Affymetrix (AFFX)

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

(MARK ONE)

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

FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2006

OR

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

FOR THE TRANSITION PERIOD FROM          TO          .

COMMISSION FILE NO. 0-28218

AFFYMETRIX, INC.

(Exact name of Registrant as specified in its charter)

 

Registrant’s telephone number, including area code: (408) 731-5000

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 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 x

COMMON SHARES OUTSTANDING ON NOVEMBER 3, 2006: 67,847,821

AFFYMETRIX, INC.

TABLE OF CONTENTS

PART I. FINANCIAL INFORMATION
	Item 1.	Financial Statements (Unaudited), as restated
		Condensed Consolidated Balance Sheets at September 30, 2006 and December 31, 2005, as restated
		Condensed Consolidated Statements of (Loss) Income for the Three and Nine Months Ended September 30, 2006 and 2005, as restated
		Condensed Consolidated Statements of Cash Flows for the Nine Months Ended September 30, 2006 and 2005, as restated
		Notes to Condensed Consolidated Financial Statements, as restated
	Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations
	Item 3.	Quantitative and Qualitative Disclosures About Market Risk
	Item 4.	Controls and Procedures
PART II. OTHER INFORMATION
	Item 1.	Legal Proceedings
	Item 1A.	Risk Factors
	Item 5.	Other Information
	Item 6.	Exhibits
SIGNATURES

 

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PART I. FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

AFFYMETRIX, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(IN THOUSANDS)

(UNAUDITED)

		September 30, 2006			December 31, 2005
					Note 1 (as restated)
ASSETS
Current assets:
Cash and cash equivalents		$	66,487		$	100,236
Available-for-sale securities – short-term		179,055			184,696
Accounts receivable, net		65,097			93,028
Accounts receivable from Perlegen Sciences		5,153			4,082
Inventories		45,654			35,980
Deferred tax assets—current portion		26,375			26,230
Prepaid expenses and other current assets		7,584			12,622
Total current assets		395,405			456,874
Property and equipment, net		132,465			85,560
Acquired technology rights, net		57,204			61,426
Goodwill		124,787			124,498
Deferred tax assets—long-term portion		18,087			17,594
Notes receivable from employees		2,364			1,824
Other assets		33,051			27,318
		$	763,363		$	775,094
LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
Accounts payable and accrued liabilities		$	60,939		$	71,551
Deferred revenue — current portion		34,316			35,644
Total current liabilities		95,255			107,195
Deferred revenue — long-term portion		12,029			15,606
Other long-term liabilities		5,279			4,184
Convertible notes		120,000			120,000
Stockholders’ equity:
Common stock		678			672
Additional paid-in capital		660,732			646,186
Deferred stock compensation		—			(10,799		)
Accumulated other comprehensive loss		(1,503		)	(1,227		)
Accumulated deficit		(129,107		)	(106,723		)
Total stockholders’ equity		530,800			528,109
		$	763,363		$	775,094

 

Note 1:                             The condensed consolidated balance sheet at December 31, 2005 has been derived from the audited consolidated financial statements at that date included in the Company’s Form 10-K/A for the fiscal year ended December 31, 2005.

See accompanying notes.

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AFFYMETRIX, INC.

CONDENSED CONSOLIDATED STATEMENTS OF (LOSS) INCOME

(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)

(UNAUDITED)

		Three Months Ended September 30,						Nine Months Ended September 30,
		2006			2005			2006			2005
					(as restated)						(as restated)
Revenue
Product sales		$	56,139		$	69,044		$	183,154		$	211,808
Product related revenue		17,971			10,456			45,621			32,707
Total product and product related revenue		74,110			79,500			228,775			244,515
Royalties and other revenue		5,969			1,727			10,263			5,280
Revenue from Perlegen Sciences		4,593			2,220			12,091			6,318
Total revenue		84,672			83,447			251,129			256,113
Costs and expenses:
Cost of product sales		23,618			20,755			62,338			57,986
Cost of product related revenue		8,859			2,655			22,712			7,619
Cost of revenue from Perlegen Sciences		1,646			1,359			4,304			4,351
Research and development		21,639			19,835			66,737			57,724
Selling, general and administrative		35,865			30,362			114,107			92,499
Stock-based compensation		—			141			—			257
Restructuring		10,008			—			10,008			—
Total costs and expenses		101,635			75,107			280,206			220,436
(Loss) income from operations		(16,963		)	8,340			(29,077		)	35,677
Interest income and other, net		2,942			2,294			10,949			3,961
Interest expense		(350		)	(413		)	(1,174		)	(1,129		)
(Loss) income before income taxes		(14,371		)	10,221			(19,302		)	38,509
Income tax benefit (provision)		216			(823		)	(3,082		)	(3,330		)
Net (loss) income		(14,155		)	$	9,398		(22,384		)	$	35,179
Basic net (loss) income per common share		$	(0.21	)	$	0.15		$	(0.33	)	$	0.56
Diluted net (loss) income per common share		$	(0.21	)	$	0.14		$	(0.33	)	$	0.52
Shares used in computing basic net (loss) income per share		67,248			63,786			67,320			63,112
Shares used in computing diluted net (loss) income per share		67,248			70,463			67,320			69,966

 

See accompanying notes.

