Affymetrix 10-Q 2008 Documents found in this filing:
UNITED STATES WASHINGTON, D.C. 20549
FORM 10-Q
(MARK ONE)
FOR THE TRANSITION PERIOD FROM TO .
COMMISSION FILE NO. 0-28218
AFFYMETRIX, INC. (Exact name of Registrant as specified in its charter)
Registrants telephone number, including area code: (408) 731-5000
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No o
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See definitions of large accelerated filer, accelerated filer, and smaller reporting company 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 OCTOBER 31, 2008: 70,202,630
AFFYMETRIX, INC.
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AFFYMETRIX, INC. CONDENSED CONSOLIDATED BALANCE SHEETS (In thousands) (Unaudited)
Note 1: The condensed consolidated balance sheet at December 31, 2007 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, 2007.
See accompanying notes.
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AFFYMETRIX, INC. CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (In thousands, except per share amounts) (Unaudited)
See accompanying notes.
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AFFYMETRIX, INC. CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (In
thousands)
See accompanying notes.
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AFFYMETRIX, INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS SEPTEMBER
30, 2008
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. and its wholly owned subsidiaries (Affymetrix or the Company). 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, 2007, as filed with the Securities and Exchange Commission on February 29, 2008.
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.
Reclassification
Certain prior year revenue and cost of sales amounts in the Companys Condensed Consolidated Statements of Operations have been reclassified to conform to the current period presentation.
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 products, services or other sources of revenue 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.
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Product Sales
Product sales, as well as revenues from Perlegen Sciences (a related party, see Note 10), 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.
Services
Services revenue includes equipment service revenue; scientific services revenue, which includes associated consumables; and revenue from custom probe array design fees.
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 license revenue; royalties earned from third party license agreements; milestones and royalties earned from collaborative product development and supply agreements; subscription fees earned under GeneChip® array access programs; and research revenue which mainly consists of amounts earned under government grants; and non-recurring intellectual property payments.
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.
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.
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 from subscription fees earned under GeneChip® array access programs is recorded ratably over the related supply term.
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.
Transactions with Distributors
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 collectability is reasonably assured. The Companys agreements with distributors do not include rights of return.
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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). There are no dilutive warrants and convertible debt in any of the periods presented in the table below.
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 earnings per common share, on an actual outstanding basis, as they were anti-dilutive (in thousands):
Restructuring
The Company has in recent years 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 the Companys estimates, the amount of the restructuring charges could be materially impacted. For a full description of the Companys restructuring actions, see Note 4.
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Recent Accounting Pronouncements
In May 2008, the FASB issued Statement of Financial Accounting Standards (SFAS) No. 162, The Hierarchy of Generally Accepted Accounting Principles (SFAS 162). SFAS 162 identifies the sources of accounting principles and the framework for selecting the principles used in the preparation of financial statements. SFAS 162 is effective 60 days following the SECs approval of the Public Company Accounting Oversight Board amendments to AU Section 411, The Meaning of Present Fairly in Conformity with Generally Accepted Accounting Principles. The implementation of this standard will not have a material impact on our consolidated financial position and results of operations.
In March 2008, the FASB issued SFAS No. 161, Disclosures About Derivative Instruments and Hedging Activities an amendment of FASB Statement No. 133 (SFAS 161). SFAS 161 expands quarterly disclosure requirements in SFAS No. 133 about an entitys derivative instruments and hedging activities. SFAS 161 is effective for fiscal years beginning after November 15, 2008. The Company is currently assessing the impact of SFAS 161 on its consolidated results of operations and financial condition.
Effective January 1, 2008, the Company adopted SFAS No. 157, Fair Value Measurements (SFAS 157). In February 2008, the FASB issued FASB Staff Position No. FAS 157-2, Effective Date of FASB Statement No. 157, which provides a one year deferral of the effective date of SFAS 157 for non-financial assets and non-financial liabilities, except those that are recognized or disclosed in the financial statements at fair value at least annually. Therefore, the Company has adopted the provisions of SFAS 157 with respect to its financial assets and liabilities only. SFAS 157 defines fair value, establishes a framework for measuring fair value under generally accepted accounting principles and enhances disclosures about fair value measurements. Fair value is defined under SFAS 157 as the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. Valuation techniques used to measure fair value under SFAS 157 must maximize the use of observable inputs and minimize the use of unobservable inputs. The standard describes a fair value hierarchy based on three levels of inputs, of which the first two are considered observable and the last unobservable, that may be used to measure fair value which are the following:
The adoption of SFAS 157 did not have a material effect on the Companys financial position, results of operations, or cash flows.
