Affymetrix 10-Q 2010
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FOR THE TRANSITION PERIOD FROM TO .
COMMISSION FILE NO. 0-28218
(Exact name of Registrant as specified in its charter)
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
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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):
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COMMON SHARES OUTSTANDING ON OCTOBER 29, 2010: 70,639,688
(In thousands, except per share amounts)
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2010
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 (“GAAP”) 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, 2009, as filed with the Securities and Exchange Commission on March 1, 2010.
Certain prior year amounts have been reclassified to conform to current year presentation. During the second quarter, as a result of expanded disclosures of its available-for-sale securities in accordance with newly issued accounting guidance, certain investments were reclassified as different security types from the prior year.
Use of Estimates
The preparation of the consolidated financial statements is in conformity with GAAP, which requires management to make estimates and assumptions that affect amounts reported in the financial statements and accompanying notes. Actual results could differ materially from those estimates.
The Company recognizes revenue when persuasive evidence of an arrangement exists, delivery has occurred, the fee is fixed or determinable, and collectability is reasonably assured. In instances where final acceptance of the product or system is required or performance obligations remain, revenue is deferred until all the acceptance criteria or performance obligations have been met.
The Company derives the majority of its revenue from product sales of 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 upon delivery or performance of multiple products, services and/or rights to use assets, 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.
Effective January 1, 2010, the Company early adopted the recently revised accounting guidance related to revenue recognition for multiple element arrangements on a prospective basis, which establishes the relative selling price method whereby the Company is required to allocate consideration to all deliverables at the inception of the arrangement based on their relative selling prices. In order to determine the selling price of a deliverable, the Company applies the following hierarchy: 1) vendor-specific objective evidence (“VSOE”); 2) third-party evidence if VSOE is not available; and 3) the Company’s best estimate of selling price for the deliverable if neither VSOE nor third-party evidence is available.
The Company primarily expects to utilize VSOE in determining the selling price of each deliverable in a multiple element arrangement as the Company historically has been able to establish fair value of a deliverable based on the price charged when it is sold separately. In the event that VSOE is not determinable, and where no third-party evidence is available, the Company will use estimated selling price in its allocation of arrangement consideration. Several factors are considered when determining the estimated selling price of a deliverable, including, but not limited to, the cost to produce the deliverable, the expected margin on that deliverable, the Company’s ongoing pricing strategy and policies and the value-added components of differentiated deliverables, if determinable.
The revised accounting guidance also refined the criteria for determining when a deliverable should be accounted for as a separate unit of accounting. Both of the following criteria must be met in order to be considered a separate unit of accounting: 1) the delivered item or items have value to the customer on a standalone basis; and 2) when a general right of return exists, the delivery or performance of an undelivered item is considered probable and under the control of the Company. The Company has determined that a deliverable has standalone value when the item is sold separately by the Company or another vendor or can be resold by the customer. The Company’s revenue arrangements generally do not have a general right of return. When a deliverable does not meet the criteria to be considered a separate unit of accounting, the Company groups it with other deliverables that, when combined, meet the criteria, and the appropriate allocation of arrangement consideration and revenue recognition is determined.
Product sales include sales of probe arrays, reagents and related instrumentation. Probe array, reagent and instrumentation revenue is 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 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® CustomExpress™ and CustomSeq™ 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 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; research revenue, which mainly consists of amounts earned under government grants; and non-recurring intellectual property payments.
License revenue is 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 revenue is 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.
Research revenue results 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. Revenue from research contracts is 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.
The Company recognizes revenue from transactions with distributors 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.
