer, which is then diced into individual chips. Given the large amount of unique sequences represented in our probe arrays, our technology enables the efficient analysis of a multitude of DNA probes to analyze DNA or RNA sequences in a test sample.

In the semiconductor industry, the principle that the number of transistors in a semiconductor chip doubles every 18 months based on feature shrink, or increased resolution, is known as Moore’s Law. Because we leverage photolithographic manufacturing processes adapted from the semiconductor industry, we have also been able to continually “shrink” the size of features, or oligonucleotide probes of a given sequence, on our GeneChip® arrays. Our first commercial GeneChip® products, which we shipped in 1994, had a feature size of 100 microns and by 2005, we introduced our Human Exon Array product with a 5 micron feature size. We have thus been able to increase the amount of genetic information packaged onto our GeneChip® arrays by nearly 400 times since the introduction of our first products.

Because we manufacture our chips in wafer format, we can vary the number of chips manufactured per wafer. We can therefore manufacture thousands of chips per wafer with low information content and lower cost of goods sold or decrease the number of chips per wafer and increase the information content. We expect that we will continue to benefit from this manufacturing leverage as our technology development activities enable further feature shrink. We believe that our unique manufacturing process is a significant competitive advantage.

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Products

Overview

Our products form an integral part of our GeneChip® system that is designed for use by pharmaceutical, biotechnology, agrichemical, diagnostics and consumer products companies, as well as academic research centers, private government research foundations and clinical reference laboratories. The GeneChip® system consists of several integrated components: disposable probe arrays containing genetic information on a chip, reagents for extracting, amplifying and labeling target nucleic acids, a fluidics station for introducing the test sample to the probe arrays, a hybridization oven for optimizing the binding of samples to the probe arrays, a scanner to read the fluorescent image from the probe arrays, and software to analyze and manage the resulting genetic information. The function of each single-stranded sequence on the GeneChip® probe array is to bind to its complementary single strand of DNA or RNA from a biological sample. Each unique sequence feature on the GeneChip® probe array contains multiple copies of the same single strand of DNA. The nucleic acid (DNA or RNA) to be tested is isolated from a sample, such as blood or biopsy tissue, amplified and fluorescently labeled by one of several standard biochemical methods. The test sample is then washed over the probe array, where the now labeled individual nucleic acid sequences that represent the genetic content or expressed genes of the sample hybridize to their complementary sequences bound on the array. When scanned by a laser, which is part of the scanner instrument, the test sample generates a fluorescent signal. The locations where a fluorescent signal is detected by an optical detection system on the scanner instrument correspond to sequences complementary to the test sample. Sequence variation, or the quantification of specific sequences of nucleic acids in the sample, can be determined by detecting the relative strength of these signals since the sequence and position of each complementary DNA probe on the probe array is known. The combination of a particular GeneChip® probe array, together with an optimized set of reagents and a user protocol describing how to carry out the procedure, is referred to as an “assay.”

We currently market products for two principal applications: monitoring of gene expression levels and investigation of genetic variation (DNA analysis including single nucleotide polymorphism (SNP) genotype analysis and resequencing). Our GeneChip® expression monitoring arrays enable our customers to qualitatively and quantitatively measure gene expression levels in a number of biologically relevant organisms. Our catalog GeneChip® expression arrays are available for the study of human, rat, mouse and a broad range of other mammalian and model organisms. Additionally, we market CustomExpress™, CustomSeq™ and NimbleExpress™ products which enable our customers to design their own custom GeneChip® expression arrays or sequence arrays for organisms of interest to them. Our GeneChip® DNA analysis arrays and variant detection systems are available to enable researchers to perform high throughput polymorphism analysis and to carry out large scale resequencing (comparing the DNA sequence of multiple samples against a known reference sequence, e.g. the published human genome sequence). With its unique, parallel analysis capability, GeneChip® technology enables our customers to perform accurate and cost-effective genetic analysis, using minute amounts of sample DNA, in their own laboratories on a scale that was previously only possible in specialist high throughput centers.

In addition, we believe that genetic analysis and testing products will be a core component in the area of clinical research and molecular diagnostic applications and we are developing our GeneChip® system for clinical research and diagnostic analysis of both gene expression and DNA analysis. Together with our collaborative partners, we are focusing on the development and commercialization of diagnostic products in cancer, osteoporosis, cardiovascular, inflammatory, metabolic, infectious and other diseases, and believe that our GeneChip® assays will facilitate more efficient and effective disease detection, prognosis and treatment selection, leading to overall improved patient management. To further our clinical research and molecular diagnostics strategy, we have established partnerships and customer relationships with leading academic researchers, pharmaceutical and biotechnology companies, including F. Hoffmann-La Roche Ltd. (“Roche”), bioMérieux, Inc. (“bioMérieux”), and Veridex, LLC, a Johnson & Johnson

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company (“Veridex”). We believe that the rapid growth of the clinical research and the diagnostic devices markets holds the potential for GeneChip® technology applications ranging from basic research to clinical trials and, ultimately, diagnostic devices. As a result we are working with leaders in molecular diagnostics to provide custom made GeneChip® probe arrays to their specifications. Our partners subsequently package the chips into kits, seek regulatory approval for their diagnostic use, and sell them into the diagnostic markets using their sales channels. We are leveraging our partners’ strengths in research, development, regulatory practices and distribution while leveraging our strengths in array technology. These products are marketed as being Powered by Affymetrix™.

Gene Expression Monitoring Arrays

Gene expression monitoring is a valuable tool for identifying correlations between genes, determining their biological functions and identifying patterns that might be useful in classifying diseases. To monitor gene expression, we design and manufacture probe arrays with single-stranded DNA molecules that are complementary to sequences within genes of interest. By synthesizing specific probes for multiple genes on a single probe array, we enable researchers to quickly, quantitatively and simultaneously monitor the expression of a large number of genes of interest. By monitoring the expression of such genes under different conditions and at different times, researchers can use the probe arrays to understand the dynamic relationship between gene expression and biological activity. We believe such information will be an important tool in understanding gene function and for the development of new drugs and diagnostic tools. Increasingly, clinical research is showing that gene expression patterns in tissue samples, particularly those from cancerous tissues, can be used to characterize disease sub-types and hopefully to predict therapeutic responses and likely outcomes.

The range of GeneChip® Expression products is described below:

·       Standard Expression Monitoring Arrays.   We are currently selling a portfolio of standard expression monitoring GeneChip® arrays. Our current offering of standard arrays includes products that monitor the expression of the majority of full-length and partial gene sequences contained in publicly available sequence databases, which correspond with human, mouse, rat, canine, Drosophila melanogaster (fruit fly), Caenorhabditis elegans (nematode), Xenopus laevis (frog), Danio rario (zebrafish), Saccharomyces cerevisiae (yeast), Escherichia coli (bacteria), Pseudomonas aeruginosa (bacteria), Plasmodium falciparum (malarial parasite), Anopheles (mosquito vector of malaria), Arabidopsis thaliana (mustard plant, a common model organism for plants), bovine (cow), chicken, maize (corn), medicago (alfalfa), poplar (tree), porcine (pig), Rhesus macaque (monkey), rice, soy, sugar cane, tomato, Vitis vinifera (wine grapes) and citrus arrays.

·       GeneChip® Exon Arrays.   We are now offering exon arrays that interrogate the expression of individual exons, the building blocks that make up a transcript. It is well known that alternative utilization of different exons from the same gene (known as alternative splicing) leads to the generation of various protein products, leading to diverse functional consequences. In addition, mis-regulation of splicing has been associated with many different diseases including cancer and diabetes. The exon array is the first experimental tool to discover new splicing events on a genome-wide scale to help researchers better understand disease mechanisms which can lead to the design of novel therapies for treatment and more informative diagnostic signatures.

·       Whole Genome Tiling Arrays.   We offer tiling arrays for the genomes of a number of major organisms including human, mouse, drosophila, C.elegans and yeast. These designs use evenly spaced probes across the non-repetitive portion of the genome and rely only on genomic DNA sequence and not functional annotation for their design. The arrays are used for mapping the entire collection of transcribed elements (including non-coding RNAs that are used for structural and regulatory purposes), identifying protein binding and methylation sites and identification of genomic origins of replication.

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·       Custom Express Arrays.   We have established a GeneChip® CustomExpress™ Array Program enabling customers to design affordable arrays tailored to their specific research needs. Our CustomExpress™ arrays enable customers to select probes from any of our probe sequences on our catalog arrays and/or to incorporate probes from their own proprietary gene sequences. These arrays are then produced utilizing the same manufacturing technologies as our other GeneChip® whole genome expression arrays.

·       Made-to-Order Arrays.   We offer the GeneChip® Made-to-Order Array Program to enable our customers to use arrays from selected custom designs and previous-generation GeneChip® arrays which are no longer available as catalog products.

DNA Analysis Arrays

As genes and regulatory regions in the human genome are mapped, identified, and sequenced, the value of understanding the variability of sequences among individuals increases. Researchers seek to determine the normal sequence of the gene, which mutations or polymorphisms exist in a population, and whether these variations correlate with a disease or other aspect of the human condition. Studies of the genetics of complex diseases have historically been challenging due to high costs of sequencing or genotyping of large numbers of affected and unaffected individuals. Genetic variation also impacts how individuals respond to therapeutics. The study of these effects is known as pharmacogenetics. This is part of the broader field of pharmacogenomics, which seeks to understand how the overall composition and expression of the genome affects therapeutic response, drug efficacy and the incidence of adverse side effects to therapy. We believe pharmacogenomics will become increasingly important both in clinical drug trials and patient care. By using our resequencing and genotyping technologies, we believe that our GeneChip® probe arrays could significantly reduce the cost and time required for high-volume polymorphism analysis, which is currently performed through more labor-intensive techniques.

We have initiated product research and development efforts on several genetic analysis probe arrays and variant detection analysis systems and formed collaborations to accelerate the development of our genotyping products. For additional information concerning these efforts and collaborations see the sections of this Form 10-K entitled “Research and Development” and “Our Collaborative Partners.” We currently market the following DNA analysis products:

·       GeneChip® Human Mapping 500K Set.   The Mapping 500K Set is our newest whole genome genotyping product and the third in a family of products for large scale genome-wide genotyping using a simple, scalable, one-primer assay. The 500K Set genotypes over 500,000 SNPs on a two array set. The 500K Set is enabling novel genetic experiments (called genome-wide association studies) to understand the genes involved in complex disease and drug response using real-world disease populations. Researchers have for many years sought to study major diseases in unrelated populations, but the information density (hundreds of thousands of markers) and experiment size (hundreds or thousands of samples) made these experiments unaffordable. The 500K Set is the first and market leading product in making large scale whole genome analysis cost effective.

·       GeneChip® Human Mapping 100K Set and 10K Array.   We offer two other products based on the same scalable one primer assay as our 500K product: the 100K Set and the 10K Array. The 100K Set genotypes over 100,000 SNPs on a two array set and the 10K Array genotypes over 10,000 SNPs on a single array. The 100K Set was the first product to enable genome-wide association studies and is also used for chromosomal copy number analysis. The 10K Array is used primarily for linkage analysis, the study of the inheritance of disease in families.

·       Targeted Genotyping Products.   We offer a variety of targeted genotyping products for the analysis of between 1,500 and 20,000 SNPs per sample, using a highly multiplexed assay for use with GeneChip® Universal Tag Arrays. This innovative assay enables customers to genotype selected

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SNPs in a single assay with only one primer per SNP. We offer the widest variety of standard panels of pre-selected SNPs for major diseases (e.g., inflammatory disease), model organisms (e.g., mouse), and specific applications (e.g., drug metabolizing enzymes), as well as custom capabilities that offer customers the highest conversion rates to genotype more of the SNPs they want.

The assay described above and the products offered through this product line represent the technology and products acquired through the ParAllele acquisition described elsewhere in this report.

·       GeneChip® CustomSeq™ Resequencing Arrays.   Version 2 of this product line was released in 2005, increasing sequence content per array by tenfold. The CustomSeq™ sequence variation product line now enables customers to sequence up to 300,000 bases on one array in just two days with high accuracy. CustomSeq™ arrays offer researchers a powerful complementary tool to our whole genome genotyping and whole genome expression products on the same industry-standard GeneChip® platform, and are currently being used in a wide variety of applications ranging from infectious disease research to detailed sequence analysis following up association studies to full mitochondrial genome sequencing.

DNA Analysis Products Powered by Affymetrix™

·       Roche AmpliChip™ CYP450.   The Powered by Affymetrix™ program and collaboration with Roche announced in January 2003 resulted in the June 2003 release of the Roche AmpliChip™ CYP450 microarray. The AmpliChip CYP450 microarray allows for complex sequence information to be analyzed for the purpose of genotyping the CYP2D6 and CYP2C19 genes. Sequence variation in these genes can result in marked differences in the way individuals metabolize, and hence respond to, an estimated 25% of all drugs. In late 2004, Roche obtained in-vitro diagnostic status for the product in the United States and Europe.

Access Programs for Our GeneChip® Arrays

We offer a variety of sales programs for our gene expression monitoring and DNA analysis arrays, tailored to the needs of industrial, biotech and academic/government customers. These programs are tied to volume usage and customers can select a program that best meets their needs to receive favorable pricing per array.

Reagents for Our GeneChip® Systems

Our GeneChip® reagent kits contain validated reagents critical for the success of expression monitoring and DNA analysis experiments. The 2005 additions to the Affymetrix GeneChip® reagent family are listed below:

Whole Transcript Reagents.   With the launch of the GeneChip® Whole Transcript (WT) Sense Target Labeling Assay, we introduced: GeneChip® WT Terminal Labeling Kit and GeneChip® WT cDNA Synthesis and Amplification Kit, each available in 10 or 30 reactions.

Array Station Reagents.   We introduced two new GeneChip® reagent kits developed and optimized specifically for target preparation on the GeneChip® Array Station: GeneChip® HT One-Cycle cDNA synthesis Kit and GeneChip® HT IVT Labeling Kit in 96 reactions.

Mapping 500K Reagents.   With the launch of the GeneChip® Human Mapping 500K Array Set, we introduced the GeneChip® Mapping 250K Sty Assay Kit and the GeneChip® Mapping 250K Nsp Assay Kit, each available in 30 or 100 reactions.

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Hybridization Wash and Stain Reagents.   In December 2005 we introduced the GeneChip® Hybridization Wash and Stain Kit which contains reagents formulated into the fewest number of individual components possible.

For our expression probe arrays, we offer the following reagents: One-Cycle cDNA Synthesis Kit, Two-Cycle cDNA Synthesis Kit, GeneChip® Expression 3’-Amplification Reagents for IVT Labeling, GeneChip® Sample Cleanup Module, GeneChip® IVT cRNA Clean up Kit, T7-Oligo(dT) Promoter Primer Kit, Eukaryotic Poly-A RNA Control Kit and Eukaryotic Hybridization Control Kit, GeneChip® WT Terminal Labeling Kit, GeneChip® WT cDNA Synthesis and Amplification Kit, GeneChip® HT One-Cycle cDNA synthesis Kit, GeneChip® HT IVT Labeling Kit, and the GeneChip® Hybridization Wash and Stain Kit.

For our DNA analysis arrays, we offer the following reagents: GeneChip® Resequencing Assay Kit, GeneChip® Mapping 10K Xba Assay Kit, GeneChip® Mapping 50K Xba Assay Kit, GeneChip® Mapping 50K Hind Assay Kit, GeneChip® Mapping 250K Sty Assay Kit and the GeneChip® Mapping 250K Nsp Assay Kit.

Instruments for Our GeneChip® Systems

Our GeneChip® instruments provide a fully integrated system for conducting research using GeneChip® probe arrays. The instrument system consists of four hardware devices, each providing for robust preparation and analysis of samples using GeneChip® arrays. The first device is a hybridization oven to control the timing and temperature required for hybridization of the test sample to the probe array. The second device is a fluidics station that controls exposure of the probe array to solutions containing prepared sample and labeled detection reagents across the probe array. The fluidics station can process four probe arrays simultaneously. The fluidics station protocols conclude with a reagent wash that leaves the labeled, hybridized test sample bound to the probe array.

The third device, a laser scanner, is used after completion of protocols on the fluidics and hybridization stations, at which time the cartridge containing the probe array is placed in the scanner and read. The scanner consists of a laser, high-resolution optics, robotics to position and scan the probe array, a fluorescence detector and an interface to a computer workstation. The labeled material that is bound to the hybridized test sample emits fluorescent signals when exposed to the light from the laser. The locations and intensities of the fluorescent signals are recorded by the scanner and stored in the computer for analysis. The fourth device is an autoloader, which is a 48-array carousel that interfaces with the scanner to allow walk-away automation of the scanning steps, while maintaining the loaded arrays at the optimum storage temperature.

The individual components of our GeneChip® instrument system are described in more detail below.

·       GeneChip® Hybridization Oven 640.   The GeneChip® Hybridization Oven 640 is used to control the timing and temperature required for hybridization of the test sample to the probe array. The GeneChip® Hybridization Oven 640 holds up to eight probe array cartridge carriers (each with eight cartridge slots) that rotate for controlled hybridization of up to 64 probe arrays. This unit delivers temperature control for consistent performance across all probe array applications.

·       Fluidics Station 450.   The Fluidics Station 450 is used to control exposure of the probe array to solutions containing prepared sample and labeled detection reagents across the probe array and can independently process four probe arrays simultaneously. The fluidics station protocols conclude with a reagent wash that leaves the labeled, hybridized test sample bound to the probe array. Multiple fluidics stations can be connected to the same computer workstation in order to expedite array processing in high throughput laboratories.

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·       GeneChip® Scanner 3000.   The GeneChip® Scanner 3000 uses proprietary laser scanning technology and high resolution optics to read the fluorescent signal from GeneChip® arrays. The GeneChip® Scanner 3000, developed and manufactured by Affymetrix, represents the next generation in scanner technology. The Flying Objective™ scanning technology incorporated into this scanner has been adapted to provide faster scanning of GeneChip® probe arrays with a high degree of image uniformity and accuracy. The current version of the GeneChip® Scanner 3000 has been validated to allow imaging of GeneChip® arrays with feature sizes as small as 5 microns and can support multicolor assays. The GeneChip® Scanner 3000 is purchased with a computer workstation loaded with Affymetrix GeneChip® Operating Software (“GCOS”) (discussed below under “Software for Our GeneChip® Systems and Analysis Tools”).