In December 2007, the FASB issued SFAS No. 141R, Business Combinations (SFAS 141R). SFAS 141R amends SFAS 141 and provides revised guidance for recognizing and measuring identifiable assets and goodwill acquired, liabilities assumed, and any non-controlling interest in the acquiree. It also provides disclosure requirements to enable users of the financial statements to evaluate the nature and financial effects of the business combination. It is effective for fiscal years beginning on or after December 15, 2008 and will be applied prospectively. The Company is currently assessing the impact of SFAS 141R on its consolidated results of operations and financial condition.
In October 2008, the FASB issued FSP 157-3 Determining Fair Value of a Financial Asset in a Market That Is Not Active (FSP 157-3). FSP 157-3 clarified the application of SFAS No. 157 in an inactive market. It demonstrated how the fair value of a financial asset is determined when the market for that financial asset is inactive. FSP 157-3 was effective upon issuance, including prior periods for which financial statements had not been issued. The implementation of this standard did not have a material impact on the Companys consolidated results of operations and financial condition.
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NOTE 2FAIR VALUE
In accordance with SFAS 157, the following table represents the Companys fair value hierarchy for its financial assets (cash equivalents and investments) measured at fair value on a recurring basis as of September 30, 2008 (in thousands):
As of September 30, 2008, the Company had no financial assets or liabilities requiring Level 3 classification.
NOTE 3STOCK-BASED COMPENSATION
Stock-Based Compensation Plans
The Company has a stock-based compensation program that provides the Board of Directors broad discretion in creating equity incentives for employees, officers, directors and consultants. This program includes incentive and non-qualified stock options and non-vested stock awards (also known as restricted stock) granted under various stock plans. Stock options are generally time-based, vesting 25% on each annual anniversary of the grant date over four years and expire 7 to 10 years from the grant date. Non-vested stock awards are generally time-based, vesting 25% on each annual anniversary of the grant date over four years. On June 11, 2008, at the annual shareholders meeting, the shareholders approved the amendment to increase the maximum number of shares of the Companys common stock authorized for issuance under the Companys Amended and Restated 2000 Equity Incentive Plan by 4.2 million shares. As of September 30, 2008, the Company had approximately 3.3 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 Company allocated stock-based compensation expense under SFAS No. 123R, Share-Based Payment, as follows (in thousands):
As of September 30, 2008, $38.1 million of total unrecognized stock-based compensation expense related to non-vested awards is expected to be recognized over the respective vesting terms of each award through 2012. The weighted average term of the unrecognized stock-based compensation expense is 3.1 years.
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Stock Option Assumptions
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 is based on a blend of historical and market-based implied volatility. Using the assumptions above, the weighted average grant date fair value of options granted during the three months ended September 30, 2008 and 2007 was $3.51 and $9.90, respectively, and for the nine months ended September 30, 2008 and 2007 was $4.55 and $9.90, respectively.
NOTE 4RESTRUCTURING
Fiscal 2008 Restructuring Plan
In February 2008, the Company committed to a restructuring plan (the 2008 Plan) designed primarily to optimize its production capacity and cost structure and improve its future gross margins. The restructuring plan was approved as part of the Companys ongoing efforts to reduce costs.
This phase of the restructuring plan involves moving the majority of the Companys probe array manufacturing from its West Sacramento, California facility to its Singapore facility by the end of 2008. The Company estimates the total restructuring expenses to be incurred in connection with this phase of the 2008 Plan will be approximately $14.0 million. Of this total, approximately $1.5 million relates to employee severance and $12.5 million relates to non-cash charges associated with the abandonment of certain long-lived manufacturing assets.
In July 2008, the Company decided to expand the 2008 Plan to include the closing of its West Sacramento manufacturing facility. Following the closure of its West Sacramento manufacturing facility, all of its products will be manufactured at its Singapore and Ohio facilities, as well as by third parties. The Company expects the closure of the West Sacramento facility to be substantially complete by the end of the second quarter of 2009. In this phase of the 2008 Plan, the Company currently expects to incur a total of approximately $36 million in charges related to this expansion of its restructuring plan. Of this total, the Company expects that approximately $18 million will be included as a component of total cost of product sales, $12 million of which relates to accelerated depreciation charges associated with the continued use of certain long-lived manufacturing assets and $6 million of which relates to manufacturing transition and other costs. Additionally, the Company expects to recognize approximately $18 million in the line item labeled as Restructuring charges in its Condensed Consolidated Statements of Operations, $14 million of which relates to asset impairment charges associated with the facility itself and to certain long-lived manufacturing assets and $4 million related to employee severance costs. In accordance with SFAS No. 146, Accounting for Costs Associated with Exit or Disposal Activities (SFAS 146), the costs relating to employee severance and relocation are being recognized as expense over the remaining service periods of the employees.
