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Affymetrix 10-Q 2007

Documents found in this filing:

  1. 10-Q
  2. Ex-31.1
  3. Ex-31.2
  4. Ex-32.1
  5. Ex-32.2
  6. Ex-32.2

 

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, 2007

 

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)

 

DELAWARE

 

77-0319159

(State or other jurisdiction of
incorporation or organization)

 

(I.R.S. Employer
Identification Number)

 

 

 

3420 CENTRAL EXPRESSWAY
SANTA CLARA, CALIFORNIA

 

95051

(Address of principal executive offices)

 

(Zip Code)

 

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 ¨

 

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 2, 2007: 69,031,982

 

 



 

AFFYMETRIX, INC.

TABLE OF CONTENTS

 

PART I. FINANCIAL INFORMATION

 

 

 

 

Item 1.

Financial Statements (Unaudited)

 

 

 

 

 

 

 

Condensed Consolidated Balance Sheets at September 30, 2007 and December 31, 2006

 

 

 

 

 

 

 

Condensed Consolidated Statements of Operations for the Three and Nine Months Ended September 30, 2007 and 2006

 

 

 

 

 

 

 

Condensed Consolidated Statements of Cash Flows for the Nine Months Ended September 30, 2007 and 2006

 

 

 

 

 

 

 

Notes to Condensed Consolidated Financial Statements

 

 

 

 

 

 

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

 

 

2



 

PART I. FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

 

AFFYMETRIX, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(In thousands)

(Unaudited)

 

 

 

September 30,
2007

 

December 31,
2006

 

 

 

 

 

Note 1

 

ASSETS

 

 

 

 

 

Current assets:

 

 

 

 

 

Cash and cash equivalents

 

$

123,736

 

$

119,063

 

Available-for-sale securities — short-term

 

127,081

 

118,088

 

Accounts receivable, net

 

68,261

 

75,553

 

Accounts receivable from Perlegen Sciences

 

267

 

2,290

 

Inventories

 

48,608

 

46,506

 

Deferred tax assets—current portion

 

14,604

 

13,534

 

Notes receivable from employees – short-term portion

 

1,719

 

 

Prepaid expenses and other current assets

 

15,958

 

8,858

 

Total current assets

 

400,234

 

383,892

 

Available-for-sale securities – long-term

 

5,129

 

10,601

 

Property and equipment, net

 

145,693

 

141,322

 

Acquired technology rights, net

 

48,881

 

55,125

 

Goodwill

 

125,050

 

124,916

 

Deferred tax assets—long-term portion

 

32,472

 

29,170

 

Notes receivable from employees – long-term portion

 

330

 

2,186

 

Other assets

 

30,954

 

34,003

 

Total assets

 

$

788,743

 

$

781,215

 

 

 

 

 

 

 

LIABILITIES AND STOCKHOLDERS’ EQUITY

 

 

 

 

 

Current liabilities:

 

 

 

 

 

Accounts payable and accrued liabilities

 

$

52,065

 

$

62,893

 

Deferred revenue — current portion

 

27,400

 

30,697

 

Total current liabilities

 

79,465

 

93,590

 

Deferred revenue — long-term portion

 

4,008

 

9,562

 

Other long-term liabilities

 

11,209

 

5,100

 

Convertible notes

 

120,000

 

120,000

 

Stockholders’ equity:

 

 

 

 

 

Common stock

 

689

 

679

 

Additional paid-in capital

 

694,546

 

674,428

 

Accumulated other comprehensive income (loss)

 

74

 

(1,717

)

Accumulated deficit

 

(121,248

)

(120,427

)

Total stockholders’ equity

 

574,061

 

552,963

 

Total liabilities and stockholders’ equity

 

$

788,743

 

$

781,215

 

 


Note 1:               The condensed consolidated balance sheet at December 31, 2006 has been derived from the audited consolidated financial statements at that date included in the Company’s Form 10-K for the fiscal year ended December 31, 2006.

 

See accompanying notes.

 

3



 

AFFYMETRIX, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(In thousands, except per share amounts)

(Unaudited)

 

 

 

Three Months Ended
September 30,

 

Nine Months Ended
September 30,

 

 

 

2007

 

2006

 

2007

 

2006

 

 

 

 

 

 

 

 

 

 

 

Revenue:

 

 

 

 

 

 

 

 

 

Product sales

 

$

69,373

 

$

56,139

 

$

191,166

 

$

183,154

 

Product related revenue

 

15,758

 

17,971

 

46,453

 

45,621

 

Total product and product related revenue

 

85,131

 

74,110

 

237,619

 

228,775

 

Royalties and other revenue

 

9,500

 

5,969

 

14,653

 

10,263

 

Revenue from Perlegen Sciences

 

355

 

4,593

 

11,456

 

12,091

 

Total revenue

 

94,986

 

84,672

 

263,728

 

251,129

 

 

 

 

 

 

 

 

 

 

 

Costs and expenses:

 

 

 

 

 

 

 

 

 

Cost of product sales

 

28,082

 

23,618

 

71,636

 

62,338

 

Cost of product related revenue

 

7,344

 

8,859

 

24,645

 

22,712

 

Cost of revenue from Perlegen Sciences

 

166

 

1,646

 

4,494

 

4,304

 

Research and development

 

16,489

 

21,639

 

55,143

 

66,737

 

Selling, general and administrative

 

33,300

 

35,865

 

102,800

 

114,107

 

Restructuring charges

 

5,737

 

10,008

 

12,879

 

10,008

 

Total costs and expenses

 

91,118

 

101,635

 

271,597

 

280,206

 

Income (loss) from operations

 

3,868

 

(16,963

)

(7,869

)

(29,077

)

Interest income and other, net

 

291

 

2,942

 

8,382

 

10,949

 

Interest expense

 

(417

)

(350

)

(1,246

)

(1,174

)

 

 

 

 

 

 

 

 

 

 

Income (loss) before income taxes

 

3,742

 

(14,371

)

(733

)

(19,302

)

Income tax (provision) benefit

 

(1,162

)

216

 

550

 

(3,082

)

Net income (loss)

 

$

2,580

 

$

(14,155

)

$

(183

)

$

(22,384

)

 

 

 

 

 

 

 

 

 

 

Basic and diluted net income (loss) per common share

 

$

0.04

 

$

(0.21

)

$

(0.00

)

$

(0.33

)

 

 

 

 

 

 

 

 

 

 

Shares used in computing basic net income (loss) per share

 

68,356

 

67,248

 

68,170

 

67,320

 

Shares used in computing diluted net income (loss) per share

 

68,725

 

67,248

 

68,170

 

67,320

 

 

See accompanying notes.