·       GeneChip® AutoLoader.   The GeneChip® AutoLoader, developed and manufactured by Affymetrix, is a 48-array carousel that automatically loads and unloads arrays from the scanner, helping researchers automate their array processing and providing walk-away use in the lab. The GeneChip® Scanner with AutoLoader can load and scan 48 current catalog arrays in 28 hours or less, depending on the feature size and array format that is scanned. Thermostatic control allows the stored arrays to be held in a cooled environment and then warmed to optimum temperature for scanning. The AutoLoader attaches to the top of the scanner, saving valuable bench space, and does not require any additional power source.

·       Workstations.   We offer workstations to accommodate varied research needs. The Type I GeneChip® Workstation (Windows NT) is configured with system software enabling it to operate the GeneChip® Scanner 3000 and multiple Fluidics Stations. Our Type II GeneChip® Workstation (Windows NT and Windows 2000) can operate independently of the scanner and fluidics station instruments.

·       GeneChip® Array Station.   Through our collaboration with Caliper Life Sciences, Inc., we launched the Affymetrix GeneChip® Array Station that has the capacity to process hundreds of biological samples per week with minimal human supervision, reducing operating costs and variability in target preparation in 2005. The GeneChip® Array Station is designed to perform target preparation for both cartridges and array plates as well as perform the wash and stain function for the array plates. The GeneChip® Array Station adapts the same industry-standard GeneChip® technology to a standard 96-well microtiter plate, and runs on an automated system built with off-the-shelf robotic components. In addition, we launched the GeneChip® HT Scanner that utilizes CCD based technology for imaging of the new array plates. The GeneChip® Array Station automates the most labor intensive steps in GeneChip® probe array processing, dramatically reducing the cost per assay. The decrease in cost and increase in throughput makes the GeneChip® Array Station well suited for downstream development applications such as compound profiling, molecular toxicology and clinical trials.

Software for Our GeneChip® Systems and Analysis Tools

Our “GCOS” software is supplied as part of an integrated system and runs on an industry standard PC platform. The fluorescence intensity data captured from the scanner are used in conjunction with computer files containing the probe sequence and location of all the probes on the probe array to determine the expression level of a particular gene or to identify particular DNA sequence variations of the test sample.

Our Data Mining Tool® and GeneChip® Operating Software Server (“GCOS Server”) software products allow for sophisticated analyses of gene expression results and provide a means of linking and integrating this information with other databases.

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Customers may choose operating or other software products provided by third party vendors that have been developed through our OpenSystems™ program, which includes the provision of a Software Developer’s Kit to interested commercial and academic parties. Through this program we intend to stimulate a wide range of independent groups to develop tools for use with our platform, further enhancing our customers’ capability to generate unique biological insights from the high quality data provided by the GeneChip® platform.

Finally, our NetAffx™ Analysis Center (www.affymetrix.com/analysis/) is our exclusive online informatics resource for our customers and provides streamlined, open access to design information and biological annotations associated with our GeneChip® arrays. It was created to assist genomic researchers with the design and analysis of DNA array based experiments. NetAffx™ offers researchers a searchable catalog of Affymetrix GeneChip® probe array content, a range of publicly available and Affymetrix generated databases, and links to important third party resources.

Instruments for Use in Molecular Diagnostics

The GeneChip® System 3000Dx (GCS3000Dx) is configured especially for the molecular diagnostic market. In September 2004, the GCS3000Dx received Conformite Europeene (CE) certification, clearing it for use as an in-vitro diagnostic (IVD) product in the European Union. In December 2004, the GCS3000Dx was also cleared by the United States Food and Drug Administration (FDA) as an IVD to be used in conjunction with the Roche Diagnostics AmpliChip™ CYP450 Test. The AmpliChip™ CYP450 Test also received CE certification and FDA clearance in 2004 making it the first Powered by Affymetrix™ IVD test. This test, which utilizes an Affymetrix microarray produced specifically for Roche Diagnostics, analyzes a patient’s Cytochrome P450 2D6 and 2C19 genotypes to look for variations that can influence drug metabolism. The GCS3000Dx will support all Powered by Affymetrix™ molecular diagnostic tests. The system includes the GCS3000Dx Scanner with Autoloader Dx, FS450Dx Fluidics Station, and Workstation with GCOS Dx software.

We believe that our GeneChip® technology can be effectively applied to complex molecular diagnostic testing. We have formed collaborations and intend to further partner with, or license technology to, established diagnostic and medical device companies to develop, obtain regulatory approval for, and commercialize probe arrays and instrumentation. We anticipate broader use of probe arrays as components of diagnostic products and clinical research applications. We believe that to support large central laboratories, additional instrumentation and automation will need to be developed to allow for handling the large volume testing of the clinical diagnostic setting. To further our molecular diagnostics strategy, we have established a number of collaborations with leading academic researchers, diagnostic companies, pharmaceutical and biotechnology companies.

For example, we are non-exclusively collaborating with Roche to develop and commercialize GeneChip® diagnostic tests for DNA analysis, genotyping and resequencing applications, as well as for RNA expression analysis, in a broad range of human disease areas. Using our GeneChip®technologies, Roche intends to develop and market diagnostic tests for diseases such as cancer and osteoporosis and cardiovascular, metabolic, infectious and inflammatory diseases.

In oncology, we are non-exclusively collaborating with Veridex, a Johnson & Johnson company, to develop and commercialize GeneChip® diagnostic tests for oncology. Using our GeneChip® technologies, Veridex intends to develop and market tests for cancer.

We have a non-exclusive collaborative development agreement and an associated supply agreement for probe arrays with bioMérieux, Inc. in breast cancer and in bacteriology to identify the species and drug resistance profiles of those bacteria causing human infection. The agreements also allow for non-exclusive development of DNA probe arrays for certain diagnostic viral tests and for the fields of food and industrial testing.

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We have also entered into non-exclusive collaborative development and associated supply agreement with a number of other smaller companies in focused areas of cancer and certain other diseases.

We and our Powered by Affymetrix™ partners believe that developing diagnostic products for cancer and other human diseases will establish new standards for molecular diagnostic testing. Ultimately, these products will allow physicians to better diagnose and treat human disease.

We have also entered into a series of agreements with Beckman Coulter that give it the right to develop probe array-based diagnostic products using some elements of our GeneChip® technology. Under these agreements, we have also agreed to grant Beckman Coulter licenses to commercialize probe arrays manufactured using certain of our technologies other than light-directed synthesis. Under the arrangement, Beckman Coulter would pay us transfer prices and royalties on sales of these products.

For additional information concerning our collaborations, see the section of this Form 10-K entitled “Our Collaborative Partners.”

Our Collaborative Partners

Our strategy is to establish the GeneChip® system as the platform of choice for analyzing complex genetic information, to expand the applications of our technology and to acquire access to complementary technologies and resources. Accordingly, we have entered into and intend to enter into additional collaborative agreements to further this strategy. The information below is a selected listing of collaborators with whom we have current agreements, together with the related products and programs and the commencement dates of the most recent agreement with each. The section is organized by reference to the product area that represents the most significant portion of the collaboration; however, the collaboration may also involve other areas of our business and product line.

Gene Expression Monitoring

Qiagen, GmbH.   In February 2002, we entered into a three-year supply agreement with Qiagen, GmbH (“Qiagen”) for Qiagen to supply us with certain nucleic acid purification products for use with our GeneChip® arrays for target labeling in expression analysis and have collaboration and co-marketing agreements in place that support the complementary use of Qiagen’s sample prep instrumentation and reagents with Affymetrix GeneChip® arrays. The term of this supply agreement has been extended for an additional two-year period.

PreAnalytiX GmbH.   In October 2003, we entered into a collaborative agreement with PreAnalytiX GmbH, a joint venture between QIAGEN N.V. and Becton, Dickinson and Company. The goal of the collaboration will be to develop improved methods for the use of PreAnalytiX technology with GeneChip® expression analysis arrays. By combining PreAnalytiX and Affymetrix technologies, our goal is to develop a complete, standardized process for expression profiling starting from whole blood samples.

Invitrogen Corporation.   In November 2003 we signed a collaboration and supply agreement to develop and market a new line of GeneChip® brand expression reagents including two new cDNA Synthesis Kits. Both of the new cDNA Synthesis Kits were developed in collaboration with Invitrogen and contain Invitrogen’s industry-leading SuperScript™ reverse transcriptase (RT). These reagents have been optimized for use with Affymetrix GeneChip® technology, offering a complete, standardized sample preparation system that is easier to use and will help customers produce more robust and consistent array results. The One-Cycle cDNA Synthesis Kit offers all necessary reagents for standard target labeling. This protocol has been used by the majority of Affymetrix customers already, but the new kit provides improved configuration and greater convenience. The new Two-Cycle cDNA Synthesis Kit offers customers a streamlined procedure for preparing samples using a small amount of material, such as biopsy or laser capture dissected samples.

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DNA Analysis

Perlegen Sciences, Inc.   In March 2001, we contributed to Perlegen the rights to use certain intellectual property with no cost basis and received from Perlegen the rights to use and commercialize certain data generated by Perlegen in the array field. Using access to whole-wafer technology developed by Affymetrix, Perlegen focuses on identifying the millions of genetic variations (known as single nucleotide polymorphisms or “SNPs”) among individuals, and finding patterns in those variations that might be predictive of disease susceptibility or drug response. In January 2003, we obtained accelerated access to Perlegen’s SNP database which was used to help develop our Mapping 500K Array Set and will also be used in future products. In addition, our collaborative arrangement with Perlegen provides us with access and commercialization rights to certain whole genome technologies, including 248,000 chip-optimized assays covering the genome that we intend to make available to our customers for use in resequencing and genotyping. For additional information concerning our relationship with Perlegen, including our ownership interest in Perlegen, our collaborative relationship with Perlegen and existing relationships between certain of our directors and officers and Perlegen, see the section of this Form 10-K entitled “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and Note 11 to our Consolidated Financial Statements.

Molecular Diagnostics

bioMérieux, Inc.   In September 1996, we entered into a collaborative development agreement and associated supply agreement for probe arrays with bioMérieux, Inc. (“bioMérieux”) to identify the species and drug resistance profiles of bacteria causing human infection. As part of the collaboration, bioMérieux is developing instrumentation for the use of these probe arrays in a molecular diagnostic setting. Under the terms of the agreements, bioMérieux provides research and development support and makes payments to us upon achievement of certain milestones. In addition, bioMérieux pays specified prices for the supply of probe arrays and royalties on any resulting product sales. In December 1997 and January 1998, we expanded the collaboration with bioMérieux to include the non-exclusive development of DNA probe arrays for molecular diagnostic tests in the fields of virology and food and industrial testing. In March 2003, the collaboration agreement was amended in order to reinstate bioMérieux’s licenses and in March 2005, the collaboration was further expanded to include breast cancer. bioMérieux has launched the FoodExpertID array under this collaboration. For additional information, see the section of this 10-K entitled “DNA Analysis Products Powered by Affymetrix™.”

F. Hoffmann-La Roche Ltd.   In February 1998, we entered into a non-exclusive collaborative development agreement with F. Hoffmann-La Roche Ltd. (“Roche”) to initially develop human probe array-based diagnostic products. Under the terms of the agreement the parties are collaborating to develop mutually agreed upon arrays, as well as associated instrumentation and reagents. In January 2003, we expanded our collaboration with Roche by granting Roche access to our GeneChip® technologies to develop and commercialize GeneChip® diagnostic laboratory tests for DNA analysis, genotyping and resequencing applications, as well as for RNA expression analysis, in a broad range of human disease areas. Using our GeneChip® technologies, Roche intends to develop and market diagnostic tests for diseases such as cancer and osteoporosis and cardiovascular, metabolic, infectious and inflammatory diseases. Affymetrix and Roche believe that developing targeted microarray expression profiles for cancer, plus genotyping and resequencing profiles for other diseases will enable the creation and commercialization of novel standardized diagnostic solutions. These solutions ultimately will allow physicians to better diagnose and treat human disease. Under the terms of the collaborative agreement, Roche paid us an access fee of $70 million relating to the first five years of the arrangement. The agreement, which is subject to Roche’s option to terminate on December 31, 2007, or any time on or after June 2, 2013 with one year’s prior notice, includes a broad range of other compensation payable by Roche to Affymetrix throughout the life of the agreement based on royalties on sales of diagnostic kits, milestone

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payments for technical and commercial achievements, a manufacturing and supply agreement, and related license installments. As part of the agreement, Affymetrix will manufacture and supply Roche with microarrays and related instrumentation based on Affymetrix’ GeneChip® platform. In 2003, Roche launched the AmpliChip® CYP450 array product initially for research use only, but in late 2004 obtained CE marking and FDA regulatory approvals of the product for in-vitro diagnostic use.

Veridex, LLC.   In December 2004, we entered into a non-exclusive collaboration agreement with Veridex LLC, a Johnson & Johnson company, to develop and commercialize GeneChip® based diagnostic products for use in the field of oncology. Veridex was granted long-term and comprehensive access to our GeneChip® technology to create and market in-vitro diagnostics for cancer. The agreement, made under the Powered by Affymetrix™ program, gives Veridex non-exclusive rights to Affymetrix’ patented arrays, instrumentation systems and planned improvements to these technologies.

Other Collaborations

The Broad Institute.   In September 2004, we entered into a supply and research collaboration agreement with the Broad Institute and Massachusetts Institute of Technology. The agreement provides Affymetrix technology on preferential terms to the Broad Institute for applications development in return for the option to make commercial products available from the resulting research. The collaboration is focused on whole genome SNP analysis, resequencing and high throughput expression analysis.

National Cancer Institute.   In January 2001, we entered into a collaboration agreement with the National Cancer Institute on a human transcriptome initiative which seeks to construct maps locating the sites of RNA transcription across the entire human genome using high-density whole-genome arrays interrogating at resolutions and throughput rates never before attempted. The transcriptome is defined as the complete collection of transcribed elements of the genome. In addition to mRNAs, it also represents non-coding RNAs that are used for structural and gene regulation purposes. Alterations in the structure or levels of expression of any one of these RNAs or their proteins could contribute to disease. An understanding of the transcriptome may provide valuable insights in the research for novel drugs. We have made the data from this initiative freely available to the public via the Web through a version of the data integration and analysis software platform developed by Biotique Systems, Inc., a company that provides decision support tools and services for the emerging field of pharmacogenomics. We are using the Biotique Local Integration System to house this transcriptome data and to provide an interface for researchers to access, query and use this information. This collaboration was extended during fiscal 2003 to address the identification of transcriptional binding sites, methylation sites, origins of replication and other genomic features.

Caliper Life Sciences, Inc.   In January 2004, we signed a collaboration and supply agreement to develop and provide automated target preparation instruments for the GeneChip® Probe Array system. These new automation systems are expected to cut array processing, reduce variability and labor costs, and enable researchers to industrialize their genomic research. The two companies will develop products that leverage Caliper’s expertise in high-throughput automation and microfluidics with our expertise in microarray technology and applications. The first products were launched in 2004 and automate GeneChip® microarray target preparation steps including hybridization, washing and staining for expression and DNA analysis. The automated system enables a single operator to run up to 96 RNA samples at a time, compared to the manual rate of 20 to 24 samples. In 2005 we launched the Affymetrix GeneChip® Array Station that has the capacity to process hundreds of biological samples per week with minimal human supervision, reducing operating costs and variability in target preparation. The GeneChip® Array Station is designed to perform target preparation for both cartridges and array plates as well as perform the wash and stain function for the array plates. The GeneChip® Array Station adapts the same industry-standard GeneChip® technology to a standard 96-well microtiter plate, and runs on an automated system built with off-the-shelf robotic components.

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Marketing and Distribution

The markets for our products include all aspects of molecular biology research in the life sciences, including basic human disease research, clinical research, pharmaceutical drug discovery and development, including pharmacogenomics and toxicogenomics and agricultural research, amongst others. Our customers include pharmaceutical, biotechnology, agrichemical, diagnostics, industrial and consumer products companies, as well as academic research centers, laboratories in government agencies, private research foundations and clinical and industrial reference laboratories. The following factors, among others, influence the size and development of our markets:

·       the availability of genomic sequence and sequence variation data for the human population and for other organisms;

·       technological innovation that increases throughput and lowers the cost of genomic and genetic analysis;

·       the development of new computational techniques to handle and analyze large amounts of genomic data;

·       the availability of government funding for basic and disease-related research;

·       the amount of capital and ongoing expenditures allocated to research and development and outsourced spending by biotechnology, pharmaceutical and diagnostic companies for products and services;

·       the application of genomics to new areas including molecular diagnostics, agriculture, human identity and consumer goods; and

·       the availability of genetic markers and signatures of diagnostic value.

In North America and major European markets, our GeneChip® products are marketed principally through our own sales and distribution organizations. We own or lease sales and service offices in the United States, Europe, Japan and Singapore. We are finalizing plans to open offices in China in 2006, although our primary route to market in China will continue to be through distributors. In markets outside of North America and Europe, we sell our GeneChip® products principally through third party distributors, primarily in Mexico, India, the Middle East and Asia Pacific. These distributors are life science supply specialists within their own countries and operate as our sole distributors within a defined country or other geographic area.

For molecular diagnostic and industrial applications market opportunities, we supply our partners with arrays and instruments, which they incorporate into diagnostic products and take on the primary commercialization responsibilities. Current collaborative partners include Roche, bioMérieux, and Veridex, a Johnson & Johnson company. For additional information concerning our collaborative partners, see the section of this Form 10-K entitled “Our Collaborative Partners.”

Manufacturing and Raw Materials

We manufacture our GeneChip® probe arrays, GCS 3000 scanner, fluidics stations, instrument control software and certain reagents in-house and contract with third-party suppliers to manufacture our hybridization oven, GCAS and HT Scanner and certain reagents for our GeneChip® system. Additionally, through our GeneChip-compatible™ application program, a number of third-party software suppliers develop, market and sell genomic data analysis software that interfaces with data files generated by our GeneChip® system.