The estimated cash outlays to be incurred in connection with the 2008 Plan are estimated to be approximately $12.5 million. Depending on the rate at which the Company transfers its production capacity out of its West Sacramento facility, the Company may incur additional expenses. During the first nine months of 2008, the Company recognized approximately $2.9 million of expense for employee termination benefits associated with the 2008 Plan and $25.8 million of non-cash charges related to the abandonment and impairment of certain manufacturing assets. These expenses are presented as a component of Restructuring charges in the Companys Condensed Consolidated Statements of Operations.
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Fiscal 2007 Restructuring Plan
In July 2007, the Company announced that it was 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 and December 2007, the Company terminated certain employees in the research and development and selling, general and administrative functions. The Sunnyvale, California facility was vacated during the fourth quarter of 2007. The estimated cash outlays to be incurred in connection with these restructuring activities are estimated to be approximately $5 million. During the nine months ended September 30, 2008, the Company recognized approximately $0.4 million related to contract termination costs associated with the 2007 Plan.
Fiscal 2006 Restructuring Plan
In 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. Cash outlays incurred in connection with these restructuring activities are estimated to be approximately $16 million. During the nine months ended September 30, 2008, the amount of expense recognized associated with the 2006 Plan was not material. The activity for the restructuring plans above for the nine months ended September 30, 2008 and estimated costs for the amounts expected to be recognized as Restructuring charges in the Companys Condensed Consolidated Statements of Operations is as follows (in thousands):
NOTE 5ACQUISITIONSUSB Corporation
On January 30, 2008, the Company acquired 100% of the outstanding shares of USB Corporation (USB), a privately held Cleveland, Ohio-based company that develops, manufactures and markets an extensive line of molecular biology and biochemical reagent products. The acquisition will enable the Company to accelerate the development and commercialization of new genetic analysis solutions and increase the value of its current product portfolio.
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Affymetrix accounted for the merger under the purchase method of accounting in accordance with the provisions of SFAS No. 141, Business Combinations (SFAS 141). In accordance with SFAS 141, the Company recorded the assets acquired and liabilities assumed at their estimated fair value, with the excess purchase price reflected as goodwill. Additionally, certain costs directly related to the merger were reflected as additional purchase price in excess of net assets acquired. The results of operations of USB have been included in Affymetrix consolidated financial statements since January 31, 2008.Purchase PriceThe total purchase price of the USB acquisition was $72.9 million and includes the following components (in thousands):
Purchase Price Allocation
During the third quarter of 2008, the Company reduced the estimated fair value of the tangible assets, net acquired by $3.1 million due to increasing USBs inventory reserves to conform to the Companys inventory reserve methodology, resulting in a corresponding increase of $3.1 million to goodwill. The following table allocates the purchase price based on the estimated fair values of the assets acquired and liabilities assumed as of the acquisition date (in thousands):
Intangible Assets and Goodwill
A valuation of the purchased intangible assets was undertaken by Affymetrix management in its determination of the estimated fair value of such assets. The $6.1 million value assigned to developed technology and patents and core technology is included in acquired technology rights on the Companys Condensed Consolidated Balance Sheet and will be amortized to cost of product sales over the estimated useful lives of these assets, generally four to five years. Affymetrix recorded amortization expense of approximately $0.3 million and $0.9 million for the three and nine months ended September 30, 2008, respectively, related to these acquired patents and technology. The $10.2 million value assigned to customer contracts and trade names and trademarks will be amortized to selling, general and administrative expenses over the estimated useful lives of these assets, generally four to eight years. Affymetrix recorded amortization expense of approximately $0.4 and $1.2 million for the three and nine months ended September 30, 2008, respectively, related to customer contracts and trade names and trademarks. Goodwill of $51.8 million was recorded as the excess of the purchase price over the net assets acquired. Goodwill will not be amortized, but will be assessed for impairment on an annual basis or when an indication of potential impairment exists.
In-process Technology
Management determined the estimated fair value of certain research and development programs in-process at the acquisition date that had not yet reached technological feasibility and had no alternative future use. These projects primarily included certain molecular biology projects. The fair values of these projects were determined using the Income Approach whereby management estimated each projects related future net cash flows between 2008 and 2014 and discounted them to their present value using a risk adjusted discount rate of 21%. This discount rate is based on the Companys estimated weighted average cost of capital adjusted upward for the risks associated with the projects acquired. The projected cash flows from the acquired projects were based on estimates of revenues and operating profits related to the projects considering the stage of development of each potential product acquired, the time and resources needed to complete the development and approval of each product, the life of each potential commercialized product and the inherent difficulties and uncertainties in developing products and services based on complex genetic technologies and biochemical processes. The Company expects cash flows from these projects to begin in 2009 and is not anticipating any material changes to its historical pricing, expense levels or gross margins related to these products.