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AFFYMETRIX, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(IN THOUSANDS)
(UNAUDITED)

		Nine Months Ended September 30,
		2006			2005
					(as restated)
Cash flows from operating activities:
Net (loss) income		$	(22,384	)	$	35,178
Adjustments to reconcile net (loss) income to net cash provided by operating activities:
Depreciation and amortization		16,733			15,289
Amortization of intangible assets		6,236			5,666
Amortization of investment discounts, net		(664		)	(1,256		)
Stock-based compensation		20,058			257
Realized (gain) loss on sales of available for sale securities		(7		)	114
Realized loss on equity method investment in Perlegen Sciences		—			2,000
Deferred tax assets		(1,362		)	(2,436		)
Write down of equity investment		165			123
Tax benefit from employee stock options		—			6,096
Amortization of debt offering costs		569			569
Accretion of interest on notes receivable		(40		)	(78		)
Loss on write-off of equipment		631			10
Change in operating assets and liabilities:
Accounts receivable, net		26,860			25,988
Inventories		(9,674		)	(16,643		)
Prepaid expenses and other current assets		(5,160		)	(6,379		)
Accounts payable and accrued and other current liabilities		(10,860		)	(5,394		)
Deferred revenue		(4,905		)	(11,001		)
Other long-term liabilities		1,095			(524		)
Net cash provided by operating activities		17,291			47,579
Cash flows from investing activities:
Capital expenditures		(64,269		)	(18,492		)
Purchases of available-for-sale securities		(85,642		)	(220,645		)
Proceeds from the sales or maturities of available-for-sale securities		94,260			160,799
Proceeds from the capital distribution of a non-marketable equity investment		—			411
Purchase of non-marketable equity investment in Perlegen Sciences		—			(2,000		)
Purchase of non-marketable equity investment		(950		)	(1,000		)
Purchase of technology rights		(250		)	(500		)
Issuance of loan receivable		—			(4,500		)
Net cash used in investing activities		(56,851		)	(85,927		)
Cash flows from financing activities:
Issuance of common stock through the Company’s stock option plans		5,728			47,079
Net cash provided by financing activities		5,728			47,079
Effect of exchange rate changes on cash and cash equivalents		83			375
Net (decrease) increase in cash and cash equivalents		(33,749		)	9,106
Cash and cash equivalents at beginning of period		100,236			42,595
Cash and cash equivalents at end of period		$	66,487		$	51,701

 

See accompanying notes.

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AFFYMETRIX, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2006
(UNAUDITED)

NOTE 1—SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Basis of Presentation

The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with generally accepted accounting principles for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by U.S. generally accepted accounting principles for complete financial statements. The condensed consolidated financial statements include the accounts of Affymetrix, Inc. (“Affymetrix” or the “Company”) and its wholly owned subsidiaries. All significant intercompany accounts and transactions have been eliminated in consolidation. In the opinion of management, all adjustments (consisting of normal recurring entries) considered necessary for a fair presentation have been included.

Results for any interim period are not necessarily indicative of results for any future interim period or for the entire year. The accompanying condensed consolidated financial statements should be read in conjunction with the financial statements and notes thereto included in the Company’s Annual Report on Form 10-K/A for the year ended December 31, 2005, as filed with the Securities and Exchange Commission on August 30, 2006.

Restatement of Prior Period Information

The financial results of operations for the three and nine month periods ended September 30, 2005 have been restated to correct certain errors resulting from the recording of additional non-cash stock-based compensation expense, and the related income tax impact.  Refer to the Company’s Annual Report on Form 10-K/A for the year ended December 31, 2005 for a detailed discussion of the restatement.

Use of Estimates

The preparation of the condensed consolidated financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect amounts reported in the financial statements and accompanying notes. Actual results could differ materially from those estimates.

Revenue Recognition

Overview

The Company recognizes revenue when persuasive evidence of an arrangement exists, delivery has occurred, the fee is fixed or determinable, and collectibility is reasonably assured. In instances where final acceptance of the product or system is required, revenue is deferred until all the acceptance criteria have been met.

The Company derives the majority of its revenue from product sales of GeneChip® probe arrays, reagents, and related instrumentation that may be sold individually or combined with any of the product or product related revenue items listed below. When a sale combines multiple elements, the Company accounts for multiple element arrangements under Emerging Issues Task Force Issue No. 00-21 (“EITF 00-21”), “Revenue Arrangements with Multiple Deliverables.”

EITF 00-21 provides guidance on accounting for arrangements that involve the delivery or performance of multiple products, services and/or rights to use assets. In accordance with EITF 00-21, the Company allocates revenue for transactions or collaborations that include multiple elements to each unit of accounting based on its relative fair value, and recognizes revenue for each unit of accounting when the revenue recognition criteria have been met. The price charged when the element is sold separately generally determines fair value. In the absence of fair value of a delivered element, the Company allocates revenue first to the fair value of the undelivered elements and the residual revenue to the delivered elements. The Company recognizes revenue for delivered elements when the delivered elements have standalone value and the Company has objective and reliable evidence of fair value for each undelivered element. If the fair value of any undelivered element included in a multiple element arrangement cannot be objectively determined, revenue is deferred until all elements are delivered and services have been performed, or until fair value can objectively be determined for any remaining undelivered elements.

Product Sales

Product sales, as well as revenues from Perlegen Sciences, include sales of GeneChip® probe arrays, reagents and related instrumentation. Probe array, reagent and instrumentation revenues are recognized when earned, which is generally upon shipment

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and transfer of title to the customer and fulfillment of any significant post-delivery obligations. Accruals are provided for anticipated warranty expenses at the time the associated revenue is recognized.

Product Related Revenue

Product related revenue includes subscription fees earned under GeneChip® array access programs; license fees; milestones and royalties earned from collaborative product development and supply agreements; equipment service revenue; product related scientific services revenue; and revenue from custom probe array design fees.

Revenue from subscription fees earned under GeneChip® array access programs is recorded ratably over the related supply term.

The Company enters into collaborative arrangements which generally include a research and product development phase and a manufacturing and product supply phase. These arrangements may include up-front nonrefundable license fees, milestones, the rights to royalties based on the sale of final product by the partner, product supply agreements and distribution arrangements.

Any up-front, nonrefundable payments from collaborative product development agreements are recognized ratably over the research and product development period, and at-risk substantive based milestones are recognized when earned. Any payments received which are not yet earned are included in deferred revenue.

Revenue related to extended warranty arrangements is deferred and recognized ratably over the applicable periods. Revenue from custom probe array design fees associated with the Company’s GeneChip® CustomExpressÔ and CustomSeqÔ products are recognized when the associated products are shipped.