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Our probe array manufacturing process involves wafer preparation, probe synthesis, dicing of synthesized wafers into chips, assembly of chips and quality control. We have developed software programs that extensively automate the design of photolithographic masks used in probe array manufacturing and that control the probe array manufacturing lines. Glass wafers are prepared for synthesis through the application of chemical coatings. GeneChip® probe arrays are synthesized on the wafers using our proprietary, combinatorial photolithographic process. The completed wafers can then be diced to yield individual probe arrays, which are assembled and packaged for shipment.

We are currently manufacturing GeneChip® probe arrays for sale to customers as well as for internal and collaborative purposes. Probe arrays are manufactured at our dedicated manufacturing facility located in West Sacramento, California. We also maintain a manufacturing process engineering and development facility in Santa Clara, California, and a manufacturing and development facility in Bedford, Massachusetts to support our instrumentation products. All of our instrument and array manufacturing facilities comply with Good Manufacturing Practices as a subset of the Quality System Regulation (21 CFR 820).

Currently, we have physical capacity under optimal conditions to produce approximately 27,000 wafers annually. The actual number of probe arrays we are able to manufacture depends on the available equipment capacity, the yield of probe arrays that pass quality control testing and the number of probe arrays manufactured on each wafer. For instance, in 2005, we announced that due to low initial-production yields of our commercial Mapping 500K Array Set, shipment volumes had been constrained and, as a result, we were unable to manufacture enough product to meet our revenue targets for the third and fourth quarters of 2005. We are taking steps to increase our manufacturing capacity, including an expansion of our existing West Sacramento, California probe array manufacturing facility and are scheduled to begin commercial probe array production at our Singapore facility in the second half of 2006. We will continue to invest in additional capital equipment for our West Sacramento facility and our new facility in Singapore to both increase production capacity and increase the flexibility of this capacity to produce a broader range of products. See Item 7. Off-Balance Sheet Arrangements and Aggregate Contractual Obligations for further information.

We perform quality tests on selected probe arrays from each wafer and selected probes on such probe arrays. We largely rely on in-process and internal quality control procedures, including controls on the manufacturing process and sample testing, to verify the correct completion of the manufacturing process. In addition, we and our customers rely on the accuracy of genetic sequence information contained in the public databases upon which our products are based. Our probe array manufacturing process is designed to allow us to meet our performance specifications before arrays are shipped. We have a customer inquiry and complaint process in place and we rely on this process to identify and resolve product performance issues that may arise from time to time.

We perform quality tests on in-house and third party reagents to verify performance of reagent components and assembled reagent kits. We have qualified second source vendors for labeling reagents and oligonucleotides.

Key parts of the GeneChip® product line, such as hybridization ovens are available from single sources. We take such steps as we believe are appropriate to ensure that supplies from these vendors are not materially delayed or interrupted, since any such delays or interruptions could in turn delay our ability to deliver these products to our customers. Likewise, certain raw materials or components used in the synthesis of probe arrays or the assembly of instrumentation are currently available only from a single source or limited sources. We take such steps as we believe are appropriate to ensure that materials and components from these vendors are not materially delayed or interrupted, since any such delays or interruptions could in turn delay our ability to produce probe arrays or other components for our GeneChip® system in a timely fashion, in sufficient quantities or under acceptable terms. Alternative sources of supply may be time consuming and expensive to qualify. In addition, we are dependent on our

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vendors to provide components of appropriate quality and reliability, and to meet applicable regulatory requirements. Accordingly, we also take what we believe are appropriate measures to prevent the delay or interruption of supplies from these vendors and to ensure the appropriate quality for our customers.

Research and Development

We believe a substantial investment in research and development is essential to a long-term sustainable competitive advantage and critical to expansion into high-value markets such as toxicogenomics, pharmacogenomics, and molecular diagnostic and applied testing applications. Our research and development effort is divided into the major areas of basic research, product research and development, and manufacturing process development. Our research and development expenses for the years ended December 31, 2005, 2004 and 2003, were $77.4 million, $73.4 million and $65.9 million, respectively. In addition, on October 21, 2005, we recorded a charge of approximately $8.3 million to acquired in-process technology related to our acquisition of ParAllele BioScience, Inc. (“ParAllele”), a provider of comprehensive genetic discovery solutions to the life science research, pharmaceutical and diagnostic sectors.

Basic Research

Basic research efforts are carried out through our Affymetrix Research Laboratories to further advance our GeneChip® platform, develop new concepts that can be rapidly productized, and create innovations that will influence our business model in the future. Our initial focus is on basic technology research including high throughput systems, high resolution chip fabrication and detection, genotyping, and gene expression and analysis of the human transcriptome and of other model organism genomes. We are focusing our genotyping research efforts on the development of new assays principally designed to perform whole genome analysis at various resolutions. We believe that products based on this research will ultimately help researchers understand the molecular biology of genomes, to develop more effective therapeutics and help identify the diagnostic markers and tests useful in molecular diagnostic applications.

Product Research and Development

Our product research and development efforts are focused primarily on expanding the applications of the GeneChip® technology including development of new probe array products, improving the overall performance of GeneChip® assays, increasing the information capacity per probe array and simplifying highly complex assays. Our research and development efforts are intended to continue to develop new products based on information from the human and other model organism genomes as well as new genotyping and DNA analysis products. In addition, we intend to continue developing custom product lines for both expression and DNA analysis so that customers can analyze gene expression or DNA variability for any organism. We plan continued software and instrumentation development efforts to enhance the performance and level of automation of our entire GeneChip® system solution.

Manufacturing Process and Development

We are conducting research aimed at enhancing the manufacturing process currently employed in the production of our GeneChip® probe arrays. This process, which leverages semiconductor photolithographic fabrication techniques, is combinatorial in that the number of different compounds synthesized grows exponentially with the number of cycles in the synthesis. The objective of this research is to allow us to produce arrays with higher information density in the same unit area, similar to advances achieved in the semiconductor industry, which has produced silicon chip capacity closely following Moore’s Law. Moore’s Law is the observation that the number of transistors per square inch on a silicon chip had doubled every 18 months since the silicon chip was invented. To date, we have also been able to achieve rapid advances in genetic information content, reducing commercial product feature size from 100 microns

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in 1994 to 5 microns in 2005 with the introduction of our Human Exon Array product. We are continuing research aimed at using smaller feature technology in commercial products and implementing novel, cost-effective packaging approaches for the small array formats including packaging these into the standard industry microtiter plate format.

Intellectual Property

We rely on a combination of patent, copyright, and trade secret laws, know-how and licensing opportunities to establish and protect our proprietary technologies and products. Our success depends in part on our ability to obtain patent protection for our products and processes, to preserve our copyrights and trade secrets, to operate without infringing the proprietary rights of third parties and to acquire licenses related to enabling technology or products used with our GeneChip® technology.

We are pursuing a patent strategy designed to facilitate our research and development program and the commercialization of our current and future products. We have been issued 335 patents in the United States and we hold approximately 537 pending United States patent applications. Many of these patents and applications have been filed and/or issued in one or more foreign countries. While no one patent is considered essential to our success, we aggressively seek to protect our patent rights as our patent portfolio as a whole is material to the success of the business.

There are a significant number of United States and foreign patents and patent applications in our areas of interest, and we believe that there will continue to be significant litigation in the industry regarding patent and other intellectual property rights. Others have filed, and in the future are likely to file, patent applications that are similar or identical to ours or those of our licensors. It may be necessary for us to enter into litigation to defend against or assert claims of infringement, to enforce patents issued to us, to protect trade secrets or know-how owned by us or to determine the scope and validity of the proprietary rights of others. To determine the priority of inventions, it may be necessary for us to participate in interference proceedings declared by the United States Patent and Trademark Office. Litigation or interference proceedings could result in substantial costs to and distraction from our core business and our efforts in respect to such proceedings may not be successful. For further information see Item 3, Legal Proceedings.

We also rely upon copyright and trade secrets to protect our confidential and proprietary information. We seek to protect our proprietary technology and processes by confidentiality agreements with our employees and certain consultants and contractors. These agreements may be breached, we may not have adequate remedies for any breach and our trade secrets may otherwise become known or be independently discovered by competitors. To the extent that our employees or our consultants or contractors use intellectual property owned by others in their work for us, disputes may also arise as to the rights in related or resulting know-how and inventions.

We are party to various option, supply and license agreements with third parties which grant us rights to use certain aspects of our technologies. We take such measures as we believe are appropriate to maintain rights to such technology under these agreements. In addition, our academic collaborators have certain rights to publish data and information in which we have rights. There is considerable pressure on academic institutions to publish discoveries in the genetics and genomics fields. We take such steps as we believe are appropriate to ensure that such publication will not adversely affect our ability to obtain patent protection for information in which we may have a commercial interest.

Competition

Competition in gene expression monitoring, DNA analysis and molecular diagnostics is intense and is expected to increase. Further, the technologies for monitoring gene expression, discovering and analyzing polymorphisms associated with significant diseases, and approaches for commercializing those discoveries

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are new and rapidly evolving. Currently, our principal competition comes from existing technologies and other DNA array technologies that are used to perform many of the same functions for which we market our GeneChip® systems.

In the gene expression monitoring and DNA analysis fields, existing competitive technologies include gel-based sequencing using instruments provided by companies such as Applied Biosystems, Inc. (an Applera company), Beckman Coulter, Inc. and General Electric (GE) Healthcare. Other companies developing or marketing potentially competitive DNA array technology include: Agilent Technologies, Inc., Applied Biosystems, Inc., BD Biosciences, Clontech, CombiMatrix Corporation, Digital Gene Technologies, Inc., GE Healthcare, Illumina, Inc., Invitrogen Corporation (formerly Xeotron, Inc.), Molecular Devices, Inc. (formerly Axon Instruments, Inc.), Nanogen, Inc., NimbleGen Systems, Inc., Sequenom, Inc., Solexa, Inc. (formerly Lynx Therapeutics, Inc.), and Visible Genetics Inc. (recently acquired by Bayer). For example, companies such as Agilent Technologies, Inc., Applied Biosystems, Inc., GE Healthcare and Illumina, Inc. have products for DNA analysis which are directly competitive with our GeneChip® Mapping Array products. In order to compete against existing and emerging technologies, we will need to be successful in demonstrating to customers that the GeneChip® system provides a competitive advantage.

In Japan, the former Amersham Biosciences K.K. (acquired by GE Healthcare), from which we transitioned to our own sales operation during 2003, is a competitor, as well as a licensee of certain of our technology. In addition, we have several other third party licensees that could offer products that compete with our product offering.

The market for molecular diagnostic products derived from gene discovery is currently limited and highly competitive, with several large corporations already having significant market share. Established diagnostic companies could compete with us by developing new products. Companies such as Abbott Laboratories, Bayer AG, Beckman Coulter, Becton Dickinson, bioMérieux , Johnson & Johnson and Roche have the strategic commitment to diagnostics, the financial and other resources to invest in new technologies, substantial intellectual property portfolios, substantial experience in new product development, regulatory expertise, manufacturing capabilities and the distribution channels to deliver products to customers. Established diagnostic companies also have an installed base of instruments in several markets, including clinical and reference laboratories, which are not compatible with the GeneChip® system and could slow acceptance of our products. In addition, these companies have formed alliances with genomics companies which provide them access to genetic information that may be incorporated into their diagnostic tests.

Future competition in existing and potential markets will likely come from existing competitors as well as other companies seeking to develop new technologies for sequencing and analyzing genetic information. In addition, pharmaceutical and biotechnology companies have significant needs for genomic information and may choose to develop or acquire competing technologies to meet these needs. Through 2005 we have significantly expanded our network of approved service providers in America, Japan and Europe. While these companies expand the reach of Affymetrix technology and make its analytical power available to a wider base of users they may act as a substitute for outright purchase of instruments and arrays by those end users. In the molecular diagnostic field, competition will likely come from established diagnostic companies, companies developing and marketing DNA probe tests for genetic and other diseases, and other companies conducting research on new technologies to ascertain and analyze genetic information.

Government Regulation

Regulation by governmental authorities in the United States and other countries will likely be a significant factor in the manufacturing, labeling, distribution and marketing of certain products and services that may be developed by us or our collaborative partners. In particular, diagnostic products we

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are developing with our collaborative partners may require regulatory approval by governmental agencies when distributed outside of the research environment.

Commercially available diagnostic tests are regulated as medical devices and are generally subject to rigorous testing and other approval procedures by the United States Food and Drug Administration (FDA). The FDA’s Quality System Regulations also apply in connection with our manufacture of arrays and systems as components for use in diagnostic products developed by our partners. Obtaining these clearances or approvals and the compliance with these regulations require the expenditure of substantial resources over a significant period of time, and there can be no assurance that any clearances or approvals will be granted on a timely basis, if at all. Once granted, a clearance or approval may place substantial restrictions on how the device is marketed or labeled or to whom it may be sold. In addition, various federal and state statutes and regulations govern or influence the manufacturing, safety, storage of our products and components of our products and our record keeping.

Medical device laws and regulations, including those covering in vitro diagnostic products, are also in effect in the European Union, and many of the countries in which we may do business outside the United States. These range from comprehensive device approval requirements for some or all of our medical device products to requests for product data or self-certifications. We may not be able to obtain regulatory approvals in such countries or may incur significant costs in obtaining or maintaining our non-US regulatory approvals. In addition, the export by us of certain of our products which have not yet been cleared for domestic commercial distribution may be subject to FDA or other export restrictions.

Our diagnostic clinical laboratory will be subject to extensive federal and state regulation including the requirements of the Clinical Laboratory Improvement Act of 1988 (CLIA). CLIA is intended to ensure the quality and reliability of clinical laboratories in the United States by requiring all laboratories to meet specified standards in the areas of personnel qualification, administration, participation in proficiency testing, patient test management, quality control, quality assurance and inspections. There can be no assurance that regulations under and future administrative interpretations of CLIA will not have an adverse impact on the potential market for our diagnostic clinical laboratory.

Reimbursement

The design of our products and the potential market for their use may be directly or indirectly affected by U.S. and other government regulations governing reimbursement for clinical testing services. The availability of third-party reimbursement for our products and services may be limited or uncertain, particularly with respect to genetic tests and other clinical applications products.

Third-party payors may deny reimbursement if they determine that a prescribed health care product or service has not received appropriate FDA or other governmental regulatory clearances, is not used in accordance with cost-effective treatment methods as determined by the payor, or is deemed by the third-party payor to be experimental, unnecessary or inappropriate. Furthermore, third-party payors are increasingly challenging the prices charged for health care products and services.

Currently, sales of our products and services are not subject to third-party reimbursement. However, we are currently developing diagnostic and therapeutic products with our collaborative partners which may be subject to reimbursement issues. The ability of our collaborators to commercialize such products may depend, in part, on the extent to which reimbursement for the cost of these products will be available under U.S. and foreign regulations governing reimbursement for clinical testing services by government authorities, private health insurers and other organizations. In addition, we are establishing a diagnostic clinical laboratory which will provide subcontract services to primary clinical laboratories. Our diagnostic clinical laboratory may be subject to reimbursement issues and the ability of primary clinical laboratories to utilize our laboratory services may depend, in part, on the extent to which reimbursement for the cost of clinical services will be available.

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In the United States, third-party payor price resistance, the trend towards managed health care and legislative proposals to reform health care or reduce government insurance programs could reduce prices for health care products and services, adversely affect the profits of our customers and collaborative partners and reduce our future royalties and product sales.

Environmental Matters

We are dedicated to compliance and protection of the environment and individuals. Our operations require the use of hazardous materials (including biological materials) which subject us to a variety of federal, state and local environmental and safety laws and regulations. We believe we are in material compliance with current and applicable laws and regulations. However, some of the regulations under the current regulatory structure allow for “strict liability,” holding a party potentially liable without regard to fault or negligence. We could be held liable for damages and fines as a result of our, or others’, business operations should contamination of the environment or individual exposure to hazardous substances occur. We cannot predict how changes in these laws or development of new regulations will affect our business operations or the cost of compliance.

Employees

As of March 2, 2006, we had 1,101 full-time employees. The employee group includes chemists, engineers, computer scientists, mathematicians and molecular biologists with experience in the diagnostic products, medical products, semiconductor, computer software and electronics industries. None of our employees are represented by a collective bargaining agreement, nor have we experienced work stoppages. We believe that we maintain good relationships with our employees. Our success depends in large part on our ability to attract and retain skilled and experienced employees.

Seasonality

Customer demand for probe arrays and instrumentation systems is typically highest in the fourth quarter of the calendar year as customers spend unused budget allocations before the end of the financial year.

Backlog

Because most customer orders are shipped in the quarter in which they are received, we believe that backlog at quarter end is typically not a material indicator of future sales. In addition, backlog may not result in sales because of cancellation of orders or other factors. On a few occasions we have experienced, and made public announcements about, short-term increases in backlog as a result of factors such as new product introductions or supply constraints. For example, due to low initial production yields on our new Mapping 500K Array product we announced that probe array shipments were constrained during the third and fourth quarters of fiscal 2005. Although these capacity constraints may have increased our backlog with respect to our Mapping 500K Array product, we continue to believe that backlog information is not material to an understanding of our business taken as a whole.

Financial Information About Industry Segments

We operate in one business segment, for the development, manufacture, and commercialization of systems for genetic analysis in the life sciences and diagnostic industry. Our operations are treated as one segment as we only report operating information on a total enterprise level to our chief operating decision-makers. Further, resource allocations are also made at the enterprise level by our chief operating decision-makers.

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Financial Information About Geographic Areas

Our consolidated product and product related revenue from customers outside of the United States for fiscal years 2005, 2004 and 2003 was $176.7 million, $159.2 million and $127.8 million, or 50.5%, 48.1% and 45.5%, respectively, of our consolidated product and product related revenue. A summary of revenues from external customers attributed to each of our geographic areas for the fiscal years ended December 31, 2005, 2004 and 2003, is included in Note 17 of our Consolidated Financial Statements included in this report.

Available Information

Our internet address is www.affymetrix.com. Information included in our website is not part of this Form 10-K. We make available free of charge on our website our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and all amendments to those reports as soon as reasonably practicable after such material is electronically filed with or furnished to the SEC. In addition, copies of our annual reports are available free of charge upon written request. The SEC also maintains an Internet site that contains reports, proxy and information statements, and other information regarding issuers that file electronically with the SEC. The address of that site is http://www.sec.gov.

