Affymetrix 10-Q 2006
WASHINGTON, D.C. 20549
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
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
(Exact name of Registrant as specified in its charter)
Registrants 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
TABLE OF CONTENTS
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 Companys Form 10-K/A for the fiscal year ended December 31, 2005.
See accompanying notes.
(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
See accompanying notes.
See accompanying notes.
NOTE 1SUMMARY 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 Companys 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 Companys 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.
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, 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
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 Companys 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 Companys intellectual property.
Royalty revenues are earned from the sale of products by third parties who have been licensed under the Companys 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 Companys technical staff and include the costs for material and subcontract efforts. The Companys 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 sellers price is fixed or determinable, and collectibility is reasonably assured. The Companys 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).
The following table sets forth a reconciliation of basic and diluted net (loss) income per share (in thousands, except per share amounts):
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):
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.
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 Companys financial statements and is not yet in a position to determine such effects, if any.
NOTE 2RESTATEMENT 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 Companys decision to restate its financial statements was based on the results of an internal review of the Companys 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 Companys 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 Companys 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 Companys attention that should have been adjusted in its previously issued consolidated financial statements.
The following tables set forth the effects of the restatement on certain line items within the Companys consolidated statements of income for three and nine months ended September 30, 2005 and condensed consolidated balance sheet as of December 31, 2005:
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 3STOCK-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.
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 Companys 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 Companys 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 Companys 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 Companys Condensed Consolidated Statements of (Loss) Income upon the adoption of SFAS 123R (in thousands):
Selling, general and administrative expense included a $1.1 million charge in the second quarter of 2006 due to the modification of an executive officers 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 employees 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 Companys 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.
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):
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:
The risk free interest rate for periods within the contractual life of the Companys 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 Companys 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 Companys management changed its expected volatility estimation approach based upon the availability of actively traded options on the Companys 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.
Activity under the Companys stock plans for the nine months ended September 30, 2006 is as follows (in thousands, except per share amounts):
The aggregate intrinsic value in the table above represents the total pretax intrinsic value (i.e., the difference between the Companys 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 Companys 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.
The following table summarizes the Companys non-vested restricted stock activity for the nine months ended September 30, 2006 (in thousands, except per share amounts):
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.
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 Companys current business outlook. The Companys 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 facilitys instrument manufacturing operations with its probe array manufacturing facility in West Sacramento, California. The Companys 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.
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 Companys Statement of (Loss) Income, of which approximately $7.5 million of the expense related to the modification of a former Neomorphic employees 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:
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 Companys Annual Report on Form 10-K/A for the year ended December 31, 2005.
Inventories consist of the following (in thousands):
NOTE 7ACQUIRED 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 Companys acquired technology rights and other intangible assets is as follows (in thousands):
NOTE 8ACCOUNTS PAYABLE AND ACCRUED LIABILITIES
Accounts payable and accrued liabilities consist of the following (in thousands):
NOTE 9COMPREHENSIVE (LOSS) INCOME
The components of comprehensive (loss) income are as follows (in thousands):
NOTE 10RELATED PARTY TRANSACTIONS
Perlegen Sciences, Inc.
As of September 30, 2006, the Company, and certain of its affiliates, including the Companys 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 Perlegens board of directors are also members of the Companys board of directors. See the Companys 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 Perlegens 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 Companys investment in Perlegen had no cost basis; accordingly, the Company has not recorded its proportionate share of Perlegens operating losses in its financial statements since the completion of
Perlegens initial financing. In February 2005, the Company participated in Perlegens Series D preferred stock financing and recorded a $2.0 million investment related to this transaction, which was included in the Companys 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 Perlegens 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 Companys 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 Companys 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 11COMMITMENTS 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 Companys 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 Companys product warranty liability for the three and nine months ended September 30, 2006, respectively, was as follows (in thousands):
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
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 Companys GeneChip® brand technology, and the Companys 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 Companys 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 Companys Form 10-K/A for the year ended December 31, 2005, the Companys 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 Companys 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 SECs notice that the SECs 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.
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 Companys proprietary
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 Enzos alleged breaches of the 1998 agreement, its alleged tortious interference with the Companys business relationships and prospective economic advantage, and Enzos 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 Companys case. There is no trial date in the actions between Enzo and the Company.
The Company believes that the claims set forth in Enzos 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 Companys 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 Companys 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 Companys 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 Companys patent protection being significantly modified or reduced, and could result in significant costs and consume substantial managerial resources.