 

4



 

AFFYMETRIX, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(In thousands)
(Unaudited)

 

 

 

Nine Months Ended
September 30,

 

 

 

2007

 

2006

 

 

 

 

 

 

 

Cash flows from operating activities:

 

 

 

 

 

Net loss

 

$

(183

)

$

(22,384

)

Adjustments to reconcile net loss to net cash provided by operating activities:

 

 

 

 

 

Depreciation and amortization

 

17,495

 

16,733

 

Amortization of intangible assets

 

6,244

 

6,236

 

Amortization of investment discounts, net

 

109

 

(664

)

Stock-based compensation

 

7,901

 

20,058

 

Restructuring charges

 

50

 

 

Realized gain on sales of available for sale securities

 

(99

)

(7

)

Deferred tax assets

 

(327

)

(1,362

)

Write-down of equity investment

 

3,249

 

165

 

Amortization of debt offering costs

 

570

 

569

 

Accretion of interest on notes receivable

 

(48

)

(40

)

Loss on disposal of equipment

 

1,088

 

631

 

Change in operating assets and liabilities:

 

 

 

 

 

Accounts receivable, net

 

9,315

 

26,860

 

Inventories

 

(2,102

)

(9,674

)

Prepaid expenses and other current assets

 

(5,604

)

(5,160

)

Accounts payable and accrued and other current liabilities

 

(10,878

)

(10,860

)

Deferred revenue

 

(8,851

)

(4,905

)

Other long-term liabilities

 

1,427

 

1,095

 

Net cash provided by operating activities

 

19,356

 

17,291

 

 

 

 

 

 

 

Cash flows from investing activities:

 

 

 

 

 

Capital expenditures

 

(22,954

)

(64,269

)

Purchases of available-for-sale securities

 

(82,074

)

(85,642

)

Proceeds from the sales or maturities of available-for-sale securities

 

77,712

 

94,260

 

Purchase of non-marketable equity investment

 

(800

)

(950

)

Capital distribution of non-marketable securities

 

902

 

 

Purchase of technology rights

 

 

(250

)

Net cash used in investing activities

 

(27,214

)

(56,851

)

 

 

 

 

 

 

Cash flows from financing activities:

 

 

 

 

 

Issuance of common stock through the Company’s stock option plans

 

12,227

 

5,728

 

Net cash provided by financing activities

 

12,227

 

5,728

 

Effect of exchange rate changes on cash and cash equivalents

 

304

 

83

 

Net increase (decrease) in cash and cash equivalents

 

4,673

 

(33,749

)

Cash and cash equivalents at beginning of period

 

119,063

 

100,236

 

Cash and cash equivalents at end of period

 

$

123,736

 

$

66,487

 

 

See accompanying notes.

 

5



 

AFFYMETRIX, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

SEPTEMBER 30, 2007
(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 for the year ended December 31, 2006, as filed with the Securities and Exchange Commission on March 1, 2007.

 

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, Revenue Arrangements with Multiple Deliverables (“EITF 00-21”).

 

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 (a related party, see Note 8), include sales of GeneChip® probe arrays, reagents and related instrumentation. Probe array, reagent and instrumentation revenues are recognized when

 

6



 

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 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. 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.

 

7



 

Net Income (Loss) Per Share

 

Basic net income (loss) 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 income (loss) 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 income (loss) per share (in thousands, except per share amounts):

 

 

 

Three Months Ended
September 30,

 

Nine Months Ended
September 30,

 

 

 

2007

 

2006

 

2007

 

2006

 

 

 

 

 

 

 

 

 

 

 

Numerator:

 

 

 

 

 

 

 

 

 

Net income (loss) — basic

 

$

2,580

 

$

(14,155

)

$

(183

)

$

(22,384

)

Add effect of dilutive securities:

 

 

 

 

 

 

 

 

 

Interest on convertible notes (inclusive of amortization of debt issuance costs)

 

415

 

 

 

 

Net income (loss) — diluted

 

$

2,995

 

$

(14,155

)

$

(183

)

$

(22,384

)

Denominator:

 

 

 

 

 

 

 

 

 

Weighted-average shares outstanding

 

68,935

 

67,498

 

68,607

 

67,430

 

Less: weighted-average shares of common stock subject to repurchase

 

(579

)

(250

)

(437

)

(110

)

Shares used in computing basic net income (loss) per common share

 

68,356

 

67,248

 

68,170

 

67,320

 

Add effect of dilutive securities:

 

 

 

 

 

 

 

 

 

Employee stock options

 

327

 

 

 

 

Common stock subject to repurchase

 

42

 

 

 

 

Shares used in computing diluted net income (loss) per common share

 

68,725

 

67,248

 

68,170

 

67,320

 

Basic net income (loss) per common share

 

$

0.04

 

$

(0.21

)

$

(0.00

)

$

(0.33

)

Diluted net income (loss) per common share

 

$

0.04

 

$

(0.21

)

$

(0.00

)

$

(0.33

)

 

The following securities were excluded from the computation of diluted net income (loss) 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,

 

 

 

2007

 

2006

 

2007

 

2006

 

 

 

 

 

 

 

 

 

 

 

Employee stock options

 

3,876

 

6,878

 

5,479

 

6,878

 

Common stock subject to repurchase

 

96

 

250

 

577

 

110

 

Convertible notes

 

3,870

 

3,870

 

3,870

 

3,870

 

 

 

 

 

 

 

 

 

 

 

Total

 

7,842

 

10,998

 

9,926

 

10,858

 

 

Restructuring

 

Commencing in the third quarter of fiscal 2006, the Company 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 cancellations, realizable values of assets that may become duplicative or obsolete, and other exit costs. If the actual amounts differ from the Company’s estimates, the amount of the restructuring charges could be materially impacted. For a full description of the Company’s restructuring actions, see Note 3.