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Escrow Agreement
Pursuant to the terms of the USB merger agreement, the Company withheld from the merger consideration $4.0 million and delivered those funds to an escrow account which shall be released to the USB shareholders upon achievement of certain revenue targets in fiscal 2008. Quarterly, the Company must review the revenue targets and to the extent they are achieved, all or a portion of the escrow funds shall be disbursed to the USB shareholders consistent with the terms of the merger agreement. If the prescribed revenue targets are not achieved, some or all of the escrow funds shall be released from restriction. As funds are disbursed to the USB shareholders, the Company will reflect these payments as additional goodwill and will reduce restricted cash. Any funds remaining in escrow at the end of the fiscal year 2008 which are not payable to the USB shareholders and are released from restriction will be reclassified to cash and cash equivalents. As of September 30, 2008, $0.4 million had been disbursed from the escrow account as a result of the achievement of certain revenue targets. Accordingly, $3.6 million is presented as a component of restricted cash in the Companys Condensed Consolidated Balance Sheet at September 30, 2008.
True Materials, Inc.
On July 17, 2008, Affymetrix acquired 100% of the outstanding shares of True Materials, Inc. (TMI), a privately held San Francisco-based company that develops digitally encoded microparticle technology. This technology is applicable to the research, applied and diagnostic markets and will enable the Company to enter low to mid-multiplex markets.
Affymetrix accounted for the merger under the purchase method of accounting in accordance with the provisions of SFAS No. 141. In accordance with SFAS 141, the Company recorded the assets acquired and liabilities assumed at their estimated fair value, with the excess purchase price reflected as goodwill. Additionally, certain costs directly related to the merger were reflected as additional purchase price in excess of net liabilities assumed. The results of operations have been included in Affymetrix consolidated financial statements since July 18, 2008.
Purchase PriceThe total purchase price of the acquisition was $20.4 million and includes the following components (in thousands):
Purchase Price Allocation
In-process Technology
Management determined the estimated fair value of certain research and development programs in-process at the acquisition date that had not yet reached technological feasibility and had no alternative future use. These projects primarily included materials research projects. The fair values of these projects were determined using the Income Approach whereby management estimated each projects related future net cash flows between 2009 and 2015 and discounted them to their present value using a risk adjusted discount rate of 30%. This discount rate is based on the Companys estimated weighted average cost of capital adjusted upward for the risks associated with the projects acquired. The projected cash flows from the acquired projects were based on estimates of revenues and operating profits related to the projects considering the stage of development of each potential product acquired, the time and resources needed to complete the development and approval of each product, the life of each potential commercialized product and the inherent difficulties and uncertainties in developing products and services based on complex genetic technologies and biochemical processes. The Company expects cash flows from these projects to begin in 2009 and is not anticipating any material changes to its historical pricing, expense levels or gross margins related to these products.
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Escrow Agreement
Pursuant to the terms of the merger agreement, the Company withheld from the merger consideration $5.1 million and delivered those funds to an escrow account, which shall be released to the founder and certain key employees of TMI upon achievement of certain employment milestones. As the continuous employment milestones are achieved, a portion of the escrow funds shall be disbursed to the founder and certain key employees consistent with the terms of the merger agreement. The Company will record these payments as additional goodwill. As of September 30, 2008, $0.3 million had been disbursed from the escrow account.
NOTE 6 GOODWILL AND OTHER INTANGIBLE ASSETS
Goodwill balance is presented below (in thousands):
During 2008, the Company recorded additional goodwill totaling approximately $68.0 million, of which approximately $51.7 million pertained to the acquisition of USB in the first quarter of fiscal 2008 and approximately $16.2 million pertained to the acquisition of True Materials, Inc. during the third quarter of fiscal year 2008. As of September 30, 2008, the Companys goodwill totaled approximately $193.0 million, or 16% of total assets, and its other intangible assets, consisting of net acquired technology rights totaled approximately $54.9 million, or 5% of its total assets (see Note 8).
SFAS No. 142, Goodwill and Other Intangible Assets (SFAS 142) requires that goodwill be assessed for impairment at least annually or whenever changes in circumstances indicate that the carrying amount may not be recoverable from estimated future cash flows. Factors that may be considered a change in circumstance indicating the carrying value of our intangible assets, including goodwill, may not be recoverable include, but are not limited to, significant underperformance relative to historical or projected future operating results, a significant decline in our stock price and market capitalization, and negative industry or economic trends. Additionally, the Company periodically evaluates the recoverability and the amortization period of its acquired technology rights.
The Company performed its required annual impairment test in June 2008 and determined that goodwill was not impaired. During the third quarter of 2008, the Companys stock price fell below the Companys net book value per share. The stock price decline, along with other conditions in the Companys business, are defined as indicators of impairment of goodwill and other intangibles under SFAS 142. Accordingly, the Company was required to assess whether or not an impairment of its intangible assets, including goodwill, had occurred. The Company performed an impairment test using a market based approach as of September 30, 2008 and determined that there was no impairment.