ITEM 1A.   RISK FACTORS

This Form 10-K contains forward-looking information based on our current expectations. Because our actual results may differ materially from any forward-looking statements made by or on behalf of Affymetrix, this section includes a discussion of important risk factors that could affect our actual future results.

We may not maintain profitability.

We incurred losses each year from our inception through the year ended December 31, 2003, and as a result we had an accumulated deficit of approximately $93.5 million at December 31, 2005. We expect to continue experiencing fluctuations in our operating results and cannot assure sustained profitability. Our losses have resulted principally from costs incurred in research and development, manufacturing and from selling, general and administrative costs associated with our operations.

Our ability to generate significant revenues and maintain profitability is dependent in large part on our ability to expand our customer base, increase sales of our current products to existing customers, manage our expense growth, and enter into additional supply, license and collaborative arrangements as well as on our ability and that of our collaborative partners to successfully manufacture and commercialize products incorporating our technologies in new applications and in new markets. If our revenues grow more slowly than we anticipate, or if our operating expenses increase more than we expect or cannot be reduced in the event of lower revenues, our business will be materially and adversely affected.

Our quarterly results have historically fluctuated significantly and may continue to fluctuate unpredictably and any failure to meet financial expectations may disappoint securities analysts or investors and result in a decline in our stock price.

Our revenues and operating results may fluctuate significantly due in part to factors that are beyond our control and which we cannot predict. The timing of our customers’ orders may fluctuate from quarter to quarter. However, we have historically experienced customer ordering patterns for GeneChip® instrumentation and GeneChip® arrays where the majority of the shipments occur in the last month of the quarter. These ordering patterns may limit management’s ability to accurately forecast our future revenues. Because our expenses are largely fixed in the short to medium term, any material shortfall in revenues will materially reduce our profitability and may cause us to experience losses. In particular, our

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revenue growth and profitability depend on sales of our GeneChip® products. Factors that could cause sales for these products to fluctuate include:

·        our inability to produce products in sufficient quantities and with appropriate quality;

·        the loss of or reduction in orders from key customers;

·        the frequency of experiments conducted by our customers;

·        our customers’ inventory of GeneChip® products;

·        the receipt of relatively large orders with short lead times; and

·        our customers’ expectations as to how long it takes us to fill future orders.

Some additional factors that could cause our operating results to fluctuate include:

·        weakness in the global economy and changing market conditions;

·        general economic conditions affecting our target customers;

·        changes in the amounts or timing of government funding to companies and research institutions;

·        changes in the attitude of the pharmaceutical industry towards the use of genetic information and genetic testing as a methodology for drug discovery and development; and

·        changes in the competitive landscape.

We cannot forecast with any certainty the impact of these and other factors on our sales and operating results in any future period. Results of operations in any period, therefore, should not be considered indicative of the results to be expected for any future period. Because of this difficulty in predicting future performance, our operating results may fall below the expectations of securities analysts or investors in some future quarter or quarters. Our failure in the past to meet these expectations has adversely affected the market price of our common stock and may continue to do so.

We may lose customers or experience lost sales if we are unable to manufacture our products and ensure their proper performance and quality.

We produce our GeneChip® products in an innovative and complicated manufacturing process which has the potential for significant variability in manufacturing yields. We have encountered and may in the future encounter difficulties in manufacturing our products and, due to the complexity of our products and our manufacturing process, we may not fully understand all of the factors that affect our manufacturing processes or product performance. For example, in 2005, we announced that due to low initial-production yields of our commercial Mapping 500K Array Set, shipment volumes had been constrained and, as a result, we were unable to manufacture enough product to meet our revenue targets for the third and fourth quarters of 2005.

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Although we are taking steps to increase our manufacturing capacity, including the expansion of our existing West Sacramento, California probe array manufacturing facility and the development of a new probe array manufacturing facility in Singapore, there are uncertainties inherent in the expansion of our manufacturing capabilities and there can be no assurance as to when any additional capacity may be available to us. For example, manufacturing and product quality issues may arise as we begin our manufacturing operations at the new Singapore facility or as we increase production rates at our West Sacramento facility and launch new products. In addition, we base our manufacturing capabilities on our forecasted product mix for the quarter. If the actual product mix varies significantly from our forecast, we may not be able to fill some orders during that quarter, which could adversely impact our financial results. Difficulties in meeting customer, collaborator and internal demand could also cause us to lose customers or require us to delay new product introductions, which could in turn result in reduced demand for our products.

We rely on internal quality control procedures to verify our manufacturing processes. Due to the complexity of our products and manufacturing process, however, it is possible that probe arrays that do not meet all of our performance specifications may not be identified before they are shipped. If our products do not consistently meet our customers’ performance expectations, demand for our products will decline. In addition, we do not maintain any backup manufacturing capabilities for the production of our GeneChip® instruments. Any interruption in our ability to continue operations at our existing manufacturing facilities could delay our ability to develop or sell our products, which could result in lost revenue and seriously harm our business, financial condition and results of operations.

We may not be able to deliver acceptable products to our customers due to the rapidly evolving nature of genetic sequence information upon which our products are based.

The genetic sequence information upon which we rely to develop and manufacture our products is contained in a variety of public databases throughout the world. These databases are rapidly expanding and evolving. In addition, the accuracy of such databases and resulting genetic research is dependent on various scientific interpretations and it is not expected that global genetic research efforts will result in standardized genetic sequence databases for particular genomes in the near future. Although we have implemented ongoing internal quality control efforts to help ensure the quality and accuracy of our products, the fundamental nature of our products requires us to rely on genetic sequence databases and scientific interpretations which are continuously evolving. As a result, these variables may cause us to develop and manufacture products that incorporate sequence errors or ambiguities. The magnitude and importance of these errors depends on multiple and complex factors that would be considered in determining the appropriate actions required to remedy any inaccuracies. Our inability to timely deliver acceptable products as a result of these factors would likely adversely affect our relationship with customers, and could have a material adverse effect on our business, financial condition and results of operations.

We face risks associated with technological obsolescence and emergence of standardized systems for genetic analysis.

The RNA/DNA probe array field is undergoing rapid technological changes. New technologies, techniques or products could emerge which might allow the packaging and analysis of genomic information at densities similar to or higher than our microarray technology. Other companies may begin to offer products that are directly competitive with, or are technologically superior, to our products. There can be no guarantee that we will be able to maintain our technological advantages over emerging technologies in the future. Over time, we will need to respond to technological innovation in a rapidly changing industry. In addition, although we believe that we are recognized as a market leader in creating systems for genetic analysis in the life sciences, standardization of tools and systems for genetic research is still ongoing and

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there can be no assurance that our products will emerge as the standard for genetic research. The emergence of competing technologies and systems as market standards for genetic research may result in our products becoming uncompetitive and could cause our business to suffer.

Our success depends on the continuous development of new products and our ability to manage the transition from our older products to new products.

We compete in markets that are new, intensely competitive, highly fragmented and rapidly changing, and many of our current and potential competitors have significantly greater financial, technical, marketing and other resources than we do. In addition, many current and potential competitors have greater name recognition, more extensive customer bases and access to proprietary genetic content. The continued success of our GeneChip® products will depend on our ability to produce products with smaller feature sizes, our ability to dice the wafer, and create greater information capacity at our current or lower costs. The successful development, manufacture and introduction of our new products is a complicated process and depends on our ability to manufacture enough products in sufficient quantity and at acceptable cost in order to meet customer demand. If we fail to keep pace with emerging technologies or are unable to develop, manufacture and introduce new products, we will become uncompetitive, our pricing and margins will decline and our business will suffer.

Our failure to successfully manage the transition between our older products and our new products may adversely affect our financial results. As we introduce new or enhanced products, we must successfully manage the transition from older products to minimize disruption in customers’ ordering patterns, avoid excessive levels of older product inventories and provide sufficient supplies of new products to meet customer demands. When we introduce new or enhanced products, we face numerous risks relating to product transitions, including the inability to accurately forecast demand and difficulties in managing different sales and support requirements due to the type or complexity of the new products. For instance, many of our existing customers are currently scaling up production on the Mapping 500K Array Set and some of these customers are experiencing challenges in the scale up which may affect the timing of future 500K Set product reorders.

We expect to face increasing competition.

Future competition will likely come from existing competitors as well as other companies seeking to develop new technologies for analyzing genetic information. For example, companies such as Agilent Technologies, Applied Biosystems, GE Healthcare (through its acquisition of Amersham Biosciences) and Illumina have products for gene expression research and analysis which are directly competitive with our GeneChip® Mapping array products. In addition, pharmaceutical and biotechnology companies have significant needs for genomic information and may choose to develop or acquire competing technologies to meet these needs. In the molecular diagnostics field, competition will likely come from established diagnostic companies, companies developing and marketing DNA probe tests for genetic and other diseases and other companies conducting research on new technologies to ascertain and analyze genetic information. Further, in the event that we develop new technology and products that compete with existing technology and products of well established companies, there can be no guarantee that the marketplace will readily adopt any such new technology and products that we may introduce in the future.

The market for molecular diagnostics products is currently limited and highly competitive, with several large companies already having significant market share. Companies such as Abbott Laboratories, Bayer AG, Beckman Coulter, Becton Dickinson, bioMérieux, Celera Diagnostics, Johnson & Johnson and Roche Diagnostics have made strategic commitments to diagnostics, have financial and other resources to invest in new technologies, and have substantial intellectual property portfolios, substantial experience in new product development, regulatory expertise, manufacturing capabilities and the distribution channels to deliver products to customers. Established diagnostic companies also have an installed base of

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instruments in several markets, including clinical and reference laboratories, which are not compatible with the GeneChip® system and could deter acceptance of our products. In addition, these companies have formed alliances with genomics companies which provide them access to genetic information that may be incorporated into their diagnostic tests.

Recent accounting pronouncements may impact our future financial position and results of operations.

There have been new accounting pronouncements or regulatory rulings that will have an impact on our future financial position and results of operations. For instance, on December 16, 2004, the Financial Accounting Standards Board (FASB) issued FASB Statement No. 123 (revised 2004), “Share-Based Payment”, which is a revision of FASB Statement No. 123, “Accounting for Stock-Based Compensation”. SFAS 123(R) supersedes APB Opinion No. 25, “Accounting for Stock Issued to Employees”, and amends FASB Statement No. 95, “Statement of Cash Flows”. Generally, the approach in SFAS 123(R) is similar to the approach described in Statement 123. However, SFAS 123(R) requires all share-based payments to employees, including grants of employee stock options, to be recognized in the income statement based on their fair values. Pro forma disclosure is no longer an alternative. We expect to adopt SFAS 123(R) effective January 1, 2006 under the modified-prospective method. The adoption of SFAS 123(R)’s fair value method will have a significant impact on our result of operations, although it will have no impact on our overall financial position. With the adoption of SFAS 123(R), we expect to record stock-based compensation of approximately $11.0 million, net of tax, or $0.15 per diluted share in 2006. Our estimate of stock-based compensation expense is affected by our stock price, the number of stock-based awards we may grant in 2006, as well as a number of complex and subjective valuation assumptions and the related tax effect. These valuation assumptions include, but are not limited to, the volatility of our stock price, the estimated forfeiture rates and employee stock option exercise behaviors.

Our effective tax rate may vary significantly.

Our future effective tax rates could be adversely affected by various internal and external factors. These factors include, but are not limited to, earnings being lower than anticipated in countries where we have lower statutory rates and higher than anticipated in countries where we have higher statutory rates; changes in the valuation of our deferred tax assets and liabilities; or changes in tax laws or interpretations thereof; changes in tax rates, future levels of research and development spending, and changes in overall levels of pretax earnings. Any new interpretative accounting guidance related to accounting for uncertain tax positions could adversely affect our tax provision.

Our business depends on research and development spending levels for pharmaceutical and biotechnology companies and academic and governmental research institutions.

We expect that our revenues in the foreseeable future will be derived primarily from products and services provided to a relatively small number of pharmaceutical and biotechnology companies and academic, governmental and other research institutions. Our success will depend upon their demand for and use of our products and services. Our operating results may fluctuate substantially due to reductions and delays in research and development expenditures by these customers. For example, reductions in capital expenditures by these customers may result in lower than expected instrumentation sales and similarly, reductions in operating expenditures by these customers could result in lower than expected GeneChip® array and reagent sales. These reductions and delays may result from factors that are not within our control, such as:

·       changes in economic conditions;

·       changes in government programs that provide funding to companies and research institutions;

·       changes in the regulatory environment affecting life sciences companies and life sciences research;

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·       market-driven pressures on companies to consolidate and reduce costs; and

·       other factors affecting research and development spending.

Our success in penetrating emerging market opportunities in molecular diagnostics depends on the efforts of our partners and the ability of our GeneChip® technologies to be used in clinical applications for diagnosing and informing the treatment of disease.

The clinical applications of GeneChip® technologies for diagnosing and informing the treatment of disease is an emerging market opportunity in molecular diagnostics that seeks to improve the effectiveness of health care by collecting information about DNA variation and RNA expression in patients at various times from diagnosis through prognosis and on to the end of therapy. However, there can be no assurances that molecular diagnostic markets will develop as quickly as we expect or reach what we believe is their full potential. Although we believe that there will be clinical applications of our GeneChip® technologies that will be utilized for diagnosing and informing the treatment of disease, there can be no certainty of the technical or commercial success our technologies will achieve in such markets.

The molecular diagnostics market is relatively new for us and presents us with new risks and uncertainties. Our success in this area depends to a large extent on our collaborative relationships and the ability of our collaborative partners to successfully market and sell products using our GeneChip® technologies. As a result, we are also dependent on the ability of our collaborative partners to achieve regulatory approval for such products in the United States and in overseas markets. Although Roche received FDA approval of the first diagnostic genotyping test for use with our GeneChip® System 3000Dx in late 2004, there can be no assurance that other products using our GeneChip® technologies will achieve needed approvals.

We may not successfully obtain regulatory approval of any diagnostic or other product or service that we or our collaborative partners develop.

The FDA must approve certain in-vitro diagnostic products before they can be marketed in the U.S. Certain in-vitro diagnostic products must also be approved by the regulatory agencies of foreign governments or jurisdictions before the product can be sold outside the U.S. Commercialization of our and our collaborative partners’ in-vitro diagnostic products outside of the research environment that may depend upon successful completion of clinical trials. Clinical development is a long, expensive and uncertain process and we do not know whether we, or any of our collaborative partners, will be permitted to undertake clinical trials of any potential in-vitro diagnostic products. It may take us or our collaborative partners many years to complete any such testing, and failure can occur at any stage. Delays or rejections of potential products may be encountered based on changes in regulatory policy for product approval during the period of product development and regulatory agency review. Moreover, if and when our projects reach clinical trials, we or our collaborative partners may decide to discontinue development of any or all of these projects at any time for commercial, scientific or other reasons. Any of the foregoing matters could have a material adverse effect on our business, financial condition and results of operations.

Even where a product is exempted from FDA clearance or approval, the FDA may impose restrictions as to the types of customers to which we can market and sell our products. Such restrictions may materially and adversely affect our business, financial condition and results of operations.

Medical device laws and regulations are also in effect in many countries, ranging from comprehensive device approval requirements to requests for product data or certifications. The number and scope of these requirements are increasing. We may not be able to obtain regulatory approvals in such countries or may incur significant costs in obtaining or maintaining our foreign regulatory approvals. In addition, the export by us of certain of our products which have not yet been cleared for domestic commercial distribution may be subject to FDA or other export restrictions.

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Our diagnostic clinical laboratory will be subject to extensive federal and state regulation including the requirements of the Clinical Laboratory Improvement Act of 1988 (CLIA). CLIA is intended to ensure the quality and reliability of clinical laboratories in the United States by requiring all laboratories to meet specified standards in the areas of personnel qualification, administration, participation in proficiency testing, patient test management, quality control, quality assurance and inspections. There can be no assurance that regulations under and future administrative interpretations of CLIA will not have an adverse impact on the potential market for our diagnostic clinical laboratory.

Healthcare reform and restrictions on reimbursements may limit our returns on molecular diagnostic products that we may develop with our collaborators.

We are currently developing diagnostic and therapeutic products with our collaborators. The ability of our collaborators to commercialize such products may depend, in part, on the extent to which reimbursement for the cost of these products will be available under U.S. and foreign regulations that govern reimbursement for clinical testing services by government authorities, private health insurers and other organizations. In the U.S., third-party payor price resistance, the trend towards managed health care and legislative proposals to reform health care or reduce government insurance programs could reduce prices for health care products and services, adversely affect the profits of our customers and collaborative partners and reduce our future royalties.

We depend on a limited number of suppliers and we will be unable to manufacture our products if shipments from these suppliers are delayed or interrupted.

We depend on our vendors to provide components of our products in required volumes, at appropriate quality and reliability levels, and in compliance with regulatory requirements. Key parts of the GeneChip® product line are currently available only from a single source or limited sources. In addition, components of our manufacturing equipment and certain raw materials used in the synthesis of probe arrays are available from limited sources. If supplies from these vendors were delayed or interrupted for any reason, we would not be able to get manufacturing equipment, produce probe arrays, or sell scanners or other components for our GeneChip® products in a timely fashion or in sufficient quantities or under acceptable terms. Furthermore, our business is dependent on our ability to forecast the needs for components and products in the GeneChip® product line and our suppliers’ ability to deliver such components and products in time to meet critical manufacturing and product release schedules. Our business could be adversely affected, for example, if suppliers fail to meet product release schedules, if we experience supply constraints, if we fail to negotiate favorable pricing or if we experience any other interruption or delay in the supply chain which interferes with our ability to manufacture our products or manage our inventory levels.

Our success will require that we establish a strong intellectual property position and that we can defend ourselves against intellectual property claims from others.