 

Recent Accounting Pronouncements

 

In February 2007, FASB issued Statement of Financial of Accounting Standards (“SFAS”) No. 159, The Fair Value Option for Financial Assets and Financial Liabilities – Including an Amendment of FASB No. 115 (“SFAS 159”). The

 

8



 

Statement permits entities to choose, at specified election dates, to measure many financial instruments and certain other items at fair value that are not currently measured at fair value. Unrealized gains and losses on items for which the fair value option has been elected would be reported in earnings at each subsequent reporting date. SFAS 159 also establishes presentation and disclosure requirements in order to facilitate comparisons between entities choosing different measurement attributes for similar types of assets and liabilities. SFAS 159 does not affect existing accounting requirements for certain assets and liabilities to be carried at fair value and the Company is currently evaluating the impact, if any, of SFAS 159 on its financial position, results of operation and cash flows. This statement is effective for fiscal years beginning after November 15, 2007 and is required to be adopted by the Company for the fiscal year ending December 31, 2008.

 

In September 2006, the FASB issued SFAS No. 157, Fair Value Measurements (“SFAS 157”). SFAS 157 establishes a framework for measuring fair value and expands disclosures about fair value measurements. SFAS 157 applies under other accounting pronouncements that require or permit fair value measurements. SFAS 157 does not require any new fair value measurement and the Company is currently evaluating the impact, if any, of SFAS 157 on its financial position, results of operations and cash flows. SFAS 157 requires prospective application for fiscal year ending December 31, 2008.

 

NOTE 2—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, non-vested stock awards (also known as restricted stock), and restricted stock units 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 stock awards are generally time-based, vesting 25% on each annual anniversary of the grant date over four years. As of September 30, 2007, the Company had approximately 1.4 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.

 

The total stock-based compensation expense, before taxes, associated with the Company’s stock-based employee compensation plans was $3.3 million and $11.2 million for the three months ended September 30, 2007 and 2006, respectively, and $7.9 million and $20.1 million for the nine months ended September 30, 2007 and 2006, respectively.

 

The Company allocated stock-based compensation expense under SFAS No. 123R, Share-Based Payment, (“SFAS 123R”) as follows (in thousands):

 

 

 

Three Months Ended
September 30,

 

Nine Months Ended
September 30,

 

 

 

2007

 

2006

 

2007

 

2006

 

Costs of product sales

 

$

229

 

$

408

 

$

775

 

$

1,126

 

Research and development

 

417

 

934

 

1,578

 

3,038

 

Selling, general and administrative

 

2,306

 

2,290

 

5,208

 

8,350

 

Restructuring

 

340

 

7,544

 

340

 

7,544

 

Total stock-based compensation expense

 

$

3,292

 

$

11,176

 

$

7,901

 

$

20,058

 

Income tax effect

 

(635

)

(1,596

)

(2,095

)

(3,326

)

Total stock-based compensation expense, net of tax

 

$

2,657

 

$

9,580

 

$

5,806

 

$

16,732

 

 

As of September 30, 2007, $26.8 million of total unrecognized stock-based compensation expense related to non-vested awards is expected to be recognized on a straight line basis over the respective vesting terms of each award through June 2011. The weighted average term of the unrecognized stock-based compensation expense is 2.3 years.

 

9



 

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,

 

 

 

2007

 

2006

 

2007

 

2006

 

Risk free interest rate

 

4.2

%

4.5

%

4.2

%

5.0

%

Expected dividend yield

 

%

%

%

%

Expected volatility

 

42.0

%

39.4

%

42.0

%

39.4

%

Expected option term (in years)

 

4.5

 

4.5

 

4.5

 

4.5

 

 

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, 2007 and 2006 is based on a blend of historical and market-based implied volatility. Using the assumptions above, the weighted average grant date fair value per share of options granted during the three months ended September 30, 2007 and 2006 was $9.90 and $8.12, respectively, and for the nine months ended September 30, 2007 and 2006 was $9.90 and $11.77, respectively.

 

Activity under the Company’s stock plans for the nine months ended September 30, 2007 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, 2006

 

6,466

 

$

31.42

 

 

 

 

 

Grants

 

650

 

$

25.80

 

 

 

 

 

Exercises

 

(673

)

$

19.00

 

 

 

 

 

Forfeitures, cancellations or expirations

 

(964

)

$

37.43

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Outstanding at September 30, 2007

 

5,479

 

$

31.22

 

3.72

 

$

6,842

 

 

 

 

 

 

 

 

 

 

 

Vested and expected to vest at September 30, 2007

 

5,116

 

$

31.29

 

3.59

 

$

6,309

 

 

 

 

 

 

 

 

 

 

 

Exercisable at September 30, 2007

 

3,814

 

$

31.75

 

2.89

 

$

5,621

 

 

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 third quarter of 2007 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, 2007. This amount changes based on the fair market value of the Company’s stock. Total intrinsic value of options exercised is $0.3 million and $0.6 million for the three months ended September 30, 2007 and 2006, respectively, and $5.3 million and $4.7 million for the nine months ended September 30, 2007 and 2006, respectively.