NOTE 12INCOME 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 13OTHER EVENTS
Default Under Convertible Notes
The Company violated the reporting covenant under the indentures governing the Companys $120 million aggregate principal amount 0.75% Senior Convertible Notes due 2033 (the Notes) as a result of the Companys 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.
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 Companys 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.
ITEM 2. MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
This Managements Discussion and Analysis of Financial Condition and Results of Operations as of September 30, 2006 and for the three and nine month periods ended September 30, 2006 and 2005 should be read in conjunction with the Managements Discussion and Analysis of Financial Condition and Results of Operations included in our Annual Report on Form 10-K/A for the year ended December 31, 2005.
All statements in this quarterly report that are not historical are forward-looking statements within the meaning of Section 21E of the Securities Exchange Act 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, risks of our ability to achieve and sustain higher levels of revenue, higher gross margins, reduced operating expenses, market acceptance, personnel retention, global economic conditions, the fluctuations in overall capital spending in the academic and biotechnology sectors, changes in government funding policies, unpredictable fluctuations in quarterly revenues, uncertainties related to cost and pricing of Affymetrix products, dependence on collaborative partners, uncertainties relating to sole source suppliers, uncertainties relating to FDA, and other regulatory approvals, risks relating to intellectual property of others and the uncertainties of patent protection and litigation.
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.
Restatement of Consolidated Financial Statements
On August 9, 2006, we concluded that our 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. Our decision to restate our financial statements was based on the results of an internal review of our 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.
We 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, we 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.
We 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, we 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, we recorded an income tax benefit of $8.3 million in 2005. Principally as a result of cumulative losses incurred through 2004, we 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 our 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 our review, we assessed whether there were other matters that should have been corrected in our previously issued consolidated financial statements. Apart from the errors underlying the restatement described above, no other matters came to our attention that should have been adjusted in our previously issued consolidated financial statements.
We are engaged in the development, manufacture and sale of consumables, systems and services for genetic analysis in the life sciences and clinical diagnostics fields. Other emerging markets we are focused on include agricultural, environmental testing, pathogen detection and bio-defense. There are a number of factors that influence the size and development of our industry, including: 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, the Middle East and Asia Pacific regions, including China. We have incurred net losses and negative cash flows from operations in the past, have achieved profitability for the three previous consecutive fiscal years, but have now incurred a net loss for the first nine months of fiscal 2006. The following overview describes key elements of our business strategy and our goals:
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 work to decrease the unit costs of our GeneChip® products, we aim to encourage our customers to expand their uses for our GeneChip® system, which we believe 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.
Strengthen our product line. Our goal is to grow our product and product related revenue. We can achieve this goal through growth in sales of our consumable probe arrays and reagents as well as instruments and related services as we focus on new product solutions for the genotyping market, new advances in the expression arena, and continued progress in the clinical products market. In 2006, we have experienced a decline in instrument sales and we expect this decline to continue for the remainder of fiscal 2006 as we finish our instrument upgrade cycle.
Maintain our operating margins. Management is focused on growing the business and increasing its operating profitability. We will continue to closely manage our manufacturing costs and operating expenses. We expect a decline in gross margins for 2006 as we continue to expand our manufacturing capacity to support our anticipated sales growth in consumables and forward price our 500K genotyping product in expectation of launching this onto one chip later this year. In addition, we will see increased operating costs and expenses related to our adoption of SFAS 123R and our integration of the ParAllele acquisition. In July 2006, we announced our intent to restructure our general and administrative cost structure, including rationalizing our facilities requirements in order to bring our operating expenses in line with our current business requirements. We began those efforts and have incurred charges of approximately $10.0 million in the third quarter of 2006 and anticipate seeing a decrease in headcount related expenses in our general and administrative functions starting in the fourth quarter of 2006. We expect to incur additional charges through the third quarter of fiscal 2007 of approximately $18.0 million related to this effort.
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. ParAlleles 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 results of operations of ParAllele have been included in the accompanying consolidated financial statements from the date of acquisition. See Note 5 for further information regarding this acquisition.
Critical Accounting Policies & Estimates
The following section of Managements Discussion and Analysis of Financial Condition and Results of Operations is based upon our condensed consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires 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 certain assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.
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.
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.
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 customers inability to meet its financial obligations to us, such as in the case of bankruptcy filings or deterioration in the customers 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.
