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Affymetrix 10-Q 2008

Table of Contents

 

 

 

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

 


 

FORM 10-Q

 


 

(MARK ONE)

 

x

 

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

 

 

 

FOR THE QUARTERLY PERIOD ENDED JUNE 30, 2008

 

 

 

OR

 

 

 

o

 

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

 

FOR THE TRANSITION PERIOD FROM          TO          .

 

COMMISSION FILE NO. 0-28218

 


 

AFFYMETRIX, INC.

(Exact name of Registrant as specified in its charter)

 

DELAWARE

 

77-0319159

(State or other jurisdiction of

 

(I.R.S. Employer

incorporation or organization)

 

Identification Number)

 

 

 

3420 CENTRAL EXPRESSWAY

 

 

SANTA CLARA, CALIFORNIA

 

95051

(Address of principal executive offices)

 

(Zip Code)

 

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

 


 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No 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):

 

Large accelerated filer x

 

Accelerated filer o

 

 

 

Non-accelerated filer o

 

Smaller reporting company o

(Do not check if a smaller reporting company)

 

 

 

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 AUGUST 1, 2008: 70,247,951

 

 

 



Table of Contents

 

AFFYMETRIX, INC.

 

TABLE OF CONTENTS

 

PART I. FINANCIAL INFORMATION

 

3

 

 

 

 

 

 

Item 1.

Financial Statements (Unaudited)

 

3

 

 

 

 

 

 

 

Condensed Consolidated Balance Sheets at June 30, 2008 and December 31, 2007

 

3

 

 

 

 

 

 

 

Condensed Consolidated Statements of Operations for the Three and Six Months Ended June 30, 2008 and 2007

 

4

 

 

 

 

 

 

 

Condensed Consolidated Statements of Cash Flows for the Six Months Ended June 30, 2008 and 2007

 

5

 

 

 

 

 

 

 

Notes to Condensed Consolidated Financial Statements

 

6

 

 

 

 

 

 

Item 2.

Management’s Discussion and Analysis of Financial Condition and Results of Operations

 

17

 

 

 

 

 

 

Item 3.

Quantitative and Qualitative Disclosures About Market Risk

 

26

 

 

 

 

 

 

Item 4.

Controls and Procedures

 

26

 

 

 

 

 

PART II. OTHER INFORMATION

 

27

 

 

 

 

 

 

Item 1.

Legal Proceedings

 

27

 

 

 

 

 

 

Item 1A.

Risk Factors

 

27

 

 

 

 

 

 

Item 4.

Submission of Matters to a Vote of Security Holders

 

36

 

 

 

 

 

 

Item 5.

Other Information

 

36

 

 

 

 

 

 

Item 6.

Exhibits

 

36

 

 

 

 

 

SIGNATURES

 

37

 

2



Table of Contents

 

PART I. FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

 

AFFYMETRIX, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(In thousands)

(Unaudited)

 

 

 

June 30,

 

December 31,

 

 

 

2008

 

2007

 

ASSETS:

 

 

 

 

 

Current assets:

 

 

 

 

 

Cash and cash equivalents

 

$

325,728

 

$

288,644

 

Restricted cash

 

4,000

 

 

Available-for-sale securities—short-term portion

 

263,948

 

205,718

 

Accounts receivable, net ($67 in 2008 and $389 in 2007 from Perlegen Sciences)

 

77,889

 

81,941

 

Inventories

 

49,296

 

42,912

 

Deferred tax assets—current portion

 

15,322

 

28,584

 

Notes receivable from employees—current portion

 

135

 

1,376

 

Prepaid expenses and other current assets

 

10,275

 

17,933

 

Total current assets

 

746,593

 

667,108

 

Available-for-sale securities—long-term portion

 

19,658

 

89,912

 

Property and equipment, net

 

126,639

 

143,884

 

Acquired technology rights, net

 

57,717

 

46,797

 

Goodwill

 

174,129

 

125,050

 

Deferred tax assets—long-term portion

 

38,942

 

18,426

 

Notes receivable from employees—long-term portion

 

 

487

 

Other assets

 

35,151

 

41,927

 

Total assets

 

$

1,198,829

 

$

1,133,591

 

 

 

 

 

 

 

LIABILITIES AND STOCKHOLDERS’ EQUITY:

 

 

 

 

 

Current liabilities:

 

 

 

 

 

Accounts payable and accrued liabilities

 

$

60,609

 

$

61,543

 

Deferred revenue—current portion

 

18,024

 

22,498

 

Total current liabilities

 

78,633

 

84,041

 

Deferred revenue—long-term portion

 

3,754

 

3,922

 

Other long-term liabilities

 

10,587

 

10,971

 

Convertible notes

 

436,250

 

436,250

 

Stockholders’ equity:

 

 

 

 

 

Common stock

 

702

 

692

 

Additional paid-in capital

 

734,658

 

704,189

 

Accumulated other comprehensive income

 

100

 

1,998

 

Accumulated deficit

 

(65,855

)

(108,472

)

Total stockholders’ equity

 

669,605

 

598,407

 

Total liabilities and stockholders’ equity

 

$

1,198,829

 

$

1,133,591

 

 


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 Company’s Form 10-K for the fiscal year ended December 31, 2007.

 

See accompanying notes.