 

Restricted Stock
 

The following table summarizes the Company’s non-vested restricted stock activity for the nine months ended September 30, 2007 (in thousands, except per share amounts):

 

 

 

Number of Shares

 

Weighted-Average
Grant Date Fair Value

 

Non-vested stock at December 31, 2006

 

247

 

$

30.81

 

Granted

 

508

 

$

26.02

 

Vested

 

(75

)

$

25.30

 

Forfeited

 

(117

)

$

33.44

 

Non-vested stock at September 30, 2007

 

563

 

$

26.64

 

 

Total fair value of shares vested is approximately $1.9 million and $1.7 million for the nine months ended September 30, 2007 and 2006, respectively.

 

10



 

NOTE 3—RESTRUCTURING

 

2006 Restructuring Plan

 

In the third quarter of 2006, the Company initiated a restructuring plan (“the 2006 Plan”) to better align certain of its expenses with the Company’s current business outlook. The Company’s primary focus of the 2006 Plan was in the general and administrative functions and included rationalizing its facilities. In August 2006, the Company terminated certain employees in the general and administrative functions. Additionally, in September 2006, the Company announced its plan to close its Bedford, Massachusetts based instrumentation manufacturing and development facility. In the second quarter of 2007, the Company began to consolidate the Bedford facility’s instrument manufacturing  operations with its probe array manufacturing facility located in West Sacramento, California. The Company also began to consolidate its instrumentation development capabilities with its principal research and development facilities located in Santa Clara, California. These consolidations, along with the implementation of the workforce severance and relocation elements of the Bedford facility closure, were materially completed during the third quarter of fiscal 2007. As a final element of the 2006 Plan, the Company terminated certain employees in the sales, marketing and research and development functions in Santa Clara, California during January 2007.

 

The Company estimates that the total restructuring expenses to be incurred in connection with the 2006 Plan will be approximately $26 million. Of this total, the Company estimates that approximately $21 million relates to employee severance and relocation benefits, approximately $3 million relates to contract termination costs associated with vacating the leased Bedford facility, which began to be recognized when the facility ceased to be used during the third quarter of 2007, and approximately $2 million relates to other restructuring costs such as fixed asset write down and equipment and inventory relocation costs. The Company has incurred non-employee related restructuring expenses beginning in 2007 and expects these expenses to continue into fiscal 2008. Total cash outlays incurred in connection with these restructuring activities are estimated to be approximately $17 million. In accordance with Statement of Financial Accounting Standards No. 146, Accounting for Costs Associated with Exit or Disposal Activities (“SFAS 146”), the costs relating to employee severance and relocation are being accrued over the remaining service periods of the employees.

 

During the third quarter of 2007, the Company recognized approximately $3.8 million of expense related to the 2006 Plan which was presented as a component of the line item labeled “Restructuring charges” in the Company’s Statement of Operations, of which approximately $0.5 million related to employee termination benefit costs and approximately $3.3 million related to facility exit costs. The Company has incurred restructuring charges of approximately $13.5 million in fiscal 2006 and $11.0 million in the first nine months of 2007.

 

The following table summarizes the accrual balances and utilization by cost type for the 2006 Plan (in thousands):

 

 

 

Employee
severance and
relocation
benefits

 

Facility exit,
lease
termination
costs and other

 

Total

 

 

 

 

 

 

 

 

 

Balance as of September 30, 2006

 

923

 

 

923

 

Restructuring charges accrued

 

3,489

 

 

3,489

 

Cash payments

 

(282

)

 

(282

)

Balance as of December 31, 2006

 

4,130

 

 

4,130

 

Restructuring charges accrued

 

4,804

 

567

 

5,371

 

Cash payments

 

(4,153

)

(480

)

(4,633

)

Balance as of March 31, 2007

 

4,781

 

87

 

4,868

 

Restructuring charges accrued

 

1,502

 

269

 

1,771

 

Cash payments

 

(3,527

)

(272

)

(3,799

)

Non-cash settlement

 

 

(84

)

(84

)

Balance as of June 30, 2007

 

2,756

 

 

2,756

 

Restructuring charges accrued

 

479

 

3,299

 

3,778

 

Cash payments

 

(2,094

)

(306

)

(2,400

)

Non-cash settlement

 

 

(894

)

(894

)

Balance as of September 30, 2007

 

$

1,141

 

$

2,099

 

$

3,240

 

 

11



 

2007 Restructuring Plan

 

In July 2007, the Company announced that it will be consolidating an administrative facility located in Sunnyvale, California into its main campus in Santa Clara, California during the fourth quarter of 2007 (the “2007 Plan”). Additionally, in August 2007, the Company terminated certain employees in the research and development and selling, general and administrative functions. The Company estimates that the total restructuring expenses to be incurred in connection with the 2007 Plan will be approximately $4 million. Of this total, the Company estimates that approximately $2 million relates to employee severance, approximately $2 million relates to contract termination and other costs associated with vacating the leased Kifer facility, which will begin to be recognized when the facility is vacated, which is expected to be during the fourth quarter of 2007. The estimated cash outlays to be incurred in connection with these restructuring activities are estimated to be approximately $4 million. In accordance with SFAS 146, the costs relating to employee severance and relocation are being accrued over the remaining service periods of the employees.

 

During the third quarter and for the first nine months of 2007, the Company recognized approximately $1.9 million of expense related to employee termination benefits associated with the 2007 Plan, which was presented as a component of the line item labeled “Restructuring charges” in the Company’s Statement of Operations.

 

The following table summarizes the accrual balances and utilization by cost type for the 2007 Plan (in thousands):

 

 

 

Employee
severance and
relocation
benefits

 

Facility exit,
lease
termination
costs and other

 

Total

 

 

 

 

 

 

 

 

 

Balance as of June 30, 2007

 

$

 

$

 

$

 

Restructuring charges accrued

 

1,959

 

 

1,959

 

Cash payments

 

(794

)

 

(794

)

Non-cash settlement

 

(225

)

 

(225

)

Balance as of September 30, 2007

 

$

940

 

$

 

$

940

 

 

The Company has incurred total restructuring charges for both the 2006 Plan and the 2007 Plan of approximately $5.7 million in the third quarter of 2007 and $12.9 million in the first nine months of 2007.