Maintaining a strong patent position is critical to our business. Litigation on these matters has been prevalent in our industry and we expect that this will continue. Patent law relating to the scope of claims in the technology fields in which we operate is still evolving and the extent of future protection is highly uncertain, so there can be no assurance that the patent rights that we have or may obtain will be valuable. Others have filed, and in the future are likely to file, patent applications that are similar or identical to ours or those of our licensors. To determine the priority of inventions, we will have to participate in interference proceedings declared by the United States Patent and Trademark Office that could result in substantial costs in legal fees and could substantially affect the scope of our patent protection. We cannot assure investors that any such patent applications will not have priority over our patent applications. Also, our intellectual property may be subject to significant administrative and litigation proceedings such as

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opposition proceedings against our patents in Europe, Japan and other jurisdictions. In addition, we have incurred and may in future periods incur substantial costs in litigation to defend against patent suits brought by third parties or initiated by us. For example, we currently are engaged in litigation regarding intellectual property rights with Multilyte Ltd. and Enzo Life Sciences, Inc. For additional information concerning intellectual property litigation and administrative proceedings, see Part I, Item 3, Legal Proceedings, of this Form 10-K.

In addition to patent protection, we also rely upon copyright and trade secret protection for our confidential and proprietary information. There can be no assurance, however, that such measures will provide adequate protection for our copyrights, trade secrets or other proprietary information. In addition, there can be no assurance that trade secrets and other proprietary information will not be disclosed, or that others will not independently develop substantially equivalent proprietary information and techniques or otherwise gain access to or disclose our trade secrets and other proprietary information. There can also be no assurance that we will be able to effectively protect our copyrights, trade secrets or other proprietary information. If we cannot obtain, maintain or enforce intellectual property rights, our competitors may be able to offer probe array systems similar to our GeneChip® technology.

Our success also depends in part on us neither infringing patents or other proprietary rights of third parties nor breaching any licenses that may relate to our technologies and products. We are aware of third-party patents that may relate to our technology, including reagents used in probe array synthesis and in probe array assays, probe array scanners, synthesis techniques, polynucleotide amplification techniques, assays, and probe arrays. We routinely receive notices claiming infringement from third parties as well as invitations to take licenses under third party patents. There can be no assurance that we will not infringe on these patents or other patents or proprietary rights or that we would be able to obtain a license to such patents or proprietary rights on commercially acceptable terms, if at all.

If we are unable to maintain our relationships with collaborative partners, we may have difficulty developing and selling our products and services.

We believe that our success in penetrating our target markets depends in part on our ability to develop and maintain collaborative relationships with key companies as well as with key academic researchers. Currently, our significant collaborative partners include Qiagen GmBH for sample preparation and purification systems, Invitrogen Corporation for reagents, and Ingenuity Systems, Inc. for analytical software. We collaborate with both Beckman Coulter Inc. and Caliper Life Sciences in the development of automation for GeneChip® technology applications for use in drug discovery, drug development and clinical research. Roche, bioMérieux and Veridex are collaborative partners in the development of chip products for medical diagnostic and applied testing markets. Relying on these or other collaborative relationships is risky to our future success because:

·        our partners may develop technologies or components competitive with our GeneChip® products;

·        our existing collaborations may preclude us from entering into additional future arrangements;

·        our partners may not obtain regulatory approvals necessary to continue the collaborations in a timely manner;

·        some of our agreements may terminate prematurely due to disagreements between us and our partners;

·        our partners may not devote sufficient resources to the development and sale of our products;

·        our partners may be unable to provide the resources required for us to progress in the collaboration on a timely basis;

·        our collaborations may be unsuccessful; or

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·        we may not be able to negotiate future collaborative arrangements on acceptable terms.

The size and structure of our current sales, marketing and technical support organizations may limit our ability to sell our products.

Although we have invested significant other resources to expand our direct sales force and our technical and support staff, we may not be able to establish a sufficiently sized global sales, marketing or technical support organization to sell, market or support our products globally. To assist our sales and support activities, we have entered into distribution agreements through certain distributors, principally in markets outside of North America and Europe. These and other third parties on whom we rely for sales, marketing and technical support in these geographic areas may decide to develop and sell competitive products or otherwise become our competitors, which could harm our business.

Due to the international nature of our business, political or economic changes or other factors could harm our business.

A significant amount of our revenue is currently generated from sales outside the United States. Though such transactions are denominated in both U.S. dollars and foreign currencies, our future revenue, gross margin, expenses and financial condition are still affected by such factors as changes in foreign currency exchange rates; unexpected changes in, or impositions of, legislative or regulatory requirements, including export and trade barriers and taxes; longer payment cycles and greater difficulty in accounts receivable collection. We are also subject to general geopolitical risks in connection with international operations, such as political, social and economic instability, potential hostilities and changes in diplomatic and trade relationships. We cannot assure investors that one or more of the foregoing factors will not have a material adverse effect on our business, financial condition and operating results or require us to modify our current business practices.

We may be exposed to liability due to product defects.

The risk of product liability claims is inherent in the testing, manufacturing, marketing and sale of human diagnostic and therapeutic products. We may seek to acquire additional insurance for clinical liability risks. We may not be able to obtain such insurance or general product liability insurance on acceptable terms or in sufficient amounts. A product liability claim or recall could have a serious adverse effect on our business, financial condition and results of operations.

Ethical, legal and social concerns surrounding the use of genetic information could reduce demand for our products.

Genetic testing has raised ethical issues regarding privacy and the appropriate uses of the resulting information. For these reasons, governmental authorities may call for limits on or regulation of the use of genetic testing or prohibit testing for genetic predisposition to certain conditions, particularly for those that have no known cure. Similarly, such concerns may lead individuals to refuse to use genetics tests even if permissible. Any of these scenarios could reduce the potential markets for our molecular diagnostic products, which could have a material adverse effect on our business, financial condition and results of operations.

Because our business depends on key executives and scientists, our inability to recruit and retain these people could hinder our business expansion plans.

We are highly dependent on our officers and our senior scientists and engineers, including scientific advisors. Our product development and marketing efforts could be delayed or curtailed if we are unable to attract or retain key talent.

32




We rely on our scientific advisors and consultants to assist us in formulating our research, development and commercialization strategy. All of these individuals are engaged by other employers and have commitments to other entities that may limit their availability to us. A scientific advisor’s other obligations may prevent him or her from assisting us in developing our technical and business strategies.

To expand our research, product development and sales efforts we need additional people skilled in areas such as bioinformatics, organic chemistry, information services, regulatory affairs, manufacturing, sales, marketing and technical support. Competition for these people is intense. We will not be able to expand our business if we are unable to hire, train and retain a sufficient number of qualified employees. There can be no assurance that we will be successful in hiring or retaining qualified personnel and our failure to do so could have a material adverse impact on our business, financial condition and results of operations.

Our strategic equity investments may result in losses.

We periodically make strategic equity investments in various publicly traded and non-publicly traded companies with businesses or technologies that may complement our business. The market values of these strategic equity investments may fluctuate due to market conditions and other conditions over which we have no control. Other than temporary declines in the market price and valuations of the securities that we hold in other companies will require us to record losses relative to our ownership interest. This could result in future charges on our earnings and as a result, it is uncertain whether or not we will realize any long term benefits associated with these strategic investments.

Future acquisitions may disrupt our business and distract our management.

We have previously engaged in acquisitions and may do so in the future in order to exploit technology or market opportunities. If we acquire another company, we may not be able to successfully integrate the acquired business into our existing business in a timely and non-disruptive manner, or at all. Furthermore, an acquisition may not produce the revenues, earnings or business synergies that we anticipate. If we fail to integrate the acquired business effectively or if key employees of that business leave, the anticipated benefits of the acquisition would be jeopardized. The time, capital management and other resources spent on an acquisition that fails to meet our expectations could cause our business and financial condition to be materially and adversely affected. For example, on October 21, 2005, we completed the acquisition of ParAllele BioScience, Inc. We may not realize the anticipated benefits of the acquisition because of integration and other challenges which include, among others, unanticipated incompatibility of corporate and administrative infrastructures, the ability to retain key employees, including key scientists, the diversion of management’s attention from ongoing business concerns, and the potential adverse reaction of customers to the merger or resulting changes to the combined company’s product and services offerings. In addition, acquisitions can involve substantial charges and amortization of significant amounts of deferred stock compensation that could adversely affect our results of operations.

The market price of our common stock has been volatile.

The market price of our common stock is volatile. To demonstrate this volatility, during the twelve-month period ending on December 31, 2005, the volume of our common stock traded on any given day ranged from 215,200 to 11,118,700 shares. Moreover, during that period, our common stock traded as low as $33.94 per share and as high as $59.73 per share.

Furthermore, volatility in the stock price of other companies has often led to securities class action litigation against those companies. Any future securities litigation against us could result in substantial costs and divert management’s attention and resources, which could seriously harm our business, financial condition and results of operations.

33




ITEM 1B.   UNRESOLVED STAFF COMMENTS

None.

ITEM 2.   PROPERTIES

The following chart indicates the facilities that we own or lease, the location and size of each such facility and their designated use. We expect our facilities needs to increase over the next several years as we continue to expand our worldwide commercial operations and our manufacturing capabilities.

Location

 

 

 

Approximate
Square Feet

 

Operation

 

Own or Lease (Expiration)

Bedford, MA

 

80,000 sq. ft.

 

R&D, Manufacturing, Administrative

 

Lease expires 2013

Emeryville, CA

 

11,000 sq. ft.

 

Software Development

 

Lease expires 2010

Osaka, Japan

 

710 sq. ft.

 

Administrative

 

Lease expires 2007

Santa Clara, CA

 

200,000 sq. ft.

 

R&D, Administrative

 

Lease expires 2013

Singapore

 

1,700 sq. ft.

 

Administrative

 

Lease expires 2007

 

 

147,000 sq. ft

 

Manufacturing

 

Lease expires 2008

Sunnyvale, CA

 

31,000 sq. ft.

 

R&D

 

Lease expires 2008

 

 

57,000 sq. ft.

 

Administrative

 

Lease expires 2010

Tokyo, Japan

 

11,000 sq. ft.

 

Administrative

 

Lease expires 2007

Wooburn Green, UK

 

10,000 sq. ft.

 

Administrative

 

Lease expires 2016

West Sacramento, CA

 

52,000 sq. ft.

 

Manufacturing

 

Own (facility and land)

 

 

3,800 sq. ft.

 

Warehouse

 

Lease expires 2006

Shanghai, China

 

4,000 sq. ft.

 

Administrative

 

Lease expires 2009

South San Francisco, CA

 

35,000 sq.ft.

 

R&D, Manufacturing, Administrative

 

Lease expires 2007

 

ITEM 3.   LEGAL PROCEEDINGS

GENERAL

We have been in the past and continue to be a party to litigation which has consumed and may in the future continue to consume substantial financial and managerial resources which could adversely affect our business, financial condition and results of operations. If in any pending or future intellectual property litigation involving us or our collaborative partners, we are found to have infringed the valid intellectual property rights of third parties, we, or our collaborative partners, could be subject to significant liability for damages, could be required to obtain a license from a third party, which may not be available on reasonable terms or at all, or could be prevented from manufacturing and selling our products. In addition, if we are unable to enforce our patents and other intellectual property rights against others, or if our patents are found to be invalid or unenforceable, third parties may more easily be able to introduce and sell DNA array technologies that compete with our GeneChip® brand technology, and our competitive position could suffer. We expect to devote substantial financial and managerial resources to protect our intellectual property rights and to defend against the claims described below as well as any future claims asserted against us. Further, because of the substantial amount of discovery required in connection with any litigation, there is a risk that confidential information could be compromised by disclosure.

Multilyte Litigation

Multilyte Ltd., a British corporation, and Affymetrix are engaged in legal proceedings in Germany and the United States to address allegations made by Multilyte that we infringe certain patents owned by Multilyte (the “Multilyte patents”) by making and selling our GeneChip® DNA microarray products.

34




Germany

In the actions pending in Germany, on July 18, 2003, Multilyte filed proceedings in the state court of Düsseldorf, alleging infringement of the Multilyte patents. In a separate action in Germany, on October 15, 2003, we commenced nullity proceedings in German Federal Patent Court in Munich alleging that the German part of Multilyte’s two European patents (EPs 0 134 215 and 0 304 202) are invalid. On June 29 and 30, 2004, the German Federal Patent Court in Munich held that both Multilyte European patents are invalid in Germany. Following that ruling, on July 12, 2004, the Düsseldorf court stayed both sets of infringement proceedings before it, pending Multilyte’s appeal of the decisions of the German Federal Patent Court in Munich nullifying both Multilyte patents. We were notified on April 5, 2005 that Multilyte has abandoned its appeal of the decision nullifying the European Patent 0 134 215.

United States

In the U.S. action, on August 13, 2003, we commenced proceedings in the United States District Court for the Northern District of California seeking a declaratory judgment that eight Multilyte patents are not infringed and are invalid. Multilyte has agreed that we do not infringe five of the eight named patents. On October 24, 2003, we filed an amended complaint seeking a declaratory judgment as to three of the original eight named patents—U.S. Patents 5,432,099, 5,599,720 and 5,807,755. Multilyte answered our complaint for declaratory judgment and asserted counterclaims against us alleging infringement of the three patents named by us in our complaint. Multilyte has submitted the three patents-in-suit to the United States Patent and Trademark Office for voluntary re-examination. These patents remain in re-examination in the USPTO. On April 28, 2005, the Court granted our motions for summary judgment of non-infringement and entered a final judgment in the action in favor of us against Multilyte. On May 5, 2005, Multilyte filed a notice of motion to amend the judgment asserting that the Court’s entry of final judgment was premature because it did not give Multilyte the opportunity to present evidence showing infringement under the Court’s most recent claim construction. On June 23, 2005, the Court again granted summary judgment of non-infringement in favor of us. Multilyte has appealed the Court’s decision to the United States Court of Appeals for the Federal Circuit which held oral argument on the appeal on March 7, 2006.

We believe that Multilyte’s remaining claims against us are without merit and have filed the declaratory judgment and nullity actions to protect our interests. However, we cannot be sure that we will prevail in these matters. Our failure to successfully defend against these allegations could result in a material adverse effect on our business, financial condition and results of operations.

Enzo Litigation

On October 28, 2003, Enzo Life Sciences, Inc., a wholly-owned subsidiary of Enzo Biochem, Inc. (collectively “Enzo”) filed a complaint against us that is now pending in the United States District Court for the Southern District of New York for breach of contract, injunctive relief and declaratory judgment. The Enzo complaint relates to a 1998 distributorship agreement with Enzo under which we served as a non-exclusive distributor of certain reagent labeling kits supplied by Enzo. In its complaint, Enzo seeks monetary damages and an injunction against us from using, manufacturing or selling Enzo products and from inducing collaborators and customers to use Enzo products in violation of the 1998 agreement. Enzo also seeks the transfer of certain Affymetrix patents to Enzo. In connection with its complaint, Enzo provided us with a notice of termination of the 1998 agreement effective on November 12, 2003.

On November 10, 2003, we filed a complaint against Enzo in the United States District Court for the Southern District of New York for declaratory judgment, breach of contract and injunctive relief relating to the 1998 agreement. In our complaint, we allege that Enzo has engaged in a pattern of wrongful conduct against us and other Enzo labeling reagent customers by, among other things, asserting improperly broad rights in its patent portfolio, improperly using the 1998 agreement and distributorship agreements with

35




others in order to corner the market for non-radioactive labeling reagents, and improperly using the 1998 agreement to claim ownership rights to our proprietary technology. We seek declarations that we have not breached the 1998 agreement, that we are entitled to sell our remaining inventory of Enzo reagent labeling kits, and that nine Enzo patents that are identified in the 1998 agreement are invalid and/or not infringed by us. We also seek damages and injunctive relief to redress Enzo’s alleged breaches of the 1998 agreement, its alleged tortious interference with the Company’s business relationships and prospective economic advantage, and Enzo’s alleged unfair competition. We filed a notice of related case stating that our complaint against Enzo is related to the complaints already pending in the Southern District of New York against eight other former Enzo distributors. The U.S. District Court for the Southern District of New York has related our case. There is no trial date in the actions between Enzo and us.

We believe that the claims set forth in Enzo’s complaint are without merit and have filed the action in the Southern District of New York to protect our interests. However, we cannot be sure that we will prevail in these matters. Our failure to successfully defend against these allegations could result in a material adverse effect on our business, financial condition and results of operation.

Administrative Litigation and Proceedings

Our intellectual property is subject to a number of significant administrative and litigation actions. For example, in Europe and Japan, we expect third parties to oppose significant patents that we own or control. Currently, Multilyte Ltd. and ProtoGene Laboratories, Inc. have filed oppositions against our EP 0 619 321 patent in the European Patent Office. PamGene B.V. filed an opposition against our EP 0 728 520 patent and it was revoked at oral proceedings on January 14, 2004. Affymetrix has appealed this ruling. Also, Abbott Laboratories, Applera, Clondiag and CombiMatrix are parties in opposition against our EP 0 834 575. An oral hearing was conducted by the Opposition Division which upheld the patent on December 4, 2004, and this decision has been appealed. Abbott Laboratories, CombiMatrix, PamGene B.V., Applera and Dr. Peter Schneider filed an opposition against our EP 0 834 576 patent. The Opposition Division revoked the patent during an oral hearing on February 23, 2005 and we have appealed this ruling. CombiMatrix has filed an opposition against EP 0 695 941, Agilent, CombiMatrix, Clondiag and Applera have filed an opposition against EP 0 853 679, Applera has opposed EP 0 972 564 and Degussa AG has filed an opposition against EP 1 086 742. These procedures will result in the respective patents being either upheld in their entirety, allowed to issue in amended form in designated European countries, or revoked.

Further, in the United States, we expect that third parties will continue to “copy” the claims of our patents in order to provoke interferences in the United States Patent & Trademark Office, and we may copy the claims of others. These proceedings could result in our patent protection being significantly modified or reduced, and could result in significant costs and consume substantial managerial resources.

At this time, we cannot determine the outcome of any of the matters described above.

ITEM 4.    SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

No matters were submitted during the fourth quarter of the year ended December 31, 2005.

36




PART II

ITEM 5.                MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER REPURCHASES OF EQUITY SECURITIES

Our common stock is traded on the Nasdaq National Market System under the symbol of AFFX. The following table sets forth, for the periods indicated, the low and high bid prices per share for our common stock as reported by the Nasdaq National Market.