 

3



Table of Contents

 

AFFYMETRIX, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(In thousands, except per share amounts)

(Unaudited)

 

 

 

Three Months Ended

 

Six Months Ended

 

 

 

June 30,

 

June 30,

 

 

 

2008

 

2007

 

2008

 

2007

 

REVENUE:

 

 

 

 

 

 

 

 

 

Product sales ($6 and $797 in 2008 and $4,423 and $11,101 in 2007 from Perlegen Sciences)

 

$

75,022

 

$

68,409

 

$

137,828

 

$

132,894

 

Services

 

9,005

 

12,031

 

17,425

 

20,788

 

Royalties and other revenue

 

2,884

 

7,867

 

101,233

 

15,060

 

Total revenue

 

86,911

 

88,307

 

256,486

 

168,742

 

COSTS AND EXPENSES:

 

 

 

 

 

 

 

 

 

Cost of product sales ($0 and $442 in 2008 and $1,907 and $4,328 in 2007 from Perlegen Sciences)

 

32,257

 

25,726

 

58,234

 

47,871

 

Cost of services

 

6,691

 

10,760

 

12,369

 

17,166

 

Cost of royalties and other revenue

 

52

 

80

 

52

 

146

 

Research and development

 

19,591

 

19,427

 

38,359

 

38,654

 

Selling, general and administrative

 

29,640

 

33,643

 

64,373

 

69,501

 

Acquired in-process technology

 

 

 

800

 

 

Restructuring charges

 

898

 

1,771

 

14,808

 

7,142

 

Total costs and expenses

 

89,129

 

91,407

 

188,995

 

180,480

 

(Loss) income from operations

 

(2,218

)

(3,100

)

67,491

 

(11,738

)

Interest income and other, net

 

2,286

 

5,340

 

9,158

 

8,091

 

Interest expense

 

(3,548

)

(414

)

(7,137

)

(829

)

(Loss) income before income taxes

 

(3,480

)

1,826

 

69,512

 

(4,476

)

Income tax (provision) benefit

 

(155

)

(584

)

(26,895

)

1,712

 

Net (loss) income

 

$

(3,635

)

$

1,242

 

$

42,617

 

$

(2,764

)

 

 

 

 

 

 

 

 

 

 

Basic net (loss) income per common share

 

$

(0.05

)

$

0.02

 

$

0.62

 

$

(0.04

)

Diluted net (loss) income per common share

 

$

(0.05

)

$

0.02

 

$

0.56

 

$

(0.04

)

 

 

 

 

 

 

 

 

 

 

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

 

68,540

 

68,244

 

68,522

 

68,075

 

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

 

68,540

 

68,758

 

82,971

 

68,075

 

 

 See accompanying notes.

 

4



Table of Contents

 

AFFYMETRIX, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(In thousands)
(Unaudited)

 

 

 

Six Months Ended

 

 

 

June 30,

 

 

 

2008

 

2007

 

CASH FLOWS FROM OPERATING ACTIVITIES:

 

 

 

 

 

Net income (loss)

 

$

42,617

 

$

(2,764

)

Adjustments to reconcile net income (loss) to net cash provided by (used in) operating activities:

 

 

 

 

 

Depreciation and amortization

 

14,240

 

11,608

 

Amortization of intangible assets

 

5,455

 

4,165

 

Charge for acquired in-process technology

 

800

 

 

Amortization of investment premiums, net

 

371

 

(23

)

Stock-based compensation

 

3,267

 

4,609

 

Restructuring charges

 

(2,279

)

(1,375

)

Realized (gain) loss on equity investments

 

(19

)

199

 

Realized gain on the sales of investments

 

(35

)

(86

)

Deferred tax assets

 

21,479

 

(213

)

Amortization of debt offering costs

 

1,056

 

380

 

Accretion of interest on notes receivable

 

(7

)

(41

)

Loss on disposal of property and equipment

 

12,560

 

144

 

Changes in operating assets and liabilities:

 

 

 

 

 

Restricted cash

 

(4,000

)

(6,087

)

Accounts receivable, net

 

7,084

 

5,783

 

Inventories

 

809

 

(9,828

)

Prepaid expenses and other assets

 

8,413

 

(24

)

Accounts payable and accrued liabilities

 

(10,809

)

(12,413

)

Deferred revenue

 

(4,642

)

1,083

 

Other long-term liabilities

 

(384

)

326

 

Net cash provided by (used in) operating activities

 

95,976

 

(4,557

)

CASH FLOWS FROM INVESTING ACTIVITIES:

 

 

 

 

 

Capital expenditures

 

(7,432

)

(16,868

)

Purchases of available-for-sale securities

 

(263,831

)

(76,025

)

Proceeds from sales and maturities of available-for-sale securities

 

277,547

 

58,044

 

Acquisition of USB, net of cash acquired

 

(65,159

)

 

Purchase of non-marketable equity investments

 

(311

)

(800

)

Capital distribution of non-marketable equity investments

 

 

902

 

Net cash used in investing activities

 

(59,186

)

(34,747

)

CASH FLOWS FROM FINANCING ACTIVITIES:

 

 

 

 

 

Issuance of common stock

 

(3

)

11,321

 

Net cash (used in) provided by financing activities

 

(3

)

11,321

 

Effect of exchange rate changes on cash and cash equivalents

 

297

 

60

 

Net increase (decrease) in cash and cash equivalents

 

37,084

 

(27,923

)

Cash and cash equivalents at beginning of period

 

288,644

 

119,063

 

Cash and cash equivalents at end of period

 

$

325,728

 

$

91,140

 

 

See accompanying notes.

 

5



Table of Contents

 

AFFYMETRIX, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

JUNE 30, 2008
(UNAUDITED)

 

NOTE 1—SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

 

Basis of Presentation

 

The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with generally accepted accounting principles for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by U.S. generally accepted accounting principles for complete financial statements. The condensed consolidated financial statements include the accounts of Affymetrix, Inc. 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 Company’s 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 Company’s 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.

 

6



Table of Contents

 

Product Sales

 

Product sales, as well as revenues from Perlegen Sciences (a related party, see Note 9), 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 Company’s GeneChip® CustomExpressÔ and CustomSeqÔ products are recognized when the associated products are shipped.

 

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

 

Royalties and Other Revenue

 

Royalties and other revenue include 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 Company’s intellectual property portfolio. Revenue from minimum royalties is amortized over the term of the creditable royalty period. Any royalties received in excess of minimum royalty payments are recognized under the terms of the related agreement, generally upon notification of manufacture or shipment of a product by a licensee.

 

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 Company’s technical staff and include the costs for material and subcontract efforts. The Company’s research grant contracts generally provide for the payment of negotiated fixed hourly rates for labor hours incurred plus reimbursement of other allowable costs. Research revenue is recorded in the period in which the associated costs are incurred, up to the limit of the prior approval funding amounts contained in each agreement. The costs associated with these grants are reported as research and development expense.