 

NOTE 4—INVENTORIES

 

Inventories consist of the following (in thousands):

 

 

 

September 30,
2007

 

December 31,
2006

 

Raw materials

 

$

21,594

 

$

21,612

 

Work-in-process

 

11,531

 

13,127

 

Finished goods

 

15,483

 

11,767

 

Total

 

$

48,608

 

$

46,506

 

 

12



 

NOTE 5—ACQUIRED TECHNOLOGY RIGHTS

 

Acquired technology rights are comprised of licenses to technology covered by patents acquired from 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 $36.9 million and $30.2 million at September 30, 2007 and December 31, 2006, 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

 

2007, remainder thereof

 

$

2,082

 

2008

 

8,314

 

2009

 

7,446

 

2010

 

6,676

 

2011

 

6,280

 

Thereafter

 

18,083

 

Total expected future annual amortization

 

$

48,881

 

 

NOTE 6—ACCOUNTS PAYABLE AND ACCRUED LIABILITIES

 

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

 

 

 

September 30,
2007

 

December 31,
2006

 

Accounts payable

 

$

14,903

 

$

23,248

 

Accrued compensation and related liabilities

 

24,242

 

19,050

 

Accrued taxes

 

2,909

 

6,362

 

Accrued legal

 

1,415

 

2,426

 

Accrued warranties

 

3,325

 

6,801

 

Other

 

5,271

 

5,006

 

Total

 

$

52,065

 

$

62,893

 

 

NOTE 7—COMPREHENSIVE INCOME (LOSS)

 

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

 

 

 

Three Months Ended
September 30,

 

Nine Months Ended
September 30,

 

 

 

2007

 

2006

 

2007

 

2006

 

 

 

 

 

 

 

 

 

 

 

Net income (loss)

 

$

2,580

 

$

(14,155

)

$

(183

)

$

(22,384

)

Foreign currency translation adjustment

 

243

 

(26

)

303

 

83

 

Unrealized (loss) gain on debt securities

 

(996

)

(436

)

1,488

 

(111

)

Unrealized gain (loss) on hedging contracts

 

 

356

 

 

(248

)

Comprehensive income (loss)

 

$

1,827

 

$

(14,261

)

$

1,608

 

$

(22,660

)

 

NOTE 8—RELATED PARTY TRANSACTIONS

 

Perlegen Sciences, Inc.

 

As of September 30, 2007, the Company, and certain of its affiliates, including the Company’s chief executive officer and members of the board of directors, held approximately 22% 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.

 

The Company formed Perlegen in October 2000 as a wholly-owned subsidiary and spun it off in March 2001 in a $100 million private equity financing. The Company acquired its initial ownership interest in Perlegen in an arrangement which provides Perlegen rights to use certain of the Company’s intellectual property in its development efforts, and also provides the Company rights to use and commercialize certain data generated by Perlegen in the array field.

 

13



 

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 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 Consolidation of Variable Interest Entities, an Interpretation of ARB No. 51 as amended (“FIN 46”), 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.

 

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 used Affymetrix GeneChip® technology to provide the genotypic data. The agreement ended in the third quarter of 2006 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 9—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. Since the beginning of 2007, the Company has noted that improvement in its internal quality control programs have resulted in an overall decline in product replacement claims. As a result, an adjustment decreasing the warranty reserve balance was made in the first quarter of 2007. Information regarding the changes in the Company’s product warranty liability for the nine months ended September 30, 2007, was as follows (in thousands):

 

Beginning balance at December 31, 2006

 

$

6,801

 

New warranties issued

 

1,191

 

Repairs and replacements

 

(2,315

)

Adjustments

 

(1,567

)

Ending balance at March 31, 2007

 

4,110

 

New warranties issued

 

642

 

Repairs and replacements

 

(1,074

)

Adjustments

 

 

Ending balance at June 30, 2007

 

$

3,678

 

New warranties issued

 

773

 

Repairs and replacements

 

(1,127

)

Adjustments

 

 

Ending balance at September 30, 2007

 

$

3,324

 

 

14



 

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 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

 

In 2006, three shareholders of the Company 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, one on August 30, 2006 and the other on September 13, 2006, and were subsequently consolidated. The third lawsuit was filed in the Superior Court of the State of California on October 20, 2006. The substance of the allegations in these cases is similar, and includes claims against the individual defendants for breach of fiduciary duties, unjust enrichment, and violations of federal securities laws, Generally Accepted Accounting Principles, Section 162(m) of the Internal Revenue Code, and certain state laws in each case in connection with the allegedly backdated options. The plaintiffs seek monetary and equitable relief on behalf of the Company, including damages and disgorgement from the individual defendants, changes in the Company’s corporate governance and internal control procedures, and an award of attorneys’ fees and costs. As previously disclosed in the Company’s Form 10-K/A’s 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 has responded to the request for information and is 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

 

15



 

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 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 the Company’s 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, in the incurrence of significant costs and the consumption of substantial managerial resources.

 

NOTE 10—INCOME TAXES

 

Effective January 1, 2007, the Company adopted FIN 48 as a change in accounting principle. As a result prior periods are not restated for the effect of FIN 48, and the cumulative effect of applying FIN 48 was recorded as an adjustment to accumulated deficit as of the beginning of the period of adoption.  The cumulative effect of adoption was a $0.6 million increase in the opening balance of retained deficit as a change in accounting principle.

 

The total amount of unrecognized tax benefits as of January 1, 2007 is approximately $16 million before federal benefit on state taxes of approximately $2 million.  If recognized, the amount of unrecognized tax benefits that would impact income from continuing operations and the effective tax rate is $13 million.  Any changes to acquisition related unrecognized tax benefits of approximately $1 million will impact goodwill.

 

As of January 1, 2007, the amount of unrecognized tax benefit where it is reasonably possible that a significant change may occur in the next 12 months is approximately $0.2 million.  The change would result from a possible expiration of a statute of limitations in foreign jurisdictions.