Revenue from scientific and DNA analysis services are recognized upon shipment of the required data to the customer.

Royalties and Other Revenue

Royalties and other revenue include royalties earned from third party license agreements and research revenue which mainly consists of amounts earned under government grants. Additionally, other revenue includes fees earned through the license of the Company’s intellectual property.

Royalty revenues are earned from the sale of products by third parties who have been licensed under the Company’s intellectual property portfolio. Revenue from minimum royalties is amortized over the term of the creditable royalty period. Any royalties received in excess of minimum royalty payments are recognized under the terms of the related agreement, generally upon notification of manufacture or shipment of a product by a licensee.

Research revenues result primarily from research grants received from U.S. Government entities or from subcontracts with other life science research-based companies which receive their research grant funding from the U.S. Government. Revenues from research contracts are generated from the efforts of the Company’s technical staff and include the costs for material and subcontract efforts. The Company’s research grant contracts generally provide for the payment of negotiated fixed hourly rates for labor hours incurred plus reimbursement of other allowable costs. Research revenue is recorded in the period in which the associated costs are incurred, up to the limit of the prior approval funding amounts contained in each agreement. The costs associated with these grants are reported as research and development expense.

License revenues are generally recognized upon execution of the agreement unless the Company has continuing performance obligations, in which case the license revenue is recognized ratably over the period of expected performance.

Transactions with Distributors

The Company recognizes revenue on sales to distributors in accordance with SEC Staff Accounting Bulletin No. 104, “Revenue Recognition,” or SAB 104. The Company recognizes revenue when persuasive evidence of an arrangement exists, delivery has occurred or services have been rendered, the seller’s price is fixed or determinable, and collectibility is reasonably assured. The Company’s agreements with distributors do not include rights of return.

Net (Loss) Income Per Share

Basic net (loss) income per share is calculated using the weighted-average number of common shares outstanding during the period less the weighted-average shares subject to repurchase. Diluted net (loss) income per share gives effect to the dilutive common stock subject to repurchase, stock options and warrants (calculated based on the treasury stock method), and convertible debt (calculated using an as if-converted method).

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The following table sets forth a reconciliation of basic and diluted net (loss) income per share (in thousands, except per share amounts):

		Three Months Ended September 30,						Nine Months Ended September 30,
		2006			2005			2006			2005
					(as restated)						(as restated)
Numerator:
Net (loss) income —basic		$	(14,155	)	$	9,397		$	(22,384	)	$	35,179
Add effect of dilutive securities:
Interest on convertible notes (inclusive of amortization of debt issuance costs)		—			415			—			1,244
Net (loss) income — diluted		$	(14,155	)	$	9,812		$	(22,384	)	$	36,423
Denominator:
Weighted-average shares outstanding		67,498			63,868			67,430			63,201
Less: weighted-average shares of common stock subject to repurchase		(250		)	(82		)	(110		)	(89		)
Shares used in computing basic net (loss) income per common share		67,248			63,786			67,320			63,112
Add effect of dilutive securities:
Employee stock options		—			2,725			—			2,890
Common stock subject to repurchase		—			82			—			89
Warrants to purchase common stock		—			—			—			5
Convertible notes		—			3,870			—			3,870
Shares used in computing diluted net (loss) income per common share		67,248			70,463			67,320			69,966
Basic net (loss) income per common share		$	(0.21	)	$	0.15		$	(0.33	)	$	0.56
Diluted net (loss) income per common share		$	(0.21	)	$	0.14		$	(0.33	)	$	0.52

 

The following securities were excluded from the computation of diluted net (loss) income per common share, on an actual outstanding basis, as they were anti-dilutive (in thousands):

		Three Months Ended September 30,				Nine Months Ended September 30,
		2006		2005		2006		2005
Employee stock options		6,878		507		6,878		1,647
Common stock subject to repurchase		250		—		110		—
Convertible notes		3,870		—		3,870		—
Total		10,998		507		10,858		1,647

 

Change in Functional Currency

Beginning April 1, 2006, Affymetrix, UK Ltd, a wholly-owned subsidiary incorporated in the United Kingdom, and Affymetrix Pte Ltd, a wholly-owned subsidiary incorporated in Singapore, changed their functional currencies from their local currencies to the U.S. dollar. The change in the functional currency of these subsidiaries is in accordance with SFAS 52, “Foreign Currency Translation”, (SFAS 52) and reflects the changed economic facts and circumstances pertaining to these subsidiaries. Under the requirements of SFAS 52, the Company assessed the various economic factors relating to Affymetrix, UK Ltd and Affymetrix Pte Ltd and concluded that due to changes in facts, circumstances, scope of operations and business practices, the U.S. dollar is now the currency of the primary economic environment in which these subsidiaries operate. Consequently, these subsidiaries will no longer generate translation adjustments which would impact the balance of accumulated other comprehensive income. Translation adjustments from prior periods will continue to remain in accumulated other comprehensive income.

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Recent Accounting Pronouncement

In July 2006, the FASB issued Interpretation No. 48, “Accounting for Uncertainty in Income Taxes, an interpretation of FASB Statement No. 109” (“FIN 48”).  Under FIN 48 a company would recognize the benefit from a tax position only if it is more-likely-than-not that the position would be sustained upon audit based solely on the technical merits of the tax position.  FIN 48 clarifies how a company would measure the income tax benefits from the tax positions that are recognized, provides guidance as to the timing of the derecognition of previously recognized tax benefits and describes the methods for classifying and disclosing the liabilities within the financial statements for any unrecognized tax benefits.  FIN 48 also addresses when a company should record interest and penalties related to tax positions and how the interest and penalties may be classified within the income statement and presented in the balance sheet.  FIN 48 is effective for fiscal years beginning after December 15, 2006 and is required to be adopted by the Company effective January 1, 2007.  The cumulative effects, if any, of applying FIN 48 will be recorded as an adjustment to retained earnings as of the beginning of the period of adoption.  The Company is currently evaluating FIN 48 and its possible impacts on the Company’s financial statements and is not yet in a position to determine such effects, if any.