 

Transactions with Distributors

 

The Company recognizes revenue when persuasive evidence of an arrangement exists, delivery has occurred or services have been rendered, the seller’s price is fixed or determinable, and collectability is reasonably assured. The Company’s agreements with distributors do not include rights of return.

 

7



Table of Contents

 

Net Income (Loss) Per Share

 

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

 

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

 

 

 

Three Months Ended

 

Six Months Ended

 

 

 

June 30,

 

June 30,

 

 

 

 

 

 

 

 

 

2008

 

2007

 

2008

 

2007

 

Numerator:

 

 

 

 

 

 

 

 

 

Net (loss) income - basic

 

$

(3,635

)

$

1,242

 

$

42,617

 

$

(2,764

)

Add effect of dilutive securities:

 

 

 

 

 

 

 

 

 

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

 

 

415

 

4,232

 

 

Net (loss) income - diluted

 

$

(3,635

)

$

1,657

 

$

46,849

 

$

(2,764

)

 

 

 

 

 

 

 

 

 

 

Denominator:

 

 

 

 

 

 

 

 

 

Weighted-average shares outstanding

 

69,479

 

68,666

 

69,396

 

68,440

 

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

 

(939

)

(422

)

(874

)

(365

)

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

 

68,540

 

68,244

 

68,522

 

68,075

 

Add effect of dilutive securities:

 

 

 

 

 

 

 

 

 

Employee stock options

 

 

449

 

52

 

 

Common stock subject to repurchase

 

 

65

 

28

 

 

Convertible notes

 

 

 

14,369

 

 

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

 

68,540

 

68,758

 

82,971

 

68,075

 

Basic net (loss) income per common share

 

$

(0.05

)

$

0.02

 

$

0.62

 

$

(0.04

)

Diluted net (loss) income per common share

 

$

(0.05

)

$

0.02

 

$

0.56

 

$

(0.04

)

 

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):

 

 

 

Three Months Ended

 

Six Months Ended

 

 

 

June 30,

 

June 30,

 

 

 

2008

 

2007

 

2008

 

2007

 

Employee stock options

 

6,666

 

3,319

 

4,697

 

5,814

 

Restricted stock subject to repurchase

 

1,702

 

601

 

599

 

601

 

Convertible notes

 

14,369

 

3,870

 

 

3,870

 

Total

 

22,737

 

7,790

 

5,296

 

10,285

 

 

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 Company’s estimates, the amount of the restructuring charges could be materially impacted. For a full description of the Company’s restructuring actions, see Notes 4 and 12.

 

8



Table of Contents

 

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 SEC’s 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 entity’s 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:

 

·

 

Level 1 - Quoted prices in active markets for identical assets or liabilities.

 

 

 

·

 

Level 2 - Inputs other than Level 1 that are observable, either directly or indirectly, such as quoted prices for similar assets or liabilities; quoted prices in markets that are not active; or other inputs that are observable or can be corroborated by observable market data for substantially the full term of the assets or liabilities.

 

 

 

·

 

Level 3 - Unobservable inputs that are supported by little or no market activity and that are significant to the fair value of the assets or liabilities.

 

The adoption of SFAS 157 did not have a material effect on the Company’s 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 February 2007, the FASB issued SFAS No. 159, The Fair Value Option for Financial Assets and Financial Liabilities-including an amendment of FASB Statement No. 115 (“SFAS 159”). SFAS 159 expands the use of fair value accounting but does not affect existing standards which require assets or liabilities to be carried at fair value. The objective of SFAS 159 is to improve financial reporting by providing companies with the opportunity to mitigate volatility in reported earnings caused by measuring related assets and liabilities differently without having to apply complex hedge accounting provisions. Under SFAS 159, an entity may elect to use fair value to measure eligible items including accounts receivable, available-for-sale and held-to-maturity securities, equity method investments, accounts payable, guarantees, and issued debt. The Company has elected not to adopt the fair value option on existing eligible financial instruments as of January 1, 2008. However, because the SFAS 159 election is based on an instrument-by-instrument election at the time the Company first recognizes an eligible item or enters into an eligible firm commitment, the Company may decide to exercise the option on new items when business reason support doing so in the future. The adoption of SFAS 159 would not be expected to have a significant impact on the Company’s consolidated results of operations and financial condition.

 

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NOTE 2—FAIR VALUE

 

In accordance with SFAS 157,  the following table represents the Company’s fair value hierarchy for its financial assets (cash equivalents and investments) measured at fair value on a recurring basis as of June 30, 2008 (in thousands):

 

 

 

Level 1

 

Level 2

 

Total

 

Non-U.S. equity securities

 

$

869

 

$

 

$

869

 

U.S. government obligations and agencies

 

 

346,306

 

346,306

 

U.S. corporate debt

 

 

69,257

 

69,257

 

Total

 

$

869

 

$

415,563

 

$

416,432

 

 

As of June 30, 2008, the Company had no financial assets or liabilities requiring Level 3 classification.

 

NOTE 3—STOCK-BASED COMPENSATION

 

Stock-Based Compensation Plans

 

The Company has a stock-based compensation program that provides the Board of Directors broad discretion in creating equity incentives for employees, officers, directors and consultants. This program includes incentive and non-qualified stock options and non-vested stock awards (also known as restricted stock) granted under various stock plans. Stock options are generally time-based, vesting 25% on each annual anniversary of the grant date over four years and expire 7 to 10 years from the grant date. Non-vested 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 Company’s common stock authorized for issuance under the Company’s Amended and Restated 2000 Equity Incentive Plan by 4,200,000 shares. As of June 30, 2008, the Company had approximately 2.9 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):

 

 

 

Three Months Ended

 

Six Months Ended

 

 

 

June 30,

 

June 30,

 

 

 

2008

 

2007

 

2008

 

2007

 

Costs of product sales

 

$

224

 

$

249

 

$

588

 

$

546

 

Research and development

 

341

 

599

 

864

 

1,161

 

Selling, general and administrative

 

80

 

1,036

 

1,815

 

2,902

 

Total stock-based compensation expense

 

645

 

1,884

 

3,267

 

4,609

 

Income tax benefit

 

(41

)

(654

)

(871

)

(1,460

)

Total stock-based compensation expense, net of tax

 

$

604

 

$

1,230

 

$

2,396

 

$

3,149

 

 

As of June 30, 2008, $41.7 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 3.3 years.