Net Income (Loss) Per Common Share
Basic net income (loss) per common 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 common share gives effect to dilutive common stock subject to repurchase, stock options (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 common share (in thousands except per diluted share amounts):
Diluted earnings per common share include certain potential dilutive securities from outstanding stock options (on the treasury stock method), common stock subject to repurchase and convertible notes (on the as-if-converted basis). The antidilutive securities excluded from diluted earnings per common share, on an actual outstanding basis, were as follows (in thousands):
Cash Equivalents, Available-for-Sale Securities and Investments
The Company’s investments consist of marketable equity and debt securities including U.S. government notes and bonds; corporate notes, bonds and asset-backed securities; mortgage-backed securities, municipal notes and bonds; and publicly traded equity securities. The Company reports all securities with maturities at the date of purchase of 90 days or less that are readily convertible into cash and have insignificant interest rate risk as cash equivalents. The Company’s investments are carried at fair value with unrealized gains and losses reported in accumulated other comprehensive income (loss) in stockholders’ equity. The cost of its marketable securities is adjusted for the amortization of premiums and discounts to maturity. This amortization is included in interest income and other, net. Realized gains and losses, as well as interest income, on available-for-sale securities are also included in interest income and other, net. The cost of securities sold is based on the specific identification method. The fair values of securities are based on quoted market prices. The Company includes its available-for-sale securities that have an effective maturity of less than twelve months as of the balance sheet date in current assets and those with an effective maturity greater than twelve months as of the balance sheet date in non-current assets.
The Company conducts a review of investment securities on a quarterly basis for the presence of impairment that is deemed to be other-than-temporary (“OTTI”). As part of its review, the Company is required to take into consideration current market conditions, fair value in relationship to cost, extent and nature of change in fair value, issuer rating changes and trends, volatility of earnings, current analysts’ evaluations, all available information relevant to the collectability of debt securities, its ability to hold until, and whether it will more likely than not be required to sell prior to, a recovery of fair value, which may be maturity, and other factors when evaluating for the existence of OTTI in its securities portfolio. Under these circumstances, OTTI is considered to have occurred if (1) the Company intends to sell the security; (2) it is “more likely than not” that the Company will be required to sell the security before recovery of its amortized cost basis or (3) the present value of expected cash flows is not expected to recover the entire amortized cost basis. Any credit-related OTTI is to be recognized in earnings while noncredit-related OTTI on securities not expected to be sold is to be recognized in other comprehensive income (“OCI”). Noncredit-related OTTI is based on other factors, including illiquidity. Presentation of OTTI is made in the Condensed Consolidated Statements of Operations on a gross basis with an offset for the amount of OTTI recognized in OCI.
As part of the Company’s strategic efforts to gain access to potential new products and technologies, it invests in equity securities of certain private biotechnology companies. These investments are included in other assets in the Condensed Consolidated Balance Sheets and are carried at cost. The Company also invests in a limited partnership investment fund that is accounted for under the equity method. The Company periodically monitors the liquidity and financing activities of the respective investments to determine if any impairment exists and accordingly writes down to the extent necessary, the carrying value of the non-marketable equity securities to their estimated fair values. In order to determine whether a decline in value is other-than-temporary, the Company evaluates, among other factors: the duration and extent to which the fair value has been less than the carrying value; the financial condition of and business outlook of the issuer for the company, including key operational and cash flow metrics, current market conditions; and the Company’s intent and ability to retain the investment for a period of time sufficient to allow for any anticipated recovery in estimated fair value. The Company recognized $5.3 million of OTTI expense on two investments in private biotechnology companies in interest income and other, net in the Condensed Consolidated Statements of Operations for the nine months ended September 30, 2010. Refer to Note 2. “Fair Value of Financial Instruments” for further information.
The Company has in recent years engaged 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. Refer to Note 4. “Restructuring” for further information.
NOTE 2—FAIR VALUE OF FINANCIAL INSTRUMENTS
Fair value is defined as the price that would be received from selling an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. When determining the fair value measurements for assets and liabilities required to be recorded at fair value, the Company considers the principal or most advantageous market in which it would transact and consider assumptions that market participants would use when pricing the asset or liability, such as inherent risk, transfer restrictions and risk of nonperformance.
A fair value hierarchy was established which requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. A financial instrument’s categorization within the fair value hierarchy is based upon the lowest level of input that is significant to the fair value measurement. The three levels of inputs that may be used to measure fair value are as follows:
Financial Assets and Liabilities Measured at Fair Value on a Recurring Basis
The following table represents the Company’s fair value hierarchy for its financial assets and liabilities measured at fair value on a recurring basis as of September 30, 2010 and December 31, 2009 (in thousands):
* Included in these security types were the Company’s mortgage-backed investments which were approximately 2% and 1% of the total portfolio for the nine months ended September 30, 2010 and December 31, 2009, respectively.