NOTE 2—RESTATEMENT OF PREVIOUSLY ISSUED FINANCIAL STATEMENTS

On August 9, 2006, the Company concluded that its consolidated financial statements for the years ended December 31, 2005, 2004 and 2003 should be restated to record additional non-cash stock-based compensation expense, and the related income tax impact, resulting from stock options granted during fiscal years 1997 to 1999 that were incorrectly accounted for under U.S. generally accepted accounting principles. The Company’s decision to restate its financial statements was based on the results of an internal review of the Company’s historical stock option granting practices from January 1, 1997 through May 31, 2006 performed under the direction of the Audit Committee of the Board of Directors.  The internal review identified certain errors and documentation lapses but did not find any pattern or practice of inappropriately identifying grant dates with hindsight in order to provide “discounted” or “in-the-money” grants.

The Company concluded that there was a material accounting error as a result of a documentation lapse in July 1999, in which the option grant for an aggregate of 1.99 million shares should have been measured for accounting purposes as of a later date.  In light of the restatement required by this matter, the Company also included in this restatement corrections relating to certain other errors and documentation lapses in the fiscal years 1997 and 1998.  Approximately 97% of the charges relating to the restatement arose from the documentation lapse in July 1999.

The Company determined that the cumulative, pre-tax, non-cash, stock-based compensation expense resulting from revised measurement dates for options granted between 1997 and 1999 was approximately $21.5 million. Accordingly, the Company recorded stock-based compensation expense of $0, $0, and $1.7 million for the years ended December 31, 2005, 2004 and 2003, respectively, and $19.8 million for the five years preceding 2003, based on the vesting periods of the respective grants.  In addition, the Company recorded an income tax benefit of $8.3 million in 2005.  Principally as a result of cumulative losses incurred through 2004, the Company recorded a full valuation allowance against all deferred tax assets for the years ended December 31, 2004 and 2003 and consequently, there was no income tax effect of the additional stock-based compensation expense recorded in those years.  The cumulative effect of the restatement adjustments on the Company’s consolidated balance sheet at December 31, 2005 was an increase in additional paid-in capital of $21.5 million offset by an increase in the accumulated deficit of $13.2 million, which resulted in a net effect on stockholders’ equity of $8.3 million.  The adjustments increased previously reported basic and diluted net income per common share by $0.13 and $0.12, respectively, for the year ended December 31, 2005 and decreased basic and diluted net income per common share by $0.03 for the year ended December 31, 2003.

As part of the Company’s review, the Company assessed whether there were other matters that should have been corrected in its previously issued consolidated financial statements. Apart from the errors underlying the restatement described above, no other matters came to the Company’s attention that should have been adjusted in its previously issued consolidated financial statements.

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The following tables set forth the effects of the restatement on certain line items within the Company’s consolidated statements of income for three and nine months ended September 30, 2005 and condensed consolidated balance sheet as of December 31, 2005:

		Three months ended September 30, 2005			Nine months ended September 30, 2005
Income tax provision:
As previously reported		$	1,508		$	5,767
As restated		$	824		$	3,330
Net income:
As previously reported		$	8,713		$	32,742
As restated		$	9,398		$	35,179
Basic net income per share:
As previously reported		$	0.14		$	0.52
As restated		$	0.15		$	0.56
Diluted net income per share:
As previously reported		$	0.13		$	0.49
As restated		$	0.14		$	0.52

 

		December 31, 2005
Deferred tax assets – current portion:
As previously reported		$	22,117
As restated		$	26,230
Deferred tax assets – long-term portion:
As previously reported		$	13,436
As restated		$	17,594
Additional paid-in capital:
As previously reported		$	624,727
As restated		$	646,186
Accumulated deficit:
As previously reported		$	(93,535	)
As restated		$	(106,723	)

 

Certain other footnotes appearing in these financial statements were impacted by the error corrections reflected in the restatement.  Refer to footnotes 1, 3, and 8.

NOTE 3—STOCK-BASED COMPENSATION

Stock-Based Compensation Plans

The Company has a stock-based compensation program that provides the Board of Directors broad discretion in creating equity incentives for employees, officers, directors and consultants. This program includes incentive and non-qualified stock options and non-vested stock awards (also known as restricted stock) granted under various stock plans. Stock options are generally time-based, vesting 25% on each annual anniversary of the grant date over four years and expire 7 to 10 years from the grant date. Non-vested restricted stock awards are generally time-based, vesting 33% on each of the second, third and fourth anniversaries of the grant date. As of September 30, 2006, the Company had approximately 1.2 million shares of common stock reserved for future issuance under its stock-based compensation plans. New shares are issued as a result of stock option exercises and non-vested restricted stock awards.

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Adoption of SFAS 123R

Effective January 1, 2006, the Company adopted the fair value recognition provisions of SFAS 123R using the modified prospective transition method.  Under the modified prospective transition method, prior periods are not restated for the effect of SFAS 123R.  Commencing with the first quarter of 2006, compensation cost includes all share-based payments granted prior to, but not yet vested as of January 1, 2006, based on the grant date fair value estimated in accordance with the original provisions of SFAS 123, and compensation for all share-based payments granted subsequent to January 1, 2006, based on the grant date fair value estimated in accordance with the provisions of SFAS 123R. The Company recognizes the fair value of its stock option awards as compensation expense over the requisite service period of each award, generally four years. Compensation expense related to stock options granted prior to January 1, 2006 is recognized using the graded method while compensation expense related to stock options granted on or after January 1, 2006 is recognized on a straight-line basis.