 

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:

 

 

 

Three Months Ended

 

Six Months Ended

 

 

 

June 30,

 

June 30,

 

 

 

2008

 

2007

 

2008

 

2007

 

Risk free interest rate

 

2.5

%

5.0

%

2.5

%

4.9

%

Expected dividend yield

 

0.0

%

0.0

%

0.0

%

0.0

%

Expected volatility

 

42

%

42

%

42

%

42

%

Expected option term (in years)

 

4.5

 

4.5

 

4.5

 

4.5

 

 

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The risk free interest rate for periods within the contractual life of the Company’s stock options is based on the U.S. Treasury yield curve in effect at the time of grant. The expected term is derived from an analysis of the Company’s historical exercise trends over ten years. The expected volatility 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 June 30, 2008 and 2007 was $4.05 and $10.77, respectively, and for the six months ended June 30, 2008 and 2007 was $4.61 and $10.78, respectively.

 

NOTE 4—RESTRUCTURING

 

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 Company’s ongoing efforts to reduce costs.

 

The restructuring plan involves moving the majority of the Company’s 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 the 2008 Plan will be approximately $15.4 million. Of this total, approximately $2.9 million relates to employee severance and $12.5 million relates to non-cash charges associated with the abandonment of certain long-lived manufacturing assets.  Depending on the rate at which the Company transfers its production capacity to Singapore, the Company may incur additional expenses associated with the reduction of capacity in the West Sacramento, California facility.  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 accrued over the remaining service periods of the employees.

 

During the first six months of 2008, the Company recognized approximately $2.1 million of expense related to employee termination benefits associated with the 2008 Plan and $12.5 million of non-cash charges related to the abandonment of certain manufacturing assets.  These expenses were presented as a component of the line item labeled “Restructuring charges” in the Company’s Condensed Consolidated Statements of Operations.

 

The activity in the accrued restructuring balances related to the 2008 Plan described above for the six months ended June 30, 2008 was as follows (in thousands):

 

 

 

 

 

 

 

 

 

 

 

 

 

As of

 

 

 

 

 

 

 

 

 

 

 

 

 

June 30, 2008

 

 

 

Balance as of

 

 

 

 

 

 

 

Balance as of

 

Total

 

Total

 

 

 

December 31,

 

2008

 

Cash

 

Non-Cash

 

June 30,

 

costs

 

expected

 

 

 

2007

 

Charges

 

Payments

 

Settlements

 

2008

 

to date

 

costs

 

Employee severance and relocation benefits

 

$

 

$

2,085

 

$

(897

)

$

(179

)

$

1,009

 

$

2,085

 

$

2,900

 

Abandonment of certain long- lived manufacturing assets

 

 

12,498

 

 

(12,498

)

 

12,498

 

12,500

 

Total restructuring costs

 

$

 

$

14,583

 

$

(897

)

$

(12,677

)

$

1,009

 

$

14,583

 

$

15,400

 

 

In July 2008, the Company decided to expand its restructuring plan by closing its West Sacramento manufacturing facility, see Note 12 for further information.

 

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 $6.2 million.

 

During the six months ended June 30, 2008 and 2007, the amount of expense recognized associated with the 2007 Plan was not material.

 

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The activity in the accrued restructuring balances related to the 2007 Plan described above for the six months ended June 30, 2008 was as follows (in thousands):

 

 

 

 

 

 

 

 

 

 

 

 

 

As of
June 30, 2008

 

 

 

Balance as of

 

 

 

 

 

 

 

Balance as of

 

Total

 

Total

 

 

 

December 31,

 

2008

 

Cash

 

Non-Cash

 

June 30,

 

costs

 

expected

 

 

 

2007

 

Charges

 

Payments

 

Settlements

 

2008

 

to date

 

costs

 

Employee severance and relocation benefits

 

$

1,295

 

$

7

 

$

(1,295

)

$

 

$

7

 

$

2,895

 

$

3,000

 

Contract termination costs

 

1,122

 

29

 

(574

)

 

577

 

1,245

 

3,000

 

Other restructuring costs

 

 

 

 

 

 

114

 

200

 

Total restructuring costs

 

$

2,417

 

$

36

 

$

(1,869

)

$

 

$

584

 

$

4,254

 

$

6,200

 

 

Fiscal 2006 Restructuring Plan

 

In 2006, the Company initiated a restructuring plan (the “2006 Plan”) to better align certain of its expenses with the Company’s current business outlook. The Company’s primary focus of the 2006 Plan was in the general and administrative functions and included rationalizing its facilities. In August 2006, the Company terminated certain employees in the general and administrative functions. Additionally, in September, the Company announced its plan to close its Bedford, Massachusetts based instrumentation manufacturing and development facility. The Company consolidated the Bedford facility’s instrument manufacturing operations with its probe array manufacturing facility in West Sacramento, California. The Company’s instrumentation development capabilities were consolidated with its principal research and development facilities located in Santa Clara, California. Implementation of the 2006 Plan began in the fourth quarter of 2006 and continued into the first half of 2007 and eliminated or transferred certain positions. The closure of the Bedford, Massachusetts facility was substantially completed by the third quarter of fiscal 2007. Cash outlays incurred in connection with these restructuring activities are estimated to be approximately $15.6 million.

 

During the six months ended June 30, 2008, the amount of expense recognized associated with the 2006 Plan was not material. During the six months ended June 30, 2007, the Company recognized approximately $7.1 million of expense related to the plan which was presented in a single line item labeled “Restructuring charges” in the Company’s Condensed Consolidated Statements of Operations, of which approximately $6.3 million related to employee termination benefit costs and approximately $0.8 million related to facility exit costs.
 