The continued decline of the Companys stock price subsequent to September 30, 2008 and the resulting book value per share being in excess of market value per share, along with other conditions in its business, are indicators that it is more likely than not that the fair value of the Company is less than the carrying value. Therefore, in the fourth quarter of 2008, the Company will assess whether or not an impairment of its goodwill and other intangible assets has occurred and will be conducting an evaluation of the fair market value of these assets. If the implied fair values of goodwill and other intangible assets are less than the carrying amounts, impairment losses will be recognized for the differences.
NOTE 7INVENTORIES
Inventories consist of the following (in thousands):
NOTE 8ACQUIRED TECHNOLOGY RIGHTS
Acquired technology rights are comprised of licenses to technology covered by patents to third parties and are amortized over the expected useful life of the underlying patents, which range from one to fifteen years. Accumulated amortization of these rights amounted to approximately $47.3 million and $39.0 million at September 30, 2008 and December 31, 2007, respectively.
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The expected future annual amortization expense of the Companys acquired technology rights and other intangible assets is as follows (in thousands):
NOTE 9COMPREHENSIVE INCOME (LOSS)
The components of comprehensive income (loss) are as follows (in thousands):
NOTE 10RELATED PARTY TRANSACTIONS
Perlegen Sciences, Inc.
As of September 30, 2008, 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.
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NOTE 11COMMITMENTS AND CONTINGENCIES
Legal Proceedings
The Company has been in the past and continues to be a party to litigation which has consumed and may continue to consume substantial financial and managerial resources. This could adversely affect our business, financial condition and results of operations. If the Company is found to have infringed the valid intellectual property rights of third parties in any litigation involving the Company or its collaborative partners, the Company or its collaborative partners could be subject to significant liability for damages, prevented from manufacturing and selling its products, or required to obtain a license from a third party, which may not be available on reasonable terms or at all.
The Company expects to devote substantial financial and managerial resources to protect its intellectual property rights and to defend itself against the claims described below.
E8 Pharmaceuticals LLC Litigation
On July 1, 2008, the Company was named as a defendant in a complaint filed by plaintiffs E8 Pharmaceuticals LLC and Massachusetts Institute of Technology (MIT) in the United States District Court of Massachusetts. In the complaint, the plaintiffs allege that the Company is infringing upon one patent owned by MIT and licensed to E8 Pharmaceuticals by making and selling the Companys GeneChip® products to customers and teaching its customers how to use the products. The plaintiffs seek a permanent injunction enjoining the Company from further infringement, and unspecified monetary damages, including lost profits, enhanced damages pursuant to 35 U.S.C. § 284, costs, attorneys fees and other relief as the court deems just and proper. The Company believes that the plaintiffs claims are without merit and will vigorously defend against the claims advanced in the complaint.
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 Forms 10-K/A for the year ended December 31, 2005, the Companys decision to restate its consolidated financial statements was based on the results of an internal review of its historical stock option granting practices from January 1, 1997 through May 31, 2006 performed under the direction of the Audit Committee of the Board of Directors. The review did not find any pattern or practice of inappropriately identifying grant dates with hindsight in order to provide discounted or in-the-money grants. On March 31, 2008, the federal district court presiding over the two consolidated cases issued an order granting in part and denying in part the motion of the Company and the individual defendants to dismiss the amended consolidated shareholder derivative complaint. The court allowed the plaintiffs leave to amend, and the plaintiffs filed a second amended consolidated shareholder derivative complaint on April 18, 2008. The individual defendants filed motions to dismiss the second amended consolidated derivative complaint on May 15, 2008. On October 24, 2008, the Court issued a decision granting in part and denying in part the motions to dismiss, and scheduled a case management conference for December 15, 2008. The case in California Superior Court is currently stayed pending resolution of the consolidated federal cases. 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 was conducting an informal inquiry into the Companys stock option practices. The Company responded to the request for information and cooperated 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.
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Enzo Litigation
On October 28, 2003, Enzo Life Sciences, Inc., a wholly-owned subsidiary of Enzo Biochem, Inc. (collectively Enzo) filed a complaint against the Company that is now pending in the United States District Court for the Southern District of New York for breach of contract, injunctive relief and declaratory judgment. The Enzo complaint relates to a 1998 distributorship agreement with Enzo under which the Company served as a non-exclusive distributor of certain reagent labeling kits supplied by Enzo. In its complaint, Enzo seeks monetary damages and an injunction against the Company from using, manufacturing or selling Enzo products and from inducing collaborators and customers to use Enzo products in violation of the 1998 agreement. Enzo also seeks the transfer of certain Affymetrix patents to Enzo. In connection with its complaint, Enzo provided the Company with a notice of termination of the 1998 agreement effective on November 12, 2003.