The fair value estimates provided above for the Company’s convertible notes were based on quoted market prices available at September 30, 2010 and December 31, 2009, respectively. The Company’s convertible notes are not marked-to-market and are shown in the accompanying Condensed Consolidated Balance Sheets at their original issuance value, net of amortized discount.
As of September 30, 2010 and December 31, 2009, the Company had no financial assets or liabilities using Level 3 inputs.
Investments in Debt and Equity Securities
The fair values of all available-for-sale securities are based on quoted market prices and are included in cash and cash equivalents, available-for-sale securities—short-term and available-for-sale securities—long-term on the Company’s Consolidated Balance Sheets based on the securities maturity. The following is a summary of available-for-sale securities as of September 30, 2010 (in thousands):
The following is a summary of available-for-sale securities as of December 31, 2009 (in thousands):
Realized gains for the nine months ended September 30, 2010 and 2009 were $0.6 million and $0.2 million, respectively. Realized losses for the nine months ended September 30, 2010 and 2009 were $0.2 million and $0.1 million, respectively. Realized gains and losses are included in interest income and other, net in the accompanying Condensed Consolidated Statements of Operations.
The gross unrealized losses as of September 30, 2010 and 2009, respectively, were primarily related to a mortgage-backed security that was impacted by the weakening of the global economy caused by a lack of liquidity in the credit markets, which continued through the nine months ended September 30, 2010. No significant facts or circumstances have arisen to indicate that there has been any deterioration in the creditworthiness of the issuers of the Company’s securities. Based on its review of these securities, including the assessment of the severity of the related unrealized losses, the Company has not recorded any other-than-temporary impairments on these securities for the nine months ended September 30, 2010 and 2009.
Additionally, the Company did not have any noncredit-related OTTI that was recognized in OCI on its securities during the nine months ended September 30, 2010 and 2009 as it is more likely than not the Company will hold, and has the ability to hold, the securities until maturity or a recovery of their amortized cost basis. The Company did not record any cumulative effect adjustments for any noncredit-related portion of OTTI losses previously recognized in earnings.
Derivative Financial Instruments
The Company derives a portion of its revenue in foreign currencies, predominantly in Europe and Japan. In addition, a portion of its assets are held in nonfunctional currencies of its subsidiaries. As of September 30, 2010 and December 31, 2009, the Company had no open hedging contracts.
As of September 30, 2010 and December 31, 2009, the carrying amounts of the Company’s non-marketable securities, totaling $6.9 million and $13.1 million, respectively, equaled their estimated fair values. Their estimated fair values were based on current market rates, as well as liquidation and net realizable values. During the nine months ended September 30, 2010, the Company determined that declines in the estimated fair values of two of its investments in private biotechnology companies were other-than-temporary as a result of the respective price per share paid by investors in the most recent round of financing for each company which, in each case, was significantly lower than the carrying value of the Company’s investment. Accordingly, the Company recorded impairment charges on these investments totaling approximately $0.4 million and $5.3 million in the three and nine months ended September 30, 2010, respectively. During the nine months ended September 30, 2009, the Company also determined that declines in estimated fair values of other investments in its non-marketable equity securities portfolio were other-than-temporary and recognized an additional net impairment loss of $0.9 million. Net investment losses are included in interest income and other, net in the Condensed Consolidated Statements of Operations. Depending on market conditions, the Company may incur additional charges on this investment portfolio in the future.
NOTE 3—STOCKHOLDERS’ EQUITY
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 and restricted stock awards are generally time-based, vesting 25% on each annual anniversary of the grant date over four years. Stock options expire 7 to 10 years from the grant date. In the second quarter of 2010, 4.5 million shares of common stock were added under the Affymetrix, Inc. Amended and Restated 2000 Equity Incentive Plan. As of September 30, 2010, the Company had approximately 5.2 million shares of common stock reserved for future issuance under its stock-based compensation plans. New shares are issued as a result of stock option exercises, restricted stock units vesting and restricted stock award grants.