 

 

Low

 

High

 

2004

 

 

 

 

 

First Quarter

 

$

23.18

 

$

36.30

 

Second Quarter

 

$

26.56

 

$

38.20

 

Third Quarter

 

$

24.48

 

$

32.52

 

Fourth Quarter

 

$

28.89

 

$

37.48

 

2005

 

 

 

 

 

First Quarter

 

$

33.94

 

$

45.47

 

Second Quarter

 

$

42.18

 

$

55.10

 

Third Quarter

 

$

40.03

 

$

59.73

 

Fourth Quarter

 

$

42.19

 

$

52.44

 

 

As of March 8, 2006, there were approximately 475 holders of record of our common stock, one of which is Cede & Co., a nominee for Depository Trust Company (“DTC”).  All of the shares of common stock held by brokerage firms, banks and other financial institutions as nominees for beneficial owners are deposited into participant accounts at DTC, and therefore, are considered to be held of record by Cede & Co. as one shareholder.

No dividends have been paid on our common stock. We currently intend to retain all future earnings, if any, for use in our business and do not anticipate paying any cash dividends on our common stock in the foreseeable future.

37




ITEM 6.                SELECTED FINANCIAL DATA

The following selected historical consolidated financial information has been derived from our audited consolidated financial statements. The balance sheet data as of December 31, 2005 and 2004 and statements of operations data for each of the three years in the period ended December 31, 2005 are derived from audited consolidated financial statements included in this Form 10-K. You should read this table in conjunction with Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” and Item 8, “Financial Statements and Supplementary Data.”

 

 

Year Ended December 31,

 

 

 

2005

 

2004

 

2003

 

2002

 

2001

 

 

 

(In thousands, except per share amounts)

 

Consolidated Statement of Operations Data:

 

 

 

 

 

 

 

 

 

 

 

Revenue:

 

 

 

 

 

 

 

 

 

 

 

Product and product related revenue

 

$

350,190

 

$

330,885

 

$

280,780

 

$

248,538

 

$

194,936

 

Royalties and other revenue

 

8,339

 

9,832

 

10,556

 

19,777

 

18,447

 

Revenue from Perlegen Sciences

 

9,073

 

5,245

 

9,460

 

21,559

 

11,491

 

Total revenue

 

367,602

 

345,962

 

300,796

 

289,874

 

224,874

 

Income (loss) from operations

 

57,413

 

59,719

 

17,544

 

5,266

 

(40,596

)

Net income (loss)

 

$

57,516

 

$

47,608

 

$

14,285

 

$

(1,630

)

$

(33,121

)

Basic net income (loss) per common share

 

$

0.90

 

$

0.79

 

$

0.24

 

$

(0.03

)

$

(0.58

)

Diluted net income (loss) per common share

 

$

0.84

 

$

0.74

 

$

0.24

 

$

(0.03

)

$

(0.58

)

Consolidated Balance Sheet Data:

 

 

 

 

 

 

 

 

 

 

 

Cash, cash equivalents, and available-for-sale securities

 

$

284,932

 

$

205,715

 

$

459,883

 

$

361,458

 

$

368,823

 

Working capital

 

345,566

 

226,211

 

192,778

 

371,708

 

372,718

 

Total assets(2)

 

766,823

 

499,771

 

700,164

 

601,403

 

580,015

 

Long-term obligations(1)

 

139,790

 

153,845

 

166,586

 

380,222

 

378,000

 


(1)    In September 1999, we issued $150.0 million principal amount of 5% convertible subordinated notes. In February 2000, we issued $225.0 million principal amount of 4.75% convertible subordinated notes. In August 2001, we repurchased $5.0 million principal amount of the 4.75% notes for total consideration of $3.3 million. In connection with the transaction, we recorded an extraordinary gain of approximately $1.7 million in fiscal 2001 which was reclassified during fiscal 2002 to interest income and other, net in accordance with Financial Accounting Standard (“FAS”) 145, “Rescission of FASB Statements No. 4, 44, and 64, Amendment of FASB Statement No. 13, and Technical Corrections.” In December 2002, we repurchased $1.1 million principal amount of the 4.75% notes for total consideration of approximately $0.9 million. In connection with the transaction we recorded a gain of $0.2 million which is included in interest income and other, net. In the second quarter of 2003, we repurchased $53.4 million principal amount of our 4.75% convertible subordinated notes due in 2007 and $48.0 million principal amount of our 5.0% convertible subordinated notes due in 2006. In connection with these transactions, we recognized a net loss of approximately $1.0 million which is included in interest income and other, net. In December 2003, we issued $120.0 million principal amount of 0.75% senior convertible notes. In January 2004, we completed the redemption of our 5.0% notes ($102.0 million face value). In connection with the redemption, we recorded a charge of $3.2 million to interest expense in the first quarter of 2004, related to the unamortized issuance costs and redemption fee associated with the repurchased 5.0% notes. In February 2004, we also completed the redemption of our 4.75% notes ($165.5 million face value). In connection with the redemption, we recorded a charge of $4.9 million to interest expense related to the unamortized issuance costs and redemption fee associated with the repurchased 4.75% notes.

Included in long-term obligations in 2003 through 2005 is the long term portion of deferred revenue relating primarily to our collaboration agreement with Roche. In January 2003, we expanded our collaboration with Roche. Under the terms of the collaborative agreement, Roche paid us an up-front, nonrefundable license fee of $70.0 million. We are recognizing this amount as a component of product related revenue over the research and product development phase which is expected to approximate five years.

(2)    On October 21, 2005, we completed the $122.4 million acquisition of ParAllele BioScience, Inc. (“ParAllele”), a provider of comprehensive genetic discovery solutions to the life science research, pharmaceutical and diagnostic sectors.

38




ITEM 7.                MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following discussion should be read in conjunction with the consolidated financial statements and the related notes that appear elsewhere in this document.

This discussion should be read in conjunction with the other sections of this Annual Report on Form 10-K, including “Item 1: Business”; “Item 1A: Risk Factors”; “Item 6: Selected Financial Data”; and “Item 8: Financial Statements and Supplementary Data.” The various sections of this discussion contain a number of forward-looking statements, all of which are based on our current expectations and could be affected by the uncertainties and risk factors described throughout this filing. Our actual results may differ materially.

All statements in this Annual Report on Form 10-K that are not historical are “forward-looking statements” within the meaning of Section 21E of the Securities Exchange Act of 1934 as amended, including statements regarding our “expectations,” “beliefs,” “hopes,” “intentions,” “strategies” or the like. Such statements are based on our current expectations and are subject to a number of factors and uncertainties that could cause actual results to differ materially from those described in the forward-looking statements. We caution investors that there can be no assurance that actual results or business conditions will not differ materially from those projected or suggested in such forward-looking statements as a result of various factors, including, but not limited to, the risk factors discussed in this Annual Report on Form 10-K in Item 1A. We expressly disclaim any obligation or undertaking to release publicly any updates or revisions to any forward-looking statements contained herein to reflect any change in our expectations with regard thereto or any change in events, conditions, or circumstances on which any such statements are based.

Overview

We are engaged in the development, manufacture, sale and service of consumables and systems for genetic analysis for use in the life sciences and in clinical diagnostics, and emerging markets outside of healthcare including agricultural markets, environmental testing and bio-defense applications. Our industry is affected by a number of factors that influence its size and development. These factors include the availability of genomic sequence data for human and other organisms, technological innovation that increases throughput and lowers the cost of genomic and genetic analysis, the development of new computational techniques to handle and analyze large amounts of genomic data, the availability of government and private funding for basic and disease-related research, the amount of capital and ongoing expenditures allocated to research and development spending by biotechnology, pharmaceutical and diagnostic companies, the application of genomics to new areas including molecular diagnostics, agriculture, human identity and consumer goods, and the availability of genetic markers and signatures of diagnostic value.

We have established our GeneChip® system as the platform of choice for acquiring, analyzing and managing complex genetic information. Our integrated GeneChip® platform includes disposable DNA probe arrays (chips) consisting of gene sequences set out in an ordered, high density pattern; certain reagents for use with the probe arrays; a scanner and other instruments used to process the probe arrays; and software to analyze and manage genomic information obtained from the probe arrays. We currently sell our products directly to pharmaceutical, biotechnology, agrichemical, diagnostics and consumer products companies as well as academic research centers, government research laboratories, private foundation laboratories and clinical reference laboratories in North America, Europe and Japan. We also sell our products through life science supply specialists acting as authorized distributors in Latin America, India, the Middle East, and Asia Pacific regions, including China. We have incurred net losses and negative cash flows from operations in the past, but have now achieved profitability for three consecutive fiscal years. The following overview describes key elements of our business strategy and our goals for fiscal 2006:

39




Continue to develop and expand sales of our GeneChip® system.   We intend to continue to enhance our GeneChip® technology through substantial investments in research and development and collaborations. As we continue to enhance the functionality and decrease the unit costs of our GeneChip® products, we aim to encourage our customers to expand their research uses for our GeneChip® system, which will create new market opportunities for us.

Leverage our technologies into new markets.   A key driver will be increasing the breadth of scientific and diagnostic applications of our technology, while also industrializing, automating and standardizing our technology to open new markets which will assist us in driving revenue growth. The aim of our automation efforts is to reduce the cost per experiment, minimize operator variability and improve experimental throughput. We believe that our automation solutions will enjoy commercial success in industrial applications and high-volume markets just as our bench-top systems have in the research markets. We have several active collaborations aimed at extending our existing technologies and products into diagnostic applications and we continue to look for new applications for our technology, new collaborative opportunities and new markets.

Increase sales related to our consumables:   Our goal in 2006 is to continue to grow our product and product related revenue. We expect to achieve this goal through continued growth in sales of our consumable probe arrays and reagents as well as related services as we expand our product lines, applications and add new customers. We anticipate that our continued growth in consumables will offset an expected decline in instrument sales as we finish our instrument upgrade cycle.

Maintain our operating margins.   Management is focused on growing the business and increasing its operating profitability. In addition to the revenue growth opportunities described above, we will continue to closely manage our manufacturing costs and operating expenses. We expect a slight decline in gross margins for 2006 as we continue to expand our manufacturing capacity to support our anticipated sales growth in consumables. In addition, we will see increased operating costs and expenses related to our adoption of SFAS 123(R) and our integration of the ParAllele acquisition.

Acquisition

On October 21, 2005, Affymetrix acquired 100% of the outstanding shares of ParAllele BioScience, Inc. (“ParAllele”), a provider of comprehensive genetic discovery solutions to the life science research, pharmaceutical and diagnostic sectors. ParAllele’s products and services utilize a unique approach that leverages novel biochemical processes rather than complex instrumentation to discover and analyze minute variations in the human genome. We expect the acquisition to accelerate the development and commercialization of new products and create greater opportunities for market penetration and revenue generation as well as increase our core assay development capabilities.

The total purchase price of the ParAllele acquisition was $122.4 million and includes the following components (in thousands):

Fair value of Affymetrix common stock issued

 

$

99,446

 

Merger consideration paid in cash

 

11,723

 

Fair value of stock options assumed

 

7,666

 

Direct transaction costs

 

3,582

 

Total purchase price

 

$

122,417

 

 

The results of operations of ParAllele have been included in the accompanying consolidated financial statements from the date of acquisition. See Note 3 for further information regarding this acquisition.

40




CRITICAL ACCOUNTING POLICIES & ESTIMATES

General

The following section of Management’s Discussion and Analysis of Financial Condition and Results of Operations is based upon our consolidated financial statements, which have been prepared in accordance with U.S. generally accepted accounting principles. The preparation of these financial statements requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenue and expenses, and related disclosure of contingent assets and liabilities. Management bases its estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.

Our significant accounting policies are fully described in Note 2 to our consolidated financial statements. However, certain accounting policies are particularly important to the reporting of our financial position and results of operations and require the application of significant judgment by our management. An accounting policy is deemed to be critical if it requires an accounting estimate to be made based on assumptions about matters that are highly uncertain at the time the estimate is made, and if different estimates that reasonably could have been used, or changes in the accounting estimates that are reasonably likely to occur periodically, could materially impact the financial statements. Management believes the following critical accounting policies reflect its more significant estimates and assumptions used in the preparation of the Consolidated Financial Statements.

REVENUE RECOGNITION

We enter into contracts to sell our products and, while the majority of our sales agreements contain standard terms and conditions, there are agreements that contain multiple elements or non-standard terms and conditions. As a result, significant contract interpretation is sometimes required to determine the appropriate accounting, including whether the deliverables specified in a multiple element arrangement should be treated as separate units of accounting for revenue recognition purposes, and if so, how the value of the arrangement should be allocated among the deliverable elements, when and how to recognize revenue for each element, and the period over which revenue should be recognized. We recognize revenue for delivered elements only when the fair values of undelivered elements are known and customer acceptance has occurred. Changes in the allocation of the sales price between delivered to undelivered elements might impact the timing of revenue recognition, but would not change the total revenue recognized on any arrangement.

ACCOUNTS RECEIVABLE

We evaluate the collectibility of our trade receivables based on a combination of factors. We regularly analyze our significant customer accounts, and, when we become aware of a specific customer’s inability to meet its financial obligations to us, such as in the case of bankruptcy filings or deterioration in the customer’s operating results or financial position, we record specific bad debt allowances to reduce the related receivable to the amount we reasonably believe is collectible. We also record allowances for bad debt on a small portion of all other customer balances based on a variety of factors including the length of time the receivables are past due, the financial health of the customer, macroeconomic considerations and historical experience. If circumstances related to specific customers change, our estimates of the recoverability of receivables could be further adjusted.

41




INVENTORIES

We enter into inventory purchases and commitments so that we can meet future shipment schedules based on forecasted demand for our products. The business environment in which we operate is subject to rapid changes in technology and customer demand. We perform a detailed assessment of inventory each period, which includes a review of, among other factors, demand requirements, product life cycle and development plans, component cost trends, product pricing, product expiration and quality issues. Based on this analysis, we record adjustments to inventory for potentially excess, obsolete or impaired goods, when appropriate, in order to report inventory at net realizable value. Revisions to our inventory adjustments may be required if actual demand, component costs, supplier arrangements, or product life cycles differ from our estimates.

NONMARKETABLE EQUITY SECURITIES

As part of our strategic efforts to gain access to potential new products and technologies, we invest in equity securities of certain private biotechnology companies. Our nonmarketable equity securities are carried at cost unless we determine that an impairment that is other than temporary has occurred, in which case we write the investment down to its impaired value. We periodically review our investments for impairment; however, the impairment analysis requires significant judgment in identifying events or circumstances that would likely have significant adverse effect on the fair value of the investment. The analysis may include assessment of the investee’s (i) revenue and earnings trend, (ii) business outlook for its products and technologies, (iii) liquidity position and the rate at which it is using its cash, and (iv) likelihood of obtaining subsequent rounds of financing. If an investee obtains additional funding at a valuation lower than our carrying value, we presume that the investment is other than temporarily impaired. We have experienced impairments in our portfolio due to the decline in equity markets over the past few years. However, we are not able to determine at the present time which specific investments are likely to be impaired in the future, or the extent or timing of the individual impairments.

DEFERRED TAXES

Income tax expense is based on pretax financial accounting income under the liability method. Deferred tax assets and liabilities are determined based on the difference between the financial statement and tax basis of assets and liabilities using enacted tax rates in effect for the year in which the differences are expected to reverse. We must then assess the likelihood that the resulting deferred tax assets will be realized. To the extent we believe that realization is not more likely than not, we establish a valuation allowance. Significant estimates are required in determining our provision for income taxes, our deferred tax assets and liabilities, and any valuation allowance to be recorded against our net deferred tax asset. Some of these estimates are based on interpretations of existing tax laws or regulations. We believe that our estimates are reasonable and that our reserves for income tax related uncertainties are adequate. Various internal and external factors may have favorable or unfavorable effects on our future effective tax rate. These factors include, but are not limited to, changes in tax laws, regulations and/or rates, changing interpretations of existing tax laws or regulations, changes in the valuation of our deferred tax assets or liabilities, future levels of research and development spending, and changes in overall levels and mix of pretax earnings.

CONTINGENCIES

We are subject to legal proceedings principally related to intellectual property matters. Based on the information available at the balance sheet dates, we assess the likelihood of any adverse judgments or outcomes to these matters, as well as potential ranges of probable losses. If losses are probable and reasonably estimable, we will record a reserve in accordance with SFAS 5, “Accounting for Contingencies.” Any reserves recorded may change in the future due to new developments in each matter.

42




RECENT ACCOUNTING PRONOUNCEMENTS

On December 16, 2004, the Financial Accounting Standards Board (FASB) issued FASB Statement No. 123 (revised 2004), “Share-Based Payment”, which is a revision of FASB Statement No. 123, “Accounting for Stock-Based Compensation”. SFAS 123(R) supersedes APB Opinion No. 25, “Accounting for Stock Issued to Employees”, and amends FASB Statement No. 95, “Statement of Cash Flows”. Generally, the approach in SFAS 123(R) is similar to the approach described in Statement 123. However, SFAS 123(R) requires all share-based payments to employees, including grants of employee stock options, to be recognized in the statement of operations based on their estimated fair values. SFAS 123(R) also requires the benefits of tax deductions in excess of recognized compensation cost to be reported as a financing cash flow, rather than as an operating cash flow as required under current accounting standards. This requirement will reduce net operating cash flows and increase net financing cash flows in periods after adoption. Pro forma disclosure in our notes to our consolidated financial statements will no longer be an alternative. We will adopt SFAS 123(R) effective January 1, 2006 under the modified-prospective method. As permitted by Statement 123, we currently account for share-based payments to employees using Opinion 25’s intrinsic value method and, as such, generally recognize no compensation cost for employee stock options. Accordingly, the adoption of SFAS 123(R)’s fair value method will have a significant impact on our results of operations, although it will have no impact on our overall financial position. With the adoption of SFAS 123(R), we expect to record stock-based compensation of approximately $11.0 million, net of tax, or $0.15 per diluted share in 2006. Our estimate of stock-based compensation expense is affected by our stock price, the number of stock-based awards it may grant in 2006, as well as a number of complex and subjective valuation assumptions and the related tax effect. These valuation assumptions include, but are not limited to, the volatility of our stock price, the estimated forfeiture rates and employee stock option exercise behaviors.

RESULTS OF OPERATIONS

The following discussion compares the historical results of operations for the years ended December 31, 2005, 2004 and 2003.