 

The Company classifies interest and penalties related to tax positions as components of income tax expense.  As of January 1, 2007, the amount of accrued interest and penalties related to tax uncertainties is approximately $0.1 million.

 

The tax years 1992-2006 remain open to examination by various major tax jurisdictions to which the Company is subject.

 

16



 

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

This Management’s Discussion and Analysis of Financial Condition and Results of Operations as of September 30, 2007 and for the three and nine month periods ended September 30, 2007 and 2006 should be read in conjunction with the Management’s Discussion and Analysis of Financial Condition and Results of Operations included in our Annual Report on Form 10-K for the year ended December 31, 2006.

 

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 related to our ability to achieve and sustain higher levels of revenue and operating income (including risks related to the outcome of our previously announced efforts to reduce expenses in the general and administrative functions including the rationalization of our facilities); uncertainties concerning our product mix and its effect on gross margins; uncertainties relating to our restructuring charges; uncertainties relating to technological approaches, manufacturing (including risks related to resolving any manufacturing problems) and product development; uncertainties relating to changes in senior management personnel and structure; uncertainties related to cost and pricing of our products; risks relating to dependence on collaborative partners; uncertainties relating to sole source suppliers; uncertainties relating to FDA and other regulatory approvals; competition; risks relating to intellectual property of others and the uncertainties of patent protection; and risks relating to intellectual property and other 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.

 

Overview

 

We are engaged in the development, manufacture, sale and service of consumables and systems for genetic analysis in the life sciences and clinical healthcare markets and are recognized as a market leader in creating breakthrough tools that are advancing our understanding of the molecular basis of life. 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 and Europe. We also sell our products through life science supply specialists acting as authorized distributors in Latin America, India, the Middle East and Asia Pacific regions, including China. Although we have achieved profitability in the past and in the third quarter of 2007, we incurred a net loss for fiscal 2006 and for the first nine months  of 2007. The following overview describes a few of the key elements of our business strategy and our goals:

 

Increase top-line revenue growth.   We intend to increase our top-line revenue through the successful commercialization of our technologies and expansion of our customer base, including leveraging our technologies into new markets. We intend to expand the overall genotyping market opportunity by giving customers the highest possible genetic power for the dollar. We believe that this is a key competitive advantage and will drive commercial momentum by continuing to enable affordable, high-volume genotyping studies. We believe that this continued path toward higher information content

 

17



 

and ever more cost-effective products will fuel market growth for years to come. In gene expression, we anticipate expanding the overall market by ensuring that customers have a clear path to clinical studies and the products to get them there. As we continue to enhance the functionality and ease of use 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.

 

Improve operating efficiencies.   We intend to monitor our expenses closely to ensure our research and development and selling, general and administrative cost structures remain in line with our revenue growth. Associated with this goal, we announced in July 2006 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 restructuring charges of approximately $13.5 million in fiscal 2006 and $12.9 million in the first nine months of fiscal 2007. We expect to incur total charges in 2007 of approximately $15 million related to this restructuring. In July 2007, we announced an additional administrative facility consolidation. As a result of these restructuring efforts and through active cost management, we have decreased expenses in our general and administrative and research and development areas in 2007. Also, as a result of our increased manufacturing capacity and changes in product mix, we may make additional changes to our cost structure in the future.

 

Critical Accounting Policies & Estimates

 

General

 

The following section of Management’s Discussion and Analysis of Financial Condition and Results of Operations is based upon our unaudited 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.

 

Revenue Recognition

 

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

 

Accounts Receivable

 

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

 

18



 

Inventories

 

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

 

Non-marketable Securities

 

As part of our strategic efforts to gain access to potential new products and technologies, we invest in equity securities of certain private biotechnology companies. Our 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 investee’s (i) revenue and earnings trend, (ii) business outlook for its products and technologies, (iii) liquidity position and the rate at which it is using its cash, and (iv) likelihood of obtaining subsequent rounds of financing. If an investee obtains additional funding at a valuation lower than our carrying value, we presume that the investment is other than temporarily impaired. We have experienced impairments in our portfolio due to the decline in equity markets over the past few years. However, we are not able to determine at the present time which specific investments are likely to be impaired in the future, or the extent or timing of the individual impairments.

 

Income Taxes

 

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

 

Beginning January 1, 2007, we apply FIN 48 in accounting for income taxes in accordance with SFAS 109.  Under FIN 48 a company recognizes 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 statement 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.

 

We evaluate the likelihood of sustaining tax positions and assess the benefit to be recognized from these positions using certain subjective assumptions.  The estimate of these key assumptions is based on historical information and judgment regarding audit experience, similar positions, as well as expert advice. As required we review our assumptions at each balance sheet date and, as a result, we may change our valuation assumptions as our experience changes.

 

Contingencies

 

We are subject to legal proceedings principally related to intellectual property matters. Based on the information available at the balance sheet dates, we assess the likelihood of any adverse judgments or outcomes to these matters, as well as potential ranges of probable losses. If losses are probable and reasonably estimable, we will record a reserve in accordance

 

19



 

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 2007, we recognized employee stock-based compensation of approximately $0.8 million in cost of product sales, approximately $1.6 million in research and development expense and approximately $5.2 million in selling, general and administrative expenses. We adopted SFAS 123R on a modified prospective basis. As of September 30, 2007, approximately $26.8 million of total unrecognized stock-based compensation expense related to non-vested awards is expected to be to be recognized over the respective vesting terms of each award through June 2011. The weighted average term of the unrecognized stock-based compensation expense is 2.3 years.

 

During the nine months ended September 30, 2006 under SFAS 123R 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 officer’s stock option grant to increase the associated exercise period.

 

Restructuring

 

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 3 to the Condensed Consolidated Financial Statements in Item 1.

 

20



 

Results of Operations

 

The following discussion compares the historical results of operations for the three and nine months ended September 30, 2007 and 2006, respectively.