The Company recognized stock-based compensation as follows (in thousands):
As of September 30, 2010, $19.5 million of total unrecognized stock-based compensation expense related to non-vested awards is expected to be recognized over the respective vesting terms of each award through 2014. The weighted-average term of the unrecognized stock-based compensation expense is 2.9 years.
The fair value of options was estimated at the date of grant using a Black-Scholes option pricing model with the following weighted-average assumptions:
The risk free interest rate for periods within the contractual life of the Company’s stock options is based on the U.S. Treasury yield curve in effect at the time of grant. The expected term is derived from an analysis of the Company’s historical exercise trends over ten years. The expected volatility for the three and nine months ended September 30, 2010 and 2009 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, 2010 and 2009 was $2.41 and $4.48, respectively, and for the nine months ended September 30, 2010 and 2009 was $2.66 and $3.02, respectively.
Since fiscal 2006, the Company has undertaken several restructuring plans that are summarized as follows:
In 2008, the Company closed its West Sacramento manufacturing facility, moving its probe array manufacturing to its Singapore facility, consolidating its reagent manufacturing to its Cleveland facility and outsourcing its instrument manufacturing operations to third parties (the “2008 Plan”). The Company made total cash payments of $8.2 million related to employee termination benefits and incurred noncash charges of $36.9 million related to the abandonment and impairment of certain manufacturing assets which were presented as a component of “Restructuring charges” in the Company’s Condensed Consolidated Statements of Operations. The Company completed the closure of the West Sacramento facility during the second quarter of 2009 and no expense was recognized during the nine months ended September 30, 2010, compared to $2.5 million of employee termination benefits expense recognized during the nine months ended September 30, 2009. The Company does not expect to incur additional expense in connection with the 2008 Plan.
In 2007, the Company consolidated an administrative facility located in Sunnyvale, California into its main campus in Santa Clara, California and terminated certain employees in the research and development and selling, general and administrative functions (the “2007 Plan”). The Sunnyvale, California facility was vacated during the fourth quarter of 2007. Additionally, in 2006, the Company initiated a restructuring plan (the “2006 Plan”) intended to better align certain of its expenses with the Company’s business outlook which primarily consisted of the reorganization of the general and administrative functions and the rationalization of its facilities. Total cash payments made in connection with the 2007 Plan and 2006 Plan were approximately $4.6 million and $16.7 million, respectively. The Company also recognized $8.5 million in noncash charges in connection with the 2006 Plan. These costs were included as a component of “Restructuring charges” in the Company’s Condensed Consolidated Statements of Operations. As of September 30, 2010, the Company had fulfilled all obligations under the 2007 Plan while the 2006 Plan had an accrual of $0.8 million related to contract termination costs, which is expected to be recorded through July 2013. During the nine months ended September 30, 2010 and 2009, the expense recorded in association with these two plans was not material. The Company does not expect to incur additional expense in connection with the 2007 and 2006 Plans.
Inventories consist of the following (in thousands):
NOTE 6—ACQUIRED TECHNOLOGY RIGHTS
Acquired technology rights are comprised of licenses to technology covered by patents owned by third parties or patents acquired by the Company and are amortized over the expected useful lives of these assets, which range from one to fifteen years. Accumulated amortization of these rights amounted to $68.5 million and $59.2 million at September 30, 2010 and December 31, 2009, respectively.
The expected future annual amortization expense of the Company’s acquired technology rights is as follows (in thousands):
NOTE 7—SENIOR CONVERTIBLE NOTES
During the nine months ended September 30, 2010 and 2009, the Company partially repurchased its 3.50% senior convertible notes due in 2038 in private transactions:
In 2010, the Company repurchased a total of $98.6 million of aggregate principal amount for total cash consideration of $91.5 million, including accrued interest of $1.5 million. The recognized gain on debt repurchase of $5.9 million is net of transaction costs of $0.2 million and accelerated amortization of deferred financing costs of $1.0 million.