The activity in the accrued restructuring balances related to the 2006 Plan described above for the six months ended June 30, 2008 was as follows (in thousands):

 

 

 

 

 

 

 

 

 

 

 

 

 

As of

 

 

 

 

 

 

 

 

 

 

 

 

 

June 30, 2008

 

 

 

Balance as of

 

 

 

 

 

 

 

Balance as of

 

Total

 

Total

 

 

 

December 31,

 

2008

 

Cash

 

Non-Cash

 

June 30,

 

costs

 

expected

 

 

 

2007

 

Charges

 

Payments

 

Settlements

 

2008

 

to date

 

costs

 

Employee severance and relocation benefits

 

$

140

 

$

(46

)

$

(94

)

$

 

$

 

$

20,197

 

$

20,200

 

Contract termination costs

 

1,761

 

28

 

(680

)

111

 

1,220

 

2,419

 

2,900

 

Other restructuring costs

 

 

207

 

(207

)

 

 

2,195

 

2,200

 

Total restructuring costs

 

$

1,901

 

$

189

 

$

(981

)

$

111

 

$

1,220

 

$

24,811

 

$

25,300

 

 

NOTE 5—ACQUISITION

 

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.
 
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.

 

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Table of Contents

 

Purchase Price
 

The total purchase price of the USB acquisition was $72.9 million and includes the following components (in thousands):

 

Merger consideration paid in cash

 

$

70,895

 

Direct acquisition costs

 

1,958

 

Total purchase price

 

$

72,853

 

 

Purchase Price Allocation

 

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):

 

Tangible assets, net

 

$

7,146

 

Amortizable intangible assets

 

16,300

 

Goodwill

 

48,607

 

In-process technology

 

800

 

Total

 

$

72,853

 

 

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 Company’s 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 $0.5 million for the three and six months ended June 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 $0.7 million for the three and six months ended June 30, 2008, respectively, related to customer contracts and trade names and trademarks. Goodwill of $48.6 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 project’s 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 Company’s 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.

 

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

 

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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 June 30, 2008, no funds had been disbursed from the escrow account nor released from restriction.  Accordingly, $4.0 million is presented as restricted cash in the Company’s Condensed Consolidated Balance Sheet at June 30, 2008.

 

NOTE 6—INVENTORIES

 

Inventories consist of the following (in thousands):

 

 

 

June 30,

 

December 31,

 

 

 

2008

 

2007

 

Raw materials

 

$

21,242

 

$

20,507

 

Work-in-process

 

10,197

 

11,297

 

Finished goods

 

17,857

 

11,108

 

Total

 

$

49,296

 

$

42,912

 

 

NOTE 7—ACQUIRED TECHNOLOGY RIGHTS

 

Acquired technology rights are comprised of licenses to technology covered by patents to third parties and are amortized over the expected useful life of the underlying patents, which range from one to fifteen years. Accumulated amortization of these rights amounted to approximately $44.4 million and $39.0 million at June 30, 2008 and December 31, 2007, respectively.

 

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

 

 

 

Amortization

 

For the Year Ending December 31,

 

Expense

 

2008, remainder thereof

 

$

5,778

 

2009

 

10,550

 

2010

 

9,780

 

2011

 

9,385

 

2012

 

7,631

 

Thereafter

 

14,593

 

Total

 

$

57,717

 

 

NOTE 8—COMPREHENSIVE INCOME (LOSS)

 

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

 

 

 

Three Months Ended

 

Six Months Ended

 

 

 

June 30,

 

June 30,

 

 

 

2008

 

2007

 

2008

 

2007

 

Net (loss) income

 

$

(3,635

)

$

1,242

 

$

42,617

 

$

(2,764

)

Foreign currency translation adjustment

 

(178

)

(1

)

297

 

60

 

Unrealized gain (loss) on debt securities

 

107

 

1,680

 

(2,195

)

2,484

 

Comprehensive (loss) income

 

$

(3,706

)

$

2,921

 

$

40,719

 

$

(220

)

 

NOTE 9—RELATED PARTY TRANSACTIONS

 

Perlegen Sciences, Inc.

 

As of June 30, 2008, the Company, and certain of its affiliates, including the Company’s chief executive officer and members of the board of directors, held approximately 22% ownership interest in Perlegen Sciences, Inc. (“Perlegen”), a privately-held biotechnology company. In addition, two members of Perlegen’s board of directors are also members of the Company’s board of directors.

 

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Table of Contents

 

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

 

The Company accounts for its ownership interest in Perlegen using the equity method as the Company and its affiliates do not control the strategic, operating, investing and financing activities of Perlegen; however, the Company does have significant influence over Perlegen’s operating activities. Further, the Company has no obligations to provide funding to Perlegen nor does it guarantee or otherwise have any obligations related to the liabilities or results of operations of Perlegen or its investors. Through January 2005, the Company’s investment in Perlegen had no cost basis; accordingly, the Company has not recorded its proportionate share of Perlegen’s operating losses in its financial statements since the completion of Perlegen’s initial financing. In February 2005, the Company participated in Perlegen’s Series D preferred stock financing and recorded a $2.0 million investment related to this transaction, which was included in the Company’s balance sheet as a component of other assets. As of June 30, 2005, the Company had reduced the carrying value of its investment to zero through the recording of its proportionate share of Perlegen’s operating losses.

 

In accordance with Financial Accounting Standards Board Interpretation No. 46, Consolidation of Variable Interest Entities, an Interpretation of ARB No. 51 as amended (“FIN 46”), the Company has concluded that Perlegen is a variable interest entity in which the Company holds a variable interest, and that the Company is not the primary beneficiary.