 

Product Sales

 

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

 

 

 

Three Months Ended
September 30,

 

Nine Months Ended
September 30,

 

 

 

2007

 

2006

 

$
Change

 

%
Change

 

2007

 

2006

 

$
Change

 

%
Change

 

Probe arrays

 

$42,868

 

$37,422

 

$5,446

 

15

%

$119,607

 

$120,790

 

(1,183

)

(1

)%

Reagents

 

15,841

 

10,166

 

5,675

 

56

%

43,619

 

30,247

 

13,372

 

44

%

Instruments

 

10,664

 

8,551

 

2,113

 

25

%

27,940

 

32,117

 

(4,177

)

(13

)%

Total product sales

 

$69,373

 

$56,139

 

$13,234

 

24

%

$191,166

 

$183,154

 

8,012

 

4

%

 

Probe array sales increased in the third quarter of 2007 due to an increase of $9.0 million primarily due to growth in genotyping unit sales. This growth was partially offset by a decrease of $3.6 million in revenue related to a reduction in the average selling price of our probe arrays. Reagent sales grew due to an increase of $3.2 million related to growth in unit sales and an additional $2.5 million because of an increase in the average selling price. Instrument sales grew due to an increase of $2.3 million related to growth in unit sales.

 

Probe array sales decreased in the first nine months of 2007 due to a decline of $15.4 million related to a reduction in the average selling price of our probe arrays. This decrease was partially offset by an increase of $14.3 million primarily due to growth in genotyping unit sales. Reagent sales grew primarily due to an increase of $9.8 million related to an increase in unit sales and an additional $3.6 million because of an increase in average selling price. Instrument sales decreased primarily due to a decline of $5.8 million because of a drop in the average selling price of our GeneChip® Scanner 3000. This decrease was partially offset by an increase of $1.7 million primarily due to growth in unit sales.

 

Product Related Revenue

 

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

 

 

 

Three Months Ended
September 30,

 

Nine Months Ended
September 30,

 

 

 

2007

 

2006

 

$

 Change

 

%
Change

 

2007

 

2006

 

$

 Change

 

%
Change

 

Subscription fees

 

$

961

 

$

1,868

 

$

(907

)

(49

)%

$

2,967

 

$

5,576

 

$

(2,609

)

(47

)%

Service and other

 

11,135

 

12,445

 

(1,310

)

(11

)%

32,524

 

29,270

 

3,254

 

11

%

License fees and milestone revenue

 

3,662

 

3,658

 

4

 

0

%

10,962

 

10,775

 

187

 

2

%

Total product related revenue

 

$

15,758

 

$

17,971

 

$

(2,213

)

(12

)%

$

46,453

 

$

45,621

 

$

832

 

2

%

 

Service and other revenue increased in the third quarter of 2007 and the first nine months of 2007 primarily due to growth of $1.5 million and $1.9 million, respectively, in revenue related to our genotyping services business and $0.3 million and $1.0 million in field services, respectively. 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 amortization of the remaining $3.6 million of deferred revenue related to this access fee is expected to be completed in the fourth quarter of  2007.

 

21



 

Royalties and Other Revenue (in thousands, except percentage amounts)

 

 

 

Three Months Ended
September 30,

 

Nine Months Ended
September 30,

 

 

 

2007

 

2006

 


Change

 

%
Change

 

2007

 

2006

 

$
Change

 

%
Change

 

Royalties and other revenue

 

$

9,500

 

$

5,969

 

$

3,531

 

59

%

$

14,653

 

$

10,263

 

$

4,390

 

43

%

 

Royalties and other revenue increased for the third quarter of 2007 and in the first nine months of 2007 primarily due to the recognition of $7.5 million in  license fees related to a change in control provision. In the third quarter of 2006, the Company recognized $4.5 million related to a license agreement with no continuing performance obligations .

 

Revenue from Perlegen Sciences (in thousands, except percentage amounts)

 

 

 

Three Months Ended
September 30,

 

Nine Months Ended
September 30,

 

 

 

2007

 

2006

 

$
Change

 

%
Change

 

2007

 

2006

 

$
Change

 

%
Change

 

Revenue from Perlegen Sciences

 

$

355

 

$

4,593

 

$

(4,238

)

(92

)%

$

11,456

 

$

12,091

 

$

(635

)

(5

)%

 

Perlegen revenue decreased for the third quarter of 2007 primarily due to decreased demand by Perlegen for our commercial products.

 

Perlegen revenue decreased for the first nine months of 2007 primarily due to a decrease of $1.5 million related to decreased demand for wafers used by Perlegen for internal research and development and a decrease of $1.0 million in royalties. These decreases were partially offset by a $1.9 million increase due to increased demand by Perlegen for our commercial probe arrays.

 

22



 

Product and Product Related Gross Margins (in thousands, except percentage/point amounts)

 

 

 

Three Months Ended
September 30,

 

Dollar /
Point Change
From

 

Nine Months Ended
September 30,

 

Dollar /
Point
Change From

 

 

 

2007

 

2006

 

2006

 

2007

 

2006

 

2006

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total gross margin on product sales

 

$

41,291

 

$

32,521

 

$

8,770

 

$

119,530

 

$

120,816

 

$

(1,286

)

Total gross margin on product related revenue

 

8,414

 

9,112

 

(698

)

21,808

 

22,909

 

(1,101

)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total gross margin on product and product related revenue

 

$

49,705

 

$

41,633

 

$

8,072

 

$

141,338

 

$

143,725

 

$

(2,387

)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Product gross margin as a percentage of product sales

 

59.5

%

57.9

%

1.6

 

62.5

%

66.0

%

(3.4

)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Product related gross margin as a percentage of product related revenue

 

53.4

%

50.7

%

2.7

 

46.9

%

50.2

%

(3.3

)

 

The 1.6 point increase in product gross margin in the third quarter of 2007 is primarily due to the following factors: 8.0 points of the increase is attributable to an increase in product gross margins due to lower chip manufacturing costs and better factory utilization and  4.5 points of the increase is attributable to an increase in the average selling price of our reagents. These increases were partially offset by 6.4 points related to a decrease in the average selling price of our probe arrays and a 4.1 point decrease in product gross margin due to higher reagent manufacturing costs.