In 2009, the Company repurchased approximately $69.1 million of aggregate principal amount for total cash consideration of $50.6 million, including accrued interest of $0.9 million. The recognized gain on debt repurchase of $17.4 million is net of transaction costs of $0.9 million and accelerated amortization of deferred financing costs of $1.0 million.
NOTE 8—COMPREHENSIVE INCOME (LOSS)
The components of comprehensive income (loss) are as follows (in thousands):
NOTE 9—COMMITMENTS AND CONTINGENCIES
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. The following are material legal proceedings to which the Company or one or more of its subsidiaries is a party:
On May 4, 2009 and November 3, 2009, the Company was named as a defendant in two separate complaints filed by plaintiff, Illumina, Inc., in the U.S. District Court for the Western District of Wisconsin. In the complaints, the plaintiff alleges that the Company is infringing Patent Nos. 7,510,841 and 7,612,020 by making and selling certain of the Company’s new peg-based array formats and instruments that run these peg-based arrays (including the GeneTitan® and GeneAtlas™ systems). The plaintiff seeks a permanent injunction enjoining the Company from further infringement and unspecified monetary damages. The two separate complaints have been consolidated into a single case. On June 4, 2010, the court conducted its Markman (claims construction) hearing, and on July 14, 2010, the court issued its claims construction ruling. The case is set for trial beginning March 14, 2011. The Company will vigorously defend against all of the plaintiff’s claims.
On July 1, 2008, the Company was named as a defendant in a complaint filed by plaintiffs E8 Pharmaceuticals LLC (“E8”) 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 Patent No. 6,703,228 that is owned by MIT and licensed to E8 by making and selling certain of the Company’s GeneChip® products to customers and teaching its customers how to use the products. Plaintiffs seek a permanent injunction enjoining the Company from further infringement and unspecified monetary damages. On January 13, 2010 the Court granted the Company’s motion to dismiss plaintiff E8, leaving MIT as the sole remaining plaintiff. There is no trial date set in this action. The Company will vigorously defend against all of the plaintiff’s claims.
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 tortuous 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’s intellectual property is subject to a number of significant administrative actions. These proceedings could result in the Company’s patent protection being significantly modified or reduced, and the incurrence of significant costs and the consumption of substantial managerial resources.
NOTE 10—INCOME TAXES
The provision for income tax for the three and nine months ended September 30, 2010 was $0.4 million and $1.3 million, respectively. The provision principally consists of foreign and state income taxes.
Due to the Company’s history of cumulative operating losses and consideration of all the available objective evidence, it is not more likely than not that all of the Company’s net deferred tax assets will be realized. Accordingly, all of the U.S. deferred tax assets, net of reserves for uncertain tax positions, continue to be subject to a valuation allowance as of September 30, 2010.
As of September 30, 2010, there have been no material changes to the total amount of unrecognized tax benefits.
ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
This Management’s Discussion and Analysis of Financial Condition and Results of Operations as of September 30, 2010 and for the three and nine months ended September 30, 2010 and 2009 should be read in conjunction with our financial statements and accompanying notes thereto included in this Quarterly Report on Form 10-Q and 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, 2009.
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,” “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 associated with our ability to offer new products and technologies; our capacity to identify and capitalize upon emerging market opportunities; market acceptance of our products versus those of our competitors; uncertainties related to cost and pricing of Affymetrix products; fluctuations in overall capital spending in the academic and biotechnology sectors; changes in government funding policies; our dependence on collaborative partners; the size and structure of our current sales, technology and technical support organizations; uncertainties relating to our suppliers and manufacturing processes; our ability to achieve and sustain higher levels of revenue, improved gross margins and reduced operating expenses; personnel retention; global and regional credit and financial market conditions; uncertainties relating to Federal and Drug Administration (“FDA”) and other regulatory approvals; risks relating to intellectual property of others and the uncertainties of patent protection and litigation; volatility of the market price of our common stock; and unpredictable fluctuations in quarterly revenue.