PRODUCT SALES

The components of product sales are as follows (in thousands, except percentage amounts):

 

 

Year ended December 31,

 

Dollar
change from

 

Percentage
change from

 

 

 

2005

 

2004

 

2003

 

2004

 

2003

 

2004

 

2003

 

Probe arrays

 

$

197,949

 

$

168,243

 

$

139,591

 

$

29,706

 

$

28,652

 

 

18

%

 

 

21

%

 

Reagents

 

42,428

 

31,744

 

20,419

 

10,684

 

11,325

 

 

34

 

 

 

55

 

 

Instruments

 

62,636

 

77,269

 

62,738

 

(14,633

)

14,531

 

 

(19

)

 

 

23

 

 

Total product sales

 

$

303,013

 

$

277,256

 

$

222,748

 

$

25,757

 

$

54,508

 

 

9

 

 

 

24

 

 

 

Total product sales increased in 2005 as compared to 2004. Probe array sales increased primarily due to an increase of $69.3 million in revenue related to growth in unit sales of our GeneChip® probe arrays. This increase was partially offset by a decrease of $39.6 million in revenue related to a decline in the average selling price of our arrays due to a change in product mix. Reagent sales increased primarily due to an increase in the average selling price of our reagents related to a change in product mix and growth in reagent unit sales associated with increased probe array unit sales. Instrument sales decreased primarily due to a decrease of $16.4 million in revenue related to a decline in unit sales of our GeneChip® Scanner 3000 upgrades as we end our GeneArray® Scanner 2500 upgrade cycle as well as a decrease of $4.4 million in revenue related to a decline in unit sales and in the average selling price of our Fluidics Station 450. These decreases were partially offset by growth of $4.4 million in revenue related to increased

43




unit sales of our new automation equipment and growth of $4.1 million in revenue related to increased unit sales of our GeneChip® Scanner 3000 high-resolution upgrades.

Total product sales increased in 2004 as compared to 2003. Probe array sales increased primarily due to an increase of $32.4 million in revenue related to growth in unit sales of our GeneChip® probe arrays. This increase was partially offset by a decrease of $4.6 million in revenue related to a decline in the average selling price of our probe arrays due to a change in product mix. The increase in unit sales of our probe arrays was primarily the result of new product introductions. Reagent sales increased primarily due to increased probe array sales and continued market acceptance of our new internally manufactured reagents. Instrument sales increased primarily due to growth of $2.5 million in revenue related to increased unit sales of our GeneChip® Scanner 3000 instruments and upgrades, growth of $6.9 million in revenue related to increased unit sales of full GeneChip® instrumentation systems including our new GCS 3000Dx system, and growth of $3.8 million in revenue related to an increase in the average selling price of our instruments due to a change in product mix.

PRODUCT RELATED REVENUE

The components of product related revenue are as follows (in thousands, except percentage amounts):

 

 

Year ended December 31,

 

Dollar
change from

 

Percentage
change from

 

 

 

2005

 

2004

 

2003

 

2004

 

2003

 

2004

 

2003

 

Subscription fees

 

$

12,448

 

$

20,669

 

$

26,208

 

$

(8,221

)

$

(5,539

)

 

(40

)%

 

 

(21

)%

 

Service and other

 

20,172

 

15,526

 

18,451

 

4,646

 

(2,925

)

 

30

 

 

 

(16

)

 

License fees and milestone revenue 

 

14,557

 

17,434

 

13,373

 

(2,877

)

4,061

 

 

(17

)

 

 

30

 

 

Total product related revenue

 

$

47,177

 

$

53,629

 

$

58,032

 

$

(6,452

)

$

(4,403

)

 

(12

)

 

 

(8

)

 

 

Total product related revenue decreased in 2005 as compared to 2004. The decrease was primarily due to the decline in subscription fees earned under our GeneChip® array access programs as we continue to transition customers to volume-based pricing on array sales. Additionally, the recognition of $2.2 million in milestone revenue due to the achievement of substantive goals as defined by our collaborative agreements in 2004 contributed to the decrease. Service and other revenue increased in 2005 primarily due to an increase of approximately $3.2 million in other revenue related to DNA analysis services pertaining to the completion of certain contracts assumed by us upon the acquisition of ParAllele in the fourth quarter of 2005 and due to increased sales of service contracts for our GeneChip® Scanner 3000.

Total product related revenue decreased in 2004 as compared to 2003. The decrease was primarily due to a decline in subscription fees earned under GeneChip® array access programs as we continue to transition customers to volume-based pricing on array sales. In addition, service and other revenue declined primarily due to a $1.8 million decline in service contract revenue due to a decrease in the number of contracts as pre-existing scanner customers upgraded to our GeneChip® Scanner 3000 which is covered by a one year warranty. These decreases were partially offset by an additional $1.1 million of license fees earned from a full year of amortization of the Roche agreement and the recognition of $2.2 million in milestone revenue due to the achievement of substantive at risk goals as defined by our collaborative agreements.

ROYALTY AND OTHER REVENUE (in thousands, except percentage amounts)

 

 

Year ended December 31,

 

Dollar
change from

 

Percentage
change from

 

 

 

2005

 

2004

 

2003

 

2004

 

2003

 

2004

 

2003

 

Royalties and other revenue

 

$

8,339

 

$

9,832

 

$

10,556

 

$

(1,493

)

$

(724

)

 

(15

)%

 

 

(7

)%

 

 

44




Royalties and other revenue decreased in 2005 as compared to 2004. The decrease was primarily due to a decline in the number of our non-core license agreements and the recognition of one monetary and one non-monetary license agreement with no continuing performance obligations in 2004 partially offset by the recognition of a $1.5 million license agreement with no continuing performance obligations in the fourth quarter of 2005.

Royalties and other revenue decreased in 2004 as compared to 2003. The decrease was primarily due to a decline in the number and average value of our remaining non-core license agreements.

REVENUE FROM PERLEGEN SCIENCES, INC. (in thousands, except percentage amounts)

 

 

Year ended December 31,

 

Dollar
change from

 

Percentage
change from

 

 

 

2005

 

2004

 

2003

 

2004

 

2003

 

2004

 

2003

 

Revenue from Perlegen Sciences

 

$

9,073

 

$

5,245

 

$

9,460

 

$

3,828

 

$

(4,215

)

 

73

%

 

 

(45

)%

 

 

Revenue from Perlegen Sciences, a related party, increased in 2005 as compared to 2004. These increases were primarily due to increased demand by Perlegen for our probe arrays and whole wafers. Probe arrays and wafers used by Perlegen for use in their research and development activities are sold at our fully burdened cost of manufacturing. We also earn a royalty on certain of these wafers if these products are used by Perlegen for certain revenue activities. Royalties recognized were $2.8 million and $1.4 million in 2005 and 2004. Beginning in the fourth quarter of 2005, we also began selling probe arrays and reagents to Perlegen for use in certain new applications, with 2005 revenues totaling $1.0 million.

Revenue from Perlegen Sciences, a related party, decreased in 2004 as compared to 2003. The decline was primarily due to decreased demand by Perlegen for our whole wafers. We sell whole wafers to Perlegen for use in Perlegen’s research and development activities at our fully burdened cost of manufacturing. Starting in the second quarter of 2004, we began recognizing royalties on the sale of probe arrays that were utilized by Perlegen for revenue generating activities. The royalities earned on the sale of these probe arrays was $1.4 million in 2004.

PRODUCT AND PRODUCT RELATED GROSS MARGINS (in thousands, except percentage amounts)

 

 

Year ended December 31,

 

Dollar /Point
change from

 

 

 

2005

 

2004

 

2003

 

2004

 

2003

 

Gross margin on product sales

 

$

218,305

 

$

195,556

 

$

142,590

 

$

22,749

 

$

52,966

 

Gross margin on product related revenue

 

35,627

 

43,995

 

48,375

 

(8,368

)

(4,380

)

Gross margin on product and product related revenue

 

$

253,932

 

$

239,551

 

$

190,965

 

$

14,381

 

$

48,586

 

Product gross margin as a percentage of product sales

 

72.0

%

70.5

%

64.0

%

1.5

 

6.5

 

Product related gross margin as a percentage of product related revenue

 

75.5

%

82.0

%

83.4

%

(6.5

)

(1.4

)

 

The gross margin percentage on product sales increased in 2005 as compared to 2004. Of the 1.5 point increase in product gross margins, approximately 1.0 point of the increase can be attributed to an increase in probe array gross margins due to the conversion of a royalty bearing technology license from Oxford Gene Technology (OGT) to a fully paid-up non-royalty bearing license in the second half of 2004. The remainder of the gross margin increase can be attributed to decreased unit costs associated with the increased utilization of our probe array manufacturing facility due to increased sales volume and a change in our overall product mix towards our higher margin products such as probe arrays and reagents. The increase was partially offset by a decrease in gross margin of approximately 1.0 point which can be

45




attributed to a $2.0 million warranty adjustment and related yield issues associated with the release of our Mapping 500K Array product in the third quarter of 2005.

The gross margin percentage on product related revenue decreased in 2005 as compared to 2004. The margin decreases were primarily due to a decline in sales of our access agreements as we continue to transition customers to volume-based pricing on array sales and the recognition of $2.2 million in milestone revenue due to the achievement of substantive goals as defined by our collaborative agreements in 2004. We also incurred costs related to the completion of contracts entered into by ParAllele prior to the closing of the acquisition in the fourth quarter of 2005.

The gross margin percentage on product sales increased from in 2004 as compared to 2003. Of the 6.5 point increase in product gross margins, approximately 2.1 points of the increase can be attributed to an increase in probe array gross margins due to the conversion of a royalty bearing technology license from OGT to a fully paid-up non-royalty bearing license in the second half of 2004. The remainder of the gross margin increase can be attributed to increased utilization of our chip and instrument manufacturing facilities due to increased sales volume as well as a change in our overall product mix.

The gross margin percentage on product related revenue decreased in 2004 as compared to 2003. The 1.4 point decrease was primarily due to a decline in sales of our access agreements as we continue to transition customers to volume-based discounting on product sales and due to an increase in expenses related to certain of our service agreements. These margin decreases were partially offset by the recognition of $2.2 million in milestone revenue due to the achievement of substantive at risk goals as defined by our collaborative agreements.

COST OF PERLEGEN REVENUES (in thousands, except percentage amounts)

 

 

Year ended December 31,

 

Dollar
change from

 

Percentage
change from

 

 

 

2005

 

2004

 

2003

 

2004

 

2003

 

2004

 

2003

 

Cost of revenue from Perlegen Sciences

 

$

5,154

 

$

3,611

 

$

9,460

 

$

1,543

 

$

(5,849

)

 

43

%

 

 

(62

)%

 

 

Cost of Perlegen revenue increased in 2005 and increased as compared to 2004 primarily due to increased demand by Perlegen for our probe arrays and whole wafers.

Cost of Perlegen revenue decreased in 2004 as compared to 2003 primarily due to the reduction in wafer purchases made by Perlegen. This decrease was partially offset by costs associated with Perlegen’s purchase of GeneChip® instruments in the first half of 2004.

RESEARCH AND DEVELOPMENT EXPENSES (in thousands, except percentage amounts)

 

 

Year ended December 31,

 

Dollar
change from

 

Percentage
change from

 

 

 

2005

 

2004

 

2003

 

2004

 

2003

 

2004

 

2003

 

Research and development

 

$

77,404

 

$

73,405

 

$

65,909

 

$

3,999

 

$

7,496

 

 

5

%

 

 

11

%

 

 

Research and development expenses increased in 2005 as compared to 2004. These increases were primarily due to an increase in the consumption of development supply materials of $2.1 million and an increase of $1.9 million in co-development costs. These increases are as a result of our preparation for new product introductions and applications expected to be introduced in the next twelve months. These increases were partially offset by a decrease of $2.5 million in performance based compensation.

Research and development expenses, which primarily consist of basic research, product research and development and manufacturing process and development increased in 2004 as compared to 2003. The growth was primarily due to $4.2 million in increased costs associated with the expanded use of our pilot

46




operations facility in Sunnyvale for new product development. We also increased our spending on basic research and product research and development.

We believe a substantial investment in research and development is essential to a long-term sustainable competitive advantage and critical to expansion into additional markets and expect our expenses to increase as we integrate our ParAllele acquisition, develop new products and incorporate our stock-based compensation charges related to our adoption of SFAS 123(R).

SELLING, GENERAL AND ADMINISTRATIVE EXPENSES (in thousands, except percentage amounts)

 

 

Year ended December 31,

 

Dollar
change from

 

Percentage
change from

 

 

 

2005

 

2004

 

2003

 

2004

 

2003

 

2004

 

2003

 

Selling, general and administrative

 

$

121,952

 

$

116,973

 

$

104,797

 

$

4,979

 

$

12,176

 

 

4

%

 

 

12

%

 

 

Selling, general and administrative expenses increased in 2005 as compared to 2004. These increases were primarily due to higher headcount-related costs from hiring new employees and normal salary increases for existing employees of $6.3 million and an increase of $2.5 million in consulting costs. Our increased headcount expenses and consulting costs were primarily due to our continued international expansion, investments in new strategic initiatives, and in anticipation of our new product introductions. These increases were partially offset by a decrease of $6.2 million in performance based compensation.

Selling, general and administrative expenses increased in 2004 as compared to 2003. The growth was partially due to an increase of $5.2 million in sales and marketing expenses which was comprised of $8.0 million related to new product introductions and increased sales volume in our American and European regions, partially offset by a decrease in sales and support costs of $2.8 million in Japan as our Japanese operations completed their obligations associated with a prior distribution agreement. In addition, general and administrative expenses increased by $7.0 million related to on-going regulatory compliance efforts and other general administrative costs. This increase is net of $3.7 million in lower legal expenses and the receipt of a cash settlement in 2004 of approximately $1.0 million in connection with the resolution of an intellectual property dispute.

Selling, general and administrative expenses are expected to continue to increase as we expand sales, marketing, and technical support functions, management and administrative functions, prosecute and defend our intellectual property position, defend against claims made by third parties in ongoing litigation, and incorporate our stock-based compensation charges related to our adoption of SFAS 123(R). We expect legal costs to vary substantially as the intensity of legal activity changes. There can be no assurance that we have adequately estimated our exposure for potential damages associated with pending or future litigation.

STOCK-BASED COMPENSATION (in thousands, except percentage amounts)

 

 

Year ended December 31,

 

Dollar
change from

 

Percentage
change from

 

 

 

2005

 

2004

 

2003

 

2004

 

2003

 

2004

 

2003

 

Stock-based compensation

 

$

1,106

 

$

920

 

$

2,238

 

$

186

 

$

(1,318

)

 

20

%

 

 

(59

)%

 

 

Stock-based compensation increased in 2005 as compared to 2004. In 2005, we recorded stock-based compensation expense related to restricted stock awards granted to certain employees and one fully vested restricted stock award granted to a non-employee. Also in 2005, stock-based compensation included the amortization of deferred stock compensation generated upon the acquisition of ParAllele in October 2005. The amortization of deferred stock-based compensation is principally attributable to research and development and selling, general and administrative employees. In 2004, stock-based compensation related

47




to the amortization of deferred stock compensation generated upon the acquisition of Neomorphic in October 2000, this was fully amortized as of December 31, 2004, except for approximately $4.3 million related to an executive level Neomorphic employee.

Stock-based compensation, which primarily includes the amortization of deferred stock compensation in fiscal 2004 and 2003, decreased $1.3 million in 2004 as compared to 2003. Upon the acquisition of Neomorphic in October 2000, the fair value of unvested common stock subject to restricted stock agreements and the intrinsic value of the unvested options held by employees were deducted from the purchase price and allocated to deferred stock compensation. The amortization of deferred stock-based compensation is principally attributable to research and development and selling, general and administrative employees. As of December 31, 2004, all of the remaining deferred stock compensation related to the Neomorphic acquisition has been amortized except for approximately $4.3 million of deferred stock compensation.

We ceased amortizing $4.3 million of deferred stock compensation related to an executive level Neomorphic employee who commenced a leave of absence during the latter part of fiscal 2001. The terms of this restricted stock arrangement permit an extended leave of absence under certain circumstances and as such, any remaining deferred compensation will be amortized if and when the employee resumes active employee status with us. We expect to continue to grant restricted stock awards to certain employees. Accordingly, since these awards will be amortized to the appropriate cost and expense lines consistent with the vesting terms, the timing or size of these restricted stock awards upon the adoption of SFAS 123(R) could have a significant impact on our future results of operations.

With our adoption of SFAS 123(R), we expect to record stock-based compensation of approximately $11.0 million, net of tax, or $0.15 per diluted share in 2006. However, our estimate of future stock-based compensation expense is affected by our stock price, the number of stock-based awards we may grant in 2006, as well as a number of complex and subjective valuation assumptions and the related tax effect. These valuation assumptions include, but are not limited to, the volatility of our stock price, the estimated forfeiture rates and employee stock option exercise behaviors. The costs associated with stock-based compensation will be included in the appropriate cost and expense lines on our Consolidated Statement of Operations for our results in 2006.

AMORTIZATION OF PURCHASED INTANGIBLES (in thousands, except percentage amounts)

 

 

Year ended December 31,

 

Dollar
change from

 

Percentage
change from

 

 

 

2005

 

2004

 

2003

 

2004

 

2003

 

2004

 

2003

 

Amortization of purchased intangibles

 

 

$

 

 

 

$

 

 

$

937

 

 

$

 

 

$

(937

)

 

%

 

(100

)%

 

We incurred no charges related to the amortization of purchased intangibles in 2004 or 2005 as we fully amortized all of our purchased intangibles during the fiscal year ended 2003.

For fiscal 2003, the amortization of purchased intangibles represents the amortization of intangibles related to the acquisition of Neomorphic, Inc. We adopted Statement of Financial Accounting Standards No. 142, “Goodwill and Other Intangible Assets” (“SFAS 142”) on January 1, 2002. In accordance with SFAS 142, we reclassified $0.8 million of assembled workforce to goodwill and ceased the amortization of goodwill.

We completed our review for potential impairment of goodwill as of June 30, 2005, and concluded there was no impairment of goodwill. In addition, there have been no indicators of potential impairment through December 31, 2005.