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.
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 non-marketable 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 investees (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.
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.
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.
Accounting for Stock-Based Compensation
Beginning January 1, 2006, we account for employee stock-based compensation in accordance with SFAS 123R. Under the provisions of SFAS 123R, we estimate the fair value of our employee stock awards at the date of grant using the Black-Scholes option-pricing model, which requires the use of certain subjective assumptions. The most significant of these assumptions are our estimates of the expected term, volatility and forfeiture rates of the awards. The expected stock price volatility assumption was determined using a combination of historical and implied volatility of our common stock. We determined that blended volatility is more reflective of market conditions and a better indicator of expected volatility than historical volatility. The estimate of these key assumptions is based on historical information and judgment regarding market factors and trends. As required under the accounting rules, we review our valuation assumptions at each grant date and, as a result, we are likely to change our valuation assumptions used to value employee stock-based awards granted in future periods.
SFAS 123R requires that employee stock-based compensation costs be recognized over the requisite service period, or the vesting period, in a manner similar to all other forms of compensation paid to employees. Accordingly, in the first nine months of 2006, we recognized employee stock-based compensation of $1.1 million in cost of product sales, $3.0 million in
research and development expense and $8.4 million in sales, general and administrative expenses, which includes approximately $1.1 million related to the modification of an executive officers stock option grant to increase the associated exercise period. We also incurred a charge of $7.5 million which was included in restructuring related to the modification of a research and development employees equity awards, all of which became fully vested under the terms of a prior severance agreement when he was involuntarily terminated as part of our cost reduction efforts. We adopted SFAS 123R on a modified prospective basis. As of September 30, 2006, $23.5 million of total unrecognized compensation cost related to non-vested stock options not yet recognized is expected to be allocated to cost of products sales and operating expenses over a weighted-average period of 1.6 years.
There was no stock-based compensation expense related to employee stock options recognized under SFAS 123R during the nine months ended September 30, 2005.
We have recently engaged in, and may continue to engage in, restructuring actions, which require management to utilize significant estimates related to expenses for severance and other employee separation costs, lease cancellation, realizable values of assets that may become duplicative or obsolete, and other exit costs. If the actual amounts differ from our estimates, the amount of the restructuring charges could be materially impacted. For a full description of our restructuring actions, see Note 4.
Results of Operations
The following discussion compares the historical results of operations for the three and nine months ended September 30, 2006 and 2005, respectively.
The components of product sales are as follows (in thousands, except percentage amounts):
Probe array sales for the third quarter of 2006 as compared to the same period in 2005 declined primarily due to a decrease of $8.2 million in revenue related to a decrease in the average selling price of our probe arrays primarily due to the reduction of the selling price of our current two-chip 500K genotyping product. This decline was partially offset by an increase in probe array revenue of $1.0 million related to an increase in unit sales. Instrument sales decreased primarily due to a decrease of $2.6 million in revenue related to a decline in unit sales of our GeneChip® Scanner 3000, a decrease of $0.8 million due to a drop in unit sales of our GeneChip® Scanner 3000 high-resolution upgrades and a decrease of $0.8 million in unit sales of our automation equipment.
Probe array sales in the first nine months of 2006 as compared to the same period in 2005 declined primarily due to a decrease of $9.4 million in revenue due to a decline in unit sales and a decrease of $8.1 million in revenue related to the reduction of the average selling price of our probe arrays primarily due to a decrease in the selling price of our current two-chip 500Kgenotyping product. Instrument sales decreased primarily due to a decrease of $7.5 million in revenue related to a decline in unit sales of our GeneChip® Scanner 3000, a decrease of $1.7 million due to a drop in unit sales of our GeneChip® Scanner 3000 high-resolution upgrades and a decrease of $1.8 million in unit sales of our automation equipment.
In July 2006, we announced a decrease in the selling price of our current two-chip 500K genotyping product as we believe this will enable scientists to run more samples, and thereby increase the power of their genetic association studies. We believe this decrease in the selling price could cause our future probe array revenues to decline from prior periods if unit sales do not increase.
Product Related Revenue
The components of product related revenue are as follows (in thousands, except percentage amounts):
Service and other revenue increased for the third quarter of 2006 and in the first nine months of 2006 as compared to the same periods in 2005 primarily due to increases of approximately $7.7 million and $16.0 million, respectively, in other revenue related to our genotyping services business. These increases were partially offset by declines in subscription fees earned under our GeneChip® array access programs as we continue to transition customers to volume-based pricing on array sales.