Overview of Company
We develop, manufacture and sell products and services for genetic analysis to the life science research and clinical healthcare markets. Researchers around the world use our technology to better understand the role that genes play in disease, the effectiveness and safety of therapies and many other biological factors that affect human well-being. We sell our products to some of the world’s largest pharmaceutical, diagnostic and biotechnology companies, as well as leading academic, government and not-for profit research institutions. More than 22,000 peer-reviewed papers have been published based on work using our products. We have more than 900 employees worldwide and maintain sales and distribution operations across the United States, Europe, Japan and Asia.
We offer a comprehensive line of products for three principal applications: gene expression, genotyping and copy number analysis. Our product sales consist primarily of sales of instruments and related consumables. We have three instrumentation systems, GeneTitan®, GeneChip® and GeneAtlas™, that employ one-time use consumables utilizing various array formats that are tailored to the needs of our customers. Our GeneChip® instruments use consumable arrays packaged in cartridges and our GeneTitan® and GeneAtlasTM instruments use consumable arrays packaged in a plate or strip format for automated high throughput processing.
We offer a variety of assays for gene expression targeting low- to mid-plex markets that are downstream of our whole genome arrays. We also offer a range of reagent kits that are compatible with our platforms as well as the products of other vendors.
Overview of Third Quarter 2010
During the third quarter of 2010, total revenue increased sequentially over the second quarter of 2010, primarily due to higher sales of RNA products and instruments, partially offset by a decline in DNA sales. We also continued to achieve our goal of improved operating leverage, generating positive operating cash flow for the fourth consecutive quarter and further decreasing our future interest payments by repurchasing a portion of our 3.50% convertible notes due 2038.
We continue to remain focused on executing our business strategy:
Expanding into new markets. Our goal is to expand our revenue base through entry into new markets and expansion of our customer base by successfully commercializing our established and acquired technologies. We continued our expansion into the genotyping marketplace with our new AxiomTM Genotyping Solution. We believe this market will continue to be an attractive growth opportunity, in particular, driven by our ability to provide flexible array packaging and novel genetic content that can assist scientists in more fully understanding human health and disease.
We have launched several important new products in 2010 including the introduction of our Axiom Genomic Database with over 7 million validated common and rare SNPs enabling customers to customize their own array designs rather than use pre-configured or catalog arrays for their genotyping studies. In the third quarter, we began commercializing the Axiom Chinese myDesign Genotyping Array which provides for genome-wide association studies specifically for Chinese populations. In addition, we launched the OncoScan FFPE Express which is a service that allows cancer researchers to analyze the genetic signatures of tumors that are Formalin-Fixed and Paraffin-Embedded.
Re-engineering our technology platform. We seek to expand our product line with new products that combine automated instrumentation, powerful new biological assays, and new array designs and content. GeneTitan® System, our new mid- to high-end instrumentation platform, enables increased efficiency and throughput for researchers conducting array-based experiments. This fully automated solution produces higher data quality by removing or minimizing many of the sources of variation in the laboratory. In the first half of 2010, we commercially released our GeneAtlasTM System which targets new users of microarray technology. With the GeneTitan® and GeneAtlasTM instruments, we also introduced alternative array plate and array strip formats to our cartridge-based consumables. We intend to provide an expanded menu of gene expression and genotyping applications for our peg array plates.
Improve operating leverage. We recognized positive cash flow from operating activities for the first half of 2010 and continued to do so in the third quarter of 2010. We have realized the cost savings and decreased expenditures as compared to the same period in 2009 as a result of our restructuring activities in past years that consolidated our manufacturing to our Cleveland and Singapore facilities and outsourced our instrument manufacturing operations. We believe that our new array plate formats have lower manufacturing costs than the cartridge-based formats and expect to incur lower operating expenses as we fully integrate our acquisitions of USB and Panomics. Additionally, we have significantly reduced our future interest payments by repurchasing a portion of our 3.50% senior convertible notes due 2038.