 

NOTE 10—COMMITMENTS 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 one patent owned by MIT and licensed to E8 Pharmaceuticals by making and selling the Company’s 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 Company’s current and former officers and directors, and allege that these officers and directors breached their fiduciary duties and breached other laws by participating in backdating stock options grants. Two of these lawsuits were filed in the United States District Court for the Northern District of California, one on August 30, 2006 and the other on September 13, 2006, and were subsequently consolidated. The third lawsuit was filed in the Superior Court of the State of California on October 20, 2006. The substance of the allegations in these cases is similar, and includes claims against the individual defendants for breach of fiduciary duties, unjust enrichment, and violations of federal securities laws, Generally Accepted Accounting Principles, Section 162(m) of the Internal Revenue Code, and certain state laws in each case in connection with the allegedly backdated options. The plaintiffs seek monetary and equitable relief on behalf of the Company, including damages and disgorgement from the individual defendants, changes in the Company’s corporate governance and internal control procedures, and an award of attorneys’ fees and costs. As previously disclosed in the Company’s Forms 10-K/A for the year ended December 31, 2005, the Company’s decision to restate its consolidated financial statements was based on the results of an internal review of its historical stock option granting practices from January 1, 1997 through May 31, 2006 performed under the direction of the Audit

 

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Table of Contents

 

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 July 2, 2008, the court took the motions to dismiss under submission after oral argument.  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 is conducting an informal inquiry into the Company’s stock option practices. The Company has responded to the request for information and is cooperating fully in the informal inquiry. The Company was advised in the SEC’s notice that the SEC’s request should not be construed as an indication by the SEC or its staff that any violations of law have occurred; and nor should the request be considered an adverse reflection upon any person, entity or security.

 

Enzo Litigation

 

On October 28, 2003, Enzo Life Sciences, Inc., a wholly-owned subsidiary of Enzo Biochem, Inc. (collectively “Enzo”) filed a complaint against the Company that is now pending in the United States District Court for the Southern District of New York for breach of contract, injunctive relief and declaratory judgment. The Enzo complaint relates to a 1998 distributorship agreement with Enzo under which the Company served as a non-exclusive distributor of certain reagent labeling kits supplied by Enzo. In its complaint, Enzo seeks monetary damages and an injunction against the Company from using, manufacturing or selling Enzo products and from inducing collaborators and customers to use Enzo products in violation of the 1998 agreement. Enzo also seeks the transfer of certain Affymetrix patents to Enzo. In connection with its complaint, Enzo provided the Company with a notice of termination of the 1998 agreement effective on November 12, 2003.

 

On November 10, 2003, the Company filed a complaint against Enzo in the United States District Court for the Southern District of New York for declaratory judgment, breach of contract and injunctive relief relating to the 1998 agreement. In its complaint, the Company alleges that Enzo has engaged in a pattern of wrongful conduct against it and other Enzo labeling reagent customers by, among other things, asserting improperly broad rights in its patent portfolio, improperly using the 1998 agreement and distributorship agreements with others in order to corner the market for non-radioactive labeling reagents, and improperly using the 1998 agreement to claim ownership rights to the Company’s proprietary technology. The Company seeks declarations that it has not breached the 1998 agreement and that nine Enzo patents that are identified in the 1998 agreement are invalid and/or not infringed by it. The Company also seeks damages and injunctive relief to redress Enzo’s alleged breaches of the 1998 agreement, its alleged tortious interference with the Company’s business relationships and prospective economic advantage, and Enzo’s alleged unfair competition. The Company filed a notice of related case stating that its complaint against Enzo is related to the complaints already pending in the Southern District of New York against eight other former Enzo distributors. The U.S. District Court for the Southern District of New York has related the Company’s case. There is no trial date in the actions between Enzo and the Company.

 

The Company believes that the claims set forth in Enzo’s complaint are without merit and have filed the action in the Southern District of New York to protect its interests. However, the Company cannot be sure that it will prevail in these matters. The Company’s failure to successfully defend against these allegations could result in a material adverse effect on its business, financial condition and results of operation.

 

Administrative Litigation and Proceedings

 

The Company’s intellectual property is subject to a number of significant administrative and litigation actions. For example, in Europe and Japan, we expect third parties to oppose significant patents that the Company owns or controls. Currently, third parties, including several of the Company’s competitors, have filed oppositions against several of the Company’s European patents in the European Patent Office and requested reexamination of several of the Company’s 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 result in the Company’s patent protection being significantly modified or reduced, in the incurrence of significant costs and the consumption of substantial managerial resources.

 

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NOTE 11—INCOME TAXES

 

The provision for income tax for the second quarter of 2008 was approximately $0.2 million.  The income tax provision for the six months ended June 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, state taxes, and state research and development tax credits.  The Company believes realization of the deferred tax assets as of June 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.

 

As of June 30, 2008, there have been no material changes to the total amount of unrecognized tax benefits.

 

NOTE 12—SUBSEQUENT EVENTS

 

Acquisition

 

In July 2008, Affymetrix 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 the Company to enter low to mid-multiplex markets and compete with bead-based platforms.

 

Restructuring

 

In July 2008, the Company decided to expand its restructuring plan by closing its West Sacramento manufacturing facility.  Following the closure of its West Sacramento manufacturing facility, all of its products will be manufactured out of its Singapore and Cleveland, Ohio facilities, as well as by third parties.  In addition to the charges incurred during the six months ended June 30, 2008, the Company expects to incur a total of approximately $42 million in charges related to this expansion of its restructuring plan.  Of this total, the Company expects that approximately $22 million will be included as a component of total cost of product sales, $17 million of which relates to accelerated depreciation charges associated with the continued use of certain long-lived manufacturing assets and $5 million of which relates to manufacturing transition and other costs.  Additionally, the Company expects to include approximately $20 million in the line item labeled “Restructuring charges” in its Condensed Consolidated Statements of Operations, $11 million of which relates to impairment charges primarily related to the facility itself and to certain long-lived manufacturing assets and $9 million related to employee severance costs.

 

The Company expects the closure of the West Sacramento facility to be substantially complete by the end of the second quarter of 2009.  The Company expects to incur approximately $26 million of the charges relating to the closure of the West Sacramento facility during the remainder of fiscal 2008 and approximately $16 million of the charges in 2009. The estimated cash outlays to be incurred in connection with these restructuring activities are estimated to be approximately $13 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.