In January 2003, under the terms of an expanded collaborative agreement, Roche paid us an access fee of $70 million, which we are recognizing as a component of product related revenue in license fees over the estimated research and development period of approximately five years. The expanded collaboration agreement, which is subject to Roches option to terminate on December 31, 2007, December 31, 2010 or any time on or after December 31, 2015, with one years prior notice, includes a broad range of other compensation payable by Roche to us throughout the life of the agreement based on annual royalties on sales of diagnostic kits, milestone payments for technical and commercial achievements, a manufacturing and supply agreement, and related license installments. In accordance with Emerging Issues Task Force Issue No. 00-21 (EITF 00-21), Revenue Arrangements with Multiple Deliverables, if this agreement is modified, it could materially affect the periods in which certain product related revenues will be recognized.
Royalties and Other Revenue (in thousands, except percentage amounts)
The increases in royalties and other revenue for the third quarter of 2006 and in the first nine months of 2006 as compared to the same periods in 2005 were primarily related to the recognition of $4.5 million related to a license agreement with no continuing performance obligations in the third quarter of 2006. We also recorded an additional $5.3 million in deferred revenue related to this license agreement which will be recognized when the payment is received which we anticipate will occur during 2008.
Revenue from Perlegen Sciences (in thousands, except percentage amounts)
Perlegen revenue increased for the third quarter of 2006 and in the first nine months of 2006 as compared to the same periods in 2005 primarily due to increases of approximately $4.0 million and $9.5 million, respectively, related to increased demand by Perlegen for our probe arrays and whole wafers used for certain new applications. These increases were partially offset by a decrease in demand for wafers used by Perlegen for internal research and development of $0.9 million and $2.7 million for the third quarter of 2006 and in the first nine months of 2006, respectively. 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 they are used by Perlegen for certain revenue activities. Royalties recognized were $1.1 million and $1.6 million in the first nine months of 2006 and 2005, respectively. We rely on reports from Perlegen to recognize royalty revenue.
Product and Product Related Gross Margins (in thousands, except percentage/point amounts)
The 12.1 point decrease in product gross margin for the third quarter of 2006 as compared to the same period in 2005 is primarily due to the following three factors: 5.3 points of the decrease can be attributed to a decrease in the average selling price of our probe arrays primarily due to a decrease in the selling price of our two-chip 500K genotyping product; 2.4 points of the decrease is due to start-up costs for our new Singapore manufacturing facility; and 6.9 points of the decrease is due to underutilized capacity in our probe array and instrument manufacturing facilities. These decreases were partially offset by an increase of 2.3 points as we sold more of our higher margin products.
The 6.7 point decrease in product gross margin in the first nine months of 2006 as compared to the same period in 2005 is primarily due to the following three factors: 1.4 points of the decrease can be attributed to a decrease in the average selling price of our probe arrays primarily due to a decrease in the selling price of our two-chip 500K genotyping product; 2.3 points of the decrease is due to start-up costs for our new Singapore manufacturing facility; and 4.5 points of the decrease is due to underutilized capacity in our probe array and instrument manufacturing facilities and increased manufacturing costs for our chips. These decreases were partially offset by a 1.3 point increase in product gross margins as we sold more of our higher margin products.
In July 2006, we announced a decrease in the selling price of our current two-chip 500K genotyping product as we believe that this will enable scientists to run more samples, and thereby increase the power of their genetic association studies. We believe this decrease in the selling price may continue to unfavorably impact our product gross margin for the remainder of fiscal 2006.
The 23.9 point and 26.5 point decrease in product related gross margin for the third quarter of 2006 and in the first nine months of 2006 as compared to the same periods in 2005 were primarily due to an increase in expenses related to our genotyping services business as well as the continuing decline in sales of our access agreements as we continue to transition customers to volume-based discounting on product sales.
Cost of Perlegen Revenues (in thousands, except percentage amounts)
Cost of Perlegen revenue was relatively flat for the third quarter of 2006 and in the first nine months of 2006 as compared to the same periods in 2005 primarily due to decreased demand by Perlegen for wafers used for internal research and development which are sold at our fully burdened cost of manufacturing which was offset by an increase in the costs of products purchased by Perlegen for use in certain new applications.
Research and Development Expenses (in thousands, except percentage amounts)