Critical Accounting Policies and Estimates
Management's Discussion and Analysis of Financial Condition and Results of Operations is based upon our Condensed Consolidated Financial Statements, which we have prepared in accordance with U.S. generally accepted accounting principles ("GAAP"). 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 it believes to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Management has discussed the development, selection and disclosure of significant estimates with the Audit Committee of our Board of Directors. Actual results may differ from these estimates under different assumptions or conditions.
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, if different estimates reasonably could have been used, or if changes in the estimate that are reasonably likely to occur could materially impact the financial statements. Other than the following discussion related to revenue recognition for multiple element arrangements, during the nine months ended September 30, 2010, there have been no significant changes in our critical accounting policies and estimates compared to the disclosures in Item 7 of our Annual Report on Form 10-K for the year ended December 31, 2009.
We enter into contracts to sell our products and, while the majority of our sales agreements contain standard terms and conditions, we have 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.
Effective January 1, 2010, we early adopted the recently revised accounting guidance on revenue recognition for multiple element arrangements on a prospective basis, which requires us to allocate consideration to all deliverables at the inception of the arrangement using the relative selling price method. The relative selling price method establishes the relative selling price of a deliverable using a hierarchy, first through vendor-specific objective evidence (“VSOE”), second through third-party evidence if VSOE is not available and finally, through estimated selling prices if neither VSOE nor third-party evidence is available. Additionally, the revised accounting guidance also refined the criteria for determining when a deliverable should be accounted for as a separate unit of accounting. Based on this guidance, we identify separate units of accounting for the multiple element arrangement if the delivered item has value to the customer on a standalone basis and, when a general right of return exists, the delivery or performance of an undelivered item is considered probable and under our control. Changes in the allocation of the sales price between delivered to undelivered elements might impact the timing of revenue recognition, but would not change the total revenue recognized on any arrangement.
We generally have been able to determine the selling price of each deliverable in a multiple element arrangement based on the price for such deliverable when it is sold separately. If VSOE is not determinable and when third-party evidence is not available, we would use the estimated selling price of a deliverable which is determined based on several factors, including, but not limited to, the cost to produce the deliverable, the expected margin on that deliverable, our ongoing pricing strategy and policies, the selling price and profit margin of similar deliverables and value-added components of differentiated deliverables, if determinable.
The change in accounting principle for revenue recognition on multiple element arrangements did not have a material impact on our financial results for the three and nine months ended September 30, 2010. We anticipate that the effect on the change in accounting principle on subsequent periods will be primarily dependent on the arrangements entered into, the ability to estimate selling prices when VSOE cannot be established and the timing of the delivery of the products and services. Additionally, had the new accounting guidance been applied for the three and nine months ended September 30, 2009, there would have been no material impact on the revenue recognized.
Recent Accounting and Financial Reporting Developments
See Note 1. “Summary of Significant Accounting Policies” to our Condensed Consolidated Financial Statements elsewhere in this Quarterly Report on Form 10-Q for a description of accounting changes and recent accounting pronouncements, including the expected dates of adoption and anticipated effects, if any, on our consolidated results of operations and financial condition.
Results of Operations
The following discussion compares the historical results of operations for the three and nine months ended September 30, 2010 and 2009.
Product Sales (in thousands, except percentage amounts)
The components of product sales are as follows:
Total product sales increased year over year in the third quarter of 2010 as compared to 2009. Consumables were down slightly primarily due to a shift in product mix. Instrument sales increased in the third quarter of 2010 as compared to 2009 as a result of sales of the GeneTitan® and GeneAtlasTM families of instruments and shipment of several GeneChip® systems during the quarter.
For the first nine months of 2010, total product sales increased year over year as compared to the first nine months of 2009, due to an increased volume of sales of our DNA consumables partially offset by a decline in the volume of sales of our RNA consumables. Instrument sales also grew in 2010 as compared to 2009, primarily due to the GeneTitan® and GeneAtlasTM families of instruments, which were introduced in late 2009 and early 2010, respectively, partially offset by declines in the volume of sales of older products.
Services (in thousands, except percentage amounts)
Total services revenue decreased in the third quarter, and for the first nine months, of 2010 as compared to 2009, primarily due to the completion in late 2009 of several genotyping projects that began in the fourth quarter of 2008, including the Wellcome Trust Case Consortium and the National Institutes of Health projects. We currently have not entered into any other significant contracts for other genotyping projects.