 

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

 

This Management’s Discussion and Analysis of Financial Condition and Results of Operations as of June 30, 2008 and for the three and six month periods ended June 30, 2008 and 2007 should be read in conjunction with the Management’s Discussion and Analysis of Financial Condition and Results of Operations included in our Annual Report on Form 10-K for the year ended December 31, 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, higher 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.

 

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Overview

 

We are engaged in the development, manufacture, sale and service of consumables and systems for genetic analysis in the life sciences and clinical healthcare markets and are recognized as a market leader in creating breakthrough tools that are advancing our understanding of the molecular basis of life. There are a number of factors that influence the size and development of our industry, including: the availability of genomic sequence data for human and other organisms, technological innovation that increases throughput and lowers the cost of genomic and genetic analysis, the development of new computational techniques to handle and analyze large amounts of genomic data, the availability of government and private funding for basic and disease-related research, the amount of capital and ongoing expenditures allocated to research and development spending by biotechnology, pharmaceutical and diagnostic companies, the application of genomics to new areas including molecular diagnostics, agriculture, human identity and consumer goods, and the availability of genetic markers and signatures of diagnostic value.

 

We have established our GeneChip® system as the platform of choice for acquiring, analyzing and managing complex genetic information. Our integrated GeneChip® platform includes disposable DNA probe arrays (chips) consisting of gene sequences set out in an ordered, high density pattern; certain reagents for use with the probe arrays; a scanner and other instruments used to process the probe arrays; and software to analyze and manage genomic information obtained from the probe arrays. We currently sell our products directly to pharmaceutical, biotechnology, agrichemical, diagnostics and consumer products companies as well as academic research centers, government research laboratories, private foundation laboratories and clinical reference laboratories in North America and Europe. We also sell our products through life science supply specialists acting as authorized distributors in Latin America, India, the Middle East and Asia Pacific regions, including China. 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.

 

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 of goods sold.  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 restructuring plan involved moving the majority of our probe array manufacturing from our West Sacramento, California facility to our Singapore facility.  In connection with these restructuring activities, for the six months ended June 30, 2008, we incurred a restructuring charge of $14.8 million.  In July 2008, we decided to expand our restructuring plan by closing our West Sacramento manufacturing facility.  Following the closure of our West Sacramento manufacturing facility, all of our products will be manufactured out of our Singapore and Cleveland, Ohio facilities, as well as by third parties. We expect the closure of the West Sacramento facility to be substantially complete by the end of the second quarter of 2009.  In addition to the charges incurred during the six months ended June 30, 2008, we expect to incur approximately $26 million of charges relating to the closure of the West Sacramento facility during the remainder of fiscal 2008 and approximately $16 million of charges in 2009.

 

Critical Accounting Policies & Estimates

 

General

 

The following section of Management’s Discussion and Analysis of Financial Condition and Results of Operations is based upon our unaudited condensed consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenue and expenses, and related disclosure of contingent assets and liabilities. Management bases its estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying

 

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values of certain assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.

 

Certain accounting policies are particularly important to the reporting of our financial position and results of operations and require the application of significant judgment by our management. An accounting policy is deemed to be critical if it requires an accounting estimate to be made based on assumptions about matters that are highly uncertain at the time the estimate is made, and if different estimates that reasonably could have been used, or changes in the accounting estimates that are reasonably likely to occur periodically, could materially impact the financial statements.

 

Revenue Recognition

 

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

 

Accounts Receivable

 

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

 

Inventories

 

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

 

Non-marketable Securities

 

As part of our strategic efforts to gain access to potential new products and technologies, we invest in equity securities of certain private biotechnology companies. Our non-marketable equity securities are carried at cost unless we determine that an impairment that is other than temporary has occurred, in which case we write the investment down to its impaired value. We periodically review our investments for impairment; however, the impairment analysis requires significant judgment in identifying events or circumstances that would likely have significant adverse effect on the fair value of the investment. The analysis may include assessment of the investee’s (i) revenue and earnings trend, (ii) business outlook for its products and technologies, (iii) liquidity position and the rate at which it is using its cash, and (iv) likelihood of obtaining subsequent rounds of financing. If an investee obtains additional funding at a valuation lower than our carrying value, we presume that the investment is other than temporarily impaired. We have experienced impairments in our portfolio due to the decline in equity markets over the past few years. However, we are not able to determine at the present time which specific investments are likely to be impaired in the future, or the extent or timing of the individual impairments.

 

Income Taxes

 

Income tax expense is based on pretax financial accounting income.  Under the liability method, deferred tax assets and liabilities are determined based on the difference between the financial statement and tax basis of assets and liabilities using enacted tax rates in effect for the year in which the differences are expected to reverse.  We must then assess the likelihood that the resulting

 

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deferred tax asserts 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 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 six months ended June 30, 2008, we recognized employee stock-based compensation of approximately $0.6 million in cost of product sales, approximately $0.9 million in research and development expense and approximately $1.8 million in selling, general and administrative expenses.  As of June 30, 2008, approximately $41.7 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 3.3 years.

 

During the six months ended June 30, 2007, we recognized employee stock-based compensation of $0.5 million in cost of product sales, $1.2 million in research and development expense and $2.9 million in selling, general and administrative expenses recognized under SFAS 123R.

 

Restructuring

 

 We have recently engaged in, and may continue to engage in, restructuring actions, which require management to utilize significant estimates related to expenses for severance and other employee separation costs, lease cancellation, realizable values of assets that may become duplicative or obsolete, and other exit costs.  If the actual amounts differ from our estimates, the amount of the restructuring charges could be materially impacted.  For a full description of our restructuring actions, see Notes 4 and 12 to the Condensed Consolidated Financial Statements in Item 1.

 

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Results of Operations

 

The following discussion compares the historical results of operations for the three and six months ended June 30, 2008 and 2007, respectively.