Prior to the adoption of SFAS 123R, the Company applied SFAS 123, amended by SFAS 148, “Accounting for Stock-Based Compensation — Transition and Disclosure” (SFAS 148), which allowed companies to apply the existing accounting rules under APB 25, “Accounting for Stock Issued to Employees,” and related Interpretations. In general, as the exercise price of options granted under the Company’s plans was equal to the market price of the underlying common stock on the grant date, no stock-based employee compensation cost was recognized in the Company’s net income (loss) for periods prior to the adoption of SFAS 123R. As required by SFAS 148 prior to the adoption of SFAS 123R, the Company provided pro forma net income (loss) and pro forma net income (loss) per common share disclosures for stock-based awards, as if the fair-value-based method defined in SFAS 123 had been applied.

As a result of adopting SFAS 123R, the Company’s loss before taxes, net loss and basic and diluted loss per share for the three months ended September 30, 2006 was $5.1 million, $4.1 million, $0.06 lower, respectively, than if the Company had continued to account for stock-based compensation under APB Opinion No. 25 and for the nine months ended September 30, 2006 was $12.6 million, $9.2 million and $0.14 lower, respectively.  In accordance with SFAS 123R, the Company is also required to present excess tax benefits from the exercise of stock options, if any, as financing cash flows rather than operating cash flows. No income tax benefit was realized from stock option exercises during the nine months ended September 30, 2006, therefore no such amounts are presented as financing cash flows.

The following table sets forth the total stock-based compensation expense resulting from stock options and non-vested stock awards included in the Company’s Condensed Consolidated Statements of (Loss) Income upon the adoption of SFAS 123R (in thousands):

		Three Months Ended September 30, 2006			Nine Months Ended September 30, 2006
Costs of product sales		$	408		$	1,126
Research and development		934			3,038
Selling, general and administrative		2,290			8,350
Restructuring		7,544			7,544
Total stock-based compensation expense		$	11,176		$	20,058
Income tax benefit		(1,596		)	(3,326		)
Total stock-based compensation expense, net of tax		$	9,580		$	16,732

 

Selling, general and administrative expense included a $1.1 million charge in the second quarter of 2006 due to the modification of an executive officer’s stock option grant to include an extension of time to exercise as well as the vesting of certain stock options without a requisite service period.  Restructuring expense included a $7.5 million charge in the third quarter of 2006 due to the modification of a former Neomorphic employee’s equity awards, all of which became fully vested under the terms of a prior leave of absence agreement when he was involuntarily terminated in connection with the Company’s third quarter restructuring effort (see Note 4).

As of September 30, 2006, $23.5 million of total unrecognized stock-based compensation expense related to non-vested awards is expected to be recognized over the respective vesting terms of each award through 2010. The weighted average term of the unrecognized stock-based compensation expense is 1.6 years.

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The following table illustrates the effect on net income and net income per share if the Company had applied the fair value recognition provisions of SFAS 123 to stock-based employee compensation (in thousands, except per share amounts):

		Three months ended September 30,						Nine months ended September 30,
		2005			2005			2005			2005
		(as previously reported)			(as restated)			(as previously reported)			(as restated)
Net income—as reported		$	8,713		$	9,398		$	32,742		$	35,179
Add: Stock-based employee compensation expense included in reported net income, net of tax		—			—			—			—
Deduct: Total stock-based employee compensation expense determined under fair value method for all awards, net of tax		(4,691		)	(4,691		)	(12,321		)	(12,321		)
Pro forma net income		$	4,022		$	4,706		$	20,421		$	22,858
Net income per share:
Basic net income per common share—as reported		$	0.14		$	0.15		$	0.52		$	0.56
Diluted net income per common share—as reported		$	0.13		$	0.14		$	0.49		$	0.52
Basic net income per common share—pro forma		$	0.06		$	0.07		$	0.32		$	0.36
Diluted net income per common share—pro forma		$	0.06		$	0.07		$	0.31		$	0.33

 

Stock Options

The fair value of options was estimated at the date of grant using a Black-Scholes option pricing model with the following weighted average assumptions:

		Three Months Ended September 30,				Nine Months Ended September 30,
		2006		2005		2006		2005
Risk free interest rate		4.5	%	4.1	%	5.0	%	3.9	%
Expected dividend yield		—	%	—	%	—	%	—	%
Expected volatility		39.4	%	46.6	%	39.4	%	48.4	%
Expected option term (in years)		4.5		3.2		4.5		3.3

 

The risk free interest rate for periods within the contractual life of the Company’s stock options is based on the U.S. Treasury yield curve in effect at the time of grant. The expected term is derived from an analysis of the Company’s historical exercise trends over ten years. The expected volatility for the three and nine months ended September 30, 2006 is based on a blend of historical and market-based implied volatility. The expected volatility for the nine months ended September 30, 2005, is based solely on historical volatility. The Company’s management changed its expected volatility estimation approach based upon the availability of actively traded options on the Company’s common stock and because management believes this blended method is more representative of future stock price trends than historical volatility alone. Using the assumptions above, the weighted average grant date fair value of options granted during the three months ended September 30, 2006 and 2005 was $8.12 and $18.49, respectively, and for the nine months ended September 30, 2006 and 2005 was $11.77 and $17.93, respectively.

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Activity under the Company’s stock plans for the nine months ended September 30, 2006 is as follows (in thousands, except per share amounts):

		Shares		Weighted-Average Exercise Price Per Share			Weighted-Average Remaining Contractual Term		Aggregate Intrinsic Value
							(in Years)
Outstanding at December 31, 2005		6,757		$	31.31
Grants		926		29.40
Exercises		(296	)	19.88
Forfeitures, cancellations or expirations		(509	)	33.85
Outstanding at September 30, 2006		6,878		$	31.37		4.6		$	6,9965
Exercisable at September 30, 2006		4,578		$	30.73		4.0		$	6,003
Vested and expected to vest at September 30, 2006		6,588		$	31.29		4.5		$	6,913

 

The aggregate intrinsic value in the table above represents the total pretax intrinsic value (i.e., the difference between the Company’s closing stock price on the last trading day of its second quarter of 2006 and the exercise price, multiplied by the number of in-the-money options) that would have been received by the option holders had all option holders exercised their options on September 30, 2006. This amount changes based on the fair market value of the Company’s stock. Total intrinsic value of options exercised is $0.6 million and $12.2 million for the three months ended September 30, 2006 and 2005, respectively and $4.7 million and $56.8 million for the nine months ended September 30, 2006 and 2005, respectively.