Royalties and Other Revenue (in thousands, except percentage amounts)
Royalties and other revenue declined in the third quarter, and for the first nine months, of 2010 as compared to 2009 as a result of the expiration of certain multi-year contracts.
Product and Services Gross Margin (in thousands, except percentage amounts)
Product gross margin for the third quarter of 2010 increased over the third quarter of 2009 primarily due to a mix shift to an increased volume of sales of higher margin products partially offset by a decrease in volume of sales of lower margin products and increased excess and obsolescence costs for products with finite lives.
The increase in product gross margin in the first nine months of 2010 as compared to the first nine months of 2009 is primarily due to the reduction of plant consolidation activities from $9.2 million in 2009 to $1.6 million in 2010. The increase in margin was also driven by a higher volume of sales of our consumables, favorable absorption and a mix shift to higher margin instrument sales. These increases were partially offset by higher excess and obsolescence costs for products with finite lives and increased warranty costs.
Service gross margin decreased in the third quarter of 2010, and for the nine months ended September 30, 2010, as compared to the same periods in 2009, primarily due to the decrease of the scientific services revenue generated from the Wellcome Trust Case Consortium and National Institutes of Health projects, which were completed in late 2009.
Research and Development Expenses (in thousands, except percentage amounts)
The decrease in research and development expenses in the third quarter, and for the first nine months, of 2010 as compared to 2009 was primarily due to lower headcount-related expenses such as compensation and benefits and a net decrease in spending on masks, chips and supplies due to a shift in product focus resulting from the commercialization of certain products in 2009.
Selling, General and Administrative Expenses (in thousands, except percentage amounts)
The decrease in selling, general and administrative expenses in the third quarter, and for the first nine months, of 2010 as compared to 2009 was primarily due to an overall decrease of $2.3 million and $7.2 million, respectively, in compensation and benefits expense resulting from lower headcount as compared to the same period in 2009. Additionally, there were decreases in facilities expenses as a result of site consolidation efforts, lower bad debt expense from better collection efforts and reduced litigation costs due to the timing of legal proceedings.
Restructuring (in thousands, except percentage amounts)
In 2006, 2007 and 2008, we undertook restructuring plans designed to improve our operating leverage. We completed the restructurings in 2009. The effects of these restructuring plans on our results of operations are discussed below.
In 2008, we closed our West Sacramento manufacturing facility, moving probe array manufacturing to our Singapore facility, consolidating reagent manufacturing to our Cleveland facility and outsourcing instrument manufacturing operations to third parties. We completed the closure of the West Sacramento facility during the second quarter of 2009 and no expenses were recognized during the nine months ended September 30, 2010, compared to $2.5 million of expense pertaining to employee severance and relocation benefits recognized during the nine months ended September 30, 2009.
For the 2006 and 2007 restructuring activities, the expense incurred on these two plans was immaterial.
Interest Income and Other, Net (in thousands, except percentage amounts)
The components of interest income and other, net, are as follows:
Interest income and other, net decreased in the third quarter of 2010 as compared to 2009 primarily due to lower interest income as a result of lower average cash balances due to the repurchases of our 3.50% senior convertible notes due 2038 during the second and third quarter of 2010 and a net realized loss on equity investments related to a $0.4 million other-than-temporary impairment loss recognized on a non-marketable investment in the third quarter of 2010. This decline was partially offset by currency gains and realized gains on our non-marketable equity securities portfolio in 2010 as compared to 2009.
For the nine months ended September 30, 2010, interest income and other, net, decreased primarily due to the net $5.3 million of other-than-temporary impairment losses recognized on non-marketable investments compared to net $0.9 million impairment charges on several investments in our non-marketable equity securities portfolio in 2009. Additionally, interest income decreased primarily due to lower effective interest rates and lower average cash balances in 2010 as compared to 2009. These declines were partially offset by currency gains in 2010 as compared to currency losses in 2009.
Interest Expense (in thousands, except percentage amounts)