On November 10, 2003, the Company filed a complaint against Enzo in the United States District Court for the Southern District of New York for declaratory judgment, breach of contract and injunctive relief relating to the 1998 agreement. In its complaint, the Company alleges that Enzo has engaged in a pattern of wrongful conduct against it and other Enzo labeling reagent customers by, among other things, asserting improperly broad rights in its patent portfolio, improperly using the 1998 agreement and distributorship agreements 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 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 tortuous interference with the Companys business relationships and prospective economic advantage, and its 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 has 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 and requested reexamination of several of the Companys patents by the United States Patent & Trademark Office. These 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 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 modify or reduce the Companys patent protection and may cause the Company to incur significant costs and consume substantial managerial resources.
NOTE 12INCOME TAXES
The income tax provision for the nine months ended September 30, 2008 differs from the amount computed by applying the 35% U.S. federal statutory rate to the consolidated income before income taxes due to various factors, including the tax impact of non-U.S. operations, non-deductible in-process research and development, and the establishment of a partial valuation allowance against the Companys U.S. deferred tax assets.
For the quarter ended September 30, 2008, the Company recorded a non-cash income tax provision of approximately $6.3 million to establish a valuation allowance to partially reserve the Companys U.S. gross deferred tax assets as of September 30, 2008. The Company evaluated both positive and negative evidence and determined that there is a need for the valuation allowance during the quarter ended September 30, 2008 due to a revised forecast that lowered projected future taxable income. The Company intends to maintain the valuation allowance until sufficient positive evidence exists to support reversal of the valuation allowance. Management periodically evaluates the realizability of the Companys net deferred tax assets based upon all available evidence. The realization of net deferred tax assets is dependent on the Companys ability to generate sufficient future taxable income. The forecasted future taxable income is highly influenced by assumptions regarding the Companys ability to achieve its forecasted revenue and its ability to effectively manage its
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expenses in line with its forecasted revenue. The Company believes realization of the deferred tax assets as of September 30, 2008 is more likely than not based upon future taxable earnings. An additional valuation allowance against deferred tax assets may be necessary if it is more likely than not that all or a portion of the deferred tax assets will not be realized, for example as a result of a change in the Companys ability to reliably project future taxable income or a reduction in the amount of future taxable income.
The Company does not expect any material changes to the estimated amount of liability associated with its uncertain tax positions within the next twelve months. As of September 30, 2008, there have been no material changes to the total amount of unrecognized tax benefits.
ITEM 2. MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
This Managements Discussion and Analysis of Financial Condition and Results of Operations as of September 30, 2008 and for the three and nine month periods ended September 30, 2008 and 2007 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, 2007.
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. Actual results or business conditions may differ materially from those projected or suggested in such forward-looking statements as a result of various factors, including, but not limited to, risks of our ability to achieve and sustain higher levels of revenue, improved gross margins, reduced operating expenses, market acceptance, personnel retention, global economic conditions, fluctuations in overall capital spending in the academic and biotechnology sectors, changes in government funding policies, unpredictable fluctuations in quarterly revenues, uncertainties related to cost and pricing of Affymetrix products, dependence on collaborative partners, uncertainties relating to sole source suppliers, uncertainties relating to FDA, and other regulatory approvals, risks relating to intellectual property of others and the uncertainties of patent protection and litigation.
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 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. The following overview describes a few of the key elements of our strategy to improve our overall business:
Develop new products and technology. We believe that the genotyping market will continue to be one of the most attractive growth opportunities in life sciences and that new content and new clinical applications will continue to drive growth. These opportunities include our new cytogenetic applications and our new Drug Metabolizing Enzymes and Transporters (DMET) product which we believe addresses a significant unmet need. We anticipate that these products and technologies will contribute to the growth of our business in 2008 and beyond. Additionally, we have been working on a technology revision cycle that we expect will lead to a new product platform. This new product platform is expected to have a lower cost basis and smaller, higher density and more flexible chip formats that will enable us to reach new customers and generate future growth.
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Targeted acquisitions to expand our market opportunities. In addition to continued innovation, we are also pursuing acquisitions to expand our market opportunities. In 2008, we completed two acquisitions. The first was USB, a privately held Cleveland, Ohio-based company that develops, manufactures and markets an extensive line of molecular biology and biochemical reagent products for approximately $73 million in cash. This acquisition is expected to accelerate next-generation reagents that will be used with new products that we have in development. In July 2008, we completed an acquisition of a privately held San Francisco-based company that develops digitally encoded microparticle technology for approximately $25 million in cash. This technology is applicable to the research, applied, and diagnostic markets and will enable us to enter low to mid-multiplex markets and compete with bead-based platforms.