Restricted Stock

The following table summarizes the Company’s non-vested restricted stock activity for the nine months ended September 30, 2006 (in thousands, except per share amounts):

		Number of Shares		Weighted-Average Grant Date Fair Value
Non-vested stock at December 31, 2005		121		$	56.54
Granted		242		26.74
Vested		(81	)	60.03
Forfeited		(8	)	31.29
Non-vested stock at September 30, 2006		274		$	29.93

 

Total fair value of shares vested is $1.7 million and $0.1 million for the nine months ended September 30, 2006 and 2005, respectively.

NOTE 4—RESTRUCTURING

Fiscal 2006 Restructuring Plan

In the third quarter of 2006, the Company initiated a restructuring plan (“the plan”) to better align certain of its expenses with the Company’s current business outlook.  The Company’s primary focus of the plan was in the general and administrative functions and included rationalizing its facilities.  In August, the Company terminated certain employees in the general and administrative functions.  Additionally, in September, the Company announced its plan to close its Bedford, Massachusetts based instrumentation manufacturing and development facility. The Company plans to consolidate the Bedford facility’s instrument manufacturing operations with its probe array manufacturing facility in West Sacramento, California. The Company’s instrumentation development capabilities will be consolidated with its principal research and development facilities located in Santa Clara, California. Implementation of the plan is expected to begin in the fourth quarter of 2006 and continue into the first half of 2007 and will eliminate or transfer certain positions. The Company expects the closure of its Bedford, Massachusetts facility to be materially completed by the third quarter of fiscal 2007.

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The Company estimates that the total restructuring expenses to be incurred in connection with the plan will be approximately $28 million. Of this total, the Company estimates that $19 million relates to employee severance and relocation benefits, $7 million relates to contract termination costs associated with vacating the leased Bedford facility, and approximately $2 million relates to other restructuring costs such as fixed asset write downs and equipment and inventory relocation costs. The Company has incurred restructuring expenses beginning in the third quarter of 2006 and expects to continue incurring related expenses through the third quarter of 2007. Cash outlays incurred in connection with these restructuring activities are estimated to be approximately $21 million.  In accordance with SFAS 146, “Accounting for Costs Associated with Exit or Disposal Activities” (“SFAS 146”), the costs relating to employee severance and relocation will be accrued over the remaining service periods of the employees.

During the third quarter of 2006, the Company recognized approximately $10.0 million of expense which was presented in a single line item labeled restructuring in the Company’s Statement of (Loss) Income, of which approximately $7.5 million of the expense related to the modification of a former Neomorphic employee’s equity awards, all of which became fully vested under the terms of a prior leave of absence agreement when he was involuntarily terminated in connection with the plan.

The activity in the accrued restructuring balances related to the plan described above for the three and nine months ended September 30, 2006 was as follows:

		Balance as			Three and nine months ended September 30,									Balance as			As of September 30, 2006
		of December 31, 2005			2006 charges (reversals)			Cash Payments			Non-Cash Settlements			of September 30, 2006			Total costs to date			Total expected costs
Employee severance and relocation benefits		$	—		$	10,008		$	(1,541	)	$	(7,544	)	$	923		$	10,008		19,000
Contract termination costs		—			—			—			—			—			—			7,000
Other restructuring costs		—			—			—			—			—			—			2,000
Total restructuring costs		$	—		$	10,008		$	(1,541	)	$	(7,544	)	$	923		$	10,008		28,000

 

NOTE 5—ACQUISITION

On October 21, 2005, the Company 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. Affymetrix accounted for the merger under the purchase method of accounting in accordance with the provisions of Statement of Financial Accounting Standards No. 141, “Business Combinations.” Under this accounting method, the Company recorded the assets acquired and liabilities assumed at their estimated fair value, with the excess purchase price reflected as goodwill. Additionally, certain costs directly related to the merger were reflected as additional purchase price in excess of net assets acquired. The results of operations of ParAllele have been included in Affymetrix’ condensed consolidated financial statements for the three and nine months ended September 30, 2006.

Upon the adoption of SFAS 123R, the Company reversed all unamortized deferred stock-based compensation against additional paid in capital. There have been no other significant changes in the ParAllele acquisition compared to the disclosures in Item 8 of the Company’s Annual Report on Form 10-K/A for the year ended December 31, 2005.

NOTE 6—INVENTORIES

Inventories consist of the following (in thousands):

		September 30, 2006			December 31, 2005
Raw materials		$	18,630		$	13,094
Work-in-process		11,743			10,423
Finished goods		15,281			12,463
Total		$	45,654		$	35,980

 

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NOTE 7—ACQUIRED TECHNOLOGY RIGHTS

Acquired technology rights are comprised of licenses to technology covered by patents to third parties and are amortized over the expected useful life of the underlying patents, which range from one to fifteen years. Accumulated amortization of these rights amounted to $28.6 million and $22.2 million at September 30, 2006 and December 31, 2005, respectively.