 

The 3.4 point decrease in product gross margin in the first nine months of 2007 is primarily due to the following factors:  8.4 points of the decrease is attributable to a decline in the average selling price of our probe arrays; 3.2 points of the decrease is attributable to a decline in the average selling price of our instrumentation products; and 2.7 points of the decrease is attributable to higher costs of production for reagents. These decreases were partially offset by a 4.7 point increase in product gross margins due to higher factory utilization as we produced and sold more probe arrays; a 4.2 point impact for increased sales volume primarily associated with DNA chips; and a 2.0 point increase in  the average selling price of our reagents.

 

The 2.7 point increases in product related gross margin for the third quarter of 2007 is primarily due to the following factors: a 5.4 point increase due to a mix shift to higher margin items and a 5.0 point increase due to lower costs in services. These increases were partially offset by a 7.9 point decrease attributable to lower pricing of strategic WGA services.

 

The 3.3 point decrease in product related gross margins in the first nine months of 2007 is primarily due to a mix shift in our product mix as our genotyping services business grew as a percentage of total product related sales. In addition, sales of our GeneChip® array access agreements declined as we continued to transition customers to volume-based discounting on product sales.

 

Cost of Perlegen Revenues (in thousands, except percentage amounts)

 

 

 

Three Months Ended
September 30,

 

Nine Months Ended
September 30,

 

 

 

2007

 

2006

 

$
Change

 

%
Change

 

2007

 

2006

 

$
Change

 

$


Change

 

Cost of revenue from Perlegen Sciences

 

$

166

 

$

1,646

 

$

(1,480

)

(90

)%

$

4,494

 

$

4,304

 

$

190

 

4

%

 

Cost of Perlegen revenue decreased for the third quarter of 2007 primarily due to decreased demand by Perlegen for our commercial products.

 

23



 

Research and Development Expenses (in thousands, except percentage amounts)

 

 

 

Three Months Ended
September 30,

 

Nine Months Ended
September 30,

 

 

 

2007

 

2006

 

$
Change

 

%
Change

 

2007

 

2006

 

$
Change

 

%
Change

 

Research and development

 

$

16,489

 

$

21,639

 

$

(5,150

)

(24

)%

$

55,143

 

$

66,737

 

$

(11,594

)

(17

)%

 

The decrease in research and development expenses in the third quarter of 2007 was primarily due to a $1.8 million decrease in total compensation and benefits due to reduction in headcount, a $1.5 million reduction of spending on supplies through cost cutting measures and a decrease in stock-based compensation expense of $0.5 million.

 

The decrease in research and development expenses in the first nine months of 2007 was primarily due to a $4.4 million reduction of spending on supplies and co-development expenses as we concluded certain co-development activities and began to focus our research and development efforts on fewer more strategic programs that will enable the development of next generation products in our key genetic analysis markets as well as overall cost cutting measures. Additionally, employee related expenses decreased $3.5 million following a corporate restructuring plan implemented in the third quarter of 2007. Lastly, stock-based compensation expense decreased $1.5 million.

 

While our research and development costs have declined in the near term, we believe a substantial investment in research and development is essential to a long-term sustainable competitive advantage and critical to expansion into additional markets.

 

Selling, General and Administrative Expenses (in thousands, except percentage amounts)

 

 

 

Three Months Ended
September 30,

 

Nine Months Ended
September 30,

 

 

 

2007

 

2006

 

$
Change

 

%
Change

 

2007

 

2006

 

$
Change

 

%
Change

 

Selling, general and administrative

 

$

33,300

 

$

35,865

 

$

(2,565

)

(7

)%

102,800

 

$

114,107

 

$

(11,307

)

(10

)%

 

The decrease in selling, general and administrative expenses in the third quarter of 2007 was primarily due to $2.7 million of lower legal expenses. The decrease for the first nine months of 2007 was primarily due to $5.3 million of lower legal expenses, $3.1 million of lower stock-based compensation expense and $1.7 million of lower employee related costs. We expect legal costs to vary substantially depending on the intensity of legal activity, such as patent litigation.

 

Restructuring charges (in thousands, except percentage amounts)

 

 

 

Three Months Ended
September 30,

 

Nine Months Ended
September 30,

 

 

 

2007

 

2006

 

$
Change

 

%
Change

 

2007

 

2006

 

$
Change

 

%
Change

 

Restructuring charges

 

$

5,737

 

$

10,008

 

$

(4,271

)

(43

)%

$

12,879

 

$

10,008

 

$

2,871

 

29

%

 

2006 Restructuring Plan

 

In the third quarter of 2006, we initiated a restructuring plan (“the 2006 Plan”) to better align certain of our expenses with our current business outlook. Our primary focus of the 2006 Plan was in the general and administrative functions and included rationalizing our facilities. In August 2006, we terminated certain employees in the general and administrative functions. Additionally, in September 2006, we announced our plan to close our Bedford, Massachusetts based instrumentation manufacturing and development facility. In the second quarter of 2007, we began to consolidate the Bedford facility’s instrument manufacturing  operations with our probe array manufacturing facility located in West Sacramento, California. We also began to consolidate our instrumentation development capabilities with our principal research and development facilities located in Santa Clara, California. These consolidations, along with the implementation of the workforce severance and relocation elements of the Bedford facility closure, were materially completed during the third quarter of fiscal 2007. As a final element of our 2006 Plan, we terminated certain employees in the sales, marketing and research and development functions in Santa Clara, California during January 2007.

 

We estimate that the total restructuring expenses to be incurred in connection with the 2006 Plan will be approximately $26 million. Of this total, we estimate that approximately $21 million relates to employee severance and

 

24