48




ACQUIRED IN-PROCESS TECHNOLOGY (in thousands, except percentage amounts)

 

 

Year ended December 31,

 

Dollar
change from

 

Percentage
change from

 

 

 

2005

 

2004

 

2003

 

2004

 

2003

 

2004

 

2003

 

Acquired in-process technology

 

$

8,315

 

 

$

 

 

$

10,096

 

$

8,315

 

$

(10,096

)

 

%

 

(100

)%

 

During the year ended December 31, 2005, we recorded a charge of approximately $8.3 million to acquired in-process technology upon the October 21, 2005 completion of our acquisition of ParAllele BioScience, Inc. (“ParAllele”), a provider of comprehensive genetic discovery solutions to the life science research, pharmaceutical and diagnostic sectors. We utilized the assistance of a third party valuation specialist to help us determine the estimated fair value of certain research and development programs in-process at the acquisition date that had not yet reached technological feasibility and had no alternative future use. These projects primarily included the development of a DNA genotyping product and to a lesser extent certain RNA and other expression products. The fair values of these projects were determined using the Income Approach whereby we estimated each project’s related future net cash flows between 2005 and 2015 and discounted them to their present value using a risk adjusted discount rate of 28%. This discount rate is based on our estimated weighted average cost of capital adjusted upward for the risks associated with the projects acquired. The projected cash flows from the acquired projects were based on estimates of revenues and operating profits related to the projects considering the stage of development of each potential product acquired, the time and resources needed to complete the development and approval of each product, the life of each potential commercialized product and the inherent difficulties and uncertainties in developing products and services based on complex genetic technologies and biochemical processes. As of October 21, 2005 and December 31, 2005, the DNA genotyping project was 33% complete and the RNA & other projects were 40% complete. We expect to incur costs of approximately $5.6 million to complete the DNA genotyping project and costs of $1.5 million to complete the RNA & other projects. We expect significant cash flows from these projects to begin in 2006 and do not anticipate any material changes to historical pricing, expense levels or gross margins related to these products.

During the year ended December 31, 2003, we recorded a charge of approximately $10.1 million to acquired in-process technology. The associated charge was for advanced access to the Perlegen SNP database and was recorded as the database has no alternative future use to us beyond our developing a limited number of closely related DNA analysis products. We did not acquire any in-process research projects from Perlegen. Therefore, as of the license date, we did not forecast any material changes from our historical gross margins for any of our DNA analysis products.

We engaged an independent third party valuation professional to assist us in determining the relative fair values of each intangible asset licensed and the allocation of the consideration paid. While we considered the work of the independent third party valuation professional, we took primary responsibility for allocating the consideration paid for the intangible assets acquired. We determined the value of the SNP database license by using the Income Approach. In applying this approach, we estimated the net present value of future cash flows expected from the sale of DNA analysis products to be developed in reliance on the content from the Perlegen SNP database. The analysis included forecasted future cash flows that were expected from the progress made on our DNA microarray development projects prior to the date of the Perlegen SNP database license. These cash flows were first estimated by forecasting total revenue associated with sales of certain of our future DNA analysis products. A portion of this revenue was then removed to account for the contribution provided by our existing core technology that was considered to benefit the DNA products under development. Appropriate operating expenses, cash flow adjustments, and contributory asset returns were deducted from the estimated cash flows to establish a forecast of net cash flows. Finally, these net cash flows were converted to a present value using a discount rate of 30%, which was based on our weighted average cost of capital adjusted for the technical and market

49




risks associated with our ongoing research project in which the SNP database content would be used. Significant cash inflows from the associated DNA products were forecasted to continue through 2008.

The estimates used by us in valuing the licensed technologies and acquired in process technologies were based upon assumptions we believe to be reasonable but which are inherently uncertain and unpredictable. Our assumptions may be incomplete or inaccurate, and no assurance can be given that unanticipated events and circumstances will not occur. Accordingly, actual results may vary from the projected results.

INTEREST INCOME AND OTHER, NET (in thousands, except percentage amounts)

The components of interest income and other, net, are as follows:

 

 

Year ended December 31,

 

Dollar
change from

 

Percentage
change from

 

 

 

2005

 

2004

 

2003

 

2004

 

2003

 

2004

 

2003

 

Interest income

 

$

8,118

 

$

4,189

 

$

7,382

 

$

3,929

 

$

(3,193

)

94

%

(43

)%

Realized loss in Perlegen

 

(2,000

)

 

 

(2,000

)

 

(100

)

 

Write (down) up of equity investment, net

 

(171

)

(2,283

)

4,876

 

2,112

 

(7,159

)

93

 

(147

)

Currency gains (losses), net

 

470

 

(458

)

3,574

 

928

 

(4,032

)

203

 

(113

)

Other

 

323

 

869

 

830

 

(546

)

39

 

(63

)

5

 

Interest income and other, net

 

$

6,740

 

$

2,317

 

$

16,662

 

$

4,423

 

$

(14,345

)

191

 

(86

)

 

Interest income and other, net, increased in 2005 as compared to 2004. The increase was primarily due to an increase in our cash and marketable securities balances as we continue to generate positive cashflows from operations and financing activities. However, these increases were partially offset by a realized loss related to the recognition of our proportionate share of Perlegen’s net loss. The carrying value of our investment in Perlegen has now been written down to zero at December 31, 2005; therefore, to the extent we do not make any additional future investments in Perlegen, we do not expect further charges related to this investment.

Interest income and other, net decreased in 2004 as compared to 2003. The decrease in interest income and other, net was primarily due to the recognition of a $4.4 million gain in 2003 on an equity investment in a privately-held biotechnology company following its acquisition by a publicly traded entity and a $1.4 million gain realized in 2003 on the sale of some of our Perlegen stock. In 2003, we also realized currency gains of $3.5 million prior to the date we began hedging a percentage of our assets in 2004 that are held in various foreign currencies of our subsidiaries with forward contracts, with the gains or losses on these contracts largely offsetting gains and losses on the change in value of the underlying assets. Interest income declined in 2004 due to lower cash and marketable securities balances following the $271.8 million of bond redemptions completed in the first quarter of 2004 and a $41.9 million license payment to OGT in the second quarter of 2004. Finally, we realized impairment charges of $2.3 million in 2004 due to other-than-temporary declines in the carrying values of certain non-marketable equity securities.

INTEREST EXPENSE (in thousands, except percentage amounts)

 

 

Year ended December 31,

 

Dollar
change from

 

Percentage
change from

 

 

 

2005

 

2004

 

2003

 

2004

 

2003

 

2004

 

2003

 

Interest expense

 

$

1,545

 

$

11,102

 

$

17,358

 

$

(9,557

)

$

(6,256

)

 

(86

)%

 

 

(36

)%

 

 

Interest expense decreased in 2005 as compared to 2004. Interest expense in 2005 primarily consists of interest and amortization of the debt issuance costs associated with our $120.0 million 0.75% senior

50




convertible notes issued in December 2003. Interest expense was higher in 2004 primarily due to the write off of approximately $3.8 million in issuance costs plus $4.3 million in redemption premiums incurred by us in connection with the redemption of our 5% and 4.75% convertible subordinated notes in January 2004.

Interest expense decreased in 2004 as compared to 2003. The decrease was primarily due to lower interest charges following the $271.8 million of bond redemptions completed in the first quarter of 2004 of our 5% and 4.75% convertible subordinated notes. This decrease was primarily due to the write off of approximately $3.8 million in issuance costs plus $4.3 million in redemption premiums incurred by us in connection with the redemption of our 5% and 4.75% convertible subordinated notes. In addition, the decrease was also offset by $1.7 million in interest expense and the amortization of debt issuance costs associated with the $120.0 million of 0.75% senior convertible notes issued in December 2003.

INCOME TAX PROVISION (in thousands, except percentage amounts)

 

 

Year ended December 31,

 

Dollar
change from

 

Percentage
change from

 

 

 

2005

 

2004

 

2003

 

2004

 

2003

 

2004

 

2003

 

Income tax provision

 

$

5,092

 

$

3,326

 

$

2,563

 

$

1,766

 

$

763

 

 

53

%

 

 

30

%

 

 

The provision for income tax was approximately $5.1 million in 2005, up from $3.3 million in 2004. In 2005, the provision principally consists of federal taxes, state taxes, and taxes payable on the taxable profits generated by our foreign operations. The provision for income tax was approximately $3.3 million in 2004, up from $2.6 million in 2003. In 2004 and 2003, the provision consists of current taxes payable on the profits attributable to our foreign operations, state taxes and federal alternative minimum tax.

Statement of Financial Accounting Standards No. 109, “Accounting for Income Taxes” (“SFAS 109”) provides for the recognition of deferred tax assets if realization of such assets is more likely than not. Based upon the weight of available evidence, which included an analysis of projected future book and taxable income, as of December 31, 2005, we provided for a valuation allowance of $82.3 million.

During fiscal 2005, we reduced our deferred tax asset valuation allowance by approximately $35.9 million. In assessing the realizability of deferred tax assets, we considered whether it is more likely than not that some portion or all of the deferred tax assets will not be realized. We considered historical book income, the scheduled reversal of deferred tax assets, and projected future book and taxable income in making this assessment. Based upon a detailed analysis of historical and projected book and taxable income, we determined that the realization of certain deferred tax assets for which a valuation allowance had been recorded is considered more likely than not for purposes of reversing the valuation allowance.

As of December 31, 2005, we had total net operating loss carryforwards of $186.9 million, comprised of $144.2 million for U.S. federal and $42.7 million for state. The net operating loss carryforwards expire in the years 2018 through 2023. Additionally, we have federal and state research and development tax credit carryforwards and other various tax credit carryforwards of approximately $35.6 million, which expire in the years 2007 through 2025. Utilization of our net operating loss and tax credit carryforwards may be subject to substantial annual limitations due to the ownership change limitations provided by the Internal Revenue Code and similar state provisions. Such an annual limitation could result in the expiration of the net operating loss before utilization.

51




LIQUIDITY AND CAPITAL RESOURCES

Cashflow (in thousands)

 

 

Year ended December 31,

 

 

 

2005

 

2004

 

2003

 

Net cash provided by operating activities

 

$

64,613

 

$

48,932

 

$

89,858

 

Net cash (used in) provided by investing activities

 

(82,304

)

(46,785

)

86,396

 

Net cash provided by (used in) financing activities

 

74,846

 

(235,083

)

32,140

 

Effect of foreign currency translation on cash and cash equivalents

 

486

 

(397

)

(354

)

Net increase (decrease) in cash and cash equivalents

 

$

57,641

 

$

(233,333

)

$

208,040

 

 

Net Cash Provided by Operating Activities

Cash provided by operating activities is primarily driven by increases in our net income. However, operating cash flows differ from net income as a result of non-cash charges or differences in the timing of cash flows and earnings recognition. Significant components of the change in cash provided by operating activities are as follows:

Net cash used to purchase inventories totaled $15.1 million during 2005. This was related to our decision to stock finished goods instrument inventory at year-end as this is generally our largest sales period.

Deferred revenues declined $13.2 million during 2005 compared to a decrease of $10.1 million in 2004. The decrease in 2005 was primarily due to the amortization of the Roche collaboration fee.

Net Cash Provided by (Used in) Investing Activities

Our investing activities, other than purchases, sales and maturities of available-for-sale securities, primarily consist of capital expenditures, strategic investments and purchased technology rights. Cash used for capital expenditures was $40.2 million, $21.9 million and $12.4 million for the years ended 2005, 2004 and 2003, respectively. Capital expenditures in 2003 through 2005 related to continued expansion in our operating facilities, investments in information management systems, and purchases of production and lab equipment. In 2005, in addition to the common stock we issued, we also used $10.9 million in cash, net of cash assumed, for our acquisition of ParAllele in October 2005. Cash used for the purchase of technology rights was $0.8 million, $43.1 million and $3.3 million in the years ended 2005, 2004 and 2003, respectively. In 2004, the primary component of purchased technology rights related to a $41.9 million license payment to OGT in the second quarter of 2004.

Net Cash Provided by (Used in) Financing Activities

Our financing activities primarily consist of activity under our employee stock plan or funds used in the redemption of or provided by the issuance of our convertible notes. Cash provided by the issuance of stock under our employee stock plan was $74.7 million, $36.2 million and $12.5 million for the years ended 2005, 2004 and 2003, respectively. Net cash used in financing activities in 2004 was primarily attributable to the $271.8 million cash outflow for the redemption of our 5% and 4.75% convertible subordinated notes. In 2003, we repurchased $53.4 million principal amount of our 4.75% convertible subordinated notes due in 2007 and $48.0 million principal amount of our 5.0% convertible subordinated notes due in 2006. Additionally, in December 2003 we raised $120.0 million from the sale of 0.75% senior convertible notes due 2033.

52




Off-Balance Sheet Arrangements and Aggregate Contractual Obligations

As part of our ongoing business, we do not participate in transactions that generate relationships with unconsolidated entities or financial partnerships, such as entities often referred to as structured finance or special purpose entities (“SPEs”), which would have been established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes. As of December 31, 2005, we are not involved in any SPE transactions.

The impact that our contractual obligations as of December 31, 2005 are expected to have on our liquidity and cash flow in future periods is as follows (in thousands):

 

 

Total

 

2006

 

2007-2008

 

2009-2010

 

After 2010

 

Senior convertible notes(1)

 

$

120,000

 

$

 

$

120,000

 

 

$

 

 

 

$

 

 

Interest on senior convertible
notes(1)

 

2,700

 

900

 

1,800

 

 

 

 

 

 

 

Operating leases

 

61,278

 

11,085

 

20,446

 

 

13,270

 

 

 

16,477

 

 

Purchase commitments(2)

 

10,042

 

8,979

 

922

 

 

141

 

 

 

 

 

Other commitments(3)

 

2,100

 

1,500

 

600

 

 

 

 

 

 

 

Total contractual obligations

 

$

196,120

 

$

22,464

 

$

143,768

 

 

$

13,411

 

 

 

$

16,477

 

 


(1)          Our 0.75% senior convertible notes are due in 2033, however holders may require us to repurchase all or a portion of their notes on December 31, 2008, 2013, 2018, 2023, and 2028.

(2)          Purchase commitments include agreements to purchase goods or services that are enforceable and legally binding on Affymetrix and that specify all significant terms, including: fixed or minimum quantities to be purchased; fixed, minimum or variable price provisions; and the approximate timing of the transaction. Purchase obligations exclude agreements that are cancelable without penalty.

(3)          Other commitments relate to an ongoing obligation held by the Company to contribute $1.5 million in a venture capital limited partnership. The venture capital limited partnership may call in this amount, in part or in full at any time according to the contract terms. Other commitments also includes a funding obligation to support two fellowships under the Bio-X Program at Stanford.

We have financed our operations primarily through product sales, sales of equity and debt securities, collaborative agreements, interest income, and licensing of our technology. As of December 31, 2005, we had cash, cash equivalents, and available-for-sale securities of approximately $284.9 million. We anticipate that our existing capital resources along with the cash to be generated from operations will enable us to maintain currently planned operations and planned capital expenditures (estimated to be approximately $65.0 million for the year ending December 31, 2006, which includes our Sacramento and Singapore expansion), for the foreseeable future. However, this expectation is based on our current operating, financing and capital expenditure plans, which are subject to change, and therefore we could require additional funding. We also expect that our capital requirements will increase over the next several years as we expand our worldwide commercial operations, expand our manufacturing capabilities, increase our investments in third parties and expand our research and development efforts. Our long-term capital expenditure requirements will depend on numerous factors, including: the expansion of commercial scale manufacturing capabilities; our ability to maintain existing collaborative and customer arrangements and establish and maintain new collaborative and customer arrangements; the progress of our research and development programs; initiation or expansion of research programs and collaborations; the costs involved in preparing, filing, prosecuting, defending and enforcing intellectual property rights; the effectiveness of product commercialization activities and arrangements; the purchase of patent licenses; and other factors.

As of December 31, 2005, we have no credit facility or other committed sources of capital. To the extent capital resources are insufficient to meet future capital requirements; we will have to raise

53




additional funds to continue the development of our technologies. There can be no assurance that such funds will be available on favorable terms, or at all. To the extent that additional capital is raised through the sale of equity or convertible debt securities, the issuance of such securities could result in dilution to our stockholders. If adequate funds are not available, we may be required to curtail operations significantly or to obtain funds by entering into collaboration agreements on unattractive terms. Our inability to raise capital would have a material adverse effect on our business, financial condition and results of operations.

ITEM 7A.   QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Interest Rate Risk

Our exposure to interest rate risk relates primarily to our investment portfolio. Fixed rate securities may have their fair market value adversely impacted due to fluctuations in interest rates, while floating rate securities may produce less income than expected if interest rates fall. Due in part to these factors, our future investment income may fall short of expectations due to changes in interest rates or we may suffer losses in principal if forced to sell securities which have declined in market value due to changes in interest rates.

The primary objective of our investment activities is to preserve principal while at the same time maximize yields without significantly increasing risk. To achieve this objective, we invest our excess cash in debt instruments of the U.S. Government and its agencies and high-quality corporate issuers, and, by policy, restrict our exposure to any single corporate issuer by imposing concentration limits. To minimize the exposure due to adverse shifts in interest rates, we maintain investments at an average maturity of less than three years.

The table below presents principal amounts and related weighted interest rates by year of maturity for our available-for-sale securities and debt obligations, all of which are denominated in United States dollars, and the fair value of each as of December 31, 2005 and 2004.

 

 

Periods of Maturity

 

 

 

Fair
Value at
December 31,

 

 

 

2006

 

2007

 

2008

 

Thereafter

 

Total

 

2005

 

ASSETS:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Available-for-sale securities

 

$

229,207

 

$

31,109

 

$

 

 

$

 

 

$

260,316

 

 

$

261,314

 

 

Average interest rate

 

2.2

%

3.3

%

 

 

 

 

 

 

 

 

 

 

 

 

LIABILITIES:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

0.75% senior convertible notes due 2033

 

$

 

$

 

$

120,000

 

 

$

 

 

$

120,000

 

 

$

189,886

 

 

Average interest rate

 

 

 

 

 

0.75

%

 

 

 

 

 

 

 

 

 

 

 

 

 

Periods of Maturity

 

 

 

Fair
Value at
December 31,

 

 

 

2005

 

2006