The expected future annual amortization expense of the Company’s acquired technology rights and other intangible assets is as follows (in thousands):

For the Year Ending December 31,		Amortization Expense
2006, remainder thereof		$	2,082
2007		8,326
2008		8,314
2009		7,446
2010		6,676
Thereafter		24,360
Total expected future annual amortization		$	57,204

 

NOTE 8—ACCOUNTS PAYABLE AND ACCRUED LIABILITIES

Accounts payable and accrued liabilities consist of the following (in thousands):

		September 30, 2006			December 31, 2005
Accounts payable		$	19,216		$	29,718
Accrued compensation and related liabilities		18,153			20,419
Accrued taxes		11,766			10,354
Accrued legal		2,733			1,357
Accrued warranties		4,865			6,223
Other		4,206			3,480
Total		$	60,939		$	71,551

 

NOTE 9—COMPREHENSIVE (LOSS) INCOME

The components of comprehensive (loss) income are as follows (in thousands):

		Three Months Ended September 30,						Nine Months Ended September 30,
		2006			2005			2006			2005
					(as restated)						(as restated)
Net (loss) income		$	(14,155	)	$	9,398		$	(22,384	)	$	35,179
Foreign currency translation adjustment		(26		)	91			83			375
Unrealized (loss) gain on debt securities		(436		)	(174		)	(111		)	17
Unrealized gain (loss) on hedging contracts		356			(348		)	(248		)	2,088
Comprehensive (loss) income		$	(14,261	)	$	8,967		$	(22,660	)	$	37,659

 

NOTE 10—RELATED PARTY TRANSACTIONS

Perlegen Sciences, Inc.

As of September 30, 2006, the Company, and certain of its affiliates, including the Company’s chief executive officer and members of the board of directors, held approximately 25% ownership interest in Perlegen Sciences, Inc. (“Perlegen”), a privately-held biotechnology company. In addition, two members of Perlegen’s board of directors are also members of the Company’s board of directors. See the Company’s most recent Proxy Statement as filed on May 1, 2006 for further information.

The Company accounts for its ownership interest in Perlegen using the equity method as the Company and its affiliates do not control the strategic, operating, investing and financing activities of Perlegen; however, the Company does have significant influence over Perlegen’s operating activities. Further, the Company has no obligations to provide funding to Perlegen nor does it guarantee or otherwise have any obligations related to the liabilities or results of operations of Perlegen or its investors. Through January 2005, the Company’s investment in Perlegen had no cost basis; accordingly, the Company has not recorded its proportionate share of Perlegen’s operating losses in its financial statements since the completion of

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Perlegen’s initial financing. In February 2005, the Company participated in Perlegen’s Series D preferred stock financing and recorded a $2.0 million investment related to this transaction, which was included in the Company’s balance sheet as a component of other assets.  As of June 30, 2005, the Company had reduced the carrying value of its investment to zero through the recording of its proportionate share of Perlegen’s operating losses.

In accordance with Financial Accounting Standards Board Interpretation No. 46 (“FIN 46”), “Consolidation of Variable Interest Entities, an Interpretation of ARB No. 51” as amended, the Company has concluded that Perlegen is a Variable Interest Entity in which the Company holds a variable interest, and that the Company is not the primary beneficiary. Accordingly, no change to the Company’s historical accounting for Perlegen is required.

In December 2003, the Company sold 950,000 shares of Perlegen preferred stock and realized a gain of $1.4 million which was included in interest and other income, net. Additionally, in January 2004, the Company sold 400,000 shares of Perlegen preferred stock and realized a gain of $0.6 million which was included in interest income and other, net.

In June 2005, the Company executed an agreement with a customer pursuant to which the Company agreed to provide genotypic data in the context of whole genome association studies. The Company had subcontracted certain elements of this agreement to Perlegen which will use Affymetrix GeneChip® technology to provide the genotypic data. As of September 2006, the agreement has ended and no expenses were incurred.

In October 2006, the Company entered into four new supply and license agreements with Perlegen.  These four agreements, consisting of a commercial products supply agreement, non-commercial products supply agreement and two intellectual property license agreements, replace the prior supply and intellectual property license agreements entered into by the Company and Perlegen in 2003.  Under the new supply agreements, which include terms that are generally consistent with the Company’s standard supply terms, the Company shall supply commercial GeneChip products and certain non-commercial custom GeneChip products for Perlegen's use in defined fields. 

NOTE 11—COMMITMENTS AND CONTINGENCIES

Product Warranty Commitment

The Company provides for anticipated warranty costs at the time the associated revenue is recognized. Product warranty costs are estimated based upon the Company’s historical experience and the warranty period. The Company periodically reviews the adequacy of its warranty reserve, and adjusts, if necessary, the warranty percentage and accrual based on actual experience and estimated costs to be incurred. In the first quarter of 2006, the Company adjusted its warranty reserve by approximately $0.4 million for anticipated costs associated with its decision to replace certain gene expression products. Information regarding the changes in the Company’s product warranty liability for the three and nine months ended September 30, 2006, respectively, was as follows (in thousands):

Beginning balance at December 31, 2005		$	6,223
New warranties issued		849
Repairs and replacements		(1,312		)
Adjustments		391
Ending balance at March 31, 2006		6,151
New warranties issued		812
Repairs and replacements		(1,880		)
Adjustments		—
Ending balance at June 30, 2006		$	5,083
New warranties issued		1,463
Repairs and replacements		(1,681		)
Adjustments		—
Ending balance at September 30, 2006		$	4,865

 

Legal Proceedings – General

The Company has been in the past and continues to be a party to litigation which has consumed and may in the future continue to consume substantial financial and managerial resources and which could adversely affect its business, financial condition and results of operations. If in any pending or future intellectual property litigation involving the Company or its collaborative partners, the Company is found to have infringed the valid intellectual property rights of third parties, the Company, or its 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

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manufacturing and selling its products. In addition, if the Company is unable to enforce its patents and other intellectual property rights against others, or if its 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 the Company’s GeneChip® brand technology, and the Company’s competitive position could suffer. The Company expects to devote substantial financial and managerial resources to protect its intellectual property rights and to defend against the claims described below as well as any future claims asserted against it. 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.