Reducing our overall cost structure. Earlier this year, we committed to a restructuring plan designed to optimize our production capacity and cost structure and improve our future gross margins. The first phase of this restructuring plan involved moving the majority of our probe array manufacturing from our West Sacramento, California facility to our Singapore facility. In July 2008, we decided to expand our restructuring plan to include the closure of our West Sacramento manufacturing facility. Following the closure of our West Sacramento manufacturing facility, all of our products will be manufactured at our Singapore and Ohio facilities, as well as by third parties.
We expect to incur additional restructuring charges of approximately $50 million relating to our 2008 restructuring plan to the close our West Sacramento facility. The estimated cash outlays to be incurred in connection with the 2008 Plan are estimated to be approximately $12 million. In connection with these and our other restructuring activities, we incurred a total restructuring charge of $29 million for the nine months ended September 30, 2008. Depending on the rate at which we transfer our production capacity out of our West Sacramento facility, we may incur additional expenses.
Critical Accounting Policies & Estimates
General
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.
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.
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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 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.
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 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.
Valuation of Goodwill and Intangible Assets
We review goodwill and intangible assets with indefinite lives for impairment annually and whenever events or changes in circumstances indicate the carrying value of goodwill may not be recoverable in accordance with SFAS No. 142, Goodwill and Other Intangible Assets (SFAS 142). Purchased intangible assets with finite useful lives are amortized using the straight-line method over their estimated useful lives and are reviewed for impairment under SFAS No. 144, Accounting for the Impairment of Disposal of Long-Lived Assets (SFAS 144). Determining the fair value of a reporting unit is judgmental in nature and involves the use of significant estimates and assumptions. These estimates and assumptions include revenue growth rates and forecasted operating margins used to calculate projected future cash flows, risk-adjusted discount rates, future economic and market conditions and determination of appropriate market comparables. We base our fair value estimates on assumptions we believe to be reasonable. Actual future results may differ from those estimates.
We performed our required annual impairment test in June 2008 and determined that goodwill was not impaired. During the third quarter of 2008, our stock price fell below our net book value per share. The stock price decline, along with other conditions in our business, are defined as indicators of impairment of goodwill and other intangibles under SFAS 142. Accordingly, we were required to assess whether or not an impairment of our intangible assets, including goodwill, had occurred. We performed an impairment test using a market-based approach as of September 30, 2008 and determined that there was no impairment.
The continued decline of our stock price subsequent to September 30, 2008 and the resulting book value per share being in excess of market value per share, along with other conditions in our business, are indicators that it is more likely than not that the fair value of the Company is less than the carrying value. Therefore, in the fourth quarter of 2008,we will assess whether or not an impairment of its goodwill and other intangible assets has occurred and will be conducting an evaluation of the fair market value of these assets. If the implied fair values of goodwill and other intangible assets are less than the carrying amounts, impairment losses will be recognized for the differences.
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, unrecognized tax benefits, 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
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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 actual and forecast pretax earnings, and ultimate outcomes of income tax audits.
Contingencies
We are subject to legal proceedings principally related to intellectual property matters. Based on the information available at the balance sheet dates, we assess the likelihood of any adverse judgments or outcomes to these matters, as well as potential ranges of probable losses. If losses are probable and reasonably estimable, we will record a reserve in accordance with SFAS No. 5, Accounting for Contingencies. Any reserves recorded may change in the future due to new developments in each matter.
Accounting for Stock-Based Compensation
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 nine months ended September 30, 2008, we recognized employee stock-based compensation of approximately $1.1 million in cost of product sales, approximately $1.5 million in research and development expense and approximately $4.0 million in selling, general and administrative expenses. During the nine months ended September 30, 2007, we recognized employee stock-based compensation of $0.8 million in cost of product sales, $1.6 million in research and development expense, $5.2 million in selling, general and administrative expenses and $0.3 million in restructuring charges recognized under SFAS 123R.
As of September 30, 2008, approximately $38.1 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 2012. The weighted-average term of the unrecognized stock-based compensation expense is 3.1 years.
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 cancellations, realizable values of assets that may become duplicative or obsolete, and other exit costs. If the actual amounts differ from our estimates, the amount of the restructuring charges could be materially impacted. For a full description of our restructuring actions, see Note 4 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, 2008 and 2007, respectively.
Product Sales
The components of product sales are as follows (in thousands, except percentage amounts):
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Total product sales decreased in the third quarter of 2008 as compared to the same period in 2007. Consumables, which include probe arrays and reagents, increased primarily due to an increase in unit sales of reagents associated with our acquisition of USB Corporation, which was partially offset by a decrease in unit sales of probe arrays. Instrument sales declined primarily due to a decrease in unit sales of our Probe Array systems and GeneChip® Scanners.
Total product sales increased in the first nine months of 2008 compared to the same period in 2007. Consumables increased primarily due to an increase in unit sales of reagents associated with our acquisition of USB Corporation. The increase in unit sales of reagents was partially offset by decreases in the average selling price of certain of our consumables. In addition, instrument sales declined primarily due to a decrease in unit sales of our Probe Array systems and GeneChip® Scanners. Sales to our pharmaceutical customers have declined in the first nine months of 2008 as compared to 2007, particularly in instrument sales.