 

Product Sales

 

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

 

 

 

Three Months Ended

 

Dollar

 

Percentage

 

Six Months Ended

 

Dollar

 

Percentage

 

 

 

June 30,

 

change from

 

change from

 

June 30,

 

change from

 

change from

 

 

 

2008

 

2007

 

2007

 

2007

 

2008

 

2007

 

2007

 

2007

 

Consumables

 

$

68,860

 

$

59,613

 

$

9,247

 

16

%

$

127,616

 

$

104,517

 

$

23,099

 

22

%

Instruments

 

6,162

 

8,796

 

(2,634

)

(30

)

10,212

 

28,377

 

(18,165

)

(64

)

Total product sales

 

$

75,022

 

$

68,409

 

$

6,613

 

10

 

$

137,828

 

$

132,894

 

$

4,934

 

4

 

 

Total product sales increased in the second quarter and first six months of 2008 as compared to 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, and a shift in product mix to our higher priced consumables.  Instrument sales declined primarily due to a decrease in unit sales of our GeneChip® Scanners.  Sales to our pharmaceutical customers have declined in the first six months of 2008 as compared to 2007, particularly in instrument sales.

 

Consumable sales for the three months ended June 30, 2008 and 2007 include six thousand dollars and $4.4 million, respectively, of revenue from Perlegen Sciences Inc. (“Perlegen”), a related party. Consumable sales for the six months ended June 30, 2008 and 2007 include $0.8 million and $11.1 million, respectively, of revenue from Perlegen.

 

Services (in thousands, except percentage amounts):

 

 

 

Three Months Ended

 

Dollar

 

Percentage

 

Six Months Ended

 

Dollar

 

Percentage

 

 

 

June 30,

 

change from

 

change from

 

June 30,

 

change from

 

change from

 

 

 

2008

 

2007

 

2007

 

2007

 

2008

 

2007

 

2007

 

2007

 

Services

 

$

9,005

 

$

12,031

 

$

(3,026

)

(25

)%

$

17,425

 

$

20,788

 

$

(3,363

)

(16

)%

 

Total services revenue decreased in the first quarter of 2008 as compared to 2007 primarily due to a decrease of $3.6 million in our genotyping services business because of the variable timing of projects, partially offset by an increase of $0.5 million in instrument service revenue. The decrease in total services revenue for the first six months of 2008 as compared to 2007 is primarily due to a decrease of $4.5 million in our genotyping services business because of the variable timing of projects, partially offset by an increase of $1.1 million in instrument service revenue.

 

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

 

 

 

Three Months Ended

 

Dollar

 

Percentage

 

Six Months Ended

 

Dollar

 

Percentage

 

 

 

June 30,

 

change from

 

change from

 

June 30,

 

change from

 

change from

 

 

 

2008

 

2007

 

2007

 

2007

 

2008

 

2007

 

2007

 

2007

 

Royalties and other revenue

 

$

2,884

 

$

7,867

 

$

(4,983

)

(63

)%

$

101,233

 

$

15,060

 

$

86,173

 

572

%

 

Royalties and other revenue decreased in the second 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 six months ended June 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.

 

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

 

 

 

Three Months Ended

 

Dollar/Point

 

Six Months Ended

 

Dollar/Point

 

 

 

June 30,

 

change from

 

June 30,

 

change from

 

 

 

2008

 

2007

 

2007

 

2008

 

2007

 

2007

 

Total gross margin on product sales

 

$

42,765

 

$

42,683

 

$

82

 

$

79,593

 

$

85,023

 

$

(5,430

)

Total gross margin on services

 

2,314

 

1,271

 

1043

 

5,056

 

3,622

 

1,434

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Product gross margin as a percentage of product sales

 

57

%

62

%

(5

)

58

%

64

%

(6

)

Service gross margin as a percentage of services

 

26

%

11

%

15

 

29

%

17

%

12

 

 

The decrease in product gross margin in the second quarter and first six months of 2008, as compared to 2007, is primarily due to higher costs for array manufacturing due to lower factory utilization.   These decreases were partially offset by a mix shift to our higher margin consumable products and a decline in reserves related to expired arrays and instrument obsolescence.

 

Gross margin on product sales for the second quarter of 2008 and 2007 includes six thousand dollars and $2.5 million, respectively, of gross margin from Perlegen and $0.4 million and $6.8 million, respectively, for the first six months of 2008 and 2007.

 

The increase in services gross margin in the second quarter and first six months of 2008 as compared to 2007 was primarily due to an increase in the average selling prices of our genotyping services business and a more favorable mix of programs.

 

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

 

 

 

Three Months Ended

 

Dollar

 

Percentage

 

Six Months Ended

 

Dollar

 

Percentage

 

 

 

June 30,

 

change from

 

change from

 

June 30,

 

change from

 

change from

 

 

 

2008

 

2007

 

2007

 

2007

 

2008

 

2007

 

2007

 

2007

 

Research and development

 

$

19,591

 

$

19,427

 

$

164

 

1

%

$

38,359

 

$

38,654

 

$

(295

)

(1

)%

 

Research and development expenses were flat for the second quarter and first six months 2008, as compared to the same periods on 2007.

 

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

 

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

 

 

 

Three Months Ended

 

Dollar

 

Percentage

 

Six Months Ended

 

Dollar

 

Percentage

 

 

 

June 30,

 

change from

 

change from

 

June 30,

 

change from

 

change from

 

 

 

2008

 

2007

 

2007

 

2007

 

2008

 

2007

 

2007

 

2007

 

Selling, general and administrative

 

$

29,640

 

$

33,643

 

$

(4,003

)

(12

)%

$

64,373

 

$

69,501

 

$

(5,128

)

(7

)%

 

The decrease in selling, general and administrative expenses for the second quarter and first six months of 2008, as compared to the same periods in 2007 was primarily due to a $4.5 million decrease in legal expenses due to lower spending on general legal, contracts and patent litigation, principally due to the settlement of the Illumina litigation in January 2008.

 

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Acquired-in-process technology (in thousands, except percentage amounts):

 

 

 

Three Months Ended

 

Dollar

 

Percentage

 

Six Months Ended

 

Dollar

 

Percentage

 

 

 

June 30,

 

change from

 

change from

 

June 30,

 

change from

 

change from

 

 

 

2008

 

2007