Shareholder Derivative Lawsuits

Three shareholders of the Company have filed purported derivative lawsuits on behalf of the Company, which lawsuits name the Company (as nominal defendant) and several of the Company's current and former officers and directors, and allege that these officers and directors breached their fiduciary duties and breached other laws by participating in backdating stock options grants.  Two of these lawsuits were filed in the United States District Court for the Northern District of California on August 30, 2006 and September 13, 2006 and the third was filed in the Superior Court of the State of California on October 20, 2006.  The substance of the allegations in all three lawsuits is similar, and the plaintiffs in the two federal actions are seeking to have those actions consolidated, relief that the Company has supported in papers filed with the Court.  Allegations made in one or more of the three actions include allegations of breaches of fiduciary duty, unjust enrichment as a result of the receipt and retention of backdated stock option grants, violations of federal securities laws, violations of Generally Accepted Accounting Principles, violations of Section 162(m) of the Internal Revenue Code, and other violations of state law including violations of the California Corporations Code.  In one or more of the actions that have been filed, the plaintiffs seek to recover, on behalf of the Company, damages resulting from the alleged violations, including treble damages pursuant to California law, disgorgement or voiding of any backdated stock options or the proceeds of any such exercised stock options from the individual defendants, changes in the Company’s corporate governance and internal control procedures, other equitable relief, punitive damages, an award of attorneys' fees and costs, and other relief.  The Company may be subject to other lawsuits from private plaintiffs concerning this subject matter based on allegations similar to those described above.  As previously disclosed in the Company’s Form 10-K/A for the year ended December 31, 2005, the Company’s decision to restate its consolidated financial statements was based on the results of an internal review of its historical stock option granting practices from January 1, 1997 through May 31, 2006 performed under the direction of the Audit Committee of the Board of Directors.  The review did not find any pattern or practice of inappropriately identifying grant dates with hindsight in order to provide “discounted” or “in-the-money” grants.  The Company does not believe that the claims in these derivative lawsuits have merit and the Company intends to vigorously defend the cases.

SEC Informal Inquiry

On September 12, 2006, the Company received written notice from the Securities and Exchange Commission that it is conducting an informal inquiry into the Company’s stock option practices.  The Company is responding to the request for information and are cooperating fully in the informal inquiry.  The Company was advised in the SEC’s notice that the SEC’s request should not be construed as an indication by the SEC or its staff that any violations of law have occurred; and nor should the request be considered an adverse reflection upon any person, entity or security. 

Enzo Litigation

On October 28, 2003, Enzo Life Sciences, Inc., a wholly-owned subsidiary of Enzo Biochem, Inc. (collectively “Enzo”) filed a complaint against the Company 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 the Company 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 the Company 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 the Company with a notice of termination of the 1998 agreement effective on November 12, 2003.

On November 10, 2003, the Company 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 its complaint, the Company alleges that Enzo has engaged in a pattern of wrongful conduct against it 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 others in order to corner the market for non-radioactive labeling reagents, and improperly using the 1998 agreement to claim ownership rights to the Company’s proprietary

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technology. The Company seeks declarations that it has not breached the 1998 agreement and that nine Enzo patents that are identified in the 1998 agreement are invalid and/or not infringed by it. The Company also seeks 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. The Company filed a notice of related case stating that its 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 the Company’s case. There is no trial date in the actions between Enzo and the Company.

The Company believes 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 its interests. However, the Company cannot be sure that it will prevail in these matters. The Company’s failure to successfully defend against these allegations could result in a material adverse effect on its business, financial condition and results of operation.

Administrative Litigation and Proceedings

The Company’s 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 the Company owns or controls. Currently, third parties, including several of Affymetrix’ competitors, have filed oppositions against several of the Company’s European patents in the European Patent Office. These opposition proceedings are at various procedural stages and 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, the Company expects that third parties will continue to “copy” the claims of its patents in order to provoke interferences in the United States Patent & Trademark Office. These proceedings could result in the Company’s patent protection being significantly modified or reduced, and could result in significant costs and consume substantial managerial resources.

NOTE 12—INCOME TAXES

For the nine months ended September 30, 2006, the tax provision principally consists of federal, state and foreign taxes partially offset by a $1.3 million reduction in an income tax reserve based on the conclusion of an audit of a foreign tax authority in the first quarter of 2006 and by a $1.8 million reduction in an income tax reserve related to U.S. and foreign transfer pricing issues in the third quarter of 2006. 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. Additionally, SFAS 123R prohibits the recognition of a deferred tax asset related to the excess tax benefit resulting from the exercise of employee stock options that has not been realized. Based upon the weight of available evidence, which included an analysis of projected future book and taxable income, as of September 30, 2006, the Company has provided for a valuation allowance of $75.2 million.

NOTE 13—OTHER EVENTS

Default Under Convertible Notes

The Company violated the reporting covenant under the indentures governing the Company’s $120 million aggregate principal amount 0.75% Senior Convertible Notes due 2033 (the “Notes”) as a result of the Company’s failure to file its Form 10-Q for the quarter ended June 30, 2006 by the required deadline. As a consequence of these violations, the holders of the Notes had the right to accelerate the maturity of such Notes if they or the trustee provide the Company with notice of the default and the Company was unable to cure the default within 60 days after that notice.  The Company cured the default within 60 days of the notice by filing its Form 10-Q for the quarter ended June 30, 2006 on August 30, 2006.

NASDAQ Notice

On August 17, 2006, the Company announced that it requested a hearing before the NASDAQ Listing Qualifications Panel (the “Panel”) in response to the receipt of a NASDAQ Staff Determination letter dated August 17, 2006 indicating that the Company is not in compliance with the filing requirements for continued listing as set forth in Marketplace Rule 4310(c)(14). As anticipated, the letter was issued in accordance with NASDAQ procedures due to the delayed filing of the Company’s Form 10-Q for the quarter ended June 30, 2006. The Company returned to compliance by filing its Form 10-Q for the quarter ended June 30, 2006 on August 30, 2006 and therefore, a hearing before the Panel was not required.

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