Affymetrix 10-Q 2007
WASHINGTON, D.C. 20549
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 ¨
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).
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
TABLE OF CONTENTS
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 Companys Form 10-K for the fiscal year ended December 31, 2006.
See accompanying notes.
(In thousands, except per share amounts)
See accompanying notes.
See accompanying notes.
SEPTEMBER 30, 2007
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 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.
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, 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
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. 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 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):
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):
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 Companys estimates, the amount of the restructuring charges could be materially impacted. For a full description of the Companys 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
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 2STOCK-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 Companys 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):
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.
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, 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 Companys stock plans for the nine months ended September 30, 2007 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 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 Companys 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.
The following table summarizes the Companys non-vested restricted stock activity for the nine months ended September 30, 2007 (in thousands, except per share amounts):
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.
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 Companys current business outlook. The Companys 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 facilitys 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 Companys 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):
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 Companys Statement of Operations.
The following table summarizes the accrual balances and utilization by cost type for the 2007 Plan (in thousands):
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.
Inventories consist of the following (in thousands):
NOTE 5ACQUIRED 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 Companys acquired technology rights and other intangible assets is as follows (in thousands):
NOTE 6ACCOUNTS PAYABLE AND ACCRUED LIABILITIES
Accounts payable and accrued liabilities consist of the following (in thousands):
NOTE 7COMPREHENSIVE INCOME (LOSS)
The components of comprehensive income (loss) are as follows (in thousands):
NOTE 8RELATED PARTY TRANSACTIONS
Perlegen Sciences, Inc.
As of September 30, 2007, the Company, and certain of its affiliates, including the Companys 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 Perlegens board of directors are also members of the Companys 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 Companys 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.
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 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 Companys standard supply terms, the Company shall supply commercial GeneChip products and certain non-commercial custom GeneChip products for Perlegens use in defined fields.
NOTE 9COMMITMENTS 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. 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 Companys product warranty liability for the nine months ended September 30, 2007, was as follows (in thousands):
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 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
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 Companys 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 Companys corporate governance and internal control procedures, and an award of attorneys fees and costs. As previously disclosed in the Companys Form 10-K/As 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 has responded to the request for information and is 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 the Companys 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, in the incurrence of significant costs and the consumption of substantial managerial resources.
NOTE 10INCOME 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.
This Managements 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 Managements 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.
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
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
The following section of Managements 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.
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 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.
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 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 officers stock option grant to increase the associated exercise period.
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.
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.
The components of product sales are as follows (in thousands, except percentage amounts):
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):
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.
Royalties and Other Revenue (in thousands, except percentage amounts)
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)
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.
Product and Product Related Gross Margins (in thousands, except percentage/point amounts)
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)
Cost of Perlegen revenue decreased for the third quarter of 2007 primarily due to decreased demand by Perlegen for our commercial products.
Research and Development Expenses (in thousands, except percentage amounts)
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)
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)
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 facilitys 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