Consumable sales for the three months ended September 30, 2008 and 2007 include $46,000 and $355,000, respectively, of revenue from Perlegen Sciences Inc. (Perlegen), a related party. Consumable sales for the nine months ended September 30, 2008 and 2007 include $0.8 million and $11.5 million, respectively, of revenue from Perlegen.
Services (in thousands, except percentage amounts):
Total services revenue decreased in the third quarter of 2008 as compared to 2007 primarily due to a decrease of $5.0 million in our genotyping services business because of the variable timing of projects, partially offset by an increase of $0.3 million in instrument service revenue. The decrease in total services revenue for the first nine months of 2008 as compared to 2007 is primarily due to a decrease of $9.5 million in our genotyping services business because of the variable timing of projects, partially offset by an increase of $1.4 million in instrument service revenue.
Royalties and Other Revenue (in thousands, except percentage amounts):
Royalties and other revenue decreased in the third quarter of 2008 as compared to 2007 primarily due to higher license and grant revenue recognized in 2007. Royalties and other revenue increased in the nine months ended September 30, 2008 as compared to 2007 primarily due to the recognition of a non-recurring $90 million intellectual property payment received in January 2008, partially offset by higher license and grant revenue recognized in 2007.
Product and Services Gross Margins (in thousands, except percentage/point amounts):
The decrease in product gross margin in the third quarter and first nine months of 2008, as compared to 2007, is primarily due to a charge for accelerated depreciation expense related to the closing of our West Sacramento manufacturing facility and lower average selling prices for certain of our consumable products. These decreases were partially offset by favorable consumable product costs.
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Gross margin on product sales for the third quarter of 2008 and 2007 includes $42,000 and $188,000, respectively, of gross margin from Perlegen and $0.4 million and $7.0 million, respectively, for the first nine months of 2008 and 2007.
The decrease in services gross margin in the third quarter and first nine months of 2008 as compared to the same period in 2007 was primarily due to lower volumes principally associated with sample acquisition delays and a proportionately higher mix of lower priced control samples.
Research and Development Expenses (in thousands, except percentage amounts):
The increase in research and development expenses in the third quarter and first nine months of 2008, as compared to the same periods in 2007 was primarily due to higher headcount related expenses and increased spending for supplies and outside services.
Our research and development costs have increased in the near term and 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 for the third quarter of 2008, as compared to the same period in 2007 was primarily due to lower headcount related expenses and lower spending for consulting and other outside services.
The decrease in selling, general and administrative expenses for the first nine months of 2008, as compared to the same period in 2007 was primarily due to a decrease in legal expenses, principally as a result of the settlement of the Illumina litigation in January 2008, lower headcount related expenses and lower spending for consulting and other outside services.
Acquired-in-process technology (in thousands, except percentage amounts):
During the third quarter of 2008, we completed the acquisition of True Materials, Inc. which we recorded a charge of approximately $5.1 million to acquired in-process technology. We believe the acquisition will enable us to enter low to mid-multiplex markets. We determined the estimated fair value of certain research and development programs in-process at the acquisition date that had not yet reached technological feasibility and had no alternative future use. The fair values of these projects were determined using the Income Approach whereby we estimated each projects related future net cash flows between 2009 and 2015 and discounted them to their present value using a risk adjusted discount rate of 30%. This discount rate is based on our estimated weighted average cost of capital adjusted upward for the risks associated with the projects acquired.
During the first quarter of 2008, we recorded a charge of approximately $0.8 million to acquired in-process technology upon the January 30, 2008 completion of our acquisition of USB. We believe the acquisition will enable us to accelerate the development and commercialization of new genetic analysis solutions and increase the value of our current product portfolio. We determined the estimated fair value of certain research and development programs in-process at the acquisition date that had not yet reached technological feasibility and had no alternative future use. These projects primarily included certain molecular biology projects. The fair values of these projects were determined using the Income Approach whereby we estimated each projects related future net cash flows between 2008 and 2014 and discounted them to their present value using a risk adjusted discount rate of 21%. This discount rate is based on our estimated weighted average cost of capital adjusted upward for the risks associated with the projects acquired.
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The projected cash flows from the acquired projects were based on estimates of revenues and operating profits related to the projects considering the stage of development of each potential product acquired, the time and resources needed to complete the development and approval of each product, the life of each potential commercialized product and the inherent difficulties and uncertainties in developing products and services based on complex genetic technologies and biochemical processes. We expect cash flows from these projects to begin in 2009 and are not anticipating any material changes to our historical pricing, expense levels or gross margins related to these products.
Restructuring charges (in thousands, except percentage amounts):
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